The OTC (over-the-counter) derivatives market is the largest overall market for derivatives, but the process of trading derivatives is manual and cumbersome, and relatively unfamiliar to most average investors. There are added levels of risk in trading OTC derivatives, versus trading public stocks for example, as derivatives trades are conducted privately between two parties, and include primarily banking contract products, such as swaps and forward rate agreements.
Fairom is a Toronto Founder Institute portfolio company adding automation to an otherwise complex and manual OTC derivatives trading process. Led by Founder Ajay Singh, Fairom is gearing up to launch into the enormous OTC derivatives market.
Derivatives markets are big, complicated, and manual.
A derivative is a financial security with a value that is reliant upon, or derived from, an underlying asset or group of assets. Examples of derivatives include futures contracts, forwards, options, and swaps, and are traded primarily by big financial institutions, like banks and investment funds.
The notional total value size of the OTC derivatives market ranges around $500 trillion, which as a basis for comparison, is an order of magnitude larger than the entire U.S. Stock Exchange’s $30 trillion market size. But beyond market sizes that boggles the minds of average investors, there are several other key areas of concern in OTC derivatives markets, two of which Fairom is working to solve.
- Because the OTC derivatives market is composed primarily of sophisticated institutional investors, it remains largely unregulated with respect to disclosure of information between parties, producing an overall lack of transparency between the key traders.
- Second, because OTC derivatives are not passed through an exchange, the speculative nature involved in these markets can combined with nontransparency for parties, and cause issues with market integrity (see: the 2008 financial crisis).
These problems arise primarily because the OTC derivatives deals are custom-tailored for the two bilateral trading parties, and the trades conducted are not documented in any centralized way. According to Founder Ajay Singh,
Fairom is developing a distributed ledger technology-based solution to automate trading and back-office operations for over-the-counter (OTC) derivatives in capital markets. The cost of trading OTC derivatives is high because of manual processes like reconciliations, monitoring, sending and verifying payments, etc. Through automation on Fairom’s platform, financial institutions can save more than 30% in managing these products.
Delivered as a cloud-based SaaS product, Fairom uses a blockchain decentralized ledger to add transparency for traders, and a level of verifiable compliance suitable for regulators or third parties.
The way things work today, accountants doing a lot of manual work, where delivering an OTC derivative deal means spending 3-5x more time on OTCs versus a derivatives deal through a market exchange counterpart. There are also the traders whospend ~10 hours per week monitoring and reconciling accounts, depending on the products being traded and their underlying financial technologies. Fairom is set to reduce the accounting team’s effort by about 30%, and save traders another 1-8 hours per week.
With the OTC-specific derivatives market being so vast, Fairom is initially focusing on the post-trade market, which accounts for around $30-$50 billion per year.
This focus makes Fairom quite unique – they “are among the few firms that are using distributed ledger technology and smart contracts to automate post-trade operations. Distributed ledger technology removes the need to reconciliations and makes it easier to handle complex products.”
Though the product itself is yet to be fully deployed, the team at Fairom have already garnered interest from some large Canadian hedge funds, and are currently working with some of the largest technology companies in the world to test on-premise deployments. This ongoing technology testing is critical for scaling Fairom to serve its customers, which will include large financial institutions and integrations to work within internal systems.
Few individual investors understand or follow OTC derivatives markets, so why watch Fairom? You may learn how automation technologies will deliver the market transparency that regulators have not delivered, and possibly even how new market transparency technologies can benefit to the investors who understand the emerging signals.