This article discusses the evolution of peer-to-peer trading – and if the market is now embracing this model as a mechanism to achieve lower spreads, reduce information leakage and minimize market impact. Understand the drivers behind this decision-making and understand how participants can potentially achieve these efficiencies through existing platforms.
Top line
Peer-to-peer trading enables end users to trade directly with each other rather than having to act as a price taker from a traditional liquidity provider or on a traditional OTC FX trading venue. Some end users – or the buy-side comprising hedge funds and asset managers, as well as corporates and commercials – are increasingly interested in this model as it enables them to be more than price takers.
Currently, the majority of the $6.6 trillion a day global foreign exchange market remains traded either on a largely bank-to-client electronic communication network (ECN) platform or on a request for quote (RFQ) basis (via either multi dealer or single dealer platforms). While this model continues to provide robust and reliable liquidity to end user customers, some buy-side market participants are looking at peer-to-peer alternatives to achieve potential enhancements to transaction costs and reductions in market impact, and ultimately to separate liquidity from credit.
Peer-to-peer: requires many-to-many
Historically, one of the most obvious challenges around developing peer-to-peer venues has been getting a critical mass of counterparts willing to take part at the same time to help find enough matching interest.
Dedicated peer-to-peer platforms have been launched which seek to establish this connected community of peers to reduce costs of trading and reduce market impact. Other potential benefits include trading in an environment with enhanced transparency, anonymity, and clear rules that can help govern conduct and evidence of how clients will meet their fiduciary responsibilities.
Many customers appear to be attracted to the peer-to-peer concept -- not just because of the potential benefits mentioned, but because the model also supports the separation of liquidity from credit, which buy-side firms have only been able to achieve in the OTC market via the use of an FX prime broker, a model that not all customers (in particular, the real money / asset management community) have embraced.
Enter the futures CLOB: The community is already connected, the features already exist
While some fintech start-ups are building platforms that attempt to deliver the potential benefits of a peer-to-peer model, an increasing number of market participants have realized that the fundamental features of the CME listed FX central limit order book (CLOB) already have them – and that the crucial factor of a large and diverse ecosystem of traders is already active and growing.
As of January 11, 2022, the number of large open positions held by customers in CME FX futures had grown +9.3% year on year (totalling 1,262), with similar continued growth in client positioning leading to the largest number of gross notional positions held by asset managers in EUR/USD FX futures (Chart 1).
Chart 1: Asset manager open gross notional in CME EUR/USD FX futures contract
Features of the FX futures CLOB
<table>
<tbody><tr><th colspan="2">The existing trading community is a large and hugely diverse ecosystem covering the full spectrum of retail, buy-side, regional banks, non-bank market makers, and Tier 1 banks.</th>
</tr><tr><td>The model enables peer-to-peer</td>
<td>The marketplace is truly all-to-all and any-to-any, enabling customers to trade with other customers while also providing liquidity from other market participants.</td>
</tr><tr><td>Credit is already separated from liquidity</td>
<td>There is no relationship that exists nor is needed between the liquidity provider and the liquidity taker.</td>
</tr><tr><td>Anonymity guaranteed, and entirely credit agnostic</td>
<td>Everyone can see and trade upon the best price, and no one knows who was involved in each trade.</td>
</tr><tr><td>Access to potentially lower spreads through passive trading</td>
<td>A trader can place passive interest and then wait to execute at that level so avoiding and potentially earning the spread; traders don’t have to act aggressively on a price provided by a liquidity provider and so don’t have to cross the spread unless they wish to for immediacy.</td>
</tr><tr><td>Removes the need for costly ISDAs and the need for credit relationships with the liquidity providers</td>
<td>Each customer just needs a clearing arrangement with an FCM; no ISDA or bilateral credit line is needed with any of the participants to trade in the CLOB.</td>
</tr></tbody></table>
| The existing trading community is a large and hugely diverse ecosystem covering the full spectrum of retail, buy-side, regional banks, non-bank market makers, and Tier 1 banks. | |
|---|---|
| The model enables peer-to-peer | The marketplace is truly all-to-all and any-to-any, enabling customers to trade with other customers while also providing liquidity from other market participants. |
| Credit is already separated from liquidity | There is no relationship that exists nor is needed between the liquidity provider and the liquidity taker. |
| Anonymity guaranteed, and entirely credit agnostic | Everyone can see and trade upon the best price, and no one knows who was involved in each trade. |
| Access to potentially lower spreads through passive trading | A trader can place passive interest and then wait to execute at that level so avoiding and potentially earning the spread; traders don’t have to act aggressively on a price provided by a liquidity provider and so don’t have to cross the spread unless they wish to for immediacy. |
| Removes the need for costly ISDAs and the need for credit relationships with the liquidity providers | Each customer just needs a clearing arrangement with an FCM; no ISDA or bilateral credit line is needed with any of the participants to trade in the CLOB. |
Confirmation of the CLOB as a vehicle to achieve potential trading efficiencies: The behaviour of the buy-side
Looking at trading in outright positions of CME EUR/USD futures over 2021, we can see that hedge funds were able to trade passively 64% of the time and asset managers/end user customers were able to trade passively ~37% of the time. Passive activity means that these customers did not have to accept a price given to them via a request for quote and didn’t have to trade on an existing price in the market by crossing a spread, but instead were able to place their interest into the CLOB at a price level that they were willing to buy or sell and then allow other market participants (potentially including their peers) to trade at their specified price level. For context, CME EUR/USD futures average daily volume for 2021 was $29.6B; as of Dec. 28, CFTC reporting shows that buy-side customers were holding 61.5% of open interest in EUR/USD futures.
Looking more recently at the December 2021 quarterly roll (where customers closed out their December 2021 CME FX futures and re-established them in the March 2022 contract), end users and asset manager customers were able to trade passively for 31% of their CLOB activity. The table below helps to show further color and context on the level of passive trading in the December quarterly roll for the five most active FX futures contracts at CME.
| Average Daily Volume in calendar spreads* - USD Notional | % of Open Interest Rolled in December | Open Interest on Dec 3rd in USD equivalent | % of roll traded passively** | |
|---|---|---|---|---|
| EUR | $24,604,144,881 | 88% | $99,740,708,650 | 31% |
| GBP | $5,337,675,000 | 74% | $19,353,254,952 | 39% |
| JPY | $5,392,143,750 | 80% | $23,278,043,794 | 31% |
| CAD | $2,945,570,000 | 74% | $11,607,352,475 | 38% |
| AUD | $3,598,520,220 | 78% | $14,783,644,605 | 44% |
* during 2 week roll period December 2021
** Asset Manager and end user roll activity during the primary roll week
The levels of volumes and customer activity, size and diversity of the ecosystem, and ability to trade passively combine to reveal a complementary liquidity pool that uses a robust and established platform to help customers achieve trading efficiencies. CME listed FX already has a hugely diverse ecosystem, and the CLOB enables peer-to-peer trading without any new technology or legal arrangements. These features have helped total open interest in listed FX grow to nearly $270B by the end of December 2021.
Bottom line
- Peer-to-peer trading is gaining the attention of segments within the global FX community as a potential mechanism to reduce their cost of trading and minimize their market impact.
- Standalone, new entrant peer-to-peer platforms have not yet achieved large-scale volumes as they have been unable to find enough matching interest between the participants on a regular basis.
- The FX futures CLOB enables peer-to-peer trading and is already established as one of the largest primary venues for price discovery, providing customers with many potential features including the ability to separate liquidity from credit.
- Recent trading data shows that buy-side customers were able to trade passively up to 64% of the time by using the FX futures CLOB, so avoiding and potentially earning the spread on their trading activity rather than being a price taker in a more traditional RFQ model.
- The futures CLOB will not suit all customers, all currency pairs nor all trade types. Relationship-based trading with chosen counterparts (enabled in block trading of FX futures as well as via RFQs in the OTC market) will absolutely continue to play a critical role within the FX market – especially for larger trades, customers wanting immediate fills, and for trades in less liquid currency pairs – but the futures CLOB may help provide a complementary source of liquidity and trading efficiencies that many customers appear to be looking for.
If you would like to discuss any of the themes in this paper, or even a piece of bespoke analysis which could provide further empirical data from actual trading history, we welcome any inquiries. Please contact fxteam@cmegroup.com or visit cmegroup.com/fx.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
