The Last Look…

A few weeks ago, a paper was published on the benefits available to FX markets from DeFi (decentralised finance) which has led to a flurry of excitable predictions from evangelists arguing they have seen the future of FX and it is in DeFi. So, is it? Well, I doubt it in the short/medium term, although there are undoubtedly areas in which it will have an influence, not least in payments and settlement much quicker than that.

I read the paper with interest, but again could not help thinking, as I often do in these circumstances, that it is trying to solve numerous problems, some of which don’t exist and the solving of which would prompt much more upheaval in the market infrastructure for a relatively small – if any – gain.

It should be stressed, the paper’s authors acknowledge the challenges, indeed it is a well-balanced read, it’s just it has been seized upon by those impatient for change for change’s sake.

Where the paper is undoubtedly right is in its claim that DeFi can reduce the cost of payments and settlement, it says by up to 80%. That said, it also talks up atomic settlement, which works really well in the retail space I would argue, but less well in the institutional where many counterparties want to settle on a net basis at either the end of a day or designated window. Forcing these trades into an atomic settlement process risks overloading the system and increasing the stress on firms’ systems.

It is there, that I see problems emerging – the solutions discussed are good, but they are largely aimed at the retail, possibly SME, end of the market. That is not to say these sectors are not in need of such innovation – they are – but more that the institutional end of the spectrum represents a whole different level of challenge, if indeed that sector even wants or needs it.

The paper cites the Bank for International Settlements’ measure of non-PvP exposures in FX, and they are indeed large, but as has been noted in these pages before, they can be over-stated because there is a large chunk of intra-company trading, as well as netted transactions that are included in that number. They do exist, however, otherwise companies like Baton would not be out there pushing a DLT-based solution to solve what is a genuine problem.

The ideas laid out in the paper are good for retail and could be deployed now, but I see too many barriers to institutional adoption

The issue then, as far as I see it, is how DeFi copes with the sheer scale of the mainstream FX market? The paper cites $124 million processed in payments since July 2022 (it was published mid-late January) using stablecoins, but at $7.5 trillion per day we are talking a different ball game when it comes to the institutional FX market.

Equally, for all the good work and words around stablecoins, there is still a doubt over their resilience – are major funds and corporates really going to entrust billions of dollars to a privately-run currency? The cost benefits are there to be seen, but who is going to be willing to take the risk, at this stage I should add, of (another) one of them blowing up?

The paper also talks about improving FX market transparency and, inevitably, recalls the benchmark rigging and market manipulation scandals. It could be argued these have been dealt with, indeed when it comes to the benchmark, I would argue the more transparent solution has made the issue worse because it has not been accompanied by other structural changes.

Before I go off on a tangent, though, let’s get back to the paper. It argues that the blockchain provides an immutable price for benchmarking against – but is it right to benchmark a billion-dollar transaction against what might be a retail payment of $300? Equally, it observes that internalisation can be detrimental to market functioning, and, I suppose, at an extreme it can, but the fact is end clients with big tickets value the anonymity and reduced market impact of internalisation, so DeFi would probably make their outcomes worse.

An interesting aspect of the paper is the use of automated market makers that could, in theory, provide “always on” liquidity on a 24/7 basis. This is a fascinated idea, but again does it ignore the realities of the institutional world? I am struggling to think of any institution that would be happy to take on risk at times of low liquidity, why would an automated market maker be any different? Clearly it would be a “hot potato” style of risk management, especially at weekends, which would undoubtedly prompt significantly wide swings in rates – again the question, how is this of use for the end user of the FX market at institutional level?

I want to stress, my problem is not with the paper itself, it acknowledges a lot more needs to be done, and as a starting point for discussions it is very good – my problem is with those who believe it is the answer now. I accept the ideas laid out in the paper are good for retail and could be deployed now, but I see too many barriers to institutional adoption – some of which I have already mentioned.

There is another significant point to be made on this as well – it could be argued that FX is already decentralised. The vast majority of trading is on a bilateral basis (and is benchmarked effectively where needed by independent third parties), so why introduce more complexity? Post-trade there is room for change, without doubt, as I have already noted, but the actual trading process?

The best functioning markets have transparency of action, not transparency of order – the latter is just an avenue to inferior execution quality

There are a couple of problems here, and they are big ones. Firstly, speed – can the infrastructure handle transactions that need to be executed, affirmed and market data published well inside of 5ms? Secondly, and relatedly, scale – can the infrastructure process fast enough at scale? As an indicator, there are around two million FX trades per day just in the UK and US, scale that globally and you’re looking above 30 trades per second. If each trade potentially has its own protocol and distinct counterparties and there’s no room for aggregation/netting, the throughput required is enormous.

So, while I think there will be elements of DeFi that will undoubtedly change the face of the FX industry, I continue to believe, at least in the short term, it will be at the retail end of the spectrum. CBDCs may shift the institutional world somewhat, but they are some way off – and in the absence of stablecoins providing a millisecond-by-millisecond audited account of the assets backing them, institutions will remain wary.

For now, change how money is moved around the world by providing those who want it with the means for PvP settlement, but when it comes to trading there is one thing to bear in mind. The best functioning markets have transparency of action, not transparency of order – the latter is just an avenue to inferior execution quality.

colin@thefullfx.com