FX on the Blockchain
R Tamara de Silva
There has been a lot of scrutiny and criticism of centralized cryptocurrency exchanges (CEXs) in the wake of FTX and other, if less spectacular centralized platform failures. Much of this criticism, as it concerns issues of opacity, and the custodial functions of CEXs as this author has written about here and here-are fairly leveled. What the history of the financial markets shows us is that crises can be salutary in that they can identify the strongest participants or even birth better ideas.
Perhaps the next better idea may come from decentralized finance or DeFi, and it may affect and alter the largest trading market of all-the $7.5 trillion a day foreign exchange (FX) trading market. FX on the blockchain could offer instant settlement and substantially lower costs for cross-border payments and exchange for people and businesses around the world.
DeFi
Decentralized finance is a new paradigm that allows for the trading, lending and borrowing functions of traditional finance to take place on blockchain networks, without the need for the intermediaries present in the financial world. Unlike the opacity often present in centralized platforms, DeFi offers transparency and This has always been one of the largest promises of blockchain technology and this paper discusses one use that may potentially dwarf others and change the world of Forex trading.
Decentralized crypto exchanges, (DEXs) have gained in volume since the fall of FTX-dramatically so.
The benefits of decentralized exchanges are that they eliminate the need for an intermediary and allow users to keep custody of their own digital assets and cryptocurrency. Without having to give up custody of their keys, users of DEXs do not have to worry about the problems that plague many centralized crypto exchanges involving the safeguarding and segregation of user assets from the that of the CEX or having their assets commingled with those of other users. The problem of losing cryptocurrency due to the adage of “not your keys not your crypto,” is not an issue.
Transactions on DEXs allow for what is called peer-to-peer (P2P) trading in a marketplace that links buyers and sellers. Buying and selling on DEXs happens through the deployment of smart contracts (computer code that is self executing when certain conditions are met).
Decentralized exchanges are built on top of blockchain networks. DEXs make money by charging fees on the transactions, much like traditional regulated derivatives and securities exchanges.
FX Market
Like the cryptocurrency market, trade in the FX market occurs 24/7 and all around the world on numerous platforms. But there are risk factors and according to the Bank of International Settlements (BIS), one such risk factor is settlement risk.
In the BIS’s last quarterly review report, it was stated that a third of all FX trading is affected by settlement risk and given the size of the global FX market, this is a significant risk with potential systemic impact.[i] FX settlement risk refers to the possibility that one party in a currency trade may not fulfill their obligation to deliver the agreed-upon currency, which can lead to substantial losses for market participants and potentially have systemic implications. On any given day this risk may affect $2.2 trillion worth of deliverable FX trade. This is where DeFi may offer a solution.
Order Books v AMMs
FX dealers are starting to show interest in the potential for automated market-making (AMM) protocols in foreign exchange to enable decentralized trading and prompt settlement.
An order book is a digital record of buy and sell orders for a particular security or instrument that are categorized by their corresponding price levels. Users will place an order to buy or sell and wait for it to be filled by being matched with a opposing order. These order books are used by virtually all exchanges for a variety of assets, such as stocks, bonds, currencies, and cryptocurrencies.
AMMs by contrast, operate by processing all transactions automatically, without the need for third-party buy/sell requests. This is done by their utilization of liquidity pools in conjunction with an algorithm that establishes token prices by analyzing the fluctuating ratio of supplied tokens.
AMMs are a recent innovation that has emerged from the world of cryptocurrency and distributed ledger technology, and it has the potential to replace central limit order books.
Uniswap, a decentralized exchange, pioneered the concept, utilizing an algorithm to match buyers and sellers instead of an order book. participate, users deposit their assets into currency-specific pools, and the algorithm determines the price based on volumes and the relative weights of the individual pools as they change. Their whitepaper on the topic can be read here.
If this concept will work in FX settlement, it will be exciting to see its application to reducing costs and intermediaries in other traded markets.
R Tamara de Silva