Fixing FX with Crypto

Level 3 - Virgin DeFi Analyst

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Today’s post is about foreign exchange and how DeFi can serve as a disruptive force. FX doubles as an onboarding mechanism and solidifies crypto’s position as a core financial primitive of the future.

Can DeFi Disrupt Foreign Exchange Services?

The exchange of foreign currencies is one of the largest markets in the world.

The Bank for International Settlements reports a *daily* turnover of $7.5 trilliondollars, of which $2.1 trillion is comprised of “spot” transactions - physically settled transactions where the currency is wired between banks (as distinct from derivatives contracts used mainly for hedging risk).

Simple Example - Replace Credit Cards

If you hold US dollars but are buying a cup of coffee - or a holiday home - in Italy, you’ll need to execute a spot foreign exchange transaction. Following the launch of Circle’s EURC stablecoin which is pegged to the currency of Italy/European Union, you can conclude spot FX transactions entirely on chain using DeFi exchanges.

Coinbase treat both USDC and EURC as equivalent to fiat currency and allow on/off-ramping with no additional conversion fee. We’d expect other fee-free ramps to follow, and perhaps some will eventually allow third party payments.

Here’s an overview of how DeFi could disrupt foreign exchange and payments in the very near future:

1. Alice has USDC in her wallet and visits Bob’s cafe in Italy.

2. Bob’s point of sale terminal prints a QR code on each bill.

3. Alice scans the code to a smart phone hot wallet and agrees to pay.

4. Behind the scenes, USDC is converted to EURC at a fair exchange rate with no intermediaries (using a DEX like Aerodrome on a low-fee L2 like Base), and sent to Bob’s Coinbase account.

5. Bob , and his PoS terminal displays payment complete within 2 seconds of Alice clicking “approve” on her wallet.

6. Bob has set up an automated task on his Coinbase account to sweep balances over 100 EURC to a fee-free EUR direct deposit to his local business bank account.

Alice is able to pay for real goods and services with her USDC, anonymously. When she’s abroad, DeFi finds the best foreign exchange rate on-chain, while charging lower fees than her bank would for a foreign currency credit card payment. As crypto increases adoption, we’d expect major stablecoin issuers to tokenize at least the G8 currencies.

Bob avoids the 1.5-3% credit card processing fee, there is no possibility of fraud or chargebacks. He can reduce his working capital requirements as he doesn’t depend on the longer settlement cycle of card payments; funds are available instantly. Bob onboarded to crypto to save a few percentage points in fees, but later leverages the composability of DeFi in other areas of his business. One example could be setting up streaming EURC payments to his staff, reducing their need for payday loans (salaries in Europe are typically paid monthly in arrears).

Migrant Remittances

Many low earning immigrant wage earners pay disproportionate fees to money transmitter businesses to send funds to family in their country of origin. By charging a flat rate - pennies - for transaction fees, and providing a low fee/slippage (e.g. 0.1%), DeFi could significantly reduce costs for these low value transactions.

Large Transfers

Purchasing a second home or making large or regular cross border business payments is fraught with unnecessary costs, delays, and sometimes payment errors.

International wires are slow and expensive: correspondent banks sometimes take an additional fee, and the bank almost inevitably applies a greedy markup to the exchange rate. Choosing stablecoins could save thousands of dollars compared to some other TradFi options when buying the median house. For large transactions (more than $50k), you can still get better rates in TradFi but we’d expect that DeFi will be able to match those soon.

Aerodrome, the leading DEX on the Coinbase L2 Base has published this interesting price comparison in an ad.

This means the USDC/EURC pool on Aerodrome is liquid enough to support cheaper swaps on-chain compared to going through some TradFi providers. While we’d never pay full percentage points to exchange currencies through a retail bank, it’s impressive to see that DeFi is able to offer a price improvement over the FinTech / Neobank companies in the foreign exchange market.

DeFi For Business

Foreign currency stablecoins can be at the core of a business treasury management strategy. Money markets like Aave provide secured borrowing services which could be used to “sell short” a foreign stablecoin to hedge risks a business faces when receiving future income. Funds can be borrowed against collateral and exchanged for the foreign currency in advance, to remove risk from future foreign expenses.

On-chain would be cheaper and more efficient than working with a currency broker or bank, where complex legal documents need to be signed and the business faces risk if its counterparty (service provider) becomes insolvent.

If a Company and its suppliers are both crypto enabled, then value transfers are frictionless compared to international wires. This is a particular issue when exchanging value between countries in different global power blocs (wiring money from China to the US for example).

The Pitfalls of Trusting TradFi

The goal of DeFi is a fair and transparent market: no intermediaries, predictable rules enforced by code (smart contracts).

Where one deals with banks or other financial intermediaries there is often a conflict of interest between the provider and the customer. When it comes to placing foreign exchange traders, whether for physical settlement or to hedge risks in the future, businesses large and small have come up against sharp practices.

There have been various cases where banks have deliberately designed a system to keep the FX trades where it makes a profit and the customer makes a loss, and to reject trades where the customer would be immediately in profit. Barclays Bank was fined $150 million:

For a detailed look at the legal issues, see the remainder of this report.

“Last Look” was a topic of controversy in the run-up to the finalisation of the Global FX Code published by the Bank for International Settlements’ Foreign Exchange Working Group - an indication that the problem is widespread within the industry. Unfortunately, this “code” is not legally binding. Enforcement remains inadequate, leaving loopholes that intermediaries can exploit to the detriment of customers.

Beyond trade pricing and execution, dealing with a salesman at a bank to help hedge your currency risk can be a losing proposition. Deutsche Bank may have mis-sold FX derivatives to more than 50 businesses in Spain, including leading hotel chain Palladium Group and Europe's largest wine exporter J Garcia-Carrion with whom it settled the mis-selling dispute for over €10mm ($11mm USD) in 2021. This is due to the banks constructing and packaging “exotic” derivatives: FX products which both fail to function as a good hedge, and expose the customer to the risk of disproportionate losses, but lure the customer in with a notionally “better” exchange rate or avoiding the need to place substantial capital with the bank (margin) to cover the trade.

The fact is that financial regulation does a poor job of protecting customers. We’ve covered this at length in $200 Billion in Bank Scams. DeFi can end these unfair practices.

Concluding Thoughts

The market is in search of real technological progress, as exhibited by the resurgence of investment interest in DeFi coins like Aave as of late. Aave is a market leading battle-tested DeFi protocol that serves a key need in the ecosystem. We believe the market has shifted and more protocols that people need are going to lead the way as more crypto professionals realize the only way forward is real progress. DeFi will be great again, as it’s one of the few real use cases that drive value to the crypto ecosystem as a whole (net positive value creation). The next ten years of crypto will be marked by more attempts to build products that people use to improve their daily life, filled with massive successes (and of course lots of spectacular failures).

If you’re interested in deep dives on the next big DeFi projects, join DeFi Education where we’ll be going into projects that our readers recommend and ones we find in our on-chain activity.

Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.

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