As recently as a year ago, Capitolis seemed to be on to something big—big enough to change the way banks finance their hedge fund clients.

The New York-based fintech’s Ionic Capital Trust program connects money market investors in search of higher yields with banks that need financing for their equity swap activities. Instead of buying shares to hedge their client exposures, banks can enter an offsetting total return swap (TRS) with Capitolis’s special-purpose vehicles (SPVs), which issue commercial paper to fund the share purchases. The service launched in 2020 with two marquee clients. By the end of 2021, it had over $20 billion of swaps outstanding with Citi and UBS.

Now, after an initial burst of activity, volumes have slumped. Assets in an Ionic vehicle that writes TRSs for UBS had fallen to $1.8 billion as of September 20, according to an industry database seen by Risk.net, the sibling publication of WatersTechnology. A separate SPV that provides swaps to Citi—Capitolis’s biggest client in January, with over $10 billion of exposure—has seen its assets drop to zero.

Gil Mandelzis, founder and chief executive officer of Capitolis, believes the setback is only temporary: “Volumes have tapered off in an environment where there’s just less need for financing. Certainly, overall financing of this kind of product has been reduced in this environment, but we expect over time there’s going to be more need for that. I’m not sure we’ll go back to where we were, but we definitely expect it to be higher over time than current levels.”

Capitolis has a lot riding on this. Since it was founded in 2017, the company has launched a suite of optimization services for foreign exchange, which have proven popular with dealers. Ionic is the first of several products Capitolis plans to roll out as part of what it calls its Capital Marketplace, a sort of peer-to-peer network where banks can source funding and capital from cash-rich institutional investors. The idea has captivated venture capital firms and Wall Street heavyweights. Capitolis’s investors include the likes of Andreessen Horowitz and Sequoia Capital alongside Citi, JP Morgan and State Street. A funding round in March valued the company at $1.6 billion.

And Capitolis isn’t alone—at least three other firms are pushing their own versions of the concept.

The idea has undeniable appeal. “The equity swap market has grown a lot in the last five to 10 years, and as balance sheets have come under pressure, banks are looking to take hedges off-balance-sheet and get them funded elsewhere,” says a prime services expert who has held senior roles at several large banks. “If you came up with a structure that trades a swap with a bank and raises money in the commercial paper market to buy these assets, they’d love that—as long as it’s done the right way.”

That caveat matters. Off-balance-sheet funding vehicles come with plenty of baggage, dating back to the global financial crisis. So does the TRS market, which has been under scrutiny since banks suffered more than $10 billion of losses from the collapse of Archegos Capital Management in March 2021.

Our pitch to the market is that we have a different source of funding that is less correlated, and that typically doesn’t have the same constraints at various times and in various market conditions

Gil Mandelzis, Capitolis

Capitolis claims to have fixed the flaws that marred pre-crisis structures, but banks are staying quiet. 10 large swap dealers, including Citi and UBS, were contacted for this article. All declined to comment.

Two large banks are understood to have reservations about the Ionic vehicles in their current form, however. Post-crisis rules that came into force on November 1, 2021, require security-based swap dealers (SBSDs) to register with the US Securities and Exchange Commission. The Bank of England and US Federal Reserve subsequently issued supervisory letters ordering banks to review the risk management of their equity finance business in the wake of Archegos.

Capitolis is registered with the SEC as an investment adviser, but not as an SBSD. A competitor, Nearwater Capital Markets, registered as an SBSD in July—a move it says is designed to address compliance concerns among prospective clients.

Capitolis maintains that it is not required to register as an SBSD, but says it will do so anyway before year-end to accommodate clients that want to face an SEC-registered swap dealer, while retaining the option to trade with an unregistered entity.

Mandelzis says the Ionic structure not only meets regulatory requirements, but is consistent with policy-makers’ broader financial stability goals: “Regulators wanted to reduce the interconnectedness between banks, and we’re helping to support that. They wanted to diversify risk in the market. We’re supporting that. When we write a billion-dollar swap with a bank, we’re literally raising a billion dollars against it to fully fund the position for the life of any transaction.”

Diversified capital

The Ionic Capital Trust program is targeted at banks that extend synthetic financing to hedge funds via equity TRSs. These instruments provide clients with the returns of an underlying stock or basket of names in exchange for a financing rate. The economics are similar to conventional securities financing, where a client purchases the underlying positions outright with borrowed cash. The crucial difference is that the prime broker holds the stocks on its books to hedge its exposure on the TRS. While this is more efficient than securities financing from a leverage and liquidity coverage perspective, the cash equity hedges count towards the bank’s risk-weighted assets (RWAs), which can quickly become a constraint.

“There is a variety of pressures on the banks, which ultimately affect the availability of critical services and costs to the overall market,” says Mandelzis. “This is the problem we’re trying to help, and we’re focused on doing it in a fashion that is robust and consistent with the regulations.”

Prime brokers can reduce RWAs by entering an offsetting TRS with another counterparty, rather than holding cash equities on their books. However, TRS hedges can be hard to come by, especially at year-end, when dealers look to reduce their balance sheets ahead of key reporting dates and the cost of wholesale funding skyrockets.

This is where Capitolis comes in. The firm funds its TRSs by issuing commercial paper to investors. The Ionic programs are rated by S&P and reflect the credit quality of the bank TRS counterparty. Both the Citi structure, Ionic Capital II Trust, and the UBS vehicle, Ionic Capital III Trust, carry short-term ratings of A-1, with a maximum capacity of $15 billion in class A notes and $500 million for B certificates.

The short-term debt instruments are sold to money market investors. Buyers have included the likes of State Street Global Advisors and Goldman Sachs Asset Management.

The first-mover advantage is very important in a default. If you’re not the first mover, you essentially take the bulk of the losses

Risk manager at a large US bank

“There’s a lot of capital that would love to participate, but does not have access,” says Mandelzis. “We’re providing that bridge in a fashion that reduces risk and brings additional capital into the system and shores up the system with tons of diversified capital that is very stable.”

The proceeds of the commercial paper issuance are used to fund the TRSs, which are backed one-for-one with cash equities held in a bankruptcy-remote SPV.

“When we do a billion dollars of a swap, we raise a billion dollars of cash and put it in a custody account, and then fully fund the position for the life of any transaction,” says Mandelzis.

“This increases capital into the system. Not only that, there’s a diversity of funding sources because it’s typically coming not from another bank that’s correlated, but from a diverse group of institutional investors who are willing to take on this specific risk.”

He says this model results in cheaper and more reliable pricing. Swap counterparties in the interdealer market are highly correlated and interconnected, meaning they are all sensitive to the same market quirks. Prime brokers typically see more demand for synthetic financing towards the end of the year, when dealers are most reluctant to take on derivatives exposures that weaken their leverage ratios. This means equity TRS prices can shoot up dramatically at year-end.

Buy-side firms that invest in commercial paper are not subject to these year-end regulatory pressures, making them a more stable source of funding. For example, equity TRSs in the interdealer market were priced around Libor plus 35–40 basis points in the first half of 2021, and blew out to triple figures later in the year. Capitolis claims its prices remained stable throughout 2021, but declined to provide exact levels.

“Our pitch to the market is that we have a different source of funding that is less correlated, and that typically doesn’t have the same constraints at various times and in various market conditions,” says Mandelzis.

“They’re a diverse group of investors, they’re not as concentrated, and as a result of that, we will be able to provide your business with a different source of funding that’s going to add stability over the course of the year.”

Locking it in

Off-balance-sheet funding vehicles—also known as asset-backed commercial paper (ABCP) conduits—have a long and chequered history. They showed up in the Enron scandal and again during the global financial crisis. Banks that used off-balance-sheet funding for their structured finance activities were forced to bring these assets back on their books when the commercial paper market froze up in 2007. Post-crisis reforms have all but eliminated this type of activity.

Capitolis says its Ionic structures are different. Crucially, its TRSs are maturity-matched to the commercial paper issued to fund them. Once Ionic issues the commercial paper and executes a TRS with a swap counterparty, neither Ionic nor the investors can terminate early. This ensures that banks can rely on the financing for the lives of the transactions, which so far have ranged from a matter of days to just over a year.

Banks have an early termination option, but must compensate commercial paper investors for lost interest or principal if they exercise it.

“The terms of the optional terminations are such that, as long as the financial institution fulfills its contractual obligations, CP noteholders will not suffer a loss to either interest or principal,” Capitolis explains in a statement.

If a bank opts to terminate early, Capitolis unwinds the swap and simultaneously sells the hedges at market close. If the hedges have declined in value since the inception of the trade, the bank pays the difference—like with any TRS contract—in addition to any future interest payments owed to investors.

While that sounds good in theory, how it will work in practice remains to be seen. Capitolis’s operations are untested during market shocks, such as a major client default, when any delay in unwinding hedges can prove costly.

The rules provide the attributes of what constitutes a dealer, and we don’t believe we have the attributes

Capitolis statement

“The first-mover advantage is very important in a default. If you’re not the first mover, you essentially take the bulk of the losses,” says a risk manager at a large US bank.

This was the case when Archegos defaulted, with counterparties that were quickest to offload hedges escaping with relatively minor losses. The risk manager says he would be reluctant to delegate responsibility for liquidating a defaulted client's positions to a third party.

Capitolis argues that those concerns are misplaced. The firm’s president, Justin Klug, stresses that Ionic’s swaps are designed to hedge diversified books of business, not individual client exposures.

“The swap has no direct linkage with specific bank client positions,” he says. “These swaps are not meant to be the only way to finance bank hedges. Banks will continue sourcing cash equities, futures, doing swaps with other banks, etc. It’s part of a toolset that can help banks out in aggregate, another arrow in the quiver.”

One of the features that Capitolis touts is a mechanism that allows banks to request daily substitutions, switching some names for others to match the exposures in their books.

Klug explains how this works: “Let’s say you take two names out, and they’ve gone up 1% since the swap was agreed. Those equities can be sold, and a resultant 1% in cash goes back to the swap counterparty, because the total return has gone up. And then the remaining proceeds can be used to purchase the new equities that are coming in, as long as they don’t breach any concentration thresholds or portfolio requirements.”

The Ionic structure also has a number of features designed to protect investors. There are strict concentration limits, which prevent excessive exposure to a particular stock or sector. Currently, only names from the main US equity indexes are permitted, although Capitolis says it is open to adding further liquid names. The SPVs can be overcollateralized, with more equities than the notional of the swap would imply, translating to an incremental reduction in the cost of capital.

The TRSs are also margined daily, even though Ionic’s SPVs have yet to breach the compliance thresholds for the regulatory initial margin regime. If required, Capitolis can repo equities to its bank counterparties in exchange for cash to post as margin. If the value of the equities increases, Capitolis typically posts equities as variation margin.

Swap dealer test

Capitolis may have addressed past problems with off-balance-sheet funding, but it has new ones to contend with—not least a growling watchdog that is increasingly baring its teeth.

“The SEC under Gary Gensler is taking a very aggressive view on swap dealer registration,” says a lawyer who previously worked for US regulatory agencies.

In November 2021, after repeated delays, Dodd-Frank Act rules took effect requiring equity swap dealers to register with the SEC. The following month, the agency also proposed additional reporting and anti-fraud rules for TRSs.

Since then, some banks are understood to have taken a more conservative line on dealing with unregistered counterparties.

“Part of the concern about swap dealer registration is that regulated financial institutions want to transact with other swap dealers because then they know they’re fully covered,” says the lawyer.

“They know there are capital requirements, know-your-customer requirements that are being followed.”

Nearwater Capital, which plans to offer a service similar to Ionic’s, has seized on this—even issuing a press release in July announcing its registration as an SBSD.

James Peterson, founder and managing partner of Nearwater, says the firm had little choice but to register: “We are obviously facilitating our counterparties’ business by entering into a security-based swap in exchange for a fee, which is the definition of dealing. All the big banks doing this business are registered, so why would we think we wouldn’t have to be registered?”

Nearwater has yet to execute an equity TRS transaction, but says it is in the process of onboarding two clients.

The SEC uses four tests to determine whether a firm meets the definition of an SBSD. The registration requirement applies to any entity that: holds itself out as a dealer in swaps; makes a market in swaps; regularly enters into swaps with counterparties as an ordinary course of business for its own account; or engages in activity causing itself to be or commonly known in the trade as a dealer or market-maker in swaps.

A firm that meets any of these tests is required to register as an SBSD. Those that register are subject to minimum capital requirements, internal risk management obligations, as well as record-keeping and reporting procedures.

Nearwater's legal advisers reviewed its proposed equity TRS service and concluded in a written opinion that its was “consistent with what is generally considered to be engaged in dealing activity in security-based swaps, [and] thus, registration is required”.

But Capitolis has a different model to Nearwater, whose swap counterparties will face a corporate entity domiciled in Ireland, rather than an SPV. Unlike the Ionic structures, there will be no direct link between the debt issued by Nearwater and the TRS contracts it executes with clients.

And while the SEC provides four relatively simple tests to determine whether an entity meets the definition of an SBSD, its guidance on applying those tests—effective since 2012—runs to 600 pages, and makes clear that much depends on the facts and circumstances of each case.

So far, Nearwater is the only firm not affiliated to a bank to register with the SEC as an SBSD. Two other firms with competing offerings—Cantor Fitzgerald and Guggenheim Partners—have not deemed it necessary to take this step.

Capitolis says its legal advisers reviewed its Ionic business, and concluded that it did not meet the definition of an SBSD. However, the firm has now decided to establish an SBSD—a move that it says has as much to do with its future plans as its current services.

“Capitolis, together with best-in-class legal advisers, looked at whether there was a need to register as an SBSD, and, like many market participants, believe there is no need,” the firm says in a statement.

“The rules provide the attributes of what constitutes a dealer, and we don’t believe we have the attributes. Our Ionic business operates with the services of an SEC-registered investment adviser. That said, for a variety of reasons, as we expand our service offerings for different activities, and to accommodate counterparties who are interested in facing an SBSD, Capitolis is establishing an SBSD, expecting to be live this year.”

That removes one of the potential obstacles to wider adoption of the Ionic structure. But that doesn’t necessarily mean it will be plain sailing from here. The prime services expert says bank compliance and accounting teams will pore over every detail of this type of structure before signing off on it. He identifies the single-seller approach that Ionic has taken to date—establishing separate SPVs for each client—as another potential issue.

“When you’ve got an SPV, and its only intention is to hold the assets from one bank, someone will say that’s not a proper hedging vehicle,” the expert says.

But if Ionic passes scrutiny, he thinks the firm could see another burst of activity when the equity market comes out of its current doldrums: “The need is there.”