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Mizuho Securities’ Spyridon Mentzas discusses the status of the Japanese exchange merger and offers thoughts on how well the two systems will merge and the benefits investors can expect.

Spyridon Mentzas, Mizuho SecuritiesCompatibility
The merger of Tokyo Stock Exchange (TSE) and Osaka Securities Exchange (OSE) is not yet finalized, but it appears they will merge in the beginning of 2013, with the details yet to be specified. The first impression is that they have nearly identical trading rules with some minor differences, such as the OSE trading until 3:10, while the TSE closes at 3:00. When TSE decided to shorten the lunch time in November, the OSE did the same. When one of the exchanges (usually, the TSE) changes the rules, then the other moves in tandem: for example, changing the tick sizes. If the merger does go ahead, it is likely that they are going to use the TSE’s cash system, arrowhead, and OSE’ J-GATE for derivatives. They will use the old systems in parallel, which will achieve a reduction in cost because they will not have to maintain two systems.

Further Industry Consolidation
The ECN’s in the US enjoyed technological superiority versus the classic exchanges, where NYSE’s latency was significantly slower than Arca’s. This would have been reason enough for TSE to consider buying a PTS, but with arrowhead’s current latency of less than 2 milliseconds (and another upgrade in the next few months to target less than a millisecond), simply buying a PTS would not give them a noticeable advantage because the TSE and OSE are on par with the PTSs. The reason why PTSs are increasing their market share is that, unlike in the UK and US, where Reg NMS and MiFID have required trading on the exchange with the best price, in Japan the PTSs draw volume through decimal points and smaller tick sizes than the incumbents.

For example, Mizuho Financial Group might trade on the TSE at 105 yen bid, 106 yen offer. That one yen spread is close to 100 basis points or almost one percent, whereas the PTS trades at 0.1 yen. This is a major incentive for investors to buy and sell on the PTSs with their smaller increments to reduce market impact and trading costs. From the beginning, the regulators have not been overly concerned with the PTSs deciding to trade in decimal places and have 0.1 yen ticks. It was always up to the PTSs to decide and the TSE could do the same. If anything, I think the new exchange would rather reduce their tick sizes, than merge again.

However, not all participants would be happy to see new tick sizes, for example, some of the proprietary houses or small firms that trade with retail, as altering their downstream systems to handle decimal places would be costly.

This will also create a fragmentation of liquidity in tick sizes. The bids and offers on the TSE are often thick, with something like 50 billion shares sitting on the bid side, so with 0.1 yen ticks, the average order size might move to 3 million or 1 million shares. Traders who want to buy a large lot will have to scroll up and down to find out how much they have to go up to absorb the available liquidity. I think for the traditional long-only traders, this might mean an increased scattering of liquidity. There is sufficient liquidity in the market at present; even for stocks trading at a low price – there are market makers trying to make 1% during the day. If smaller tick sizes are introduced, that liquidity will likely be scattered or disappear.

Led by the FPL Americas Buy-side Working Group, Post-Trade Subgroup, the benefits of using FIX for equities allocations is discussed by Greenline’s Dave Tolman, NYSE’s Chris Walsh and Fidessa’s Paul Whenham.

FIX Protocol Ltd. (FPL) launched Buy-Side Working Groups in the Americas, EMEA and Asia Pacific regions in order to provide a platform for buy-side representatives to discuss how their needs can be efficiently met by the automated trading community. The last edition of FIXGlobal focused on the group’s effort to standardize execution venue reporting and this edition will introduce another primary area of focus for the group, which has been to facilitate the expanded use of FIX for post-trade processing. To that end, the Working Group identified the primary business workflows in this area and are developing implementation guidelines for each. It is the belief of the group that industry adoption of these guidelines for implementations of these flows will substantially reduce implementation cost and time for all parties.

The objective of the FPL post-trade processing initiative for equities is to further define a FIX messaging protocol for bilateral post-trade processing between the buy-side and sell-side that can supplement existing post-trade processes and allow firms to better manage posttrade processing risks, further extend the front office success of FIX to post-trade/pre-settlement and avoid/reduce pre-transaction costs.

In post-trade processing, the buy-side allocates the trade among one or more accounts and communicates the allocations and fees to the sellside. For US equities, the sell-side accepts or rejects the allocation instruction but does not add any additional data. For non-US equities, the sell-side may communicate additional fees back to the buy-side. Once there is agreement between the buy-side and sell-side on the allocation, there is a final accountlevel trade ‘confirmation’ from the sell-side that must be ‘affirmed’ by the buy-side before the trade information is forwarded to the appropriate Central Clearing Party (CCP) for clearing and settlement.

Currently the most common process is to use an intermediary system to communicate and match allocations optionally followed by a second intermediary system to communicate confirmations, match affirmations, and pass affirmed trades to the CCP.

Dave Tolman, Greenline Technologies

Who will benefit most from the implementation of FIX allocations?

Both buy-side and sell-side benefit. First, having a bilateral alternative to using a common intermediary system reduces dependence on a single point of failure, thus improving overall availability. In addition, using FIX simplifies the matching and communication process as well as eliminating intermediary transaction costs for those allocations completed over FIX.

How can greater uniformity of allocations messaging be encouraged and how will that improve straight through processing?

There are many parties that must cooperate in the post-trade process – buy-sides, broker/dealers, custodian banks, central clearing – and multiple protocols and communication mechanisms are currently employed as well as considerable human intervention. Utilizing bilateral FIX messaging in itself reduces the complexity of the communication and matching process because the messages flow on the same FIX session as the orders and can be directly linked to the referenced trade executions resulting in many fewer matching issues, faster processing and lower costs. Having a uniform industry standard such as the FIX Protocol will reduce the cost and time for implementation because the many affected parties can reduce the number of protocols and connection types required to support their clients.

How can a smoother allocations post-trade process lower total trading costs?

The immediate opportunities for cost savings are the intermediary transaction charges and the people and time cost of resolving the more complicated intermediary allocation mis-match issues. However, if the industry standard FIX Protocol could be adopted at levels that reached all the way to the central clearing parties, there are significant opportunities for reduction in communication costs from just being able to use FIX-based communication, for which many of the order processing links already exist.

Put three men and a FIXGlobal’s Edward Mangles around a table; serve them lunch and let the tapes roll. FIXGlobal listened in on a conversation that ranged from regulators to risk and from FX to FIX.

Edward: In defense of the regulator … how should they know what’s going on when neither the sell nor buy-side seem to know?

Vincent: Recent events have shown the divide between the financial market participants and the regulator. For example, the Lehman’s mini bond issue has forced a strong dialogue between the regulator and, in particular, the broker side. But the engagement is slow.

Kent: Retail brokers tend to have a strong voice here in Hong Kong and over the years have developed a strong working relationship with the regulators. Local brokers can at times be pretty outspoken and have proven on many occasions to be an effective lobbying group. From our perspective international brokers tend to be less visible in some of these debates. We see certain common characteristics across Asia where understandably there is a good deal of focus on protecting the retail investor given the high retail investor participation in many of the stock markets in Asia including Taiwan and Korea. The challenge has certainly been in the retail space where there is an overlap of regulatory responsibility in approving and offering products.

Edward: Are we asking the impossible of the regulator to create the same rule book for retail and institutional investors?

Kent: The general principal is that retail investors are less savvy and experienced and regulations need to be explicit. There is a general assumption that as professional investors, institutions can operate with greater flexibility since they can understand the risks in a more sophisticated way. Taking account of this framework then it will not be possible to standardize for both types of investor. The risk is that setting minimum requirements to protect the retail investor may not suit the way business is transacted at an institutional level. Here we advocate consultation and support stronger trade associations.

Vincent: I don’t think you can realistically expect the same regulations for retail traders as for big institutional investors. That’s a utopia that’s never going to exist. These two  groups of investors have different needs. Many regulators – in Europe for example and Luxembourg in particular with their efforts to push through the UCITS 4 protocol – understand that you need different protocols for retail investors.

Kent: But Vincent, every investor has the same goal: making money. It’s only the detailed requirements that are different.

Gerry: There’s certainly a larger burden on the big firms to uphold ethical, legal and fiduciary standards.

Kent: Yes. Retail investors don’t generally have the same constraints on their activities. Institutional investors need a more developed investment process and must ensure fair treatment across all clients regardless of size and fees. Institutional investors will undoubtedly be looking at different investor objectives – for one, they need to be able to implement their strategies in much greater volumes, and in scale, for example.

Edward: How about the role of regulators in curtailing short-selling in many markets? Knee jerk or long-term strategy?

Kent: I’d like to see the ability to short-sell fully resumed as soon as practically possible. We’re now in a situation where some markets have suspended it, and some are allowing it again. This is not ideal. I certainly see the temporary prohibition as a knee-jerk reaction and understandable given the groundswell of public opinion and corporate pressure as the financial crisis took hold – not all of this opinion was entirely rational. In fact, short-selling restrictions can reduce volumes for trading in the markets overall. For one, we have a 130-30 fund. So in this fund, if we’re limited in the number of attractive long-short pair trades we can put on then we’ll just end up trading less. So it’s business that never happens and the unknown would-be client on the other side of our trade – whether they’re institutional or retail – through the exchange, never gets to take advantage of the liquidity. What we need is a greater understanding of how shorting operates. There is a lot of misconception around this issue.

Gerry: I see the value and merit in allowing short selling in varied markets. In markets that don’t allow it, the regulators need to develop this functionality. It encourages more liquidity and volume. But I do understand that in the current environment the regulators have little choice. We won’t know the full impact until later on.

Vincent: The problem is that there’s no consistency among the regulators. Some only forbid short selling on financials. It’s a disruption to competitiveness between various sectors.

Kent: Yes. And not being able to short, will reduce derivatives trading. The fact is, a lot of the shorting that goes on isn’t just one-way, but a strategy with a ‘long’ component to it as well. And funds that relied on the little performance boost from securities lending fees have also seen their returns diminished. The equity finance desks at the brokers have seen a real drop-off in trade volumes because of this.

Vincent: Now the regulators are trying to encourage investors to buy again in a bear market – and there’s a lot of inconsistency between the messages they’re sending now and what they were telling us six months ago.

Has the industry found its latest villain in the form of dark pools? Not so, argued a group of traditional and alternative trading venue operators over dinner in Singapore last week. Dark pools are nothing new; they’re just finding their feet in Asia’s rugged exchange landscape. FIXGlobal’s Becky Merrett took a look at developments in the industry.

Caught in the middle of a seasonal Singapore early evening downpour, a group of regional specialists make the dash from their taxis to the warmth of an Italian restaurant. The roll-call reads like the Who’s Who of trade execution – Singapore Exchange (or SGX as it is most commonly known), BlocSec, Liquidnet, Chi-X, ITG, Bank of America Merrill Lynch and Credit Suisse. Have dark pools taken over from hedge funds as the baddie-du-jour in Asia? Should dark pools and exchanges compete, cooperate or co-exist?

Before the first cork was pulled opinions were flying, fuelled by the discussion’s volunteer ‘devil’s advocate’ in the form of Credit Suisse’s James Rae, (also Co-Chair of the FPL Singapore Working Group). “What is the purpose of a dark pool versus a traditional exchange? Why do we need alternative venues in Asia? And how do they interchange?” he asked.

“Dark pools have been around for a number of years,” argued Bank of America Merrill Lynch’s Mark Wheatley, fresh off a plane from Japan. “They’re not new in Asia. It’s mostly an extension of the internal broker systems. The alternative trading systems (ATS) we see now in Asia is the industry responding to the demands of their clients by creating a more formalised system.”

Discussing whether ATS should or not should not exist was pointless it seemed, as I toyed with my antipasti. “These are market and client-driven initiatives. All markets evolve, and financial markets evolve faster than most. To try and back track is both unwanted and unwarranted. Judging from the response from the markets in the US and Europe, ATS are here to stay,” Chi-X’s Rob Rooks stated emphatically.

Competitors or complementary?
Before the starters were finished, we’d killed the notion that ATS were going to slip quietly away into the night. Instead the conversation turned to the respective roles of traditional exchanges versus off-exchange platforms.

Liquidnet’s Greg Henry weighed in. “An exchange is about price discovery, it’s about listing and taking companies to market. Our focus is on efficiency, latency, liquidity and best execution.”

Unsurprisingly, it was a common view among the alternative venues around the table. Trading activity on the NYSE, they argued, now accounted for less than 30 percent of revenue. The role of traditional exchanges was increasingly focused on listing and sourcing capital. “The stringent regulations on listing, the information required, it provides a comfort blanket for investors,” Henry argued.

“At the end of the day, we all have to create the structure that works for our clients,” Henry concluded.

The right structure for your client? It was a theme that emerged again and again over the evening. The overriding – although not unanimous – feeling was that dark pools catered for one kind of investor, while exchanges provided security and solace for others.

“We don’t want to list organisations. The compliance involved in the process doesn’t fit with our business model. We’re more interested in a symbiotic relationship between ATS and exchanges. We attract different investors with different strategies. The investors trading through our venue are more likely than not to only hold a position for 10 minutes or less,” explained Rooks.

It was time for our lone exchange operator to pitch in. “We’re comfortable with the competition. Although, if we see a proliferation of venues, such as we’ve seen in the US, this is not going to help the region,” said SGX’s Bob Caisley. “We feel that the best way to move forward is to understand what dark pools offer and to let our clients access this technology,” he added.

It was an understandable position, given the recent announcement of a joint venture between SGX and multilateral-trading facility, Chi-X. The deal, which was inked in August, is aiming to launch its Chi-East non-displayed liquidity pool by June 2010. Clearly the move has raised the stakes as it is the first time in Asia that a dark pool has the backing of a regional exchange.

Andres Araya Falcone of the Santiago Stock Exchange explains how FIX is increasing the range of services available to traders in Chile and throughout Latin America.

How is FIX facilitating DMA into the Santiago Stock Exchange?

The first concept of DMA in Chile began with what we call “direct traders” (buy-side traders) facilitating these specially authorized institutional clients, to send direct orders to the market via a “broker sponsor”. Thus, pension and mutual funds, insurance companies and other institutions, using trading terminals provided by the Stock Exchange, can trade directly in our market. The next natural step was the incorporation of electronic networks to attract order flow from the U.S., Europe and neighboring countries in Latin America, especially Brazil.

In 2006, we built the first FIX interface using version 4.0 to connect to the Marcopolo Network, to attract the order flow of our local equities market. After that, the Santiago Stock Exchange launched its initiative to modernize the equities electronic trading system and developed Telepregón HT, jointly with IBM, which went live in June 2010. This system is ready for algorithmic trading flow since it supports a throughput of over 3,000+ orders per second with sub-millisecond latency. In designing the system, we decided to use FIX 4.4 to enable easier connection via DMA with other exchanges, sell- and buy-side firms and market information vendors. This has greatly facilitated the connection to different networks, such as Bloomberg, Fidessa and SunGard, among others. For all these initiatives, FIX has been crucial in facilitating the integration with these listed networks. During 2011 we will announce new network agreements.

Currently, referring to the equity market, 11% of order flow comes from DMA which represents an  average of a 27% increase over the last 6 months, today 19% on average comes from Internet retail order flow, and the rest comes from traditional OMS and Trade Work Stations.

As foreign investment into Chile and the Chilean market continues, how will the Santiago Stock Exchange upgrade its platforms to meet increased investor and trader demands?

In 2010, the Selective Share Price Index (IPSA), the country’s main stock market indicator, gained 37.6% in Chilean pesos (equivalent to some 46% in dollars). Share trading on the Santiago Stock Exchange rose to US$60 billion in 2010, up 30.5% from 2009, setting a new annual record. Trading was particularly strong in the second half of the year, which accounted for almost 60% of the annual total, reflecting strong demand from both local and international investors.

At the same time, by the end of 2010, the Santiago Stock  Exchange had signed a linkage agreement with Brazil’s stock exchange, BM&FBOVESPA, heralding the latest in a series of cooperativeprojects being run between Latin American bourses. The agreement, signed on December 13th, will enable connectivity between both exchanges for order routing and market data dissemination. It also includes separate initiatives for further development of the Santiago Stock Exchange’s derivatives market, the establishment of joint initiatives related to settlement, clearing and central counterparty services, as well as access to the BM&FBOVESPA /CME trading platform from Chile.

Market participants in both countries will be able to route orders for stocks, stock options and related derivatives listed on the other’s exchange. Both exchanges will also be able to receive and distribute each other’s market data. Clearing and settlement of orders will be done according to local market rules of listed instruments. These kinds of initiatives imply that the Santiago Stock Exchange’s IT platform has to be prepared to manage more than 6 million orders per day.

What plans does the Santiago Stock Exchange have to accommodate High Frequency Trading and algorithmic order flow?

We are working as an integrator of a state of the art product for algorithmic trading. In conjunction with Streambase, FIXFlyer and IBM WFO, we are creating a product we will call “Broker in a Box”. The idea is to provide a framework for capital markets, including a set of algorithmic order execution strategies designed to achieve best execution, access liquidity, minimize slippage and maximize profits for trading operations. These algorithmic trading strategies (like VWAP, TWAP, Arrival Price / Implementation Shortfall, etc.), are provided as fully customizable EventFlow modules which can be used in conjunction with the frameworks. Trading firms will be able to modify each algorithm to reflect their own “secret sauce” and to differentiate their trading strategies in the market. The Santiago Stock Exchange will provide an “all in one” solution: integrated markets, market data (from Integrated Latin America Market (MILA), NYSE and NASDAQ), co-location, monitoring, local support, etc.

When I accepted a job in the Indian financial markets six months ago, my thinking was simple. First, I believed (and still believe) that India has an once-in-a-lifetime opportunity to pull away from the pack and establish itself as the largest and most dynamic financial market in Asia. Second, I thought I could contribute to the efforts of my new employer to compete more effectively and grow its business.

I expected to draw on my experience working at and for exchanges in the US and Asia for more than two decades. I also expected to draw upon my training in finance and economics. What I did not expect, was that I would find myself regularly reaching back to wisdom and inspiration from books I had read in college – particularly the inspiration and observations of US revolutionaries and civil rights heroes. Let me explain.

The Opportunity

From most perspectives, the opportunity in Indian financial markets today is spectacular. There is the confluence of factors that – unless some or all of them are seriously derailed – will allow Mumbai to emerge as a major global financial center.

First, India has the virtue of a large domestic market. In Asia, this gives China and India, a big advantage over Singapore and Hong Kong, today’s front-runners in the race to become Asian Financial Centers.

Second, the Indian economy is growing rapidly and this growth, because of India’s early stage of development, is likely to continue in the 6-8% range, and quite possibly the 8-10% range, for the next decade. Even if the size of India’s financial sector relative to GDP stays constant, it will double in absolute terms over the next decade, assuming 7% growth. A much more likely scenario, however, is that we will see dramatic financial deepening in India over this time period.

Third, India already has much of the basic financial market infrastructure in place. Admittedly, there are a few gaps – such as a vibrant “Stock Borrowing and Lending” market. And there is always room for improvement – especially when it comes to coming more into line with global best practices and standards. But, most would agree that India’s financial market “plumbing” is working well. In terms of trade processing in the equities market, for example, Indian exchanges match, clear and settle a phenomenal number of transactions each day – putting both BSE and NSE easily in the top ten globally.

Fourth, India has a reasonably effective and transparent regulatory environment – focused on investor protection and market development. Regulators are appropriately cautious in some areas. The focus has been on risk management and the gradual introduction of new products. This has generated some frustration at times for market participants who want regulatory changes to come more quickly. But, by and large regulations are evolving well, taking into account the views of the market, international practices and Indian ground realities.

Fifth, Indian financial markets are quite open to foreign participation. While there are some notable impediments — for example, restrictions on foreign retail investors – it remains true that offshore participation by foreign institutional investors (FIIs) is substantial. More significantly, if a foreign securities firm wishes to come “onshore” in India, it is to a very large extent free to compete with domestic firms. The benefits from this foreign participation, in my view, have been substantial, bringing global practices, global talent (much of it Indians working at foreign firms), and global competition into the market.

Sixth — and most relevant to my comments here – India has a competitive exchange environment that will be a critical factor in lowering trading costs, increasing liquidity and driving the development of the markets through innovation.