Liquidnet’s Seth Merrin shares how exchanges can develop a global strategy to compete today.
Following a year of failed crossborder mergers, exchanges are at a crossroads. They have worked in siloes within their respective countries but now have to create their global strategies. To move forward, there are lessons for the exchanges to learn from another industry that followed a very similar trajectory more than a decade ago—the airline industry.
Airlines share many parallels with exchanges—a strong nationalistic sentiment, a highly competitive environment driven by the entrance of low cost carriers, and a record of unsuccessful M&A activity. So what steps did the winners in the airline industry take in order to beat out the low cost competition, how did they achieve global scale and what can exchanges learn from this?
Airlines tackled the fundamental evolution of their industry by focusing on three key areas: diversification of revenue by selling more to their existing client base, differentiation of their offering by focusing on a premium customer, and development of global alliances to expand their geographic reach.
Let’s first take a look at revenue diversification and how exchanges can take a similar approach. Airlines realised they had a captive audience with their customers and once they had these customers in their seats, they could sell them more products. As a result, the airlines introduced paid-for services in coach and new premium products and services to all customers. Who hasn’t been on an aeroplane and paid for food, extra space, or, picked up an ever-expanding catalogue of duty free items?
Historically, exchanges have had two primary streams of revenue: company listings and trading. Today, these revenue streams constitute only a minor component of total revenue as exchanges have placed more emphasis on their ‘premium offerings’. The NYSE Euronext and Nasdaq, both of which have faced significant competition sooner than many of their peers, recognised that they had a captive audience in their listed companies and expanded their offering by selling premium services such as new technology offerings and premium data products and services. Today, both of these exchanges have multiple revenue streams and no single business comprises more than 20% of their overall revenue. What they have left to do—and what virtually no other exchange has done—is to develop a premium class of customer.
The entrance of low-cost providers, such as EasyJet and Ryanair, in the airline industry commoditised the price of an airline seat. As a consequence, airlines (particularly the established players) could no longer compete on price alone and needed to diversify their offering. So they went upscale, choosing instead to focus on high margins and higher value offerings, which their discount counterparts couldn’t match. While discount carriers charged for pillows, winning airlines created a premium offering and experience for their business and first class travellers. It’s not surprising that these premium passengers were willing to pay significantly more for steak, champagne, and lieflat beds because of the ultimate experience these airlines provided.
The Capital Markets Cooperative Research Centre (CMCRC)’s Alex Frino talks about his research over the past 18 months and the conclusions as to the truth about high-frequency trading.
What inspired you to focus your research on High Frequency Trading (HFT)?
There is a very poor understanding of the impact of HFTs on the market place. There is a lot of ill-informed opinion in circulation about the impact of HFT on price volatility, and their contribution to liquidity. I wanted to provide some hard data to help markets move forward and inform sensible evidence-based policy decisions.
There was also considerable interest in the idea of conducting HFT research from our regulator partners, including the FSA and ASIC.
What were your views on HFT at the outset of your research program?
When we first set about doing the research 18 months ago, I began by speaking to the investment management community to gather their views and insights into HFT and its impact on their trading. The feedback I got was overwhelmingly negative. One comment sums it up best – an investment manager said to me that “liquidity provided by the HFT community is like fog – you can see it, but when you reach out to grab it, it is not there.” So I began the program expecting to confirm these dominant views. To my surprise we discovered that the realities about HFT are almost exactly the opposite of that the investment managers were telling me.
HFT liquidity has been described as ephemeral by many on the buy-side. What does your research suggest about the ability of the buy-side to interact with HFT liquidity?
We have done research with data from the LSE, ASX, SGX, NASDAQ and NYSE Euronext on exactly this subject. The exchanges furnished us with data that identifies when HFTs are present in the market place. We then looked at the make-take decision. HFTs make liquidity when they put up a quote that gets hit by someone on the other side of the trade. They take liquidity when they hit someone else’s quote. The data clearly showed that HFTs are net makers of liquidity.
Interestingly some of our data also included information about when firms are trading through co-located servers within the exchanges. This data too showed that co-lo HFT activity was also a net provider of liquidity in those markets.
Co-location is described by some as an ‘unfair advantage’. What is your take on that given your research into the area?
My view is that if the advantage is being put to good use in providing liquidity, then it is not being misused. That pool of co-located flow is providing liquidity that would not be there otherwise, so I cannot see how that is a negative for markets.
Many market participants – including recent widely-quoted comments by Andrew Haldane of the Bank of England – are critical of the speed and sophistication of markets generally, using HFT as their example. They argue the playing field is not level and that markets should be slowed to take away perceived unfair advantages. What is your view?
I was frankly amazed by Haldane’s suggestion that markets should be slowed [by introducing speed limits and resting periods]. What he is in effect suggesting is that we should take markets backwards by a decade. That is astonishing to me because I just do not see the arguments. Market participants who do not have the technology to compete with other players can easily access brokers with algorithmic trading engines to help them execute their trades. If you cannot or do not want to build the technology yourself, you can outsource it fairly cheaply and very efficiently.
From an HFT perspective, our research demonstrates emphatically that the liquidity they provide is real and other participants interact with it constantly, so I cannot see a problem there either.
Nomura’s Jeremy Bruce summarises the current state of play in terms of European liquidity venue fragmentation, and focuses specifically on venue ownership and geographical concentration of equity execution venues.
Ownership and Location of European Equity Trading Venues
In the past few two years we have seen not only increasing liquidity fragmentation in Europe, but a significant change in the pecking order of exchange and venue size. The diagram below lists all venues with a market share of greater than 1% as well as referencing other smaller venues. As can be seen, it shows both the rise of venues, such as Chi-X Europe and BATS, as well as the proliferation of light and dark venues owned by the preexisting exchanges. Chi-X Europe in particular, is now comfortably the largest pan-European venue. There are currently two proposed mergers on the table, firstly between NYSE Euronext and Deutsche Boerse, and the second between Chi-X Europe and BATS.
The old model of a country having a primary exchange located within its borders (normally in the main financial district), where its companies’ stocks almost exclusively trade is no longer relevant. As corporate ownership of the manifold liquidity venues becomes more complex and blurred, it is perhaps more meaningful to look at the actual location of the exchange. When we say exchange, we are actually referring not to the administrative or corporate headquarters of the exchange firm, but to the location of the IT infrastructure that runs the actual live exchange matching engine. This location is then a physical data centre building, with an additional failover backup site.
In this article, Equiduct Trading’s Joint CEO Artur Fischer argues that in times of extreme structural and economic change, there is an even greater requirement for transparency. He believes that in an increasingly fragmented market, there’s an even greater risk that organisations will need even more help if they are to avoid effectively trading in the dark with no clear consolidated view of market pricing. Here he identifies the growing requirement for a new generation of virtual order book that can consolidate all the visible pre-trade information generated from significant relevant markets, effectively delivering transparency and providing firms with access to a single, unbiased source of pan-European equity price data.
The European equity markets have undergone a period of rapid and unprecedented change over the past two years. While some of these shifts have been mainly related to the still-evolving current global economic situation – leading to the disappearance or restructuring of some of the biggest names in finance – others have centred around newlyintroduced regulation, with the arrival of new types of execution venues and cross border clearing venues being among the most obvious and significant.
These changes have created some huge challenges (and it should be said equally huge opportunities) for market participants, whether they be the large broker dealers having to connect to all the new trading venues in search of liquidity, or a pension fund simply trying to understand what the “Best Execution” he has been promised actually means.
Each of the incumbent Exchanges, the new Multilateral Trading Facilities (MTF), and the growing number of Dark Pools or Crossing Networks provides an alternative USP for execution of equity orders, and each operates with a slightly different business model - both pre and post trade. This has understandably stimulated competition for order flow liquidity, introducing alternatives in the post trade space, and leading to a major shake up in fees. Not surprisingly, this has also irreversibly fragmented liquidity. However, this fragmentation is an evolving process; the picture is far from complete or even stable, and can be expected to go through several consolidation and subsequent fragmentation phases before the next “Big Bang”.
Opening up the European equity markets With new entrants into the execution space, Europe’s equity market is opening up for investors from across the world. FIX-compliant technology is enabling easier connectivity to the new venues and providing an opportunity for a wider range of firms to get access to venues over and above the incumbent. In Vol 2 Issue 8 December 2008 of FIXGlobal, John Palazzo of Cheuvreux stated “FIX affords every broker the ability to get into these markets at an unprecedented pace” – at Equiduct we certainly agree, but there are still some considerable challenges.
How, for example, do “sell-side” firms determine whether they should connect to these new venues? How do they then prioritise which to connect to? How do they choose where to actually send their order? Also, how do “buy-side” investors understand which venues their brokers should be connected to, if they are to ensure them the mythical Best Execution? What price should they be using to markto- market at the end of each day and for intraday position risk purposes?
At Equiduct, we’re hoping to provide some of the answers to these important questions. We hope to be able to shed some light on the situation and show how to achieve best execution on the various available platforms with a range of analytical tools. Uniquely, the toolset includes a Pan-European aggregated feed.
Ensuring execution on the most appropriate platform Firms across the trading spectrum, whether small or large, are increasingly using sophisticated smart-order-routing solutions and algorithmic trading systems to “slice” orders and to determine where they should distribute the pieces across the Dark Pools, MTF and Exchanges. However, in order for these systems and indeed an individual trader to start to effectively predict the future, it is important to understand the present and the past. Information providers such as Markit or Fidessa with their Fragmentation Index can confirm the common knowledge that liquidity fragmentation is a reality once a trade has been executed. However they do not have the ability to see how the market should have performed by examining the pre-trade order and price information that was available at the time of trade.
At Equiduct we have been collating all visible pre-trade information (Level II data) for the top 700 shares across Belgium, France, Germany, The Netherlands and the UK from the major European venues (BATS, Chi-X, NYSE Euronext, London Stock Exchange, Nasdaq OMX, Turquoise, Xetra) since April 2008. Yes, a significant percentage of order flow has moved away from the incumbent exchanges but what is not such common knowledge is that trades are still not always executed on the most appropriate platform. Indeed our analysis shows that in April 2009 a significant proportion of trades executed on the incumbent exchanges should have been transacted on an alternative venue, and approximately 35% of executed trades are still not transacted on the best price venue. Significant price improvement could have been achieved if this had happened. (See Diagram 1)
Can there possibly be a silver lining in the current financial meltdown? John Knuff of Equinix, argues that now is a time to upgrade your investment, allowing the Asia Pacific region to catch up with its US and European peers.
While the global financial crisis has inevitably had an impact on investment, most commentators seem to agree, that the Asia Pacific market will see on-going development, particularly as it continues to invest in the infrastructure and technologies, that will allow it to match its US and European counterparts, in key areas such as execution speed, easier market access and direct data feeds.
Analysts such as Celent see the current downturn as a significant opportunity for Asia exchanges, even suggesting in a recent report that Asian exchanges have the potential to overtake their US colleagues in the near future. Before this can happen, however, there needs to be sustained investment in the technology, skills and processes that will enable lower latency, easier access and faster data feeds across the region.
One of the key challenges remains the diversity of the region. While the geographical diversity, and vast distances involved, will always make it hard for traders to gain low latency access to multiple market centers, the added complexity of local regulations and last mile access make region-wide performance goals even more difficult to achieve. Nevertheless, factors such as direct market access, the increasing presence of alternative trading systems and the introduction of crossing networks, will have a tremendous impact shortly after local regulations ease.
Investing to close the gap with other global markets To assume that the different markets in the Asia Pacific region will progress seamlessly together towards a more deregulated and open environment would be unrealistic. The global financial crisis is already leading some Asia Pacific exchanges and regulators to be more defensive in their outlook. However, it also provides an opportunity, for more traditional venues, to develop and implement their own alternative trading strategies to compete, more favourably, with new market entrants as conditions improve.
It is this imperative to remedy the handicap of limited bandwidth and slower trading platforms, that is driving Asia Pacific financial institutions to continue to update their technology infrastructure. As many of the incumbent exchanges re-tool their matching engines and foster technology partnerships, with global leaders like NASDAQ OMX and NYSE Euronext, the broker / dealer communities are quickly positioning themselves to be the partner of choice for many of their US and European counterparts.
Given this background, we believe it’s important for Asian market participants to ensure they are making the right infrastructure and connectivity choices today, to allow them to compete more effectively tomorrow.
A world of more end points and more trading venues In an Asia Pacific market driven by the continued growth of automated and algorithmic trading, the emergence of new liquidity opportunities and increasing numbers of order destinations and market data sources, we’re increasingly going to see financial firms trading a much wider range of asset classes and instruments across broader geographies.
In those countries, where the incumbent exchanges still handle the majority of trading, these new market developments will have a significant impact as local traders who, limited by their current choices, increasingly send order flows to more accessible and transparent electronic markets. All this translates into more end points and execution venues, and is driving demand among financial services firms for a greater choice of networks with low latency/ high bandwidth capabilities to enable these higher message rates and optimise throughput.
With the landscape of the Asia Pacific market's different trading centers evolving so quickly, it’s becoming increasingly apparent that a strong element of foresight, and much broader connectivity options, will play as important a role as proximity, when it comes to making location decisions across the Asia Pacific region.
Making the right technology decisions This is important given the highly volatile and competitive nature of today’s financial markets. Trading volumes are shifting dramatically, new entrants are changing the market opportunities, and there’s a continued growth in automated, algorithmic and alternative trading strategies. At the same time, many markets are fragmenting away from their traditional single venue exchange-based structure, while major players continue to join forces in line with the trend of globalization and consolidation.
Whatever your line of business, there’s a pressing requirement for a stable, global infrastructure that assists you in achieving your market goals. Whether you’re an asset management firm or a hedge fund, you depend on the ability to access continuous streams of global market data, messaging, news, history and analysis to ensure successful execution of your trading strategy. Or you could be an exchange that needs to be able to quickly connect to participants or clients, receive orders over a range of different financial extranets and broker connections, post or match the orders almost instantly, and respond in milliseconds (or increasingly microseconds).
Appetite for risk has never been lower and liquidity has never been tougher to identify. The downstream effect is impacting every part of the electronic trading business and culture. Quod Financial's Ali Pichvai examines where he sees the sea change in trading skills and style.
We are at the midst of a structural, and subsequently cultural, change in the capital markets. Firms’ appetite for risk is shifting and counterparty risk is now high on the agenda. This trickles to each function and aspect of investment and execution; from investment decision making, to risk management, and the mechanics of the electronic trading. In addition, liquidity is increasingly fragmented across a multitude of pools and is affecting how electronic markets are evolving. So how does this landscape impact how firms will trade?
Changes on the buy-side and how the future will look are still uncertain. The hedge fund industry, the great innovator investor class, has in large part been discredited and its model will need to drastically change. The quasi-demise of this large segment will leave a void that needs to be filled. It seems that the future lies in more transparent, better risk-managed, low-cost listed products, which respond to the appetite of global multi-asset investment and execution strategy of the investors. Furthermore it is now clear that liquidity and solvency are intimately linked, and evaporating or volatile liquidity creates systemic risk on solvency. This will, without doubt, have a large impact on future capital market structures.
The buy-side transformation will inevitably accelerate the pace of the current secular trends of more electronic trading on centrally cleared liquidity venues and competing global or regional multi-asset liquidity venues. NYSE Euronext, as a global multi-asset liquidity venue, seems to be the role model for all other market participants. The liquidity fragmentation, as observed today, will certainly be greater and more complex going forward. It also seems we have entered a second age of liquidity fragmentation, with three phenomena which have appeared, or been reinforced, in the current turmoil.
Liquidity is becoming ever more dynamic. As competition increases price wars are becoming more frequent, and pricing models are being altered to attract more and more liquidity. For instance, the rebate model for passive orders (i.e. by resting a passive order, you can receive a fee) has often been used as an effective marketing tool for new alternative trading systems. Clients are therefore moving their execution on a realtime basis from venue to venue, as pricing evolves within a competitive landscape, making liquidity ever more dynamic.
Liquidity is decreasing transparency. As new dark pools and brokers internalisation profligate, with the US equities having achieved 17% of execution in these dark venues, the level of transparency is decreasing. This creates a massive trading challenge. Transparent liquidity is important since it creates an efficient price discovery model, which then disappears into a non-transparent execution model.As transparency decreases, in addition to market data sourced from the different displayed prices, there is a need to move to real-time post-trade analysis, to rebuild a more intelligent picture of liquidity.
Volatility increases fragmentation and increases execution risk. The current intraday volatility, and an even lower period volatility, is much greater than at any other time, and bigger than the impact of incurred costs. As seeking liquidity becomes more important, fragmentation will increase. The result is a new type of risk which needs to be mitigated; the execution risk. This means that the investment case can be fully redundant if the execution in a highly volatile market is not properly performed. This risk evolves from the inability to execute down to execution too far away from the investment decision. Another obvious effect is that the widespread algorithmic trading engines, which were built to limit for low volatility markets, have become obsolete. Nowadays, in an averagely volatile day, it is not uncommon to have 300 basis points of volatility, which dwarfs a single digit basis point cost impact. That means that the next cycle of investment in algorithmic trading needs to be redirected towards liquidity seeking algorithmic trading (also called smart order routing - arguably a misnomer, since it is simply routing rather than delivering a real-time decision making process).
NYSE Euronext’s Joe Mecane responds to calls for pre-trade certification of algos and describes NYSE’s efforts to manage risk.
What is the exchanges’ burden in terms of regulating High Frequency Trading (HFT)?
There are multiple components to that answer. There is not necessarily any regulation specific to High Frequency Traders as a separate type of participant, but clearly there are a lot of regulations that are applied to HFT because of the nature of their business. Sponsored access, for example, is clearly an area that impacts high frequency traders who might not be members of exchanges. Recently, there has been a lot of press and discussion around regulating algorithms, and that has a broad application around, not only HFT, but also customer-type algorithms that are developed by firms who deploy those algorithms to their customers or use them to execute customer orders.
At the same time, algorithms can be used for high frequency traders to develop proprietary algorithms. In those cases, a general supervisory responsibility falls to any of those types of participants to ensure that their algorithms are tested and working properly before they actually deploy them to the public. There has been discussion around whether that should be a more formal stringent rule, but it is more complicated because everyone has some level of responsibility and oversight with regard to deploying and developing algorithms. One thing that we have talked about is creating a ‘best practices’ standard, for people to follow, as there have been some cases of particular firms being fined for releasing algorithms that have had damaging effects on the market.
When does the exchange’s supervisory onus take place? Should exchanges evaluate algorithms in real-time as they’re trading or is it something that should be evaluated beforehand?
The problem with evaluating algorithms pre-trade is that it is not really practical to create an infrastructure that would certify an algorithm before it is deployed. While it sounds good in theory, the reality is the regulators do not currently have the resources and skill sets to sit down and review lines of code; it is just not really practical. What that means is that there is a structure, where firms have policies and procedures around how they develop, test and deploy algorithms that then can be reviewed by the regulators. It is not really practical to demand regulatory sign-off on an algorithm before it is deployed.
What would you recommend for firms as best practice for testing algorithms before deploying them?
It is up to each individual firm to outline and deploy the practices that they think are most prudent. One possible thing the industry could do is develop best practices or standards for algo development that the industry could adhere to. Some of the trader groups and some of the technology trade groups may have those types of standards already or could put them together quite easily. It is not our place as an exchange to try to define those standards, but certainly, it is something that most firms have and the industry, as a whole, could assemble from a technology development and deployment perspective.
What are some actions NYSE takes to supervise algorithms as they are deployed?
NYSE has a number of elements in place to help mitigate and oversee algorithms. On our markets we have a number of circuit breaker-type mechanisms to detect what might be unintended behaviors on the exchanges, ranging from Liquidity Replenishment Points to some of the SEC circuit breakers that have been mandated. We also have market order collars and limit order collars on Arca. On one level, we have some limits on our market that are designed to mitigate big price moves when there could be an algorithm acting in an unintended manner. At another level, we also have some safeguards that monitor excessive message traffic, so we have the ability to either moderate or throttle some message traffic if we start to see excessive message traffic coming down a particular connection. Third, and this is a market-wide thing, there are clearly defined rules in place to deal with erroneous types of trades that could happen as a result of an algorithm gone bad. The last thing is that we have outsourced the market regulation component of our responsibilities to the Financial Industry Regulatory Authority (FINRA). As a part of FINRA’s reviews, they look at a lot of the supervisory procedures and oversight that are utilized by firms in terms of deploying their algorithms, as well as development and testing.
Paul Squires, Head of Trading, AXA Investment Managers opens up about the relationship between the buy-side and exchanges, and the perceived effects of recent consolidation among exchanges.
From Trading Desk to Trading Floor
We trade on an exchange in the name of a broker, which means there is a buffer between the exchange and the buy-side. The interaction we have with the exchanges and MTF’s works much better now. The MTF’s have done a good job engaging with the buy-side over the past few years, which makes a lot of sense when you think of the evolving landscape of market structure. Historically, buy-side firms and exchanges were never quite sure if they needed to pay much attention to each other; however, there is a much more collaborative dialogue now. Most buy-side desks have mixed feelings about some of the bigger exchanges, in much the same way that some of the brokers have mixed feelings about the positioning of exchanges. On the up-side, there is a sort of national, utility element to the exchanges. For things like index funds, primary exchanges own the end of day official pricing.
Before MiFID, the primary exchanges were responsible for more of the trade and transaction reporting and it was easier to interpret that data compared with the fragmentation of trade reporting following the first MiFID installment. On the buy-side, we have this simplistic view that it is positive for reporting to be centralised through the primary exchanges because having liquidity in a single venue is something we see as beneficial. Also, the level of monitoring around the primary exchanges is higher than around the MTF’s, and therefore, things like governance and robustness tend to be greater. Generally speaking, we see the primary exchange as a kind of trustworthy elder statesmen in the world of market structure. Where I think the challenges around the exchanges lie are that innovation can be bogged down by their hierarchy and organizational structure, and therefore, cannot compete quite as dynamically as some of the MTF’s, which clearly have much lighter infrastructure considerations. It is no surprise that some of the primary exchanges have lost market share to the MTF’s, who have been nimble, technology focused and reactive in the face of a changing environment.
We find it quite fascinating to see what will happen. Given the rate of market expansion, globalization and regulatory changes - all of which lends itself to consolidation - it was an inevitability. Exchanges have to be forward thinking about what their long term roles will be and although there are different aspects to this, what we tend to focus on is cash equities only. When people think of the Toronto or London exchanges merging, they think it is kind of interesting. Deutsche Boerse and NYSE Euronext, on the other hand, is fairly mind-blowing. In a wider context, the really interesting developments for us, the market participants, are for exchanges to look into other asset classes and areas of activity to secure a revenue stream for the future. The real impetus is not from cash equities; it is very much about clearing, OTC, potentially, fixed income markets and looking at what they can do in more commercial areas.
Net Gain/Loss from Exchange Mergers
We would hope to see technical enhancements at the exchanges. By applying a rule of best practices, the things that work well for the Toronto Stock Exchange or the London Stock Exchange could be transported to the other exchange, as with Deutsche Boerse and NYSE Euronext. The technical platforms and order book layout are quite relevant, so we would hope to see some enhancement in that area. Nonetheless, I would not necessarily promote a uniform market layout or order book structure, as I do not think we need that in every single exchange we trade on. To some extent, the more that order books’ structures align, the more it helps traders who are trading multiple markets. We can pre-constrain a lot of unique exchange rules in our systems, but there are segments where human intelligence and manual control of the various elements are vital. In this respect, we would see any alignment of market practices as a fairly positive development.
The obvious potential negative outcome of the mergers is in returning to situations where the exchanges have too much of a monopolistic position and can potentially raise costs without the market having any ability to challenge it. If the MTF’s or exchanges raise their costs, we do not necessarily see that on the buy-side because of the buffer that the broker provides. There is a fairly high margin in the commission rates we pay our brokers and they cover their costs of trading our orders on the venues, and those venue transaction prices would have to increase exponentially for it to become a direct factor for us. Of course, it does eat away at margins for the brokers, and it may come to a point where they need to pass those costs on. The buy-side is somewhat safeguarded from rising venue costs, but not completely.
Ned Phillips, CEO at Chi-East, elucidates on how despite the lack of a regional trading framework, non-displayed venues are gaining momentum in delivering benefits to Asian investors.
Trading in Europe and North America is now faster and cheaper than ever before. Under the umbrella of regional regulations such as MiFID and Reg NMS, the proliferation of technology has revolutionized the ways trades are executed. An endless choice of non-displayed venues (NDVs, also commonly referred to as dark pools), lit-pools and traditional exchanges have clamored to offer traderssimplified connectivity, lower latency and better execution.
Although lacking the number of choices as their Western counterparts, Asian investors are not being left behind in the technological race to provide better trading execution and lower costs. Despite the disjointed nature of the Asian trading environment, and perceived barriers such as multiple regulatory and settlement systems, NDVs still allow Asian investors to aggressively pursue the same benefits as those enjoyed by their American and European counterparts.
Asia is an expensive place to trade, especially in comparison with the US and Europe. Large spreads have lowered liquidity in many parts of Asia, which has made life difficult for many investors, especially algorithmic and high frequency traders, by restricting them to more liquid and well-known stocks. For these investors, NDVs are alternate means for them to access both lower transaction costs and higher liquidity, allowing them to undertake more diverse trading strategies.
NDVs do this by helping the market achieve its real purpose – efficiency. Liquidity pools allow traders to reduce spreads by meeting each other halfway between a bid and an offer (mid-point pricing), rather than forcing one party to give in and meet the spread. This has enabled investors to seek best execution and capture significant savings with every trade.
In turn, lower spreads are also bringing liquidity back to lesser-traded stocks, thereby further increasing trading volumes and the overall strength of the market place.
High latency and low impact transactions
NDVs also provide investors with a fast, and most importantly, anonymous pool of liquidity on which to trade large blocks of securities without risking price movements against them. This feature is particularly attractive to brokers, who are coming under increasing pressure from algorithmic and high-frequency traders to provide discreet, fast and low-cost ways of trading Asian securities.
Lower trading costs
Commission payments still make up a large part of trading costs in Asia; while trading costs charged by exchanges remain relatively high (see side-table). NDVs are already contributing to the reduction of these costs. A report by Greenwich shows commission payments in Asia ex-Japan fell sharply in 2009, as fund managers switched to electronic trading options.
Traditional exchanges have also been forced to respond to the price challenge imposed by alternative trading platforms. Already, venues such as Hong Kong Stock Exchange are reducing their fees for certain listed products. Despite this, Asia-based NDVs continue to offer trading fees which are lower than traditional trading venues, allowing brokers and fund managers to pass on further savings to investors.
What key features do successful exchanges share that encourage liquidity; how automated trading drives growth and why markets will attract incremental liquidity with the advent of global CSAs. Robert Barnes, Managing Director, Equities of UBS Investment Bank explains.
The execution arms race continues. The prize is order flow that concentrates to those most capable, particularly in navigating market structures.
Market structures comprise the rules and institutions that determine competition and the framework of interaction, including Exchange fees, which ultimately shape order execution strategies. The focus includes external factors that impact business and operating models, driving opportunities to grow revenues and reduce costs.
Exchanges rebuilding liquidity is a priority market-wide theme in 2010 in the context of competition, transparency, and investor choice at trading and clearing layers. From a User perspective, we wish to work in a spirit of partnership with Exchanges and Regulators to promote liquidity and new business, and we thank the Authorities as they provide a framework within which we can behave as entrepreneurs.
Macro trends include rising number of trades, coincident with automated electronic trading. Regulation promotes competition, transparency, investor protection. This leads to a better result for clients via competitive execution policies. Competition, thus fragmentation, makes the world more complex. Not all brokers, however, can keep up with the technological arms race. Direct Execution models of electronic trading are evolving to address this. Latency reduction increasingly is sought for competitive advantage.
There is increasing awareness of a positive dynamic involving non-displayed pools and high frequency trading. The key insights are that markets allowing discretionary non-displayed broker crossing processes and non-discretionary dark pools effectively speed net liquidity onto order books. The benefits are lower market impact, greater efficiency, and a better result for end investors.
These benefits multiply if statistical traders are active. When orderbook liquidity increases, so too does the proportion of trading opportunities; and these stimulate further orders to the orderbook from automated strategies. This incremental liquidity, aggressive and passive, narrows spreads.
The world’s markets are split into those that support and benefit from high levels of automation, and those with the opportunity to encourage more. Investors’ current focus include global macro trends and emerging markets which means that moving toward more consistent electronic access models will help markets to take advantage of this burgeoning liquidity. A good start is to implement and enhance FIX specifications to offer advanced electronic flexibility. This adoption of standardisation can aid emerging markets in growing their scale of business.
One of the more “seismic” changes to Equity markets in recent years is the proliferation of commission unbundling and Commission Sharing Agreements, “CSAs”, or Client Commission Agreements,“CCAs”, in the USA. Initiated by UK regulators in 2006, this commission unbundling initiative spread across Europe (at the end of 2007) with the arrival of the Markets in Financial Instruments Directive, or “MiFID.” Global clients, preferring one consistent process world-wide, have led the demand for CSAs to become a market convention. With many CSAs established on a global basis, it can be easier than ever before for a newly automated market joining a broker’s network to attract liquidity.