The Seven Defining Opportunities in “On-Chain” FX
By: Alex McDougall (Stablecorp, CEO)
With: Paul Kremsky (Cumberland, Head of Global BD) and Nick Philpott (Zodia Markets, COO)
Currencies are the tectonic plates of the financial system, rooted at the base of every trade and transaction. Currencies — in their many forms over time — have underpinned our ability to transact in the real economy and in financial markets. With many different people, companies, central banks, and other government entities having many different reasons to exchange local vs foreign currencies, the foreign exchange (FX) market has grown and evolved in tandem. Today, the FX market is the largest financial market in the world, facilitating over $7.5 Tn in daily volumes and with 70% of that traded directly Over the Counter.
However, while the FX market has become the largest, most liquid market in the world, it continues to run on among the most inefficient and antiquated financial infrastructure in the world, relying on the correspondent banking and Real-Time Gross Settlement (“RTGS”) systems. To illustrate this point, although cross-border flows represent only 17% of total transaction values, they represent 27% of all global transaction fees (~$200bn), which ultimately benefits banks and other third party intermediaries.
Part 1: Digging Into the Four Key Challenges of the FX Market Today
There are four overarching challenges associated with the FX market today: settlement risk, costs of the correspondent banking system, global banking and RTGS hours, and lack of direct access to FX markets.
Challenge #1: Settlement Risk
FX settlement risk refers to the risk of one counterparty paying out a currency while not receiving the corresponding currency it bought in exchange. It is also referred to as “Herstatt” risk after Germany’s Herstatt Bank famously shut down at the end of the day in 1974 with hundreds of millions in USD FX transactions partially settled on its books that it had yet to send during US banking hours. The global counterparties who were waiting for Herstatt to play its role as a correspondent bank and settle their end of an FX trade were left with a total loss of principal. In the immediate aftermath, global transaction flows dropped precipitously as the reality and contagion of the settlement risk became apparent. Most modern financial exchanges in other asset classes manage this issue with central clearinghouses (“CCH”) that minimize settlement risk by providing a common, central counterparty (although CCHs are not without their issues). Despite the 1974 Herstatt crisis, in 1997, 85% of FX transactions were still settled directly using the correspondent banking system. By 2013, however, this had dropped to only 13% due to the introduction of a system known as the Continuously Linked Settlement (“CLS”) system.
The CLS system acted as a global CCH for FX and adopting a “payment versus payment” system, effectively managing settlement risk similar to other markets. CLS is plugged into the settlement rails of 18 central banks and essentially only releases corresponding payment one way once a payment is received the other way. However, CLS has its own challenges:
1. It is only functional in the top 18 currencies, which limits its utility among the growing relevance of emerging market (EM) currencies.
2. It is very infrastructurally cumbersome to operate and, as a result, only the 70 largest financial institutions globally have direct access to the system, leading to a “have” and “have not” scenario in global FX among those facilitating transactions.
3. This infrastructure is also expensive with CLS earning GBP 250mm in revenue in 2022, which translates into 0.13 per mm settled.
4. Because it is inextricably linked to the myriad of global banking systems, it is unable to effectively innovate on its own.
Another, slightly different form of Settlement Risk arises from a phenomenon we’d mentioned in the introduction, a significant portion of securities traded globally involve an FX transaction at some stage of the transaction. Nearly 20% of U.S. securities ($24.9Tn) are owned outside of the U.S. By itself this doesn’t pose an issue, but in May 2024, U.S. and Canadian securities settlement will move to T+1. Given approximately 50% of the FX market settles T+1 or T+2, there is a risk of not having the proper currency required to settle the securities transactions. While this may be able to be mitigated with a futures transaction, the more a treasurer needs to abstract away the true transaction with derivatives to manage the underlying settlement delay the more cost and complexity there is.
Challenge #2: Costs of the Correspondent Banking System
In addition to settlement risk, the costs and inefficiencies associated with the correspondent banking system revolve around the many intermediaries required to facilitate FX settlement. Except in rare circumstances, every transaction that takes place in a certain currency involves a bank in the home country of that currency. So when a Singapore office of an Australian bank uses JPY to buy USD from the London office of a Swiss bank, six banks are involved in the transfer and settlement of those currencies. In the example below from Zodia Markets, a THB vs IDR transaction from Thailand to Indonesia goes through six institutions in three different time zones, costs 4.3% in total transaction fees, and takes several days to settle. This is also at a time when correspondent banking relationships are becoming harder for EM banks to maintain with established banks lowering their risk tolerances.
Several structures have emerged to combat the challenges of moving fiat across borders, but the most successful payment businesses simply…don’t. Paypal, Wise, and several other global payment and fintech companies have adopted a strategy of opening bank accounts in 60–70 countries, holding currency balances in each, crediting their users with a currency “transaction” without actually moving any money across borders, and then periodically rebalancing. While this model functionally works and can provide some level of increased efficiency, there are fundamental flaws with it as well:
1. The infrastructure to manage such a global setup is enormous and expensive.
2. If there are major macro events that lead to unpredictable currency flows, the cost to move money around the globe at scale to meet demand will far outstrip what these companies are charging in spreads and fees.
3. This model does not work for true scale transactions.
Challenge #3: Global Banking and Real Time Gross Settlement Hours / Timezones
It’s so simple that it is often overlooked — being able to trigger an actual transaction in “real-time” in another, foreign jurisdiction can be extremely challenging. The banking hours of the currencies’ countries need to overlap, and the notification periods for each counterparty to notify their bankers (or CLS) to execute a payment can be extremely tight and inconvenient. For example, the CAD and JPY banking systems overlap for fewer than 5 hours a day, not to mention the added cut-off times meant to ensure proper instructions are received and sent. After the G20 endorsed a roadmap to improve cross border payments in October 2020, a key priority included extending operating hours for RTGS. Unfortunately, in a report nearly 2 years later, the BIS called out that “an extension of RTGS operating hours is likely to require technical changes to existing systems, platforms and infrastructures that will need to be carefully planned and deployed. Staffing needs could also increase in order to cover extended operating hours, and many of the associated costs may persist over time.” That sounds like billions of dollars of co-ordination cost and years to implement.
Challenge #4: Lack of Direct Access to FX Markets
If all of this talk of intermediary banks and T+2 settlement seems bizarre, it’s because the consumer is typically insulated from it. If a Canadian travels to the US and uses their debit card to buy a coffee, there is an FX transaction on the back end, but the consumer doesn’t have to think about it as an intermediary handles it for them and bakes in a substantial spread. The largest institutions in the world pays 1–3 pips for FX trades on major currencies (.01 — .03%), while the average user pays 3–5% (+100x) for a trade a fraction of the size. Even with extreme diligence and preparation, there are no executable avenues for individuals to access reasonably priced FX as the margins for intermediaries are enormous. Even a well-informed and conscientious user needs a foreign currency bank account to hold foreign currency, a foreign currency credit card to spend foreign currency, and the willingness to undertake expensive wire transfers at both ends of the transaction to settle. Alternatively, they can go to physical money exchanges (also while paying tremendous spreads) and carry cash.
Part 2: Fully Digital, Blockchain-Powered Money Can Fix This, Three Reasons Why it Hasn’t Yet
Digital assets have the ability to settle instantly, cost fractions of a cent per transaction, operate 24/7 across time zones, and are accessible to anyone with an internet connection. So why hasn’t blockchain overtaken the FX and payments markets? 3 reasons
Reason #1: Lack of Non-USD Denominated Digital Assets and On-Chain FX Markets
60% of the global currency reserves are USD, but 99% of current on-chain digital money is USD denominated. And while the on-chain USD denominated market continues to grow, non-USD digital money is slowly emerging, especially as a greater number of use cases are being identified and accepted. Stablecorp has designed QCAD to bring the Canadian dollar on-chain, while Circle has launched a Euro-denominated stablecoin (EUROC) and StraitsX has introduced a Singapore dollar stablecoin (XSGD). The Global Stablecoin Standard group has also brought together a number of top quality issuers from around the world to help rectify this gap and align on global best practices.
Global trading leader Cumberland has identified non-USD stablecoins as one of the largest growth areas and is working with global exchanges like Zodia Markets to develop liquidity for these markets.
Further, groups like Shift Markets and their Cables product on Avalanche are pricing on-chain FX pairs using spot fiat oracles and off-chain liquidity, and FX-denominated pairs on Decentralized Exchanges like Uniswap, Phoenix by Ellipsis Labs, and Stellar DEX are becoming more prevalent. At the same time, L1 and L2 blockchains are becoming increasingly optimized to facilitate on-chain FX trading and payments use cases. With low-cost fees and sub-second finality, some of these chains and L2s like Avalanche, Stellar, Solana and Arbitrum are able to make trading even a few dollars cost effective.
FX has also made its way into synthetic leverage DeFi platforms like gTrade and Tigris on Arbitrum as well, with traders able to access synthetic levered exposure to FX pairs like USD / CAD and vastly enhancing hedging ability. These various ecosystems are also identifying non-USD digital money and on-chain FX / payments as key drivers of growth and are actively fostering the proliferation of these use cases.
Reason #2: Lack of Connected / Embedded On-Off Ramps and UX
Even if there was strong liquidity for non-USD digital money, in order to bring real value to consumers, “real world functionality” remains a missing link. Even if you can transact instantly for fractions of the cost into a digital representation of your currency, if you can’t pay rent or buy a cup of coffee with it, it’s not that useful. What’s more, current on-chain wallet and other infrastructure remains clunky and difficult to use from a mass adoption perspective. This places a high importance on API-based on-off ramps and self-contained apps that utilize multi-currency stablecoins. Below shows Finoo’s platform to allow Brazilian students to send money from BRL to QCAD and pay tuition in Canada all within one app, powered by blockchain.
Reason #3: Lack of Regulatory Harmonization and Clarity
The age-old challenge with new technology lies with ensuring a conducive and consistent regulatory environment exists to enable mainstream adoption. In this respect, the digital asset world has struggled in particular with digital money, which includes “stablecoins”. That moniker itself is a good place to start as it is a particular challenge for regulators given the famous instability of certain of these coins like UST. While a full deep dive into the various stability mechanisms of digital assets is beyond the scope of this article, broadly they can be divided into:
1. Digital assets which derive their theoretical stability either from issuance and redemption algorithms, crypto collateral or fractional reserve systems, or
2. Digital Money equivalents that are fully reserved 1:1 with traditional Cash or Cash Equivalents in the same currency as the digital money.
While there have been temporary issues associated with the latter “losing their peg” in response to macro issues, the majority of stability issues have been with the former. From a regulatory perspective it is important to separate the two types. The majority of “stablecoin” legislation in process around the world has focused on the latter digital money coins with many explicitly banning the former or treating them similarly to other digital assets like BTC or ETH.
This is not to say that there is yet clarity on fully reserve backed stablecoins, with a variety of views still being debated about whether these should be regulated:
1. Under a securities law type framework similar to a debt security or
2. As a payment instrument more akin to a stored value gift card or e-money or even
3. Left explicitly unregulated, as is the case with spot foreign exchange in most jurisdictions
In the EU, UK, Singapore and some other jurisdictions there is a close parallel view with the concept of eMoney, which developed out of the payment cards businesses of the late 1990s and early 2000s. In this vein, the more advanced legislations including MiCA are leaning towards the e-money approach, while other jurisdictions remain murkier with legislation still under discussion.
That said, while this specific digital money topic remains at the top of the agenda for regulators globally, there is enough clarity to build and launch sophisticated structures and adoption.
Part 3: The Seven Defining Opportunities in On-Chain FX
Let’s get the glaringly obvious one out of the way:
Opportunity #1: Just So. So. So. Much Cheaper for Individuals and Many Small Businesses
A fully built, liquid, connected on-chain FX and payment system drastically reduces FX costs for a significant portion of the market. This means a direct cost reduction in terms of spread, as well as instant settlement and equal access for institutions, businesses, and individuals.
Direct access to DEX’s where on-chain FX is traded is a huge plus for efficiency and transparency as well. As mentioned earlier, generally the total cost of FX in a transaction (particularly a payment transaction) is a combination of a fee and a spread. For “major” currency pairs like USD / CAD the total cost can be 3–5%, for “exotic” currency pairs that can easily get into the 7–10% range quickly. Compare this with the majority of FX pairs on Uniswap v3 (including QCAD / USDC), which have fee levels of 0.05%. Further with Uniswap’s V3’s Concentrated Liquidity, it is possible to do relatively large trades, which only move the market by 0.1% to 0.2%, leading to an all in cost of 0.15–0.25%, again roughly ~90% lower than fiat FX. Further, advanced users can actually contribute liquidity to these DEXs and earn a share of those trading fees, although this does come with risks.
As these DEX’s can be plugged directly into the back end of payment and on-off ramp applications, the possibilities for highly efficient retail cross-border payment structures emerge like the Finoo example below.
Consider, a Brazilian student coming to Canada and looking to pay tuition there. Historically this would involve a laborious process of either setting up a Canadian bank account as a foreign resident or paying via a wire transfer in BRL incurring 7–8% FX fees to forcibly convert to CAD. Platforms like Finoo combine on-chain FX with on-off ramps in a single application. The student can KYC, convert BRL to QCAD for ~90% lower FX fees, and then pay university tuition in Canada right from QCAD using seamless integration with domestic rails. The Finoo app provides the wallet, access to the FX rails, and the payment capabilities all right within the application. This isn’t the distant future: it will be live in Q3 2023.
Opportunity #2: New Life for Institutional and Mid-Tier Digital Asset Exchanges
Let’s face it. The competition for the BTC / USDT trade is incredibly intense and there are enormous international exchanges that are going to win that business 9 times out of 10, sometimes without gold-plated regulatory processes. For exchanges in highly regulated jurisdictions catering to highly institutional counterparties, or those exchanges looking for different niches in which to compete, on-chain FX can be a highly lucrative specialization. There is a built-in advantage over existing FX shops due to digital asset capabilities. It also grants a differentiated value proposition to compete on a jurisdiction- by-jurisdiction basis if you can offer functionality and on-off ramps in domestic currency as well as payment and FX functionality connected in with “traditional” digital asset exchange functionality. Finally, it puts exchanges offering this functionality at the front end of a massive growth wave as the payment and FX space “tips” and updates all at once. Catching crypto trends and waves is one thing that can be lucrative in the short term, FX is universal and will be lucrative in the longest of terms.
Opportunity #3: Sizable, Accessible Arbitrage Opportunities for Hedge Funds and Traders
Arbitrageurs make the world turn. They ensure pricing parity and generally are the semi-hidden Wizards of Oz of financial markets. Whenever you need some hand-waving done on a financial structure, you can safely assume that if there is mispricing, arbitrageurs somewhere will find it and fix it.
In the digital asset space in particular, arbitrage has taken the form of:
1. Currency premiums on Bitcoin (the “Kim-Chi” premium in Korea, or the “Sake” premium in Japan)
2. The basis trade between spot and future BTC price and,
3. Arbitrage between different crypto exchanges
These arbitrage trades almost universally sprung up when crypto ran into some aspect of traditional finance that didn’t move at the same speed or had different dynamics and caused mispricing. The amount of infrastructural and speed changes when FX moves from legacy correspondent banking systems and T+2 settlement to instant settling, free flowing digital asset systems is going to be enormous. The arbitrage opportunities that will arise from this evolution will be generationally enormous as well.
Opportunity #4: “Infrastructural Optionality” For Corporate Treasurers and Asset Managers
While eventually all FX may occur digitally on a 24/7 basis, this will be a journey towards that outcome. In the short-term, for treasurers struggling with the time-zone window issues outlined above, granting programmable access to shift fiat currency into digital money at will to unlock 24/7 “infrastructural optionality” is an extremely powerful tool. Further, this infrastructural opportunity will allow treasurers to hold a much wider basket of currencies as they no longer need a bank account per currency, but simply a digital wallet which can hold a variety of stablecoins. This also can solve the back to back issues with securities transactions settling T+1 as asset managers are able to access currency on-demand. As institutional FX offerings such as that from Zodia Markets continue to partner with global clients, enhanced treasury functionality and optionality like this will become an extremely important route to adoption.
Further, there is the multi-currency and multi-jurisdictional automation angle. Putting it mildly, there is no real way to automate transactions that need to cross a border. Yes, Wise and Pay-Pal etc have APIs to manage a limited set of payment transactions, but true-scale automation will always be blocked by the correspondent banking system. A scale, liquid on-chain FX market unlocks almost complete freedom of where and what currencies can be held. With access to near instantaneous, programmable transactions across currencies, a treasurer’s toolkit for optimizing strategy grows exponentially.
Equally important is on who’s books assets can be held. Banks offer committed credit facilities, but that model doesn’t propagate through the layers to non-bank lenders or smaller credit providers. In those models, providers need to accumulate assets directly and hold them on balance sheet in the same currency and jurisdiction in order to provide fast and efficient access to capital for high velocity transactions, like supply chain finance or Buy Now Pay Later (BNPL). With automatable FX and global transactions, pools of lendable capital can be held anywhere in the globe and accessible via smart contract, drastically enhancing the efficiency of non-bank lending. These are not far flung theories either, QCAD will have one of the largest LatAm BNPL providers launching in Canada using instantly settling transactions to improve returns in Q3 2023.
Opportunity #5: Replicating Existing Fiat Infrastructure in Digital Money
As outlined in Uniswap and Circle’s paper in January 2023, using pure, automatable DeFi rails with instant settlement such as Uniswap can eliminate much of the settlement risk inherent in FX, there will still be a certain amount of settlement and/or counterparty risk for “non-automated” transactions. Whether these are simply transactions that need to be manually signed by one party, or transactions which are being transacted out of cold storage via a custodian, there may still be a timing gap for settlement of institutional FX transactions, even on-chain. The settlement risk period is drastically reduced given the lack of reliance on the correspondent banking system, but there is still some risk needed to be managed.
Into that breach can step institutional custodians, who are effectively able to replicate the “payment vs. payment” structure by acting as settlement agents. A further step will be to address the white space between the custodians by using smart contracts to replicate what, CLS provides in the traditional fiat realm.
CLS settles $6.5tn a day, almost all of which settles at least T+1, reducing a sizable portion of that to instant or at least T+0 settlement leads to cost savings in:
1. Lower margin requirements
2. Reduced interest expense
3. Lower operational and admin costs
4. Improved liquidity throughout the market
5. Enhanced capital efficiency
6. More agile trading strategies
While the total cost savings is very challenging to calculate, assuming a 4% cost of debt, the potential interest savings from removing $6.5tn a day of borrowing to bridge settlement is ~$700bn daily. Whether it is full de-risking using a DEX or instantly settling CEX, or simply a 24/7 on-chain payment vs. payment system, the efficiency and cost savings gains of speeding up the system are enormous.
Opportunity #6: Daylighting Value in Quietly Important Currencies Like CAD
There are certain currencies like CAD that quietly punch well above their weight in a global context. Despite Canada being the 9th largest economy by GDP and the 14th largest exporter in the world, CAD is the 7th highest traded currency in the global FX market (6.2% of daily volume) and the 6th largest currency held in foreign exchange reserves globally (2.43% of foreign reserves).
This highlights a trend over the last 25 years of currency diversification globally at the sovereign level, which is typically a glacial process. In 1999 FX reserves of non “Big Four” (USD, EUR, GBP and JPY) currencies was only 2%, by 2020 this was 10%. Of the non Big Four currencies which were added, CAD forms a full 23%,, only slightly behind RMB. Since 2020 CAD has continued to thrive growing by 40% to reach US$270bn in international FX reserves as of Q1 2023.
Several factors have led to this growth including:
1. Canada’s status as a stable, “soft power” liberal democracy without overly aggressive sanctions or regulators
2. A high “sharpe ratio” of interest rates to volatility leading to better risk adjusted returns for currency portfolio managers
3. A stable banking system with a demonstrated history of resilience to global financial crises
4. Enhanced global liquidity and technology leading to (relatively) lower carrying costs for diverse baskets of currencies
However, one factor that has explicitly NOT been driving the prevalence of CAD globally is its status as a commodities exporter. That market, not unlike digital assets, is still settled globally in USD. The result is that CAD-USD is one of the most active FX markets (5.5% of daily volume), on the back of revenues from commodities sales.
So, what are the opportunities of bringing digital CAD like QCAD to the global market?
1. Individuals by and large have the same diversification drivers as nation states: safety, stability, utility and return. It is highly impractical (and in many cases impossible) for an individual to hold 10+ fiat currencies in 10+ bank accounts. This can be rectified with a single digital wallet and, similar to sovereign CAD reserve growth as technology improved in the 2000s, we expect premium currencies like CAD to proliferate in individual holdings as access and liquidity grows
2. Global commodities pricing in USD have long been a hot button issue for sovereignty and are at the forefront of the “de-dollarization” charge, including the Saudi’s considering pricing all of their oil in RMB. A natural byproduct of the proliferation of digital money currency efficiency is the breaking of USD dominance and re-pricing and customization of commodities currency pricing. Canada, as the 4th largest global producer of oil, would stand to see a large increase in the prevalence of CAD as commodities contracts are settled directly in CAD.
Currencies like CAD have been quietly growing in importance and prevalence in the last 25 years for a variety of deep infrastructural reasons, all of which can be accelerated by reducing the frictions inherent in the global FX system.
Opportunity #7: Separation of Currency and Jurisdiction
As we outlined earlier, it is a somewhat underappreciated fact that each transaction in a currency generally requires a correspondent banking relationship in that country. “Eurodollars” or “Petrodollars”, which are USD held explicitly outside the U.S. and outside of Federal Reserve oversight are the exception that proves the rule. While this is frustrating from operational, cost and settlement time perspectives, sometimes it has larger sovereignty implications. Domestic banks are, almost by definition, extremely tied into the political and geopolitical situation of their home country. As outlined above, we have seen a continuing trend of diversification of reserves around the world and this paired with the signs of “de-dollarization” noted by JP Morgan earlier this summer.. This is likely not driven by the US Dollar’s waning utility, but ultimately by political pressures globally to reduce US influence on transactions, which may have been catalyzed by the US freezing Russia’s foreign currency reserves in February 2022.
With digital money, transactions no longer need to clear through on-shore domestic banks, allowing for currency transactions which are almost entirely divorced from the underlying jurisdiction. This clearly has pros and cons, as these sovereign controls have been used in combating international crime and as checks on aggressive nation states since before World War I. Enter Central Bank Digital Currencies, which aim to gain some of the efficiencies of digitization without losing the sovereignty of currency to the fray. CBDCs vs. other private issued forms of stablecoins are beyond the scope of this article, but remains an intensely relevant area of evolution.
Part 4: What Does it All Mean
Overall, we’re in the first inning of this evolution to a fully digital FX world, but until Q2 2023 we were still in warm-ups. Now:
1. There are meaningful global institutional players like Zodia Markets, Cumberland and many of their counterparties who are actively promoting and encouraging this fully digital money ecosystem.
2. There are some of the largest, fastest growing blockchain ecosystems in the world mandated to grow the volume and prevalence of non-USD digital money including QCAD and on-chain FX transaction volume
3. There is production-level technology to connect on-off ramps, on-chain FX, global KYC and payment structures together to create seamless UX experiences
4. There are open arbitrage trades between DEXs like Uniswap and centralized fiat-priced pairs like QCAD / USDC on exchanges like Shift Markets and others
5. There are institutional grade non-USD stablecoins organized in the Stablecoin Standard group like XSGD, BRZ, G-Yen, Poundtoken, BiLira, amongst others, which are aligned on this mission
6. Regulators globally are putting down policies around stablecoins, with MiCA in Europe, MAS in Singapore, and JFSA in Japan all publishing stablecoin guidelines, and Congress in the US developing a similar framework.
In the next 18 months we will see massive adoption from exchanges looking to gain a foothold in a rapidly growing space, but we will also see significant dollars flow in from hedge funds looking to capture the next significant arbitrage trade as FX goes fully digital. As Ernest Hemmingway said about going bankrupt “it happened slowly… then all at once”. This is the opposite. There is generational wealth to be created in putting the first round of infrastructure in place to fully modernize FX and we’re extremely excited to roll up our sleeves and dig in!
1. The Growth Potential of Non-USD Stablecoins — Cumberland (Paul Kremsky)
2. How DeFi Can Cut Costs and Improve Transparency in FX Markets — Uniswap and Circle
3. Building the Boring Stuff: Making On-Chain Payments and FX Sexy — Michael Casey, Alex McDougall, Gordon Liao
4. Finding Stability in On-Chain Cross Border Payments — Dante Disparte, Alex McDougall
