Vivek Shankar

P2P FX: A tough nut to crack but significant progress is being made

May 2024 in Market Commentaries

Vivek Shankar explores the increasing value proposition of Peer to Peer matching platforms in FX and how they provide solutions to this and other challenges facing market participants.

The peer-to-peer (P2P) model offers several benefits for FX market participants. Originally developed as a way to limit information leakage, P2P helps traders match interests in the market, irrespective of the instrument involved.

As electronification has grown, P2P can also free traders’ time by automating operational trades. However, firms have faced a few challenges in realising these advantages. Jay Moore, Co-founder and CEO of FX HedgePool, acknowledges these challenges while explaining why P2P makes sense for FX.

“The FX market’s diverse and global participants create a natural pool of buyers and sellers, foundational for P2P success,” he says. “However, broader adoption and becoming a market standard require workflow integration and a scalable credit framework.”

So how tough are these challenges to overcome, and how are P2P service providers helping firms overcome them?

Overcoming the factors holding back P2P adoption

“P2P models universally strive to minimise market impact, and information leakage by matching naturally offsetting flows among counterparties,” Moore explains. He says that these qualities are critical in swaps.

While spot trades tend to follow reactionary patterns, passive hedging generates consistent swap volumes—volumes that the market likely knows in advance.

“[Those] predictable flows are vulnerable to pre-hedging risk and market impact. Matching offsetting interests eliminates these risks, benefiting both our participants and their stakeholders,” states Moore.

P2P’s biggest advantages hinge on helping firms manage predictability in their flows. No matter how well managed flows are, predictability of any kind creates risk. P2P eliminates this risk by removing any chance of information leakage to the broader market before a trade.

Routine trades are great candidates for P2P execution. A trader’s greatest priority with them is minimising risk, something P2P is designed to do. For instance, by booking jumbo swap trades on a single ticket within a P2P community, traders can devote more time to strategic trades.

And for those worried about manipulation, traders can compare P2P match rates to benchmarks, removing any such fear. 

While the advantages are apparent, firms have had to deal with a few challenges when implementing P2P models. And these challenges have held back widespread adoption.

When asked what these challenges are, Moore begins with the likelihood of finding a match. “P2P success hinges on finding opposing interest within a specific timeframe, which has been difficult in spot trading due to the time-sensitive nature of the trade,” he says.

However, he notes that swaps don’t face this challenge to the same extent since they are often highly scheduled and systematic. The challenge with swaps is credit, Moore says.

“While swaps offer significant potential for P2P, they come with credit challenges.  Because buy-side firms cannot face each other from a credit perspective, they need to secure a willing credit sponsor for trade booking and settlement,” he explains. Lastly, operational challenges have traditionally held back P2P adoption.

“With FX HedgePool’s credit intermediation model solving for the credit challenges, the next step to success is conforming to specific workflow requirements to ensure operational scale,” Moore says. “Integration into existing technologies to support automation of operational workflows has proven crucial to our success.”

So what does P2P have to offer different FX market participants?

P2P for the buy side and sell side

The good news is that evolving market participant trading styles make P2P an ideal fit for stakeholders. Take the buy side, for instance. 

“Smart order routing [trade automation] has emerged as an essential way for traders to scale their desks while continuing to deliver against their best execution requirements,” Moore explains. “Many of these rules-based engines, passive hedging included, are designed to automate trades with a focus on minimising market impact and information leakage.”

These goals make P2P an ideal fit, given how the buy side’s goals align with the P2P’s aims. Moore says this makes P2P “a natural liquidity checkpoint for automated trading.”

Matching opposing interests is perhaps P2P’s biggest advantage for the buy side. Additionally, traders can realise value by matching at mid-point. Increased algo adoption also fits into the advantages P2P offers.

For instance, a trader can slice an order to minimise market impact by designating different liquidity pools to source from. P2P pools plug into this workflow seamlessly, offering traders an additional source of safe liquidity. Furthermore, the nature of algo trades on the buy side makes P2P adoption logical.

Algo trades tend to be operational and lie on the non-strategic side of a trader’s book. Firms need ways to minimise their traders’ time spent here while executing them with minimal market impact—the same goals that P2P helps firms achieve.

While the benefits for the buy side are apparent, what does the sell side have to gain from P2P? “Historically, the sell-side has relied on internal liquidity and the broker market to hedge their principal market-making book,” Moore says.

Hedging risk from the latter is expensive and prone to information leakage, unfortunately. “Offering the sell-side access to P2P, or more broadly, all-to-all liquidity pools effectively expands their equivalent of “internal liquidity”, improving the quality of the liquidity they can offer to their principal clients,” Moore explains.

From a regulatory perspective, pre-hedging has come under scrutiny these past few years—with market voices loud enough to prompt the GFXC to lay down guidelines in a working paper. Pre-hedging conducted by banks brings information leakage into focus.

“Put simply, building inventory in anticipation of an expected client order creates market impact and negatively impacts clients and their investors,” Moore explains. He believes P2P offers a solution.

“Inserting all-to-all liquidity pools like FX HedgePool between internal netting and going to the market provides another way to satisfy the banks market and risk management needs of the trade while avoiding the negative compliance risk exposure that pre-hedging in the market creates.”

Catering to market needs

Moore explains that while P2P might change how stakeholders think about liquidity matching, it must still present a familiar face. “For any new technology or trading solution to scale, it must conform to the familiar workflows of the market,” he says. 

“The FX market’s diverse and global participants create a natural pool of buyers and sellers, foundational for P2P success”

Jay Moore

When asked what service providers are focusing on delivering above all else, Moore points to credit and workflows. “In the early days of P2P, innovative traders considered it to be experimental but were willing to give it a go in a more manual fashion to prove benefits,” he says.”

As usage increases, the need for standardisation becomes more apparent and drives adoption. “For a buy-side trader to consider using any new source of liquidity with scale, P2P included, they must be able to access that liquidity through familiar and operationally proven technology that seamlessly integrates with their existing workflows,” Moore continues. “Firms like FX HedgePool have been able to get to this state of standardised “business as usual” through OMS integrations.”

Standardisation also handles another tricky question—that of compliance and regulation. Integrating with existing workflows helps P2P providers address these challenges. Moore notes that P2P platforms are evolving successfully to meet regulatory needs.

“By providing transparent and automated trading solutions within an existing trader workflow, we are gaining credibility and trust among market participants,” he says.

Moving past workflows, we arrive at the credit picture. “For liquidity matching to work there must still be a settlement home for the trade as the participants have no direct counterparty relationship for the trade and must have a credit sponsor available that aligns with their panel of existing eligible brokers,” he says.

“A core innovation of FX HedgePool when entering the P2P space was the separation of credit from liquidity,” he says. “By creating a network of banks with existing bilateral credit relationships with the network of buy-side participants, we’ve been able to allow liquidity to be sourced independently from where the trade is booked, which is the key to unlocking P2P.”

“This becomes increasingly challenging for larger global asset managers who trade on behalf of hundreds, sometimes thousands of accounts, each with their own approved broker lists.”

A diverse set of program credit sponsors eases this hurdle. “Counterparty flexibility allows for wider adoption across funds and the ability to deliver the benefits of P2P consistently across their investors in the name of Best Execution,” Moore says.

The results have been promising. Market participants are recognizing P2P’s benefits, especially when speaking of pricing, market impact, and operational efficiencies. These benefits are driving increased adoption, Moore notes.

“P2P platforms are constantly introducing innovative solutions to address challenges such as finding matching interests, addressing the credit and settlement complexities, and integration with operational workflows,” he says. “Increasing competition among P2P providers and traditional market participants will drive further innovation and improvements across our platforms, leading to enhanced services and offerings for all market participants.”

Evolving FX market participant trading styles make P2P an ideal fit for stakeholders

The road ahead

While FX market participants have faced barriers in implementing P2P in their firms, the future seems bright thanks to the innovations we have covered so far.

Simply put, P2P makes too much sense for firms to avoid adopting it at some point. However, could changing regulations and markets alter this picture? 

When asked about this, Moore says, “Continued regulatory and market structure developments will shape the landscape for P2P trading in FX. Platforms that can deliver agile and innovative solutions will maintain a competitive edge.”

He points to technology as an example of innovation that will sustain the P2P use case. “Ongoing advancements like improvements in matching engines, scalable credit, and modern integrated technologies will enhance the efficiency and effectiveness of P2P platforms, further driving adoption and usage,” he says.

He acknowledges that shifting market dynamics and trading styles will affect P2P’s utility too. However, a platform’s ability to adapt is critical here too. 

“Increasing competition among P2P providers and traditional market participants will drive further innovation blurring the lines between the buy- and sell-side, leading to enhanced services and offerings for all market participants to benefit from,” Moore says.

Ultimately, the trend of continuous innovation seems to be winning out, making P2P and all-to-all liquidity highly relevant in FX. Undoubtedly, this trend will continue and give market participants continued utility in the long run. 

Readers will have an opportunity to discover more about FX HedgePool in their front cover interview feature being published in July’s edition of e-Forex.