As long as the FCA has no remit over banks, absolutely nothing will change the privilege that single dealer platforms have with regard to last look execution. We examine the words of a senior FCA official alongside the industry’s standpoint
Last look execution is a privilege which is held by the eFX desks of Tier 1 banks, and Tier 1 banks only.
Last look is a term which refers to a facility within trade execution in which banks (or non bank electronic communication networks) can pull out of trades at the last moment if the market moves against them.
For several years, this practice has been considered controversial, and central banks across the world are relatively averse to its existence, yet it continues to be part of the overall topography of institutional electronic trading at Tier 1 bank level, thus by its very standing at the very top of the trade pricing and execution structure, is a practice which filters down by default and affects all components via aggregated liquidity feeds and eventually to retail brokerages.
In May 2015, BATS Global Markets, which operates institutional multi-asset platforms and now owns major institutional ECN Hotspot FX having bought it from KCG for $365 million, began to curb the practice over a course of several weeks, placing limits on how many ‘last look’ orders could be executed in order to take its own step in increasing transparency in the non-bank FX market.
Admirable indeed, perhaps. However, although certain measures such as this have been taken by large institutional firms, EBS, the electronic brokerage division of British interdealer broker ICAP, having gone a stage further in February this year by implementing a policy which aimed to abolish the need for last look execution altogether with the launch of the firm’s new EBS Live Ultra price feed which streams real-time market data from EBS Live which is operated by the firms EBS Broker Tec division, last look is alive and well at bank level.
Whilst not a mandatory implementation, EBS stated at the time that it took this action as a result of feedback and demand from corporate clients.
This is indeed all very well, however major banks are creating a double edged sword with regard to execution and provision of Tier 1 liquidity.
Last look execution is still in widespread practice, and shows no signs of being banished to the history books of un-transparent practices.
An example of how impotent the British financial services regulators are when it comes to expressing dismay and being able to do very little about it can be found within Edwin Schooling Latter’s diatribe in November last year, when he addressed institutional delegates at a conference in London.
Mr. Schooling Latter is Head of Markets Policy at the FCA, however his difficulty is that no matter how much thought leadership goes into how to regulate last look practices, it will remain just that – thought leadership – because the FCA has absolutely no remit over the enforcement of banking practices, as it only regulates the non-bank sector.
The Prudential Regulatory Authority, which is responsible for overseeing banking entities and is part of the Bank of England, has remained very much silent on last look practice.
Global code: Impotent or implementable?
Mr Schooling Latter said “One of the issues being grappled with as part of the phase two of the implementation of the ‘Global Code’ is is the practice of ‘last look’ – advertising a price, but reserving the right, when a client asks to trade at that price, to reject the client’s order.”
He continued “All else equal, a quoted price is clearly of more use to the client if it can also actually trade at the quoted price. This is also good for the wider market – for price discovery and for accurate valuation even for those who do not intend to trade. That is why in some other areas of financial markets regulation there are regulatory requirements for certain prices advertised through the systems of a trading venue to be firm – ie executable – and pre-trade transparent. Some stakeholders argue that last look should therefore be prohibited altogether. They consider that is has no place in a market as liquid as FX.”
“On the other hand, indicative prices will continue to be permitted in some other situations in regulated markets, providing that their indicative status is unambiguously clear to potential counterparties” said Mr. Schooling Latter.
“You will have heard arguments that allowing last look enables a market maker to offer tighter spreads. But the key for clients is, of course, the spreads that can be achieved rather than those that are quoted” he said.
As one client in the New York DFS case graphically put it: ‘We kept receiving top of the book rates from you and hitting your rate, but we got rejected by you 9 times out of 10 where we could have been well filled by other liquidity providers who have been providing competitive rates’
You will also have heard arguments that last look protects market makers against predatory HFT firms sniping stale quotes, and so enables the market maker to offer a better deal to ’real economy’ market users, allows a greater range of firms to act as market makers, and so helps to sustain liquidity in this important market.
“I would not jump directly to the conclusion that last look should be prohibited altogether. I think there is an argument for letting market discipline and customer choice determine if and where last look continues to exist, but if market discipline is to work, there must also be transparency about the practice” said Mr. Schooling Latter.
“I noted earlier how FX spot trading is in some respects outside the formal regulatory perimeter. You will have gathered from my earlier remarks that this is not because FX is not an important market. Arguably, this situation may be justified by the relative simplicity of spot FX – the instrument is easy to understand, and problems of asymmetric information might be considered less severe than in the case of more complex or bespoke instruments” Edwin Schooling Latter, Head of Markets Policy, Financial Conduct Authority
“But if the case for spot FX sitting outside the regulatory perimeter rests on this market not being characterised by unacceptable information asymmetry, that must apply to last look too.”
“And transparency does not just mean an ex ante disclosure that the dealer might take a last look. It also requires post-trade transparency, at a minimum statistics made available to all clients on the proportion of all trades, by value, that were rejected following a last look check, so that clients can make informed choices about which market maker or platform is offering the best trading opportunities, and whether they are treated fairly compared with other clients” Edwin Schooling Latter, Head of Markets Policy, Financial Conduct Authority
“Pre-hedging and then rejecting client orders through a last look engine carries a clear risk of detriment to clients” he said.
“There is also an important issue about how the market maker uses the information on the client’s request to trade if it subsequently chooses to reject that request. Purchasing currency on the back of the client order, but then declining to sell that currency to the client at the requested price, will, all else equal, have moved the market price against the client. The client is left with an unfilled order, and needing to meet their needs in a market now less favourable than it would have been. That looks uncomfortably like the point where ’pre-hedging’ turns into front running of a client order. It has uncomfortable echoes of the risks we identified in our remediation work around trading ahead of a client order.”
“Further, going back to the justification often given for last look, ie the market maker protecting itself from sniping by high-frequency traders, I can see that rejecting an HFT firm’s incoming request to trade against a quote you could not quite withdraw in time might serve that purpose. But trading yourself on the back of the client’s request – and then rejecting that request – is not necessary to protect against predators. Indeed, it begins to look rather like the very behaviour that HFT firms are sometimes accused of – sniffing out an order on one trading venue and racing ahead of the same customer’s orders sent elsewhere.”
HFT and dark pool uncertainty
Mr. Schooling Latter said “If FX spot were a regulated market we would consider a policy of pre-hedging and then rejecting client orders to be inconsistent with the regulatory obligations to avoid a conflict of interest with the client. If, for example, a dealer used information from its equity dark pool on a client’s buying intention, not to fill that client’s order, but to take a proprietary position, that would be a breach of conduct rules.”
“Pre-hedging and then rejecting client orders through a last look engine carries a clear risk of detriment to clients. There is an opportunity through the FX Global Code to eliminate this conduct risk without fear of competitive disadvantage – if the Code establishes strong safeguards against misuse of client information, and transparency meaningful enough to allow market discipline to work” he concluded.
LMAX calls out firms on last look, says only way forward is total abolition
British multilateral trading facility for FX LMAX is continuing to explore this model, by including it as part of its anonymous FX market survey which cites the perspectives of the Bank for International Settlements Foreign Exchange Working Group (FXWG) new Global Code of Conduct, in its first-phase.
David Mercer, CEO of LMAX considers the working group’s Fair and Effective Makets Review (FEMR) to be full of sound ideas and appropriate sentiments, however he also believes that the current code of conduct set out by the FXWG is too narrow in focus and impossible to enforce.
Bearing in mind that 70% of global FX trading is conducted electronically, Mr. Mercer believes that there is a central importance required in restoring trust in FX and as the adherence mechanism to enforce the code is not due to be completed until next year’s second phase, his opinion is that the industry cannot afford to wait another 12 months for the code to be completed.
LMAX believes that it is particularly important that the industry moves to combat market practices that are undermining trust in FX. Foremost among these is the use of ‘last look’, which LMAX Exchange has frequently said the market should abolish.
Controversially, LMAX states that it conducted a survey into this and one of the top matters that respondents state should be abolished is the practice of last look execution.
“Depressingly, those who are shaping the code seem to advocate standardisation of this badly broken and opaque market practice” stated Mr. Mercer.
From LMAX perspective, the practice of ‘last look’ is at the heart of fairness and transparency in the FX market. At best, it is an anachronism, designed to protect market makers in a way that today’s technology has now made unnecessary. At worst, LMAX thinks that it feels to some traders like a market practice that fundamentally and unfairly balances trade execution against them.
Aside from this, LMAX touched on b-book execution, stating that 58% of its survey respondents were not happy to trade with a b-book brokerage, whereas 66% stated that every transaction that takes place via a b-book broker should be disclosed, and 71% concurred that FX trading will eventually move to execution-only venues.
A year ago, it may have been looking as though some retail FX would be moved onto exchanges, however FinanceFeeds conducted extensive research into this, and whilst senior executives with a proponency toward exchange traded FX and those against it discussed it in great detail, it is now clear that this will not happen and actually, FinanceFeeds position is that the b-book is alive and well, and in our opinion FX will not move to execution-only venues.
What is interesting is the lack of full understanding by many traders and market participants alike that LMAX levels at the entire business. According to its research, 51% of institutions which took part in the survey had an awareness of last look, whereas 48% of professionals understood it properly.
Furthermore, LMAX cites that those who are aware of the practice, rated it as the most unacceptable FX practice, ahead of dark pools or internalization with 70% of respondents considering the use of last look whilst pre-hedging to be unacceptable FX market practice, and 62% saying that any use of last look execution is unacceptable, ahead of 46% who said internalization of orders is unacceptable FX market practice.
FinanceFeeds believes that internalization (warehousing, or operating a b-book) is perfectly acceptable practice as long as the price that is being provided and the order itself is being executed in a manner that echoes real market prices. There is nothing wrong with risk management. What is wrong is b-booking trades by using prices generated in-house with no feed from a prime brokerage or liquidity provider.
With regard to the difference of opinions between bank and non-bank respondents to LMAX survey, there is a dichotomy. 33% of banks believe last look execution should be abolished, whereas according to LMAX, 79% of non-bank participants think it should be abolished.
What was relatively unanimous is that almost all participants, bank and non-bank, told LMAX that they believe that the use of last look execution should be disclosed.
Certainly FinanceFeeds concurs with LMAX findings that the market share of non-bank liquidity providers will increase. Out of the respondents, 75% of non-bank participants believe that the market share of such liquidity providers will increase.
From FinanceFeeds own research, AFX Group, ADS Securities London, and Invast Global have all launched institutional divisions to provide liquidity to other brokers, and FXCM restarted its institutional division.
Better prime of prime relationships are indeed critical especially in these times of difficulties in obtaining credit from Tier 1 banks for OTC derivatives brokers due to banks being very wary of exposure to counterparty credit default risk.
Bridge providers and integration specialists are going down the ecosystem model route, ensuring that they lead this initiative.
LMAX states that a respondant explained “In an ideal world, I would like to see that FX should be traded through a single global exchange, where all orders are processed and so the best prices can be hit regardless of the liquidity provider.”
Whilst ideologically sound, FinanceFeeds understands that this is very unlikely to come to fruition, largely because of the prohbitive exchange membership and clearing fees, plus the extra layer in the execution stack which could cause latency.
Indeed, a very interesting perspective, even if perhaps not entirely unbiased and the identities of those surveyed having been masked, as LMAX is a no-last look facility, however these are points that are worthy of discussion nonetheless but whilst the dichotomy between non-bank and bank regulatory structures exists, the privilege will likely be weighted toward the banks.
Banks indignant and standing their ground with last look on single dealer platforms not going away
On one hand, banks have become extremely cautious with regard to extending credit to prime brokerages in order to provide aggregated liquidity feeds to the OTC derivatives market, Citigroup, the largest FX dealer by volume in the world with over 16% of all global FX order flow being handled from its Canary Wharf office, stated this year that it predicts a 56% potential default rate from OTC derivatives participants on counterparty credit, yet on the other hand, the very same banks are picking and choosing which trades to exit if the market moves against them, to the detriment of brokerages and liquidity providers globally.
Structural changes to the markets, management upheaval among many big banks, new non-bank entrants and lack of volumes and volatility have seemingly levelled the playing field among the industry’s biggest firms.
The biggest change in the rankings this year is the decline of the combined market share of the top five global banks. Their market share peaked in 2009 at 61.5% and was still above 60% as recently as 2014.
By 2015, the top five banks accounted for just 44.7% of total volume, however Barclays battles it out in the race for supremecy with Citi and Deutsche Bank, both of which also conduct their entire business from London.
So, that is the end of Barclays’ operation of branch banking across European high streets, a direction that concludes the Bank’s offloading of its entire Barclaycard credit card operations in Spain and Portugal to Bancopopular-e, a total divestment of its stake in Barclays Africa, a complete dispensement of its Egyptian operations and the sale of its wealth and investment management business in Singapore and Hong Kong.
Meanwhile, on home territory, Barclays continues to stand out in terms of procedure and its domination of market practice with regard to electronic trading with its BARX single-dealer platform.
Barclays is one of the world’s most prominent proponents of the last look execution procedure, its BARX platform which provides FX liquidity by streaming indicative prices on an in house and third party platform basis.
Barclays’ corporate standpoint on the reasons why it uses last look methodology is that being one of the world’s largest interbank FX dealers, it does not generally seek to reject trade requests. However, electronic spot FX market-making is a highly competitive industry and for the reasons set out above it necessarily exposes the liquidity provider to the risk of trading on incorrect pricing.
Barclays maintains that last look functionality is used to protect against these risks and allows liquidity providers to show considerably tighter electronically streamed prices than they otherwise could – something that the bank considers beneficial to every user of electronic FX trading platforms and is very hard line with regard to this.
The bank is aiming to get at least a 10 per cent return on capital from its markets clients and has recently launched a computer system called Flight Deck to help rank customers based on their returns levels and identify those who are currently not making the grade.
Status quo? you bet…
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