Order Routing in Japan


Osaka Securities Exchange’s Matthias Rietig reports on the most recent developments in order routing and algorithmic trading in Japanese equities and derivatives.
Upgrades to Japanese Exchanges
Although the Japanese markets have been fully electronic since 1999, last year’s upgrade to arrowhead by the Tokyo Stock Exchange (TSE), as well as Osaka Securities Exchange (OSE)’s move to J-Gate, are quantum leaps in terms of performance. In OSE’s case, the move to faster technology – internal round trip times have been reduced from 60 milliseconds (ms) to below 1-2ms across all derivatives products – also paved the way for a broad revision of trading rules. All Japan-specific rules have been abolished, making way for global standard price/time First-In-First-Out based trading. This will make OSE more transparent and efficient, and hence, a fairer market.
Since Japan is one of the three largest equity markets in the world, the move towards a more globalized market structure, coupled with technology upgrades, will transform Japan into a new hot spot for High Frequency Trading (HFT). That being said, it is important for the exchanges to navigate through this paradigm shift wisely so as to not alienate the domestic user base and very active domestic retail participants. Although TSE volumes jumped about 10% after their move to arrowhead and spreads narrowed, the domestic proprietary trading houses that could not manage the very expensive transition as well as a huge decrease in profitability were driven out of the market, which resulted in a  decrease of around 40% in the Japanese cash equity dealer population.
Although we see a proliferation of Multilateral Trading Facilities (MTFs / so called PTS’s in Japan), dark pools and crossing networks and the like entering the market, the liquidity from the domestic layers is still pretty sticky and has an exchange bias. That being said, even in Japan the times are changing and I expect the share of MTFs to increase steadily over time.
With the arrival of Chi-X Japan, all of the existing Proprietary Trading Systems (PTSs) reviewed their business models and it can be assumed that, due to the successful launch of arrowhead and a speed competitive main market, inter market arbitrage activity will rise. Since the Japanese exchanges are already very competitive with their pricing, the battle will be fought over value added services and features, like speed, tick sizes and access options. Overall, a decrease in trading fees can still be anticipated, which should benefit the end users.
While we do see the first signs of new growth of the PTS’s, overall volumes are still relatively small, with TSE capturing roughly 94%  of the overall volumes on exchange equity cash trading, OSE about 5%, and the remaining PTS’s command a combined share of roughly 1%. It will be interesting to watch how market structure will evolve with the opening up of the JSCC, which for the first time started to serve PTS’s as a clearing house in July 2010.
Competition will increase, and although Japan is often labeled as overprotective, many domestic market participants believe it is a good development, as competition clearly cultivates services. The government, itself, is committed to induce more competition among markets to gain competitiveness in an international context and re-establish Tokyo as the financial focal point in Asia.
As the equity cash market is increasingly fragmented, the situation in the equity derivatives space is less so. OSE occupies the major chunk of Japanese equity index futures trading, the most prominent being the Japanese benchmark index Nikkei 225, through the Nikkei Mini Futures, which is one of the ten most actively traded index futures contracts, globally. Furthermore, OSE occupies a 100% share in Japanese Equity Index Options.
Although overall volumes went south for most of the other Japanese derivatives exchanges for the last couple of years, trading volume increased for five consecutive years. The newly launched J-Gate derivatives platform in Tokyo aims to make the overall market proposition of Japan more cost efficient and attractive. Located in the same data center as TSE as well as some PTS’s, J-Gate will hopefully benefit from cross connectivity, analogous  to the US and European markets.
Smart order routing and algorithmic trading
Smart order routing (SOR) has been gaining traction in the last few years, and the launch of more sophisticated trading platforms, as well as the overall increase of sophistication of the buy-side, should further facilitate this trend. Although adoption by the international buy-side is already relatively widely implemented, the domestic layer has been more prudent to adopt SOR. In any case, it can be expected that the domestic players will catch up quickly, as they are currently screening the market to be ready once the overall liquidity on the PTS’s increases.
Algorithmic trading is very prevalent in Japan and has been increasing steadily over the last couple of years. The introduction of co-location, as well as the introduction of the Nikkei 225mini Futures, has increased the amount of players that can be considered HFT or latency sensitive. Roughly 30-50% of OSE’s current futures and options volumes stem from latency sensitive HFT/Ultra HFT players. If we only look at the messages generated, the overall share of HFT is much higher.
Low latency market data feeds
The recent technology upgrades also led to significant improvements in the market data feeds; opposed to the 100ms snapshot update of the old system, J-Gate sends out market data in real-time. Enhanced market data and analytics offeringswill cater to the increased demand from global quantitative traders. This will be key to fully unleash the potential of the algorithmic trading activity in Japan. It is of the essence that market data is accessible, timely and robust at all times, and in order to avoid a flash crash/flash recovery scenario, it must provide a full picture of the situation at all times.
The rise of HFT and changing trading strategies
Domestic derivatives participants have been engaging with the HFT layer at OSE for quite awhile already. Traditional participants will have to consider the costs and benefits of changing their systems in order to keep or, in some  cases, regain their ability to hit the orders they wish to. It is refreshing to see that some Japanese online brokers are embracing these changes by providing algo tools to their customers, and some are starting to host their servers in co-location facilities in Tokyo.
Regarding the change in trading styles, the recent system upgrades should promote HFT, as traders gain confidence in the stable and high performing platforms, which will support their modelbased trading. Nonetheless, HFT is certainly not the only way to operate successfully on trading platforms, and market directional activity is of the essence for a successful market to function properly.
The changes so far are very encouraging, as the  domestic retail layer is moving towards easy automation and the traditional Japanese prop trading community is starting to equip themselves with professional off-the-shelf tools that can partly or fully automate their strategies to cope with the evolving trading landscape in Japan.
The learning curve for domestic players will be steep, as a lot of information on HFT and third party solutions is widely available, hence adoption should be relatively swift. We already see encouraging first signs, especially among the younger generation within the domestic prop trading community.