Peer-to-peer currency exchange startup

Saw this pitch from WeSwap which is a peer-to-peer (p2p) fx exchange startup. Its success will depend heavily on adopters and volume of transactions that take place. But it's an interesting and ambitious attempt to apply the p2p business model to yet another aspect of the banking business model. 

Comments Published Regarding FSB's FX Benchmark Recommendations

The Financial Stability Board had issued general recommendations for changing foreign currency benchmark fixes, open to comments through August 12.  This week the FSB released the comments from 36 interested players, including asset managers, banks and others.  A page with the links to these comments is included here.

Two areas that may be considered controversial seemed to have a lot of support.  The first concerns paying the banks for taking fix orders and charging a bid/offer spread or specified fee (discussed in a prior post here).  Comments included the logic of paying for this service to reduce the incentive for banks to look for ways to make profits in ways that hurt their customers.  Comments acknowledged that any such charge will not eliminate this possibility, and thus the need for a better process / monitoring the market makers will remain.

The second involves widening the period of the fix.  The current WM Reuters fix window is one minute for major currencies.  While there was much support for this, there seemed to be concern that the period not be widened to much, perhaps beyond a half hour, as this could add difficulty to managing trading risk and could add volatility from exogenous factors such as market news impacting the fix rates.

The FSB is scheduled to issue final recommendations in early November.

Who Likes the Financial Stability Board's Recommendation of a Fee for FX Benchmark Trades?

The Financial Stability Board released a consultative study on FX benchmark rates that includes several items for the industry to consider as well as a couple of recommendations.  One recommendation was to widen the period of the window for calculating rates.  Another was that the banks should charge for the service of filling fix orders.

As it currently stands, the WM Reuters rate, the London Close benchmark which is the fix with by far the largest daily volume, includes a bid, mid-rate and offer rate for each currency pair.  Most large and many small users of the fix are filled at the mid-rate, and thus do not pay any fee or bid offer spread to their bank for filling their order.

Why does this occur?  Banks allow it as the cost of doing business with large customers.  If others are doing it, you need to do it as well - it became a market practice in effect.

Bank customers, of course, would like all trades executed for free, so how did fix trades become the only trade type executed routinely without spread or fee? This occurred as many funds use the WM Reuters FX rates to translate their local currency asset values into base currency values each day.  The investment managers then wanted to execute any trades for that day at the same rate to avoid FX tracking error for their funds.  Many managers also saw these rates as a means to achieve market rates without going through the work of negotiating rates with their banks. Others such as corporates began using the mid rate for execution purposes while hedge funds and others did so for speculative purposes.

While this seemed to be a win for the customers, it was not for the banks.  When the fix began in the early 1990s FX spreads were quite wide compared to today and perhaps the banks could more easily tolerate these "free trades".  Apparently as pressure increased on traders to perform in an environment of reducing spreads, some misconduct occurred, including collusion, as a means to generate profits on these trades.

The FSB's suggestion seems quite sensible to us.  Expecting free services does not. In effect, the actions that traders took in recent years reinforces the adage regarding no free lunches.  Using bid offer spreads or a small commission should reduce this tension between bank and customer.

While not the only change required to benchmark trading, this change is reasonable and should go along way in making this a more rational part of the FX business.

Asset managers and other fix users may not like the concept initially, but its inherent reasonableness and the need to increase market participants' faith in benchmark rates should see customers agreeing.  The devil being in the details, however, the size of any commission or spread (tracking error to many) may be much more controversial.

Junk Banks?!

(Adapted from Are Systemically Important Banks Junk Credits? Industry Commentary of the Global Association of Risk Professionals)

A great challenge for bank credit analysts is the degree to which banks rely on “extraordinary support” (a euphemism for “bailout”) from their governments.  A bond investor may build a brilliant quantitative model to understand how a bank’s leverage, asset volatility, and other financial, operational, and economic characteristics impact the bank’s estimated default likelihood.  But there’s a final overlay that is vexing:  what is the probability that a government will step in to make creditors whole if the bank fails?

As with almost all such investment analysis questions, there is no definite, unambiguous answer.  But recent research of FitchRatings provides a fascinating observation.  (See the Fitch Special Report “The Evolving Dynamics of Support for Banks,” September 11, 2013.)  For the period 1990-2012, Fitch assessed both the default rate and the failure rate for “senior creditors of systemically important” global banks with Fitch ratings.  The five-year cumulative default rate in the period (1.15%) is six times lower than the failure rate (6.95%).  Fitch defines failure as “defaulted or would … have defaulted without extraordinary support.”

A quantitative model builder might be pleased with this historical data point.  She will use her financials-based risk model to estimate failure rate and then multiply by a new “no-bailout” parameter of one-sixth (the Fitch result) to get the model’s estimated default probability.  This approach is feasible, but we’re struck by a different observation.

Stepping outside the model-building exercise, the five-year failure rate of 6.95% (call it 7%) is striking.  Referencing Fitch’s Default Study of 2012, the Global Corporate Finance Average Cumulative Default Rate for double-B rated entities is 6.91% (call that 7% also).  (See the table on page 9 of the Fitch Special Report “Fitch Ratings Global Corporate Finance 2012 Transition and Default Study,” March 2013.)  Thus, in the absence of “extraordinary support,” the world’s systemically important banks behave like junk credits.  At least, this is the blended effect of the Fitch universe for the period 1990-2012.  Neither qualification, though, is disquieting.  The universe is large and the 23-year time period is long and indicative of recent history.

To our knowledge, the dominant rating agencies do not assign underlying bank ratings (such as “bank financial strength ratings”) that are non-investment grade.  For example, Fitch itself shows a list of 28 global systemically important banks in Appendix 4 of “The Evolving Dynamics of Support for Banks” and gives a junk "viability rating” to the Bank of China only.  Hence, the rating agencies likely disagree with the characterization that “systemically important global banks are junk” absent government support.  But we appreciate the Fitch study precisely because it shows observed data rather than just potentially optimistic models and judgment.  We’re not aware of any alternative historical studies of this sort.  (If such studies exist, please tell us!)

Of course, this question matters greatly to bank regulators, investors, and taxpayers as well as to rating agencies.  The world is now tightening prudential regulation by elevating capital requirements, pondering liquidity enhancements, considering a maximum leverage ratio (absent risk weighting), forcing central clearing of derivatives, et cetera.  Do regulators and the broader community agree that the “starting point” of systemically important global bank credit quality is junk?  Or, as I suspect, is this point contentious?  We need discussion and debate!  Our view is that the Fitch study is critically important.  It deserves much wider attention and acclaim.  Like a published scientific result, the world needs other rating agencies, bank regulators, and academics to perform similar studies with other data sources to validate or dispute the finding that “banks are junk” without government support.