I would like to take this opportunity to introduce myself. My name is Simon Durno and I have recently joined clearpool.io as Head of Markets. I bring to the company 30 years plus of financial services expertise with both buy and sell side trading and management experience at two high profile financial institutions. Most recently I was head of execution at Stone Milliner, a $6bn macro hedge fund, where I traded every asset class and product, both on an OTC and exchange traded basis. Whilst at Morgan Stanley I initially traded currency futures on the CME before heading up the international sales trading team with responsibility for covering the foreign exchange and fixed income product range into the firm’s global private wealth network. In addition I have been trading and researching the digital asset space going back a number of years.
In this series of three articles I would like to discuss the Foreign Exchange (FX) and Crypto markets. In particular I would like to explore some of the similarities and differences I see in the two spaces and then go on to look at how FX has evolved over the years and whether there are any lessons for crypto on its evolutionary path.
In this first article I will look at some of the similarities between the two markets. In the second I will take a look at some of the differences I see and speculate whether any of these differences will or can be bridged at any point in the future. Finally I will map the evolution of the FX markets and try to overlay the crypto space and see how closely they align and whether FX’s historical path can give us any clues as to what lies ahead for the crypto world.
FX is defined simply as a global distributed or over the counter (OTC) market for the trading of currencies. In effect this definition is not too dissimilar to how we would define the crypto markets. Crypto trades both on exchanges and OTC, it is distributed and global, and in terms of trading, like foreign exchange, it is generally traded in pairs (whether versus fiat, stablecoins or against another token or coin). So as we can see the definition of FX alone seems to mirror the crypto space.
Let’s start with a more detailed look at some of the factors that drive the FX markets and see if those factors have a similar influence on the crypto markets.
The most obvious market force is simply the supply and demand of a particular asset. There have been several examples over the years where countries have started to print money and hence increase the supply of their currency. Reasons for doing so can be varied with Germany’s case in the 1920’s it was to pay striking workers whilst Zimbabwe in the mid 2000’s did the same to fund a war and then subsequently pay down debt. In both instances the market was flooded with an oversupply of their respective currencies causing hyperinflation and subsequently a collapse of the currencies.
There is a similar dynamic in what we see in the crypto world with inflationary tokens. However the most extreme example of late, which mirrored what was seen in Germany and Zimbabwe albeit on a much quicker timeline, was the Terra/LUNA shock from the middle of May this year. In response to the de-pegging of UST, trillions of LUNA coins were minted in accordance with the mechanics of the Terra/LUNA algorithm used to maintain the UST dollar peg whereby if the price of UST is below $1, as it was in this case, UST gets burned and LUNA is minted to help to restore the peg.
The theory behind this process was by decreasing the supply of UST its price would be supported and eventually return to $1 parity. This was counterbalanced by increasing LUNA’s supply and hence depressing its price. However the price moves were so violent the supply of LUNA shot up from 345 million in circulation to 6.5 trillion, a breathtaking 1,800,000% rise in just a few days. Unsurprisingly the price of LUNA, which had been as high as $120 earlier in the year, fell from a respectable $40 to a near worthless commodity.
FX is seen in traditional markets as one of the purest ways of expressing a macroeconomic view given that it is in effect a play on a country’s value against another one.
For example, if you felt that commodities were going to be attractive to investors and hence rise in value you may well use commodity producing countries’ currencies as a proxy for that macroeconomic play eg you’d perhaps purchase AUD or ZAR given that both countries are both rich in natural resources and have a large mining industry. Equally NOK and CAD are seen as an oil proxy given they are heavy producers of the fuel.
As the crypto market has matured over the last few years, especially as more traditional finance institutions enter the space, there has been more correlation with traditional markets. This is most obvious with the correlation we have witnessed recently between Bitcoin and the Nasdaq. During the early part of May of this year the correlation between the two had grown to a measure above 0.8 (perfect correlation is 1.0). During 2021 this correlation was negative pointing to no direct correlation between the two. Indeed Bitcoin is often referred to as a risk on asset correlating it closely to the risk proxy currencies such as AUD and NZD as well as to the Nasdaq. As the crypto market continues to mature and attract the institutional players we believe that these correlations will grow even stronger.
Equally geopolitical factors have a strong influence on the FX markets. There are several examples of this, for instance after the EU Brexit referendum in 2016, GBP fell 13% after the UK voted to leave the EU. In more recent times we saw a similar 13% decline in the Polish Zloty as USD/PLN rose from 4.05 to 4.60 over the first few days of the conflict in Ukraine given Poland’s close proximity to, and relationship with, Ukraine.
We can see now that as the crypto market has matured it too reacts to geopolitical news. At the start of the conflict in Ukraine, Bitcoin also had a 10% decline in its perceived role as a risk asset in what was obviously a period of flight to safety for markets.
It’s interesting to compare this to earlier geopolitical tensions prior to the maturation of the crypto world. Back in the late summer of 2017 tensions between North Korea and the US rose sharply as several nuclear tests and military operations were carried out on the Korean peninsula. During this period two safe haven currencies the JPY and CHF appreciated approximately 4% versus the USD. However, over the same period Bitcoin actually appreciated over 40% as the crypto market had not by then matured into the institutional mainstream, and was obviously a far smaller market lacking the significance it has now.
One of the main drivers in FX is the interest rate differential between two currencies. When this differential is seen as being extreme, market participants will often try to exploit this difference by entering a trade called the carry trade.
The carry trade entails participants buying the currency of a country whose interest rates are high (currently the Mexican Peso has interest rates of 7%) and to fund such a position they will sell currencies in countries which have low interest rates (Europe has -0.5% interest rates). As long as the currency pair is not too volatile, and hence the underlying trade does not lose too much money, the trade will generate income through the higher yield of the currency that you own (for instance here 7%) minus the funding of it (in this case -0.5%).
Such trades can also be self fulfilling as when we get more and more participants entering the trade, attracted by the carry, the currency pair starts to move in favour of the high yielder and hence adds to the potential profits of the trade. However this overpopulation has the potential to be a double edged sword as often it makes the exit trade extremely difficult.
One such example was NZD/JPY back in 2007 when NZD rates were around the 8% level with the JPY equivalent around 0.5%. Due to this interest rate differential NZD/JPY was seen as a lucrative carry trade and as such during the period between March and July of that year NZD/JPY appreciated from 78 to 98 as market participants bought the NZD to earn the yield at the expense of the lower yielding JPY. However, as the pair’s momentum slowed and some participants exited the trade, there was a rush to exit and the full appreciation of the trade was wiped out in a matter of a couple of weeks. This left many market participants sustaining larger losses from the underlying position than the profits they had earned from the yield play.
As the crypto market has matured particularly over the last few years more of the dynamics that we see in the traditional markets have started to evolve in the new world. There is now very much a yield curve evident in today’s crypto markets. It is obviously not as mature and as developed as it is in the traditional market with it existing, at present, on a much more price discovery and supply and demand driven basis. The crypto yield curve is very apparent in all the interest rates advertised by exchanges and specialist lenders that we see when we are on crypto exchanges or even riding the tube in London.
Probably the closest play in crypto to the carry trade in FX is the basis trade which was popular in the early part of 2021 whereby a market participant would buy the physical coin (predominantly BTC) and sell the underlying equivalent perpetual future in the same amount. The play here was that with no leverage there was no liquidation risk and because your long and short positions offset each other there was no underlying capital risk (other than of course the exchange itself going under).
The futures leg was in effect “rolled over” every few hours into the next trading period and subsequently a sum was paid or received by the holder of the futures depending on the underlying market conditions. During this period speculators would gladly pay a premium to buy the Bitcoin perpetual futures and hence pay the sellers a yield in the form of a positive carry captured within the “roll over” funding charge. The speculators believed that the cost of such a premium would be more than offset by the underlying Bitcoin capital appreciation.
For a time this worked very well for both sides of the market with the basis traders receiving upwards of 50% annualised returns and the speculators seeing close to 100% gains. As with all good things it sadly didn’t last too long.
The trading mechanisms of the FX and crypto markets are also very similar with both markets operating on a “trading pairs” basis so BTC/USDC is very similar to say USD/JPY in that you are exchanging one currency/coin/token for another at an agreed exchange rate.
Participants in both of the markets have morphed over time into now having very similar groupings especially as the institutional side have started to adopt crypto as a viable delivery mechanism across multiple asset classes but particularly FX-like pairs. Looking first at the major users of FX we obviously have the banks both commercial and investment as well as securities houses who, according to the latest triennial BIS survey from 2019 BIS Survey, account for just under 40% of the daily FX volume ($6.6tn) and if you include the regional banks that number climbs to just over 50%. Corporates, insurance companies and other such end users of FX account for 27%. Real money and hedge funds account for 11%, retail 9% with governments and central banks accounting for the remainder.
Crypto was long the domain of the retail investor but looking at this list now we can see that there are a lot of overlaps. We obviously know that banks are starting to become involved in the space with Goldman Sachs and the like very vocal about advertising the fact. Similarly vocal are the corporates who have adopted crypto as a tool for their treasury departments, the most obvious one being MicroStrategy who have taken that policy to another level.
The hedge fund space again is very much involved and that’s very apparent from Brevan Howard’s crypto spin outs amongst others. Other financial institutions like Blackrock similarly have been keen to promote their involvement in the space. Obviously retail is where crypto started and remains a big driver. However when we get into the world of monetary authorities, central banks and governments things start to diverge. Central banks have been very wary of crypto and via the governments and regulators have been keen to warn at best of the dangers and at worst banned, as China have, involvement in crypto. However some central banks/countries (China, Bahamas, Nigeria) have adopted or at the very least expressed their intentions to issue their own central bank digital currencies (CBDC) and through these initiatives we should see more adoption from the official sector.
The other point of difference between the participants in the two markets is the role the crypto miners play in not only mining the various coins but also the natural supply they bring to the crypto markets. There is no direct equivalent to the crypto miners in the FX space.
Finally the FX market is the closest of all the traditional markets in terms of market opening hours. As we know crypto is open 24/7 which brings some very unique market qualities into play which we shall discuss in a follow up article. The FX markets in contrast operate on a 24/5 basis which sees them closing over the weekend. This can often lead to something called “gap risk” whereby an event happens over a weekend (potentially an election result, a geopolitical event) which causes the FX market to open significantly higher or lower in early Asian time on the Monday morning from the close which we witnessed on the Friday evening in the US. However FX is by far the closest, in terms of operating hours, to the crypto space especially when we compare it to the hours seen in the equity and fixed income markets which can be open for as little as six and a half hours a day.
As you can see there are a large number of direct similarities between the two markets. Certainly the adoption by the traditional institutional players of crypto has helped to converge the two worlds. We believe that even the small differences that we point to above will be bridged sooner rather than later. Some believe that the 24/7 nature of crypto will be adopted into the mainstream markets and FX seems the most obvious and easiest place to start.
Indeed FTX’s Sam Bankman-Fried was in Washington a couple of weeks ago to appear at an opening meeting with the Commodity Futures Trading Commission to lobby for the adoption by traditional exchanges of the crypto 24/7 model with the help of the automated risk management systems that are commonly used on crypto exchanges to auto liquidate positions which are loss making and under margined. The meeting was obviously met with much resistance by the traditional financial institutions as well as representatives of the US farming community who fear their risk management and hedging of their crops will become an impossible 24/7 job. However, stepping back, it’s a further example of the influence the crypto markets are starting to have on the wider financial community and beyond. Perhaps a trial period of adoption of the 24/7 model across a small subset of products would be a good starting point and as I say above FX seems the most obvious place to start.
Similarly as the central banks around the world start to develop and issue CBDCs of their own we see them having more of an influence on the crypto space and indeed divesting into it. Surely it would make sense for central banks to have some digital assets on their balance sheets in the future? This will bring much soul searching from the truly native crypto types as they rail against the apparent erosion of decentralised governance that underpinned the libertarian values that they hold. Perhaps the next time a central bank embarks on a quantitative easing program they will purchase crypto assets alongside treasuries and mortgage backed securities?
Plenty of discussion points for another day!
In the next article in this series I shall take a look at some of the differences in the two markets and whether these differences can or will be bridged in the future.
I hope you have found this article to be of interest. By no means is this a definitive list of the similarities between the two markets but rather some that I have seen and witnessed first hand in my travels around the two worlds.