Trading's time warp

The following article first appeared in the March 2009 edition of AsianInvestor magazine. Each month we offer online a feature from the magazine. To subscribe for more in-depth industry analysis that you can't find on our website, please send an e-mail to: [email protected].

Trading costs in Asian developed and emerging markets spiked in the fourth quarter, following the collapse of Lehman Brothers. Although those costs have ostensibly come down, volumes have dried up, which suggests that were anyone to attempt to move transactions in size, they would find the cost still quite high.

This represents a setback for buy-side traders, who had begun to enjoy some of the competitive and technological advances that had already taken place in Europe and America. A year ago, Asian markets seemed to be growing more efficient and cost-effective. Today, in contrast, the lack of volume only highlights just how far Asian markets have yet to go to catch up with other regions.

"It's like being in a time warp," says Gabriel Butler, director of sales and trading at ITG in Hong Kong. "We're back to where things used to be."

ITG released a study showing how trading costs have spiked throughout the region (see table and charts). By the firm's reckoning, costs in the fourth quarter of 2008 rose nearly three times in markets ranging from Japan to Indonesia.

That data is further reflected in the widening of bid/ask spreads across the region, particularly in the developed markets of Japan, Hong Kong, Singapore and Australia (because spreads are always high in the emerging markets). Spreads are the biggest contributor to overall trading costs, particularly for small transactions. Market-impact costs are more significant for larger deals, however - an area still not well understood or monitored by many on the buy side.

What exactly links the Lehman collapse to high trading costs in Asia? Most obviously, investors, from long-only money managers to hedge funds, spent Q4 exiting positions to go to cash, often to meet redemption calls. Fears about market and economic ills continue, meaning today there remain far more sellers than buyers.

Other factors compound matters. Bulge-bracket brokers no longer have, or can no longer use, the balance sheet to provide risk financing and capital to hedge funds. Many prop desks and hedge funds have been scaled back or wiped out, so there are fewer strategies being traded, making the markets even more homogenous. The sharp decline in market valuations has cut ticket sizes. And bans on short selling or tweaking of shorting rules, notably in Australia, for a time removed a whole swath of potential counterparts.

Lastly, the advent of dark pools, direct market access (DMA), algorithmic trading and alternative electronic trading venues such as Liquidnet and Instinet can, in some cases, reduce liquidity. This is because by breaking up trading away from stock exchanges and traditional brokers, sales traders no longer have access to as much flow information. Therefore they have fewer ideas to show buy-side clients. All of these heralded improvements, in an environment of extreme volatility, have ironically backfired.

By no means are buy-side traders disillusioned with these new tools. On the contrary, all of these things, which have only been introduced to Asia Pacific markets over the past two or three years, are still regarded as crucial to improving access to liquidity. But they still lack a critical mass of buy-side participants, a situation that has worsened with the exit of so many hedge funds and prop desks. The long-only money managers remain in the market, and have always constituted the biggest volume of trading - but their strategies are too similar.

Personality also plays a role. "Many buy-side firms have the technology, but don't always use it," notes David Klinger, managing director at Liquidnet in Hong Kong.

Obtaining that critical mass won't be easy. Grace Lin, head of electronic execution at Citi in Hong Kong, notes that in America and the US, electronic communication networks such as Chi-X gained ground because they brought automation to manual markets. Most Asian markets have always been electronic. Moreover, there is nothing like Europe's Mifid directive that unbundled research and execution costs across the continent, nor a common regulatory structure or currency.

This has resulted in full-service brokers re-establishing their hold on business, at the expense of agency-only providers, which struggle when volumes are low. Full-service brokers can provide access to flows from structured-products groups, agency flow from other buy-side clients, flow from prop desks (if these still exist), and the offering of DMA, algorithms and dark pools. In recent years, frequent traders such as hedge funds became the best source of revenue for brokers, but the focus of business will now be returning to big long-only players.

Meanwhile, buy sides are being forced to shrink their broker lists, because they can't pay as much in commission anymore, and a relatively greater share of their wallet is dedicated to full-service brokers. The buy side is now paying less but asking for more, say a number of market participants - not a sustainable situation.

As a result of this, buy-side traders are opting for simpler strategies. For example, purveyors of algorithms report a shift away from volatility-weighted averaging pricing (VWAP) to time-weighted (TWAP) strategies, in which a trade is broken into sections of similar size, each traded over a slice of time.

"It's the simplest way to navigate," says Mark Brady, a sales director at Instinet. "VWAP can help you beat the market, but in a volatile market, it's not your friend, and you can be easily picked off." The best that can be said is that the buy side is at least back in familiar territory, with most of its commission going to the usual bulge-bracket names trading in fragmented, difficult markets. Barring another bout of bad news that sparks sell-offs, trading this year will remain range-bound, and low volumes will pose a constraint on execution, says Todd Prado, regional head of trading at Janus Capital.

But in respect to technology, there is no time warp.

"There's no turning back," says Christine To, head of regional trading at T. Rowe Price. And while many events are out of traders' control, their decision to use these new tools is firmly within their power.

"Other traders should be more open to dark pools," To says. "Don't be discouraged if the hit ratio is low. Put your order in, try different tools."

It's only once critical mass builds in ECNs and usage of new technology that Asia's buy side can move back to the future.