The Last Look…
Posted by Colin Lambert. Last updated: October 4, 2023
Last week gave us another example of how the crypto world, while claiming to be innovating a market structure change, is really only reaching back into existing practices and putting different names on it. Even worse, the latest example comes straight from my favourite structure – equity markets.
The proposal in the recent BIS paper to use automated market makers in a DeFi FX world sounds very much like how market makers operate on some derivatives and equities exchanges. They provide guaranteed pricing in return for a cut of trading fees, and in all probability the concept will be as successful as most equity-like ideas are when they come into foreign exchange – not very.
The final report from the BIS on Project Mariana – you can read it here – makes for interesting reading though, even though I can’t escape the sense that, not for the first time, the crypto world is over-complicating things in trying to solve a problem that doesn’t really exist.
I tend to be of the opinion that what needs solving in the FX world is the post-trade process – payment and settlement needs to be accelerated – rather than the trading process itself, and Mariana seemed to cast its net too wide for me. I like how the project took into account the principles of the FX Global Code – there is an increasing school of thought that there is a risk to the FX market from importing too many, relatively nascent, crypto industry practices – but even there, the result will be changing how participants trade currently, and I am not sure there is any desire for that.
It is not necessarily a bad thing, of course, to innovate the trading process – after all, who would have thought algos would be such a big deal even 25 years ago? – but innovation should also take into account current practice. The Mariana report highlights how breaking trades into smaller sizes is not systematically profitable under the Proof of Concept (PoC) – there are some big trades in FX, and the current practice is…to break them down into smaller trades.
Granted, this practice has come about through a diminishing appetite for risk on the part of LPs, but a lot of buy side traders who execute larger tickets seem to appreciate the benefit of breaking them down – do we want to change this? The definition of “smaller” trades in the Mariana report needs to be understood of course, it may be talking about trades of a few hundred thousand or smaller, which is probably fair enough, but my sense reading the report is it is talking bigger size – it talks about incentivising trading against one large pool of liquidity.
The report observes that to execute a EUR/CHF trade of 50 million, at a cost of 1bp, requires a pool of EUR 1.8 billion…That’s a lot of money sitting around doing nothing
The report also describes how the PoC minimises arbitrage opportunities and makes “front-running” unprofitable. I know this is a sweeping generalisation, when has that ever stopped me, but when I read, “incentivising larger trades”, “minimising arbitrage” and “less opportunity to exploit information leakage” I cannot help think that the paper is making a statement that the future market structure is very much aimed at bigger banks, rather than smaller, non-bank firms! That’s fine, but again, the structure being proposed seems to be wanting to “fit” banks into a mechanism where we all trade on one venue, but what does it mean for competition?
There are other aspects to the AMM concept that I am unsure of. For a start, the pool has to be “balanced” between liquidity providers and liquidity takers – well that is a market, but my 46 years in FX tells me that a permanently balanced market between buyers and sellers, and makers and takers, just doesn’t exist – there are too many intangibles. In theory a pool can be balanced, but can it be guaranteed? I doubt it.
What happens when, inevitably, there is a shift in the balance of risks, due to, for example, economic data? Do we change how data is released? The AMM model runs 24/7, so it’s hard to know how we take out the impact of economic surprises to name just one instance. What happens to the liquidity provider, who is getting paid, for example, when someone hits their liquidity in the pool, only to see the price change? The liquidity has to be there at all times is my assumption, or perhaps the idea is the market stops for a second around big releases? In which case, how do we deal with unscheduled surprises?
Equally, the concept of the pre-funded pool represents problems (which to be fair, the report acknowledges), because that is hardly an efficient use of capital. The report observes that to execute a EUR/CHF trade of 50 million, at a cost of 1bp, requires a pool of EUR 1.8 billion. That’s a lot of money sitting around doing nothing, and in a 24/7 world with AMMs, how do we judge who to hit first? Can it be FIFO?
As a high-level experiment Mariana is academically interesting, but I am struggling to see how it will actually improve the current FX market trading structure
It is not only the liquidity provider who may have issues with this market structure – the buy side would not be able to put LPs in competition, and, more importantly, they would be paying an explicit fee to trade. Currently a lot of them execute a substantial proportion of their trades not only at mid, but also brokerage free.
Furthermore, the buy side is becoming more attuned to accessing LP ‘axes” – the LPs themselves find this beneficial – how does that work in an AMM world? It seems to be that a large number of LPs would dilute the impact of, for instance, an ‘axed’ bid in EUR/USD, therefore would the buy side firm get the full benefit of the skewed interest?
Ultimately, there has to be a commercial incentive to change the market structure to this degree, and I am not sure this provides it for either side, (taking into account this is a PoC).
As a high-level experiment Mariana is academically interesting, but I am struggling to see how it will actually improve the current FX market trading structure. That is not to say it’s not valuable having these experiments take place – sometimes it is as valuable to know what doesn’t really work as what does – more to observe that I hope this is just the first step on a road to overhauling the structure and not a path the BIS and central banks are steadfastly committed to.
We undoubtedly need, as I noted earlier, a structural overhaul to improve the post-trade, and Mariana deals with that well. When it comes to the actual trading piece, however, this project has all the hallmarks of becoming yet another solution looking for a problem. DeFi will play a role in market structure change, I am just not sure it will occur in the front office workflow.