Japanese Markets Look Out of (and into) the Dark

By David deGraw
Daiwa Capital Markets’ David deGraw catalogs the movements of Japanese markets in 2011 and discusses the various approaches Japan could take with regard to dark pools and High Frequency Trading (HFT).
Volume and Liquidity in Japan
Right now, contagion from Europe and the turmoil from the United States have depressed equity transaction volumes across the globe. Once a recovery starts to gain steam, Asia will be the driver for growth and Japan will be a quality play. Due to the perennial underweighting of Japan, I expect volumes in Japan will quickly surpass pre-crisis levels in such a scenario. With exchange volumes being so low, non-traditional liquidity is playing an increasingly important role. We have seen transaction volumes on our nondisplayed liquidity pool as well as PTS volumes continue to grow relative to exchange volumes. We are trying to bring the benefits of crossing to as many client types as possible and our unique position as a principal domestic investment bank enables us to access semi- to non-professional liquidity sources, such as corporate and religious entities, educational endowments, quasipublic institutions, agricultural cooperatives, and retail investors.
Role of PTSs in Japan
The role of PTSs has increased steadily since the start of this year and has accounted for as high as 7-8% of market share. The success of SBI Japannext and Chi-X Japan PTS shows that the market is rewarding innovation and efficiency that is created as a result of increased openness and competition. Conversely, the closing of Kabu.com shows that a PTS’s revenue model may not be sustainable over an extended period of low trading volume. Therefore it is critical for participants to carefully evaluate the viability of a venue so that the large upfront technology investments are not wasted.
The implementation of centralized clearing through JSCC was critical for the existing PTSs to rapidly and dramatically expand their share in 2011. However, since August, growth has slowed somewhat along with the rest of the market. Having said that, there are still very good reasons to expect future growth in PTS market share. Both PTSs are working aggressively to on-board new participants and Chi-X has recently announced the introduction of liquidity rebates in Japan. Chi-X have a successful record of growing their market share in Europe with liquidity rebates, and such economic incentives are sure to be strong drivers for growth in Japan as well. In fact, it should open the door for a totally new class of venue fee arbitrageurs to trade Japanese equities. Furthermore, domestic institutions are expected to allow smart order routing to PTSs once regulations are amended to exempt PTSs from the 5% TOB rule.
On-boarding of retail clients remains an issue for PTSs as over half of the retail client base is trading on margin. The parent company of SBI Japannext also operates an online brokerage and have started to offer SOR to their PTS for their online retail client base this year. The Tokyo Stock Exchange (TSE) and Osaka Securities Exchange (OSE) merger is a sign of a mature market that is fighting for relevance against an evershrinking domestic economy that has been overtaken by China. The merger will technically create a larger single exchange for Japan, but there is no reason to expect meaningful growth in volumes or listings as a result of the union per se. Rather, it is imperative for the regulators to ensure that the new monolithic exchange does not unfairly squeeze out competition from alternative venues.
Dark Pools and HFT
Average dark pool crossing rates have increased across the board in 2011. This is a clear indication that more liquidity is available on dark pools as a result of broader acceptance by the buy-side trading desks in Japan as well as Asia. Although HFT and dark pools have not received the same backlash in Japan (as there have been no comparable cases to the US flash crash, breaches in client trust exemplified by Pipeline, or concerns over information leakage expressed towards Chi-X Europe and BA TS), it will be necessary to keep a close watch on the regulatory climate in response to the proposed regulatory changes to crossing networks outlined in MIFID II. Since the TSE and OSE have invested heavily in a bid to attract HFT liquidity, it would be contradictory for the regulators to reverse course and take a hard
line against HFT and dark pools at this point. A hard-line stance will be viewed as anti-competitive and derail the efforts by the regulators and exchanges to make the Japanese market more attractive. In the final analysis, the ultimate cost will be borne by investors in the form of increased transaction costs if the efficiencies are not realized and liquidity continues to dwindle.
Domestic Differentiators
Dark pools are attractive since clients can find liquidity in such names without disclosing their hand to the broader market. Therefore, one of the major differentiators is the ability of the broker to source liquidity in names that are typically illiquid on the exchange. The ability for a broker to source such liquidity will depend largely on its access to the wider class of non-professional institutional investors and retail clients. On the other hand, for liquid names, the differentiators are the matching ratio, the amount of price-improvement relative to the exchange, and lack of alpha leakage.