Oct 10, 2023
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By Alessandro Romani, VP, head of European derivatives at Nasdaq
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.
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:
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.
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:
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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