Galen Stops explains how OTCXN is applying blockchain technology to help firms access wholesale liquidity.
OTCXN seeks to leverage its own proprietary blockchain technology to solve what its CEO and founder, Rosario Ingargiola, says is currently the biggest challenge in the FX market: accessing wholesale liquidity.
This challenge is caused by a credit gap in the market, according to Ingargiola, that has in turn occurred because the banks have been broadly reducing the number of firms that they are willing to extend credit to.
“The inability of firms to access tier one prime brokers is one of the main growth constraints on the FX market right now,” he insists. “And even if a firm has enough balance sheet to get a prime broker, because of the way the legal agreements are structured they actually need to have more than one, as the prime broker can shut them off with little or no warning.
“We’ve seen that happen post-SNB and that’s an ongoing risk for anyone relying on that credit line access to the market,” Ingargiola continues. “From my point of view, the credit situation is not getting better, in fact it’s worse than ever and it’s not going to change any time soon given the current trend towards de-risking at the banks and increased regulatory overheads.”
Arguably, however, the current trend of FX prime brokers (FXPBs) becoming more restrictive in who they will provide credit to is simply a market correction after a period of expansion and low fees amongst FXPB businesses [See” FXPB: Which Way is the Pendulum Swinging?”]. Perhaps those firms unable to access wholesale liquidity because they can’t get the credit required to do so don’t belong in the wholesale FX market?
This is a perspective that Ingargiola rejects emphatically.
“First of all, if you’re a market maker, how are you going to continue growing your business if the only people that you can trade with are as big and sophisticated as you?” he asks. “They need to be able to face a broader range of market participants than they currently can.
“On the other side, anyone in the market that is unable to access a PB directly and has to go through another intermediary is overpaying for market access,” Ingargiola adds. “This isn’t benefitting the industry, and frankly a lot of those clients have a credit profile that would make the PBs willing to deal with them, but they can’t because there are structural issues.”
P2P FX Trading
OTCXN’s solution to this access problem is to offer peer-to-peer (P2P) FX trading that utilises blockchain technology to try and eliminate counterparty risk when trading, thus allowing a much wider range of counterparties to face one another.
To use OTCXN’s P2P system, firms need to have an account with one of the custodian banks that is working with the firm. Prospective customers post collateral with the custodian bank, which then holds this in a manner that ensures it can’t be respent. The custodian bank then issues this collateral as a token on the OTCXN network, using a software system provided by OTCXN free of charge, via which the client can trade with a leverage ratio.
“Ultimately, this provides firms with a margin account, which means they can face anyone else on the network in a bilateral way,” says Ingargiola. “Once the network is aware of the assets and trading limits of both counterparties, they can trade directly with one another. Or firms can do this multilaterally over any existing platform. We’ve had discussions with platforms and ECNs about setting up a private pool just for OTCXN members where you can post resting orders or quotes and effectively be matched against any of the order activity, whether it be resting or quote driven on a many-to-many basis within those platforms.”
The fact that the real world collateral is held by the custodian banks and the tokenised versions of these assets can move around the OTCXN network in real-time should alleviate concerns about whether a counterparty has the assets to fund the trading they are doing. Physical settlement can then occur at the OTCXN member’s direction over traditional payment rails initiated by the member’s bank.
In addition, OTCXN is also setting up a loss reserve fund and an insurance backstop to try and further eliminate trading counterpart risk for firms trading on its network.
The loss reserve fund will initially be seeded with capital by OTCXN, with the amount that will be placed within the fund still to be determined at the time of writing. Once trading begins on the network, Ingargiola says that OTCXN will be putting a percentage of all the transaction fees it receives for network access into the reserve fund so that it will continue to grow. The insurance backstop is designed to cover any potential losses that exceed the loss reserve fund balance, and Ingargiola says the firm is talking to a number of “leading” underwriters to set this up.
In terms of monetising the offering, the company aims to enable any firm willing to come and make a price via its network the ability to do so for free, while charging what Ingargiola claims will be a “modest” fee on the taker side. Prices will vary between rolled and deliverable spot, with the latter incurring a higher fee.
Big Tent Approach
OTCXN claims that the solution it offers can be beneficial to a very wide range of market participants, including hedge funds, non-bank market markers, FXPBs, ECNs and aggregators, retail brokers, real money funds and corporates. But while the value of being able to connect, for example, a non-bank market maker and a retail broker is fairly obvious, it is perhaps less clear why corporates would be clamouring to use a system such as this.
But Jan Bak, chief commercial officer at OTCXN, insists that the model also provides material benefits for this segment of the market. “If you look at what we facilitate on our system, there are three main constituents: the custodians who hold all the assets, the collateral providers who put collateral in the system, and the traders,” he says. “Now the traders can be anyone who has activity in the FX market, they do not necessarily have to be active, they can instead be passive. So corporates can also feel the benefits of using this system to reduce cost and credit risk when they trade.”
Ingargiola adds: “I think that we can get the attention of this segment of the market through price competition. There are a handful of providers that underpin a lot of the cross-border payments and exchange for physical (EFP) type activity and in terms of price, the current floor in the market is around 25 basis points, while it would be illogical to send this flow to the custodian banks as they are unlikely to provide the most aggressive prices.
“So the fact that we can offer DMA and reduce costs can have a major impact for these firms,” he adds. “In fact, real money funds and some corporates have a fiduciary obligation to use the lowest cost solution, which could ultimately drive them towards our system.”
Both Ingargiola and Bak state that the company aims to include as many different types of FX market participants as possible in its network, and are at particular pains to emphasise that they are aiming to work with the FXPBs rather than disintermediate them.
Indeed, they argue that OTCXN can augment existing FXPB businesses because they will be able to keep their own clients and continue owning that relationship while also putting these clients on the network and enabling them to face counterparties that they wouldn’t normally be able to because of credit considerations.
This involves working through the mechanics of enabling PBs, which operate on a T+2 basis, to operate on its T+0 framework. The current solution proposed by the company is to pay T+0 and get paid T+2, which Ingargiola and Bak point out would actually take some risk off the banks.
Despite the potential benefits touted by Ingargiola and Bak, it is still not a finished product. At the time of writing there are a number of moving parts that require more clarity in order to determine the ultimate long-term viability of the offering.
Much, for example, depends on the requirements imposed by the insurance underwriters. Firstly, the underwriters could impose costs on the firm for providing the insurance that has to be passed down to the customers, reducing or even potentially negating the cost benefits of the service.
Secondly, the underwriters will help determine how much of its own capital the company will have to initially put into the loss reserve fund, the legal structure of which cannot be fully defined until these underwriters have their say. And thirdly, they will also have an input regarding how the leverage ratio for clients on the network will be calculated once their assets are tokenised.
As the gatekeepers of the system and the holders of the client assets, getting the custodian banks on board is also critical for success. Not only that but, while having the big name custodian banks onboard would be a major boost, smaller FX market participants are less likely to have accounts with them. Therefore, it will be crucial for the firm to get an appropriate mix of custodian banks to buy into what it’s doing.
OTCXN will only support spot FX products at its launch, but there are plans to expand into the forwards, swaps and NDF markets next year, which also present new challenges. These challenges are mainly on the legal side, because it would have to register as a Swap Execution Facility (SEF) in the US, or acquire a SEF, in order to facilitate this type of institutional trading.
None of these challenges are insurmountable though, and OTCXN is currently in pre-production and aiming to complete the first trades on its network by the end of September.
“Our aim is just to make the market more efficient than it is today, both on the credit and settlement side. We know that the need is there in the FX market today, and what we’re trying to do is deliver efficiencies to this market that are enabled by digital solutions,” explains Bak.