Are the markets crumbling or multiplying? With Josephine Kim, Director, Asia Pacific Electronic Sales – Global Execution Services, Bank of America Merrill Lynch.
How is market fragmentation changing and developing across Asia? Japan had the first mover advantage in Asia as the first to welcome fragmentation, but it has not really blossomed, compared to Australia where we have seen a lot more volume growth on the new venues and execution channels. Hong Kong is quite interesting because most people really want to get fragmentation into that market, but there are limitations such as regulation and the proliferation of fees. Brokers do offer internal crossing engines, so a lot of clients are benefiting from those.
India is also interesting because it had two exchanges for years and recently got a third. We do not see that much activity, but at least it is creating a lot of buzz in terms of how fragmented the market is. It will be interesting to watch.
How are other Asian markets developing? It typically depends on how the exchanges are preparing themselves. If you look at Japan for example, they opened up to various alternative venues and were pretty open-minded in terms of sharing their liquidity with other independent venues. But then the exchanges decided to merge to be more competitive as they realised that liquidity is something they want to keep. Australia is forcing the exchanges to share liquidity with best execution rules.
Korea and Singapore are the two markets most likely to come next, although there are other venues like Indonesia and Malaysia where a few broker-dealers offer limited crossing engines. Korea is a very active market, especially for futures and options, so a lot of people are interested in trading, but then again, they do have the investor ID restrictions and they are trying to implement a financial transaction tax so that is going to kind of hinder the attractiveness of trading.
Singapore is slightly different because the market depth is not as attractive as Korea. Singapore used to be a hub for US and European-based high-frequency trading firms, but it just seems to be losing its ground as a hub. Having the longest trading hours in Asia may open more doors for investors from different time zones but without the market depth, it will still be a challenge for Singapore to attract investors and independent liquidity providers. Minimum crossing rules also draws interesting opinions from people as some believe this will enhance and control the market participants and reduce toxicity of the pool albeit the overall reduction on actual crossing opportunity.
How does that variation across markets affect the trading environment? The buy-side used to choose an execution broker based on the level and quality of research and their trading ideas. Today, the buy-side tends to go with the broker that has the liquidity. So, the buy-side traders are often watching the market and watching their stock, so they can see who is on the order book panel, and they tend to put their entire orders on the brokers with the most liquidity. A lot of this change is tied to unbundling, but it is also to do with the liquidity and facilitation as they often find it difficult to trade when there is less liquidity available in the market.
Are changes such as CSAs enabling that unbundling and enabling that separation between research and execution? Are these tools coming into existence to meet that desired change or are these tools enabling that change? These tools are definitely opening the doors for the traders to choose from. It is simply an option that, because of this policy, the buy-side head traders have the independency to choose the best execution brokers and feel less obligated to trade with the best research providers.
On the sell-side everyone is becoming more liquidity sensitive. The buy-side trading instructions are becoming more complicated; the buy-side still want to have the baseline of a simple VWAP or POV as their first and second algos, but when the liquidity comes in, they do not want to miss out that opportunity, so a liquidity seeking type of smart algo, with a combination of base benchmark, seems to be being used more commonly.
How are the liquidity profiles of those venues changing? Let’s use Australia, as an example. It is mandatory there to provide best execution to the client. That means that it is the broker’s responsibility to find the best execution price, across the dark or lit; it is not a choice anymore, it is an obligation. So, because of that, we started looking at the quality of liquidity pools. The number of liquidity pools has gone up a bit such as Chi-X Australia launching in 2011; and there are numerous exchange provided dark and lit pools – see Table A-1. The quality of each venue has risen as various enhancements or improvements have come online. We now care more about where orders are getting crossed within the dark liquidity, whether it is getting crossed at mid or better, or whether it is having any price reversion after the fill has been made. So, I think that quality is top of mind now.
If you look at the market share, we are still talking about a small portion of the pie – see Table A-2. One has to also have context of this and understand how dark liquidity is performing in the US and Europe – see Tables B1 and B2.
As Japan readies itself for a single primary exchange, Fidessa’s Hiroshi Matsubara, also Co-Chair FPL Japan Regional Committee, and Steve Grob look at the country’s motivations for change and ambitions for the future.
The TSE/OSE merger has been big news in Asia since it was announced last year. Creating the world’s third largest exchange by market capitalisation, the merger brings derivatives and cash under one roof and puts equities on a single trading platform. Not only will this create a much bigger and more liquid venue, but it will also give the Japanese exchange a gravitas that neither the TSE nor the OSE has enjoyed on its own.
The merger attempts to position Japan as a super resource centre for pan-Asian trading. With a vibrant and growing PTS market, Japan’s market structure is certainly one of the more advanced in Asia, although challenges still remain. One challenge that was removed earlier in the year was the 5% TOB rule.
Under Japan’s Financial Instruments and Exchange Law, investors who purchase a 5% or greater stake in any firm off the primary exchange had to launch a full tender offer bid (TOB). Because trading on PTSs was originally designated as “off exchange” they inadvertently got tripped up by this rule. This discouraged many firms from buying stock on PTSs, due to the complexities involved in knowing when exactly the 5% threshold was reached. Other firms would sell on PTSs but not buy, for the same reasons. With the relaxation of this rule being implemented in October, the barrier to using PTSs for both sides of transactions has been lowered significantly. By next summer PTS trading could account consistently for around 10% of the market in some blue chip stocks. Indeed, PTSs are already trading steadily larger volumes in the market’s biggest names. Considering PTS trading accounted for practically nothing just two years ago, the fact that SBI Japannext, for example, is regularly trading upwards of 10% in stocks like Mizuho and Mazda is a healthy sign of further growth to come.
The next challenge for PTSs is the 10% rule, stating that once a PTS reaches 10% of the national market, it must apply for a formal exchange license. It comes into effect when daily average trading values of all trading stocks on a particular venue measure 10% of all exchange and PTS trading in Japan, over a six-month period. While it’s unlikely that one PTS will breach this threshold within the next year or two, when they do, the FSA will have to re-address this rule. This is because under Japanese exchange regulation, an exchange can only trade instruments that are listed on it (unlike other jurisdictions, where multiple venues can support secondary trading on the same stocks). So, if a PTS were to become an exchange, it would suddenly have nothing to trade.
At present, smaller tick size is an important differentiation for the PTSs as it allows them to offer prices inside the spread of the main market. However, if the new Japan Exchange Group adopts decimals for tick sizes, there will be work to do in order for them to demonstrate the additional value they offer. Venues should be thinking seriously about this now. Speed has been a battleground in other regions, and SBI Japannext enhanced its platform in September, making its processing speed ten times faster than the TSE’s arrowhead.
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.
Compatibility 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.
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.
RCM’s Head of Asia Pacific Trading, Kent Rossiter, unmasks the Asian trading scene, sharing insights into how RCM navigates the unlit landscape, identifying the effects of dark liquidity and highlighting ways brokers can facilitate better buy-side decision making.
FIXGlobal: What are the main benefits of dark liquidity in Asia?
Kent Rossiter, RCM: One of the major challenges in Asia has always been accessing liquidity without other parties in the market taking advantage of your position and your need to complete the order. In cases where liquidity is scarce, knowledge that a relatively large order is being worked can expose investors to various risks. In such situations, it is advantageous for knowledge of the deal whilst it is being worked to be discreet until the order is filled. In dark pools run by brokers we can get priority on our orders through queue-jumping.
Dark pools support such an approach as they allow large block orders to be worked without showing size. In this way, trading in dark pools allows a trader to access a broker’s own internal order flow, without being gamed by the market that would otherwise risk non-fulfillment or less efficient pricing. As a result, size trading becomes the norm in dark pools and a trader gets to see blocks that may never have been available otherwise. With no information leakage we are not disadvantaged by the fading you see on lit venue quotes. From a personal perspective, the challenges that arise from dealing across a number of venues and the resulting increased use of technology make the role more exciting and satisfying.
FG: How do you limit information leakage in dark pools?
KR: With the exception of broker internalization engines, the trade sizes found in dark pools are often multiple of what they are on the exchange. So having fewer, but larger prints reduces information leakage, and in many cases we can get done on our size right away. Minimizing the number of times a print hits the tape reduces the chance of this footprint being picked up and working against the balance of your order. That said, broker internalization engines do their part well, keeping any spread savings among the two broker’s clients instead of giving it up to the general market.
FG: If you decide to seek dark liquidity, how do you decide between broker internalizers and block crossing networks?
KR: The type of dark venues being used for various trades (i.e. between block crossing networks and brokers) are different. As I mentioned, brokers for the most part are matching up little prints that otherwise would have been time-sliced in the general market, and when using these venues the goal is often to save a few basis points along the way while you work an order. You are not often micro-managing each fill, but through the process we are getting spread capture and price improvement. The type of stock you are often trading in these internalization engines are often larger, more liquid stocks; the type of orders often worked by algos.
Block crossing networks on the other hand, while still matching up electronically, are probably more confidential, and take up the function of what brokers still do upstairs - putting blocks together - so size is the real focus here. Both types of dark pools use the primary market for price sourcing since the vast majority of trades get printed at or within the best bid and offer. As the primary markets become too thin, it can cause price formation problems.
While it is not specific to the consideration of dark pools as an extra execution venue, we have to consider potential increased book out costs if we do use dark pools (except via aggregators, since we would only be using one counterparty), just as we have had to for years when deciding whether to execute a block with a single broker versus multiple counterparties. As dark pools proliferate there is an increased chance that we may not have part of our order in that pool at just the right time to take advantage of flow that may be parked there. Dark pool aggregators are aiming to provide the buy-side solutions to this.
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.
Gen Utsumi, a longtime member of the Japanese electronic trading community, talks about how the events of 11 March 2011 may indicate the future direction of electronic trading in Japan.
When I was a teenager, I loved computers. Back then it was really exciting to wait for the release of a new personal computer every year. My first PC was the NEC PC-6001MK2 which was the first Japanese PC with synthetic voice speaking ability – it had 64KB of memory and a cassette tape player. For more than 20 years, the world of computers was a very exciting place. There were always new technologies evolving in the industry and so many talented people shared that excitement.
Now, computers are even more advanced, but people are not as excited as before. The computer industry seems to have matured. Could we say the same for electronic trading?
Nine years ago, when I started to sell FIX engines in Tokyo, ‘STP’, ‘Electronic Trading’ and ‘FIX’ were the buzzwords. Having a FIX interface was an exciting thing and sometimes when an exchange introduced their FIX interface based on real needs, they also used it as a marketing tool. Electronic trading was a frontier of the financial industry and I met a lot of people with ‘frontier spirit’. Once an electronic trading link was established via FIX or other means, new services and strategies started to emerge, such as Proprietary Trading Systems, algorithms, Smart Order Routers (SORs) and dark pools.
These, along with technological advancement, brought a wave of colocation and low-latency products and the race is still going on. Now it seems that having ‘microsecond’ latencies is not surprising anymore. Would latency be exciting again if it were in nanoseconds? My guess is, probably not. While there are still ways to make money in electronic trading, the industry seems to have matured.
Allow me to make another analogy: Japan. Japan has also matured socially and economically. Infrastructure is well established yet Japan’s boom period has long since passed. General sentiment is gloomy due to government resignations, a low birth rate, low economic growth, huge government debt, and reduced trade profits because of global competition.
Then the earthquake hit on 11 March 2011. Surprisingly, people were relatively calm in Tokyo, considering the magnitude of the event. There were many rumors circulating regarding the Fukushima Nuclear Power Plant, but people continued doing business as normally as possible. I will not repeat the grave details here, but I would like to point out that many people are starting to say that this event was a sign of change.
Now three months later, there are signs of recovery here and there. With disaster of this scale, it is obvious that help from the government is not sufficient to respond to the needs of all those people affected. Refugees are being supported by volunteers, families, neighbors and friends. There are over 2,000 refugee camps and some camps are better equipped than others.
One particular refugee camp I know is getting considerable support including food, trucks, bicycles and other living needs as well as comics for the kids – all of which are brought in by supporters. People visit the camp every weekend from Tokyo and the people in the camp welcome those supporters whole-heartedly. There was a strong mutual ‘trust’ established between the people in the camp and their supporters. The camp next to it is not doing so well; they accept donations and goods at the gate, but they do not welcome volunteers and supporters to visit their camp. There was no ‘trust’ here.