Norges Bank’s latest paper in its Asset Manager Perspective series examines the feature of “last look” in foreign exchange markets. The paper, which focuses on the impact of financial innovations on long-term investors, outlines the metrics that Norges Bank has put in place to monitor liquidity providers.
“Last look” is a unique feature of foreign exchange markets that gives liquidity providers the option to reject orders received from liquidity takers in response to the provider’s quote.
Norges Bank believes that while it provides a legitimate need for liquidity providers, and can help improve available liquidity to investors, there is also room for improvement.
For one, there are intrinsic conflicts related to the asymmetry in optionality that last look introduces, as well as the potential for misuse of private information.
The paper says that last look is one approach to handling the potential of aggressive latency arbitrage in a fragmented market. It preserves quote depth at tight spreads, but introduces execution uncertainty, in contrast to the equity market which preserves execution uncertainty but reduces quote depth.
Norges Bank Investment Management advocates for greater transparency in the application of last look.
“Monitoring of liquidity providers’ behaviour will continue to be a critical element in maintaining fair implementation of Last Look,” it says.
Norges has developed a set of metrics to monitor liquidity providers’ behaviour, and believes other investors should do the same. This looks at rejection thresholds, the maximum evaluation periods permitted and the symmetry of the thresholds. It also looks at quoting and rejection behaviour of counterparties, and the price action in a currency pair following the rejection of an order through last look, and the quoting behaviour of the counterparty that rejected the order.
The paper concludes that there are three areas that Norges believes would benefit from greater transparency. They are:
The evaluation period should be limited to price comparisons only. “We believe more prescriptive codes of conduct for liquidity providers are needed in this regard.”
Over the counter dealers as liquidity providers need to be more transparent about their implementation of last look thresholds.
The reasons for the order rejection need to be more transparent.