Prime brokers dislike last look, but the bank dealer platforms continue. We look at FastMatch’s ingenious solution
Last look execution a bugbear for OTC counterparties and the preserve of the Tier 1 interbank giants? Not anymore. Prime brokerages and liquidity takers are now about to be empowered
A moot point among banks, prime brokerages and central issuing authorities alike, the execution process commonly referred to as ‘last look’ disclosure continues to be operated on a widespread basis across institutional platforms and among bank dealers.
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.
major banks are creating a double edged sword with regard to execution and provision of Tier 1 liquidity.
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.
The Financial Conduct Authority (FCA) which presides over the world’s largest institutional and retail center – London – last year conucted its own review into the supervision and transparency of some markets, including the FX market. The FCA’s Fair and Effective Markets Review, or FEMR, specifically asked asset managers and other bank clients about their views on last look.
While some foreign-exchange platforms already don’t permit last look, it is still allowed on some large venues, including the aforementioned BATS-owned Hotspot FX, as well as FXall, owned by Thomson Reuters. Hotspot and FXall account for about 25% of clients’ electronic FX trading, according to financial services industry consultants Greenwich Associates.
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.
Many single dealer platforms have specific interests in maintaining their last look execution practices regardless.
FinanceFeeds has spoken at length with a number of senior executives within the institutional and prime brokerage sector recently, many of which have openly stated that banks do not like firms that offer ‘no last look’ execution, despite the regulatory and government derision aimed at the practice.
British multilateral trading facility (MTF) for FX, LMAX, has been a fish swimming against that tide since its launch over five years ago. The firm offers no last look execution, and its CEO, David Mercer, is often outspoken with regard to this being a method of increasing transparency in execution.
LMAX does not have the lion’s share of the institutional liquidity provision to retail firms, however Mr. Mercer is a vocal proponent of the firm’s ideology with regard to execution.
This forerunning status and ‘last look’ adamancy landed Barclays with a $150m fine from the New York Department of Financial Services at the end of 2015 for abusing its last look execution facilities within its FX trading desk, contributing to further officials having doubts over the way the market polices itself.
As 2017 gets underway, innovations with regard to institutional execution practices continue to evolve.
Today, FinanceFeeds spoke to Dmitri Galinov, CEO of FastMatch in New York, in order to discuss the new methodology which has been developed by the company that could well be the antidote to exactly this problem.
In terms of corporate perspective, Mr. Galinov explained to FinanceFeeds “We would like to see the world without last look execution, because we feel that it would be more fair that way, however we do understand that the FX market is the biggest market in the world and the market has been operating with last look for all these years so it is not like one particular bank or broker is doing it and nobody else is doing it.”
“As far as we are concerned” continued Mr. Galinov, “when you think about what last look actually is, it is a type of free option. For example, if a customer comes and says that he wants to trade with your price, and you as a market maker say that you don’t want that trade anymore, this creates a free option for the market maker as to whether to transact or not.”
“One of the routes that we are taking is to offer brokerage-free trading to participants that do not use last look execution. The rationale behind this is to compensate a company financially if they dont use that option. The ‘free option’ of being able to use last look has monetary vlaue, therefore we would like to offer free brokerage to those who don’t use last last look” explained Mr. Galinov.
“The second thing we set in place with regard to this was to introduce a new order type, which is called Leak/Sweep Protection, or LSP for short. “What this order type does is outsource the entire last look facility of a trade to FastMatch. Fastmatch performs the check to see whether the trade is going to go through or not. It is for clients that are using that order type, they don’t disclose the order type to the market maker which ensures that it cannot be rejected” said Mr. Galinov.
“The reason market makers use last look and those who take liquidity dont like last look, is that this practice gives information to the market maker, and then it is not getting traded. We solved that. When the clients tried to trade, we get an order from the client but we don’t forward the order right away from the client to the market maker.
Instead, the order is held for approximately 100ms within the FastMatch system in order to see if the market is at same level and not going against the market maker and then we trnasfer it to the market maker, however if it goes agaisnt the market maker we then don’t send it to the market maker because they would reject the order. This way, relationships are better because the market maker does not know about that trade at all, we reject it to the liquidity taker instead.” – Dmitri Galinov, CEO, FastMatch
In technical terms, during the hold time, the market moves away beyond a specified PIP threshold, FastMatch will reject the order from a taker. Otherwise, FastMatch will send the order to the maker for execution at the original matched price. A maker can select a benchmark for the market movement such as its own quotes, FastMatch midpoint, FastMatch best bid/offer. FastMatch expects makers to execute 100% of orders on the connections where LSP is enabled.
Mr. Galinov considers this to have solved the issue for the industry. “We are the only platform that performs this functionality, as well as the only company that offers no brokerage fees on last look execution” he said.
One of the factors that FinanceFeeds can envisage this to resolve is that it will mitigate the amount of dissent that single dealer platforms receive from liquidity takers and prime of primes.
Last look execution is here to stay among Tier 1 banks, as their view is that they must use last look to protect themselves against clients that are sweeping the market and then as soon as the market turns, they select a market maker to execute in their favor, hence banks using it as a type of risk insurance.
Mr. Galinov also considers trade settlement to be a bete noir for OTC derivatives firms. “Trade settlement is expensive these days. If I want to see how disproportionate this is, I compare the commission on the market to the cost of settling the trade. In the exchange listed futures sector, the settlement cost is around 1/1000th of the average electronic commission, whereas in FX it is often larger than the commission” he said.
“The exchanges will be the ones that solve this” said Mr. Galinov. “It is still much cheaper to clear exchange traded derivatives than clear on an OTC basis for the FX market so I really hope that the exchanges will step up and solve this issue.”
“A particular benefit of that would be cross margining capabilities. Exchanges can cross margin all asset clases and come up with an effective system that takes care of the cost as well as the counterparty risk” – Dmitri Galinov, CEO, FastMatch
It is absolutely a major issue that OTC counterparties face, in that the curtailing of credit from banks even for well capitalized firms has caused a ‘credit crunch. With exchanges as a centralized counterparty, Mr. Galinov concurs that massively capitalized venues are much more favorable to banks and liquidity providers than having to face every party separately.
“As an example” said Mr. Galinov, “CLS does not guarantee settlement. The fact that two people traded via CLS doesnt mean two people will get their money. If you survey institutional participants and ask them whether OTC clearers guarantee the trade, they may well say that it does and this would be a misunderstanding. Exchange clearing would lower the cost and lower the risk, as you would have to settle with one well capitalized central party” he concluded.