Asian markets are evolving quickly as many electronic trading initiatives unfold. Asia is now the new frontier for developments in technology and innovations. With the launches of Chi-East, Arrowhead and SGX Reach, markets in Singapore, Japan and the rest of Asia are anticipating revolutionary changes in high frequency cross-border trading, together with the increasing popularity and prevalence of dark pools and algorithmic trading. Technology will play a vital role in this evolution, but regulation also has an important part to play.

Asian markets are evolving quickly as many electronic trading initiatives unfold. Asia is now the new frontier for developments in technology and innovations, building on (and learning from) the successes and mistakes of mature financial markets in the United States and Europe. With the launches of Chi-East, Arrowhead and SGX Reach, markets in Singapore, Japan and the rest of Asia are anticipating revolutionary changes in high frequency cross-border trading, together with the increasing popularity and prevalence of dark pools and algorithmic trading. Technology will play a vital role in this evolution, but regulation also has an important part to play, to ensure transparency, uniformity and propriety. However, finding a balance between a firm hand and efficient free markets will be difficult, as will the unifying of the disparate and unevenly developed financial domains in Asia.

Anshuman Jaswal, Senior Analyst, Celent, noted that various factors need to be in place first before high frequency trading (HFT) can be effective, including a comfort level of usage when it comes to direct market access (DMA). There must also be greater post-trade transparency, especially with co-location, which has become increasingly important in Asian markets of late.

He said: “It’s not just sufficient to have technology in place. Regulation is also very important. We need to see major regulatory change, like MiFID in Europe, to change the way the market works and reduce the issues and problems we have, with regard to cross-border trading, for example.’’

Dark pools
The popularity of dark pools is a key contributing factor to the push towards new e-trading initiatives. One of the main success factors of dark pools has come from the fragmentation of liquidity that has diminished the average trade size executed on the exchanges.

Ned Philips, CEO of Chi-East, said: “The main point of dark pools is that they lessen market impact. So if you are going to trade loads of stock, you can use a dark pool to minimise impact and bring liquidity to the market. This is especially important in Asian markets where liquidity can be a major issue.’’

Dark pools came about because of a general dissatisfaction with lit-book exchange markets, where the operating model has benefited hedge funds and high frequency traders, at the expense of traditional institutional investors. The fear of numerous traditional buy-side firms, that they were likely to be victims of predatory trading from the algorithmic trading engine of hedge funds when trading large orders on the exchange, was reinforced by the launch of hosting services by exchanges, which could favour latency arbitrage.

Said Anshuman: “Numerous buy-side firms in Europe relied on the algos provided by their brokers with little customization, and were confronted with counterparts that had a much more sophisticated approach to program trading enabling them to take advantage of the predictability of the trading strategies used by traditional buy-side firms.’’

Ned Philips pointed out that, while not everybody may understand how a dark pool, a lit pool or an algo works, they all aim to reduce cost across the markets, increase efficiency and lower latency.

He added: “So these new developments, such as Reach and Chi-East, are very much driven by straightforward and simple concepts we can all appreciate. Exchanges themselves have seen competition and, obviously, have to react in their own ways, whether by upgrading their infrastructure or partnering with technology firms.’’

Regulatory issues
In order to support an HFT environment, a unified regulatory framework is needed. Anshuman drew the example of the US Securities Exchange Commission’s recommendations for the HFT market as a likely model for Asia.

The SEC’s recommendations included mandating that market centres place additional responsibilities on certain market makers, such as mandatory quote activities or restrictions on the number of cancelled orders. It also called for more transparent post-trade reporting of activity on dark pools and more stringent risk controls for the provisioning of sponsored access, as well as requiring co-location services to be offered more transparently to the marketplace.

“We expect a refinement of the current system to increase transparency, with some additional responsibilities placed on market participants, but not truly a wholesale restructuring of the market,’’ said Anshuman, adding that not all Asian markets will have these factors taken into account. “Different markets will be at different stages of development. There is no one solution in terms of HFT. We have to understand the markets themselves.’’

Philips agreed: “It is slightly more difficult in Asia. Europe and America is one market, with one currency and one settlement cycle. It is quite a homogenous market. Asia has a range of different markets, in terms of clearing and settlement. What we will see in Asia is a market-by-market acceptance in different ways, for example, Japan with Arrowhead, Singapore with Reach. But it all boils down to the same basics, really, of bringing more liquidity.’’

With regard to Singapore, Ng Kin Yee, SVP of the Operations and Technology Group at SGX, noted that regulators are working closely with the exchanges to foster a positive relationship, despite their differing views. He stressed the importance of a regulator that is enlightened because the market is very rapidly evolving on compressed timescales, with new products and technologies.

“Regulators must be aware that market forces and innovations need to be supported, allowing changes to happen while guarding against significant negative effects. Someone mentioned that a regulator’s role is that of the person at a party who takes away the punch bowl before things get out of hand. I guess there’s an element of that, but we also must have some innovation and freedom for the market to develop,’’ he added.

Technology matters
Technology is evolving so quickly that peripheral support systems sometimes cannot keep up. TK Yap, Executive Director at OCBC Securities, said the different levels of infrastructure development in various Asian countries can pose problems, particularly for network issues.

“One has to consider whether local telcos can provide a reliable network with the right amount of uptime. One may talk of latency, but one should also look at whether that latency is stable. There are a lot of markets where latency is not stable. Sometimes it works and sometimes it doesn’t.’’

He added that these are huge obstacles to HFT, which need to be resolved quickly. “With some of the connections in some of these markets, we are seeing telco systems at a level where Singapore was six or seven years ago.’’

Ng said that exchanges are already bracing themselves for the “wave of changes’’ happening in Europe and shifting swiftly to Asia. “All exchanges and traders will have to operate very differently by looking at latencies shifting from seconds all the way to microseconds. This requires totally different infrastructure, different capabilities, different software and networks. We have to look at servers that can perform and fine-tune them to levels of bare-metal efficiencies.’’

He noted that Singapore has already decided to move from the middle to the head of the pack by launching a microsecond latency engine, which would help attract HFT liquidity providers to the Singapore securities and derivatives markets.

“Whether it’s efficiency of code, network infrastructure or how you trade in terms of your algorithms coming into play, the slightest variation can make a difference. We are talking about latencies in which a difference in milliseconds can change your revenue profile from one trader to another trader. All this is game-changing.’’

Yap also noted, however, that changes also can be made in more mundane ways. “We have one client with an arbitrage desk who took about three months to fine-tune his latency across the whole chain – from his keyboard to his exchange. There are lots of things you can tweak, like different hubs and applications, the way lines are connected, by changing versions you have already installed. And each time there can be a measurable improvement in latency.

“We also have situations where we tell people if they want to hit the close of a market, to send orders at least two seconds before the close. Otherwise they risk not having a print. We tell them this is the twilight zone: if they send an order later than this, they’re on their own, and there’s no guarantee they can make the trade. But if they follow our advice on timing, they can get in before the gate closes. So sometimes there are these other aspects that are not very technical, but it all boils down to finding out what works and what doesn’t, and then sharing it with other people.’’

Ultimately, though, all agreed that ensuring stable latency was of crucial importance. Said Philips: “The key drivers in Asia are not so different, even if we don’t necessarily want to increase speed – some institutions prefer long-term value of buying something and holding it for a year. But there is a large and growing part of the market that sees low latency and the addition of liquidity as important.’’

Implications and challenges
With greater computing power and databases, low-cost storage, high-efficiency servers, low-latency technologies, messaging protocols, and the rise of open source, what are the implications going forward?
Once HFT strategies are enabled, more US and European firms will locate their hardware and software applications closer to the exchange matching engines in Tokyo and Singapore, said Anshuman. Similarly, these firms may move to be physically closer to other exchanges in Asia, which will make co-location more important, even though he does not see the growth trajectory in Asia accelerating to the levels seen in the US and Western Europe.

Ng noted that co-location could solve the problem of unreliable telco lines, but a lot of other considerations also need to be met to attract high frequency traders. And these will have cost implications. “You must have monitoring capabilities before moving into new infrastructure and technology like fabric networks. Provide incentive schemes to attract HFT players., but then you need the ability to supervise a higher flow of traffic and have a better surveillance of the market in terms of pre-execution checks. A lot of investment needs to be put in, in order to line all the ducks in a row. And you must be able to launch all these activities before you can attract the high frequency traders.’’

“And you have to give them high predictability and a very reliable infrastructure so they can do what they do best, which is execute algorithms in a predictable way, to enjoy the liquidity that is brought to the market.’’
Yap also cautioned that a lot can go wrong when there are market makers, citing the example of prop shops doing European ETS trades. So, trading can be done in Singapore but priced elsewhere. He also noted that a lot of prop shops are not financial institutions these days, adding to counterparty risk. “These people need to trade huge volumes at very small spreads, so they need to book huge trades through you. Now, how do you take that large trade of $100m a day when the client doesn’t have an S&P rating because he is not a financial institution? You go through certain clearing houses, which then come with limitations as they have to work through brokers, and it all becomes very expensive”.

“We can address these issues slowly, bit by bit, but I feel we are far from resolving them.’’

In the US, there have been downside risks as a result of HFT, which Asia would do well to bear in mind. These include short-term volatility and price fluctuations, over-aggressive algorithm selection due to potential raised volatility, and increased implementation shortfall costs.

In Europe, Philips noted, MiFID2 is now being discussed. “When MiFID came out, the results were not exactly what they were supposed to be. As with any regulation, there are always ways to improve and enhance it. It will be interesting to see how things develop.’’

With regulatory scrutiny set to intensify through 2010 whilst volumes and execution speeds continue to increase, financial institutions, clearing houses and exchanges are under pressure to deliver a more timely, transparent and operationally efficient post-trade landscape. However, realizing these imperatives is no easy task, given the inherent difficulties of achieving real-time position monitoring and true end-to-end straight-through processing (STP) for derivatives. SunGard recently concluded Clearing Panel in Singapore where industry experts discussed the ongoing challenges that confront market participants in the post-trade derivatives processing environment.

Moderator:
Steve Edge, Principal, Asia Etrading.com

Panelists:
Todd Keenan, UBS, Director, Regional Head of ETD Operations
Emma Larkham, Morgan Stanley, Executive Director, Asia Regional Head of Listed Derivatives Operations
Thomas McMahon, Singapore Mercantile Exchange, Chief Executive Officer
Philip Joslin, Eurex Group, Head of Representative Office in Singapore

There are three key challenges in the post-trade derivatives and processing environment: regulations, transparency and efficiency. All three are crucial in the face of a fast-evolving trading landscape, especially in Asia, which saw 6.8 billion contracts traded in 2009, not including over-the-counter trades (OTCs). What were small markets 10 years ago are now global leaders. Also, with an increasing number of new contract types and product innovations on derivatives exchanges, there is perhaps a need for OTC standardization. Infrastructure upgrade is also vital so that all parties can keep up with the rapid changes.

Regulations
Asia has always been a highly regulated protectionist environment, but it is slowly opening up, said Edge. For example, the Singapore Exchange and Chi-X Global have joined forces to create ChiEast, the first multi-regional dark venue in Asia, and the Singapore Mercantile Exchange has been given a licence to operate directly against the Singapore Commodity Exchange. Australia and Japan have also mandated exchange competition. In terms of evolving a trial regulatory framework, Asia has the added advantage of observing and learning from the problems and successes of the West – for example, the European Union’s Markets in Financial Instruments Directive (MiFID). MiFID, Edge added, would be the “Holy Grail’’ for Asia, even though he acknowledged that it is still a long way away from happening.

Said Thomas McMahon, Chief Executive Officer of the Singapore Mercantile Exchange: “Singapore enjoys a very good regulatory environment. The Monetary Authority of Singapore is very forward- thinking in its ability to change. The greater question is the impact of Washington and coordination with the United States. But ultimately, the regulations will be beneficial as long as there is a concept of building a universal front across Asia, and not silos.’’

He also struck a note of caution against the standardization of products: “It’s easy to say you can stuff all the OTCs in one bag. But OTCs are unique and that’s why they’ve never been in one bag. While customization has inherent risks, trying to make them all standardized is not easy. You can do that maybe with energy products. But it’s difficult with financial products. So this needs a step-by-step approach and not a reactionary process.’’

Emma Larkham, Morgan Stanley’s Executive Director, Asia Regional Head of Listed Derivatives Operations, said that her firm was already seeing more interest from clients in OTCs, and it is working with other exchanges to observe disparate solutions. “So even while regulations are still being deliberated and a decision probably would not be made till end of 2011 or in 2012, we anticipate a rapid uptake once it does happen, so we need to be give our clients a heads-up and be prepared to support it.’’

Transparency
Risk management and visibility of risk dominate priorities in the post-trade environment, said Edge, citing how Lehman Brothers traded on a Friday and went bankrupt over the weekend, leaving clearing houses on the hook. “No one wants this to happen again. So there is a need to deliver transparency in real time or, at the very least, intra-day.’’

Risk implications needs to be understood at any given moment in time. One also needs to manage sheer volumes effectively to allow them to work more nimbly. Liquidity has to be found when needed, in order to mitigate risk, he added.

Philip Joslin, Eurex Group, Head of Representative Office in Singapore, said his company has come up with an Enhanced Risk Solution which provides margin statements to clients every 10 minutes. “This is so they can drill down more effectively into positions, which is vital to business and clients. The more data they have, the more control they have over their internal systems.’’

As for the impact of a CCP for OTCs, Larkham felt this would be a positive thing, from a risk perspective. “As a clearing broker, we are keen to see clients manage their risks. In terms of members of the CCP, however, we would recommend that they should be people who have a deep understanding of OTCs and capital derivatives in terms of actual clearing numbers. They need to be able to manage and handle default situations.’’
She also expressed a hope that OTCs will use existing trade tools available in the market to get trade information, so as to minimise risks intra-day.

However, McMahon cautioned that a concentration of risk was something to be wary of. “A clearing house can be too large. There is nothing wrong with having separate clearing venues. Asia has a 1000-year legacy in commodities trading, but for the most part, they have existed as silos. Japanese exchanges dealt in Japanese products, for example. In recent years, China and India have re-emerged rapidly but they too are largely closed markets. The issue here is to benchmark the trades, to shift risk, pricing and clearing – not to fragment centres – to Asia. There are a lot of business models that can be extended to Asia.’’

Todd Keenan, UBS, Director, Regional Head of ETD Operations, said however, that he saw commodities and OTCs as more of a growth area of the future. “Our bread and butter are still index futures and we see that market increasing there.’’

Efficiency
Edge said that straight-through processing (STP) is the goal when it comes to achieving efficiency, which, in a post trade environment, is a challenge. Some 2/3 of trade risk is borne by the back office, he noted. However, one of the hurdles to achieving true STP is that there is no messaging standard implemented across markets. “The businesses using STP are using different messaging standards. The issue of intraoperability between service providers has not been effectively explored.’’

Larkham said: “We are all very batch-driven, looking at batch processing overnight. It is currently quite difficult to see and capture which clients are making their positions intra-day.’’ She added that her company is trying to function more in real time, by giving real time statements and real time calculations around margins. “That’s going to be fundamental platform change from where we are today. Risk managers need to have tools to see what’s going on day to day. It’s still a manual process at the moment so that’s definitely a challenge.’’

The benefits of STP are many, according to Edge. These include a short settlement cycle and turnaround time; increased transparency; reduction in operational risks and errors; and faster data capturing, processing and report generation.’

However, initial challenges exist. Larkham pointed out that some work still needs to be done, particularly around margins and methodology around standards.

Keenan agreed: “We have tools in place but we have clients in Asia that have very specific demands. They expect perfection but they may not be willing to use the tools they have so we need to get them onto the tools that are already in place.’’

South-east Asian (SEA) investors are increasingly looking to trade across multiple markets, driving the need for an efficient cross-border trading infrastructure. How far has the region progressed in the creation of this seamless regional trading environment? Regulations differ from one country to another, national exchanges are working on integrating processes and platforms, and market participants need to upgrade systems to offer multi-venue trading capability to their clients. Leading experts from SEA exchanges, SunGard and the brokerage community discussed key industry initiatives, and how technology will help deliver efficient cross-border trading platforms.

Moderator:
Anshuman Jaswal, Senior Analyst, Celent

Panelists:
Azura Azman, Head, Equities Broking, RHB Investment Bank
Adikin Basirun, Director of Technology, Indonesia Stock Exchange
Daniel Lee, Business Director, DBS Vickers Securities
J.J Lim, CIO, Bursa Malaysia Berhad

Fragmentation
In Europe, MiFID and cross-border trading has driven the fragmentation of the cash equity market. The market is crowded with electronic execution venues. Numerous business model of trading venues have emerged. The dark pool phenomenon is gaining significant traction.

Said Jaswal: “The competitive environment created by MiFID has also led to a significant decrease of direct transaction costs, but these are currently outweighed by indirect cost increases, driven by side effects such as market fragmentation and lack of transparency.‘’

However, Daniel Lee, Business Director at DBS Vickers Securities, pointed out that Asian markets are not as fragmented as those overseas, especially when one talks about transparency from pre- and post-trade perspectives: pre-trade, referring to whether the price one is getting is the best possible, and post-trade to whether what was actually done at trade level was guaranteed as the best solution. “That is a summary of MiFID’s definition of transparency in trading,’’ he said.

“In those markets, you can have several quotations for the same stock, so you do not know whether the price you are seeing is the best price possible. But in this market, what you are seeing is through exchanges. We don’t have multiple markets, with the exception of some degree of dark liquidity and some degree of off-market crossing.’’ In general, he added, Asian markets are less “sophisticated’’ and therefore, do not have the same problems as those in Europe and the United States.

Nonetheless, Jaswal says Celent expects a gradual but steady evolution in market structure and fragmentation. There will be limited disruption in the first two to three years, gradually increasing over five years. As new entrants gain market share, incumbent exchanges will benefit from an overall rise in trading volumes – by as much as 15% to 20% a year, primarily driven by economic fundamentals and high-velocity traders.
Lee added that what could happen is an evolution in SEA towards multiple listings of the same security on multiple exchanges, as is the case in Europe, leading to different pricings.

“The big difference is that, in Europe, to access that security, you are supported by the same set of regulations. But in this part of the world, I think the technology has got ahead of the regulation. In terms of regulations here, it’s very much like pre-MiFID, back in 1993 in Europe. It wasn’t till 2004 that Europe did away with the concept of whole state vs home state, leading to a harmonization of regulation. That is something I hope to see eventually in ASEAN.’’

Said Adikin Basirun, Director of Technology at the Indonesia Stock Exchange: “What’s important is that, in looking for opportunities and efficiency, there must be transparency and an understanding, should there be a dispute, on how to resolve it.’’

Rising Interest in Asia for e-Trading
Azura Azman, Head of Equities Broking at RHB Investment Bank, said: “e-trading in Malaysia is very new. Our clients ask for it and we, as brokers, meet their requirements by putting in the infrastructure. There is also interest now in multiple markets from our local institutions, so the demand for information for overseas markets has risen. Retailers are also very interested in overseas markets because they see that they can make money in the United States where volatility is more than in Malaysia.

“Because of these demands, we are looking into providing multi-market platforms for our clients, to provide efficiency and market data. While it’s still very new to Malaysia, I think a lot of brokers are now looking into this.’’

Lee agreed: “I think we are going to see a lot more foreign trades going in electronically. Now, with effective dissemination of information, people do not feel they lack information relative to their competitors elsewhere. A guy sitting in Malaysia will not feel he has less information than someone in Singapore.

He noted that cross-border trading was already happening in the 1990s. “I was trading in foreign markets with a phone. But obviously, volumes then were not so high. Today, a retail investor can access all the information he needs, thanks to technology.’’

Costs and other obstacles
Fragmented post-trade infrastructures require more intermediaries to settle cross-border transactions, which increases post-trade costs dramatically. However, the implementation of technology is also a major cost factor.

Said Azura: “Putting in an electronic platform is expensive. Brokers will ask which comes first: revenue or spending on infrastructure? So that’s a difficult decision for some of the brokers in Malaysia, especially since volumes and revenues have come down. But I think some foreign brokers are actually offering cheaper alternatives to local brokers to access multiple markets. That could be an opportunity for our local brokers to make multi-market offerings to their clients.‘’

JJ Lim, CIO at Bursa Malaysia Berhad, also noted the challenge brokers face in volumes not being high enough to justify investment. This leads to a lot of transactions being done manually.
“This then requires a harmonization of rules, especially when it comes to the repository. This harmonization will evolve but the order of importance seems to be first trading and then post-trade. We might want to look at fast-tracking the area of post-trade, as it’s a significant factor.’’

Post-trade infrastructure initiatives
ASEAN countries are building an order routing link to allow trading through a single access point for issues by the stock exchanges of Singapore, Malaysia, Thailand, Indonesia, and the Philippines. The ASEAN Trading Link Initiative also plans to link the clearing houses of the five ASEAN countries, enabling their clearing houses to act as central counterparties that can clear and settle cross-border trades among them.

Said Adikin: “The ASEAN linkage initiative is a part of the commitment from our Finance Minister to have more cooperation between Asian countries by end 2015. We already have cross-border trading initiated by brokers from one to another place. But with this initiative, one aims to bring up the gross order trading to the exchange level.’’

He also expressed the intention to make ASEAN securities an attractive asset class for foreign investors, especially those from the US and Europe. “If these investors look at each ASEAN country individually, they may find it is too small for them. But if we can join together as one asset class, it might be much more interesting for them. There should be a joint effort to promote ASEAN as one region that offers better opportunities to the European and US investor.’’

Anshuman also noted that the Singapore Exchange is putting in place new post-trade systems for equities and derivatives while Japan will be launching off-exchange clearing in July 2010 by JASDEC – a revolutionary step in the region to facilitate more alternative liquidity venues and growth in PTS volumes.

But as these developments take place and the world starts taking more interest in Asia, there is a need for a unified regulatory framework. All agreed that this would be a long time coming.

Said Adikin: “That challenge will take time. The EU took a long time. I think we will take a longer time. We can learn a lot from them.’’

Lim added : “A professor from MIT once noted the difference between the US and EU and Asia and China. He pointed out that America is a union of states, and the European Union is a union of countries. Asia is very far from that. So we are now just only talking about whether we can adopt this model at ASEAN level. The fact that we are trying to come together as a whole to discuss regulation is a good step forward. But I can’t see this happening for at least another five years.’’