A proposal by Japanese regulator FSA to lift a compulsory takeover bid imposed on users of alternative trading venues will draw buy-side traders away from the primary exchange, argue industry players.
At present, the rule stipulates that investors who accumulate more than a 5% stake of a firm over a two-month period via proprietary trading systems (PTS) automatically trigger a compulsory takeover bid of that company.
Proprietary trading systems are lit venues that typically allow investors to trade in tighter tick sizes, which lower the cost of trading.
But last week the country's Financial Services Authority began a consultation process on a proposed exemption to that rule, which has long been viewed as a key constraint in capping the growth of PTSs.
Buy-side traders, analysts and brokers tell AsianInvestor changes to the rule will likely incentivise international fund managers to use PTSs, such as SBI JapanNext and Chi-X, due to their tighter spreads. The exemption will become effective this October if the proposal gains industry support.
“Fund managers who traditionally held off from trading on PTSs, as they were concerned about crossing that 5% trigger due to their internal operational constraints, would now be encouraged to use these venues once the takeover bid rule goes away,” says a head trader at a global asset management firm in Hong Kong.
Regulators in Japan have introduced measures recently that have driven a big uptake in PTS trading volume. SBI JapanNext, for example, saw daily turnover in May amounting to 5% of daily turnover of the Tokyo Stock Exchange.
Industry players expect SBI JapanNext and Chi-X to hit a combined market share of 10% before long.
A key measure in fostering growth in PTS trading volume has been in clearing. Since July 2010, PTSs have been allowed to clear trades through Japan Securities Clearing Corporation, a move that lowered counterparty and settlement risks for trades done on PTSs.
Comparing like-for-like quotes for stocks traded on the primary exchange and alternative venues, David Rabinowitz, head of direct execution for Asian equities at UBS, says that up to 75% of quotes are priced more tightly on PTSs. What is holding back further market fragmentation is general lack of depth on bid/ask orders on PTSs.
But Rabinowitz is hopeful that once SBI JapanNext and Chi-X reach a combined 10% average in daily trading volume, a tipping point for market fragmentation will have been reached.
“Once the average daily volume for the two biggest PTSs combined reaches 10%, that critical mass will become self-fulfilling with more market-makers and institutional investors displaying a heightened interest in passing orders to an alternative venue where liquidity resides,” says Rabinowitz.
The potential costs incurred and additional latencies involved in routing to more than one venue, with connectivity technology such as smart-order routing, are slowly being offset by the price improvements seen on these alternative venues, he argues.
In fact, HFT firms and market-makers have been dominant users of PTSs. Ofir Gefen, head of research and algorithmic consultant for Asia-Pacific at ITG, says the typical high-frequency user that trades on a PTS predominately trades in large caps and over 95% of the trades on the PTSs are currently in large-cap stocks.
PTS technology that offers execution at lower latency and finer tick sizes is a big draw for high-speed traders. “Unlike the TSE, current PTS technology gives them the ability to set their tick sizes at below ¥1 increments, for those wanting to slice the spread even finer,” says Gefen.
But asset managers’ dealing desks hoping to cross more trades on PTSs might first need to invest in their trading systems to be able to benefit from those finer tick sizes.
Steve Grob, director of group strategy at trading solutions provider Fidessa, says: “Many trading systems have not yet been converted to decimalisation and so cannot take advantage of the smaller tick sizes on Chi-X Japan and SBI JapanNext.
"Now that the 5% rule is going we expect to see a significant increase in firms upgrading their trading systems in this way [and including smart order routing],” says Grob. Currently, the smallest tick size on the TSE is ¥1.