Auto lenders will soon be able to hedge used-vehicle price exposure on an open derivatives market.
Exponential Exchange, a Washington, D.C.-based startup founded in 2021, has set its sights on creating a market in which auto lenders, insurance providers and rental companies, among others, can hedge volatile used-vehicle value fluctuations in an open futures market, co-founder and Head of Index Products Paul Fortin told Auto Finance News.
Derivatives are a contract between two or more parties with a price that is dependent upon, or derived from, an underlying asset, according to the nonprofit professional organization CFA Institute.
“We’re building across a bunch of different asset classes, but our common thesis is, let’s look at asset classes that could use derivatives to manage exposure,” Fortin said. “The first asset class we’re going after is automotive. We want to give a solution to large entities that have hundreds of thousands of vehicles … that need to hedge that exposure.”
Insurance providers may want to hedge against price appreciation on vehicles they’ve insured, and rental companies may want to hedge against price depreciation on their fleet.
Auto lenders, too, could hedge residual lease exposure or even credit risk, he said, noting that Exponential Exchange has already been in discussions with half a dozen finance companies.
“The beauty is that makes a very healthy market when you have one market participant that says, ‘Listen, I need downside protection,’ and [another participant that] says, ‘I need upside protection.’ Then you have your market, then you can execute a trade,” Fortin said.
Speculators, hedge funds and liquidity providers can also participate in the market, Fortin said.
Small steps
Exponential Exchange has launched the underlying index, called the Exponential Used Vehicle Index, which was listed in June on Bloomberg under the ticker ‘AUTO,’ and will be used as the tradable instrument for the derivative, Fortin said.
The company said it closed a $7.3 million seed funding round last week, led by MaC Venture Capital. Autotech Ventures and Avanta Ventures also participated in the funding round.
“What we’re doing at Exponential is we’ve identified that [the auto] market has the same exact problems as other markets in energy and finance and agriculture,” Fortin said. “They’ve all been benefiting from the fact that derivatives exist, and derivatives sometimes are based on an index exist. And so that’s what we’re replicating here.”
The endgame, Fortin said, is for the index to be listed and traded on a large futures exchange, such as Intercontinental Exchange or CME Group.
Exponential Exchange is already in discussions with a major futures exchange, he said. “We already have an agreement in hand with one of them.”
For now, Exponential Exchange is focused on proving the concept through over-the-counter transactions, which are bilateral deals brokered between two parties — largely rental companies and insurance providers, Fortin said.
“We’ll bring the two sides together and say, ‘We’re building this market; this tool will be useful to you in the future, would you want to come together to do a small trade’ — $5 million or so,” Fortin said.
Exponential Exchange expects to finalize those transactions in the second half of 2023, Fortin said.
“Then, the futures, it’s about a six-month timeframe to basically get everything lined up, so that would be basically mid-2024,” he said.
Making a market
Creating a derivatives market is no easy task, Autotech Ventures Partner Burak Cendek told AFN. Companies looking to launch a derivative have regulations to follow, and the underlying index needs to be sound, he said.
“The other side of that is, at the end of the day, it’s also a marketplace and you have the cold start problem,” Cendek said. “When you think about the derivative you have to have buyers and sellers, and you’re starting from scratch. So, zero to one is the hardest part of the problem.”
In fact, the success of any derivatives product relies on liquidity in the markets they serve, Autotech Ventures Director of Strategic Partnerships Brian Donnelly told AFN.
“And so, if you don’t have market participation, you don’t have a product worth using,” he said.
“The reason that I can go on my E-Trade account and buy any stock in the world is because there’s a very liquid and highly participant market in which there’s somebody that’s willing to sell it,” Donnelly said. “If that doesn’t exist, then you lose the liquidity in the system and you lose the ability to be able to trade.”
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Source : AutoFinanceNews
