The use of a last look window by market makers will decrease in 2018, but don’t expect the practice to disappear any time soon, says Galen Stops.
If you’re sick of reading endless articles and hearing lengthy debates at conferences regarding last look, then the first part of this prediction will be music to your ears: in 2018 the industry conversation will move on from this topic.
This prediction comes despite a second one, that last look will not disappear in 2018.
Yes, XTX Markets made headlines by committing to a zero hold time on their FX trades – not to be confused with offering firm liquidity – while other market makers have made more private assurances of a similar kind.
“I think that having a zero hold time is very important and I think that all of the ECNs are seeing the light and they will move towards a non-last-look world, I think that the only people who don’t want to do this are some of the Chicago HFTs and some of the larger banks,” says the head of FX at one European trading firm.
Similarly, a senior figure at a different European trading firm comments: “I think that if you get a critical mass of liquidity providers who move to a zero hold time, that then the buy side will reject the notion of having liquidity provided to them on a last look basis.”
These two sources may have it right that there is a trend away from using last look, and the latter is definitely on the right track by pointing out that pressure from the buy side could exacerbate this trend, but 2018 will not see last look go the way of the dodo for a number of reasons.
Firstly, despite all the controversy and debate around last look, there are still plenty of buy side firms that are perfectly happy with their FX execution and with the service provided to them by their liquidity providers, even if they practice last look. They feel that they get tight prices, in some cases with reject rates so small that they are effectively negligilbe, and have a strong bilateral relationship with their counterpart so that if there is a question regarding how they were executed, this can be discussed and explained directly.
Secondly, while some buy side firms do not like last look, they also don’t like the idea of wider spreads when trading FX. Now there have been arguments and studies about how the hidden costs associated with last look mean that these firms would be better off paying wider spreads for firm liquidity, but on the surface tighter spreads remain appealing.
Thirdly, it’s true that some of the large FX banks want to maintain the practice of last look, arguing that it has benefited the market and that as long as institutions clearly disclose how they use it there shouldn’t be a problem.
A fourth factor to consider is that buy side firms might be more willing to accept last look liquidity when trading less liquid currencies.
“For EM pairs that you can’t find pricing for on an ECN or an auto-stream, I think that clients will be willing to take liquidity with a longer hold time,” says Chris Concannon, president and COO of Cboe Global Markets. He notes, however, that for more liquid pairs, the current trend is towards shorter holding windows and auto-execution.
But here’s why last look will become less prevalent as a practice in 2018 and beyond: transparency.
There is growing pressure to make clear the divide between market making firms that are putting capital at risk and those that are not. The distinction between principal and agent, between the liquidity providers that are willing to offer clients a genuine risk transfer and the ones that fill clients only if they can get executed at a better rate elsewhere, will come into sharper focus.
In part, this will be because clients will expect more transparency from their liquidity providers about how the price they are being offered is formed. The fallout from recent scandals, and the publication of the Global Code of Conduct, has already led to more disclosures from market makers about how they use last look.
Another reason that this distinction will become clearer is due to the increased availability of data analytics that buy side firms can apply to the liquidity being provided to them.
Armed with more and better information about factors such as fill rates, response times, how long round trips take, mark- outs and the cost of rejected trades, buy side firms will find it easier to determine which firms are actually holding risk in various currency pairs and sizes. Once they have the information, it is up to the buy side firm to then effectively interpret the analytics and make a choice about where they source liquidity.
But to circle back to the original prediction, the fact that there is more transparency and more information available to help firms make a decision about their execution is exactly why the conversation around last look can perhaps – finally – move on.