Amid Growing Concern With OTC Trading, Nasdaq Introduces Custom Basket Forwards To Democratize Equity Swaps Investing

The financial system is constantly evolving. Fueled by the rise of environmental, social and governance as well as thematic investing, investors are showing an increasing appetite for customized equity exposure that mirrors their stock portfolios. However, both buyside and sellside have struggled to satisfy this demand. Stringent regulation, along with the operational complexity of trading over-the-counter products, limit their feasibility for most firms outside of the largest institutional investors.

Against this backdrop, a new generation of derivatives has emerged. Nasdaq’s recently announced Custom Basket Forwards product enables investors to create a cash-settled forward contract on a customized equity basket, with the benefits of central counterparty clearing and trading on a regulated market.

To understand the significance of this development, we must first understand the challenges that firms currently face.

 

When Renewed Interest In Equity Swaps Meets Unresolved Challenges

Multiple trends have converged to spark interest in derivatives trading, reflecting changes in priorities and strategies amongst market participants – from investment banks and hedge funds to retail investors.

Investors seek more flexibility in derivatives trading to meet specific investment targets, as well as to hedge risks in uncertain markets. This is reflected in the rise of ESG and climate investing, thematic investing (targeting specific sectors such as AI or cloud computing), exchange-traded fund replications, tailor-made indexes and equity financing.

To achieve these goals, investors are looking for capital and margin efficiency, low trading costs and operational simplicity and customizability. However, the previous generation of products, which require firms to conduct a purchase OTC derivates via bilateral agreements, suffer from multiple drawbacks that prevent wider adoption:

• Regulation: Since the 2007-2008 financial crisis, the regulation of the derivatives market has increased the operational burden of trading in OTC products – including frameworks such as Dodd-Frank and EMIR. The relatively recent Uncleared Margin Rules have increased the challenges and capital requirements associated with maintaining uncleared derivatives exposures.
• Complexity: Firms that manage multiple OTC relationships often struggle with the cost and complexity of trading under ISDA agreements. For smaller firms, the cumbersome process of signing and maintaining these documents with multiple counterparties can become excessively difficult to manage, limiting these firms’ access to markets.
• Counterparty risk concerns: An uncleared derivatives contract implies a bilateral risk with the counterparty and a bilateral dependency in the liquidity provision (if the firm needs to close or manage the position). Smaller firms are concerned about their dependence on key sell-side partners, which might pull back from certain markets or otherwise change their priorities.
• Inflexibility of ETFs as an alternative: Customers looking for tailored exposure to equities might turn to ETFs. These products are much simpler and are considered by many to be a safer investment, but they are inherently limited to the composition that is offered as part of the ETF; and launching a new ETF is prohibitively capital-intensive. Hence, this route lacks the flexibility and customizability that investors are seeking.

The result is that tailored equity exposure is often seen as either overly risky or capital-intensive for all but the largest firms. This creates inefficiency in derivative markets and prevents capital from flowing toward desired investment patterns.

 

Custom Basket Forwards: A New Generation Of Derivatives

The existing trading landscape’s challenges indicated a gap in the market and a call for innovation. Building on its core competences at the intersection of technology, data and the capital markets, Nasdaq has recently introduced a new generation of derivatives known as Custom Basket Forwards.

The Custom Basket Forwards solution is designed to meet the demand for a simpler and more efficient way of handling equity exposures. Rather than trading OTC products such as equity swaps, Custom Basket Forwards employ standardized contracts on the regulated market, which means customers can now easily manage tailored equity exposures via derivatives listed on a regulated market and cleared by a CCP.

Using Custom Basket Forwards, clients can enjoy the flexibility and some of the bespoke elements of OTC trading without the associated complexity and counterparty risks. This presents numerous benefits:

• For buyside: Many firms were not allowed to trade OTC, could not access OTC derivatives, or were finding equity swaps increasingly difficult due to the operational and regulatory challenges we’ve described. These firms now have a simple and cost-effective alternative that gives them tailored equity exposure to a broad universe of stocks – levelling the playing field and broadening access to global equity.
• For sellside: Banks with important portfolios of equity swaps are more impacted by higher capital and uncleared margin requirements. Custom Basket Forwards, as an alternative product, can alleviate the impact of these regulations. At the same time, it offers an opportunity to address new client segments with more advanced investment opportunities, which today would only be possible with OTC products.

How The Custom Basket Forwards Solution Works

• Custom Basket Forwards enable investors to create a forward contract on a customized equity basket.
• The client defines the underlying basket by selecting the base currency, the return type, and the basket’s composition. Clients can select stocks and their weights from 1700 stocks across Europe and the Nordic region. The basket’s composition can be public or kept private.
• On the next day, Nasdaq will list a cash-settled forward contract in its trading and clearing systems, allowing the members to transact.
• Trade reporting takes place during regular trading hours and Nasdaq Clearing acts as a counterparty in the transactions.
• During the lifetime of the contract, Nasdaq will calculate and administrate the basket according to standardized methodology and manage corporate action adjustments in accordance with conventional standards.
• The customized equity basket is in scope of the European Benchmarks Regulation, BMR, and is governed by a Nasdaq-registered Benchmark Administrator.

Strong Demand And Early Adoption

Nasdaq recently introduced Custom Basket Forwards and the solution is already gaining traction with leading funds across Europe and the United Kingdom.

“We see Nasdaq’s Custom Basket Forwards as the perfect instrument to address new market segments and hedge risk,” said Peter Magnusson of Cicero Fonder, a sustainability-focused fund manager. “For the strategies we want to implement, using Custom Basket Forwards is much more efficient and cost-effective compared to alternative solutions such as trading the underlying basket with equities. This will allow us to achieve better and more tailored outcomes for our customers.”

Demand is being further fueled by several investment patterns that have grown prominent in recent years.

One major ongoing trend is ESG and climate investment. Global ESG fund assets reached USD2.5 trillion in 2022 (Morningstar data); sustainability continues to be a major area of focus for investors, especially in Europe. As the ESG market matures and becomes more sophisticated, investors are looking for derivative trading tools that will let them replicate stock portfolios built on bespoke ESG or climate strategies.

Thematic investing is also coming into focus due to rapid technological innovation and the success of several publicly traded ETFs. Asset allocators are looking for new indices and products that provide cost-effective exposure to global trends, such as AI and future mobility.

Nasdaq’s Custom Basket Forwards solution allows investors to achieve these and other objectives – equity financing, leverage, tailored indices and more – without the limitations of OTC derivatives and ETFs. As investors continue to seek simple, cost-efficient and flexible exposure to global equities, Custom Basket Forwards are likely to become a key investment instrument in 2024 and beyond.

Learn more about Nasdaq’s Custom Basket Forwards

 

Author Alessandro Romani is VP, Head of European Derivatives at Nasdaq.

 

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