Over-the-counter markets famously suffer from a lack of transparency given the quote-driven model, feeding fears over dealers with spread-setting monopolies and a lack of transparency over execution process.
On the latter, one practice has come under regulatory fire: last look, which refers to market makers having a final opportunity to reject an FX order after a client commits to trade at a quoted price.
|Eliminating last look would remove some liquidity from the market|
The final report of the UK’s Fair and Effective Markets Review referred to the need for improving the controls and transparency around this practice, which it says could be abused by market makers, either by asymmetrically accepting or rejecting orders based on market moves after the order is placed, or by using the order to inform other trading activity before acceptance.
It calls for a global set of guidelines to supervise the practice.
Both Thomson Reuters and Bats Global Markets have amended their use of last look in recent months, by reducing the time available to reject trades, while large FX banks have clamped down on the activity.
In May, Hotspot reduced the time a liquidity provider has to accept/reject a trade from 200 milliseconds to 100 milliseconds, while FXall has implemented an unspecified reduction.
Hotspot participants can choose the types of liquidity they would like to access, although Bill Goodbody, senior vice-president, head of FX at Bats, observes that a mix of firm and non-firm liquidity typically yields tighter prices.
“For example, bid-offer spreads can be up to 80% tighter than spreads from firm liquidity alone,” he says.
Goodbody suggests that eliminating non-firm liquidity would be disruptive to the market and would likely lead to wider spreads for investors.
“On the basis that non-firm liquidity provision is open, transparent and disclosed to the client, we don’t believe it should be restricted,” he says. “Customers should be allowed to choose the way they want to trade.”
This point is made even more trenchantly by New Change FX managing director Andy Woolmer, who says the elimination of last look would cause spreads to widen to reflect the risk being taken by the market makers and the cost burden of actively policing the absence of last look.
“All clients can see their fill rates and who honours their pricing and who doesn’t,” states Woolmer. “If clients choose to use market makers with less than perfect fill ratios, that is up to them. They should be prepared to have meaningful conversations with their market makers where they aren’t happy with the service.”
Last-look pricing offers the hope – but not the guarantee – of a better execution fill rate, often compressing the top of book quote through aggregation and smaller deal sizes, adds ITG director Jim Cochrane.
“Eliminating last look would remove some liquidity from the market,” he says. “Since the advent of aggregation and high-frequency trading, the spot market has grown considerably – a portion of that growth would be put at risk.”
The counter-argument is that it would create a level playing field and remove the ability for orders to be handled in an asymmetrical manner, observes James Watson, managing director ADS Securities UK, who compares the ability to cancel orders to having phantom liquidity in the market.
Watson describes last look as an appropriate tool for when pricing latency was high and a lack of computer power meant platform performance was often lacking, but also states the market still comes with risk for liquidity providers and that if they cannot guard against this, prices will have to be increased.
ITG’s Cochrane says he understands why some observers feel the practice distorts the FX market, adding: “The top of book quote is only available for small trade sizes and if the market is thin, a dealer can move their quotes to a less risky level.
“Large trades are therefore susceptible to considerable market impact if liquidity is low and volatility is high. A no-last-look price would be guaranteed for a short time; a last-look trade is not guaranteed at all.”
As a general principle, Deutsche Asset & Wealth Management is not in favour of last look, says its global head of fixed income and FX trading, Juan Landazabal.
He rejects the view that eliminating last look would impact the market from a liquidity perspective and says it might even lead to better transparency and conduct, while acknowledging this could also leave the market without a legitimate mechanism to resolve situations where two or more counterparties were tied in price.
According to Alex McDonald, CEO of the Wholesale Markets Brokers’ Association, tensions between market makers and counterparties could be reduced by the use of agreed market standards and codes of conduct.
“These would be evidenced in the exchange of documentation, making the market fairer for the client whilst encouraging efficiencies in market making and providing narrower spreads for the dealer bank,” he says.
Watson at ADS agrees that greater transparency around the use of last look and a common standard for reporting the real price in the underlying market could go a long way to addressing concerns.
“However, these are industry-wide issues that need to be addressed on a global scale,” he warns.