Generally speaking, buy side firms source FX liquidity from a panel of banks with whom they’ve got trading agreements, accounts set up and credit lines established. These banks provide liquidity across a range of FX instruments at rates that reflect the risk of doing so – factoring in the credit, personnel, technology, compliance and of course the cost of risk transfer.
The implicit spreads applied to FX trades are necessary for banks’ FX businesses to cover their costs and be profitable. Being a market maker is risky and expensive –ultimately translating to costs and performance drag to the underlying investors. Market makers are simply being compensated for providing a valuable service that reflect the risk of doing business.
What if, instead, the buy side could eliminate these market driven costs by creating a self-sustaining community of peers acting as both the suppliers and consumers of matched liquidity?
We’ll explore the various aspects of what must drive a successful peer-to-peer solution and what has prevented peer-to-peer matching from becoming the holy grail that the buy side has been searching for.
Given the obvious benefits of peer-to-peer liquidity, the buy side has been on the hunt for technologies that allow them to access offsetting liquidity directly from peers for many years. This is not a new concept in FX, nor has it been overlooked. So, why has it not emerged as part of every trader’s workflows?
Before examining the question of “why” peer-to-peer hasn’t achieved a greater degree of success, let’s first explore “what” the buy side is interested in achieving when they talk about sourcing liquidity from peers.
What Peer-to-Peer Seeks to IMPROVE:
- Bid/Offer Spreads - Fair spreads that are not dependent on a bank’s ability to hedge their risk
- Market Impact - Execution without information leakage where market impact can negatively impact investor performance
- Investment Performance - Align execution with specific price & time requirements to minimize performance slippage
- Operational Efficiency - Ensure dependable and predictable matching to alleviate operational uncertainties and resource strains - allowing trading desks to deploy talent most effectively
The notion of peer-to-peer is simple. So where to begin? The most obvious peer-to-peer solution would naturally start by focusing on spot trading where complexities like credit and tenor alignment can either be ignored or easily solved for.
Challenges of Spot Matching
Spot trading is typically a reaction to something else that’s happened, such as the purchase or sale of underlying foreign portfolio securities, foreign investor subscriptions or redemptions or some other form of foreign cash flow or corporate action event. The resulting FX spot trades from these transactions are typically not only price sensitive, but time sensitive.
In a peer-to-peer world, being time sensitive means a match must be identified and acted upon within a very short window of time, typically only a few hours or less. The trouble is that the nature of these transactions tends to result in the direction of trading among peers to be highly correlated, so offsetting flow is difficult to come by, especially in the absence of longer periods of time to identify a match.
Moreover, the reactive nature of spot trading means that today’s trades have little to no relationship to tomorrow’s trades. Therefore, any peer match you may have been lucky enough to hit today is not an indication of tomorrow’s potential for continued matching, making dependability a source of frustration.
Bottom line is that the reason peer-to-peer in FX spot trading hasn’t gained momentum isn’t due to lack of innovation or thoughtful solutions, but due to the structure and behavior of the market.
As a matter of fact, there have been some strong technology solutions made available in the peer-to-peer spot space over the past 5-8 years. Given the relatively small influence that credit has on a spot trade, most of these peer-to-peer products have typically imposed central prime broker models where all trades would centrally settle. While this model makes perfect sense from an operational/technology perspective, the only way for such a model to be convincing enough for real money managers to invoke change would be to demonstrate a significant and reliable matching rate of peer liquidity.
On the flip side, creating dependable matching in the spot space requires a “critical mass” of diversified users willing to incur the on-boarding costs, creating a chicken or egg situation.
Even if one could convince a large enough group of peers to participate, getting acceptance from real money firms to on-board a prime brokers or new settlement counterparties in a market where trading desks are looking to optimize counterparty lists and very rarely use PB’s is a tall order to say the least.
Furthermore, for a spot peer-to-peer solution to be viable, it must be able to sustain itself entirely without the need for traditional sell side banks to play a role. Specifically, banks have historically cringed at the notion of peer-to-peer as they see it as an attempt to “cut out the middleman”.
Given the challenges laid out related to peer-to-peer spot flow, a few things must be materially different to create a viable solution in other FX instruments or trade types:
- the predictability and dependability of matching must improve
- the credit and settlement model needs to be familiar and non-disruptive
- support from the sell side is imperative
Enter the FX Swaps markets
FX swap volumes have grown faster than any other segment of the FX markets, primarily driven by the growth in passive hedging programs, which are mandated by their investment guidelines and must be maintained regardless of market volatility, liquidity or price levels.
Because of the non-discretionary nature of these programs, the size and direction of passive hedging programs is extremely predictable and dependable - a characteristic that plays perfectly into a peer to peer solution allowing the ability to selectively curate a community of peers to maximize matching potential for long run sustainability.
Conversely, when trading with market makers, the large size and predictive nature of these trades exposes the buy side to increased likelihood of more severe market impact than most other trades. Given the relatively small universe of market makers available to price these trades, it’s often the case that banks may preposition (ie. pre-hedge) themselves well in advance of the trades being communicated to the market. This pre-hedging may significantly influence market price to the disadvantage of the buy side trader.
Many buy side FX desks, including some outsourced hedging providers, have even less capacity to negotiate with a broad panel of counterparty banks – therefore they end up being captive to a small number of banks, or in some cases a single bank. This makes spread negotiation difficult if not impossible, while simultaneously amplifying the risk of market impact.
Ultimately, pre-hedging is an exercise in self-preservation, in the form of risk management – which is entirely understandable. If, for example, a bank knows they’ve got a buy side client who’s monthly roll of €500 million is approaching and it’s clear that they’ll be one of a handful of banks required to provide this liquidity, pre-hedging may be necessary to avoid market risk.
In a peer-to-peer network, where positions naturally offset, there is no market impact – because only the community of peers have knowledge of what, in the aggregate, the pool is doing: the market simply doesn’t see it. Creating a community exclusively of buy side peers, without exception, can avoid information leakage and behavior that would otherwise be to the detriment of its members.
Regardless of how sophisticated and influential a buy side trading desk may be, market impact is difficult to manage. This makes the cloak of confidentiality provided by peer-to-peer a compelling defense against market impact. Moreover, the awareness that these positions need to be rolled well in advance allows the buy side the opportunity to effectively plan for matching with their peers, unlike spot trading.
The Credit Element
FX hedges are most often implemented using rolling one (sometime three) - month forward contracts, which introduces the complex element of credit risk. In addition to the various market risk, technology, connectivity and staffing costs of any FX trade, banks must now consider the required return on capital hurdles related to holding credit exposure on their balance sheet.
Similarly, the buy side have their own credit diversification requirements, meaning any peer-to-peer matching solution would require the ability to diversify credit and provide integrated allocation tools across numerous credit providers to be successful.
While banks are losing share of wallet in the spot space to non-bank disruptors, the forwards and swaps markets have lagged when it comes to innovation. Banks are getting more and more pressure to be competitive and markets businesses globally are facing shrinking margins while fighting for every dollar of additional volume. At the same time, the buy side is armed with better tools for TCA and have a lower tolerance to pass unnecessary costs to their investors, making it more and more difficult for market makers to generate revenue on FX swaps.
With the existing infrastructure of the bilateral swaps trading market (ISDA’s, account setup and credit lines already established), there’s an opportunity for banks to secure long-term, annuity-like revenue streams via credit provision. Unlike the spot and forward outright markets, where banks generate trading spreads and peer-to-peer platforms would be seen as competition, swaps are very often considered lower margin, loss-leading transactions. The reason the banks are still competing for these monthly rolls is to increase the likelihood of winning higher margin intra-month rebalance and transaction settlement trades where they can earn a spread.
To create harmony between market innovation and sustainable revenues, peer to peer in the swap space introduces the opportunity for banks to offer credit services - creating sustainable revenues while enhancing strategic relationships. Illustrating the support from the sell side community, a number of banks have already begun offering the buy side the ability to disentangle credit from the search for liquidity by participating FX HedgePool, a recently launched FX swaps matching utility.
With peer-to-peer continuing to gain interest, especially as market volatility continues, sourcing liquidity from peers as it relates to passive hedging programs has already proven to deliver meaningful and sustainable benefits to the buy side. By substituting the market elements of FX trading – such as price discovery – with liquidity sourced from a network of their peers, buy side participants are significantly reducing transaction costs while simultaneously acquiring a dependable, transparent and workflow-efficient way to manage their systematic trading requirements.