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Vanguard’s Move Into FX Trading Spells Big Trouble for Big Banks

October 7, 2019, 5:41 PM UTC

When it comes to adapting to a rapidly evolving investment environment, the big banks can’t catch a break these days.

It’s no secret that a wave of tech-enabled innovation has thrown a wrench in Wall Street’s traditional securities trading model, compressing margins and allowing non-bank players to take a bigger piece of what once was a very lucrative pie. Couple that with historically low interest rates that are only getting lower, and you have revenues that have hit post-recession lows, forcing firms to take a hatchet to their head counts.

The disruption shows no signs of abating. On Thursday, it emerged that The Vanguard Group—the $5 trillion asset management giant that revolutionized index fund investing more than 40 years ago—has drawn up plans for a new foreign exchange trading platform that would see it encroach on territory long dominated by the major investment banks.

Vanguard’s platform would deploy technology—blockchain, specifically—to streamline the currency trading market, allowing institutional buy-side firms to trade directly with each other. It would create a peer-to-peer FX trading model to reduce costs for currency investors, allowing them to bypass the banks—who have long acted as the price-setting middlemen in the FX market—and their hefty commissions.

Andy Maack, Vanguard’s global head of FX trading, described the model as “disintermediation” in an interview with investment management industry publication The Trade last month. “Trading would be decoupled from banks and price discovery could potentially happen outside platforms, where there might be better facilities to enable peer-to-peer matching,” he said.

A spokesperson for Vanguard confirmed to Fortune the firm is “currently piloting a project focused on improving the efficiency and reducing [the] risk of FX hedging,” but declined to comment further.

For some, this sort of attempt at disrupting the $6 trillion-a-day currency market was only a matter of time. Mayra Rodriguez Valladares, managing principal at capital markets consultancy MRV Associates, says she is “surprised that it has taken the buy-side this long” to challenge the FX market’s status quo.

“There is no reason that with blockchain and other technological innovations, giant asset managers such as Vanguard, [Charles] Schwab, and Fidelity could not participate in foreign exchange markets more significantly without banks as intermediaries,” according to Valladares. With Vanguard alone trading $2.5 trillion worth of currencies annually, it is an opportunity “that would reduce the buy-side’s costs significantly,” she notes.

The platform would be indicative of a larger trend within financial services, and one that’s hitting the banks where it hurts: the development of lower-cost, tech-driven alternatives to traditional trading models.

“Vanguard can potentially open [the market] up and say, ‘Look, we know we’re buying and selling all these different currencies—maybe there’s an opportunity for us to trade directly [with other buy-side firms],’” says Brad Bailey, a research director at financial services consultancy Celent’s capital markets division.

While that would “dramatically cut costs for trading and hedging FX portfolios” for investors, it would also “cut into a lot of banks’ profitability within their FX businesses,” Bailey notes.

“The margins have gotten so tight as more buy-side institutions get intelligent about what the market structures are,” he adds. “Vanguard has always been at the vanguard of making trading as cheap as possible, so they can pass those savings on to their investors.”

It would also be a huge step forward for the practical application of blockchain technology, at least beyond the highly speculative and much-debated realm of cryptocurrencies. Vanguard isn’t the first player in the FX space to look to deploy the blockchain as a means of cutting costs and increasing efficiency; in January, HSBC announced that it had utilized the distributed ledger technology to settle $250 billion in FX transactions on its “FX Everywhere” platform.

Mark Williamson, HSBC’s global COO of FX cash trading and risk management, subsequently told Reuters that the blockchain-based system had reduced the cost of settling FX trades by roughly a quarter.

HSBC’s experiment with blockchain is an example of a big bank trying to stay ahead of the curve when it comes to the technological disruption of a major business line. And given the sheer scale of the banks’ presence in the FX market, and their ability to provide credit to currency investors, there’s little chance that a venture like Vanguard’s will completely recalibrate the currency market overnight.

What the asset manager’s tech-fueled foray into the FX realm does indicate, however, is that there are few areas within the financial services sector that aren’t prone to disruption. The big banks, for their part, will have to continue to account for nimble, and often well-funded, newcomers promising cheaper alternatives in an increasingly fragmented investment landscape—or else find their margins further squeezed.

“FX is a huge market, and there’s always going to be a space for the banks—but each step a buy-side institution like [Vanguard] makes is going to cut costs and put pressure on the banks,” Bailey says. “There’s no standing still in terms of technological investment; if you’re standing still, you’re going backward. That’s the reality for the banks.”

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