The Intricate Mechanics of Price Creation in the OTC Market

In the previous article of this comprehensive five-part series, we explored the fundamentals of the Over-The-Counter (OTC) market. Now, it's time to delve deeper into the intricate mechanics employed by large financial institutions, such as banks and market makers, to create prices in this decentralized market. Understanding these mechanics is crucial for traders seeking to navigate the OTC market effectively.

• A Recap on OTC Market Pricing: As previously discussed, the OTC market is characterized by the coexistence of numerous prices for the same asset at any given moment, and all of these prices can be considered valid. Due to its decentralized nature, gathering prices from various sources is essential to form a comprehensive view of the current "fair" price. This ongoing process of price collection involves the continuous updating of prices, referred to as "ticks."
• Defining a "Tick": A tick, in essence, is a price update – it can be a price sent from a price provider to a broker or from a broker to a trader. The frequency of ticks varies among different providers and instruments and can depend on the time of day. Some brokers may receive as few as 0-10 ticks per minute, while others may experience a torrent of over 20,000 ticks per minute during periods of normal liquidity. Reputable market makers typically receive ticks from multiple price data vendors, considering all of them when constructing their own prices.

Diverse Approaches of Market Makers

Market makers may employ different strategies when deciding which ticks to convey to their clients. Some brokers opt for simplicity by passing on prices from their providers as they receive them. Others choose to widen spreads before delivering ticks to clients. Additionally, brokers exist that select the best bid and ask prices from various sources, add their spreads, and then provide this composite price to clients. Some brokers rely on third-party aggregators with their internal logic for combining prices, while the most sophisticated institutions employ custom methods for aggregating prices.

Tick Filtering Explained

To optimize server performance and facilitate faster execution, brokers often employ tick filtering. Correct tick filtering is essential, as over-filtering may result in missed market movements, while underfiltering could burden server performance with irrelevant ticks. An example illustrates this: Two trading venues source pricing from the same providers, but venue 1 filters out ticks differing by less than 20% of the spread, whereas venue 2 only filters ticks differing by less than 10% of the spread. Consider a gold spread of $0.20; if the price moves from $2000.00 to $2000.03 to $2000.05, venue 1 would filter the middle tick, displaying only $2000.00 and $2000.05, while venue 2 would retain all three prices.

Some brokers may also filter ticks based on time, allowing ticks with significant time gaps since the last tick to pass through.

Handling Volatile Markets

During major news events, market volatility escalates, resulting in an increased number of ticks as more trades occur. In response, some market makers may tighten tick filtration to reduce server load. However, this approach carries the risk of filtering out ticks containing genuine market movements, potentially preventing client trades from executing despite the market reaching those levels. Striking the right balance in tick filtration during volatile periods is a delicate task.

Understanding Spread Dynamics

After news releases, spreads often widen as the market grapples with uncertainty. Just like with tick filtering, traders benefit from stable and narrow spreads during these events. A stable spread increases the likelihood of trades being triggered by genuine market movements, rather than spread widening.

Traders are advised to select brokers meticulously, considering factors such as tick rates, spreads (especially after news releases), and any gaps between ticks following significant news events. By doing so, traders can ensure they are receiving the best possible pricing from their chosen broker. In the next installment of this series, we will explore how brokers evaluate the quality of their price sources or providers, shedding light on another critical aspect of the OTC market.