Imagine a world where a party could buy or sell currencies at the market rate, and get their hands on the cash in close to real time without having wait for the trade to settle two days later. Settlement and counterparty risk would be close to zero and funding costs would be slashed. Fewer intermediaries would mean simpler – and potentially cheaper – transactions.

This is the golden future envisioned by the proponents of on-chain foreign exchange, where parties would exchange digital currencies on the blockchain via so-called automated market-makers, or AMMs. Once exchanged, the currencies could then be converted from their tokenised form into fiat currencies for use in the real world where required.

While the infrastructure is nowhere near ready to handle institutional type flow, the ideas behind it are gathering momentum.

“Digital assets have a significant role to play in the future of the FX marketplace,” says David Puth, an independent adviser and former head of CLS, the market-standard FX settlement entity. “Money is going to be more digital, whether it is central bank digital currencies or stablecoins, which will ultimately lead to a digital FX market.”

Digital assets have a significant role to play in the future of the FX marketplace

David Puth, independent adviser

But of course, when you reduce one risk, you are often introducing another. In this case, there are concerns that the new and unproven technology may crimp liquidity. Furthermore, as the FX markets are already so liquid and bid/ask spreads on most currency pairs are so tight, these new digital assets markets have an extremely high bar to meet.

It’s not just digital asset obsessives that are interested in on-chain FX, though – central banks are also working on a way for market participants to exchange central bank digital currencies via an AMM. While the project is in an experimental phase, it does offer a future framework around how liquidity providers could trade tokenised currencies.

However, the prospects for on-chain FX hinge on whether the project can solve real-world problems.

“Will it bring you operational cost cutting, will it reduce your operational risk? Does it remove the need for settlement systems? And for FX, which is a global network, it all needs to be able to operate together, because otherwise, how do you get cross-border FX?” says an FX executive at an international trade association.

Centre of gravity

There are two prevailing approaches to trading digital assets like cryptocurrencies and stablecoins: centralised and decentralised finance.

Centralised exchanges such as Binance and Coinbase have dominated the market. In this model, the exchange takes custody of member funds to be used for trading tokens – similar to a traditional stock brokerage or investment firm. The exchange has limit order books that are off-chain, with transactions executed and recorded off the blockchain network.

Because custody of assets is held by the exchange, the private keys for crypto wallets that enable access to the tokens on the blockchain are also held by the centralised exchange.

But the model carries its own set of risks. A centralised exchange and its users can be exposed to hacks, reduced privacy on trades, potential insolvency and asset freezes from mismanagement – as with the case of former exchange FTX.

A decentralised exchange (DEX), such as Uniswap, is a marketplace where users can trade tokens on-chain and provide liquidity with their assets without an intermediary or third party to facilitate the transfer and custody of assets. The key advantage of a DEX is its permissionless and non-custodial wallets, whereby users always retain direct control over their assets.

Quants Alex Lipton and Artur Sepp released a paper last year proposing a framework for exchanging fiat currencies on chain. DeFi firm Uniswap Labs also published research in January, co-authored with stablecoin issuer Circle, looking at recent euro/US dollar stablecoin trading activity on its own exchange through an AMM model.

Under the Uniswap framework, liquidity providers deposit US dollar- and euro-denominated stablecoins – USDC and EUROC, respectively – into separate pools. If someone wants to exchange US dollars for euros, they pay USDC into the USDC pool and withdraw EUROC from the other pool, with the exchange rate determined by the protocol. As the balance between the two pools changes over time, the price changes to encourage a rebalancing of the pool.

Instead of earning a bid/offer spread like on a traditional FX trading venue, AMM liquidity providers that have deposited coins into the pools to facilitate trading are paid a cut of the transaction fees charged by Uniswap.

The smart contract takes the amount from the pool and the amount from a users’ wallet and exchanges them on the blockchain in a few minutes, cutting settlement time. If a user wants to convert those stablecoins back into cash, they can transfer the stablecoins from their wallet to a centralised exchange like Coinbase and swap USDC for USD at the usual 1:1 peg, and withdraw the funds to their bank account.

Lipton, head of quantitative research and development at the Abu Dhabi Investment Authority, believes this model will eventually replace the conventional centralised exchanges that rely on traditional market-making techniques.

The Uniswap and Circle paper states: “As one asset is traded for the other, the relative prices of the two assets shift, and a new market rate for both is determined… In this dynamic, a buyer or seller trades directly with the pool, rather than with specific orders left by other parties.”

Using stablecoin pairs begins to question things like T+2 settlement, settlement risk and the need for CLS

Ramy Soliman, GMO-Z

The paper claims the on-chain transactions traded within a few basis points of prices seen in traditional markets. As of 11am on August 31, the EUR/USD price on Bloomberg was 1.0868; on Uniswap, the AMM pool exchange rate of EUROC versus USDC was 1.0845. The AMM pool had $347,000 of volume in the previous 24 hours.

The authors of the paper believe that on-chain FX technology could result in cheaper transaction costs, particularly around clearing and settlement, where it estimates savings through disintermediation could be as high as 80%. This is because DEX and DeFi uses the blockchain technology to enable atomic, payment-verses-payment (PvP) settlement.

In normal PvP settlement, one leg of the transaction cannot be delivered until the other currency is provided. Atomic settlement involves both instantaneous and simultaneous settlement, whereby the transfer of one currency is dependent on the transfer of the other. In theory, this could eliminate credit risk in the settlement process and reduce the potential for errors as the messaging and settlement layers are combined.

Banks are positive about the possible benefits this technology brings, and feel this concept where settlement can occur concurrently and is linked together on-chain could provide major benefits to the whole value chain.

Settlement risk has been in the crosshairs of regulators and central banks. According to the Bank for International Settlements’ latest triennial survey, settlement risk in FX transactions has increased by more than 15% since 2019, with $2.2 trillion of daily FX turnover not subject to any risk mitigation.

Furthermore, the shift to a T+1 securities settlement cycle in the US and Canada from May 24 has also raised the prospect of many buy-side firms missing CLS’s settlement window for their FX-related transaction.

“Using stablecoin pairs begins to question things like T+2 settlement, settlement risk and the need for CLS,” says Ramy Soliman, co-founder of industry body Stablecoin Standard and president of GMO-Z, a stablecoin issuer. “These are all mechanisms that can be removed by using digital currencies. To be able to transfer value with immediate finality is just such an improvement in capital efficiencies.”

Counting the cost

Yet the AMM and the DEX model carries some potential harmful risks and inefficiencies.

First, traders face high gas fees and bid/offer spreads can be huge. For example, on Uniswap, the bid/offer spread for EUROC/USDC is more than 10 basis points, as of August 31, with a gas fee of $5 – the fee to use the blockchain – but this can be much higher depending on network usage. The most popular network, Ethereum, can sometimes cost $25 or more per transaction in busy periods.

In comparison, spot FX spreads have compressed to a point where margins for some liquidity providers’ trades on multi-dealer platforms have hit zero.

Liquidity on DEXs can also be inconsistent and shallow. On November 10, 2022, daily volumes of EUROC/USDC peaked at $8.2 million on Uniswap – following the collapse of FTX and the criticisms levied against centralised exchanges. Another peak of $4 million came on March 11, following the downfall of Silicon Valley Bank. Outside of those two dates, volumes have rarely topped $500,000, with the lowest for this year of $300 traded on July 2.

As of September 1, the size of the overall EUROC/USDC liquidity pool on Uniswap was $611,000.

Another risk for liquidity providers in the AMM model is known as impermanent losses. As the composition of the pool changes due to trading, the liquidity provider may not get back the same proportion of assets put in. If there is price volatility, it can be difficult to manage the market risk of that position.

Meanwhile, some other DEX platforms are also building an order book whereby the market price of an asset is determined by the lowest asking price (sell order) or the highest bidding price.

Other concerns include security risks – hackers have routinely drained liquidity pools on decentralised exchanges after exploiting the smart contracts that underpin them – and a lack of know-your-customer requirements which could see regulated institutions trading indirectly with individuals they would rather avoid.

Growing pains

Nevertheless, the technology is still in its early days, and many crypto evangelists hope that the growth of activity on so-called layer 2 blockchains with reduced fees, such as Arbitrum and Optimism, will help grow liquidity pools. This could attract more arbitrage activity that will keep prices closer to market rates, and in turn lead to reduced spreads.

In addition, central banks are keen to gain a better understanding of this technology as it evolves. The Bank for International Settlements, for example, is working with the central banks of Europe, Switzerland and Singapore to explore the trading and settlement of central bank digital currencies through an AMM model.

The idea – named Project Mariana – is testing whether there can be a set of common standards for wholesale CBDC tokens, including design features based on central bank requirements, to enable decentralised FX trading and settlement. This would allow for interoperability of different CBDCs within the same AMM protocol and provide a set of governance mechanisms at the token level without relying on a platform operator.

Where it differs from the models of Uniswap and the other DEXs is that involves both central banks and commercial banks. The central banks would issue the wholesale CBDC on their respective domestic platforms, while the commercial banks that have access to them can act as liquidity providers by transferring the wholesale CBDCs into the wider international network for transactions with other banks. Meanwhile, the AMM will enable decentralised FX trading and settlement using the digital currencies.

The liquidity pool underpinning Project Mariana’s AMM is designed as a three-token pool, made up of euro, Singapore dollar and Swiss franc wholesale CBDC. Liquidity takers can trade currencies against the pool, facing transaction fees based on how balanced the pool is.

“Combining all currencies in one pool increases the potential size of the pool and reduces fragmentation, increasing its chance of providing a reference price,” the BIS says in a report published in June.

Looking forward, Soliman at GMO-Z is bullish on dealer banks entering the market to provide liquidity. “I would imagine that over time, as those dealer banks become comfortable with digitalisation, stable coins, and tokenised versions of currency, that they would then be incentivised to provide liquidity in a digital format.”

But developing a deep liquidity pool will be critical for participants. And the market should be able to handle large transactions, as in the FX market, without causing large price swings.

Lipton is also optimistic of the role that financial institutions can play in this developing area. “If I were a betting man, which I am not, I would say that major banks would actually participate in this activity and can provide it as a service for their customers.”

Edited by Joe Parsons and Alex Krohn