Are FX Swaps Ready for Blockchain Settlement?

Profit & Loss recently reported on a new venture designed to settle FX swaps via blockchain-based technology. Galen Stops takes a closer look at the genesis and the mechanics of this solution.

Having worked in liquidity management at Bank of Ireland and then UBS, Brian Nolan observed firsthand how the regulatory expectations around intraday liquidity management increased substantially post-financial crisis, particularly with the implementation of new rules contained within Basel III.

As a result of this, he observed that it was becoming very expensive for big, global banks to manage their liquidity and recognised that there was a need for a market that would allow these banks to lend to each other for hours at a time instead of overnight and longer. This is why Nolan, along with his co-founder Zbigniew Czapran, founded Finteum, which is leveraging R3’s Corda platform to create this market for intraday liquidity. 

“A few years ago, I started learning about blockchain and distributed ledger technology [DLT], and this was at the same time that I had this problem of intraday liquidity in my head. I recognised two key benefits of distributed ledger technology for intraday borrowing and lending — the first one is having shared data records for pre-trade and post-trade,” Nolan tells Profit & Loss

This means that before a trade is matched, a bank creates a shared ‘order’ data record on the Finteum Corda business network, which is shared between the bank that has initiated the order and a matching node on the network, which works the same way as a broker. The trades are then matched via a matching engine built on top of Corda and after they settle, there is a shared data record between the counterparts to the trade – what Nolan refers to as a “a distributed trade repository”.

Brian Nolan, Finteum

“That process means that we don’t have failed settlements, we don’t have out trades and we have signed, shared data records for regulatory reporting or for internal reporting in the banks,” says Nolan. 

The second reason why Nolan thinks that DLT is a good fit for improving intraday liquidity management is because it is easier to move money and securities around when a ledger solution is being used for settlement. This is why Finteum is partnering with Fnality to try and use its Utility Settlement Coin (USC), a digital cash system that uses blockchain technology to settle financial transactions.

“This collaboration with Fnality is quite interesting, because we’ll be able to settle the cash legs of trades,” explains Nolan, “and we’ll be able to settle them at pre-defined moments in time. So when you’re doing an intraday borrowing or lending transaction, it’s very important that if you scheduled it to mature at 5pm today, that you’re able to settle that maturity at exactly that time. Settling on a ledger gives people far more timing certainty than the existing legacy settlement rails.”

Looking towards FX swaps

Finteum is still at the pre-seed stage of funding, with Nolan and Czapran working full-time at the company for about a year. During this year, Nolan estimates that the pair have talked with 40 banks about the model that they’re proposing, they built their first application and did a trial earlier this year involving four banks with a combined balance sheet of $2 trillion. 

“During that initial build phase we were focused on a number of different financial products, but especially repo. But at the same time, bank treasurers were telling us that they were quite interested in a payment versus payment or cash versus cash product because, along with repo, FX swaps is one of the main financial products that treasuries use to manage their cash positions. So for the last few months we’ve been taking the Corda app that we built to match orders and create a distributed trade repository for intraday repo and extending it to intraday FX swaps,” says Nolan.

The FX swaps market has hardly been at the forefront of technological innovation within the overall FX industry, as evidenced by the fact that much of this market is still traded over the phone. Indeed, Profit & Loss has written extensively about this fact, and how some firms are trying to update the infrastructure and technology around the trading of these products. Will blockchain technology prove to be a step too far for this part of the market then?

Charley Cooper, managing director at R3, argues that it is precisely this lack of existing technology that makes the FX swaps market suited to this type of innovation. 

Charley Cooper, R3

“I think it’s precisely because these markets are so archaic and so many of the systems and processes that they’re operating on are so dated that this opens up an opportunity for them to leapfrog potentially decades of legacy systems and move to something like blockchain in a way that greatly enhances the market compared to where it’s at today and addresses many of the frustrations that I think people in the FX market feel has not been addressed to date. We’re hearing a lot from clients about this and there’s definitely an appetite for this type of solution,” he says.

For example, Cooper points out that matching platforms in the FX market operate in milliseconds and so blockchain wouldn’t be necessary to improve their efficiency. By contrast, he says that the pre- and post-trade infrastructure in the market is less technologically advanced and doesn’t require the same level of low latency and therefore it could benefit from blockchain-based solutions.

The promise of a decentralised future

Looking ahead, the big challenge for Finteum is likely to be two-fold. Firstly, the firm has yet to connect its technology to all of the big banks, and this integration is going to be a big hurdle that it will need to clear. Secondly, it needs to get regulatory approval in order to ensure the possibility of adoption amongst the banks. Nolan says that he has been in conversation with regulators to ensure that they have no objections with Finteum’s approach, but recognises that this is not the same as regulatory approval, which is something that the firm is in the process of seeking.

Of course, one additional challenge could simply be that for all the talk about the need for more shared infrastructure in financial markets over the years, there still remains relatively few examples of it. In the FX industry, CLS remains perhaps the last instance of a shared infrastructure project that has made a significant impact on the market.

“I think the key difference here is that in the past, shared infrastructure projects were often directed in areas where they would only make marginal changes to the market. I think that blockchain has the ability to break down the role of various different intermediaries and the way in which markets work in such a profound way that it offers the promise of a shared future, which is very different to what any prior talk of shared infrastructure could address. So rather than tinkering around the edges, this is a significant enough change that I think people are taking it far more seriously than other efforts to introduce shared infrastructure,” responds Cooper.

He continues: “I would also say that discussions regarding shared infrastructure in the past never really addressed market structure so much as just the infrastructure piece itself. Now that may sound like the same thing, but what I’m talking about is the promise of a blockchain world where the marketplace is much more decentralised and there aren’t a limited number of companies that control the means through which business is done and therefore sit in a position of control over the market. I think the idea of this decentralised future holds a lot of promise that we didn’t see in past shared infrastructure projects.”

An interesting backdrop to this topic is the latest figures from the Bank for International Settlements’ (BIS) triennial survey of the FX market, which showed that the FX swaps market grew by 35% compared to the 2016 survey results, accounting for 49% of the overall daily turnover volume. The prominence of these products within the overall FX market suggests that attention needs to be given to how they trade and settle in order to improve this segment of the industry.

Or as Nolan puts it: “If you’re settling $3.2 trillion per day, and I think that CLS says that about $300 million of this is same day activity, then you have to look at the infrastructure that you’re using to settle all of this volume. On the same day side, we need new solutions so that it’s no longer the case that one bank is paying dollars to another and just hoping that they receive their euros at some point later in the day. We need atomic settlements for same day FX activity and it needs to be distributed so that we have a robust system that’s not reliant on one or two entities to run it.”

Galen Stops

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