Measuring Change To Find A New Path

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By Ben Jefferys, Head of Trading Solutions, IRESS
Whether you look at it from a global, regional or local perspective, markets have changed a lot in recent times. A lot of this is to do with newer regulatory requirements but in markets where more than one exchange competes there has been a lot of competitive innovation too. With no sign of the rate of change slowing anytime soon could there be a better way for the industry to move forward? To explore this we first take a look at the effects of recent regulatory change on trading volumes and patterns.
Despite slight increases in overall market volume, the value of share trading today is averaging lower than where it was a year ago. Some brief periods of increased volatility supported higher volumes but relatively speaking markets remain quiet. Still the number of transactions across the board continues to rise as the markets further fragment. We now have well over a year of trading since the Australian regulator ASIC made changes to off-market transactions relating to price improvement and block sized trades.

Message rates on the Australian exchanges have remained stable for 2014. By looking at the number of create, amend and cancel messages on each exchange we see both ASX and Chi-X exchanges are following a similar level of activity this year. Even though the ASX is effectively a busier exchange in terms of the headline number of messages it looks a little different when we compare it to the actual amount of volume transacted on each exchange.

Here we can look back a bit further to the start of 2013 and see that the total Chi-X volume has been slowly increasing whilst the total ASX volume even though being more volatile is slowly decreasing. Overall Chi-X still trails ASX in terms of market share but the message rate on Chi-X relative to its traded volume is higher than the ASX giving it a higher order to trade ratio. What we see here in Australia is really no different to what we see in other markets around the world where newer alternative exchanges are competing with the incumbent exchange. The newer alternative exchanges need market makers passively resting in their order books at the same or better prices than the incumbent so that broker smart order routers will target these exchanges. As prices move around on the incumbent exchange the market makers tend to move in sync on the alternative exchange adding to its ‘busyness’ whilst not transacting as much volume.
Because the messaging rate has remained reasonably stable whilst the volume on Chi-X is slowly growing it is a positive result for those supporting competition. The market is becoming more confident in trading away from the incumbent exchange. Market makers are supplying more liquidity by sitting passively with more volume. At the same time sell side brokers are also happy to post liquidity into these exchanges driven primarily by cheaper execution costs and a reduced queue time for stocks where this counts.
But these last 12 months have also been interesting from a post regulatory change point of view. In May 2013 ASIC changes regarding off market crossings for dark liquidity took effect. ASIC have recently made public comment on these changes in “Report 394 – Review of recent rule changes affecting dark liquidity”. A lot of focus has been put into trading around the new block special tiers but it is equally interesting to look at the effect on trades below block size that are now referred to as trades “with meaningful price improvement”.
ASIC were concerned with the amount of off market trading taking place away from the lit exchanges of ASX and Chi-X and for amongst other reasons its effect on price formation. Previously below block size crossings could take place at the best bid/offer and within the spread. The rule changes sought to address the situation and protect market quality by limiting what can be done off market and encouraging brokers to post liquidity back onto the lit exchanges. Nowadays these off market crossings below block size can only trade within the spread and offer a meaningful price improvement.
Looking at some sample data helps illustrate just what the effect has been. Telstra is a great example to use because it is well fragmented not only due to its size but also because of the way it trades. Telstra is a “queue stock” where establishing priority for passive orders is important.

Prior to the rule changes vast amounts of Telstra traded via NX crossings that could be done at the bid or offer. Brokers would always try and establish queue priority but then jump the queue and cross with an opposing order when the opportunity arose. The immediate effect of the rule change was a sharp drop in the number of below block size crossings. In fact these ‘NX’ crossings were down +60% the following month. Since then the number of NX crossings has remained fairly stable. It’s worth noting that in this example we don’t include what were known as ASX Priority Crossings that would extend the effect of the change as some broker crossing engines still used this order type at the time.

It is also interesting to look at how the competing exchanges fared with these changes. Again using Telstra we have taken a snapshot of trading for the month leading up to the rule change in May 2013 and then compared it with a year later. Below is the breakdown of all TLS.ASX trades for the months of April 2013 and April 2014.

From the earlier chart we could see that the number of crossings dropped off a cliff and the same is evident here. The proportion of trades executed as an NX crossing in April 2014 is far less than a year before. Successfully for ASIC some volume has returned to the lit order books – or what we refer to as the Central Limit Order Book (CLOB). The same goes for other types of trades that have all increased to the detriment of the NX crossings. ASX Centre Point continues to grow and the same for Chi-X’s integrated order book that offers automatic price improvement (marked as HL for Hidden Liquidity).
Accessing the order books
Whilst a lot of the focus for the sell side in Australia has been regulatory change there has been a whole lot of exchange innovation thrown into the mix – a common theme seen throughout the world where incumbent exchanges are competing to protect their market share whilst new entrants are doing everything they can to take it from them.
These innovation changes typically appear as either new order types or even new liquidity pools and venues. Today there is plenty of choice when it comes to where and how to send an order to market albeit in an overall diminishing pool of liquidity.
In Australia not so long ago the available order types were straightforward and looked something like the table below:

 
 
 
Compare that to today where we have competition across exchanges and all of a sudden there are many more choices on how and where to create an order:

These order types all have specific uses and target certain types of liquidity. All in all it is quite a complex suite of tools available to the trader. Pardon the pun but where is the limit to just how many the market needs? Some of these are direct responses to a competitor’s product, others are innovations designed to fill a gap in the existing offering. Unfortunately not all are well received nor well used by the sell side. One cannot blame the exchanges when looking at this from a competitive and evolutionary point of view but in hindsight when all involved are time and resource constrained most would agree that we need to be spending our time and resources on the most important issues at that time.
Ability to change
Likewise the topic of over regulation is often discussed and it is prevalent here in Australia right now. It not only encompasses just how far regulatory controls extend into a market but also and importantly just how quickly the market can absorb and deal with the changes. Sell side brokers continue to cut costs out of their businesses and dealing with regulatory and exchange change has always been a cost of doing business in this industry. But as the regulatory burden increased we have seen some of the ASIC changes in Australia delayed a number of times and some eventually abandoned. This in part can be attributed to the industry’s ability to meet the requirement within the specified time. As trading technology deployments get more complex it takes more time and money to change them.
Perhaps all of this highlights that we need a better way to move forward in the future. Sell side, buy side, exchanges, regulators and vendors all need an efficient way to collectively move forward. There is no doubt that each has their own agenda or clients to service but we all operate in the same space. Finding the best way to jointly progress as an industry in a world where cost pressures continue as trading volumes remain supressed might just be the challenge for the next year ahead.