Barriers To Market Structure Evolution In Japan


By Michael Kim
Order flow internalization and off-exchange crossing has been a common market practice in Japan for years. In 1998, Japanese regulators approved the introduction of the proprietary trading system (PTS), a privately operated night time marketplace. Then around 2005, we started to see PTSs operating during day time hours in direct competition with the traditional exchanges. In fact, PTSs are lit venues that operate similarly to the exchange. They have well defined market structure and market participants with price formation taking place in the visible order book. Most PTSs define their tick increments at about 1/10th that of the exchange. One major hurdle for PTSs is that they can not be more than 10% of the market share. Once they reach that point and hope to grow further, they will need to apply to become an exchange.

Dark pools started to appear in Japan in earnest around 2005. In the last couple of years they have become a standard product offering for major international brokerage houses as well as some of the large domestic institutions. Global firms have been able to leverage their expertise and investments in dark pools and smart-order routers in the US and Europe, and have implemented Japanese dark pools with varying degrees of success.

Despite over 10 years of PTS history and a regulatory environment ripe for internalization, alternative trading venues have only managed to capture 1-2% market share from the Tokyo Stock Exchange. What are the reasons for this lack of success in alternative execution venues? What are the catalysts that may move more volume off the exchange?

1. Smart-order routing Infrastructure

In order to effectively access PTSs and dark pools, participants need a smart-order routing system. Smartorder routers can constantly scan available execution venues for best available price, and then execute optimally based on various internal and market rules. The smartorder routing technology needs to operate effectively with both lit pools and dark pools. It needs logic that can handle various market structure related constraints, antigaming rules and the different cost structure of each trading venue.

Most of the global broker-dealers already operate smart-order routers for their US and European businesses, so for them, implementing smartorder routing is a relatively straight forward exercise of localization. However, for those firms without the same infrastructure in place, scratch building a competitive smart-order router is a fairly difficult task. As a result, most of the international broker dealers operate smart-order routers in Japan, while there are only a handful of domestic firms with smart-order routing technology. Not surprisingly, there is almost no retail or on-line brokers operating a competitive smart-order routing technology.

2. Best Execution policies

In Japan every execution agreement mentions a best execution policy. Unlike in other countries, there is no single overarching regulatory framework, such as RegNMS in the US or MIFID in Europe, which outlines the details of best execution. As a result, more often than not, the brokers’ execution agreements are not uniform from one broker to another. Many of these agreements use primary exchange as the default execution venue. There have been efforts across many of the dark pool operating firms to “re-paper” best execution agreements, but ultimately there are no regulatory drivers expanding best execution practices to span multiple liquidity venues.

3. Fund mandates

Many of the domestic pension and traditional funds have mandates that require them to execute at the primary exchanges like TSE or OSE. For those funds, executing in PTSs would be a breach of their mandate. These funds would need to amend their mandates before they could allow their orders to be executed in PTSs. However, given the current level of PTS market share, there is no strong incentive for these funds to add PTS amendments to their mandates.

4. Regulatory Environments

The practice of short selling in PTS has never been clearly outlined in the regulations until 2009. Until then, each PTS operator depended on its interpretations and some have decided to allow such a practice. In March 2010 the regulators have further clarified the short sell rules are to be followed in that PTSs as well as in the exchange. This has effectively halted, and even reversed, the growth in certain PTSs. Significant volume has moved off of the PTSs in the subsequent days and months. On top of that, the TSE’s introduction of Arrow Head system accelerated migration of liquidity from PTSs. Moreover, the recent regulation requiring dark pools to report trades through TOSTNET potentially puts additional restrictions on taking liquidity off exchange. These types of ad hoc regulatory changes have had negative impact on the overall market structure and at least in the short term, a negative impact on the growth of PTSs.

5. Market Makers

In the US and European MTFs, the role of market makers have proven to be critical in ensuring liquidity in the execution venues. At almost all venues in Japan, there are no incentives provided for market makers to provide liquidity. By way of comparison, in the US, market makers normally receive rebates for the liquidity they provide to a venue. Most market makers in Japan, however, have to trade on their alpha or make the market wide enough to capture better spread in order to compensate for risk and cost.

6. PTS fragmentation

There are 6 PTSs in operation in Japan. Many of the PTSs are not open to institutional participation and are retail only. Once we exclude them, we are down to Instinet,, SBI JapanNext and soon to appear Chi-X Japan. There is no clear market leader at this point. The aggregated liquidity across all the venues still falls short of 1 or 2% of the TSE. Having looked at some of the barriers to PTS and dark pools, let’s look at some of the catalysts. Obviously, the single most effective catalyst is the sweeping regulatory change similar to that of US and Europe. For this discussion, I will assume regulations will not change.

JSCC Clearing

From July 2010, the PTS executed trades can be cleared through Japan Securities Clearing Corporation (JSCC). The benefits are 1) guaranteed settlement on PTS trades (no counterparty risk), and 2) straight-through-processing for trade settlement. This is a major development for the benefit of the PTSs as some firms of the counterparty risk limits and operational ticketing inefficiencies will disappear.

Trading cost reduction

In order to attract flow, the PTSs will need to reduce their rates dramatically. The cost of trading at TSE is roughly 0.2 bps. Currently, most PTSs price themselves relative to the TSE cost. I believe the cost of trading at PTS will need to come down to below 0.2 bps and zero for orders that are providing liquidity.

Incentives for Market Makers

There needs to be an incentive structure for firms that are market making. There are regulatory restrictions for rebates in Japan; however, I believe PTSs can be imaginative in terms of incentives for those who are systematically providing liquidity.

Liquidity Aggregation

The concept of liquidity aggregator is not new. But, given the current smart-order technology a PTS can act as a liquidity aggregator thus consolidating order books at other PTSs and performing onward routing functions. This is simply connecting and accessing to multiple PTSs for firms that do not have that technology.

In summary, given Japan’s regulatory environment and relatively low cost of trading, we should be experiencing more active off exchange liquidity. I believe there are opportunities for firms to think out of the box and willing to invest to build the right business model.