Can you describe the SFC’s recent regulatory initiative on electronic trading? There’s a huge amount of work and thought being put into the regulatory approach to electronic trading internationally, and this effort has been underway for some time.
In Hong Kong, we published our new rules in March after a public consultation.
The initiatives are intended to provide much needed clarity to intermediaries and traders and, in common with much post-financial crisis regulation, are about safety, soundness and transparency. The rules are broadly in line with regulations across other major international markets and the principles published by the International Organization of Securities Commissions (IOSCO).
In essence, the rules apply to internet trading, Direct Market Access (DMA) and algorithmic trading, and are aimed at ensuring that undue risks are not borne by investors.
What are the comments of the industry on the new SFC regime of electronic trading? Feedback was pretty open and honest. There was no significant resistance to the proposals; it is pretty evident that sensible regulation is necessarily about system safety, testing, internal controls and the risks of DMA.
Of course some comments focused on the ever present tension between the extent of safety measures required to minimise risk to an acceptable level and the costs of those measures to the industry – and to end users.
For example, smaller firms were concerned about the extent they have to employ resources to check out an electronic system that is bought off-the-shelf. The answer is that you absolutely need to check it out – because if you don’t, the risks you are taking on are unknowable; you would be flying blind.
Although the new requirements will inevitably increase operating costs, we believe that the framework will actually facilitate the long-term growth of electronic trading in our market; electronic trading is here to stay and the regime ensures that investors are informed and can be confident. One thing we are very conscious of in Hong Kong is that we deal with a vast range of financial institutions from the very big to the very small. The impact of regulation on them, including electronic trading, can therefore vary, and that’s something we have to be sensitive to. Clearly, large firms may be better able to absorb additional costs than smaller firms.
With that in mind, the new regime will become effective on 1 January 2014 to allow sufficient time for all firms to implement internal control policies and procedures, as well as to make changes to their electronic trading and record keeping systems.
How are you examining dark liquidity? Fundamentally, with dark pools and dark liquidity, we are talking about trading off-exchange on platforms that do not offer pre-trade price transparency. Since the imposition of mandatory flagging of reported dark pool transactions by the Hong Kong stock exchange last year, the reported volume of trades executed in dark pools in Hong Kong has increased steadily, accounting for 2.2% to 2.5% of monthly turnover. This, of course, is very small compared to markets that have actively embraced alternative venues – and are now struggling with how to regulate them and find an optimal balance between the roles of “lit” and “dark” trading platforms.
We have identified a set of key issues concerning dark liquidity – clarity to users as to how a dark pool operates; involvement of retail investors; who within a financial institution can see what’s occurring in a dark pool; what ‘best execution’ means within dark pools; and proprietary orders within dark pools – e.g. the priority of proprietary orders versus genuine client orders.
So, unlike the new electronic trading rules – which are about firms operating between a trading platform and a client, this is a separate topic about the platforms themselves.
We’ve already come across some problems with existing dark pools. They have different configurations and different target clients, and of course they were originally developed to facilitate large trades by large institutions – but have moved on from this to deal with smaller trades. Those banks or brokers who operate their own “internal” dark pools tend to say that they are simply a benign electronic overlay to traditional brokerage operations. Exchanges counter this by saying that all trading needs to have pre-trade price and order book transparency and what the dark pools operators are doing is operating alternative exchanges, free riding on lit market pricing. To address these issues, we have actively discussed the situation with existing dark pool operators with a view to imposing carefully calibrated licensing conditions.
We will also consult the market later this year about codifying our stance to ensure a consistent, level playing field for all operators.
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.
Emma Quinn, AllianceBernstein’s Head of Asia Pacific Trading discusses accessing liquidity through dark pools, aggregation and asset allocation.
Trading Volumes, Liquidity and Asset Allocation I think that you’ll see trading volumes rise when you get an asset allocation back into equities, and people have more conviction in the markets. The reason that there’s just no liquidity in the markets is not because people are worried about exchange mechanisms or aspects like that, it’s about the macroeconomic environment and the allocation into equity.
I don’t think that we’re going to see volumes in other asset classes recover faster than allocation into equities as we’ve already seen that allocation change. People are either bullish or bearish, and are set for what they think is going to happen. And so we are in a position that people will just trade around their positions without making any significant move either way until we get some clarity on the macroeconomic environment.
The Rapid Expansion of Dark Pools and Access to Desirable Liquidity We use dark pools to access liquidity for orders we would not normally place in the central limit order book. I think dark pools aid price discovery. There has to be post-trade transparency but once that happens you’ve actually got more transparency on a market than you normally would. In this sort of environment, because you’re not putting out so much into a central limit order book, what used to be 10% of average daily volume is now 30% of average daily volume, you’re obviously leaving more in a dark pool if your order size hasn’t changed. I do think dark pool liquidity aids you, as your expected cost is going to be lower and thanks to post trade transparency in dark pools the market sees a block trade that it would not have seen.
With regard to desirable liquidity, I think the onus is on the buyside to actually put in parameters that can minimize risk. Obviously, you don’t want to go into a dark pool blindly. The same thing could be said of going on to the central limit order book. The same thing can happen to you on a central order book as can in a dark pool, if you’re not smart about the way you trade in a fragmented environment you leave yourself open to be gamed.
Best Execution We have an unbundled commission policy and as such our traders are not limited to paying based on a research vote. We have the discretion to use the broker that will give us the best execution outcome. This discretion is important and enables us to focus purely on the best execution outcomes for our clients.
Impact of Direct and Indirect Costs Imposed on Buy-side Traders by Liquidity Fragmentation We spend a lot of time on quantitative trading strategies and both post and pre-trade cost analysis – we have pre-trade expected costs in our trader management system and we also look at post trade – both daily and weekly as it is not enough just to look at one trade in isolation as so many factors can contribute to whether you have got a trade right or wrong.
Some of the cost of fragmentation has already been borne by the buy-side and sell-side, such as having to have smarter systems and employ quantitative trading. Brokers are now wearing additional costs with some regulators looking to recoup the costs that come with the increase in surveillance costs for a fragmented market. The brokers may have made savings due to the fact that we now have multiple markets and with that came a compression on exchange fees, but they could well and truly be paying that out now to regulators.
Wendy Rudd of the Investment Industry Regulatory Organization of Canada (IIROC) describes the Canadian approach to circuit breakers, minimum size and increment requirements and the role of dark liquidity.
What is currently driving the regulatory policy agenda with regard to circuit breakers? Globally, and Canada is no exception, we have seen the introduction of new rules in several areas related to the mitigation of volatility. Circuit breakers are just one of those areas. While some reforms may have been in the works already, the Flash Crash of May 2010 certainly served as a catalyst for a broader debate about market structure, trading activity and the reliability and stability of our equity trading venues.
Volatility is inevitable, so when does it become a regulatory concern? From our perspective – and we regulate all trading activity on Canada’s three equity exchanges and eight alternative trading systems – we see it as a priority to mitigate the kind of shortterm volatility that interrupts a fair and orderly market. We do not expect to handle this role alone; it is a shared responsibility that includes appropriate order handling by industry participants and consistent volatility controls at the exchange/ATS level.
What are the benefits of harmonizing circuit breaker rules with US markets? One main advantage to a shared or complementary approach is that it limits the potential for certain kinds of regulatory arbitrage in markets that operate in the same time zone. Many Canadian-listed stocks also trade in the US, and roughly half of the dollar value traded in those shares takes place on US markets each day.
Which approaches are you considering taking for market-wide circuit breakers? We are monitoring developments in the US, where regulators have proposed changes which include lower trigger thresholds calculated daily, using the S&P 500 (instead of the Dow Jones Industrial Average) and shorter pauses when those thresholds are triggered. We are currently exploring options for marketwide circuit breakers which include continuing our existing policy of harmonizing with the US, pursuing a ‘made-in-Canada’ alternative or identifying a hybrid approach that does a little bit of both. At this stage, we are soliciting industry feedback on the merits of these three approaches. With the help of that feedback, we expect to be able to choose the appropriate path soon. It is important to note that these kinds of circuit breakers are an important control but have traditionally acted more as insurance – they have only been tripped once in the US and Canada since being introduced in 1988.
How similar is IIROC’s new Single-Stock Circuit Breaker (SSCB) rule to the US rules? Single-stock circuit breakers are relatively new for both jurisdictions. The US and Canada have implemented SSCBs which are similar in that a five-minute halt is triggered when a stock swings 10% within a five-minute period. Otherwise, the Canadian approach differs in several ways. For example, our SSCB does not trigger on a large swing in price if a stock were trading on widely disseminated news after a formal regulatory halt.
Do you believe circuit breakers, market-wide or single-stock, have a deterrent effect on momentum trading? We did not set out with a prescriptive approach to influence or change trading behaviour or strategy. IIROC’s circuit breaker policies were developed to provide added insurance against extraordinary short-term volatility. We intend to study the impact of any changes and we may be able to learn more about the impact of policy changes on trading behaviour.
BNP Paribas Dealing Services Asia’s Francis So opens up about their new structure, how they use Transaction Cost Analysis (TCA) and their preferences regarding dark pools and High Frequency Trading (HFT) flow.
The Hong Kong dealing desk has been restructured as an externalised/outsourced dealing desk for the buy-side. As a result we are now independent of the asset management group and belong to BNP Paribas Securities Services. Our current name is BNP Paribas Fin’AMS Asia Ltd but this will soon change to BNP Paribas Dealing Services, better reflecting the services we provide. BNP Paribas Securities Services provides middle and back office outsourcing services for buyand sell- side, as well as corporate clients. This new dealing service allows us to provide a full suite of front to back office solutions to meet the needs of the clients. The trend has been for the outsourcing of back office activities and I think it is only a natural progression to consider front office activities. Given the market environment, cost reduction is a key element for asset managers/asset owners. Outsourcing the dealing activity can help reduce cost but more importantly allows the asset manager to focus on delivering greater value to their clients. Our Paris office has been very successful in attracting external clients and in Asia we plan to ramp up activity in 2012.
We treat BNP Paribas Investment Partners (the asset management company of the Group) as one of our most sophisticated clients and as such must ensure that the services provided to them are kept to the highest standard. This will be the same for new clients as one of the keys to attracting and maintaining new client relationships is our ability to provide tailor made solutions and services. Clients can range from new start-ups to existing asset managers that already have a dealing desk. We offer flexibility to asset managers such that they can choose the asset class and/or geographical region they want to outsource. For example, some asset managers that already have dealing capabilities in their home market may decide to invest in overseas markets or new asset classes. They need to ask themselves whether it makes sense from a cost perspective to create a new dealing desk where initial volume is expected to remain low.
We have the knowledge, the expertise and the global reach. We have locations in Europe and Asia to cover all asset classes globally. We also serve fund managers located in different geographical regions.
It is important to stress that we are in no way competing against the sell-side. Our clients keep their contractual and daily relationships with brokers. We act as an agency-only trading desk and we do not have any prop flow or take any positions.
We work together with the portfolio manager to determine what benchmarks best suit their needs. They are able to send orders to our global Order Management System (OMS) with a specific benchmark. By doing so, we can measure our execution performance using their specified benchmark, be it Implementation Shortfall (IS), VWAP or a specific measurable benchmark.
Michael Thom, Equities Trader, Genus Capital Management offers a look into the Canadian equities world, including perspectives on dark pools as well as algo implementation and usage.
Inverted pricing models
We have just seen the introduction of more innovative pricing models in Canada, essentially since the launch of TMX Select. For most buy-side participants like me, we do not see our tick fees as rebates because they are bundled into the commissions we pay to our brokers. This is an exciting development for participants that thrive on different market structures, but I would not say that we particularly benefit from this market model. From an intellectual perspective, it is interesting to wonder what will happen as a result of these developments, but I would not say it has any immediate net benefit to us or our clients.
Trends for Dark Pools in Canada
Canadian regulators have taken the right approach. There are lessons to be learned from other jurisdictions where dark liquidity was left to develop and regulators then had to play catch up. I applaud the Canadian regulators for giving their approach to dark liquidity critical thought before it gets to the point of significantly damaging market quality. Regulators in Canada are at a point now where if they change the regulations significantly, venues and firms would be able to adjust. The debate over the trade-at rule in the US shows that whole business models are built around sub-penny pricing and trading not at the touch. I do not think that is where we want to go in Canada.
I am a little cautious around some of the regulators’ specific proposals on minimum size. I am more in favor of the minimum increment being set at a half penny. The minimum size is the more difficult concept because anything that functions around a single pivot size, either in value or number of shares, can disseminate information through trading around that pivot point.
Although to my knowledge very few participants choose to structure their orders in such a way, it should be up to market participants to build into their orders the minimum execution quantities for dark pools as they see fit. I do not think a lot of buy-side participants are currently building their orders or customizing their third party algorithms to that level of detail. From where I sit, it is not a perfect solution, but this compromise might be the best of the difficult alternatives.
It is important to point out that they are not putting in a minimum size right away. The architecture is built to allow the regulator to, on very short notice or if they start to see some compelling data points, put limits in place without going through the full comment and review process, which is all very prudent. They are giving themselves the tools to deal with all possible market outcomes. Flexibility does not come easily to regulators. Typically, they adopt very specific proposals and if those proposals fail, it is back to square one, whereas here they have given themselves a degree of latitude which is commendable.
Simplifying Algo Implementation The algo and DMA providers who are winning our business are those who can give us transparency right down to how they are interacting with each individual venue, what order types they are using and how they are implementing venue specific idiosyncrasies. If a venue has very unique order types, our providers should say how they are using those and why they made the decision to use the order types they did. Providing a transparent, empirical basis for decisions regarding algo structure, architecture, order types and routing is really important. Many decisions go into building quality algorithms and routing, and those who will share the data behind it are my providers of choice. Algo providers seem to now be more willing to tailor and be empirical about constantly improving the product to fit a firm’s or a trader’s trading styles. That is where algorithmic trading is headed, as it relates to buy-side, and we are just starting to see the leading edge of that in Canada.
Lee Porter, Liquidnet, explores the new territory of alternative trading platforms in Indonesia and Malaysia as traders seek new opportunities for growth.
In a relatively short time, alternative trading platforms in Asia have emerged as critical venues for institutional traders to source offexchange liquidity. They provide choice and ultimately help reduce costs through reduced transaction costs and lower market impact. So-called ‘dark pools’ have largely been focused on trading around the established financial centres of Hong Kong, Japan, Singapore and Australia, where the majority of the region’s liquidity is located. The next stage in the industry’s evolution in Asia is a push into emerging markets, and moves are well underway.
The increasing interest in South- East Asia stems from two long-term trends impacting the buy-side: high economic growth which is fuelling demand to trade locally listed securities where there is often low liquidity, and high market impact. As regards the first point, the story of South-East Asia’s economic transformation has been remarkable. Real GDP growth is expected to average 6% between 2011-2015, supported by strong domestic demand, according to the OECD. Meanwhile, South-East Asia’s population jumped 15% in the ten years to 2010, climbing to 607 million.
These demographics continue to attract global investors, helping push higher the local equity markets. For example, the benchmark Jakarta Composite Index gained more than 45% in 2010, making it the best performer among Asia’s ten biggest markets. More money is expected to flow into the region in the coming years. At the same time, liquidity in South-East Asia remains scarce, presenting a significant challenge for institutions looking to trade large volumes of shares.
The Jakarta Stock Exchange in Q1 2011 recorded an average execution size of US$4,677. This compares to an average execution size of around US$1.1 million on on our platform for Indonesianlisted securities during the same period, i.e. 234 times larger than the local exchange. The story is similar in Malaysia where the Bursa Malaysia in Q1 2011 recorded an average execution size of US$6,053 compared to US$1 million reported by Liquidnet.
Local exchanges across South- East Asia, like most of their global peers, are geared towards the needs of retail investors, as seen by relatively small transaction sizes. Moving forward, we see growing demand from institutional investors to access large blocks of shares in those markets (See  next page). The rising demand on alternative trading platforms for South-East Asian securities has been strong.
For example, principal traded on Liquidnet’s platform in Indonesia, Malaysia and Singapore for Q1 2011 was close to US$380 million. This was a jump of over 176% from Q4 2010 (See  next page). When traders find a match in Indonesia they are far more likely to execute the trade, we suspect, because of issues surrounding a lack of liquidity and potential market impact costs.
In addition, traders seeking to execute on public venues in South-East Asia are contending with very wide spreads. This is a factor which can be mitigated on alternative trading platforms, helping institutional traders transact at the fairest price. The problems institutional investors face in Malaysia, Indonesia and Singapore are in fact universal. The solution for many traders is to allow institutions to transact large blocks of shares in a safe and secure environment.
Looking ahead, other markets of South East Asia may draw alternative trading platforms, such as Liquidnet. While it may be too early to speculate about a likely entry date, it is fair to say that the demographics and market dynamics support the entry of alternative trading platforms, which in turn, help support the needs of institutional traders.
Logistically, the issue of connectivity for Malaysia and Indonesia is straight forward. In both markets, some alternative trading platforms trade off-shore and transactions are processed through a licenced third-party broker and reported to the local exchange. While there are occasionally misconceptions about the role of alternative trading venues in some markets, our experience in South-East Asia has been overwhelmingly positive.