By Murat Atamer
Credit Suisse’s Murat Atamer explains the rise of high frequency trading and alternative venues in Asia Pacific and what it means for algo traders.
As seen in the US ‘Flash Crash’ of May 6, changes to the equity trading landscape bring with them new responsibilities for brokers, and it is up to the broker community to meet them. By using algorithms designed to stop executing trades if prices start to behave abnormally, brokers can look out for temporary price spikes, which do not serve investors’ interests or which could be caused by ‘fat finger’ errors, and so on. All DMA orders and algorithm slices orders should be vetted against the order book to gauge any potential market impact before they ever reach the market.
Investors’ relentless search for alpha in increasingly crowded markets means that HFT and liquidity fragmentation have taken a permanent place in the daily trading activities of many Asian investors. Of course, there are critics, but it is becoming increasingly clear that they will change the way investors trade Asian equities over the next decade.
India has recently offered a great example of this. Earlier this month, the first completed trades in India, using Smart Order Routing (SOR) in that highly fragmented market have so far achieved an average price enhancement of 6bp, more than the bid/offer spread for the names traded on the day. That is good news for investors.
Consider HFT, first. Credit Suisse estimates that some 10% of market trading activity in Asia Pacific is now driven by HFT, although this is closer to 40% in Tokyo. This remains a small proportion by comparison to Europe, where it is estimated that HFT accounts for 35% of total trading activity, or the US, where estimate the figure to be 60% (Exhibit 1).
The rise of HFT in Asia outside Japan is due to a number of factors converging and feeding off each other to create ideal conditions for the exponential growth of this trading style.
Firstly, Asian trading volumes have increased markedly, led by global investor demand for exposure to the regional growth story and the strong performance of regional markets. Since January 2010 alone, the number of shares traded in Asia ex-Japan each day has increased by around 60%. Secondly, Asian exchanges have been competing ferociously with each other to increase trade volumes and are now engaged in a technology arms race as they strive to capture more business (Exhibit 2).
Co-location facilities – that is, the close physical proximity of brokers’ servers to exchange servers to help increase trading speeds – are now common across Asia Pacific, helping drive the momentum for HFT in the region. According to the Tokyo Stock Exchange, around 30% of trading activity is conducted through co-location services. Australia sees 15% of its trading activity from HFT, followed by less than 5% for Hong Kong, Singapore and others. Because it helps drive exchange volumes, HFT has faced little of the regulatory friction, unlike alternative execution venues in the region.
That does not mean HFT is flourishing in every market, though. As FIXGlobal readers will know, high frequency traders try to identify market anomalies and patterns and use technology to take advantage of these. For equities, they generally favor liquid names in markets where execution costs are low. Japan and Australia are well-positioned in this respect, but relatively high trading costs in Hong Kong, Taiwan and Korea are major impediments to HFT. As a result, HFT may make more progress in Singapore than in these markets, and while cash liquidity is relative low on the SGX, its regulatory regime is supportive to HFT; moreover, other factors such as market cost, stock borrow cost and availability, futures liquidity and spreads are all reasonably conducive (Exhibit 3).
Japan is the most advanced Asia Pacific market in terms of both HFT and liquidity fragmentation, offering many insights into how these trends will develop elsewhere in the region. There is, for instance, much debate among electronic traders about whether electronic trading improves market structure by adding to order book depth and narrowing bid/offer spreads. The results so far are inconclusive.
Interestingly, the introduction of the TSE’s new high-speed arrowhead trading system in January 2010, which should have been a boon to HFT, has not coincided with any great change in volumes (Exhibit 4). Bid-offer spreads, on the other hand, have declined by 30% in basis point terms, following the launch of arrowhead, but in terms of ticks, there has been no difference in pattern between small cap stocks and the large cap stocks typically favored by HFTs (Exhibit 5).
Despite little improvement in ‘real’ trading activity and execution costs, the one-month rolling average for intraday spread volatility (which can be a proxy for sudden order book movements) increased the most for large cap names generally favored by high frequency traders in Japan (Exhibit 6).
Why? It seems the benefits that HFT can bring to other market users in terms of spread reduction could not fully materialize because of trading restrictions. In this respect, the Financial Services Agency’s (FSA) recent proposal to drop the uptick rule and standardize lot sizes are, therefore, very positive for the Japanese market volumes.
As Asia’s exemplar, with respect to the impact of multiple trading venues, Japan also tells us an interesting story. As a proportion of total trading for Nikkei 225 stocks and Nintendo, Japan’s Proprietary Trading Systems (PTSs) have grown from around 0.2% in January 2009 to 2.4% today. Chi-X Japan launched in August and the market’s latest entrant is aggressively growing its share of volumes. While 1.4% remains a small share of volumes (Chi-X alone had a 25.7% share of FTSE100 trading in London on December 6), the entrance of global players has served as a wake-up call to both Japan’s exchanges and the local PTSs, reminding them of the need to cut costs and improve efficiency (Exhibit 7).
The dawning of Asian liquidity fragmentation in Japan should also remind buy-side traders of the importance of having immediate access to the best price available across multiple venues.
With Australia also licensing new market operators for the first time, the outlook for liquidity fragmentation in Asia is slowly looking more positive. The lack of a single regulatory framework to drive this process, as in Europe, means that it will take longer in Asia. But even the threat of fragmentation itself has resulted in considerable benefits for end-investors, in the form of smaller bid-offer sizes and lower execution costs. For example, in early 2008, kabu.com’s move to support trading during day time with its attractive tick size structure prompted the primary exchanges in Japan to reduce tick sizes by 10% as well. Later in early 2010, the introduction of arrowhead reduced tick sizes by another 30% as well as reducing latency. In the light of the competitive threat from other market operators, Australia’s ASX also introduced a new trading system with much lower latency, new order types to cater to different trading needs and lower executions costs.
As competition between execution venues gradually increases in Asia, investors will be able to leverage technology to achieve lower and lower execution costs. There is however, no free lunch, and brokers can no longer avoid their fiduciary responsibility of providing ‘safer’ algorithms.