What is an Equity Swap?

An equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also commonly referred to as the "floating leg". The other leg of the swap is based on the performance of either a share of stock or a stock market index. This leg is commonly referred to as the "equity leg". Most equity swaps involve a floating leg and an equity leg.

The Problem with Traditional Equity Swaps

Traditional equity swaps have to be continuously updated for multiple variables such as interest rates, closing market prices, stock splits and dividend payments which requires a substantial amount of staff and time. Equity swaps are trustless so disagreements happen regularly as the counterparties to the swap transaction each maintain their own records and books detailing the initial trade terms and tracking changes throughout the trade life-cycle. Reconciling differences requires lots of time and staff.  For larger multinational investment banks and financial services companies with large, active volumes the traditional infrastructure results in inevitable data handling errors and frequent data discrepancies both within and between counterparties.  Such inconsistencies slow down completion of the equity swaps and results in increased operational costs for doing manual reconciliation of records against each other (again both internally and between counterparties). 

Larger banks and multinationals would increase efficiency and decrease costs if there was a better way to resolve issues of data, trust and processing of equity swaps.

A Blockchain Solution

This problem seems an ideal fit with blockchain smart contracts but until now banks have been reluctant to use fully decentralized blockchain ledgers.  Enter Axoni, a tech firm that has developed AxCore a distributed ledger software based on Ethereum’s code.  The software is being deployed as a private, centralized blockchain platform that can help overcome the problems of equity swap inefficiencies.  Axoni  gained major backing from 11 big firms for its work to develop this private distributed ledger technology. Goldman Sachs and Citi  Group were the parties involved in the first on blockchain equity swap.  Both Goldman and Citi are Axoni investors.

What Does This Mean?

• A small group of large multinational financial institutions are backing a private blockchain and software developed by Axoni specifically to improve equity swap transactions.
• Axoni’s distributed ledger software and solution provides trusted market data, including equity prices, FX rates, benchmark rates, and corporate actions directly on the blockchain to enable the smart contracts’ automated workflows. The software synchronizes data throughout the transaction lifecycle, thus communicating changes in real-time.
• Anoxi’s blockchain will allow counterparties to build trade and post-trade solutions that synchronize data and automate business processes using a common infrastructure. The implementation employs blockchain smart contracts and uses an optimized data structure in a distributed, peer-to-peer network to ensure perpetual reconciliation. 
• The first equity swap using smart contracts is a proof of concept milestone for financial institutions. The smart contracts can provide a level of trust to agreed upon, constantly reconciled data facilitating equity swaps without disagreements.  

The equity swap platform shows that big banks and big financial players are developing and adopting blockchain solutions for improved efficiency.  It is bullish for the decentralized finance (DeFi) space in general as banks and financial institutions continue to adopt cryptocurrency and blockchain solutions. Other platforms that create similar private blockchains or require communication between private blockchains / public and private blockchains or  public blockchains will require the use of established oracles and inter-operability solutions.  It means projects such as Chainlink, Kyber Network, and Synthetix will be increasingly in demand.

Investors with an eye to the longer-term would do well to hold some Ethereum DeFi tokens in their portfolios as well as Ethereum (as the tokens transact through ETH).