End of last look execution? The boot is on the other foot now!

The Tier 1 bank market makers have always been able to defend the last look execution practice, however with non bank market makers now ousting the banks for FX market share, their ability to challenge last look may well be taken seriously. Is this the dawn of the OTC world having the upper hand over the banks? Here is our detailed analysis

The practice of last look execution has long since been a moot point among all OTC derivatives professionals, and a moot point that has been accepted by the vast majority due to the inability to really do much about its existence.

For many years, Tier 1 bank FX dealing systems, usually the Single Dealer Platforms operated by the major Tier 1 banks that have dominated the top level of FX market making for decades, have stuck rigidly to the principle that last look execution is their preserved right, as they are the highest in the order routing chain and therefore must mitigate their own risk as they have nowhere else to pass a trade once it reaches the bank for execution.

Last look is a trading practice where the liquidity provider provides a quote rather than a firm price into the trading system or execution venue.

When a request to trade against the quoted price is received, the bank may hold the request for some time, execute the trade at the price quoted, offer an alternative price or decline to trade.

Firm liquidity venues on the other hand operate an open central limit order book where trades are matched without optionality. This quote driven behaviour is commonly argued to be necessary to protect the liquidity providers in a fragmented and unregulated market place where there is no central exchange.

It has been often stated by FinanceFeeds that there would be a tremendous outrage if any non-bank entity attempted to implement last look practices, with potential accusations of ‘cherry picking’ or even operating a type of bucket shop where orders are only executed if in the interest of the broker, yet banks do it routinely and it is widely accepted, largely due to the bank being the provider of all liquidity to the FX market, and the might of the Tier 1 FX market makers which would be impossible to challenge.

Things, however, may well be about to change!

Last look execution may well have been impossible to challenge even just two years ago, as demonstrated by now defunct FX brokerage Alpari (US) who admirably attempted to take several banks – including at-the-time largest FX dealer in the world Citigroup and other major banks – to court for damages that it alleged were caused by banks effecting last look execution on Alpari client orders sent to the live market for execution.

At the time, FinanceFeeds spoke to many FX industry executives about this, and the response was tremendous.

Admirable though this may be, it was inevitable that Alpari (US) was never going to win against the banks, especially considering that last look execution has always been a very important advantage that the Tier 1 FX dealers had over their liquidity takers.

Just two years on, things are somewhat different as we are for the first time half way through a whole year during which XTX Markets, a non-bank market maker, has held the top global position for FX market share, with the banks languishing behind it.

Non-bank market makers do not practice last look execution, and during the period of retraction from the extension of counterparty credit to OTC derivatives firms by banks between 2012 and 2017, non bank market makers stepped in to provide fast execution and a more aligned solution for brokerages.

As last week drew to a close, six of the largest non-bank market makers raised this subject again, this time very seriously indeed.

These particular firms, which are the largest non-bank liquidity providers in FX began publicly calling for the practice of last look to be eradicated and replaced with firm pricing.

Citadel Securities, Flow Traders, HC Tech, Jump Trading, Virtu Financial and XTX Markets issued statements denouncing last look and demonstrated their opposition to opaque and inconsistent practices among market-makers.

Just a three years ago, during the height of the tug of war between OTC derivatives liquidity takers and Tier 1 banks which created a sense of dependency by showing their reluctance to extend counterparty credit to OTC liquidity takers yet still give them the impression that they had to rely on banks, there was a very different dialog, with banks firmly in charge.

FX experts contended at that time that market makers need access to last look to protect against trading on stale prices due to latency and from high frequency trading clients that have asynchronous information advantages. Over time, last look was also a factor that allowed for non-bank liquidity providers to enter the market, noted Lowry. Some supporters contend it allowed for more liquidity and more competitive pricing.

“Last look came about as a protection for the banks against latency arbitrage because they didn’t have the speed of technology. The rules were you could have last look. It’s kind of morphed into some places where it’s actually a free option,” said David Ogg, CEO of Ogg Trading at Market’s Media’s Global Market Summit in December 2016.

Yet, others question whether last look is necessary since market makers now have faster technology and sophisticated risk management systems that can automatically hedge their spot FX exposures.

It had to happen at some point, the question was always surrounding exactly when, and which non-bank electronic trading firm would actually have the mettle to stand up to the Tier 1 banks.

In my opinion, it is about time this was addressed, largely on the basis that execution quality has been the priority of financial markets regulators, brokerages with B2B relationships with their prime of prime providers, and retail customers alike, to the point where slippage, requotes, rejections and non-instantaneous trade closing have become absolutely unacceptable.

I have said before, on different occasions, that whilst retail FX brokerages and the prime of prime brokers that supply them with aggregated liquidity are absolutely bound by contract (even more so when MiFID II is invoked and makes them stick religiously to the specific execution type that they are registered to conduct) to provide absolutely transparent and timely execution, banks are allowed to decide whether to reject trades, placing the onus back on the liquidity taker to process it and ensure that they not only mitigate risk, but ensure the client orders are filled so that nobody does their stack at the user end.

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 2017 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.

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 which, before XTX Markets took the top slot, was 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 which stands proud outside my living room window, stated last 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 – conducted its own review into the supervision and transparency of some markets in 2016, 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.

No wonder the exchange and derivatives firms that want to get into retail FX are buying up market makers – they know full well that creating their own non-bank end to end structure is perhaps the future.

In terms of legacy behavior, lets take Barclays as an example. 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.

All credit to Alpari US, Barclays’ BARX platform is also implicated in its law suit against those who engage in last look practice.

Beneficial to who? That is the question.

In January 2016, the Foreign Exchange Professionals Association (FXPA), held a webinar on examining the implications of last look for the FX markets.

Attorneys with Steptoe & Johnson on the ‘last look’ webinar, advised market makers to be more transparent about how their last look systems operate.

“Regulators take a very dim view of institutional practices that emphasize a lack of transparency and that encourage employees to give either misdirection or less than complete information to counterparties when direct questions are asked,” said Mike Miller, litigation partner at Steptoe & Johnson, who spoke during the webinar.

All they could do, however, was advise. Fancy fighting the banks as a large, London-based attorney? No, didn’t think so.

In one high-profile case, a global bank used its spot FX trading platform to reject unprofitable trades. When customers asked why the trades were rejected, the bank reportedly gave “vague or misleading answers,” said Steptoe partner Jason Weinstein who analyzed the case during the webinar.

After a regulatory settlement, the bank posted detailed disclosures on its web site and also paid a steep fine, setting a precedent that could impact other banks, brokers and market-making firms.

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. Let’s hope that this matter is raised as a legal precedent in the Alpari US case.

A review of the fairness of wholesale markets this year by the Bank of England questioned the practice by which market makers get a final opportunity lasting a few milliseconds to reject an order after a client commits to a trade at a quoted price. Unable to decide, the BoE called for further study on “whether it should remain an acceptable market practice”.

Suspicions deepened after Barclays allegedly used its own FX platform to reject unprofitable trades and lied to clients about the reasons. A senior Barclays executive told staffers to “just obfuscate and stonewall” when the sales teams asked questions, and subsequently this issue has focused attention on the inner workings of the highly electronic FX market. Spreads in prices of the most popular currency pairs are so tight they are quoted to at least four decimal places, and because it is bank dominated, the market lacks a centralised place to discover prices, so trading is split between banks and independent venues.

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.

Two years ago, in the City of London, I met NatWest Markets, a division of RBS which operates its Tier 1 prime brokerage and has become a very popular source of Tier 1 liquidity for prime of primes in London recently, largely due to its less draconian stance with regard to OTC derivatives.

Now, two years on, very few OTC FX firms are using NatWest Markets as a Tier 1 liquidity provider and its head of FX who attempted to take the less draconian stance has moved to Nomura.

Light at the end of the (fiber optic) tunnel? Let’s hope so!