Last week the British Investment Association issued guidelines that will address concerns about the transparency of forex trading, particularly with the use of ‘Last Look’.
This is something that asset managers had been complaining about, since it potentially means banks can misuse trade information to gain an unfair advantage. This also means asset managers cannot serve their clients as effectively as they would like.
What is Last Look?
Last Look is a controversial practice, where liquidity providers such as banks, can confirm or reject a trade request even after the trader has met the quoted price. They can take a ‘last look’ at the order and decide if they want to go ahead. This can be frustrating for the trader in many ways, including:
- Slippage on trades, where the order is executed at the next best price.
- Not receiving any explanation for the trade being rejected.
- Trades taking longer to be executed, due to multiple rejections.
- Not knowing which quoted orders are executable.
In the last couple of years, we have seen regulators attempting to clean up the foreign exchange market. In recent months we have seen fines issued to banks where the traders were performing ‘spoofing’ in the futures market. We also saw charges brought against traders last year who were found to be ‘front-running’ large client orders.
However, the Investment Association (IA) is not a regulator, it is a trade body. They represent over 200 UK investment managers, which collectively manage over £6.9 trillion on behalf of clients worldwide. In addition to working with investment companies and investors, the IA also works alongside regulators and governments; helping to set the rules that govern the investment industry.
Therefore, this is a trade body that carries some serious weight, especially since London accounts for 37% of the world’s $5 trillion a day foreign exchange market – so the British Investment Association is clearly important.
Part of the new guidelines will stop liquidity providers from withholding information and will force them to be more transparent. Previously, providers would reject a trade during the ‘Last Look’ and not send any notification or explanation as to why this was done, whereas now they will be required to provide an explanation.
This explanation can be taken from a proposed list of standard reasons including things such as speed, price improvements and internal credit checks. Traders and funds will now know the real reason why a trade was rejected.
Liquidity providers have also been asked to outline their policies and procedures on Last Look, which will provide further transparency. We can already see Barclays have done this for their BARX FX Clients.
Barclays suggest that Last Look is used bilaterally, not just when it benefits the bank. In a nutshell, they claim that since the market is decentralised, there can sometimes be price discrepancies. When a trade comes through, the refreshed price is compared with the trade request price. At this point, if the price has moved beyond a certain amount of price tolerance in either direction, the trade will be rejected. They say that since they are one of the largest market makers in the electronic spot FX market, they do not want to reject trade requests, but they find it beneficial and find it leads to better service for clients.
There are, in fact, proposed benefits of Last Look. This includes things like tighter spreads (since the liquidity providers know they can reject the trade if they need to) and greater liquidity (since more providers will quote prices since they have Last Look and high volumes will not end up being detrimental to them).
$150 Million Fine
Barclays is a particularly appropriate example, since they were actually fined in 2015 for abusing their Last Look system. They were ordered to pay $150 million to the New York Department of Financial Services.
The bank was found to be rejecting trades that would be unprofitable for them and were then lying to clients about the reasons for the trades being rejected. Essentially they were holding trades for hundreds of milliseconds and would only approve the trade if the price moved in their favour.
In fact, to totally incriminate them, a message was sent to Barclays traders and IT staff in 2011 which the FT reports as saying: if clients asked why large numbers of their foreign exchange trades were being rejected at the last minute, they should “just obfuscate and stonewall”.
Impact on Liquidity
If liquidity providers must make these changes, perhaps it will mean there is less liquidity, since engaging in market making may be detrimental for some firms. But perhaps that is simply an excuse.
In recent years, it has been obvious that the FICC (Fixed Income, Currency and Commodity) trading divisions of banks have not been performing well due to low market volatility. This has even led to many companies scaling back their FICC operations. However, the drought may be over, as this month it was announced that forex volumes have increased by a reported 24% compared to the same time last year. Therefore, it is doubtful that many firms in this business will be rushing for the exits.
There is always more potential for shady operations in foreign exchange, since it is a decentralised market. But the good news is that central banks seem to be intent on cleaning up the industry and restoring the reputation of currency markets.
At the start of February, it was announced that all central banks in the EU, including the Bank of England, were signing up to a new code aimed at keeping forex markets clean. They will also be urging all banks and dealers to sign up as well. This is all a step closer to providing a clean and transparent market. As Dave Ramsden, the Bank of England Deputy Governor for markets and banking says:
“Fair, transparent and robust markets, underpinned by high standards, benefit all participants”.
We can only hope!