Daiwa Capital Markets’ David deGraw catalogs the movements of Japanese markets in 2011 and discusses the various approaches Japan could take with regard to dark pools and High Frequency Trading (HFT).
Volume and Liquidity in Japan Right now, contagion from Europe and the turmoil from the United States have depressed equity transaction volumes across the globe. Once a recovery starts to gain steam, Asia will be the driver for growth and Japan will be a quality play. Due to the perennial underweighting of Japan, I expect volumes in Japan will quickly surpass pre-crisis levels in such a scenario. With exchange volumes being so low, non-traditional liquidity is playing an increasingly important role. We have seen transaction volumes on our nondisplayed liquidity pool as well as PTS volumes continue to grow relative to exchange volumes. We are trying to bring the benefits of crossing to as many client types as possible and our unique position as a principal domestic investment bank enables us to access semi- to non-professional liquidity sources, such as corporate and religious entities, educational endowments, quasipublic institutions, agricultural cooperatives, and retail investors.
Role of PTSs in Japan The role of PTSs has increased steadily since the start of this year and has accounted for as high as 7-8% of market share. The success of SBI Japannext and Chi-X Japan PTS shows that the market is rewarding innovation and efficiency that is created as a result of increased openness and competition. Conversely, the closing of Kabu.com shows that a PTS’s revenue model may not be sustainable over an extended period of low trading volume. Therefore it is critical for participants to carefully evaluate the viability of a venue so that the large upfront technology investments are not wasted.
The implementation of centralized clearing through JSCC was critical for the existing PTSs to rapidly and dramatically expand their share in 2011. However, since August, growth has slowed somewhat along with the rest of the market. Having said that, there are still very good reasons to expect future growth in PTS market share. Both PTSs are working aggressively to on-board new participants and Chi-X has recently announced the introduction of liquidity rebates in Japan. Chi-X have a successful record of growing their market share in Europe with liquidity rebates, and such economic incentives are sure to be strong drivers for growth in Japan as well. In fact, it should open the door for a totally new class of venue fee arbitrageurs to trade Japanese equities. Furthermore, domestic institutions are expected to allow smart order routing to PTSs once regulations are amended to exempt PTSs from the 5% TOB rule.
Australian Securities and Investments Commission’s (ASIC) Greg Yanco tells FIXGlobal how Australian markets are preparing for the future, including the launch of Chi-X Australia.
What are ASIC’s goals for an Australian consolidated tape?
ASIC has consulted with industry in relation to options to consolidate data from all venues. In Consultation Paper 145: Australian equity market structures: proposals (CP145), two options were put forward – a single provider established by tender process or multiple providers provided by ASIC. To this end, respondents overwhelmingly preferred a multiple consolidator model. As we have previously stated in the Response to Submissions on CP145 Australian equity market structure: proposals (REP237), this was based on industry expectation that existing data services can produce the most efficient outcome for users.
Submissions also overwhelmingly supported the proposal that market operators should be obligated to provide information to consolidators on a non-discriminatory basis in order to maintain a level playing field. While ASIC expects that more than one consolidator will emerge in Australia, if it becomes apparent that no industry solution is likely to eventuate to consolidate data from all markets, ASIC may revisit the issue and consider introducing a single consolidator via a public tender process.
Are additional clearing agents needed in Australia?
ASIC is aware that the topic of additional clearing agents in Australia is indeed a timely one. It is currently in discussion between industry representative bodies, ASXClear and RBA (as the regulator in the clearing & settlement space) with ASIC as an observer. Issues have arisen as to both quality and quantity of third party clearers, as ASXClear seeks to significantly increase minimum capital adequacy requirements for clearing participants, in particular third party clearers.
It is an area that ASIC will continue to monitor and a discussion that will be followed with great interest, both inside and outside of ASIC. We look forward to continued frank and candid discussions with the financial industry in this space.
How can smart order routing be most effective?
Smart Order Routers (SORs) will assist market participants in meetingtheir best execution obligations in a multi-market environment. Some participants will use SORs developed by independent service providers and some will build their own systems in-house.
Trading participants will be able to route orders automatically to different venues depending on specified criteria. In a multimarket environment the routing of orders could be split across venues depending on liquidity. In this way, ASIC expects that clients will received a better outcome overall, particularly so for retail clients, who will receive the best price across the markets unless they wish to instruct otherwise (e.g. for an order to be executed with an emphasis on speed, rather than price).
Does ASIC seek to encourage high frequency trading in Australia? If so, under what terms?
ASIC neither encourages nor discourages the practice. High frequency trading is, however, an area that is continuously monitored by ASIC, and we will respond if necessary to ensure that any such activity does not interfere with market integrity and fair, orderly and transparent obligations. In addition, market operator platforms must have adequate and scalable throughput capacity.
In the coming months, ASIC will release a consultation paper (CP) pertaining to the broader enhanced market structure. This CP will discuss, among other things, the issue of market makers in the cash equity products. We look forward to industry feedback to this CP when released in the next few months.
Osaka Securities Exchange’s Matthias Rietig reports on the most recent developments in order routing and algorithmic trading in Japanese equities and derivatives.
Upgrades to Japanese Exchanges
Although the Japanese markets have been fully electronic since 1999, last year’s upgrade to arrowhead by the Tokyo Stock Exchange (TSE), as well as Osaka Securities Exchange (OSE)’s move to J-Gate, are quantum leaps in terms of performance. In OSE’s case, the move to faster technology - internal round trip times have been reduced from 60 milliseconds (ms) to below 1-2ms across all derivatives products - also paved the way for a broad revision of trading rules. All Japan-specific rules have been abolished, making way for global standard price/time First-In-First-Out based trading. This will make OSE more transparent and efficient, and hence, a fairer market.
Since Japan is one of the three largest equity markets in the world, the move towards a more globalized market structure, coupled with technology upgrades, will transform Japan into a new hot spot for High Frequency Trading (HFT). That being said, it is important for the exchanges to navigate through this paradigm shift wisely so as to not alienate the domestic user base and very active domestic retail participants. Although TSE volumes jumped about 10% after their move to arrowhead and spreads narrowed, the domestic proprietary trading houses that could not manage the very expensive transition as well as a huge decrease in profitability were driven out of the market, which resulted in a decrease of around 40% in the Japanese cash equity dealer population.
Although we see a proliferation of Multilateral Trading Facilities (MTFs / so called PTS’s in Japan), dark pools and crossing networks and the like entering the market, the liquidity from the domestic layers is still pretty sticky and has an exchange bias. That being said, even in Japan the times are changing and I expect the share of MTFs to increase steadily over time.
With the arrival of Chi-X Japan, all of the existing Proprietary Trading Systems (PTSs) reviewed their business models and it can be assumed that, due to the successful launch of arrowhead and a speed competitive main market, inter market arbitrage activity will rise. Since the Japanese exchanges are already very competitive with their pricing, the battle will be fought over value added services and features, like speed, tick sizes and access options. Overall, a decrease in trading fees can still be anticipated, which should benefit the end users.
While we do see the first signs of new growth of the PTS’s, overall volumes are still relatively small, with TSE capturing roughly 94% of the overall volumes on exchange equity cash trading, OSE about 5%, and the remaining PTS’s command a combined share of roughly 1%. It will be interesting to watch how market structure will evolve with the opening up of the JSCC, which for the first time started to serve PTS’s as a clearing house in July 2010.
Competition will increase, and although Japan is often labeled as overprotective, many domestic market participants believe it is a good development, as competition clearly cultivates services. The government, itself, is committed to induce more competition among markets to gain competitiveness in an international context and re-establish Tokyo as the financial focal point in Asia.
As the equity cash market is increasingly fragmented, the situation in the equity derivatives space is less so. OSE occupies the major chunk of Japanese equity index futures trading, the most prominent being the Japanese benchmark index Nikkei 225, through the Nikkei Mini Futures, which is one of the ten most actively traded index futures contracts, globally． Furthermore, OSE occupies a 100% share in Japanese Equity Index Options.
Although overall volumes went south for most of the other Japanese derivatives exchanges for the last couple of years, trading volume increased for five consecutive years. The newly launched J-Gate derivatives platform in Tokyo aims to make the overall market proposition of Japan more cost efficient and attractive. Located in the same data center as TSE as well as some PTS’s, J-Gate will hopefully benefit from cross connectivity, analogous to the US and European markets.
Smart order routing and algorithmic trading
Smart order routing (SOR) has been gaining traction in the last few years, and the launch of more sophisticated trading platforms, as well as the overall increase of sophistication of the buy-side, should further facilitate this trend. Although adoption by the international buy-side is already relatively widely implemented, the domestic layer has been more prudent to adopt SOR. In any case, it can be expected that the domestic players will catch up quickly, as they are currently screening the market to be ready once the overall liquidity on the PTS’s increases.
Yoichi Ishikawa of kabu.com Securities navigates the developments of PTSs in Japan and their effects on markets, traders and regulators.
(1) Could you tell us about the history of PTS in Japan and its growth over the past 3 years?
The history of Proprietary Trading Systems (PTS) in Japan began with the launch of PTS trading in September 2000 as the country’s first alternative stock trading platform. Initially, two brokerages developed and launched PTS operations geared primarily toward after-hours trading for retail investors, using the closing price at exchanges and VWAP for certain institutional investors. As a result, until April 2007, PTS trading never accounted for more than 0.2% of overall market volume (monthly basis). PTS trading volume, however, gradually began to expand starting in the second half of 2007 owing to the added liquidity provided by new link-ups between PTS operators and brokerage houses. In 2008, PTS midday trading was launched, offering smaller minimum price movements than the exchanges. PTS operators expanded to six firms, and a small number of international brokers began smart-order routing (SOR) operations.
2009 brought even smaller minimum price movements - less than 1 yen - and the launch of PTS stock price streaming through major information vendors such as Thomson Reuters, Bloomberg and QUICK. As a result of these advances, PTS trading exceeded 1% of overall market volume (monthly basis) for the first time in October 2009. Although the launch of the Tokyo Stock Exchange’s (TSE) advanced trading platform, Arrowhead, at the start of 2010 resulted in reduced latency and reduction of tick size, overall market trading value, including the Tokyo bourse, has not witnessed a significant increase. While PTS trading value, too, has not seen much in the way of growth, PTS trading is now primarily used by brokerage houses for algorithmic and electronic trading to capitalize on arbitrage trading opportunities to leverage the price discrepancy between the Arrowhead System and the smaller PTS price ticks. Arbitrage trading will likely grow to represent over half of all trading on the kabu.com PTS platform.
(2) What are the implications of the growth of alternative platforms/PTS - On clients?
Since 2009, Japan Consolidated Tape, which displays the best price from multiple markets (traditional exchanges and PTSs) using streams from major information vendors, has become the focus of attention regarding the trend toward a reduction of tick size, including less than 1 yen. While institutional investors are considering using SOR to efficiently execute trades at this best price, the challenges faced include: developing systems (OMS, back office administration, etc.) to link with PTSs, which have not been used until now; the formulation of internal rules and regulations; and dealing with environmental changes arising from greater liquidity in the Japanese equities markets, including PTSs.
- On sell-side firms?
Brokerage houses have focused attention on organizing internal policy governing PTS usage, the pursuit of reduced latency using collocation and the review of whether PTSs represent a viable alternative market trading platform and the capabilities of SOR, such as whether orders can be routed efficiently to multiple markets. From a policy perspective, after the start of 2010 several brokerage houses in Japan have revised their best execution policy to clarify SOR connections to PTSs.
As for settlement cost and counterparty risk, a growing number of firms, including those who previously avoided connecting to PTSs, are now considering using PTSs more intently because the Japan Securities Clearing Corporation (JSCC) will offer clearing services to alleviate these risks from July 2010. On the other hand, in terms of technology, the ability to develop advanced and sophisticated IT systems, including reduced latency networks and direct feeds from the markets, represents a pressing need in the battle for best execution, especially considering prices can fluctuate by the millisecond in SOR.
Order flow internalization and off-exchange crossing has been a common market practice in Japan for years. In 1998, Japanese regulators approved the introduction of the proprietary trading system (PTS), a privately operated night time marketplace. Then around 2005, we started to see PTSs operating during day time hours in direct competition with the traditional exchanges. In fact, PTSs are lit venues that operate similarly to the exchange. They have well defined market structure and market participants with price formation taking place in the visible order book. Most PTSs define their tick increments at about 1/10th that of the exchange. One major hurdle for PTSs is that they can not be more than 10% of the market share. Once they reach that point and hope to grow further, they will need to apply to become an exchange.
Dark pools started to appear in Japan in earnest around 2005. In the last couple of years they have become a standard product offering for major international brokerage houses as well as some of the large domestic institutions. Global firms have been able to leverage their expertise and investments in dark pools and smart-order routers in the US and Europe, and have implemented Japanese dark pools with varying degrees of success.
Despite over 10 years of PTS history and a regulatory environment ripe for internalization, alternative trading venues have only managed to capture 1-2% market share from the Tokyo Stock Exchange. What are the reasons for this lack of success in alternative execution venues? What are the catalysts that may move more volume off the exchange?
1. Smart-order routing Infrastructure
In order to effectively access PTSs and dark pools, participants need a smart-order routing system. Smartorder routers can constantly scan available execution venues for best available price, and then execute optimally based on various internal and market rules. The smartorder routing technology needs to operate effectively with both lit pools and dark pools. It needs logic that can handle various market structure related constraints, antigaming rules and the different cost structure of each trading venue.
Most of the global broker-dealers already operate smart-order routers for their US and European businesses, so for them, implementing smartorder routing is a relatively straight forward exercise of localization. However, for those firms without the same infrastructure in place, scratch building a competitive smart-order router is a fairly difficult task. As a result, most of the international broker dealers operate smart-order routers in Japan, while there are only a handful of domestic firms with smart-order routing technology. Not surprisingly, there is almost no retail or on-line brokers operating a competitive smart-order routing technology.
2. Best Execution policies
In Japan every execution agreement mentions a best execution policy. Unlike in other countries, there is no single overarching regulatory framework, such as RegNMS in the US or MIFID in Europe, which outlines the details of best execution. As a result, more often than not, the brokers’ execution agreements are not uniform from one broker to another. Many of these agreements use primary exchange as the default execution venue. There have been efforts across many of the dark pool operating firms to “re-paper” best execution agreements, but ultimately there are no regulatory drivers expanding best execution practices to span multiple liquidity venues.
3. Fund mandates
Many of the domestic pension and traditional funds have mandates that require them to execute at the primary exchanges like TSE or OSE. For those funds, executing in PTSs would be a breach of their mandate. These funds would need to amend their mandates before they could allow their orders to be executed in PTSs. However, given the current level of PTS market share, there is no strong incentive for these funds to add PTS amendments to their mandates.
Fragmentation has evolved in the U.S. and Europe, but the diverse Asian markets are likely to forge their own course, as technological advances and regulatory developments make their impact felt around the region, argues Steve Grob, Strategy Director at Fidessa.
Fragmentation of liquidity has completely reshaped the equities trading landscape in the US and in Europe. It changed the roles of market participants forever by breaking the national monopolies of major exchanges and replacing them with a dazzling array of lit and dark venues. At the same time, it has also blurred the previously clear cut distinction between venues, brokers and buy-sides as each jostles for position in the new liquidity workflow. The next generation of winners and losers is now emerging – the trading equivalent of the“haves” and “have nots” – as different market players seek to embrace the challenge of fragmentation and turn it to their advantage.
This article looks at what may happen across Asian markets in terms of fragmentation. There are, of course, many differences between the trading environment across Asia and the more homogonous environments we see in Europe and, particularly, in the US. Top of the list is the fact there is nothing like the regulatory mandate for change in Asia as we have witnessed in the US and in Europe. Nevertheless, a number of isolated “bush fires”have already broken out in the region, and these raise the issue of whether fragmentation will really take hold and how it might spread. And, if it does, how will it be similar (or different) to our experiences in other parts of the globe?
RegNMS and its European cous
RegNMS and its European cousin MiFID were two pieces of legislation that introduced a concept of “best execution” for both retail and institutional investors aimed at providing greater transparency throughout the whole trading life-cycle. This was achieved by dismantling the national monopolies of the existing stock exchanges and fostering the creation of low cost alternative venues that focussed solely on providing markets for secondary trading in equities. Because these new venues were unencumbered by the other operations of stock exchanges (primary listings, trade reporting, supervision, etc.) they were able to operate on a much smaller cost base. These venues also invested in the latest matching technology which operated faster and at lower cost. The net result of this was that ECNs in the US and MTFs in Europe were able to aggressively compete for trading volumes and, in many cases, caught the incumbent exchanges napping. On top of this, they also introduced maker-taker pricing models which rewarded participants for posting passive liquidity and charged traders for removing or aggregating liquidity.
Many of these new venues were backed by the new Electronic Liquidity Providers (ELPs) such as Getco, Citadel, Optiver and Knight. These firms are able to use their technological prowess to benefit from tiny differences in prices and trading fees between the different venues. Such is their dominance that, according to the TABB Group, High Frequency Trading (HFT) of this sort now accounts for nearly 50% of US equities volume and over a third of the trading in Europe.
The large banks and brokers sought to leverage their own crossing networks against this backdrop too, whilst the alternative and primary market centres also jumped at the opportunity to introduce their own “dark pools” into the mix.