Liquidity Fragmentation: Is it Asia’s Turn to Go Next?

By Steve Grob

Fragmentation has evolved in the U.S. and Europe, but the diverse Asian markets are likely to forge their own course, as technological advances and regulatory developments make their impact felt around the region, argues Steve Grob, Strategy Director at Fidessa.
Fragmentation of liquidity has completely reshaped the equities trading landscape in the US and in Europe. It changed the roles of market participants forever by breaking the national monopolies of major exchanges and replacing them with a dazzling array of lit and dark venues. At the same time, it has also blurred the previously clear cut distinction between venues, brokers and buy-sides as each jostles for position in the new liquidity workflow. The next generation of winners and losers is now emerging – the trading equivalent of the“haves” and “have nots” – as different market players seek to embrace the challenge of fragmentation and turn it to their advantage.
This article looks at what may happen across Asian markets in terms of fragmentation. There are, of course, many differences between the trading environment across Asia and the more homogonous environments we see in Europe and, particularly, in the US. Top of the list is the fact there is nothing like the regulatory mandate for change in Asia as we have witnessed in the US and in Europe. Nevertheless, a number of isolated “bush fires”have already broken out in the region, and these raise the issue of whether fragmentation will really take hold and how it might spread. And, if it does, how will it be similar (or different) to our experiences in other parts of the globe?
RegNMS and its European cous
RegNMS and its European cousin MiFID were two pieces of legislation that introduced a concept of “best execution” for both retail and institutional investors aimed at providing greater transparency throughout the whole trading life-cycle. This was achieved by dismantling the national monopolies of the existing stock exchanges and fostering the creation of low cost alternative venues that focussed solely on providing markets for secondary trading in equities. Because these new venues were unencumbered by the other operations of stock exchanges (primary listings, trade reporting, supervision, etc.) they were able to operate on a much smaller cost base. These venues also invested in the latest matching technology which operated faster and at lower cost. The net result of this was that ECNs in the US and MTFs in Europe were able to aggressively compete for trading volumes and, in many cases, caught the incumbent exchanges napping. On top of this, they also introduced maker-taker pricing models which rewarded participants for posting passive liquidity and charged traders for removing or aggregating liquidity.
Many of these new venues were backed by the new Electronic Liquidity Providers (ELPs) such as Getco, Citadel, Optiver and Knight. These firms are able to use their technological prowess to benefit from tiny differences in prices and trading fees between the different venues. Such is their dominance that, according to the TABB Group, High Frequency Trading (HFT) of this sort now accounts for nearly 50% of US equities volume and over a third of the trading in Europe.
The large banks and brokers sought to leverage their own crossing networks against this backdrop too, whilst the alternative and primary market centres also jumped at the opportunity to introduce their own “dark pools” into the mix.
US and European stocks now regularly trade across many different lit and dark venues. According to the Fidessa Fragulator (a free global market share analysis tool  – www.fragmentation.fidessa.com), the stocks that comprise the FTSE 100 and DAX indices, for example, trade daily on over 15 different venues. This proliferation of venues has forced the broker community to adopt sophisticated Smart Order-Routing (SOR) technology that can navigate this new landscape and, at the same time, prove to their customers that they are indeed achieving best or at least better execution. This new liquidity flow is shown in the diagram below: Because the changes in the US and Europe have been so profound, it is only natural that market participants are looking at how their considerable investment in this area can be applied in other regions such as Asia.
JAPAN
Of course, broker crossing networks have existed in Asia for some time as have alternative PTSs in Japan such as SBI Japannext and Kabu.com. A number of new initiatives, however, may well cause the rate of Asian fragmentation to accelerate dramatically. First is the introduction of Arrowhead by the Tokyo Stock Exchange (TSE). This is a new generation matching platform that now puts Japan’s primary bourse on a par with other global exchanges in terms of speed. This in turn has opened the door for the ELP/HFT community that was responsible for fanning the flames of fragmentation across the US and Europe in the first place. In July of this year, one of the most successful alternative venue operators, Chi-X, launched its local Japanese operation – Chi-X Japan. The introduction of such a well regarded alternative venue into the domestic Japanese market has become a clarion call to other alternative operators in the region too. This is especially the case, considering that Chi-X Global (unlike its European counterpart) is still majority owned by Japanese banking giants Nomura.
Taken together, these facts mean that the Japanese broker community is now investing in the appropriate SOR technology in order to seek out better execution opportunities. The paradox is that as more and more SOR systems are switched on then the pace of fragmentation fidessa graph.pdf 2010/8/24 11:37:30 AM Taken together, these facts mean that the Japanese broker community is now investing in the appropriate SOR technology in order to seek out better execution opportunities. The paradox is that as more and more SOR systems are switched on then the pace of fragmentation fidessa graph.pdf 2010/8/24 11:37:30 AM Whilst it’s too early to tell exactly what will happen in Japan, it is evident that, perhaps for the first time, a “perfect storm” is gathering that combines a vibrant HFT community, fast enough matching platforms and the widespread deployment of SOR technology. Those Japanese broking firms that can establish their SOR credentials early on in all this will be disappointed then if they don’t ultimately make it into the winner’s enclosure.
AUSTRALIA
 
 
Australia presents a different set of opportunities and challenges. In August 2009, regulatory supervision of financial markets was transferred from the Australian Securities Exchange (ASX),the primary market operator to the Australian Securities & Investments Commission (ASIC). This means that the likelihood of alternative trading venue licences being granted is now almost a certainty. First off the blocks has been Chi-X which aims to go live in Sydney before the end of the year, subject to final approval from ASIC. The response from the incumbent, however, has been equally dramatic. ASX has introduced two new markets – Volumematch (dark pool) and Purematch (low latency) to meet this threat, as well as upgrading many elements of its core operating structure and announcing various fee reductions.
Interestingly though, the competition to ASX may come from some of the larger banks and brokers rather than pure play venues such as Chi-X. This is because the cost of implementing effective SOR technology is high and, in some cases, out of reach for the smaller and medium sized brokers. This allows the large brokers to potentially step in front of ASX by offering their own SOR capabilities to these smaller brokers. These SOR systems, of course, will be configured to benefit the mainstream brokers first by internalising as much order flow as possible and then only routing unmatched “exhaust” flow onto the exchange itself.
SINGAPORE
 
 
 
A third Asian example that has sprung up is the joint venture between Chi-X Global and SGX out of Singapore. The new venture is called Chi-East and represents a dark pool that initially will trade only Singapore stocks but then intends to offer dark order matching on a fully pan-Asian basis. This is an intriguing initiative as it combines the might and distribution of SGX with the nimble footed, low cost capabilities of Chi-X. This fact alone will ensure it will become a relevant venue and, as we are starting to see in Japan, fragmentation only goes in one direction once the SOR technology is in place.
So, despite the lack of any fundamental legislative change, a number of very real fragmentation scenarios are already being played out across Asia. Other initiatives are underway too as the global banks and brokers seek to leverage their huge investment in internalisation, smart routing and best execution in other geographies such as Asia.
But is the end investor actually getting a better deal? The results between the US and Europe have varied but, in both markets, trading costs have fallen in the face of greater competition. Overall volumes have generally increased too as more venues means more opportunities for the HFT players. On the other hand, post-trade processing and transparency have suffered as unbiased, reliable and timely information on which stocks actually trade becomes harder and harder to come by.
With this in mind, it will be fascinating to see if the Asian fragmentation experience provides a better or worse end result for the investment community. Will the free market competition we are seeing across Asia produce a more level playing field than the highly deterministic approach taken by regulators elsewhere?
Only time will provide a true answer to this but, in the meantime, one thing is certain. Market participants in Asia will need to take an increasingly diverse view of equities trading if they are to navigate between all the new venues that are emerging, without a common framework that interprets trading patterns across all these venues, this will be a very hard thing to do.