With Firas Hadj Taieb, Head of Product Solutions, Execution Services, Nomura and Gael Vasseur, Head of Products Strategy, Execution Services, Nomura
The Small Tick Program introduced by the Tokyo Stock Exchange (TSE) between January 2014 and September 2015 has deeply modified Japan’s market microstructure and the way domestic and international investors interact. Launched in three phases, the program progressively reduced the tick size of TSE stocks by a significant factor of 2-10 times.
Before the TSE changes, alternative venues had significantly smaller tick sizes than the TSE, which allowed market makers to quote within the TSE spread and attract liquidity by naturally providing investors with price improvement. At this time, PTS volumes were above 9% of TSE while dark pools claimed around 6%. The overall market share of alternative venues was growing. On the TSE, because the tick sizes were large there were significant price jumps between each quote, and relatively large spreads. These induced traders to wait, so the queue on the exchange was very important and many algos were tuned for patience.
After the tick size change, TSE spreads shrank by about 65%, helping to reduce some of the trading costs. The liquidity that was accumulated (i.e. the orders queued) at the few price levels available before the change began to spread across several more granular levels.
Traders can now choose where they want to execute, among multiple prices. In addition, sending the whole order at one price level is often no longer an option as the market can detect the order, increasing the chances of adverse price movements.
With every microstructure change, the trading environment is impacted and investors need time to adjust.
We believe that the participants most affected by the changes were market makers, who faced smaller spreads and higher intraday tick level volatility, creating more challenging market conditions to provide liquidity on the TSE. At the same time, flow to PTS venues decreased as the price improvement incentive for investors also diminished. Meanwhile, investors faced liquidity issues as the visible liquidity shrank. However, they welcomed these changes as trading costs decreased.
While HFT firms were recalibrating their models and adjusting their strategies, Nomura enhanced client algos and included new features to take advantage of the new microstructure (smaller spreads, thinner order book, higher tick volatility). Improvements in the logic had to ensure that the algos perform as well as before for the stocks with unchanged tick sizes, while allowing a very different behaviour for the stocks affected. Various features, such as advanced order placement preventing information leakage during TSE order placing, revised signals and logics to take liquidity, new logic to interact with dark pools, and a focus on impact reduction instead of spread cost savings were required after the TSE tick changes. In particular, examinations of multiple price levels and introductions of artificial intelligence signals were implemented to help traders capture small price movements and forecast them in the coming minutes.
Now that the microstructure is stable, investors are evolving, liquidity is coming back on to PTS and dark venues, and volumes are increasing.
Traditionally, domestic asset managers used VWAP as the main trading benchmark. It is passive in nature and has a relatively low impact by spreading the order during the whole day. On the other hand, international investors often use arrival price as their benchmark for better control of the execution price and avoidance of market risk. However, this accelerates the execution pace and controlling market impact becomes more important.
Whatever the benchmark used, Institutional Investors including the Japanese buy-side constantly express a need for liquidity, especially as the markets get faster, while tick sizes, spreads and the order book get thinner. Finding additional sources of liquidity and blocks is their first priority. However, the price difference based on varying benchmarks complicates this search for natural liquidity and, despite a common need for liquidity, often posts a challenge for brokers to help domestic and international investors to interact with each other.
In recent months, a convergence has begun and certain domestic Japanese portfolio managers are now switching to the arrival price benchmark and Nomura is helping them during this transition. Domestic and international investors’ trading patterns are aligning, especially in the way traders use dark pools. Investors appreciate dark pools as a means to reduce the volume executed on the main board and limit market impact. Moreover, when spreads are small, the cost saving is less relevant than the overall pressure they put on the price on the main exchange.
Domestic asset managers are now actively moving to a more aggressive style. If they see an opportunity to cross a whole order in a dark pool, they will do so while trying to execute on the exchange. That opens the door to more and larger blocks available in the dark pool which is what offshore investors have been looking for.
Future of the markets
After a long period of recurring changes, Japanese microstructure is expected to stay stable. Circuit breakers and short selling regulations that could affect the microstructure have also been recently modified. Overall, circuit breakers have been in place for some time in the Japanese market. Similar to other regions, the Japanese regulators are currently reviewing the status of electronic trading in line with the introduction of Europe’s MiFID II regulations. Electronic trading’s omnipresence justifies regular, accurate assessments of how electronic flow is managed, who are the main players and what risk controls are in place to ensure healthy markets.
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