Going Off-Market: Can Alternative Venues Give Solace in a Skittish Market?


By Yoichi Ishikawa
National exchanges worldwide have been pummeled by the recent economic turmoil and Japan’s Tokyo Stock Exchange (TSE) has been among the hard hit, both in terms of value and volume. The trend towards alternative trading venues, seen in the US and Europe over recent years, has spread to Asia, with Japan being among the first adopters. kabu.com’s Yoichi Ishikawa asks whether these new venues may prove a popular option in tumultuous times.
In the first two months of 2009, the stock market in Japan saw continuous low levels of trading and ongoing fears that liquidity would dry up permanently. Daily trading volumes on the TSE dipped below Y2 trillion. Adding to trading fears, the volume share traded on the exchange exceeded 90 percent of Japan’s entire domestic market. This concentration of trading on one exchange has, in fact, been the norm for many years in Japan, but concerns are growing a single exchange environment is curbing market efficiency, with transactions often not achieving best execution. Under these circumstances, several new and sophisticated proprietary trading systems (PTS’) have emerged for offmarket transactions in 2008. The goal, for these PTS’, has been to create an electronic trading method that allows the selection of the best price among multiple prices for a single issue.
Japan’s financial system has allowed for such off-market online transactions since 1998, and in 2001 two companies set up operations. However, investor interest was slow to materialise, as a lack of sophistication in early versions meant that prices could not be formed in the same manner as on the exchange. These system weaknesses kept the share of PTS transactions below two percent on offmarket trading between 2001 and 2006. A revision of the law in 2005 prompted a major shift allowing for price formation in the same manner as on the exchange. In response to this change and a perceived demand for extended hour trading, kabu.com was launched in 2006 offering night time trading.
By 2007, the share of PTS trading had reached about 4 percent. While growth was still slow, the stage had been set for the increasing popularity of PTS’. The following year, market share expanded to 5.5 percent, with a single-month record high of over 9 percent in November 2008.
Driving factors for growth
Soon after, two companies (including kabu.com) began daytime PTS trading using the same auction format as the exchange, enabling investors to do full-scale ‘offmarket’ trading in the same way as ‘on exchange’ trading. These companies also began transmitting market data to global information providers (such as Thomson Reuters), which allowed for real-time PTS market price information, including multiple quotations (depth).

The new PTS’ also allowed transactions at nominal prices, at smaller units than the exchange. Adding to the sophistication, transactions using advanced algorithms – mainly by foreign securities firms – opened up a new trading method that brought new liquidity to the PTS market. New players to the PTS market, (bringing the total number of operators to six, with the two new companies licensed focusing on individual investors), helped raise awareness of PTS’ among institutional and individual investors alike. Together the companies offered off-market trading to individual and/ or institutional investors. (See diagram A on next page.)
Trade by comparing multiple prices
Diagram B shows a typical kabu.com interface, tailored for individual investors. It allows users to see information on both kabu.com and the TSE. Market information tools, allow for share price comparison across multiple PTS’ and exchanges. With a number of traders offering identical prices on the Exchange, long queues to execute trades can occur. PTS’, on the other hand, has fewer traders, meaning shorter queues. They also allow for arbitrage trading at prices different from the Exchange, or even at the same time as the Exchange.

Equally, as PTS’ allow for smaller price units – one-tenth of those on the Exchange – it makes for easier algorithmic trading and breaking orders up into smaller trades. Together these advantages allow institutional investors to save on costs.
This sophisticated trading environment has allowed PTS’ to accommodate electronic trading by foreign securities firms, using advanced algorithms and other trading formats. This resulted, in our case, of an average trading volume per day of approx. Y1 billion between October 31 and December 31, 2008, representing an approx. 16 percent increase compared to the previous quarter, with a record high of Y4.7 billion set on October 7, 2008. Although, since October 2008, financial uncertainty resulted in a sluggish overall market, pushing down the number of orders, the number of contracts increased, making the contract rate jump from 0.6 percent to 1.0 percent (see figures following).
Sophistication of the offmarket e-marketplace
Looking back, it was the ability of PTS’ to trade at par with the exchange that drove technological advances and investor interest in the off-market trading format. The sellside enjoyed the advanced functionality that automatically sought out the right market and best price, allowing for best execution and forward orders. From 2009, these systems are available to foreign securities firms, many of whom are already familiar with alternative trading venues elsewhere in the world and Smart Order Routing (SOR) systems.

These SOR applications not only take into account price and cost considerations, but also allow for orders to be electronically and automatically forwarded to the most advantageous market, including exchanges, dark pools or PTS’.
Scheduled for launch in January 2010, the TSE is developing a new highspeed exchange system that takes into account the proliferation of PTS’ and the widespread adoption of electronic markets.
To be compatible, sell-side SOR systems will be expected to provide high-speed order execution capabilities. Also, with the sophistication and unit minimisation of best execution orders, transactions that allow for the trading of large orders using VWAP (volume weighted average price) by PTS’ look set to become commonplace in 2009.
In summary, the rapid development of PTS’ in Japan over the past year is driving the establishment of a new execution market that supplements the exchange both electronically and functionally, and looks set to reduce trading and liquidity risks across the broader market. In parallel, Japan will see the advanced automation of best execution for institutional investors, and continued adoption of SOR systems by the sell-side to allow for best execution.