XRP in FX Hedging market

Whether you're a small family business importing tequila from Mexico or a large asset manager, you are exposed to currency exchange rate risks. And if you're an established small family business you probably don't have a currency risk hedging desk, but definitely your bank has you covered from within your credit facility. If you're a large business, you do your own hedging because the currency exchange rate risk is real, measurable and hedgeable. And that makes FX Hedging an important business inside the financial industry. With a stroke of a pen or a couple of phone calls from Donald Trump, a digital asset could be positioned to make life a lot easier, cheaper and better for the entire FX Hedging business. Or similarly, an event like SWIFT announcing the use of XRP for international transfers would trigger events in many legs of the financial industry, one of which would be the FX Hedging, a sector that didn't attract that much attention so far.

If I were a hedger, such an announcement would only mean one thing to me: I do my hedging by exposing my business to XRP contracts instead of EUR/USD, USD/JPY, GBP/USD and what have you. Why? Because one hedge covers all FX pairs with highest effectiveness and at the same cost, instead of having one hedge for each FX pair with varying degrees of effectiveness and at different costs and increased mis-management risk. 

 

But before I can do my FX hedging by XRP exposure, some things need to happen to the XRP market. XRP has to have: liquidity (including orderbook depth), cost (very low spreads) and effectiveness (price stability). And while the pillars can be set by strategic decisions or executive order and fall into place gradually or suddenly (don't forget, money is a creature of law!), meaning that XRP will necessarily get the liquidity, cost and effectiveness of the USD once they have been linked, there is a component that is left to the market: price. The good part is that, while the law is a matter of will, the market can't forever defy gravity and in the end everything will reach equilibrium under the mechanics of supply and demand and will settle on a certain price. Let's run the real-world numbers out there today and see what are the conditions that XRP needs to meet during price discovery, somewhat long before it can run the FX Hedging market. And remember, this only one leg of the financial industry, there are many other legs that pressure this very same price.

 

A finance name equivalent to  crypto's TVL is Notional Amounts Outstanding. The Notional is the face-value on which future cash-flows are exchanged. Below the Notional sits the Gross Market Value (GMV) – the replacement cost if all contracts were closed out today. If we either use the latest BIS release (June 2024) and put GMV for FX derivatives at roughly 0.6 % of Notional or use previous releases and put it higher (2.3% of Notional in June 2019), GMV sits well below the Notional because most contracts are very short-dated and near-par.

In any other type of derivatives the Notional is just a reference for the GMV because what matters is mark-to-market value, the actual cash that changes hands. But not here, not in FX hedging. In FX hedging, hedgers set ratios off the Notional. To cite BIS work: “Payment obligations arising from FX swaps/forwards and currency swaps are staggering […] outstanding amounts at end‑June 2022 reached USD 97 trillion.” (BIS link) – i.e. the full payment obligation is what matters, not just mark‑to‑market.  If it's not clear enough, let's cite the same authors: “FX swaps and forwards differ from most other types of derivatives in one crucial respect: the notional amount is exchanged. […] Notional amounts must be paid and thus matter a great deal; in fact, there is nothing notional about them.” (CEPR link ).

Now that we have a market where there's noting notional about the Notional, let's figure out what the Notional is made out of and how big it is; the global OTC FX market at the end of 2024 was $130 trillion. Exchange-traded layer is thin: CME records of $347.5 bn and FIA contract data imply a global listed range of $0.8 – 1.2 trn, meaning less than 1% of the OTC figure. Putting the pieces together:

Global FX market (Notional) $130 trn (OTC) + $1 trn (listed) = $131 trn. This calculation will be useful for other legs of the financial industry too, but out of all this money, the global FX hedging market is $111 trn.

Where did the FX Hedging trillions sit at EoY 2024? In two OTC instruments:

 1. FX swaps + outright forwards, $74 trn (2/3 of the $111 trn swap-complex) 

    1.1   Typical tenor: 75 % mature within 12 months, 30 % maturity within one week (this is very important for XRP velocity);

    1.2   Main holders: Dealers (banks) on one side; asset-managers, pensions and insurers on the                                        non-dealer side.

2.  Cross-currency swaps,  $37 trn (balance of the US $ 111 trn)

     2.1   Typical tenor: 1 – 30 years (matched to bond liabilities or funding programs);

     2.2   Main holders: Corporates and long-term real-money investors.

How are the $131 trillion accounted for? Most of this exposure is booked off-balance-sheet on dealers (banks) and reported to trade repositories; the asset-manager’s balance sheet shows only net fair-value (mark-to-market) plus the collateral they have posted, under IFRS 9. 

Now, let's dive into the workflow of a typical US-based global bond fund worth $1 trn, that needs to do typical hedging of its FX risks:

Step 1.  Exposure measurement: the risk system aggregates asset values by currency each day.

What is the exposure? Large US bond/equity funds typically hold 35–45 % abroad. 

Step 2.  Hedge-ratio decision: the chief risk officer sets the hedge ratio. 

What is the hedge ratio? Same studies show hedge ratios of 90 %–100 %. 0.4*$1 trn =  $400 bn. That is the hedge the asset manager needs to keep in its books at any moment.

Step 3. Pre‑trade checks: the system blocks trades that would breach collateral limits or counterparty concentration.

Step 4. Execution: the FX stock is split and traded in trade size clips.

Step 5. Trade reporting & confirmation: the trade is auto‑reported to the swap data repository and matched by both sides in the settlement system.

Step 6. Collateral cycle: GMV is 0.6 % of Notional, meaning $2.4 bn in cash is used for collateral and costs on the $400 bn book.

Step 7. Settlement: the system settles both currency legs. An FX forward or swap require each party to deliver the full-face amount of its currency on value‑date and a party that is short the funding currency must borrow or liquidate assets to meet the principal payment and this is why there is nothing notional about the Notional. Even if the asset manager uses only $2.4 bn to hedge, the entirety of the $400 bn book is traded and settled.

Step 8. Roll process: before expiry, the desk offsets the maturing forward and simultaneously puts on the next 1‑month leg. The whole book $400 bn turns over 12 times per year. 

Step 9. Accounting & effectiveness test: hedge effectiveness is tested quarterly and must stay within 80–125 %. 

Step 10. Governance review: internal audit reviews limit breaches, at the end of the year. 

 

The main pillars of FX in general and FX hedging in particular, are: liquidity (including orderbook depth), cost (very low spreads) and effectiveness (price stability). Linking XRP to the dollar leg of FX will necessarily tranfer the USD metrics to XRP, gradually or overnight. Let's take a look at EUR/USD metrics:

Liquidity: EUR/USD accounts for 30 % of global FX turnover. Actually, the USD accounts for one of the currency legs for 90% of FX swaps and forwards, and EUR, JPY, GBP, CHF and CAD jointly account for one currency leg for 60% of FX swaps and forwards, so the top 5 FX pairs make up 54% of the global FX turnover.

Cost: EUR/USD bid‑ask median spread is 0.53 bp. The long-run mean spread for USD/EUR/JPY/GBP, 2000 to 2023, was between 2.77 and 3.60 bp, pair dependent.

Effectiveness:  Correlation of 1‑month forward price with spot price is 0.99, which means it is extremely stable. Deloitte and PwC put the variation between the 1-month forward rate and spot-rate of EUR/USD to ± 1%; the ratio of any G-10 FX pair never strays outside 95–105 %.

For XRP this effectiveness would mean that if XRP is $100 now on spot, it should be somewhere between $95 and $105 on spot a month from now. Remember the second step of the hedge workflow, the hedge-ratio decision? Well, each day, if the deviation from the hedge-ratio decided upon is more than ±2 % it triggers an automatic rebalance order which buys or sells enough to get back within the ratio. Those automatic rebalancing orders on books worth $111 trn make up for a lot of money stabilizing their positions hence stabilizing the XRP price every day.

So what is the last shoe to drop here? The price, which can only fall within the limits set by all the numbers we've talked about so far.  The Ripple-linked equation that gives the long-term fundamental value per unit of currency includes a discount rate that the authors needed to use in order to discount the predicted price back to today. But the discount rate isn't applicable to this calculation because this calculation uses real data existing today and it derives the price that XRP needs to get to in a short time-frame, before it can serve the today's FX Hedging market. Let's run those numbers assuming that all the XRP minted would be used to serve this market:

Addressable market: $100 trn

Global FX hedging market: $111 trn;
USD leg of FX stock: 90%; 
0.9*111 = 99.9 

Circulating supply: XRP 96 bn

Market maker inventories to cover imbalances between pay‑in and pay‑out corridors, to quote spreads and for safety buffer need to be at 4% (CLS link)
100 - 100*0.04 = 96   

XRP Velocity: 15 

1. FX swaps + forwards, $74 trn
- maturity within one week: $30 trn worth of XRP tokens with a velocity of 48 (27.03% of aggregate velocity); 
- maturity within one month, excluding one week: $0.75 trn worth of XRP tokens with a velocity of 12 (0.68% of aggregate velocity); 
- maturity within one year, excluding one week and one month: $43 trn (balance of $74 trn) worth of XRP tokens with a velocity of 3.5 (38.74% of aggregate velocity), average between 6 months and 1 year since publicly available data doesn't cover the exact brackets (BIS link).  

2.  Cross-currency swaps, $37 trn (balance of the $111 trn)
- maturity within one year: $7.4 trn worth of XRP tokens with a velocity of 3.5 (6.67% of aggregate velocity), average between 6 months and 1 year since publicly available data doesn't cover the exact brackets; 
- maturity within five years, excluding one year: $18.2 trn worth of XRP tokens with a velocity of 0.35 (16.40% of aggregate velocity), average between 2 and 5 years since publicly available data doesn't cover the exact brackets;
- maturity within more than five years: $10.5 trn worth of XRP tokens with a velocity of 0.1 (9.46 % of aggregate velocity), average between 6 and 30 years since publicly available data doesn't cover the exact brackets (BIS link).   

Weighted average velocity:  1,633/110 = 14.85 

Liquidity buffer (XRP market cap): $6.67 trn

In order to reuse XRP 15-fold while serving a market of $100 trn, all the circulating supply needs to add up to $100 trn / 15 = $6.67 trn

XRP price: $70

XRP 96 bn circulating supply adding up to $6.67 trn means $6.67 trn / XRP 96 bn = $69.48

This is the minimum necessary, long-term stable mechanical floor price which XRP cannot fall under. XRP will get to it during price discovery, before it will be used for FX hedging alone. 

This price covers only the standing stock of dollar legs at today’s levels and assumes perfectly even recycling of the entire XRP inventory, 15 times per roll. As we know, the entire XRP supply of 100 billion tokens will never be perfectly recycled, it will only get smaller in time and parts of the inventory will be used for other purposes. The velocity calculation lanscape is almost infinite and is only driving the number lower, because it granulates down to daily locking XRP tokens for different amounts of time; the lower the velocity, the higher the price - but let's leave velocity for another time while remembering that this is only one leg of the financial industry - there are many other legs adjoining it, and all the legs together will drive the XRP rock-bottom floor to many multiples of $70. 

 

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