Barriers To Market Structure Evolution In Japan
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, kabu.com, 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.
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.
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.