The daily turnover in global FX markets now exceeds US$ 6.0 trillion per day, according to data from the Bank for International Settlements 2019 triennial survey. In a market of that size, any savings that can be achieved on transaction and settlement costs can quickly accrue into serious money.
Two new initiatives have recently come to light, which are aimed squarely at reducing those costs for institutional FX traders and investors. The two new P2P or Peer to Peer platforms have sprung up independently of each other on opposites sides of the Atlantic.
In the USA fund management and ETF giant Vanguard is backing FX Hedgepool.
Launched in April the service, which has yet to go live, is targeting buy-side FX traders. Hedge funds and investment managers that have FX exposure as part of their investment strategy, or as a result of it.
Meanwhile, over in Europe more than ten large investors are putting their weight behind a business known as Siege, who have a similar target market in mind.
What both groups are hoping to do is to create a system that allows fund managers and other buy-side participants to match or net off their FX exposure/requirements with their peers, rather than relying on banks, brokers or other third-party intermediaries and in doing so, to remove or greatly reduce the costs of trading in FX.
FX Hedge Pool is not directly aimed at managers who want to take speculative FX positions but rather those who have flows they need to hedge. Perhaps arising from overseas bonds or equity holdings. The idea being that these naturally occurring FX flows can be matched off against someone with an equal and opposite position.
FX Hedgepool is not aiming at the spot or physical FX markets but rather FX Swaps.
To be clear the interbank spot FX market is deliverable one, i.e. if you buy £10 million and sell 12.50 million USD then in two days’ time you will need to take delivery of and pay for those British pounds by delivering the US dollars to your counterparty. However, the FX swaps market works differently, it works on a collateralised and margin basis with the counterparties to the Swap exchanging cash flows and payments as the underlying rates between two currencies move. Typically these swaps contracts would be longer-term, extending for a year or more. In effect, they are similar to the CFD and rolling spot FX contracts that most retail margin traders are familiar with.
London based Siege led by the former head of FX and commodity sales at HSBC, Claude Goulet, will take a different approach by removing the spread, the difference between the bid and offer prices in the market, and offer a single “ choice “ price at which its clients can transact.
Research suggests that the cost of dealing in FX can increase significantly over the course of the business day and for largely historical reasons (the timing of London FX market fixings) the late afternoon is when many of these institutional customers look to put on their hedging trades.
By eliminating the spread from trading Siege hopes to capitalise on this niche.
There have been many attempts to create P2P networks and matching services since the financial deregulation of the 1980s and 90s. Most of which have met with limited success, some have attained a respectable market share but many have fallen by the wayside.
Despite that, we applaud the effort to reduce cost and increase in the wholesale FX markets, the ultimate beneficiaries of which should be the retail investor
Whether through trickle-down or as a result of reduced costs and lower fees from their investment and pension funds.
However, at the same time, we recognise the challenges that these new matching services face
Firstly they will rely on two or more potential counterparties having equal and opposite requirements at exactly the same time in our experience, fund managers and particularly the asset allocators within in them tend to move in same direction playing market themes which could mean that are plenty of sellers at a given moment in time but not many buyers or vice versa.
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Secondly, FX is a business that has historically revolved around credit banks trade with each other and their clients based on the size of their credit lines, when those lines are “ tapped out” they simply stop trading with that entity until such time as they have headroom again.
Fund managers may manage billions in underlying investments for clients but the business itself could be lightly capitalised in FX market terms, that may make justification and qualification of the counterparty risk involved in using a P2P network, just too complicated.
Banks and FX brokers have built up their market share by providing liquidity and price making services i.e. market-making and through credit intermediation, that is the provision of credit lines, prime brokerage services and leverage.
The use of a central counterparty to settle and guarantee trades could help P2P matching services, but clearinghouse memberships often involve significant capital guarantees and established futures exchanges such as the CME and Cboe already offer centrally cleared FX contracts.
The real test for both Siege and FX Hedge Pool will be to get to what we might term critical mass
that is to be able to drive enough volume their business to be an attractive and valid proposition for their potential customer base to pay attention to them. But that could be something of a chicken and an egg situation because without the necessary volume in the first place the buy-side may simply choose to keep that business where it is.
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