This is the second feature of a two-part series exploring dealing practices in the foreign exchange spot market. The first part, looking at non-bank liquidity providers, is available here.
 

It has been two years since a global code of conduct was introduced to bring more transparency to the spot foreign exchange market.

Since then, new debates have sprung up around how that applies to anonymous trading platforms and providers of agency execution algorithms, while old ones around the levels of disclosure of FX dealing terms remain.

As of August 6, some 18 electronic communications networks (ECNs) have signed the FX Global Code. But they don’t see it as their role to ensure liquidity providers (LPs) on their platforms comply: “We’re not the policeman of the code,” says a source at one ECN.

While the code covers a broad range of areas, most of the focus is on LPs’ so-called last look policies. These policies cover the period of time after an order is received but before execution, during which an LP conducts credit and price checks, sometimes with an add-on period for further monitoring.

Last year, FX Week sister site Risk.net look at 15 banks to see how the major dealers’ last look policies stacked up. This year, the survey was extended to the top 50 LPs from the most recent Euromoney foreign exchange survey, including non-banks (see table A).

The research found patchy levels of disclosure across the top 50. While the Global Foreign Exchange Committee (GFXC), a forum of central banks and private sector participants overseeing the development of the code, is pushing for more public disclosures of last look policies, nearly a quarter of LPs don’t have them.

Within the disclosures, there are big differences in how LPs describe their policies. Principle 17 of the code asks firms to disclose the length of last look and hold times, but Risk.net was only able to find this information for fewer than half of the top 50 LPs.

However, LPs were more forthcoming about whether they pre-hedge during the last look window – a practice discouraged under principle 17 – with nearly three-quarters confirming they do not.

We need to have a trusting relationship with our counterparty, so the more open and transparent they are with us, the better

James Binny, State Street Global Advisors

Guy Debelle, deputy governor of the Reserve Bank of Australia and chair of the GFXC, says that although public disclosure of this information is useful for customers – as it gives them a starting point for discussions with LPs – more information should be available to them in bilateral discussions. “We’re encouraging disclosures to be publicly available to make life easier for people, but in the end it’s probably just a first step along the route to discussions with your counterparty, not the last step,” he says.

But James Binny, global head of currency at State Street Global Advisors (SSGA), says that if firms have client-friendly last look policies, they should have nothing to fear in making them public: “If disclosures aren’t publicly available then it doesn’t really pass the smell test. If LPs have got something to be ashamed of in their disclosures then there’s an issue.”

“We need to have a trusting relationship with our counterparty, so the more open and transparent they are with us, the better. It’s common sense, but it’s amazing that people are reluctant to make disclosures public,” he adds.

The patchy nature of public disclosures raises other key issues. For firms that offer agency algorithms, there is a risk that clients could be steered to price-makers with last look policies that are unknown – which could be detrimental to pricing and create potential reputational risk for algo providers. Some firms have already cut certain LPs out of their algos as a result.

It also has a bearing when trading on anonymous ECNs. Although some platforms such as LMAX, EBS Market and Reuters Matching only provide firm liquidity pricing – and thus forego last look altogether – this isn’t the case for all ECNs. Cboe, Euronext and 360TGTX are among those that give users the option to trade on both firm liquidity prices or last look prices. For those platforms where last look is enabled, the lack of public disclosures means participants are unable to see the policies of all the potential counterparties on the platform.

Some believe that these platforms have a role to play in policing last look activity. But the platforms tend not to have strict policies and don’t see their role as being the nightclub bouncer who keeps out undesirables.

“As a platform it’s important to show non-discrimination. We provide participants with as much information as possible, so they can make their own decisions as to who they trade with,” says Serge Marston, a managing director for Europe, the Middle East and Africa sales at CME Group, which acquired interdealer platform EBS last year.

Keeping schtum

The FX Global Code – first published by the GFXC in May 2017 after a series of fixing scandals – sets out conduct standards for trading in the forex market. Part of the code asks LPs to disclose their last look policies.

The GXFC has been pushing for all professional FX market users to adhere to the code. It has had good success in getting LPs on board, going from 11% in 2017 to 55% in 2018, according to a GFXC survey of more than 500 global FX market participants. As of August 6, some 92% of the top 50 LPs in Risk.net’s study had signed up to it.

It’s unclear why the remaining firms are yet to do so. “I’m surprised there are still people who haven’t signed the code,” says SSGA’s Binny. “If they’re not signing up for it then what’s their problem? It feels a bit wrong. Why not sign up?”

While much of the code is fairly uncontroversial, the suggestions relating to disclosure of last look policies have attracted the most attention.

Market participants have their own definitions of what last look entails, but broadly it consists of two elements. The first is a price check conducted by the dealer – which could last anywhere from five to 300 milliseconds – where they can see multiple price updates from trading platforms. Depending on the dealer’s policies, it can then decide to reject an order if it moves too far from an agreed price.

The second element is a so-called hold time, sometimes referred to as a ‘speed bump’, which can be applied on top of the last look check and could be used to see whether a client’s behaviour leads to market movements against the LP, making it harder to lock in a profit.

The code doesn’t differentiate between the two, and simply defines last look as a risk control mechanism where final checks are made against credit limits and price. Last look has been a fixture in the FX market for years, though some more recent entrants say it is a dinosaur that should be abolished.

Just because someone doesn’t mention they’re not hedging in the last look window doesn’t mean they’re doing it

Guy Debelle, Reserve Bank of Australia and Global Foreign Exchange Committee

The code asks that LPs at the very least share information with clients about “whether, and if so how, changes to price in either direction may impact the decision to accept or reject the trade, the expected or typical period of time for making that decision, and more broadly the purpose for using last look”.

This doesn’t necessarily have to be public, but a February 2019 report from the GFXC suggested public disclosure was one way to improve transparency.

One question is whether LPs take a ‘symmetrical’ approach by rejecting trade requests that move beyond a certain threshold in either direction, or an asymmetrical approach where only moves that benefit the client are rejected. On this, more than 80% of the top 50 have revealed their policies.

Despite this guidance, only 28% of the top 50 LPs explicitly mention in their public disclosures how long last look checks typically take or whether there is a hold time placed on orders. Risk.net asked the non-disclosing firms separately for their policies and in total managed to obtain them from 46% of the top 50 LPs, leaving more than half that still do not disclose their stance publicly.

Another controversial topic, whether LPs pre-hedge client trades in the last look window, also suffers from sparse disclosures. Critics of the practice say it can impair the price a client receives, but there is a carve-out for LPs that operate a so-called cover-and-deal approach, where the LP hedges the client trade before executing to avoid taking market risk.

Of the top 50 LPs, 74% confirmed they do not pre-hedge during the last look window. The remainder either declined to comment or did not respond. Three non-banks – HC Tech, Jump Trading and Virtu Financial – confirmed they do so, under certain conditions.

“The fact that so few people disclose this information is shocking to me as it’s one of the key things that should be within a disclosure. Do hold times exist? How long are they? And what are they actually used for?” says Darryl Hooker, chief executive of Harperdan Consulting.

While some believe that the firms keeping quiet on this issue might not have a great story to tell, the RBA’s Debelle argues that’s too simplistic a view. If an LP has signed the code, he says, they may not feel the need to reiterate that they don’t engage in pre-hedging within their disclosure as their statement of commitment to the code already indicates they abide by principle 17.

“Just because someone doesn’t mention they’re not hedging in the last look window doesn’t mean they’re doing it. If the client wants to know for sure then they certainly have the right to ask their counterparty – in fact, we encourage them to ask. If they don’t get an answer, or don’t like the answer, then they have the capacity to take their business somewhere else,” says Debelle.

Similarly, only 26% of the LPs explicitly state in their disclosures that they do not use information from rejected trade order requests for the purposes of adjusting their trading or risk management strategy – a controversial topic that is attracting greater focus. After further investigation, 70% of the LPs confirmed that they do not use such information, with the remainder either declining to comment or failing to respond to a request for comment.

While there is much debate about whether the use of rejected order information is ever acceptable in the first place, the only guidance on the issue is contained in the GFXC’s February report, which suggests that the topic should form part of bilateral discussions between LPs and their clients. Debelle says the GFXC may look to provide firmer guidance in this area at some point in the future.

Reputational risk

The patchy nature of disclosures across the market creates risks when using agency-style execution algorithms.

Agency execution has become an increasingly popular service in the FX market, where trades are executed on a client’s behalf through the use of smart-routing algorithms that scour multiple LPs and trading venues to find the best price, with the agent merely charging a fixed fee for their service.

However, LPs acting in an agency capacity could potentially face reputational risk if they don’t make clients aware of the last look practices of other LPs within their liquidity pool – for example, if other LPs have an asymmetric last look and will therefore trade only when the price moves against the client.

“If an agency business isn’t concerned about the last look practices of their LPs then it seems to me they would be turning a blind eye to reputational risk,” says James Wood-Collins, chief executive of Record Currency Management.

If an agency business isn’t concerned about the last look practices of their LPs then it seems to me they would be turning a blind eye to reputational risk

James Wood-Collins, Record Currency Management

“If we were extensively undertaking agency spot execution for clients, I feel we should absolutely understand the last look practices of the banks with whom we are executing. If you really want to be acting as a fiduciary agent on behalf of your client then you need to understand whether and how any of those parties could act against your clients’ interests,” he adds.

Some firms identified the risk well ahead of time. The head of e-FX trading at one global dealer says it removed two non-banks from its algo liquidity pool prior to the introduction of the FX Global Code because of their last look policies.

Harperdan’s Hooker agrees that dealers should be proactive in helping clients decide which LPs they want exposure to. “The best way to get around any reputational risk would be for agents to give all of these disclosures to their clients and ask whether there are any LPs they don’t want to be connected to,” he says.

Consultant and former head of FX at Deutsche Bank, Kevin Rodgers, says the onus should be on clients, rather than agents, to understand which last look practices may adversely affect them.

“Unless the client tells you they don’t want to deal with X LP because of Y last look practices, then realistically it’s a bit tricky for you as an agent to winnow out who’s doing what. Unless clients tell you otherwise, you’re just going to go out into the market and deal with whoever you can to get them the best price,” he says.

But Wood-Collins says that although clients may want to understand the last look practices of other LPs as part of their own due diligence, the responsibility should ultimately remain with the agent acting on their behalf: “It’s the agent’s responsibility to have the skills, the ability, the resources, and most importantly, the commitment, to fulfil that fiduciary role. It shouldn’t really be the client’s job.”

Citadel Securities is a major disclosed, direct streaming liquidity provider to the client algo platforms of large banks. Kevin Kimmel, the firm’s global head of e-FX, says the algo providers are “very rigorous” about reviewing Citadel’s trading practices and execution quality.

“For every bank we partner with on the algo side, we send them our trading disclosures and our trading practices are scrutinised. Our disclosures can then be passed down to all of their clients as well,” says Kimmel.

Different banks have different policies on providing this information to clients, however. “We have some that disclose that we are the liquidity provider behind the scenes,” Kimmel adds. “Our view is that more transparency there is good. We feel very confident in our execution quality because we have some of the largest banks regularly evaluating our trading performance.”

The role of ECNs

ECNs are also coming under more scrutiny over the role they should be playing to uphold last look standards in the market. The ECNs are typically anonymous, meaning it’s impossible to know what a counterparty’s last look policy is before execution. And a user wouldn’t be able to see the last look policies of all LPs on the platform as not all are publicly disclosed.

While not included in the code, the role that ECNs play in the FX market has been an increasing focus of the GFXC and will form part of its three-year review of the code in 2020.

“Anonymous trading is one area where the market has moved on from when we developed the code three years ago, so that’s definitely one clear area of focus for our review,” says Debelle.

We have a role to provide transparency, but ultimately it’s up to market participants to decide who they want to trade with

Serge Marston, CME Group

Some believe ECNs could be gatekeepers to ensure there are basic standards of last look practices for all LPs on a given platform. But for now, market participants say some of the platforms do not set boundaries on the use of last look by LPs. “I don’t get the sense that ECNs police their platforms. I’ve never had a platform come and tell me they police last look really well so I should come and trade on their platform,” says one senior FX source.

Some ECNs do have minimum standards in place. One of them – a signatory to the code – enforces a maximum order review timeframe of 100 milliseconds and a minimum order acceptance rate of 75%. As a result, some LPs were removed from its liquidity pool.

“At one point, we had 39 designated market-makers on our platform. Once we implemented our standards, we reduced that to 30. So there have been a few market-makers that we’ve had to remove,” says a source at the ECN. “That’s done to improve the overall quality of the liquidity in the platform. By implementing these standards, the benefit is for the liquidity takers – they end up getting higher fill rates and hopefully better spreads.”

However, the ECN has no policy on pre-hedging trades during the last look window. “We’ve signed the forex global code but there’s a misunderstanding out there in terms of what that means for a platform,” says a second source at the ECN, adding that he doesn’t see it as their role to monitor LPs’ compliance with the code.

Similarly, EBS – another signatory to the code – provides platform users with a filter in the form of analytics on metrics such as an LP’s typical market impact and its cost of rejects, as well as flagging which providers on the platform have signed the code.

“There have been some industry conversations around the role of the platforms when it comes to the global code. Do we just sit there and do nothing? No, we have a role to provide transparency, but ultimately it’s up to market participants to decide who they want to trade with,” says CME’s Marston. 

This article first appeared on sister website Risk.net.