By Hiroshi Matsubara, Philip Slavin,
According to the World Federation of Exchanges, in December 2008, BATS was the third largest exchange on the planet: larger than Tokyo and London combined. It’s an incredible story for an exchange that no one had heard of three years ago, and which only launched in Europe four months ago.
The rate at which the markets have adopted alternative trading venues, is a vivid illustration of the way the capital markets are changing. The singlemarket environment has disappeared in the US and Europe, with venues like BATS creating a credible alternative to traditional exchanges. As a result, in the US, more than 40 execution venues, including incumbent exchanges as well as the new electronic crossing networks (ECN) and alternative trading Systems (ATS), compete with each other for share of order book trades. The growth of ATSs is such that they now have more than 30 percent of the trading share in US equities.
The story is similar in Europe, following the full implementation of the Markets in Financial Instruments Directive (MiFID) and the abolition of the concentration rules. The combined share of the four multi-lateral trading facilities (MTFs) that are currently operational – Chi-X, Turquoise, Nasdaq OMX and BATS Europe – together account for 16 percent of the trading volume in Europe for large cap stocks.
The state of fragmentation in Japan
Just like algo trading before it, which has moved East from the US to Europe and Asia, market fragmentation will inevitably arrive in Japan. We are already seeing signs of it. Japan’s exchange concentration rule was abolished several years ago, and the move toward diversification of execution venues has started.
As in Europe, fragmentation has to date largely been driven by foreign brokers. Several have already introduced internal crossing services and three block crossing networks are in operation. Whereas those PTSs (an equivalent term in Japan to ECN or MTF), used to be with retail flows only, they are now absorbing institutional prop and agency flows by linking together with leading institutional brokers. Domestic brokers who wish to compete should be prepared to invest now, at least by establishing their own internal markets and smart routing orders between them and the TSE.
However, it is important not to over-state the current levels of development. Although the share of off-the-floor trading taken by alternative execution venues and broker principal bids is gradually increasing and now covers around 7 to 8 percent of total volume, fragmentation is still in its infancy in Japan, as is the adoption of Smart Order Routing.
Indeed, 90 percent of the all transactions of Japanese cash equities take place on the TSE. The Financial Instruments Exchange Act (FIEA), the latest Japanese market regulation which has been in force since September 2007, is mainly focused on retail trading markets and is seen as weak when it comes to defining what is expected from the institutional market participants for achieving best execution. It is perhaps not surprising then that the majority of Tokyo brokers define their best execution policy as “to execute on the Tokyo Stock Exchange. ”Japanese institutional fund sponsors are missing some fund performance with the current status of the Japanese market.
Role of smart order routing
Nonetheless, one result of changes in the market and the role now occupied by PTSs, is that smart order routing(SOR) is beginning to establish a presence in Japan.
The route of a trade is moving, albeit slowly, away from the traditional route from buy-side blotter through a selected brokerage, on to a traditional exchange and then to a clearing house. Where SOR is deployed, the road to execution can be more diverse, as it becomes possible to break up orders, trade them separately on multiple venues and then clear through a variety of competing clearing and settlement regimes. These components then need to be reassembled so as to present a single, unified picture of the original order back to the end customer.
To prepare for this eventuality, some of Tokyo’s leading brokers have already adopted SOR for the Tokyo market, and those that haven’t are investigating their options for introducing it. In fact, the concept of smart order routing is attracting a great deal of interest from buy-sides as well as sell-sides.
In particular, brokers are starting to recognise that they cannot get by without intelligent access to multiple liquidity sources. The ability to probe the most optimal liquidity source dynamically and to route orders intelligently is an added value to their execution services. Differentiation will depend on how smart the router is and where it sits in the value chain.
In doing so, they are following a path that their counterparts in America and Europe have already travelled. Where multiple trading venues are firmly established, SOR is regarded as an essential trading tool for delivering best execution.
Upgrading the system
However, SOR will only truly succeed if the latency within the existing exchanges is improved. Without a low-latency platform a smart order router’s interaction between external exchanges and internal crossing, for example, would not make sense.
The good news is that the incumbent exchanges are in the process of strengthening their trading system infrastructure in order to promote low latency and high data volume. What’s more, forthcoming market milestones such as the launch of Tdex+, TSE’s new trading system for options, in July 2009, as well as Arrowhead, the next-generation trading system for cash equities due in January 2010 should boost the market adoption of SOR. To help matters along, the OSE has also announced it will introduce a next generation trading system, and both the TSE and OSE have announced the introduction of co-location and remote membership schemes.
What is still needed, however, is the right regulatory framework. We believe that the Japanese FSA should try to look again at the adoption and definition of best execution duties, especially for asset managers serving institutional clients. More fundamentally, those institutional fund sponsors, such as pension funds, should raise their awareness of the importance of trading costs among the total fund performance. These will be critical for the creation of more efficient market trading structures and the total uptake of further electronic trading in Japan.
In Europe and the
US, many firms have recognised the absolute need to implement a coherent SOR strategy, and Japanese firms are likely to follow. Whether this is deployed on site or via a third party, the net effect is the same – the computer is now taking a much bigger role in the overall decision-making process of how and where an order gets executed.
Beyond SOR
As we have established, SOR’s role of intelligently breaking up orders and sending them on to different venues is only part of the story. The resulting multiple executions need to be fed all the way through to the back office while still associated with the original order. Each execution will need to reflect the different trading fees and clearing regimes of the venue concerned. Another crucial part of the process is the ability to rewind the tape to see exactly how and why an order was executed. This is central to any best-execution policy, yet is often overlooked by pure-play SOR vendors.
It is essential that firms do not implement SOR systems thinking they will be acquiring a one-stop solution for all the challenges of trading across multiple venues; an SOR system without a complete smart workflow strategy behind it has very limited application. In addition, SOR technology needs to be integrated within the overall workflow, which may combine smart routing, DMA or other forms of sponsored access.
Therefore, SOR must be supported by, and operate in conjunction with, order management, market data, market connectivity, trade management, position keeping and audit trail. Although the marketsthemselves are fragmented, the technology package cannot be: smart trading functions must be tightly integrated into the trading platform.
Eventually, SOR and the other components that are needed for intelligent liquidity access will become embedded as standard features in quality order management systems, in much the same way as advanced trading tools and the ability to handle multiple asset classes have been. This is because SOR is fundamental to the way that trading works in a market place in which multiple venues trade the same stock.
The strong likelihood is that SOR will become the minimum requirement in a package of tools and strategies that are necessary for intelligent liquidity access. Organisations that can successfully combine smart routing across lit and dark liquidity together with real distribution and intelligent workflow will emerge the winners in this new environment.
