The advent of electronic trading has multiple causes, of which two stand out: the reality on the ground in Asia-Pacific of poor liquidity, and growing sophistication on the buy-side.
This is spurring the development of alternative trading venues, changing the way people trade, impacting how exchanges operate, and ultimately improving the liquidity conditions that led to the electronic revolution in the first place, according to “Smaller, cheaper, faster”, a new report on trading Asian equities published this month as a supplement to AsianInvestor magazine.
First, liquidity. Asia-Pacific equity market capitalisation is about the same as the United States’, but turnover is only about 20% of America’s. Asian stocks trade a lot less. Reasons include the basic fact that Asia consists of multiple countries with their own exchanges, their own regulation, and in some cases, capital controls.
Even if these markets were magically combined – and attempts have been made, notably Singapore Exchange’s failed acquisition of the Australian Stock Exchange in 2011 – they would still be marked by lower free floats, due to heavy family or state-owned enterprise ownership.
An already difficult liquidity situation has gotten worse of late. The final quarter of 2012 saw turnover fall dramatically in Australia, Hong Kong and Japan, the region’s three biggest markets. The Western sovereign debt problems has sucked liquidity out of Asia, as investors sit on their hands or repatriate capital, leading to dramatically wider spreads in Asian equities markets.
The good news is that after hitting a nadir in December, volumes are up again and spreads are narrowing, particularly in those markets, such as India, where global investors are buying again.
The vagaries of global investor sentiment are a primary determinant of Asian market liquidity. But that’s little comfort to investors with dedicated Asia portfolios, or to actual Asian investors. They have to live in these markets, and when liquidity dries up, they can no longer rely on traditional means of accessing bids and offers.
Which leads us to changes on the buy-side. Global fund management companies have introduced some of the tools and mindset they use in the US and other more developed markets. As Asia has become a bigger part of their business, they have transferred experienced traders to the region, consolidated desks, and given them tools to measure and improve performance.
In terms of measurement, more buy-sides are adopting transaction-cost analysis. They want to understand how they perform. Initially, TCA found many buy-sides wanting, because the market norm was to trade against benchmarks that were simply in line with the market. Asia is a VWAP marketplace – that is, traders follow volume-weighted average prices, the ratio of value traded to total volume traded over the course of a day.
If you peg your execution to VWAP, you will trade at the average price a stock traded, regardless of whatever actually happens in the market – if there’s a spike during an opening or a close, or an event that could have enabled a trader to buy or sell more quickly.
The benefit to VWAP is that volume-in-line style trading can reduce market impact, but most traders consider it a lazy way to go. It is the de-facto standard in Asia partly as a result of thin liquidity, but mainly because of lack of experience with other ways to do things, or a lack of the right systems to take advantage of market events.
Global managers using TCA have found they can use other benchmarks that generate alpha performance, in which traders can win narrower spreads or implement trades more quickly.
In addition to analysing performance and adopting more sophisticated benchmarks, buy-sides have imported trading technologies from the West to help them execute more effectively.
In the US, up to 70% of total market turnover is now done electronically, versus over a phone. Asia isn’t at that level, and probably will never be, but brokers report some clients are now trading up to 30% of their volume electronically, either by interacting with a broker via an algorithm (a program), or accessing local stock exchanges directly (via DMA, or direct market access). Most buy-sides’ electronic activity remains far below that level, but the direction is clear.
Alternative trading venues have sprung up in response to the rise of electronic trading. Some of these are direct competitors to stock exchanges, such as the proprietary trading systems in Japan (SBI Japannext and Chi-X Japan) and Chi-X Australia. Others are brokers’ internal crossing engines, ‘dark pools’, or buy-side-only crossing networks (Liquidnet). These offer the benefit of anonymous trading, which helps ensure a trader’s intention is kept secret.
Exchanges have responded by vastly upgrading their matching platforms, to reduce latency (speed of execution) to micro-seconds. As liquidity in markets such as Japan and Australia improves, high-frequency traders (HFT) and other market makers have moved in. Liquidity begets liquidity, but HFT is controversial. On the one hand, such players vastly enhance market liquidity. On the other hand, many long-only and hedge-fund traders don’t like to connect with HFT flow, which they feel is predatory.
Since the May 6, 2010 ‘flash crash’ in the US, regulators in Asia have also taken a dimmer view of HFT, to the point that they have sometimes ignored the need to boost their own market’s competitiveness. But, love them or hate them, high-frequency traders are a part of the electronic trading landscape. They are here to stay.
Taken together, these trends have changed the way buy-sides execute. The holy grail is a block trade: being able to buy or sell a large order without disturbing the market. This is hard to achieve in small, lightly traded markets.
But by using algos, whether as DMA, broker orders, or tapping electronic venues, investors are finding they can break down their trades into much smaller pieces and get work done that way. The new mantra is smaller, cheaper, faster.
This doesn’t change liquidity: finishing an order all at once or finishing it in slices over time results in the same turnover. But that activity will now take place across multiple venues, over different periods of time, and often at tighter spreads, which can give the advantage to the buy-side dealer.
But to make this happen requires more use of algos, and real skill. Hence it remains a work in progress in Asia, as both buy and sell sides upgrade their people and their technology.
Although the most fascinating, and far-reaching, changes to trading equities in Asia remains the advent of electronic execution, that’s not the entire story. Activity has become bifurcated, with buy-sides increasing their use of algos/electronic on the one hand, and asking their brokers to facilitate (ie, underwrite with their own capital) trades.
This feature appears in a new report on trading Asian equities titled “Smaller, cheaper, faster”, along with features covering facilitation, commissions, dark pools, liquidity aggregators and stock exchanges. To subscribe, please email Richard Santoro or call him on +852 3175 1980.