By Ned Philips
Trading in Europe and North America is now faster and cheaper than ever before. Under the umbrella of regional regulations such as MiFID and Reg NMS, the proliferation of technology has revolutionized the ways trades are executed. An endless choice of non-displayed venues (NDVs, also commonly referred to as dark pools), lit-pools and traditional exchanges have clamored to offer traderssimplified connectivity, lower latency and better execution.
Although lacking the number of choices as their Western counterparts, Asian investors are not being left behind in the technological race to provide better trading execution and lower costs. Despite the disjointed nature of the Asian trading environment, and perceived barriers such as multiple regulatory and settlement systems, NDVs still allow Asian investors to aggressively pursue the same benefits as those enjoyed by their American and European counterparts.
Asia is an expensive place to trade, especially in comparison with the US and Europe. Large spreads have lowered liquidity in many parts of Asia, which has made life difficult for many investors, especially algorithmic and high frequency traders, by restricting them to more liquid and well-known stocks. For these investors, NDVs are alternate means for them to access both lower transaction costs and higher liquidity, allowing them to undertake more diverse trading strategies.
NDVs do this by helping the market achieve its real purpose – efficiency. Liquidity pools allow traders to reduce spreads by meeting each other halfway between a bid and an offer (mid-point pricing), rather than forcing one party to give in and meet the spread. This has enabled investors to seek best execution and capture significant savings with every trade.
In turn, lower spreads are also bringing liquidity back to lesser-traded stocks, thereby further increasing trading volumes and the overall strength of the market place.
High latency and low impact transactions
NDVs also provide investors with a fast, and most importantly, anonymous pool of liquidity on which to trade large blocks of securities without risking price movements against them. This feature is particularly attractive to brokers, who are coming under increasing pressure from algorithmic and high-frequency traders to provide discreet, fast and low-cost ways of trading Asian securities.
Lower trading costs
Commission payments still make up a large part of trading costs in Asia; while trading costs charged by exchanges remain relatively high (see side-table). NDVs are already contributing to the reduction of these costs. A report by Greenwich shows commission payments in Asia ex-Japan fell sharply in 2009, as fund managers switched to electronic trading options.
Traditional exchanges have also been forced to respond to the price challenge imposed by alternative trading platforms. Already, venues such as Hong Kong Stock Exchange are reducing their fees for certain listed products. Despite this, Asia-based NDVs continue to offer trading fees which are lower than traditional trading venues, allowing brokers and fund managers to pass on further savings to investors.
Asia’s fragmented trading environment has long been a natural barrier for traders pursuing the same level of regional investment strategy as they would in places such as Europe. For example, investors wishing to trade simultaneously in Japan, Hong Kong and Singapore must deal with multiple settlement procedures and custodian relationships, which drive up the cost of pan-Asian trading and force investors to focus on individual markets.
This is frustrating to many outside investors who are very keen to access Asia’s fast growing markets. According to the US Federal Reserve, overseas investments by American investors in the third quarter of 2009 shot up to US$3.94 trillion from US$2.85 trillion in the same period of 2008. The majority of this has flowed to Asia and other emerging markets.
As portfolio allocations are spread between multiple markets in Asia, NDVs have an important role to play in re-aggregating trade across the region and are a cost-efficient option. For example, the rise of cross-border NDVs has led to the introduction of more large-scale and cost-efficient clearinghouses and settlement agencies to facilitate all stock transactions all under one roof no matter where they are listed, a first for the region.
As Asia’s NDV industry continues to develop, investors will gain more options to seek pan-Asian exposure, increasing overall liquidity and the vitality of the regional trading environment.
Are NDVs benefiting all?
Given the experience of US and European markets, I believe the growth of NDVs in Asia will benefit all market players and institutions, and accelerate the local implementation of new trading technology, as well as the development of the regional trading environment. Key advantages for each type of players include:
• Better pricing for end-users
Lower trading costs and reduced spreads will provide a more competitive costing regime for allinvestors, including the sell-side who trade on NDVs and their buy-side clients. This will ultimately benefit end-users, including the majority of retail investors who invest via pension funds, mutual funds etc.
• Enhanced trading options for investors
NDVs allow pan-Asian investors to access and trade securities trading in multiple markets, all under one roof. This will overcome many of the cost barriers faced by traders looking to implement similar regional investment strategies to those possible in Europe and the US.
• Better execution for brokers
Brokers-dealers now have better means to provide their clients with better execution options, including minimizing market impact, lower latency, as well as cost-efficient clearing and settlement processes. The ability to provide low impact trades will be welcomed by many institutional investors.
• More liquidity and trading volumes for exchanges
NDVs are now providing an important stream of liquidity for traditional exchanges. In Asia particularly, NDVs are set to provide an important function by bringing together the fragmented markets which make up the Asian trading environment and facilitating cross-border trade flows. Lower spreads will also funnel liquidity back into lower-traded stocks, greatly enhancing the overall trading quality of the market.
NDVs increase overall trading volume for the equities market. This higher liquidity will benefit all market participants, allowing investors to choose the best venue for trade execution and the more efficient venues to execute their trades.
Experience in Europe and the US has shown that the broad uptake of new trading introduction has seen many exchanges witnessing an increase in trading volumes, a testament to the liquidity boosts provided by NDVs to the overall market.
NDVs also provide exchanges with an opportunity to expand their service offerings. For example, bourses such as Singapore Stock Exchange, London Stock Exchange, Nasdaq OMX and NYSE Euronext have adopted NDVs as part of their business model.
As new trading technology continues to gain broad acceptance, NDVs are also becoming increasingly responsive to global criticism on the limited information available about the trades conducted on non-lit platforms. In Asia, NDVs are already working with regulators and exchanges by providing accurate post-trade data to local exchanges and/or via leading third-party data vendors. However, given the increasingly important role NDVs are playing in deepening the regional trading environment, I am confident that NDVs will gain strong buyin from financial regulators.
Future outlook for NDVs in Asia
Over recent years, the regional uptake of trading technology has accelerated quickly (take for instance Tokyo’s Arrowhead system) and we are already seeing both internal dark pools as well as external non-lit crossing venues becoming well established in markets such as Japan, Hong Kong and Singapore.
However, given the number of markets present in the region, the uptake of NDVs has differed from market to market and is likely to stay that way in the medium term. While regional NDVs have so far focused mostly on individual markets, I believe the biggest impact will come from the introduction of alternative platforms which are able to deliver cross-border trades.
As more and more hedge funds and traders continue to relocate to Asia, they will join their Asia-based colleagues in demanding the same trading options they enjoyed in the US and Europe.
By Ned Philips