There have been numerous attempts in the past to create buy side to buy side matching pools for FX, with very limited success. FX HedgePool is the latest venture seeking to do this and, as the company edges towards launch, Galen Stops takes a look at what it is doing differently.
In April, Profit & Loss reported on the planned launch of a new buy side to buy side matching platform, FX HedgePool, which is designed specifically for firms executing passive FX hedging programs.
Now, it has long been the dream of many FX market participants to create a trading venue where buy side firms, and in particular large asset managers, can go to match up their FX trades directly, without the need for a bank or another intermediary to sit between them. On paper, this makes sense, as it would reduce costs for these buy side firms while also eliminating potential market impact.
Thus far, however, the reality of this prospect has proven tricky, to say the least.
Profit & Loss managing editor, Colin Lambert, has opined (at length) on the problems with peer-to-peer matching in FX, but amongst the most intractable are the fact that a lot of the flows in each direction simply won’t match up to a degree that would be significantly useful – both in terms of the size and currencies being traded – but also when each firm needs to execute their trades. Indeed, Lambert decries those believing that asset managers and corporates can actually match off against one another as living in a “Narnia world”.
But Jay Moore, CEO of FX HedgePool, believes he – along with his co-founders Richard Leader and Emin Tatosian – can succeed in creating an effective buy side-only FX matching platform where others have failed. The reason for this, he says, is that the predecessors that have gone before them have, quite simply, been focusing on the wrong flow.
“The problem has been that everyone is focused on spot FX, and to a degree that makes sense because spot is the most direct route to go down. You don’t have to deal with tenor alignment or the credit side of things, certainly not to the extent that you do in the forwards space. That said, the issue with spot is that flows tend to be correlated, and therefore getting meaningful, repeatable hit rates on a consistent basis is nearly impossible,” Moore explains.
He estimates that in a spot FX peer-to-peer matching environment, a 20-30% matching rate would probably constitute a huge success – and from a savings perspective it could be – but that this matching rate is unlikely to remain consistent. So, while a firm could match off 30% of its trades one day, it might only match 3% the next day, leaving them frustrated and unable to depend on such a platform for consistent execution.
Separating credit and liquidity
This is why FX HedgePool is, instead, only designed for firms using passive FX hedging programs, meaning that they have a scheduled, predictable and repeatable need for execution.
Traditionally, buy side firms have gone to the banks for their hedging needs because their liquidity has been tied to their credit providers. So, between the banks that they have relationships with, these buy side firms pick the best price, transfer the risk to the bank that then needs to offset that somewhere – either from internally warehoused risk or from another bank or client. But this takes effort and creates market risk, it requires traders and risk management teams, technology to support this activity, and connectivity to multibank platforms – all of which contribute costs to what is generally a fairly low margin business – costs that are then passed onto the buy side firms.
“Hedgers often know who is trading in the opposite direction, they just don’t have a mechanism to discover and connect to each other”
Moore specifically points out, “We are not trying to push out or disintermediate the banks. Quite the opposite. Because FX HedgePool is solving for monthly roll liquidity only, the buy side may be able to actually strengthen trading relationships. FX HedgePool allows traders on both sides to focus on the higher value intra-month activity, while offering banks the ability to substitute the risks and costs associated with rolls for predictable revenue linked to more optimal balance sheet usage.”
While FX HedgePool’s primary mission is to create a buy side liquidity pool, its founders are also aware of the credit requirements and preferences of its members. As such, they have developed, alongside Standard Chartered Bank, what Moore describes as a unique, yet low touch multilateral credit model.
“We are delighted to be partnering with a global institution of Standard Chartered Bank’s calibre to help bring FX HedgePool to life. Their insights along with their quantitative, yet innovative approach to balance sheet management and credit facilitation, have opened doors that we strongly believe will allow us to deliver a highly unique and valued solution,” he says.
By separating the credit elements of what banks provide from the liquidity provision and allowing these buy side firms to match with liquidity from their peers, FX HedgePool seeks to significantly reduce costs while eliminating any potential for market impact. Because the platform is only for passively hedged FX flows, Moore claims that, with curation, matching rates upwards of 80% are not unrealistic.
“I’ve been in the hedging space for 20 years now and I’ve seen the potential offsets that are available amongst institutional hedgers. And in fact, the hedgers often know who is trading in the opposite direction, they just don’t have a mechanism to discover and connect to each other,” he says.
For this reason, FX HedgePool will be a membership-based community of peers with specific acceptance criteria and new member referral incentives with guidance from its Member Advisory Council, which will provide buy side perspectives and insights with the aim of further strengthening the pool.
Moore explains: “What we’ve created is a streamlined, simple utility with a proprietary netting engine that allows accepted participants to privately and securely contribute their positions to a community of like-purpose peers for liquidity matching. It’s not about the number of participants, but the right participation with the right positions that lead to recurring and sustainable savings.”
Andrew Maack, global head of FX trading at Vanguard, is confirmed as a participant in FX HedgePool’s Member Advisory Council and he argues that, even if the platform falls well short of an 80%–plus matching rate, it can still prove significantly valuable for buy side firms.
“The numbers that are required to hedge portfolios are growing significant, so even if there’s only a 40% or 50% match–off rate, that can be hundreds of billions of dollars in the hedged market. So it doesn’t take a tremendous amount of actual matching to make it worthwhile. If I could reduce the amount of flow that I need to go to the market with by $100 billion, that’s significant and it doesn’t take a high percentage of matching to achieve that,” he says.
Despite this, FX HedgePool will need to confront the same chicken and egg conundrum facing any new trading platform, namely how does it build up enough flows in each direction to reach a critical mass whereby it can start demonstrating real value to buy side firms?
“The key has been to find early adopters and forward-thinking trading desks who understand the costs and liquidity challenges better than anyone. Of course, the benefits of using a new technology have to be weighed against the costs of onboarding, which is why we’ve made the user experience a top priority with a focus on streamlining the integration while introducing operational enhancements to what many consider to be a burdensome process for their trading teams. This combination has been very well received. We’re currently in discussions with a number of large institutions that hedge in the billions each month – and now have the exciting task and ability to curate the book around a few anchor tenants to create a substantial base with high coverage when we launch in the fall,” says Moore.
“This is interesting and unique because it focuses on the swaps market, and we really haven’t seen anything around the potential matching of offsetting flows in this space before”
Under-served part of FX
The FX HedgePool team are at pains to emphasise the work that has gone into making the onboarding process as smooth and easy as possible, which will be important given that the client base that they’re targeting will invariably be subjecting the firm to a rigorous due diligence process.
“Co-founding the firm with Emin and Richard underscores the critical importance we’ve placed on scalable and resilient technology. Each of them brings more than 10 years’ financial markets technology expertise. Since 2008, they have worked together on numerous transactional platforms – predominantly in e-FX – for leading institutions globally. In stewarding the buildout of FX HedgePool, they’ve led the development of a deliberately modern, microservices-based approach – marrying the most appropriate and up-to-date technology with the timeless considerations of operational robustness, data integrity, privacy and security,” says Moore.
There is also a broader challenge here that exists for any startup looking to work with large buy side firms – the sell-cycle for this client segment is notoriously long, while some clients are reluctant about committing to working with startups until they are completely sure about the long-term viability of the firm.
Maack agrees that this is a challenge for smaller firms, adding that Vanguard takes the vetting process for such firms very seriously.
“We have a whole team that goes out and conducts tests, looks at the pipes, examines the contingency plans and conducts a thorough analysis, which includes a look at the financials of the company in question. Because the last thing that we want to do is commit a significant amount of flow to something that isn’t stable; we owe it to our shareholders to make sure that we do our due diligence regarding any firm that we work with,” he says.
This challenge is certainly not insurmountable though, and Maack himself is enthusiastic about the potential of FX HedgePool. He says that, as the head of FX execution, finding alternative sources of liquidity whereby market impact can be potentially be reduced and transaction costs lowered is always of interest. But more specifically, he sees this platform addressing a previously under-served part of the FX market.
“This is interesting and unique because it focuses on the swaps market, and we really haven’t seen anything around the potential matching of offsetting flows in this space before. It’s something that I’ve been talking about for five years now, but this is the first product that I’ve seen that I’m really excited about,” he says.
Maack adds: “This idea and the way that the team there is thinking about this space is definitely something that would be good for markets, Ultimately, it would be good for passive hedgers or people looking to hedge portfolios consistently, and it’s probably one of the best ideas that I’ve seen in the past five years in FX.”