Harnessing Passive Liquidity: A Win-Win using algos to create pools of natural liquidity

By Jay Moore, Founder & CEO of FX HedgePool

In the world of foreign exchange, the multitude of participants around the globe represent a wide range of business types, investment styles, and trading requirements. Tier 1 banks, regional banks, corporate treasuries, asset managers, asset owners, overlay managers and even outsourced trading desks each have particular procedures and approaches to execution.

The FX industry is a highly liquid, transparent, and efficient market when it comes to spot; yet the FX swaps market endures myriad inefficiencies. But that hasn’t stopped growth in the market. The proportion of FX swaps have grown to account for nearly half of overall FX market turnover. According to the 2019 Bank for International Settlements’ Triennial Central Bank Survey of FX & OTC Derivatives Markets, FX swaps volume grew over the three-year period by nearly 35%, reaching an average of $3.2 trillion transacted each day.

The largest driver of growth in the FX swaps market is related to the demand for passively hedged investment strategies – led by asset managers and asset owners. These hedging programs are mandated under rules-based investment guidelines to maintain consistent protection against the implicit effects of foreign exchange risks in their portfolios/funds. Most hedging programs are implemented using short dated (1- to 3-month tenor) swaps that require being rolled as each “hedge” nears expiration. Maintaining a consistent hedge results in a scheduled trading pattern with currency pair, size and direction being highly predictable. This trading pattern has led to inefficiencies that may be, at least partially, addressed by the use of some form of algorithmic trading model.

Part of the FX swaps market’s inefficiencies lie within the nature of the OTC market construct. Since an FX swap involves two parties agreeing to the simultaneous exchange of two currencies at a specified point in the future, there’s the implicit and critical presence of credit risk. For two parties to commit to a future exchange of currencies, there must be assurances that both parties will fulfill their obligations over that period. These assurances are typically satisfied with ISDAs and collateral arrangements, which create a natural link between credit and liquidity. The efforts to on-board and manage a panel of banks to ensure ample liquidity inherently force credit concentration among a relatively few. Herein lies the challenge.

Passive rolls are highly predictable and are typically scheduled on monthly or quarterly cycles of swap execution. The regularity of these trades creates not only an ongoing resource drag and operational risks, but introduce concerns around market footprint. The prescribed nature of passive hedges offers the market a clear window into the trade details (timing, size and direction), meaning there’s a significant potential for others to game the price of the market to the detriment of the passive hedger who is simply following an investment mandate.

Moreover, the continued growth of the passive hedging market strongly suggests that there is a broad community of peers with the same intentions and objections: to execute their swaps with as little friction as possible to the benefit of their investors. Leaving relatively few banks at the nexus of liquidity prohibits the natural matching of offsetting market participants as until recently there has not been a mechanism for discovering each other. This is where a passive hedge matching utility such as FX HedgePool comes into focus.

The algo of alignment

Technology is driving necessary and beneficial change – and algos sit at the heart of this industry’s evolution, operating as the engine creating pools of liquidity that are improving workflows and effecting cost efficiencies for a wide range of participants through matching offsetting flow.

When one thinks of algos, it is often within the context of high-speed execution. But beyond this, an algo can be the engine that creates a natural liquidity pool for a highly specialized, curated group of participants such as passive hedgers. As with any algo, there must be “rules of the road” to prevent toxic or disruptive flow. Passive hedging swaps – particularly the predictable rolls required to maintain rules-based hedging policies – are, by definition, non-toxic “pure” liquidity, making this segment of the industry an ideal target for a new way of transacting in this trillion-dollar market.

Liquidity pools can be curated based on trade types, pairs, direction, and volumes. Aligning passive hedgers to provide liquidity directly to each other (via the medium of each one’s desired credit provider bank) eliminates unnecessary friction while creating an ecosystem for consistent and dependable participation. The trade cycle itself can be developed with a set of parameters and timing requirements – catering to the needs of members who must prepare for each roll cycle with adequate time to manage residual balances.

While a matching algorithm likely won’t net everything, matches that do occur reduce the amount that goes to the open market for trading. The more a trader can reduce the need to send low value, high volume passive swap trades to the market, the more efficiency can be created. By curating a pool that aligns the right flow from the right source at the right time, an algo can go on to the business of finding the offset that eliminates market impact, and helps the client realize recurring and sustainable savings.

Unbundling liquidity from credit

As the buy side increasingly focuses on costs and quality of execution, the ability to disentangle liquidity from credit becomes a game changer. Achieving best execution can be a challenge, particularly when the best price showing may not be from a liquidity provider that a firm has credit with, which limits its ability to access fair and sustainable pricing whilst posing a credit utilization imbalance. The optimization comes when credit can be disentangled from pricing – and that pricing can come from anywhere, including other passive hedgers with aligned objectives.

Separate from the sourcing of liquidity, credit can be optimized among a panel of high credit quality banks – that may or may not have formed part of a firm’s regular roster. By allowing banks to separate the requirement to compete on price from the ability to provide credit as a standalone FX service, balance sheets can be optimized, revenues stabilized, and relationships enhanced to create more value.

Moreover, an FX swaps algo – where passive hedgers can match liquidity independently amongst each other – can free up balance sheet usage for higher value trading; while underutilized banks can deploy balance sheet to enhance revenues and support non-alpha generating trades (such as the passive rolls that originating in hedging programs). Effectively, this breaks the chain that links liquidity and credit – and that also creates inefficiencies. If you can achieve that, you can create more optimal dealing conditions for both buy and sell sides.

Nature of the flow vs nature of the institution

What is a peer really? Both the buy and sell sides can be guilty of defining their respective worlds in an ‘us vs them’ kind of way. Much like a bank that internalizes its client flow, this netting phenomenon can happen at micro levels. An asset manager can internalize to the extent that they compress their book across funds as a bank does across its clients, while an overlay manager can do so across its mandates.

For buy side firms that have scheduled, predictable, and repeatable needs each month, their challenges are less around the spread they pay than the risk of market impact, tracking error, and general operational inefficiencies. This cries out for more efficient methods of trading these passive hedges, and an insulated, unique liquidity pool that serves this particular sector has the opportunity to make life easier, and cheaper, for a large swathe of users.

The traditional buy side players such as asset owners and asset managers are natural candidates for such a pool – as they have the scale, volume, and in many cases the fiduciary responsibilities that accompany best execution requirements. And buy side trading desks have a lot of different stakeholders to satisfy – whether it is the underlying investors, the relative performance to a benchmark, their internal management teams, plan beneficiaries, or regulators. Hence the more efficient they can become, the more competitive, cost effective and thus responsible they can be. Their ability to match off flows, in any way they can, reduces the amount that a participant has to transact in the open market.

The same holds true for overlay managers and outsourced trading desks that need to differentiate while also providing value. Identifying internal offsets across independent mandates that can be prioritized before they go out the door – by netting inside a dedicated pool – reduces the costs across all clients/mandates. Having new tools in the shed to compete better – and matching off against a network of peers’ offsetting flow – can be a highly valuable and competitively differentiating tool.

Meanwhile, custodian banks who support their clients’ passive hedging needs could be finding natural offsets with institutional peers for these monthly passive flows. This would not only remove the need to pre-hedge large flows, but also bring interbank spreads and brokerage costs down so they can manage the book in a more predictable and sustainable way.

A passive liquidity pool can be a win-win for the traditional sell side as well. For banks that are able to participate as credit providers, there is opportunity to capture market share and monetize their balance sheet without taking on principal market risk. The flow is predictable, occurring at month- and quarter-ends. The monthly rolls can be burdensome, low margin, high risk trades for banks – which makes the notion of carving out a portion of existing credit lines for a fee-based (annuity-like) revenue stream appealing.

Therefore, matching not only provides larger banks with an opportunity to earn fee-based revenues without carrying market risk – but smaller banks also have a chance to win business that they may not be seeing. If you can eliminate the market risk associated with FX swaps through a matching utility, you can eliminate a lot of the costs – people, technology, risk, compliance – that is priced into the spread. What you’re left with is credit and settlement as a service. So, if passive hedging liquidity can be packaged with credit provided by banks, then the banks get a consistent, dependable revenue stream and the hedgers themselves get execution at stable, highly transparent prices.

Ultimately, the term peer-to-peer isn’t as cut and dried as it once appeared. With an algo sitting at the heart of a dedicated pool that matches regular and predictable flow, passive hedgers can offset as much as possible between member firms in a common, safe pool of pure, non-toxic liquidity. Perhaps most importantly, creating a central exchange for the matching of FX swaps can eliminate unnecessary friction, costs, and risks for all sides of the market – for a true win-win proposition.