It could be years before we get to hear cloak-and-dagger stories of intrepid traders based in Tokyo or Hong Kong stealing powerful proprietary algorithmic trading techniques from their banks to make their tainted billions before they are caught.
But by the looks of it, high frequency trading is taking an unprecedented leap in Asia, the buzz around it spreading like wildfire, especially in recent months.
Industry conferences on high frequency trades have become money-makers for conference organizers – and a dime a dozen are happening this year across the region, from Mumbai to Tokyo, from Hong Kong to Jakarta.
Regional exchanges such as those in Singapore, Taiwan, and India have announced ambitions plans to invest in systems (especially in co-locating data centres) to cope with the unique demands of high-speed trading while bulge-bracket investment banks and securities houses have been rolling out highly evolved algo products and smart order routing systems to help clients access vast pools of liquidity across different asset classes.
The launch of Tokyo Stock Exchange’s Arrowhead trading platform in January this year too, with better capability to handle high-frequency trades, has injected a considerable degree of excitement among investment banks and their large institutional and hedge fund clients in the US.
It used to be different. For decades, the region has viewed with strong suspicion high-speed, high-frequency trading, which is also referred to as automated or programmed trading. The large stock market crash of 1987, for instance, was blamed mostly on programmed trading since they exacerbated the panic that swept through America’s financial heartland. In 2009, high-frequency trades stirred debate in the US on worries that Goldman Sachs’s proprietary algorithms were giving it undue advantage over other traders.
In May, highly evolved algorithms used by high-frequency traders were blamed for the sudden nosedive in US shares that has mystified even the most eagle-eyed regulators.
Hand in hand
Two years ago, recalls Zach Tuckwell, head of Asia electronic trading at Morgan Stanley, electronic trading hardly made up 10% of their client’s trading activity in Asia. Now it is about 20%, and likely to reach 30% in a year-and-a-half. “It’s been a phenomenal jump every year and I believe our client business in Asia will soon see its level of electronic trading activity approach what we have in Europe – which is around 40-45%.”
Tuckwell says Morgan Stanley’s main clients include institutional funds and large hedge funds and a fair proportion is based in the US and is starting to get a wider exposure in the region.
Shalabi: Happy to notch up small gains on a day-to-day basis
Hani Shalabi, head of Advanced Execution Services (AES®) for the Asia-Pacific at Credit Suisse, says several factors have helped push high-frequency trading activity in Asia in recent years. The most decisive was the market crash in 2008. Shalabi argues that the collapse of equity prices and the uncertainty that followed in the early part of 2009 forced numerous asset managers to seriously consider alternative strategies to diversify returns.
“Most of those who managed to show some positive P&L during the meltdown were high-frequency traders employing more systematic strategies. They made money regardless of whether the market went up or down since their trades were uncorrelated with market direction and mainly took advantage of volatility to generate returns.” The more volatile the markets, the robuster the returns generated by high-frequency traders – with a lot of them surpassing the returns achieved by the more established fund managers. By adopting the right investment strategy and employing high-speed trading to realize that strategy, they generally gained positive returns.
Does this mean that technology has usurped investment savvy? Hardly, says Shalabi, both go hand in hand in achieving market success. “Technology is a powerful enabler, but you still need to have a winning strategy to make money.”
Tokyo undergoes major changes
Tuckwell of Morgan Stanley credits the sweeping changes sweeping through Japanese trading infrastructure as another factor injecting excitement to electronic trading in the region. In early July, Chi-X Japan finally obtained a proprietary trading system (PTS) licence from the Japan Financial Services Agency (FSA) and is expected to trade on the Japanese equities platform by July 29.
Six months earlier, the TSE had established its Arrowhead platform, which has whetted the appetite of American institutions for algorithmic trading in Japan, according to Tuckwell, since it allows TSE to better handle high-frequency trades. The platform handles cash products such as stocks and convertible bonds and has declared its goal of achieving order response period of less than 10 milliseconds (ms) – the time a honey bee needs for two wing flaps – combined with high reliability.
Neil McGovern, director of marketing at Sybase, a data management firm , noted in his blog last year that TSE has been facing the same data pressures as the exchanges in North America and Europe in view of the rapidly growing number of orders per day, smaller share/trade figures and a downward trend in the execution rate. With Arrowhead, TSE will ensure that it remains competitive, he argued, especially against a PTS such as Chi-X.
A Singapore Exchange (SGX) spokesperson says high-frequency trades now contribute about 25% to 30% of the exchange’s daily derivatives trading volume, which is more than double the level two years ago. In the securities market, however, their share has yet to grow to a more significant proportion, which is one of the reasons, she explains, the exchange is rolling out its S$250 million (US$182 million) Reach initiative.
“Over a seven-year period, Reach will create the world’s fastest trading engine, a world-class data centre offering co-location facilities, and over the next 12 to 18 months, we expect to establish international communication hubs at major financial centres such as Chicago, New York, London and Tokyo,” she enthuses. “These hubs will facilitate the connection of customers from those locations to our trading facilities here in Singapore and enhance the distribution of SGX’s various investment products there.”
The hubs, the spokesperson clarifies, are not the same as the co-location offering in Singapore. SGX will offer co-location services only in Singapore, at SGX’s new data centre located in Keppel Digihub from early 2011 and will provide co-location customers with ultra-low latency access to the engines. The SGX derivatives trading engine has an order response time which is on par, if not better, than TSE’s Arrowhead, claims the spokesperson, adding that SGX Reach has been benchmarked at an order response time of 90 µs “door to door”, which is over 50 times faster than Arrow-head. [A microsecond (µs) is equal to one millionth of a second.] “With Reach in place, SGX will advance to the top of the pack among exchanges.”
HAL 9000
Opportunities and challenges indeed abound, but is the Asia-Pacific region ready for the automated trading revolution that swept through American and European markets in decades past? Who will be the winners and losers in this race of which the ultimate logic could see humans being completely removed from the trading equation, in a bid to deliver the most efficient and error-free trades.
For Luddites and technophobes, the whole trend heralds a most disturbing trend, which is the unstoppable advent of an age where machines take over, with individuals or human decisions in the future completely excised from involvement in trading, all the decisions to buy and sell securities or any form of assets being made by the algorithms themselves.
While men still design and formulate the algorithm, it is not hard to see the machines themselves eventually designing their own unique algorithms thus completely shutting off humans from the process, making trading completely non-human.
If that is not enough to trigger existentialist fear, think of the myriads of small stock brokers in the region struggling to survive from shrinking margins and once again they already see the threat of re-marginalization from sizeable investment houses that are able to invest in systems that allow them to thrive in this environment.
The proliferation of alternative trading system thriving through automated trades has already created a ripple of fear among stocks exchanges. They worry it could mean the end their long-entrenched monopoly on the trading of shares in their respective countries.
There is one large factor, however, that stands in the way of a massive adoption of automated trading in the region: the considerable fragmentation of markets in the region with their own unique trading rules and circumstances.
Then there is the fear that electronic trading could be planting the seed for a true market apocalypse. The unrelenting logic of some algorithms could lead to massive losses or spectacular windfalls if massive sell-orders are triggered in a downturn. This teetering between chaos and complete perdition is evident in how some high-frequency trading firms behave.
In May, the Dow Jones Industrial Average plunged over 900 points in a single session. In the early part of the slide, when the index was tracking a 500-point loss, many traders stopped trading altogether, a decision which – some analysts believe – added to the gravity of the market sell-off that day.
Reports says Tradebot Systems, a large high-frequency trading firm based in Kansas City, Missouri, closed down its computer trading systems when the Dow Jones Industrial Average had dropped about 500 points while Tradeworx, a New Jersey firm that operates a high-frequency fund, also stopped trading during the market turmoil, according to a person familiar with the firm.
Singapore leads the way
While electronic trading has taken off in Japan, it has yet to really make its impact on other Asian markets including that of Australia Hong Kong and Singapore, although the exchanges in these markets are considered to be some of the more efficient, boasting low latency – which means trades are executed in a fast and efficient manner.
Traders says the volumes in the region remain relatively small for high-frequency trading considering that there are not that many stocks in the region where daily trade volume reaches above US$10 million everyday. Then there are certain regulations, specifically the rigid tic rules (adopted by a host of exchanges after the 1997-1998 Asian financial crisis) that hamper numerous algorithmic trades from being executed.
Mittal: We are building from the ground up
The degree of willingness or unwillingness of the exchanges to open their platform to alternative venues that provide faster and less costly execution is crucial says Punit Mittal, the head of electronic trading at Daiwa Capital Markets. He says this is the reason why initiatives taken by SGX, the Singapore exchange, last year to work with alternative trading platform Chi-X is considered one of the more significant steps being taken to revolutionize electronic trading in the region. The joint venture is called Chi-East.
In August last year SGX signed a heads of terms agreement with Chi-X to launch the first exchange-backed dark pool in the Asia-Pacific region. The non-displayed trading platform aims to initially offer block-crossing facilities for equities listed on SGX, and on an offshore basis for the Australia, Hong Kong and Japan exchanges.
The industry, according to Mittal, has been surprised at the momentum at which the SGX and ChiX partnership has been evolving. “From Day One, the SGX has been thinking in really strategic terms how it can leverage the tie-up with Chi-X. Now they are building hubs around the region that will start operating only a year from now.”
The partnership is moving towards providing a common data centre and co-location facility for SGX and Chi-X providing clients with the ability to trade on multiple-venues from the same co-location site, Mittal explains. No other exchange is currently doing that in the regionl. “While Chi-X has been allowed to operate in Japan as well, its arrangements with Tokyo Stock Exchange do not even come close to what it has worked out with SGX since their data centres remain separate and so in essence they are not really working together in Tokyo.”
Shalabi of Credit Suisse says the region was a couple of years behind the US with algorithmic trading. This kicked off in the US in 2000 and reached Asia in 2003. Smart Order Routing (SOR) began in the Asia-Pacific with Credit Suisse’s introduction of Pathfinder – its own SOR system – in Japan in April 2009. Before the rise of alternative venues in Japan, no Asian markets had the multiple trading venues to make SOR necessary.
The entry of new players plus the willingness of bulge-bracket investment banks to invest in new systems, the surprisingly proactive engagement of exchanges to upgrade their systems as well as the growing interest among local institutions for such service have fuelled the spread of electronic and high-frequency trading in Asia.
Algorithmic trading or automated trading, involves the use of computer programs which decide how orders are executed in the market. It will decide on timing, price, or quantity of the order, or will initiate the order, usually without human intervention. Algorithmic trading heavily relies on real-time data and this has prompted considerable investment among exchanges to establish additional data centres that can make information available to the market not in ms but in µs.
This “co-location” shaves crucial ms from the time it takes to complete a trade. Traders located at a far distant from an exchange do often face a delay of at least one ms whenever they seek to trade a price via their computer screen. The more serious investors – particularly large hedge funds in the US – cannot afford prices that flash that late. The blink of a human eye takes 300 to 400 ms. A fair number of traders now operate in the smaller realm of µs.
Being faster than rivals to the best price – that is, achieving the lowest “latency” – has thus become a key goal for a lot of markets. This explains why the Taiwan Stock Exchange is establishing a data centre rental and co-location service to meet the needs of offshore and domestic traders. The service gives broker-dealers the opportunity to rent and install their servers in the exchange’s data centre, allowing them to improve the efficiency of their trading network and reduce the repair and operating costs of maintaining their own data centres.
The service will serve additional functions, such as providing more back-up options for broker-dealers. The move, which has been given the go-ahead by the regulator, has stirred a hubbub of activity in the exchange as it prepares to roll out the new rental service of its data centre by late this year. Taiwanese officials say all the arrangements are expected to be completed by September 2010, with the co-location service to be launched in the fourth quarter of the year.
High-frequency trading is considered a special class of algorithmic trading where trades are initiated by computers based on information they have received electronically. The algorithm takes extremely short positions on the shares being traded. The computers process the information before human traders are able to do so.
Bigger may be better
The advent of high-speed trading in Asia can only serve to reconfigure the whole brokerage business in the region. What repercussions it will have for small brokerage firms remain to be seen, since it introduces another differentiating dimension into the services and capabilities offered. Shalabi believes that not everyone will be able to afford the cost of the technology involved in high-frequency trading.
“Brokers tend to concentrate on their core strength and among small brokers, technology has never been a core strength. They might offer some unique boutique features or have effective insights into specific markets that allow them to trade those markets really well. For them though, technology is an expensive proposition and it makes more sense to rent this technology from a large broker which has the economies of scale to make that kind of investment.”
Only global brokerage houses are truly capable of building advanced technologies such as SOR, internal crossing networks and ultra-low latency DMA infrastructure critical for high-frequency traders, thinks Shalabi. “What will happen if the small brokers need to offer some of those features which they cannot afford to build? They will probably have to rent it. Most of these brokers don’t have a seat on all Asian exchanges and so they need to go through a large broker to access these markets. As a bonus, they get access to SOR, crossing networks, advanced algorithms and high-speed execution.”
The large investment banks seem to think that the time has come for algorithmic-driven trading to achieve the scale at which it had achieved in the US and Europe. In June this year, Morgan Stanley rolled Algorithm Manager into Asia, which it describes as a new tool providing traders with dynamic control over the execution strategy of individual orders. The bank says the launch is part of the global expansion of its customizable electronic trading platform.
The bank says the Algorithm Manager allows traders to automatically switch an order between several different Morgan Stanley Electronic Trading (MSET) algorithms depending on market conditions, time or quantity executed.
Bespoke algo
Tuckwell says that as the marketplace in Asia becomes more electronic, it is more important than ever that his clients are “armed with the most sophisticated and flexible tools available to react to various factors and changes in market conditions.” Electronic trading has particularly been a major focus for Morgan Stanley in Asia in the last 18 months, he adds.
“We have been investing heavily in systems and people, developers and programmers and a qualitative team,” he continues. “Senior management has realized that this is an important part of our equity offering in the region. Many of our Asia-based clients have seen the benefits of algorithmic trading from their European and US colleagues.”
How will the suite of algorithms fare in some of the inefficient markets of the region? Tuckwell holds that there will be markets with low latency where algorithmic trades very well, but that it is not so much latency and rather functionality where Morgan Stanley’s proprietary algorithm proves to be of value to investors. What the Algorithm Manager does electronically, Tuckwell notes, is to mimic human trading behaviour at the press of the button.
Algorithm Manager allows a trader to trade in the same way day after day. The offering allows investors to, in Tuckwell’s words, “design his strategy in the way he wants to trade.” Rather than offering the clients a bewildering number of algorithm techniques, what Morgan Stanley has done is streamline their number and incorporate more functionality into each algo so that the traders can design its use for their particularly needs.
The provision of direct market access to clients has become a focus of attention for a slew of securities firms as well. In the same week Morgan Stanley rolled out its new algorithmic platform in the region, rival Credit Suisse announced that it can now offer clients trading Hong Kong listed equities direct market access speeds of under one millisecond via AES® Velocity.
The bank boasts that AES® Velocity has achieved latency figures of 600 µs in Hong Kong. By comparison, it says, the typical human reaction speed is around 150 ms, or 250 times slower. AES® Velocity has been available in Japan since January 2010 providing clients with the fastest speed in the market. Credit Suisse says AES® Velocity will soon be available in Australia and Singapore.
There is still debate whether high-frequency traders exacerbate volatility in the market. Shalabi of Credit Suisse argues there is no solid proof that this is the case. What high-frequency trading provides, he argues, is abundant liquidity. “When they are acting on both sides – buying as well as selling – they create pressure on both sides and so minimize any sharp movements in share prices.”
While the fall in US markets after the so-called “Flash Crash” in May 2010 was exacerbated by the pullout of market makers it does not necessarily mean that they were the root cause of the fall. “The US market is so liquid that people trust that an order sent at market with no limit price will be executed at current levels. It’s only when that liquidity disappears, that you realize how dangerous market orders can be.”
Shalabi says best execution entails the best price at the time of execution and access to all available liquidity. The latter means considerable investment in smart order routing and internal crossing engines as well as providing faster and smarter algorithms. This is something that every broker has to do, but we have been doing it better and for longer than the rest. “We will definitely keep investing in systems and technology to help clients.
Shalabi is not shy in claiming that Credit Suisse stands out as among the best providers of electronic trading in the street. “We started earlier than everyone else with electronic trading. Back in 2000, we were already laying the foundations, while other players did not start until 2004 and 2005. We have won a multitude of awards for electronic trading and that is for a reason – we have the most advanced electronic trading platform and the widest breadth of products.”
Shalabi admits that volume handled in the second quarter this year shrank considerably. “People are more cautious and there is a lack of conviction about price direction. This has translated into some very low volume days during June.”
High-frequency traders need time to let earnings accumulate
Not just another job
The job of a high-frequency traders isn’t easy at all. While they may be relying on algorithms and lightning-speed execution, they have to keep innovating to maintain returns and fend off competition. And returns are steady rather than spectacular. “High-frequency trading profits are consistent but generally not remarkable on any given day – it’s a case of numerous small wins rather than home runs,” says Hani Shalabi at Credit Suisse.
High-frequency traders generate profits steadily. “Most are quite careful and are happy to notch up small gains on a day-to-day basis. Their earnings accumulate.” Shalabi explains that following the significant volatility the market went through early this year, hedge funds in the region wanted to employ different strategies to achieve diversified returns.
The uncertain investing environment since 2009 has made it imperative for people to explore new ways of making money in the market, according to Shalabi. “There was less interest before 2008 because there was less incentive: the great bull market was delivering outstanding returns to long investors almost regardless.”
Shalabi notes that generating pure alpha in the US in recent years has grown tougher and more challenging. “Most of the institutions engaged in high-frequency trading are usually US-based and they are now looking at ways to make money in Asian markets where the competition has yet to percolate. Japan is the first Asian country where they have been significantly active.”
Hedged index arbs
Shalabi says that high-frequency traders use different parameters than traditional investors when weighing opportunities. “The factors that apply to other investors do not apply to these guys. What they are most attracted to is liquidity, easy of borrow, low cost and flexible regulations.” Depending on their strategy, these factors determine the number of markets they can trade in. “What they have found so far is the best combination of factors have appeared in Japan and Australia. Both jurisdictions offer cheap execution, deep borrow and good liquidity in a diverse number of names.”
Korea, Hong Kong and Taiwan are considered middle tier because most factors are really good, except they are expensive in terms of fees. While Singapore is reasonably cheap, it is still considered illiquid compared to the other markets mentioned. “It has liquid index futures so some index arb players do trade there since it is not as expensive as Hong Kong.” China’s cash equities markets is the largest but remains mostly inaccessible due to quota limitations while liquidity remains a thorny issue in markets such as Thailand, Indonesia, Malaysia. “Those countries hardly have any stocks that trade at least US$10 million a day which is a ballpark level that high-frequency traders look for to call a stock ‘liquid’.”
Korea’s strength is in the futures and option markets, which are among the most sizeable and most liquid in the world, while futures trading rather than cash equities has taken off in a major way in India because of the difficulty of selling shares until they are settled two and half days later.
Shalabi says the various high-frequency traders in the market each have their own unique strategies. Traditional market-makers adopt the most predictable tack putting out buy and sell offers on stocks whose spread sizes outweigh the cost. Statistical arbitrage traders analyze a wide variety of factors and look for signals that statistically return more positive than negative results over time.
Index arb traders buy and sell index baskets and hedge through index futures, depending on whether the basket is cheap or expensive. In general, Shalabi notes most of the players are almost always fully hedged by the end of the day either with the exact opposite number of futures or by drawing their positions down to zero. “They actively buy and sell but close out their positions at the end of the trading day so that they are not subject to any overnight risk. During the day when they perform any market action they immediately, or in a very short timeframe, engage in an opposite action that locks in a small margin of profit.
Building automation from the ground up
Blank canvass
Daiwa Capital Markets is a relatively new entrant in the automated trading arena but it has great ambitions in Asia. Punit Mittal, its global head of electronic trading, says they will not make the mistakes made by some Western investment banks that have struggled to make their automated trading platform relevant in the region.
Punit Mittal knows exactly where he and his group stand at the moment. The global head of electronic trading at Daiwa Capital Markets describes his group’s initiative in building its automated trading business to be almost similar to that of building and creating on a blank canvass. “We’re building from the ground up, with no legacy structures to wrestle with.”
He does not consider this to be a major hurdle or short-coming, arguing that they have successfully leap-frogged the barriers in establishing the business thanks to the new wave of technology and breakthroughs that have swept through the automated trading landscape in the last few years. “The technology has changed dramatically in the last few years. There is new hardware and new software that was not available two or three years ago. We are using those products to build a much more stable system.”
He laughs off claims by Western global investment banks that they are way ahead in automated trading in the region, saying that in the last couple of years, several of them have struggled to make their business sufficiently relevant to generate enough fees and revenues. Asia, he adds, is a market completely different from what they are used to in the US and Europe.
“Several global investment banks have been investing massively in Asia in terms of high-frequency trading, but a fair proportion now realizes that the reason why the strategy is not working is that the conditions prevailing in the region are so different from those in the US and Europe. Their systems won’t work because of the different ways markets are accessed. The risk filters are different. Much else is different.”
Mittal explains that numerous banks spending large sums of money in the last two years building their electronic and automated trading capabilities in the region soon find that what they have been offering was not the best product in the market “because after all the patching which they have applied, it was simply not the right one for the market”.
Justified expansion
Daiwa Capital, he insists, is not making those mistakes. “We just started our expansion strategy. We have a blank canvass. We can build something from the ground up.”
Mittal notes that some of the trading arrangements they have with Hong Kong and Singapore clients were completed at a much faster rate in terms of time to market and have turned out to be more competitive than those of US rivals. That explains why Daiwa Capital has been attracting a lot of attention from some of the large hedge funds operating in the market, he proudly points out. Post-Lehman, a host of major Western investments houses have experienced a significant consolidation of their operation in the region, he explains, with some deciding instead to mostly focus on their main markets in the US and Europe.
“For Daiwa, Asia and Japan are our core markets and we are not going away. We don’t want to focus globally but we want to focus on Asia and all our investments are being spent to focus solely on expanding our operations in the region.” But they are not expanding simply for the sake of expanding.
While it has, for instance, built a powerful crossing engine in Japan, the group has no plans to roll out in other parts of the world in the near future, adding that any deployment has to be justified in terms of Daiwa bringing the most relevant technology and liquidity to other markets.
Mittal admits, however, that his group has been holding discussions with a large retail broker in Hong Kong about the possibility of a tie-up that would allow them to roll out their Japanese crossing engine in the business enclave.
Mittal says Daiwa’s key strength and attraction for a majority of hedge funds and institutional traders is that it was the first Japanese brokerage house to aggregate flows across retailing and institutional clients. “No other house has been able to bring Japanese retail flow and institutional flows together and that has been an interesting proposition for lots of our institutional clients.”
Enhancing liquidity management
Daiwa Capital Markets launched its electronic trading platform in Asia for cash and listed derivatives in December and became fully operational in January this year. It offers institutional clients globally the ability to trade in Australia, Hong Kong, Korea, Singapore, India and Taiwan through a suite of advanced electronic trading tools including algorithmic trading, crossing engine, direct market access (DMA) trading and smart order router (SOR).
Mittal says Daiwa has committed significant resources to building a first-class electronic trading platform and plans to hire an additional dozen professionals in Japan and Hong Kong to serve clients across the region. “The demand for electronic trading strategies has increased dramatically in the last few years as more buyside clients have opted for the unbundling of research and execution to achieve better efficiency and lower transaction costs,” said Mittal.
After the launch of Daiwa Algorithmic Trading this year, Daiwa rolled out the next generation crossing platform and SOR with the ability to sweep liquidity across all available execution venues in early 2010. “Helping clients enhance liquidity management is a key focus for Daiwa, considering that 89% of total equity trading cost can be attributed to indirect costs such as market impact costs, and opportunity costs due to information leakage, says Mittal.
Daiwa has already launched a low-latency DMA platform using the co-location facility provided by the Tokyo Stock Exchange (TSE) after Arrowhead, TSE’s next generation trading system, went live in January 2010.
The Fast DMA will be used mainly by high-frequency traders who trade actively through computer-generated arbitrage models. “Daiwa is committed to becoming a full service investment bank in order to tap into the growing Asian markets,” states Mittal. “To that end, we are expanding across all divisions including investment banking, electronic trading, equity financing and derivatives to service global institutional clients.”
Daiwa has announced its plan to invest 100 billion yen in its operations in Asia ex Japan and to increase headcount in the region by more than 400. The bank is already a leader in equity trading, Daiwa’s addition of an electronic trading platform is one of a number of planned initiatives designed to expand its service offerings to meet the evolving needs of institutional clients.
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