Hedging market exposure of a Gateway when Issuing Currencies

[fedlope]

Hello, 

We are currently building an infrastructure using Interledger, Connectors, XRP.L. 

While constructing the value movement structure, we have to consider what kind of market risk the Gateway is exposed to when Issuing Currencies.

Assuming the clients are looking to store value in different type of assets using Issued Currencies, (leaving value transfer aside from the analysis), we have the following risk: 

If my client A has fiat USD and the interest to store value in CAD, she sends USD to the Gateway and has in correspondence an equivalent value of CAD.GTW in the ledger. 

From the client perspective, she has a positive exposure to the price of CAD. -CAD goes up, she wins, goes down, she loses.-

On the other side, from the Gateway perspective, it has the opposing exposure to CAD, -CAD goes up, it loses, goes down, it wins. - However this is not of the interest of the Gateway, the objective is to transfer value, not have speculative exposure to markets (exposure to whatever asset it allows, USD, GOLD, OIL, etc).

Although this exposure is very real and enough to bankrupt a financial institution, we have not seen this topic being discussed. Makes us question whether there is a simpler solution built in the ledger.

Now taking into account a full operational Gateway with a value movement and store, our Hedging proposal would be the following:

-At a high level-

1.      Have a real time evaluation of market exposure. As payments will flow from side to side, the Gateway will have to track the net exposure of the different assets it holds. This will be more active for currency assets (CAD, MXN, BTC), than value store (OIL, GOLD).

2.      Knowing the net exposure of market risk, evaluate if there is an opportunity by covering net negative or net positive exposure. Conversely evaluate if the Gateway is in pro of having an over or under exposure to certain markets depending on market conditions.

3.      Hedge net exposure with third parties. Best option; derivative markets.

 

Hope we can hear some other perspectives.

 

 

 

[opaopa]

Why should your client use your service if you are in your turn hedging the exposure with third parties? Your client could instead just use that hedge themselves directly with equal results but with less intermediaries and reduced cost.

[fedlope]

Opaopa, thanks for your reply. 

When I refer that the Gateway must hedge its positions, is because it will assume all market risk for its clients. If I receive 100 USD and give back 130 CAD equivalent, and the promise of giving back (in an indefinitely amount of time) the 100 USD to what ever price the CADUSD is, then I as Gateway am exposing my self to what ever movement the CADUSD makes in what ever time range. This is high risk.

From the client perspective, he is already exposed (or hedge depending on the client needs) as he has bought 100 USD in equivalent CAD -Just like real fiat-. And he is not paying for the service of holding the asset (as would in derivatives contracts as they have due dates and roll-over costs), just a transaction fee (same as current operating services). At the end is just like buying real fiat, no extra cost.

In delivering this service to the client, we receive the opposing risk, that's why the need of hedging our self's.

Why do we assume this risk? because it is not the main thing, we are looking to build a system that allows instant payment between agents and regions, with all this, the possibility to save and invest in other currencies and asset classes. 

For a fully functional Gateway I think the exposure could be minimal as it will receive payments from side to side continually netting the position.  

 

 

 

[opaopa]

16 hours ago, fedlope said:

Opaopa, thanks for your reply. 

When I refer that the Gateway must hedge its positions, is because it will assume all market risk for its clients. If I receive 100 USD and give back 130 CAD equivalent, and the promise of giving back (in an indefinitely amount of time) the 100 USD to what ever price the CADUSD is, then I as Gateway am exposing my self to what ever movement the CADUSD makes in what ever time range. This is high risk.

From the client perspective, he is already exposed (or hedge depending on the client needs) as he has bought 100 USD in equivalent CAD -Just like real fiat-. And he is not paying for the service of holding the asset (as would in derivatives contracts as they have due dates and roll-over costs), just a transaction fee (same as current operating services). At the end is just like buying real fiat, no extra cost.

In delivering this service to the client, we receive the opposing risk, that's why the need of hedging our self's.

Why do we assume this risk? because it is not the main thing, we are looking to build a system that allows instant payment between agents and regions, with all this, the possibility to save and invest in other currencies and asset classes. 

For a fully functional Gateway I think the exposure could be minimal as it will receive payments from side to side continually netting the position.  

 

 

 

Yes, I think I understand you business idea. However, the problem you are describing is in and of itself the whole problem behind a massive market, the FX derivatives market.  You solution delivers to the client the same effects as an FX hedge, but according to you, to a reduced cost. As you describe, you then move the market risk problem from you customers to yourselves, which has the potential to (and undoubtedly will, given enough time) bankrupt your business if you don't hedge that exposure. Now, you in turn must purchase FX derivatives. So, how will you be able to compete with your offering against available FX derivatives, when you are just a middle man for your customers to purchase such derivatives?

Also, since you don't contract a due date, you may be stuck with a derivative for an extended period of time to cover the market risk your customer has exposed you too, without any possibility to charge the customer for their privilege. During that time paying interest and fees for the derivative instrument.

The only solution to your problem is

1. to actually transact the CAD <> USD FX transaction to eliminate that exposure. However, I'm sure you agree that such a solution is very expensive given the total spread cost in performing Fiat to Fiat conversion through XRPL.

2. Or, as you say, match the market risk with a position in the opposing direction. Counting on the problem to resolve itself in that manner is counting on luck, and ill advised.

Edited November 19, 2020 by opaopa

[fedlope]

No, I am sorry but you are going off topic. 

We are building a structure with Interledger to be able to make instant value transfer with no regional limitation, value store within XRP.L. There is no offering of speculative or hedging products. 

The Value store in the XRP.L as Issued Currencies, digital valuation of multiple assets. This is an XRP.L development, not us. You can check further information in the manuals. 

The point of an IC is to have a digital representation of an asset, so if I sell digital value representation of GOLD, I am selling the asset, therefore there is no risk implied from the buyer, on the other side there is a risk since I don't have the real asset I am selling. Therefore, hedging is a sub necessity of the Issue Currency part. Is analogous to asking what type of security does ripple recommend to save client information. This is not the main product of the system. 

Also hedging is not something we invented, it is a financial method to cover risk, this has been applied for decades. The topic of the post is aimed into what would be a good strategy for doing this an whether if there is some functionality in the ledger for this or supporting this need. 

On the other side,
Q:how are we going to compete with already derivative brokers?         A: we are not intending to 

Q: due date of contracts.       A. there is no cost for holding a derivative contract, there is liquidity to open and close so there is no need to over expose for an extra time. 

Q: interest and fees             A: there are no interest, just transaction fees 5 USD per side per contract any size. 

Q: if there is possibility that the client does it by itself.                A: they could if they have the following. 1. knowledge on derivative markets, 2. a brokerage account, 3. a big exposure to cover for, (the smallest FX contract in CEM is for 10k AUD with a 200 USD margin) 4. the ability and resources to trade for multiple assets, and most important 5. a reason to hedge, witch they don't. 

 

 

 

 

[TaylorWarden]

On 11/18/2020 at 10:53 AM, fedlope said:

...

If I receive 100 USD and give back 130 CAD equivalent, and the promise of giving back (in an indefinitely amount of time) the 100 USD to what ever price the CADUSD is, then I as Gateway am exposing my self to what ever movement the CADUSD makes in what ever time range. This is high risk.

...

In the situation that you have described here you would take the 100 USD at the current market price of CAD, say approximately 131$ (the exchange rate is exactly 130.973$CAD actually), and you would charge a service fee on the deposit for processing the transaction through the XRPL.  You as a Gateway earn revenue by defining a fee structure which provides revenue to you and you hold exactly the 130$CAD that is owed to the client to be repaid upon redemption of the Ripple IOUs which would act as warehouse receipts onto the physical (nowadays digital) delvery of the tangible financial assets you advertise you manage.