Electronic trade gains traction

This was published in the November 2010 issue of The Asset magazine

The buzz of activity in Asia’s electronic trading space is unmistakable and 2010 may yet be remembered as the year it all came together for the industry. While the US ‘flash crash’ incident in May of this year, which briefly shaved US$1 trillion off the value of US equities, hit a raw nerve among electronic trading participants and affected the level of transaction, liquidity has rebounded and most venues report a return in verve and confidence among traders.

The industry has been making great strides in building the right infrastructure despite concerns abroad about the growth of trades driven by highly sophisticated algorithms.

The leading exchanges in the region are investing in trading platforms that can cope with large volumes of electronic trades driven by algorithms and high-frequency traders. Even more compelling has been the arrival of alternative trading exchanges and dark pools into the region hoping to win business away from brick-and-mortar trading exchanges.

More hubbub was generated in November with the launch of Chi East, a dark pool where the sellside institutions can trade blocks of stocks listed on the various exchanges including the Tokyo Stock Exchange (TSE), Singapore Exchange (SGX), Hong Kong Exchange (HKEx) and the Australian Stock Exchange (ASX). Although brokers and traders admit it is still early days, the region is becoming increasingly sophisticated in the way securities (especially equities) are traded electronically.

Vast improvements in speed

All this excites Glenn Lesko. The CEO of Instinet Asia-Pacific states that electronic trading has become a major component of the liquidity that is coursing through Asian markets. He considers as quite dramatic the vast improvement in speed and efficiency in which exchanges such as the Tokyo Stock Exchange now absorb the volume of electronic trades flooding their way. Tokyo successfully put in place its Arrowhead platform this year that expanded its capability to handle all types of trades including high-frequency trades. “The exchanges are much faster this year and Singapore and Australia have embarked upon creating new platforms to enhance speed and increase capacity that will be able to better handle the scale of electronic trades swamping the region.”

Celent, a consulting firm, describes the vast changes sweeping through the region in a report on Asia-wide electronic trading published in October. The leading markets in the region, according to the report, are moving towards greater efficiency with the build-up of state-of-the art electronic trading infrastructures.

Anshuman Jaswal, the author of the report, acknowledges the progress made, particularly by stock exchanges, in using faster matching engines and cites the growth of co-location services across the region, which are becoming de rigeur among the leading brokers in the region. Brokers co-locate their servers in exchanges so that they can reduce the latency for clients during trading. Exchanges such as ASX, SGX and NSE (National Stock Exchange of India) now provide co-location services. This service is critical for high-frequency trades, which requires ultra-fast servers to send their algorithmic buy or sell orders to the exchanges.

On top of that, market data fees are being revamped in the region, while more brokers have been providing clients with direct market access and direct strategy access.

Other strong indicators of the robust growth in electronic trading in the region is the growing use of the FIX messaging protocol and the willingness of regulators in the region from Korea to Singapore and from Tokyo to Sydney to encourage the operation of alternative trading systems.

Arbitraging fuels HFT
While the report enumerates the recent gains and advances, it is quick to point out that the experience of the region differs significantly from country to country. In terms of the overall quality of infrastructure and participation from the buyside, Australia and Japan are considered the most conducive for high-frequency trading (HFT). The use of sophisticated trading algorithms has become prevalent in those two markets.

Korea has been the pioneer in the region for HFT in futures. Singapore and Hong Kong enjoy sufficient liquidity for high-frequency trades to thrive and their vibrancy as a hub for HFT is reflected in the higher level of index arbitrage between equity and futures.

Jaswal says interest in HFT in the region can only accelerate in view of the rise in the cross-listing of exchange indices across Asia and the possibility of exploiting arbitrage opportunities. He sees evidence of a Nikkei arbitrage between the Osaka Stock Exchange and SGX and a Nifty arbitrage between NSE and SGX and expects other arbitrage opportunities to come up in the region. He notes that a number of hedge funds undertake arbitrage between the US market and respective Asian markets for ADRs in Singapore and predicts HFT volumes could rise in the region.

Mike Gilbert, global head of professional trading group (PTG) and the Asia-Pacific head of sales for clearing and PTG at Newedge, a futures and options broker, says the last ten years have been an exciting time for electronic trading in the region, especially in view of the birth of HFT.

“It is growing exponentially and we are definitely going to see more activity,” he says, “the industry will continue to evolve, including the role of clearing houses, and we expect volumes to climb over time.” He suggested, though, that clearing exchanges and brokers in the region should take a closer look at the risks and benefits involved. “There is often a misconception about the role of electronic trading and stakeholders need to be aware of the enormous benefits, including reduced trading costs and increased liquidity.”

Before joining Newedge in 2004, Gilbert worked with an independent trading software vendor and prior to that he traded equity options for eight years in London.

Electronic business volume to double
The speed of change sweeping through the region’s electronic landscape has prompted Lesko to predict that Instinet, which has always operated as an online broker, may double its penetration of the region in five years or less. “It is quite feasible [especially] in countries where we have a physical presence on the back of the region’s improving infrastructure for electronic trading. Instinet now basically covers much of the region and where it does not, it works through a local broker-partner. The reality is that we are covering everything across markets, except Chinese A-shares which must be accessed by brokers onshore in China.”

Instinet, which is owned by Nomura, has been operating in the region for 20 years. It started in Hong Kong, established itself in Japan and gained an onshore presence in Singapore four years ago and in Australia last year. The group has a number of liquidity pool offerings. The largest ones are Japan Crossing, which includes a VWAP (Volume Weighted Average Price) cross, and CBX (Continuous Block Cross) in Hong Kong and Japan, both of which are pools where traders can opt whether or not to display their orders. There is a VWAP cross too in Korea. Through those pools, Instinet manages US$85 million to US$100 million of internal liquidity, Lesko points out. Instinet estimates its VWAP cross ratio is around 10%.

The roll-out of more alternative trading systems into the region is happening despite the controversy that their use has spawned in the US and European markets. In late July, Chi-X Global’s roll-out of proprietary trading system Chi-X Japan was followed in November by the roll-out of Chi East, a pan-Asian dark pool joint venture with the Singapore Exchange. Chi-X Australia is due to launch in the first quarter of 2011.

More brokers have launched internal crossing and dark pool aggregation services across the region. Everyone is looking at China, but the country remains one of the few markets where HFT remains limited since Chinese regulations restrict the activity.

Cut-throat competition
While Lesko is happy about the growth of the volume for electronic broking, he faces growing competition. Pricing has turned even more cut-throat for online broking because bulge-bracket firms such as Goldman Sachs, Morgan Stanley, Barclays Capital and even its parent company Nomura are spending a lot of money building their electronic trading platforms competing with Instinet’s. “They try to differentiate themselves from each other, but with so many new platforms being marketed at once that drives lower prices.”

Lesko believes that one cannot truly differentiate between the various technologies that are provided. HFT is a tiny part of the total trading volume. “HFT is extremely low-margin business and many brokers almost make nothing out of it but they do it since they get to provide their clients with a full suite of services, including financing and prime brokerage.”

But Instinet does not currently operate a prime-broking or financing facility and only focusses on equity trade execution. This is the reason, according to Lesko, why most of the business is the plain-vanilla type of mutual funds or trusts, pension funds or long/short hedge funds.