FX market participants have long contended with information leakage impacting trade outcomes. Peer-to-peer (P2P) trading, originally an antidote to this problem, has evolved significantly to offer additional benefits to market stakeholders. Vivek Shankar investigates.
P2P service providers list benefits such as minimizing costs, tracking error reduction, and boosting strategic trading as benefits of the model. However, some deficiencies remain. Detractors point to P2P’s inability to replicate bank risk warehousing abilities when markets experience strong directional moves. For example, LoopFX has recently launched a dark pool that follows a peer-to-peer-to-bank model in response to these events, believing the traditional P2P model needs an overhaul. So, how are P2P service providers addressing these needs, and what form could P2P shortly take?
Gains for the buy-side
“The most important advantage that the buy-side gains is the opportunity to minimize market impact by matching against opposite buy-side interest,” says James Singleton, Chairman and CEO at Cürex. “Saving spread by matching at a midpoint is a nice additional feature but not the real value driver,” he adds.
P2P’s ability to match buy-side interests levels the playing field, irrespective of the kind of trade involved. When asked about the broad advantages P2P offers market participants, Jay Moore, CEO and co-founder of FX HedgePool, concurs with Singleton’s observations and adds that some instruments benefit more than others.
“Take swaps for example,” he says. “Swaps are the largest part of the largest capital market in the world and volumes have grown in large part due to the increased demand for passive hedging from everyday investors. Unlike reactionary spot trading, passive hedging generates predictable, recurring, and directionally consistent swap volume that most of the market knows is coming – making swaps arguably the most vulnerable orders in the market with the most to gain from peer-to-peer trading. Recycling this type of benign liquidity through the market unquestionably creates excess costs that are ultimately borne by investors. FX HedgePool brings the natural partners together to avoid that.”
One of P2P’s underrated advantages for buy-side desks is its ability to slot into operational workflows. For instance, P2P effectively automates operational trades, freeing up a trader’s time to focus on strategically important positions in a portfolio. With some venues offering fully electronic execution, buy-side desks can now potentially automate their operational trades, using P2P as a liquidity source. “The use of algo execution is becoming more and more prominent with the buy side,” Singleton explains. “Once an FX trader understands and adapts to the advantages of “slicing” an order, he or she can then determine which liquidity sources to incorporate in that execution, including a peer-to-peer pool if available.”
When asked about incorporating algo-based execution, Singleton says, “Our platform delivers the advantages of electronic execution – execution speed, anonymity, no last look, and low market impact – without the disadvantages of other ECNs – last look and risk of information leakage.”
Continuing the algo adoption theme, Moore notes that P2P adoption is increasing since it fulfills many of the same requirements traders demand off algos. P2P delivers benefits such as streamlining operational trades and automating non-strategic trade execution, mirroring the ones that algos originally offered.
“Just as algos have become a standard tool for today’s traders, P2P is emerging as a standard “first stop” for much of tomorrow’s liquidity,” he says. “In our experience, it’s the same traders who embraced algos early are the same ones who are embracing P2P.”
Supporting best execution and transparency
“Best execution” is relative in FX. Despite different definitions, almost every buy-side trader agrees that achieving it is challenging. Information leakage and establishing a pattern that LPs recognize before execution impacts prices, thanks to pre-hedging. While the GFXC’s paper on the subject addressed the issue, the problem persists.
Moore points out that information leakage, or any form of predictability, creates an adverse market impact for the buy-side. “No matter how carefully managed, whenever there is predictability, there is market impact,” he says. “The challenge, and perhaps why many choose to ignore the problem, is that market impact is not captured in the “point-in-time” TCA that the market currently relies on to demonstrate best execution.”
“Peer-to-peer takes the market impact challenge off the table by removing all information leakage and the hazard of pre-hedging from the equation entirely,” he continues. “This makes P2P a tool that every buy-side trader should have in their tool kit, particularly for predictable trades, like rolling passive hedges.”
Singleton concurs with this view and notes that match rates cannot be manipulated since traders can compare them to benchmarks. In essence, Moore and Singleton say, P2P is changing the conversation around best execution.
In addition, P2P is also impacting operational workflows in FX significantly. Moore highlights the issues traders face with swaps tied to passive hedge positions and how FX HedgePool’s P2P community is solving them.
“These trades are considered routine, non-alpha generating and, by definition, create predictability, operational risk, and cost,” he says. “A buy-side trader’s job is to minimize each of these effects by being discreet, efficient, and diligent with their LPs. All of this effort simply to survive another day and do it all again the next month. By joining our community of passive hedgers, they can find dependable, natural offsets for their routine hedging needs.”
He explains that traders can consistently and anonymously book jumbo swap trades on a single ticket against a community of peers, ensuring zero market impact. FX HedgePool participants match at mid-market rates at fixed fees, eliminating any tedious negotiation for routine trades while avoiding volatile spreads they might otherwise receive from LPs.
“Routine, passive trades detract from the strategic benefits of the buy- to sell-side relationship where market risk management is so essential. Our goal is to create more space for traders to focus on the trades where their expertise is needed most,” Moore concludes.
Increasing access and unique services
While P2P’s benefits offer compelling use cases, ease of onboarding and access are critical to greater adoption. To this end, Singleton and Moore highlight their efforts in minimizing any disruptions traders might face when incorporating P2P in their trade workflows.
“When Cürex was designing its peer-to-peer matching platform, we consulted with our largest buy-side customers to make sure we were building a product that addressed their principal concerns,” Singleton says. “We worked with those institutions’ banks to address credit issues related to P2P matching. Our solution, which also addressed important workflow concerns, relied on the algo providing banks to access our P2P platform on behalf of those buy-side institutions.”
Singleton notes that Cürex is working on expanding beyond the seven participating algo banks it currently has on board. “We view this as a win-win situation where we bring more customer access to our P2P platform and the participating algo banks provide an additional and attractive liquidity pool for the same fee they are charging their clients,” he says.
FX HedgePool, Moore says, has focused on workflow automation and integration over the past year. “Our efforts have led to fully integrated and automated access to FX HedgePool via the primary Order Management Systems used by the vast majority of the buy-side today – including Blackrock’s Aladdin and Charles River Development (CRD),” he explains. “These integrations allow traders to direct orders to FX HedgePool in a familiar workflow to their typical trading process, which has been a game changer for onboarding new clients.”
Increasing pool diversity is not a priority for either FX HedgePool or Cürex. Singleton explains, “Candidly, we don’t believe the buy side needs more liquidity pools. P2P liquidity is a potential additional liquidity source with tremendous benefits. Adding other layers of liquidity pools beyond the myriad that already exists probably provides no additional benefit, especially when buy-side traders typically execute with the same top five liquidity providers.”
Instead, these service providers are delivering unique functionality that boosts P2P’s appeal. Singleton highlights Cürex’s efforts to maintain a clean pool, free of hedge funds and HFTs. Matching technology comes into play here, something Singleton says Cürex is highly devoted to.
“Cürex also provides an auditable benchmark for all executions through our proprietary benchmark calculations with FTSE/Russell,” he says. “Our Cipher analytics platform documents the outcomes of customer trades in relation to pre-trade market conditions, including those trades resulting from P2P matches.”
FX HedgePool’s focus on swaps has forced them to look at things differently. Moore explains that separating credit from liquidity is a critical innovation that FX HedgePool has introduced to solve a longstanding issue. “Historically speaking,” he says, “there’s been a dependency between liquidity and credit, which is particularly relevant to swaps and forwards. Buy-side traders rely on the banks with whom they’ve got ISDAs in place to access pricing. This creates a bottleneck of liquidity amongst the top-tier banks that have competitive market-making capabilities AND the resources necessary to onboard and maintain a broad network of buy-side relationships.”
He explains that P2P liquidity, and swaps specifically, needs credit intermediation since buy-side firms lack credit relationships with each other to settle trades bilaterally. Real money buy-side firms do not use traditional intermediation models thanks to credit diversification requirements and broker restrictions across their accounts to consider.
“We looked at things differently and recognized that there are several high credit quality banks with balance sheet capacity, ISDAs in place, and strong relationships that were not meeting their volume capacity. Leveraging the documentation and risk management framework of existing bilateral trading arrangements, FX HedgePool introduced the concept of credit-as-a-service (CaaS) where participating banks can offer credit/settlement services to our common buy-side clients without the need to take market risk or compete for liquidity.”
“This model allows our members to match naturally offsetting liquidity with each other, while distributing credit across their familiar bank relationships at fixed, transparent credit fees – creating a new credit marketplace in the swaps market,” he continues. “This “novel, yet familiar” model has allowed us to build a healthy balance between serving the buy-side and the sell-side simultaneously – optimizing idle capacity and creating the space to do more of what they do best.”
Rising electronification and P2P
As electronification rises in FX, where does this leave P2P? Moore is optimistic about its prospects. “Given the growing volumes and higher time demands on buy and sell-side traders,” he says, “cost management and automation without compromising pricing or transparency will be paramount. Alternative sources of liquidity combined with automation will be a common theme – the space that FX HedgePool is designed for.”
Singleton is similarly optimistic about electronification assisting P2P’s growth. “Peer-to-peer matching can only exist in the electronic environment,” he says. “We think the buy side will focus on one or two alternative solutions to maximize the benefit of more volume matched with no market impact.”
Time will tell how the P2P landscape in FX changes and how successful new approaches like Peer-To-Peer-To-Bank are likely to become. Either way, there’s no doubt that service providers are constantly innovating to deliver better experiences to their clients with novel technology.
Original post on e-Forex.
