FX Aggregation and Execution. Liquidity Mirage, Last Look, HFT and Latency
“Here is your VWAP for 100 units, which can be traded with the push of a button” results in the same as “Here is your remote control. Push the button all the way down and your car will drive realllllllly fast” (picture below)
Choose your liquidity wisely and partner with your Providers. The FX Market and its providers have gotten a bad rap over the past years. After all issues with the WM/Reuters fix, the focus moved to “Last Look” and also there, fines have been spoken. This post is not about bashing or defending any market makers. Rather, I would like to point out a few issues that exist in the “OTC FX Spot Market,” which can have a great impact on execution costs. Even you trade electronically. You still should know how your counterparties handle your trades and what the rules are on the ECN’s of your choice.
What vendors often forget to talk about: Liquidity Mirage, Last Look, HFT, and Latency.
Liquidity mirage – Victims and complainers. Connecting to LP’s and ECN’s results in a great “order book”. Plenty of bids and offers can be filtered and visualized. Your vendor most likely explained a VWAP for 100 units as Liquidity that can be aggressed with a “push of a button”, sending out multiple orders and sweeping down the book to the 100th unit. Works great on the test system! Will look very differently on live trades. The more you push that button for a big sweep, the smaller will the executed quantity be and the wider will the spread be, to aggress that kind of liquidity the next time around. Guaranteed! Designing and implementing the correct strategy will have a significant impact on your execution costs. An open dialogue with your LP’s and the selection of the right LPs for a particular currency pair is critical. Only this way can issues, like the one below, be avoided or at least minimized.
Last Look and the Brothers Grimm. Single Dealer Platforms and API’s, Multi Dealer Platforms and ECNs rely heavily on the capacity of Tier1 and Tier2 banks to provide bids and offers to multiple venues at the same time. As a gatekeeper, to not allow too many trades at the same time, on the same side, at the same rate, banks use Last Look. The Last Look allows banks also to check credit, validate order parameters and to calculate price tolerance. The time used, very much depends on the provider and the trading style of the customer. Most respond with “done” or “rejected “within 20 to 100 milliseconds, to a neutral customer. A few take longer, but this does not necessarily correspond with a higher rejection ratio. We do not see the Last Look as unfair or a deadly sin, as long as price tolerance is to some degree applied to both sides.
Once the Last Look gets programmed by the Brothers Grimm “The good ones go into the pot the bad ones go into your crop,” or if hedging is done before the trade is accepted, it is not used for what it was designed for. With a proper Trading Cost Analysis, the brothers Grimm can be identified and banned from your LP list.
It gets harder when the Last Look is used on anonymous ECN’s but also there, TCA will tell you if it is even worth your time to attempt to trade on particular ECN’s, in a specified currency at a certain time.
Be careful what you wish for. Calls to ban the Last Look in FX are loud and getting louder. I would caution against such a ban and would leave it to the consumer of liquidity, to choose where they see value in directing their orders. A ban would have quite massive consequences on market liquidity and could call out other demons. If you would like a preview of what the FX Market could face, should further regulation push FX OTC to Exchange trading, just peak over to the Equity Markets. Some will say that you should not worry, as FX ECN’s will throttle updates or have speed bumps. This is not what a modern HFTrader, with considerable market share, wishes to see. IEX is planning to add a 350 MICROseconds speed bump, in an attempt to create a level playing field, and is facing strong opposition.
HFT and the 2 TV’s. HFT firms entered the FX Market many years ago. First came the arbitrage firms. For them, the fragmented OTC FX Spot Market was The Land of Milk and Honey. It forced the banks to invest further in technology to hold up but did not allow them to catch up really. The book Flash Boys brought many issues of HFT in the Equity Markets into the open. I would recommend this book to anybody that is involved in any kind of trading.
With the latest flash crashes, also regulators started to pay attention to the machines taking over markets. The investment into technology is massive and gives HFT a distinct advantage over everyone else. Understandable for anyone, described by Mark Cuban in his jab at high-frequency trading.
“Have you ever been in a situation where there are two TVs in two different rooms, watching the same game, and one TV is a couple of seconds behind the other? Imagine if you could be watching the faster TV and make bets with a person watching the slower TV. You could bet last second what happens in the next play, knowing you see the outcome before the other person.”
HFT firms are now active market makers on ECN’s and also provide liquidity to the buy and sell side directly. They are taking the risk, while individual banks try to avoid exactly this. Even some of the Tier 1 banks, use HFT firms as a source of liquidity. With such a widespread presence, HFT is part of everybody’s aggregation and needs measuring like any other liquidity. TCA on fill ratios and rejects, and market impact while trading in open markets, needs to be done the same way, as trading with any LP.
Latency. Missing trades is part of the game. The bigger the sweep, the higher is the chance for a partial fill. If these rejects come from last look or missed quotes, is not relevant. Measuring the outcome of your attempts to trade, is key to improve your execution strategy. You need to find the liquidity, which best suits your trading style. Be this with Bank LP’s, HFT firms, ECN’s with last look, ECN’s with no last look or dark pools. Only a proper TCA will help buy-side participants to optimize their execution strategy and allows them to get what they see.
Certainly, there are further components that are part of a successful execution strategy. I picked the above points as they have been of interest in past discussions and also the cause of some anxiety amongst our customers and friends alike.
For your feedback, questions or to get further information about our consulting services for buy & sell side FX participants, please do not hesitate to email me at firstname.lastname@example.org