Last look in foreign exchange: Balancing Cost and Efficiency

Last look in foreign exchange is a complex process that requires a delicate balance between cost and efficiency. The average cost of a last look opportunity is around 0.1-0.2 basis points.

To achieve this balance, banks and financial institutions must carefully manage their last look windows, which can be as short as 100 milliseconds. This means they need to make quick decisions without sacrificing too much in terms of cost.

The cost of a last look opportunity can add up quickly, especially when dealing with large transactions. A study found that for every $1 billion traded, the cost of last look can range from $1,000 to $2,000.

By streamlining their processes and using advanced technology, banks can reduce the cost of last look and increase efficiency. This can be achieved through the use of automation and machine learning algorithms that can quickly analyze market data and make informed decisions.

Explore further: Efficiency Ratio

Regulators have taken notice of last look liquidity in the FX market, with the Bank of England conducting a 'Fair and Effective Markets Review' (FEMR) that included recommendations for the FX industry.

The FX industry has responded by adopting a global code of conduct, but surveys indicate that many FX market participants don't believe the situation has improved in the last two years.

The Bank of England has questioned the fairness of wholesale markets, particularly in the context of last look. The regulator has called for clearer standards regarding the practice.

The absence of timestamps in FX trading can make it difficult for investors to assess the efficiency of their FX executions, creating potential opportunities for abusive practices.

Transaction cost analysis (TCA) is a method used by buy-side traders to assess the quality of execution from all liquidity providers.

It helps determine if they are at a disadvantage from last look, as described by the FEMR review final report.

Buy-side traders can use TCA to evaluate the costs associated with last look, which can be a significant factor in their trading decisions.

A unique perspective: World's Best Day Trader

Transaction cost analysis (TCA) is a method used by buy side traders to assess the quality of execution from all liquidity providers.

This approach helps traders determine if they're at a disadvantage due to last look, a feature that some liquidity providers offer.

For your interest: Best Day Traders to Follow

Reducing hold time is crucial for efficient trading.

Christian Lønborg Thomsen, Team Lead of e-Trading Client Services at Saxo Bank, is okay with last look as long as there is no additional hold time.

Hold times have come down substantially in recent years.

In some cases, liquidity providers have handled these reductions proactively, and at other times, they have had to be requested to come down.

Swissquote has observed a significant reduction in hold time for trades subject to Last Look, especially those executed through direct API connections.

The average hold time for spot across institutional platforms stands at 7ms this year compared to 12ms in 2021.

Further investment in credit check technology is expected to bring hold times close to zero.

This trend is expected to continue, with no impact on spreads.

Last Look can never be completely removed due to the effect on bid/offer spreads.

Removing last look completely would force liquidity providers to widen spreads, which would not necessarily result in better execution for the client.

Related reading: Expected Loss

Buy-side firms like AlphaSimplex are also raising concerns about last look, with Steven List saying it's "an anathema to a fair market." He doesn't see how it will "pass the smell test."

The buy-side can protect itself from last look by using Transaction Cost Analysis (TCA) to identify excessive holding times, high reject rates, and partial fills.

For another approach, see: Side Hustle Bible James Altucher

BlackRock, a leading asset manager, has called last look "problematic" in the FX market, comparing it unfavorably to indications-of-interest in equities.

In January 2015, BlackRock submitted written comments to the BoE's fairness review, expressing concerns that last look creates "phantom liquidity" and would prefer "liquidity on which we can deal, even if this comes at a higher cost."

The practice of last look is an issue that currency traders should be able to identify, according to FlexTrade's Ullrich, who suggests that accuracy in timestamping provides traders with the tools to see what's going on.

With advances in transaction cost analysis, buy-side firms can access their execution data and check the timestamps related to when they sent an order as compared to the price and time it was executed.

Steven List, head of trading for AlphaSimplex, has also expressed concerns about last look, calling it "an anathema to a fair market" where banks or automated traders want the last look.

Excessive holding times, high reject rates, and partial fills all point to potential issues with last look, according to Ullrich, who emphasizes the importance of evaluating the quality of execution in FX.

On a similar theme: Swap Execution Facility

As a buy-side firm, it's essential to understand the concept of pre-hedging, which involves taking positions in derivatives to mitigate potential losses from future market movements.

Pre-hedging can be a valuable tool for managing risk, but it's crucial to do it correctly. According to a study, 75% of buy-side firms use pre-hedging to manage market risk, while 45% use it to manage credit risk.

Pre-hedging strategies can be complex, so it's vital to have a solid understanding of the underlying market dynamics. For example, a firm may use a collar strategy to hedge against potential losses from a stock's price movement.

A collar strategy involves buying a put option and selling a call option to limit potential losses. This strategy can be particularly effective for firms with a high degree of market volatility.

Pre-hedging can also involve using derivatives such as futures and options to hedge against potential losses. According to a study, 62% of buy-side firms use futures contracts to hedge against market risk.

Firms must carefully consider their pre-hedging strategies to ensure they align with their overall risk management goals. A well-designed pre-hedging strategy can help mitigate potential losses and protect a firm's assets.

By taking a proactive approach to pre-hedging, firms can reduce their exposure to market risk and achieve a more stable financial position.

Additional reading: Nvidia Growth Potential

Banning last look could have unintended consequences. Eliminating last look will affect liquidity, warned a former FX e-trading professional.

Some bank liquidity providers quote prices on 20 or 30 platforms. This means they can protect themselves symmetrically by letting one customer have one or two trades, but not all of them.

It's possible that one customer will try to hit their price on 10 platforms at the same time. This could lead to a situation where the bank can't fulfill all the trades.

A unique perspective: San Diego Building Trades Council V. Garmon

Last look in foreign exchange has been a topic of debate, with both supporters and critics weighing in on its pros and cons.

Last look was initially introduced as a protection for banks against latency arbitrage due to their lack of speed in technology.

Some argue that last look allows for more liquidity and competitive pricing, enabling non-bank liquidity providers to enter the market.

However, others question its necessity, citing that market makers now have faster technology and sophisticated risk management systems to automatically hedge their spot FX exposures.

The purpose of last look is often seen as a way for market makers to reject unprofitable trades, eliminating them to maximize profit opportunities and provide a mirage of liquidity.

This can lead to above-average reject rates and excessive holding times, which can be a red flag for traders.

Last look also opens up the potential for front running currency orders, where the customer shares its intentions with the liquidity provider, potentially giving them an unfair advantage.

In contrast, a more meaningful electronic trading process might widen spreads, but ironically, it could improve overall liquidity by reducing drop rates and lessening the negative outcome for liquidity providers.

Regulators will likely continue to monitor FX dealing systems for signs of abuse or unfair market practices.

The decision on whether to eliminate last look is reportedly up to a group of central banks, including the BoE, who are working on a single rulebook to govern foreign-exchange trading.

Banks are advised to be transparent about how their last look systems work, as disclosure and transparency can solve many problems with regulators and civil class action lawsuits.

Market makers could disclose their fill ratios and rejection rates, which would give counterparties a better understanding of how last look is impacting their trading performance.

Regulators will not look favorably on last look systems that favor the house over the customer.

A symmetrical system is one that triggers a rejection of trades when the market moves in both directions, and banks may explain this as a rule that rejects trades when latency appears on the system, regardless of whether it was in their favor.

Market forces are likely to push market makers in the direction of additional changes to their last look practices to create more fairness.

By providing more disclosure, it becomes harder for market participants to take issue with the practice, so last look systems may be here to stay, but with more data and analysis tools for the buy-side.

Check this out: Warren Buffet Trades