By all accounts, 2022 was a year for dealmakers in derivatives markets.
- In May, the London Stock Exchange Group bought MayStreet, a specialist in the business of providing low latency market data, and merged it into Refinitiv, the financial data business that LSEG bought from Thomson Reuters in 2019.
- In June, Trading Technologies, a leading provider of systems for futures trading, announced a partnership with Talos, a technology vendor that provides institutional-grade infrastructure for trading cryptocurrencies.
- In August, Baton Systems, a payments technology startup, extended its collateral management network to the Options Clearing Corporation, the largest equity derivatives clearinghouse in the world.
- That same month, Two Sigma, a quantitative trading firm based in New York, struck a deal with Hivemind, a London-based startup, to buy its software platform as a way to enhance its internal data workflows and machine learning capabilities.
- In November, Intercontinental Exchange, which operates the largest emission allowances market in the world, joined a group of firms that are backing BeZero Carbon, a two year-old startup with a ratings service for the voluntary carbon market.
- In December, Raft Technologies, an Israeli company that uses high-frequency radio waves to reduce the time it takes to transmit data, revealed plans for a new ultra-fast link between London and Tokyo.
What these six developments had in common was the involvement of a fintech startup – a young company founded by entrepreneurs with a focus on financial technology. All six developments highlighted an important trend – startups are helping drive innovation in the trading and clearing of futures, options and swaps.
FIA has a unique perspective on this trend through its Innovators Pavilion, the association's annual Chicago showcase for startups. More than 200 startups have participated in the eight years since the Pavilion's launch at the FIA Expo in 2015. Each of these companies has offered a unique solution for use in the trading and clearing workflow. Collectively they provide a window into the technology trends that are transforming the industry.
There are many other sources of technological innovation, of course. The established vendor community is constantly searching for new ways to apply the latest advances in technology to the trading and clearing workflow. And many large banks and exchanges have set up internal groups to explore uses for artificial intelligence, distributed ledgers, low-code computing, big data, and other innovative forms of technology.
Startups, however, tend to be more agile and more willing to experiment with new technologies and new ways of doing business. Many of them fail, but when they succeed, they challenge established players to adjust, adapt and innovate.
Looking back at FIA's showcase for fintech innovation, seven areas stand out as places where startups are impacting various parts of the derivatives markets ecosystem: data, trading, carbon markets, risk and collateral, post-trade operations, crypto markets and regtech. In each case, the article focuses on specific startups that participated in FIA's Innovator Pavilion as examples of the innovations that are coming into the industry.
MayStreet was founded in 2012 by two computer science engineers, Patrick Flannery and Michael Lehr. They built software that captured the vast streams of market data flowing out of exchanges down to the level of each packet—the most complete and most accurate way to record every activity taking place on an exchange. This type of data is critically important for many parts of the trading workflow, including the development and back-testing of trading strategies, the surveillance of trading activity, and regulatory reporting.
In 2016, the company participated in the Innovators Pavilion, giving FIA members a first-hand look at its market data capabilities. In 2020, the company received a $21 million investment from the venture capital arm of Credit Suisse's asset management business, and said it would use the funding to expand its business in terms of both geography and asset classes.
Two years later the London Stock Exchange Group decided to buy the company outright. For LSEG, the attraction was not only the chance to take over MayStreet's existing business. More importantly, it could use MayStreet's technological capabilities to modernize the much larger financial data business operated by Refinitiv.
Another example in the data area was Two Sigma's purchase of data analytics software developed by Hivemind. The software was originally developed by a team of data scientists working at Winton Capital, a quantitative hedge fund based in London. In 2018, they set up a separate company to market the software. A year later Hivemind participated in the Innovators Pavilion and won the top Innovator of the Year award at the competition.
The company's key innovation was its approach to collecting and normalizing unstructured data such as text documents, email messages and video files and then applying artificial intelligence to clean up the data so that it can be processed and analyzed. Two Sigma, which prides itself on pushing the frontiers of data science, bought the company's platform to strengthen its own internal data handling capabilities, and in particular the onboarding of unstructured data into the machine learning systems that inform its trading strategies. Two Sigma has more than $60 billion in assets under management and trades more than 300 million shares daily, and its securities arm is one of the top market making firms in the world, providing liquidity to equity, futures, options and ETF markets.
In the last several years, there has been a surge of interest in the trading of carbon credits. These markets provide a way for companies to offset their carbon emissions by buying credits that represent removals or reductions in greenhouse gases. Several derivatives exchanges such as CME Group, ICE and Nodal Exchange list futures based on these credits, and trading volume has been picking up.
A key challenge, however, is the lack of standardization of these credits and doubts about whether they are genuine. That is where BeZero Carbon steps in. The London-based company has developed a system for rating the quality of carbon offset projects in terms of the likelihood that the credit issued by those projects actually removes or avoids a ton of carbon emissions. Those ratings serve a vital role by helping market participants make better judgements on how these credits should be priced.
BeZero participated in the 2022 Innovators Pavilion and won the competition for Innovator of the Year. That same month the company announced a $50 million round of funding from venture capital funds as well as the venture capital arms of ICE, EDF, the French power company, and Hitachi, the Japanese conglomerate. The diverse nature of the funding round—industrial, financial and venture capital investors—highlights the widespread interest in this new market and its potential value as governments and corporations attempt to reduce their carbon emissions.
A few years ago, people said trading could not get any faster. Well, not quite. Fiber optic cable was once seen as the fastest possible way to transmit data, and thousands of miles of cable was installed to provide high-speed connections between financial centers. Then a handful of firms discovered that microwave could give them an edge, and they built networks of microwave towers across the US and Europe to send their trading signals.
Now Raft Technologies, an Israeli company founded in 2013, is developing another way to speed up trading. The company's key innovation is to use "skywaves" to send data. These are high frequency radio waves that are transmitted in such a way that they bounce off the atmosphere. This approach is faster than sending messages through fiber optic cable, and unlike microwave, it does not require a long string of towers on land, so it is especially well suited for sending data long distances across oceans.
Raft started by building links between London, Chicago and Frankfurt, three financial centers that host major derivatives exchanges. Companies using this network can receive data and send order messages from one center to another in milliseconds. In 2019, the company participated in the Innovators Pavilion and pitched the advantages of its approach to principal trading firms based in Chicago, many of which need ultra-low latency connections for their market-making businesses. In 2022, the company added another leg to its network—London to Tokyo—and said the time it takes to send a message from one end to the other is less than 50 milliseconds. Next on its road map—Mumbai and São Paulo, the homes of two of the largest and fastest growing derivatives exchanges in the world.
Risk and collateral
A top priority for many firms in the derivatives markets in recent years has been improving the efficiency of their clearing operations and reducing the collateral required by clearinghouses. A handful of startups have sprung up to address this need by combining technology innovation with in-depth understanding of the margining process.
One example is Quantile, a London-based company that uses sophisticated algorithms to optimize the amount of collateral that its clients have to post to cover the risks in their outstanding positions. The need for this type of optimization became obvious when it became mandatory to clear interest rate swaps and other OTC derivatives. Swap dealers realized that they would have to post large amounts of collateral to meet the margin requirements on these positions, and Quantile's optimization software gave them—and their customers—a way to identify offsetting positions and reduce their margin requirements.
Quantile participated in the Innovators Pavilion in 2017, two years after it was founded, and by the end of 2020 its optimization service was reducing billions of dollars of initial margin each month. In early 2021 it attracted a $51 million investment from a private equity firm that saw its growth potential. They were right; in December 2021, LSEG announced an agreement to buy the company outright for £274 million.
It took a year to actually complete the deal, mainly because the UK competition authority launched an investigation to make sure that it would not impede competitors such as TriOptima. In December 2022 the deal closed, and LSEG is now able to offer Quantile's margin optimization service alongside the clearing services offered by its subsidiary LCH, the world's largest clearinghouse for interest rate swaps. As Dan Maguire, head of LCH, explained shortly after the deal was announced, adding Quantile's optimization services gives the group more ways to help banks and other customers manage their capital and margin more efficiently.
Another example in the post-trade space is Baton Systems, a startup that has built a platform for clearing, settling and managing payments between financial institutions – like a "PayPal" for institutions. One of its main use cases is focused on helping derivatives clearing firms manage the margining process more efficiently.
The company's platform has direct, real-time interfaces with several leading clearinghouses and custodians. That allows clearing firms connected to the platform to monitor their margin obligations and collateral flows on an intraday basis. The platform also can connect into a clearing firm's payments systems and enable a firm to send instructions to custodians for moving cash and securities. The key benefit is that clearing firms can avoid posting more collateral than needed by measuring their margin obligations more precisely on an intraday basis. That is becoming more of a priority as banks look to reduce the amount of capital tied up in the clearing process.
The company participated in the Innovators Pavilion in 2016 and since then it has gradually expanded its platform and its customer base. In 2022, it added two more clearinghouses to its network—LCH SA in Paris and OCC in Chicago—bringing the total number to 11. The company also announced a partnership with BNY Mellon, a big player in the collateral management business, with the goal of helping clients mobilize collateral faster and more efficiently for both their cleared and uncleared derivatives.
Another top priority for many firms in the derivatives industry is improving efficiency at every step of the trading lifecycle. The front-end of the process is lightning quick, thanks to years of effort and billions of dollars invested in automation, connectivity and processing speed. The middle and back office functions, however, have not kept up, and this is where a number of startups are targeting their efforts.
One example is Theorem Technologies, a Chicago-based company that focuses on helping fund managers consolidate information about their trading more efficiently. Theorem's software was originally developed by an introducing broker, Thales, that worked with hedge funds and commodity trading advisers. As is often the case in futures markets, they were using multiple clearing brokers, and the differences in how each broker transmitted information made it difficult to get a consolidate view.
Thales built a system to pull together all the relevant information and provide reporting, analytics and other trade processing and administrative functions. The company then realized that it could spin it out as a separate company and market it more broadly. Theorem was launched in 2017 and participated in the Innovators Pavilion that same year.
One particular focus is on matching trade information on an intraday basis. This may sound like a minor issue, but in reality it is a huge challenge for the industry. As trades travel from end-users through the execution process to the exchange and then through the clearing process, they pass through many different systems, and the lack of standardization requires careful review to make sure that all the details match.
Theorem has built a trade matching solution that identifies breaks during the course of the day, allowing for faster reconciliation, more accurate reporting, and more accurate calculations of margin requirements. The company is working with hedge funds and commodity trading advisors and says it is seeing increasing adoption of this solution.
Another example, this time in over-the-counter markets, is Wematch, an Israeli company that has built matching and workflow solutions for dealer to dealer trading. This segment of the derivatives markets still relies heavily on conversations via phone or chat messages. Rather than replacing this model of trading, Wematch has built a platform to bring more automation to the process. In practical terms, that means automating and digitizing the steps that dealers take to find liquidity, negotiate the terms, execute the trade and then manage the lifecycle of those trades over time.
The company was founded in 2016 and quickly attracted support from several banks. J.P. Morgan and Société Générale both chose the company to participate in their incubator programs, which work with early stage companies to help them develop their solutions, and then opted into using the company's platform and financing its growth with equity investments.
The company has grown rapidly, and currently its platform is used by 90 institutions. And it appears to be poised for further growth. In late 2021, it announced $28 million of funding from several banks and venture capital funds as well as Deutsche Börse, the parent company of Eurex, Europe's largest derivatives exchange. The company said the additional capital would help expand its offerings and bring on more staff. It also has set its sights on expanding into North America. In fact, Joseph Seroussi, the chief executive officer, moved from the headquarters in Tel Aviv to New York in 2022 to oversee the expansion personally.
Perhaps the most exciting—and controversial—area of innovation has been in the cryptocurrency markets. The Innovators Pavilion has had nearly a dozen participants with a crypto-related product or service, and this segment has always attracted a lot of interest from the FIA community.
One simple reason is that traders want to trade, and cryptocurrency markets have offered many opportunities to apply their skills and expertise in a new arena. The cryptocurrency markets are very young, however, and the infrastructure is nowhere near as sophisticated or reliable as what prevails on futures exchanges. This has created a strong demand for institutional-grade platforms and systems, and a number of startups have stepped into the space.
One example is Talos. The company was founded in 2018 with the vision of providing the "building blocks" for institutional trading of digital assets and quickly attracted support from a wide range of venture capital firms and financial institutions. The two founders, Anton Katz and Ethan Feldman, had years of experience building trading systems for banks and asset managers before they started Talos. They drew on that experience in designing the various functions that it supports, which cover the full lifecycle of digital asset trading, from price discovery to execution through to settlement.
The company participated in the Innovators Pavilion in 2021. In May 2022, the company announced a $105 million funding round led by General Atlantic, a large private equity firm with a long track record of investing in financial markets infrastructure. The funding round included investors in both the traditional finance and digital asset spaces, notably BNY Mellon, Citi, DRW and Wells Fargo.
In June, it announced a partnership with Trading Technologies that gives TT's large customer base in the futures industry access to a wider range of crypto markets. Jason Shaffer, an executive vice president at TT, commented that the partnership would help TT's clients "participate in the crypto space with ease and confidence."
There has also been a lot of interest in bringing institutional-grade risk controls and market surveillance tools to the space. The futures industry is heavily regulated, and most cryptocurrency trading takes place in markets that are lightly regulated or not regulated at all. This is another area where startups have taken the lead.
One example is Chainalysis, a provider of compliance and investigative tools. The company was founded in 2014 and has become one of the primary resources for exchanges and law enforcement to track transactions in bitcoin and other crypto currencies. The company participated in the Innovators Pavilion in 2018 and has grown rapidly since then, with more than 750 customers in 70 countries, including more than 100 financial institutions. In May 2022, it raised $170 million from a group of investors led by GIC, Singapore's sovereign wealth fund. That funding round brought the company value to $8.6 billion, a sign of just how much demand there is for tracking flows in the global cryptocurrency markets.
Cryptocurrency markets are not the only markets where compliance is in demand. Ever since the financial crisis of 2008, regulators around the world have put in place an array of reporting requirements for swap dealers and other firms involved in trading OTC derivatives. The goal is to make sure that regulators have more transparency into swaps trading and the risks to participants in those markets. Meeting these requirements is a heavy lift for the affected firms, and accuracy is critically important. Numerous firms have had to pay large fines for missing or inaccurate data.
That is where Kaizen Reporting found its niche. The London-based firm was established in 2013 by a former regulator who recognized the need to improve accuracy in regulatory reporting. The firm combines automated testing techniques with regulatory expertise. Initially it focused on European requirements, but today it has the ability to test the accuracy of reports mandated by a wide range of reporting regimes around the world, including the European Union, the U.K., the U.S., Australia, Hong Kong and Singapore.
The company now has more than 140 clients, and demand continues to grow amid two major overhauls of reporting requirements. In the U.S., the Commodity Futures Trading Commission went live with its "rewrite" in December 2022, and in Europe, the European Securities and Markets Authority will go live with its "EMIR Refit" in April 2024. In both cases, the number of fields in the reports—and the kinds of information that must be collected and reported—have changed substantially. That makes the independent testing and validation that Kaizen provides all the more valuable.
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