Japanese Markets Look Out of (and into) the Dark

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.