Australian Securities and Investment Commission’s (ASIC), Senior Executive Leader, Markets & Participant Supervision, Greg Yanco, discusses dark pools and HFT, on a recent GlobalTrading conference call, with market participants Matt Saul, Head of Trading Asia ex. Japan at Fidelity Investment Managers, Rob Liable, Division Director at Macquarie, and Nathan Lewis, Sales Trader at CLSA.
Greg Yanco, ASIC: The one part of dark liquidity where I think we are still concerned regards the impact of too much business going into the dark, to the point where it might impact the quality of the lit market. However, we have recently made the rule to require meaningful price improvement in the dark, which we think will arrest the drift of a lot of business into the dark or reverse the trend. We have seen some promising data from Canada where they already have this rule in place. So the dark liquidity task force we have established is looking at the impact of both of those developments on the quality and integrity of the market. We have undertaken a thematic review of dark pools and high frequency trading. A thematic review is a term that for a regulator means we are looking for misconduct as well as looking at the market quality issues.
So, with the dark pools, one of our concerns was about the impact on market quality. We have found research suggesting that we are already seeing some impact, but I believe that the proposal regarding meaningful price improvement will address that. We are still looking at the concept of a minimum order size in dark pools. I think that will come out again in our consultation. Tick size is an interesting area, as there are a number of stocks always used as examples where it’s said that the tick size is too big. Really the key is if the spread is too big people don’t want to jump over, so they trade in the dark within the spread. So we are looking at other markets, looking at different tick sizes. We are also finding a lack of transparency in dark pools; there is a lot of high frequency trading in there, but it isn’t described as high frequency trading. We have been looking at whether there should be obligations requiring transparency about what is in a dark pool. I did a presentation recently in Singapore with some of our findings. We are seeing some predatory trading but the dynamic here is that the buy-side clients are pretty big, and they have taken an active interest in their brokers’ other clients, as in what high frequency traders they have got in the dark pools.
On high frequency trading generally I think the brokers here are alert to the fact that the high frequency clients aren’t always their best clients, so they have been very responsive to our enquiries about some of the unwelcome behaviour that we have seen. There are not that many high frequency traders that are large enough to cause problems, so we are really dealing with that using our existing powers. We might look at some of the guidance around manipulation but we think that the tools we have got are sufficient. We are sending a few matters through to enforcement, so most of these have been about disorderly conduct. We are also looking at what we can do about noisy small orders. I don’t think we will eliminate them, but we may do something to actively discourage very small orders.
Rob and Nathan, are you finding the same as well with your buyside clients coming in and asking about your other clients and asking about that HFT data? Nathan Lewis, CLSA: Our traditional clientele is the big long-only fund, as we are an agency-only broker without the hedge fund focus in the past. So yes, the guys who are looking down into our crossing engine want to know who is in it, and we don’t have any HFT or aggregators inside, because that’s what suits our clientele best [laughter].
Rob Laible, Macquarie Bank: We do not have HFT clients in general, or aggregators inside our dark pool either. In general, clients want the flexibility to control who they trade against – principal risk or agency. I am just wondering, when you talk about dark pools and them potentially affecting the quality of the lit market, what’s your observation around the overall volume that is done off exchange? Has that been pretty much flat and are dark pools taking some of that liquidity from the upstairs market or is something else happening?
Greg: Well there are two things, one is that last point you made is correct. But the upstairs trades are getting smaller and being executed using broker algorithms in dark pools and on the lit market as well, which is another issue. Another thing we found is that a lot of the disruption that we hear the buy-side is concerned about is actually caused by other similar buy-side algorithms. But the second part of the thing about the market share of dark liquidity is the lit market, even though overall I think there has been a reduction, conditions have been bad, there has been increase in electronic trading on lit markets. So if high frequency trading wasn’t in the lit market, I think if it didn’t exist there would be a much bigger appearance of growth in the dark pools. But what we have seen is growth in dark pools taking business from the lit market, but also from the upstairs market.
Ben Jefferys, Head of Trading Solutions, IRESS, looks back at a year of the multi-market environment, and the future growth potential.
With almost a year of a multi-market environment in Australia, it’s time to stop and reflect on the year that has just passed. The question often talked about town is whether expectations have been met; but depending on who you are or who you talk to those expectations were very different things, if anything at all.
As Australia anticipated the launch of Chi-X and its rival ASX PureMatch we looked abroad to get a sense of what to expect. It didn’t take long to realise that the legislative framework and market structure within Australia was different to other countries and regions in the world. Many felt that the Canadian experience would be the closest, but still there were enough significant differences to ensure that Australia’s journey was a unique one.
The most relevant point of difference between Australia and other parts of the world was just what happens when there is a better price on one market compared to another. In Australia there are no hard and fast rules about having to solely execute at the better price. It comes down to the market participant (i.e. the broker) and their respective best execution policies. The latest guidance from the regulator, ASIC, says that a broker needs to make a decision on whether to trade on markets other than the ASX if outcomes, including all costs involved, are consistently delivering better results for clients.
In Europe where the European Union’s Markets in Financial Instruments Directive (MiFID) applies, best execution is “principles based” where the premise lies in achieving the best outcome for the client. It is important to note that it states best outcome and not just best price.
The US and Canada have what are known as trade-through protection rules but then the definition in each country differs. For the US, if there is a better quoted price on another exchange, then the order must be forwarded by the receiving exchange to the exchange with a better price. In Canada it is similar but not quite the same. If there is a better price elsewhere, then the exchange must reject the order and the broker must then try again and send it to the exchange where the better price exists.
Delving into the detail of how each market is structured and how their respective legislative frameworks operate one would have found it increasingly difficult to predict just what might happen in Australia in a multi-market environment.
Depending on what side of the fence you sat those expectations ranged from cheaper transaction costs through to tighter spreads and everything in between. If you went and asked the industry as to whether these last 12 months constituted success for multi-markets in Australia, sadly the response is most likely to be one of indifference.
The Arrival of Fragmentation But a lot has been achieved in the last two years by exchanges, market participants, regulators and vendors. The change has been immense. If we focus just on innovation around the fragmentation of the Australian marketplace most people would be surprised at just how long this change has been in motion. It was back in June 2010 when the ASX fragmented its own market with the CentrePoint and VolumeMatch products. The latter traded once and has not since, whilst CentrePoint has developed into a successful alternative market where price improvements can be realised by trading at the mid-point of the spread.
Then on 31 October 2011 Chi-X Australia commenced trading on a small number of stocks and was in full swing by 9 November 2011 trading all ASX 200 stocks plus ETFs. Similarly, the ASX soft-launched its competing PureMatch product a month later on 28 November 2011.
As the issues surrounding dark liquidity grow more and more contentious, Steve Grob, Fidessa’s Director of Group Strategy, looks at the Australian trading landscape, how this type of trading has evolved and what the dark future holds.
Over the past few years, much attention in Australia has focused on the competition between ASX and Chi-X. But, in fact, multi-venue trading (via dark pools) was available to Australian investors long before Chi-X ever opened its doors back in November 2011. The term ‘dark pool’, however, has now become a catch-all phrase that describes a variety of activities that match trades but do not distribute pre-trade prices. Partly because of their name and partly because they are misunderstood, dark pools have attracted great controversy worldwide, and Australia has been no exception to this. So, what does the Australian dark landscape really look like, who is in it and what value does dark trading really bring to the market?
In 1997, ITG launched POSIT, a pre-market VWAP cross, Australia’s first alternative venue. However, it wasn’t until 2008 – anticipating the end of the ten-second rule1 – that Liquidnet followed with its buy-side crossing network, and finally Instinet with its BLX crossing network in 2011.
Likewise, broker dark pools were also around before Chi-X was born. UBS PIN (Price Improvement Network) launched in 2009 with other major brokers quickly following. These days most of the big brokers in Australia operate dark pools, although UBS PIN remains the biggest.
Finally, ASX’s own dark pool, Centre Point, was launched with much fanfare in 2010, and it is thriving (see diagram 1); it in fact has greater market share than Chi-X. To illustrate the complexity of these issues though, at a conference in Melbourne in May 2012 ASX chief Elmer Funke Kupper warned of the dangers dark pools presented to the Australian trading landscape, even though ASX earns 0.5bps on the AU$100 million-odd worth of trades executed on its venue every day.2
Genesis of Dark Pool Trading Institutional buy-sides have always preferred to cross their order flow with other buy-sides that have the ‘natural’ other side in the stock they are looking to buy or sell. The reason for this is anonymity, or not divulging their trading intention to the market at large. The larger the order size the greater the value placed on this anonymity. Dark pools provide exactly this – but have they always been available or are they a new luxury brought about by the wonders of electronic trading?
In the days before widespread computer usage, if an institution wanted to move a big line of stock, and didn’t want to send it down to the exchange for fear of moving the market, they’d call their broker. Often the broker would call their internal counterparts to see whether they, or a client, was buying or selling a similar block and would execute an ‘upstairs’ trade at an internally negotiated price. Depending upon the skill of the broker, this provided a high degree of anonymity and certainly more than would be achieve by just dumping the order on a lit market for all to see.
Greg Yanco, Senior Executive Leader of Market and Participant Supervision, ASIC looks at the electronic trading environment in Australia and where regulation can play a role.
ASIC is Australia’s corporate, markets and financial services regulator. In relation to its responsibilities supervising markets, ASIC believes that well-regulated, transparent and well-functioning capital markets are the engine room for economic growth: matching companies that wish to raise capital to grow their businesses, with investors that wish to place their funds for a return in a liquid market.
ASIC constantly monitors changes in global equity markets and draws on the surveillance experience of other regulators. It is clear that technology has increased the speed, capacity and sophistication of trading. Along with the new opportunities that this presents for participants, it also poses new regulatory challenges for ASIC.
Flexible Advanced Surveillance Technologies (FAST) In the May federal budget, the Australian Government announced a commitment to invest in new technologies to enhance ASIC’s capabilities in market surveillance and enforcement. The $43.7 million over four years will allow ASIC to plan for a future that includes greatly increased message traffic, new trading technologies and techniques, increased competition between trading venues, and the increasing globalisation of capital markets.
The funding allows ASIC to provide four key deliverables. Firstly, it allows for the replacement of ASIC’s market surveillance system – a system which was originally designed for a single market and for which the contract expires in 2013. ASIC’s new system will continue to use the existing FIX specification. The upgrade will add capacity and capability, and enable the system to cope with both a multi-market environment and the increase in high frequency trading (HFT) and algorithmic trading. It will also allow for real-time surveillance of futures markets, which is currently post-trade. The new system will provide the capacity to handle the dramatic increase in messaging, with the ability to handle up to one billion messages per day.
Secondly, the system will allow for advanced analytics; for analysts to search data records and identify suspicious trading by connecting patterns and relationships. This will be crucial for greater levels of detection of insider relationships, and will also allow for the development of post-trade surveillance capabilities to identify market trends, patterns of trading behavior and repeated or systemic behavior. These capabilities are common in other comparable markets.
Thirdly, the new system will also include a portal for market participants to connect with ASIC. This will allow for the enhancement of efficiencies in dealing with ASIC, and enable participants to electronically lodge certain material in accordance with their obligations. Fourth, the development of a workflow system will help ASIC improve the management of cases from the moment ASIC receives an alert, complaint or enquiry, to the end of an enforcement action.
With Australia having some of the highest levels of share ownership globally, this funding is crucial in allowing ASIC to strive towards one of its strategic priorities of confident and informed investors and financial consumers. This is achieved through markets operating with integrity and efficiency which, in turn, helps to achieve another strategic priority: fair and efficient financial markets.
The funding costs will be smoothed and recovered over 10 years to minimise impact. In our view, the cost will be outweighed by the medium to long-term benefits of competition and of well regulated, fair and efficient markets. These costs also reflect the additional costs of supervision due to the increased speed and complexity of trading and dispersed trading venues, including dark pools. As a percentage of market turnover, the cost of market supervision remains favourable to comparable jurisdictions.
Ben Read, Electronic Sales, Merrill Lynch, examines the ongoing trends and potential pitfalls in electronic trading in Australia.
To the year ended July 31, turnover on the ASX had fallen 46% over the previous year on year, with eight down months out of the 12. (Please see diagram1 on next page). August provided some relief, with turnover up 23%, but globally equity volumes continue to decline through the seasonally quiet summer months; driven by a continued rotation out of equities amidst global economic uncertainty – the European Sovereign Debt Crisis, the US election and “Fiscal Cliff”, and Chinese growth moderation at the same time as a once-in-a-decade leadership change, all weigh heavily.
Beyond the macroeconomic (cyclical) challenges over the past 18 months, there has been a significant structural shift in the Australian market. Most significantly, in executing orders on behalf of investors, participants now have two public, or lit, venues and exchange-run/broker dark pools to consider. Best execution obligations set out in the corresponding ASIC Market Integrity Rules have introduced a new set of market integrity rules, which bear resemblance to the European Union’s Markets in Financial Instruments Directive (MiFID). Each require every market participant to now have a policy in place which sets out the framework in which it will meet its best execution obligations to its clients. The similarity to MiFID is its principles-based nature of this best execution requirement, which allows each broker to decide how it determines the best outcome for clients.
This is driving electronic trading/execution to become a more significant part of how Australian markets trade. Globally, we have witnessed this over the past decade and recent data estimates that 75% of US and 55% of European volumes are now being executed electronically. In Australia, we estimate this figure to be closer to 35%; up significantly over the past 2-3 years, but still very low by global standards, which, to us, implies that there is still substantial growth ahead. ASIC has been following this shift towards electronic, or direct, execution and in its recent consultation paper (CP184) provided guidance and rules on automated trading. One point was to ensure that all participants maintain robust filters and controls across all platforms that access the market, with a key requirement to have a kill switch in place that can shut down parts of the execution infrastructure when behaviour outside accepted patterns is detected.
A kill switch can take two forms: it can either be software coded, or hardware-based. The former is a functionality that exists across the execution platform. It allows the trading desk, in combination with oversight functions, to quickly shut down either flow from a particular client, or a particular algorithm, that they believe is not behaving correctly. A hardware-based solution is more complex and involves the physical disconnection of parts of a market participant’s order routing platform from the exchange infrastructure. This is typically accomplished by closing or blocking network switches that exist between the two.
Also vitally important is the real-time monitoring that alerts trading desks to any form of execution that is occurring outside acceptable parameters. Most market participants with established electronic trading platforms have pre-trade filters based on a percentage of AD V, value of single orders, total notional and net delta. Taking this further is the implementation of systems that can alert on abnormal patterns of messages, trades and realised profit and loss. Significant deviations from historical patterns can significantly speed up decision making in whether to involve a kill switch.
After the recent events in the US involving Knight Securities, SEC Chairman, Mary Schapiro commented that “when broker-dealers with access to markets use computers to trade, trade fast, or trade frequently, they must check those systems to ensure they are operating properly.1 ”
In Australia, the investment community is supportive of such initiatives to ensure that overall market integrity and confidence is maintained and that investors and participants are protected from similar events occurring. In the immediate aftermath of Knight Capital, sell-side lines of business right across the industry conducted thorough reviews of their internal risk frameworks and there was plenty of dialogue with clients on what their trading limits were with different trading desks they faced. The majority of this work started before ASIC formally published CP184.
Ilan Israelstam, Head of Strategy at BetaShares, looks at the past, present, and future, of ETFs on the Australian market.
The first exchange traded fund (ETF) was quoted on the Australian Securities Exchange (ASX) on 27 August 2001, and while growth was slow in the early days, since 2009, assets under management of Australian Exchange Traded Products (ETP) have doubled, with approximately $5.5 billion invested as of August 2012. The last 12 months in particular have been significant in terms of the development of the Australian ETF industry, with all major asset classes now available for investors in ETF form. In addition, new money into the industry was significantly positive – with over $200m of net net inflows in the last 6 months alone.
Additionally, the number of products and exposures now available on the ASX has increased substantially, with 26 new ETPs listed since June 2011. To put this number in context, in July 2010, almost nine years after the first ETF was launched in Australia, there were only 37 ETPs quoted on the ASX, and in the last two years, we have seen this number more than double. Of the 26 new ETPs listed on the ASX since July 2011, investors now have exposure to a range of currencies, fixed income, cash and commodities such as agriculture and oil. With all these asset classes now available, we are also beginning to see greater interest and some investment in ETFs by institutional investors.
Institutional Investors’ Usage Still Limited – but Significant Upside Available While there has been plenty of interest in ETFs by Australian institutions, uptake has been limited to date. However, despite this, activity has definitely picked up in the last 12 months including initial ETF investments by SunSuper, a major Australian pension fund, and van Eyk, a multi-manager, both allocating to emerging markets through ETFs. Recently, there has also been institutional use of the US dollar ETF (which aims to profit from a fall in the Australian dollar against the US dollar), as well as in the high interest cash ETF (which aims to provide returns greater than the Reserve Bank of Australia cash rate). Just recently, a resources sector ETF experienced some block trading as institutional investors looked to obtain tactical tilts to Australia’s largest sector of the economy. The above progress notwithstanding, there is still a long way to go. In other markets such as Europe or the US, up to 50% of ETF assets under management are institutional and ETFs are almost always in the top 10 securities traded in terms of exchange turnover. Compare this with Australia, where ETFs only make up a small portion of the total trading value, with a majority of the money retail based. It appears as though significant upside still exists for institutional usage of ETFs in Australia.
The Attractiveness of the Australian ETF Market Despite not being as advanced as other ETF markets, there are some characteristics for Australian ETF issuers which make the local market attractive. First off, by sheer virtue of being a laggard market, local ETF issuers and regulators can learn from the scrutiny of ETFs that occurs in more developed markets, especially when it comes to regulatory issues. As an example, Australian ETF structures benefit from ‘best practice’ in existence around the globe. To illustrate this, currently all ‘synthetic’ ETFs listed in Australia are backed by cash held in a depositary account. Such a structure avoids some of the controversy that occurred when similar ETFs quoted in overseas markets utilised alternative forms of collateral in their structures. The second point is that the Australian ETF market has a lot of room to grow. If we compare Australia to Canada, there are a lot of similarities in terms of GDP, population size and being a resources driven economy. However, there is a huge difference in terms of size of the ETF market with the Canadian industry being approximately C$40 billion compared with just over A$5 billion locally. The size of the potential is particularly striking when one notes that Australia has the fourth largest pension pool in the world, just having tipped A$1.4 trillion. This clearly presents strong growth opportunities for ETFs as retail and institutional investors continue adopting ETFs in portfolios. Depending on market conditions, we believe the Australian ETF market has potential to grow exponentially over the next three years reaching up to A$15 billion by 2015.
Senrigan’s Head of Trading, John Tompkins, and RBS’ Andrew Freyre-Sanders discuss the way event based funds use liquidity and the effect of ID markets in Asia.
Andrew Freyre-Sanders, RBS: What would you say Senrigan is known for among Asia hedge funds?
John Tompkins, Senrigan: What we are most known for now is being an event-driven fund that is entirely based out of Asia. Nick Taylor founded Senrigan in 2009, and he is known for doing event-driven trading and has been verysuccessful at it. Nick was at Goldman Sachs and Credit Suisse, where he ran Modal Capital Partners for nine years before going to Citadel with his team. Senrigan’s capital raising and first year metrics made the first two years a success.
AFS: I know you trade in the US and Europe as well, so is the global fund entirely based out of Asia?
JT: The entire firm is based in Hong Kong, although we have some analysts who spend extended periods of time in the regions of focus. If we do any US and European trading, it always has an Asian bent to it; for example, a UK or European listed company that has a large percentage of their business located in Asia. The few examples are Renault-Nissan, all the Chinese Depository Receipts (DRs) in the US and some Canadian companies doing M&A into Australia.
AFS: Event driven funds require quick access to liquidity. How does the type of deal or event catalyst affect the relative weighting of these items?
JT: The exchanges and companies are smarter, so they generally halt or suspend the names coming into the announcement, and then you have a short window until a given stock starts to trade up towards the terms. Any reasonably-sized fund is not going to be able to get anything done in that time period. After the event, the main concern is your targeted rate of return for the particular deal, which is impacted by the closing timeframe, surrounding risk, regulatory approval, dividend payments, etc, and you set levels where you want to be involved.
Traditionally safe deals with very tight spreads are viewed as the simplest way to risk-reduce, so people take those off and we give liquidity then because we are comfortable with what we are taking on. A lot of people think about the event as just the announcement on the day, but it is actually the time between when you see it and the range gets set. Only if it closes sporadically do you need access to greater liquidity; most of the time, you just need to be in touch with providers rather than have direct access.
AFS: From a trading perspective, once a deal is gone, it is not about that deal. The only speed liquidity advantage is in having systems that can take advantage of the spreads when they may be moving around a certain level. Is that the case for you?
JT: It definitely is. The big differences between Europe and Asia are the number of auctions and the number of times stocks stop trading, which is quite significant. Between three and four distinct times a day, you will have dislocations in spreads for a variety of reasons, and this is an opportunity to improve. Beyond that, a majority of sell-side firms are setting up their own dark pools and there are alternative exchanges in Japan. In those venues, we deal with liquidity providers and market makers who do not care about the individual mechanics of a name; they simply care about the level of spread that they can access.
The most relevant thing is making sure you have the connectivity turned on to access all the forms of liquidity that exist. There is a big differentiation between counterparties in Asia from an executing broker’s standpoint: e.g. what is their default, what do they turn on for you right away, whatcountries do they have their crossing engines in, who do they have in their pool as liquidity providers? You have to know to ask those questions, and it has been very helpful to do that.
RCM’s Head of Asia Pacific Trading, Kent Rossiter, points out some of the good and bad of Indian SOR and reflects on Hong Kong market structure.
Are Smart Order Routers (SORs) in India working well?
SORs sure are working in India. I am not sure what is more of a raging success in the Asian equity SOR world, India or Japan, but the cost savings estimate numbers we are hearing are evidence enough to suggest that Indian SOR development is a big plus.
For ages, there have been two meaningfully big markets; the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). Up until a year ago, when Securities and Exchange Board of India (SEBI) opened the playing field up, investors who wanted the liquidity of both had to do so by manually monitoring their screens. This was painfully labor intensive and with the thin displayed liquidity of bids and offers, difficult to actually execute. You would often find fills from one exchange or another being executed at inferior prices to the other as a dealer had their eyes off the ball. Those executions were inevitably followed by a conversation with a dozen excuses. I would be told what I was seeing on my screen was not the real situation, but a latency delayed picture.
For the most part we are only using brokers with SOR for our Indian executions, and these brokers co-locate servers so latency is no longer a concern. We are getting fills at the best prices available and from two pools of liquidity where we may have only had one in the past. Only if the order is really small would we limit ourselves to one exchange in an effort to save on ticketing charges.
SOR is just the most recent visible step in the broader trend of the evolution of markets. Accordingly, the buy-side and sell-side traders have to educate themselves and keep up.
What are the issues with Indian SOR?
It is the lack of interoperability at the post-trade clearing level that has limited the true savings many investors would have benefited from otherwise. This is a challenge that SEBI continues to address. The lack a central clearing counterparty for the NSE and the BSE causes settlement costs to be about twice what they would be if only one exchange were used, and this is a consideration for most institutions when deciding whether or not to use two exchanges. If the exchanges and SEBI could reach a solution in terms of interoperability arrangements for SORs, the cost savings and benefits of SOR usage could be passed to the end users. Until then, its true potential remains yet to be uncovered.