FX trading not ready to benefit from safeguards of blockchain

Updated with correction

The promise of blockchain technology in financial services could apply to foreign-exchange trading in the future, but for now, sources said, FX isn't ready to cash in on the technology behind bitcoin.

The parallel between bitcoin and foreign-exchange trades is there, however. Potential application of FX to blockchain technology, which essentially records and stores transactions as well as account balances, could dovetail with recent moves toward more 24-hour FX pricing and less use of traditional FX benchmarks.

“The interesting part of block-chain is that it was created in sort of a foreign-exchange paradigm, given that it was originally intended for a cyber currency in the bitcoin,” said Terry Roche, principal and head of fintech research, TABB Group, New York.

But, Mr. Roche and others added, that's where the currency parallels end.

Bitcoin transactions through the blockchain are “minuscule” compared with the sheer volume of FX trades, the largest securities market in the world with average daily trading volume of about 5 billion, said John Halligan, president, Global Trading Analytics LLC, Rutherford, N.J. “Change in this business tends to come slowly,” said Mr. Halligan. “Think about how long it's taken to go from voice brokers to electronic trading.”

Foreign exchange “is a very fast market with a tremendous amount of volume,” said Daniel Connell, managing director, head of market strategy and technology, Greenwich Associates, Stamford, Conn. “The blockchain as it currently exists would fall woefully short in being able to handle that volume, in terms of vast amounts of transactions per second that's needed for FX trading. But it's still early days. I would think to something like foreign exchange, it might be a stretch now but maybe not in the future. Like with all new technology, it's best to walk before we can run. We should walk right away, but not run until we're ready.”

One reason FX applications of blockchain technology should be taken slowly is because the foreign exchange market is already a heavily electronic marketplace. Other settlement processes, Mr. Roche said, are seen as more applicable now to the blockchain because they're more driven by manual back-office processes, add: such as syndicated loans.

“Whether the technology can handle the volume and velocity of FX trading, there's really not an application of that yet,” said Mr. Roche. “The first place for financial services most likely to begin with blockchain is with syndicated loans. Right now, reconciling those loans uses a manually driven process that takes more than 20 days. Since it's highly manual, it's a good place to start.”

Added Sean Ristau, head of wealth management and derivatives at Raptor Trading Systems Inc. Columbia, Md.: “It's important to note that many firms are working under the covers on items like this. The technology in its current state is most viable for the settlement and clearing process.” Mr. Ristau is co-chairman of the Digital Currency and Blockchain Working Group at FIX Trading Community, a London-based industry group that establishes standards for trading.

“Blockchain could work” for FX, said Greenwich's Mr. Connell, “but you'd really have to think about all the implications. Would it be a public blockchain with proof of work? You're talking about adding orders of magnitude (an exponential change in valuing foreign exchange); who's going to do that? And how will that be compensated? And if it's a private blockchain, how do you do that with some many participants? There are so many things to be worked out; that's not happening anytime soon.”

Foreign-exchange-related fines in the past six months against major banks over market manipulation have led some to see the blockchain as a safe alternative for FX. Most recently, the New York state Department of Financial Services on Nov. 18 levied an additional $150 million fine against Barclays PLC over the bank's last-minute rejection of unprofitable trades through its automated electronic system. That fine was on top of a combined $1.4 billion in fines levied against the firm by New York state regulators, the Commodity Futures Trading Commission and the U.K.'s Financial Conduct Authority in May.

But Mr. Connell said that while the blockchain is seen as more secure than traditional Internet-based systems, it isn't risk-free. “We don't completely alleviate all concerns about risk with the blockchain,” Mr. Connell said. “There's a lot of safety and security in the public and disruptive nature of it. But there are bad actors out there, and is foreign exchange interesting enough to have bad actors try and take advantage of it? Hard to say. But there's always the possibility of that risk.”

Given the technology is suited more for back-office functions like settlements, applying the blockchain to FX could be done, but it wouldn't alleviate concerns over market manipulation, or lawsuits over standing instruction transaction in which the timing and pricing of trades is left to a custodial bank, said John Betts, founder and CEO, Noble Markets, a New York-based capital markets settlement firm now looking to apply blockchain technology to capital markets.

“This is not a blockchain problem,” said Mr. Betts. “There's a lot of talk about blockchain solving all sorts of problem, including foreign exchange; just like years ago when people thought the Internet would solve all our problems. But blockchain doesn't change business problems, just how we communicate. It all comes down to a fundamental misconception on where blockchain fits in the financial ecosystem. Blockchain sits in the back office, but FX is a front-office problem. Blockchain works if I have euros that I need to send somewhere directly, It doesn't solve the problem of how you change them to another currency.

“Ultimately, the blockchain is just a database,” Mr. Betts added. “These problems are more structural, created by how markets have evolved over the years.”