How Does the ‘Last Look’ Practice by Liquidity Providers Complicate RFQ Slippage Management?

Concept

The practice of ‘last look’ by liquidity providers fundamentally redefines the nature of a price quote within a Request for Quote (RFQ) system. An RFQ is designed to be a definitive, bilateral price discovery mechanism, where a liquidity consumer requests a firm price for a specific transaction. The introduction of a last look provision transforms that firm price into a contingent one, an option held by the liquidity provider to re-evaluate the trade at the moment of execution. This introduces a critical layer of uncertainty and potential for slippage that complicates risk management for the liquidity consumer.

Slippage in the context of an RFQ is the difference between the expected execution price and the actual execution price. In a firm-price RFQ system, slippage is typically minimal and attributable to latency. With last look, the potential for slippage expands dramatically.

The liquidity provider, armed with the final decision to accept or reject the trade, can protect themselves from adverse price movements during the “last look window” ▴ the period between the trade request and its final acceptance. This protection for the liquidity provider directly translates into risk for the liquidity consumer, who is exposed to market fluctuations during this period of uncertainty.

The Mechanics of Last Look

When a liquidity provider offers a quote with a last look provision, they are not offering a binding contract to trade at that price. Instead, they are offering an invitation to treat. The liquidity consumer, by accepting the quote, is making an offer to the liquidity provider.

The liquidity provider then has the “last look” at the market before deciding to accept or reject that offer. This process can be broken down into several steps:

1. RFQ Submission The liquidity consumer submits a request for a quote to one or more liquidity providers.
2. Quote Provision The liquidity provider responds with a price, subject to a last look provision.
3. Trade Request The liquidity consumer accepts the quote and submits a trade request.
4. Last Look Window The liquidity provider holds the trade request for a brief period, typically milliseconds, to assess market conditions.
5. Final Decision The liquidity provider can then choose to:
   • Accept The trade is executed at the quoted price.
   • Reject The trade is not executed, and the liquidity consumer must re-submit their RFQ.
   • Re-quote The liquidity provider offers a new price, which the liquidity consumer can accept or reject.

This final decision point is the source of the complication for slippage management. The rejection of a trade forces the liquidity consumer back into the market, where prices may have moved against them. This is particularly problematic in volatile markets, where the risk of significant price movement during the last look window is heightened.

The ‘last look’ practice transforms a supposedly firm price into a provider-held option, introducing a critical period of uncertainty that directly impacts slippage.

Why Do Liquidity Providers Use Last Look?

Liquidity providers argue that last look is a necessary risk management tool in a fragmented and high-speed market. They face the risk of being “picked off” by high-frequency traders who can exploit latency advantages to trade on stale quotes. Last look allows them to protect themselves from these “latency arbitrage” strategies. Additionally, in the foreign exchange market, which lacks a central exchange, last look provides a mechanism for liquidity providers to manage their risk across multiple trading venues.

While these are valid concerns for liquidity providers, the practice has been criticized for its lack of transparency and potential for abuse. Some liquidity providers have been accused of using the last look window to their advantage, rejecting trades that would be unprofitable for them while accepting those that are. This asymmetric application of last look, where the liquidity provider only trades when the price moves in their favor, is a major source of concern for liquidity consumers.

Strategy

The strategic implications of last look for a liquidity consumer are significant. The practice introduces an element of game theory into the RFQ process, where the consumer must anticipate the behavior of the liquidity provider. The consumer’s primary goal is to minimize slippage, while the liquidity provider’s goal is to manage their risk. These two objectives are often in direct conflict.

A key strategic consideration for the liquidity consumer is the selection of liquidity providers. Not all liquidity providers apply last look in the same way. Some may have shorter last look windows, while others may be more transparent about their rejection policies. Transaction Cost Analysis (TCA) can be a valuable tool in this regard, allowing consumers to analyze the performance of different liquidity providers and identify those with the most favorable execution quality.

The Liquidity Mirage

One of the most significant strategic challenges posed by last look is the “liquidity mirage.” This refers to the phenomenon where the depth of tradeable liquidity appears to be much greater than it actually is. In a last look environment, liquidity providers can display aggressive quotes to attract order flow, knowing that they can reject trades if the market moves against them. This creates a false sense of security for the liquidity consumer, who may believe they have access to deep liquidity at a tight spread.

In reality, this liquidity can evaporate in volatile market conditions, precisely when it is needed most. The rejection rate of trades can spike, and the consumer is left scrambling to find liquidity at a much worse price. This can lead to significant slippage and can be particularly damaging for large or urgent trades.

Strategies for Mitigating Last Look Risk

There are several strategies that liquidity consumers can employ to mitigate the risks associated with last look:

• Diversify Liquidity Providers By spreading their order flow across a diverse set of liquidity providers, consumers can reduce their reliance on any single provider and increase their chances of finding firm liquidity.
• Use Firm Liquidity Venues Where possible, consumers can choose to trade on venues that offer firm liquidity, such as central limit order books. While the spreads on these venues may be wider, the certainty of execution can be worth the extra cost.
• Negotiate Bilateral Agreements Large institutional consumers may be able to negotiate bilateral agreements with their liquidity providers that limit or eliminate the use of last look.
• Employ Sophisticated Trading Algorithms Advanced trading algorithms can be used to “slice and dice” large orders into smaller pieces, reducing their market impact and making them less likely to be rejected.

The ‘liquidity mirage’ created by last look can lead to a false sense of security, with the true cost of execution only becoming apparent in volatile market conditions.

How Does Pre-Hedging Affect Slippage?

A particularly controversial aspect of last look is the practice of “pre-hedging.” This is where a liquidity provider will hedge their risk in the market before deciding whether to accept or reject a client’s trade. Critics argue that this practice can create a conflict of interest, as the liquidity provider’s hedging activity can move the market against the client, increasing the likelihood that their trade will be rejected.

The FX Global Code of Conduct has discouraged the practice of pre-hedging during the last look window, but it is still a concern for many market participants. Liquidity consumers should be aware of their providers’ policies on pre-hedging and should factor this into their execution strategy.

Execution

From an execution perspective, managing RFQ slippage in a last look environment requires a deep understanding of the underlying market microstructure and a disciplined approach to trading. The execution process is no longer a simple matter of finding the best price; it is a complex exercise in risk management and provider selection.

The first step in effective execution is to have a clear understanding of the last look policies of your liquidity providers. This includes the length of the last look window, the provider’s rejection methodology, and their policy on pre-hedging. This information can be difficult to obtain, as many providers are not fully transparent about their practices. However, it is essential for making informed trading decisions.

Quantitative Analysis of Last Look Costs

The cost of last look can be quantified through a rigorous process of Transaction Cost Analysis (TCA). By analyzing their execution data, liquidity consumers can measure the slippage they are experiencing from different providers and identify those who are consistently rejecting trades in their favor. This data can then be used to create a “rejection curve” for each provider, which shows the likelihood of a trade being rejected at different levels of market movement.

The following table provides a simplified example of how TCA can be used to compare the performance of two different liquidity providers:

In this example, Provider A has a higher fill rate than Provider B, but also has higher slippage on both filled and rejected orders. The “effective spread” is a key metric that takes into account the cost of re-trading rejected orders. In this case, Provider B has a lower effective spread, making them the more cost-effective choice, despite their lower fill rate.

Effective slippage management in a last look environment requires a shift from a simple focus on quoted spreads to a more sophisticated analysis of fill rates and rejection costs.

The Role of the FX Global Code of Conduct

The FX Global Code of Conduct, developed by the Global Foreign Exchange Committee (GFXC), has been a significant step forward in promoting transparency and fairness in the FX market. The code provides a set of principles that market participants are expected to adhere to, including guidelines on the use of last look. While the code is voluntary, it has been widely adopted by major banks and liquidity providers.

The code has helped to standardize the terminology around last look and has encouraged providers to be more transparent about their practices. However, there is still work to be done. Many providers still do not publicly disclose their last look policies, and the practice of pre-hedging remains a concern.

What Is the Future of Last Look?

The debate over last look is likely to continue for the foreseeable future. While liquidity providers argue that it is a necessary risk management tool, liquidity consumers are increasingly demanding greater transparency and fairness. The trend towards disclosed and curated liquidity venues, where consumers can trade directly with a select group of providers, may help to alleviate some of the concerns around last look.

Ultimately, the future of last look will depend on the ability of the industry to find a balance between the needs of liquidity providers and the rights of liquidity consumers. The FX Global Code of Conduct provides a framework for achieving this balance, but it will require a concerted effort from all market participants to ensure that the market is fair and efficient for everyone.

The following table outlines some of the key principles of the FX Global Code of Conduct related to last look:

Reflection

The complexities introduced by last look into the RFQ process underscore a fundamental truth of modern market structure ▴ the pursuit of efficient execution is a continuous process of adaptation and learning. The knowledge gained from this analysis should not be viewed as a static set of rules, but as a component of a larger system of intelligence. How does your own operational framework account for the contingent nature of liquidity in a last look environment?

Does your TCA process adequately capture the true cost of rejected trades? The answers to these questions will determine your ability to navigate the evolving landscape of electronic trading and achieve a decisive edge.