Market Structure Change in China : Prospects For HFT'S
High Frequency Trading (HFT) is creating waves the world over, and Asia is no exception. With the challenges HFT presents being highlighted by many, and the benefits it offers markets being stressed by many others, Ronald Gould, Chief Executive Officer, Asia Pacific, Chi-X Global, focuses on their likely prospects in the enticing markets of China.
Developments in market structure generally occur in conjunction with three things. First, such developments require a receptive regulatory environment, one that permits change and encourages innovation. The second requirement is trading venue technology, generally coupled with the existence of more than one trading venue. Trading technology availability is improving but it would be wrong to suggest that markets everywhere are equal in this respect. Finally, there needs to be a user environment that is supportive of market change and willing to help drive innovation. These ingredients are observable in varying measure across markets in Asia, some at the forefront of change and others warily fighting against it. In most places in Asia, the current status of market change is in limbo as a result of hesitance on the part of one party or another to begin the process. Our own experience indicates that Japan, Singapore and Australia are leaders in this change while others are either cautious or opposed.
If we survey the market structure scene in Asia, some places present a more ambiguous picture than others. One of the most intriguing and perplexing pictures is China, a market filled with potential, intriguing to investors, clearly interested in innovation and change but whose plans and objectives are often opaque to the outside world. Given China’s growing importance to investors, an effort to make the picture of change clearer must be a useful one. First, it is helpful to establish a baseline from which to start, a description of the situation today.
According to figures published at the end of 2009 by the World Federation of Exchanges (“WFE”), China is now the world’s second biggest equities market based on total market capitalization. Free float is much smaller however, as both State and corporate holdings are still substantial. The market is heavily dominated by retail investors, of whom there are more than 50 million with active accounts and more arriving daily. Institutional investing is at an earlier stage although mutual funds have grown rapidly and Exchange Traded Funds (ETF’s) represent a major growth area as well. Because many of China’s largest companies were previously state owned and with shareholding still tightly controlled, turnover rates among institutional investors are very low. While a block trading facility exists in Shanghai, it is not as yet widely used and probably needs upgrading if it is to attract a greater audience among investors. The new generation trading system for the Shanghai Exchange was launched in Dec 2009, purchased from Deutsche Boerse and adapted with the help of Accenture for rather different market conditions over several years. Latency is not something that gets much scrutiny by investors in Shanghai but it is not a characteristic as yet highly valued. The question we confront today is whether we are at an inflection point for change in China, a point at which the instinct for innovation begins to drive a greater openness. Let’s look at the evidence.
Starting with regulation, the CSRC (China Securities Regulatory Commission) has long made clear its interest in innovation and change as a means of preparing China’s markets for a bigger role in the national economy and greater interplay with international investors. They have encouraged developments of new trading venues, new product areas in derivatives and permitted the expansion of the QFII (Qualified Foreign Institutional Investor) and QDII (Qualified Domestic Institutional Investor) schemes. They have even allowed a start with margin trading and short sales. This suggests that the instincts of the regulator lie in the right direction but says nothing definitive as yet on their willingness to tackle some of the most common equity trading issues that have been addressed elsewhere and led to major market structure change. From the outside investor’s perspective, China remains a market with constraints both on FX and the nature of trading. We have not yet reached the tipping point in the size and flexibility of the QFII programme such that fund flows would be seen as relatively unrestricted. This is likely to happen when it suits a domestic agenda and that moment has not yet arrived. There is no structure at the moment that would easily permit the development of MTF (Multilateral Trading Facility) type platforms in China and the notion of non-exchange trading venues has not yet taken root, regardless of their sponsorship. There will need to be some longer term efforts to encourage innovation in this area and it is still early days. QFII investment holding periods of three months are obviously not HFT friendly but here too, there is active discussion of change. The decisive factor may be a better appreciation of the market-making role of HFT’s in improving liquidity for institutional investors as that group rises in importance for Chinese markets.
The second requirement I noted for the kind of market structure change that would attract HFT’s is technology driven and here again, there are signs of movement in the right direction. Brokers are becoming more sophisticated in their use of technology and the major foreign investment bank partnerships are clearly leading the way. The major exchanges are grappling with technology change challenges but neither Shanghai nor Shenzhen have as yet made any clear decisions on their next steps although both are carefully examining a number of options. China’s market structure holds some special hurdles for any new technology, especially because of the position retail investors have in the market. It may well be that the development of more institutionally oriented trading platforms within the main exchanges can provide an interesting way around these technology challenges but the outcome is not yet clear. However, there are some very smart people working on these issues so that technology as a driver of market structure change is unlikely to be a constraint for very long.
The last element I suggested as a driver of change is demand from the user community, both brokers and end-investors. This is an interesting piece in the puzzle because institutional activity is not dominant in China’s markets
and the retail investor is not yet motivated to be very interested. Liquidity in Chinese markets is highly variable and institutional block trading very small indeed, at least for now. There is certainly a demand for better liquidity for institutional size orders that would be helped by HFT involvement in the market and that would go hand in hand with the availability of new, lower latency technology. The most likely starting point for HFT activity in China will be if there is an emergence of some home grown players, something that the environment has not yet stimulated. For now, HFT–type investors will need to experiment with a variety of strategies that may work within a very different kind of market structure environment if they want to be ready for a more active future in China’s markets. The limits imposed by current QFII rules make this an ambitious challenge for now. As the importance of Chinese institutional investors rises and there is an increased drive towards access to more foreign liquidity, ways will certainly be found to capture the opportunity, probably opening the prospects for HFT firms more broadly. For now, it’s a waiting game.