The logic behind price creation in the OTC market
By Reem Bacha
21 December 2023
The previous article in this five-part series broke down the fundamentals of the OTC market. Now it’s time to delve deeper into the typical mechanics that large financial institutions such as banks or market makers use to create their prices, and how differences can occur.
For the purposes of this article, we will be using the terms “broker” and “market maker” interchangeably.
A brief refresher on pricing in the OTC market
As we touched on in the previous article, many prices for the same asset can coexist at any point in time, and all of them can be valid.
Therefore, due to the decentralized nature of the OTC markets, you need to collect prices from various sources to get a comprehensive picture of the current “fair” price.
This process of price collection never stops as the markets keep changing, with each new price update being called a tick.
What is a tick?
A tick is a price - e.g. it can be a price sent from a price provider to a broker, or from a broker to a trader.
Tick rates vary across different providers and instruments, and also depend on the time of day. When brokers receive ticks from their providers, it can sometimes be as few as 0-10 ticks per minute, or over 20,000 ticks per minute.
During periods of normal liquidity, it is typical for brokers that have multiple providers to receive thousands of ticks per minute. Reputable market makers will typically receive ticks from multiple price data vendors and take all of them into consideration when creating their own prices.
The different logical approaches market makers take
Market makers can differ when it comes to deciding which ticks to send to their clients. Some of them just take prices from their providers and deliver them to their clients as they are, because it is the simplest thing to do. Others mark up the spreads before passing the ticks to clients.
Then there are the brokers that take the best bid and ask prices from a variety of different sources, add their spread, and pass this price to clients. You also have brokers that use third-party aggregators that have their own internal logic for combining prices from various sources.
Finally, the most sophisticated brokers and banks have their own custom way of aggregating prices from different sources. They use custom logic to decide which ticks to trust, and advanced mathematical models to generate the ticks that best represent the market at that moment, which they then pass to clients. These models consider prices from several sources, to come up with their own unique prices and spreads for each instrument. Now let’s take a look at the concept of tick filtering.
What is tick filtering?
Brokers filter the ticks they send to clients to limit the load on their servers and deliver faster execution. It is crucial that tick filtering is done correctly because, if not, brokers run the risk of over-filtering and losing important market moves. Or, conversely, they could underfilter and pass on too many ticks that contain no new information, slowing server performance down. Let’s take an example:
Two trading venues have the same sources for their pricing, but trading venue 1 might filter out ticks that differ from the previous tick by less than 20% of the spread, while venue 2 only filters ticks that differ by less than 10% of the spread.
Let’s say the spread of gold is $0.20, and let’s consider mid prices, for simplicity. If the gold price changes from $2000.00 to $2000.03 to $2000.05, venue 1 will filter the middle tick and will only show $2000.00 and 2000.05, while venue 2 will contain all 3 prices.
This means that sometimes, some smaller price movements may not be reflected in the pricing of the first venue, but can be observed with venue 2.
Some brokers also filter based on time, so even if a similar tick comes through, but there is a significant time gap since the last tick, they will let it pass through to the client.
So what happens during volatile markets?
During major news events, the markets often become more volatile, with more ticks coming through as more trades take place.
In response, some market makers may make their tick filtration stricter in an effort to reduce the load on their servers. The risk with this approach is that they can then filter out ticks that contain actual market movements, resulting in client trades not being triggered or filled even though the market did go to those levels.
This is because each tick can trigger trade execution, and the system can significantly slow down while trying to process all the ticks and execute trades.
At the same time, during and after news events, some brokers could have gaps in pricing that are longer than others. This period can range from dozens of milliseconds to several seconds. Ideally, the best pricing would have the highest tick rate with the shortest time gaps between ticks following news releases.
Now let’s tackle spreads
After news releases, spread widening is common as the market is uncertain about where the real rates are.
Just like with tick filtering, the best pricing for traders would be the one that offers the most stable and low spreads during news releases. Stable spreads mean traders have an increased chance of their trades being triggered due to genuine market movements, rather than due to spread widening.
Widening spreads or increasing tick filtration during news events is something that brokers may do to protect themselves from market risk and/or keep their servers stable. That said, it may also restrict traders, particularly those who rely on rapid price movements and high-frequency trading strategies that benefit from market volatility.
As a general rule of thumb, traders should consider selecting a broker that is detailed and thorough in its approach to price generation, tick filtration, and spread management.
To do this, you should compare and contrast tick rates and spreads (especially after news releases), and check for any gaps between ticks following major news events. This way, you’ll be able to ensure that the broker you choose to trade with is providing you with the best pricing possible.
Read the next installment of this series to get an inside look into how brokers determine the quality of their price sources or providers.
This is not investment advice. Past performance is not an indication of future results. Your capital is at risk, please trade responsibly.
Reem Bacha is a dedicated content professional and product communications specialist with over 8 years of experience in the FinTech sector.