The act of exchanging currencies, particularly to pay for products and services in another country, has always had one essential fault — the need for a third party to be involved. With a transaction where both parties are using the same currency, the process is a very easy one and rarely requires any involvement from outside influences, but the complication of multiple currencies has always required someone who is prepared to accept funds in one currency and issue them in another.
Aside from the simple fact that this adds an additional layer of complexity to what should be a relatively simple transaction, it also inevitably added extra costs — in some cases, substantial costs. The entity acting as a go-between — typically a bank — would naturally want to charge for their services. Given the lack of alternatives available, they could effectively charge whatever they wanted, leading to huge fees for any company wanting to do business abroad. Said companies would inevitably have to just grin and bear it, partially out of having no choice and partially because the fee was often hidden in the less-than-favourable exchange rate.
And then peer-to-peer financial services became a thing.
How does P2P FX work?
The concept is pretty simple, in theory. In fact, it’s exactly what it sounds like — you do your foreign currency exchange directly with another customer rather than through a bank.
As an example, if a Thai company wanted to buy something from a UK company, they would ordinarily have to send the money through a bank, which would convert the baht to pounds (at a poor rate and with a hefty fee added on) and pass it on to the seller. P2P FX avoids that slow, expensive and complicated process by matching the Thai company with someone in the UK who wants to send money in the other direction — that is, they want to convert their pounds into baht. Equal values of the two currencies are swapped and everyone’s happy. The Thai company can now pay for goods in the UK and the person in the UK now has his Thai baht to use as they please.
There is slightly more to it than this over-simplified example suggests, but not very much. The only addition to the equation is some sort of service provider to match the two people wanting to exchange currencies and a service that allows them to do so. This is where P2P FX websites come in. They provide a marketplace for folks looking to make a swap. Each party creates an account on the same site, deposit their funds with said site and then ownership of those funds is swapped around. It works effectively the same as a remittance service, in this regard, with no money ever actually crossing an international border.
A question of scale
This approach obviously raises the question of how you are going to find a person in the other country who not only happens to want your country’s currency, but wants it in the sort of amounts that you plan to spend. On a small, individual level, it’s at least semi-realistic. A British tourist, for example, might want some Thai baht to spend on their holiday and would probably be willing to swap currencies with a Thai tourist visiting the UK. However, big companies tend to work in significantly larger sums than tourists. For this reason, the P2P FX market had something of a troubled start.
Even working on an individual level, there’s always the risk that there will be no one to match you with who wants your money or has the currency that you want. Under these circumstances, some P2P FX service providers offer the option to exchange your money for liquidity, albeit with a higher fee attached — typically double the fee, in fact. The alternative is to just be patient and wait until someone comes on who can make the exchange happen at the usual fee, but there is no telling how long that will take.
One of the other reasons why P2P FX initially struggled to attract big commercial clients is that banks typically bundle their foreign exchange services with other essential services in a package for their customers. Companies need those other financial services and are reluctant to spend money on another service provider when they already have FX services included in their deal.
One way P2P FX providers have found a way around both of these problems is with FX hedging programmes. Not only do these still require the input of banks, but it also removes the unpredictability of finding the currency you want in the supply you need. They achieve this using forward contracts on a monthly or quarterly basis. This means that the FX swaps become extremely predictable, creating a flow of foreign currencies that can be relied upon. With this approach and a little bit of adaptation to integrate with the existing workflows employed by banks, P2P FX could enter the mainstream.
As long as it works…
While the P2P aspect of P2P FX is certainly an interesting one, the service providers in the industry have found that it is one that most customers — both at the retail and corporate level — really don’t care about it. Their observations have revealed that most people just care about getting the money they need as soon as possible and at a reasonable cost. For this reason, the real reason for the rise of peer-to-peer FX is removing the emphasis on it being peer-to-peer.
In working closer with banks, P2P FX businesses got access to the same wholesale interbank market that the large banks already had and depended on. They simply use that system is a subtly different way to ensure that they can provide their customers with exactly what they want — low-cost and on-demand foreign currency exchange, allowing them to [nearly] instantly close deals with overseas companies without waiting days for payment processing.
Still further to go
This story is not one that has reached its final chapter yet. As stated above, P2P FX services still suffer from the competition created by banks bundling their own services in with other, more important financial services. However, there is only so long that the old argument of “we’ve always done in this way so why change now” will be enough to counter the savings and convenience that P2P FX services can offer.
Just as with equities and securities markets before, peer-to-peer services have become an important source of alternative liquidity. In fact, FX stands out from its predecessors, in this regard, as it has a more homogeneous set of instruments and a greater diversity of participants. That being the case, there is a great deal of scope for expansion and development in interesting directions.
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