For buyside firms, there are currently a number of challenges which need to be overcome in their aim to achieve best execution for their investors. This is primarily due to best execution not being solely down to price, says Claude Goulet, CEO at Siege FX. “It is complicated for FX because historically execution was always linked to credit provision,” he adds. “The challenge for buy side firms when you are talking about best execution is that it has to go beyond just looking at the price you get at that specific point in time.” Goulet explains that as recently as five to ten years ago, for example, banks held risk as a principal for much longer than they do now. Buyside firms also need to consider the overall risk exposure of trading. In order to do this successfully, Goulet argues “there is a need to unbundle the costs of credit and balance sheet from liquidity and market access.”
This is where Siege FX can prove useful. “Siege provides a mechanism which completely decouples price formation from the transaction and by doing so provides access to liquidity without any market impact,” says Goulet. “P2P is gaining popularity because the buyside is more and more aware that banks cannot warehouse risk the same way they used to. They have to go to market more quickly, and obviously this causes greater market impact.” Larger participants already know that as part of their best execution strategy, the solution is to break these orders down into smaller clips over a longer period of time to reduce information leakage and minimise their market impact. “This generates demand for algo execution, or at the very least, a different style of execution than a full risk transfer. If you are conscious that you are holding that risk, then P2P can provide you with a way to net away from the market,” Goulet adds.
In the case of FX swaps trading, the hurdles to achieving best execution are even more pronounced, says Jay Moore, Founder and CEO of FX HedgePool. Specifically, in the passive hedging space, FX swaps are traded as per mandated requirements of firm’s hedging programmes and as such, are routinely performed on a calendar basis with a relatively small number of counterparty banks. “Rolling hedges are highly scheduled and therefore, predictable trades.” Moore explains. “The buyside have historically relied on a limited number of banks with whom they have credit with to provide prices. As a result, banks must manage the large position risk of these hedges which often results in market impact. At the end of the day, it comes down to this – peer-to-peer matching eliminates market trades, which in turn eliminates market impact.”
FX HedgePool doesn’t cut out the banks, however. Banks continue to play an essential role as credit provider - leveraging the documentation, account set up and credit lines currently available with their buy side clients. Under this model, the buyside is able to source pure liquidity from peers while continuing to settle against banks with whom they currently trade with. “Banks are paid for credit use only, creating a new source of reliable and sustainable revenue with a more optimal use of balance sheets.”, says Moore. “It’s a win-win for both the buyside who are better able to achieve best execution and the sellside who are able to avoid position risk altogether.”
Addressing new issues
The return of volatility to the FX markets may have further exacerbated some of the existing issues around market making and risk. A sell side firm providing a buyside client with a price is now more likely to hedge out of that position very quickly and earn a spread for providing that liquidity. Moore adds: “When trading in competition during times of higher volatility, the certainty of where a bank can get out of that position is much lower and so they have to price in that risk in the form of wider spreads. With peer to peer, naturally offsetting positions can be matched in a safe and dependable marketplace, eliminating the market risk entirely, along with the corresponding spread.”
To demonstrate this, BestX recently analysed FX HedgePool’s trades from 2020, validating that the fixed FX HedgePool spreads were significantly favourable to the unpredictable and sizable expected costs had those trades been executed in the market.
In turn, Goulet explains that netting even a small percentage of trades at mid can be disproportionately beneficial to firms because cost distribution is very much weighted towards the tail of their execution ie the more they go to market, the more expensive
it becomes. “These costs can be significantly reduced while also benefitting from the absence of market impact for amounts netted through Siege,” he says. Even so, the adoption of P2P in FX is still relatively slow in a practical sense. Goulet believes that this will be helped by a change in mindset where the buyside is starting to view the banks more as a credit provider and not just as a liquidity or market maker. “This has started to happen more in recent years,” he says. “There is also a false belief that P2P in FX, as opposed to other asset classes such as equities, will not be so successful. Yet there is no reason why netting can take place in thousands of securities but not across a far more limited universe of currency pairs.”
If banks were previously more resistant to client P2P models, this dated back to when they were still very much focused on spread income from market making, Goulet says. With increased electronic workflows, greater transparency, better cost measurement and the unbundling of services, P2P has become a more achievable proposition which can be developed in partnership with sell side firms, he adds. “Now that dynamic has shifted and banks have far more offerings including market access through the use of FX algos, but also from prime brokerage and other credit services,” Goulet explains. “The client relationship as a whole has becomes more important for banks and these fee driven revenue models are becoming more interesting to them. As this evolves, we expect to see more and more support for peer-to-peer models.”
The push for greater transparency in the market, which also form some of the key principles behind the FX Global Code, may be another reason behind the rise in interest for P2P models. FX HedgePool and other P2P matching services are perfectly aligned with the Global Code, explains Moore. “There’s been a significant level of attention on the banks use of pre-hedging and the negative impact it may have on price - but banks have risk to manage and costs to cover.” Jay adds “Banks are expected to price trades for their clients, so it’s not uncommon to build an inventory in advance, but this just translates to unavoidable market impact.” says Moore. “Our technology-based solution is opening channels of new, pure liquidity, both created and consumed by peers with a common goal – getting the trade done with as little cost as possible. Peer-to-peer trading doesn’t minimize that problem, it eliminates it.”
Benefits become clear
An additional benefit is how readily P2P provider’s technology can be incorporated into existing workflows, explains Goulet. “The reality is that nobody wants disruption, what people want is optimisation. They want better, smoother and cheaper processes and that’s what we’re trying to do for them.” The approach taken by Siege FX, for example, is to connect directly into client systems and manage the messaging between the systems. “That’s usually the tricky part,” Goulet says. “People forget that all of this is based on data exchange. So that’s the key component of what we’ve built. Siege a FIX destination - an in and out module that can absorb and transmit all this information across a variety of systems. It is key for us to integrate with existing client systems, as opposed to trying to dislodge them
Looking forward however, Goulet notes that the adoption of emerging technologies, such as distributed ledger, could serve to make them even more efficient and to be able to further reduce operational costs. In addition, this would improve the ability of clients to access data more quickly and to create a better ‘golden source’ of data in real time. A move in FX to unbundle credit from access to liquidity and the actual price, which is seen in other asset classes, is also starting to happen, he says. “Clients want the ability to see the data, the TCA, to evaluate how their executions have done compared to everyone else in the market, not just compared to themselves,” Goulet says. “There is no such golden source of data at the moment, but the market will continue to evolve as better data and new processes begin to emerge. As Siege FX continues to grow its community and increase the netting activity, we’ll look at offering a wider range of currencies and products, as well as selective access within and across liquidity pools.”
In the coming months, FX HedgePool also plans to broaden its existing offering by introducing quarterly IMM’s in addition to the monthly rolls to expand its product suite for FX swaps. Overall, while the concept of P2P is not new in the FX space, Moore believes that the last two years have certainly shown that it’s becoming a far more serious consideration for many. “We’re optimizing the FX Swaps market by leveraging technology to streamline a complicated problem. Using credit models that have reshaped how the market operates by separating liquidity from credit has unlocked significant potential for more optimal results for all. It’s long overdue and I only see that momentum growing.” Moore concludes.