Peer-to-peer FX trading offers buy-side traders more efficient execution

Published on 5 November 2020

Where access to FX liquidity for the buy side is contingent upon availability of credit supplied by the sell side. That can impact access to best price – and therefore best execution – due to the ties between counterparties, rather than a decision made on the trading desk.

Peer-to-peer trading has been a success in the corporate bond and equity markets where it has enabled buy-side firms to transcend the limits of risk trading by dealers, or to find a better price than was possible through sell-side equity trading. Jay Moore, founder and CEO of FX HedgePool believes this all-to-all model applied across FX instruments in addition to the spot market will help asset managers find best execution for their investors.

Dan Barnes Welcome to Trader TV, I’m Dan Barnes. FX Trading state is dependent upon buy-side firms having access to credit from the sell-side, however that market structure creates constraints. Today, I’m speaking with Jay Moore, the founder and CEO of FX HedgePool, about how to overcome those barriers. Jay, welcome to Trader TV.

Jay Moore Thanks Dan, pleasure to be here.

Dan Barnes So tell us how does market structures today restrict execution choices in FX trading?

Jay Moore As long as you can remember, I’m sure, the FX markets as an OTC market is operated where you get liquidity from the banks with whom you have credit. So there’s this natural tie between credit and liquidity and there’s an effort that goes into getting that credit available from the buy-side to the sell-side. So obviously, the larger a buy-side firm you are, the more resources you have, the more leverage you might have for negotiating with those banks. You might have more resources just to even get the documentation in place to have those trading relationships available to you. So size, sophistication, investment, technology, all of these things really fully determine how a buy-side accesses liquidity, and the banks really depend on that credit relationship for making markets.

Dan Barnes So what effect does that have on trading outcomes?

Jay Moore When you’re tied to a limited source of liquidity; if you are a smaller manager and you only have two or three banks or you trade exclusively with your custody bank, you know, you’re negotiating power is quite low. So that’s certainly going to be reflected in your pricing. And if you’re a larger buy-side firm where you may have 10, 15, 20 different counterparties available to you, you’re still in a constant optimization struggle between the use of credit and the availability of the liquidity. In other words, you might find that you’ve got X amount of credit available with Bank A, and Bank A may have the best price, but I can’t actually use all of the volume that I need with Bank A, because I’m restricted or constrained by the credit available, which means naturally, I need to go to Bank B who may have the second best price and therefore you continue down that ladder until you’ve filled all of your execution needs. So there’s this constant constraint of credit within your availability of liquidity and your ability to get the best price.

Dan Barnes How are you challenging the assumptions about trading relationships?

Jay Moore We looked at the landscape and saw that there was an opportunity and a demand for peer-to-peer. And there’s been numerous attempts at getting a solution out there, all of them focused on spot trading. They really haven’t picked up in volume in any way, partly because we see that a spot peer-to-peer universe needs to have critical mass. You need to have many, many users to get some sort of volume, where there’s a meaningful enough offset potential on a day-to-day basis. So it’s a chicken and egg problem for one. And then two is that even if you do have that critical mass and you have a position that gets matched to the peer today, that tells you nothing about what your likelihood of getting matched tomorrow will be, because every day with spot trading is a fresh start. In HedgePool we’re focused exclusively on passive hedging flow and the roles that are required to maintain those passive hedges. So, for example, most index trackers, passive hedgers, share class hedgers, and portfolio hedgers use either one or three months forwards to continuously roll those positions for the length of the mandate.

Jay Moore Positions are known in advance, they’re relatively stable, subject to market volatility and inflows and outflows to the funds. So the amounts, the timing, the calendars are generally set well in advance. And so that allows a much more predictable peer-to-peer matching type of solution to actually work. However, in the forward space now you have credit to consider again vs spot trading where it’s a much smaller component. So for us, the big challenge at the beginning of this is; how do we allow large institutions and small institutions to match flow off against each other, when we know that they don’t have credit relationships with each other? Nor will they likely have credit relationships with each other for the foreseeable future. So there’s still a need to go through banks who are providing credit. And so we thought a little bit differently and said, well, what if we separate the two and we allow liquidity to be sourced between peers? And then allow those peers to use their existing credit lines with the banks that they’re already documented with? They’ve already got lines in place and accounts set up and it is designed. We expected banks would hate this, thinking, well, why on earth would I want to participate in this?

Jay Moore Funny enough, we found that it was actually quite the opposite; there are a lot of great banks out there with very strong balance sheets and great credit and FX capabilities that are competing with a very few that monopolize this space. So they’ve done the work. They’ve got the accounts set at the limits, but they’re not being utilized. So if we can allow them to get paid for providing credit and utilize the FX pipes that they’ve got in place, they actually can be a very important part of this ecosystem and get rewarded for the work that they’ve already done.

Dan Barnes So if you decouple credit from liquidity, what does that change?

Jay Moore It allows you to optimize your credit usage. If the four banks that dominate the FX markets are the ones that consistently have the best prices, but you have gigantic amount of balance sheet available from, let’s say, a dozen or more other banks on a global basis, you can take the credit away from the banks at the best price, reallocate that credit and utilize it in a much more efficient way, preserving the credit with those dominant banks for your more strategic trade in multiple different asset classes.

Dan Barnes That’s fantastic. Jay, thanks very much.

Jay Moore Thanks very much Dan, it was a pleasure.

Dan Barnes I’d like to thank James for his insights today and, of course, you for watching to catch up on our other stories. Also subscribe to our newsletter, visit TraderTV.net or ETFTV.net.