The global foreign exchange (FX) market is hugely diverse, trading more than $6.6 trillion a day1 across a large array of electronic communications networks (ECNs), exchanges, single dealer platforms, and bilaterally against chosen liquidity providers. G10 currency pairs such as EUR/USD are the most actively traded products and pricing in these pairs is likely to be available on multiple platforms at the same time. However, not all platforms or trading relationships operate in the same way and one of the key differences is whether a price is ‘firm’ or subject to ‘last look’.
Trading on last look liquidity in ‘normal’ market conditions can arguably offer the same reliability as firm pricing, but in times of market stress and uncertainty, such as those seen in late Q1 2020, it runs the potential for slippage and execution risk. The uncertainty experienced during 2020 helped to underscore the value of firm pricing on platforms including EBS Market, CME, and Refinitiv FX Matching ‒ all of which forego last look altogether.
At CME, not only is the FX futures central limit order book (CLOB) based on the principles of firm pricing and no last look, but it is also backed by a transparent rulebook as well as the guaranty of the CME clearing house as counterpart for all open positions. This structure means that every price is available on an all-to-all credit agnostic basis – i.e. equally and fairly to every single participant, which is not possible on credit enabled platforms with bilateral trading. This transparency and reliability have helped to underpin record open interest, record large open interest holders, and high numbers of client adoption for CME FX futures during 20202.
‘Firm pricing’ means that the price received by the client from the liquidity provider (LP) is the price that can be traded on, with no need to have to ‘firm up’ the quote price after acceptance. This means that as a price taker, subject to the latency of distance and decision-making processes, you have nearly immediate access to your transaction price, which can be especially advantageous for buy-side traders using a price limit for a portfolio manager.
In contrast, almost all bilateral FX trading venues will employ some degree of last look processes with varying average hold periods from milliseconds to hundreds of milliseconds. ‘Last look’ is a practice that assists LPs in making quotes as it provides them with optionality, providing them with the benefit of having the final opportunity to accept or decline a trade request. Given the fragmented nature of the FX market this last look optionality is an important protection feature for LPs who quote prices across multiple venues, and therefore, is a key enabler for them to be able to provide competitive quotes on many different venues.
When a request to trade against a quoted price is received on a venue that allows last look, the LP has a few options: they may end up holding the request for some time, filling the trade at the price quoted, offering an alternative price as a requote, or declining to trade ‒ resulting in a reject. All of these outcomes create degrees of uncertainty for the liquidity consumer in achieving their desired transaction and the price at which they will be able to trade.
The opportunity cost of firm vs. last look liquidity can be described as the potential cost of the rejected trade ‒ the market movement from the order time to the time the client can retry and execute the trade following a rejection. For example, if a client needs to buy $5 million GBP/USD and the market mid is 1.37795 (where the market is 1.3779/1.3780) and the client attempts to trade at 1.3780 and is rejected, it would be necessary to record the market mid move from the first attempt to the time they try to re-trade. If the market is 1.3781/1.3782 at the re-trade time, this implies a mid of 1.37815 and the cost of the reject is two pips. On a $5 million trade, that would equal a cost of ~$725 to the client. Whilst some participants factor in this potential cost of a reject to their total cost analysis, recent industry press3 suggests that most customers are not explicitly capturing or including this in their cost of execution.
From a market best practice perspective, the FX industry has moved towards implementing the FX Global Code of Conduct (May 2017). On the back of the Global Code, there have been developments such as more disclosure and transparency from LPs around their last look protocols, as well as more symmetry in the way trades are dealt with. The use of transaction cost analysis (TCA) has also become more sophisticated and widespread and is defined in industry comment as a method by which buy-side traders may evaluate the quality of execution from all LPs and decide if the execution via a last look venue benefits them over that of firm liquidity.
Whilst the Global Code provides clear guidelines for the use of last look, it is not currently mandated for LPs or venues to disclose who is adhering to those guidelines. That being said, a significant number of market participants have used the Statement of Commitment (SoC) to the Global Code as a means to demonstrate adherence to the guidelines, and as an example of this, EBS Direct reports which LPs have signed up to the SoC ‒ providing clients with additional comfort as to disclosure and transparency around their LPs last look protocols.
In line with these industry developments, it is becoming increasingly common for market participants to analyze their trading data to self-police last look criteria and benchmark their LPs accordingly. These include, what the average holding period is before a price is firm, which LPs have the most favorable timings on receiving a price back, and then, the total roundtrip time for the execution of the trade. Also, increasingly more venues are producing monthly reports on cost of rejects i.e. how much the LPs who hold trades and later reject them cost the client.
As an example of the tools available to assist customers in this analysis, the EBS Quant Analytics platform4 provides the liquidity consumer with a detailed analysis of all their bilateral trades transacted on the EBS Direct platform. It shows the consumer what their average LPs holding times are and compares them with similar transactions across the ecosystem, as well as the costs to the consumer of those rejects.
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1 BIS Triennial FX survey 2019 – https://www.bis.org/statistics/rpfx19_fx.htm
2 Note that there is a latency in the structure that means a price level may have moved whilst the order is in transit and being processed, meaning that whilst you still get a firm price, it has the potential to be both either slightly worse or slightly better than expected – which is an example of price risk as opposed to execution risk.