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Hani Shalabi, executive director, Direct Execution – sales, UBS, Hong Kong, assesses the trends most likely to impact trading desks active in Asia in 2008.

In looking at what lies ahead for equity traders in the Asian region in 2008, a number of trends can be seen as an extension or reinforcement of developments witnessed this year.

Algorithms
Algorithms have been growing in popularity across the Asian region in all the markets that allow them. Last year saw an effort by the sellside to hook up more customers. Asia was then predominantly a VWAP area. In 2007, we have observed a shift from VWAP to the more targeted implementation shortfall. This indicates that asset management firms and hedge funds in the region are taking a more active view of their performance. Implementation shortfall forces traders to choose when they think is a good time to buy or sell, whereas VWAP effectively relieves the trader of that responsibility.

While we expect the shift from VWAP to implementation shortfall to continue in 2008, we will also see more clients asking for customisation. This will take two forms: specific algorithms will be fine-tuned for a particular client; and more parameters will become available, although the OMS and EMS vendors will still need to add these to their offering for the clients to benefit from the refinements.

Parameters such as limit, maximum volume percentage, start and end time, and whether to participate in the open or close can generally already be varied. In the US and EU, but not yet in Asian markets, we are seeing the addition of completion price to the list. This is essentially an instruction that says, “I'm happy to do VWAP until a particular price, but if the stock hits that price, finish it.” Once you can make your algorithm understand this new parameter, you then have to go to the vendors that provide connectivity to clients of your algorithmic service and get them to add the appropriate text box into the screen they display for your firm’s algorithmic offering. That may slow take-up in the Asian region in the short term, but will not interrupt the trend.

Internal crossing
The performance of an algorithm generally depends on a number of market structure attributes, primarily spread size, volatility, and depth of shares on each price level. In the case of most Asian markets, these factors combine to introduce queuing as a regular feature of the trading environment.

In some cases, where you're number 500 in line, you will simply not make it to the front of the queue during the trading day. In these conditions, broker-dealers with internal crossing engines become much more attractive.

Regulators are reasonably comfortable with crossing in roughly half the markets in the region. Crossing becomes more difficult in the ID markets where restrictions apply on foreign investor participation. The exact mechanisms to enable crosses involving foreign investors need to be considered. Nevertheless, internal crossing networks can be very effective when the firms operating them have significant two-sided flow across a wide range of stocks. Clients can choose not to participate in a broker’s internal crossing network, but it involves no extra effort on their part to do so. If we and our peers have the other side in our system, we give it to them.

It is on the level of the child orders that this is most useful, whether as a way of ‘jumping’ the queue or where two different algorithmic benchmarks prevent crossing at the parent level. The percentage of each order for which a cross can be manufactured will, we believe, become a differentiator in 2008.

We also expect crossing to be available in more markets. We do not, however, expect the concept of dark pools to gain significant traction in Asian markets in the short term. In the EU, MiFID allows alternative execution venues to add significant value, but in markets such as Hong Kong, where even if you cross you still have to pay the 10bps stamp duty, the incentive to create such alternative venues is reduced.

The role of exchanges
We are more likely to see an evolution in exchange regulations, removing some restrictions and tightening the spreads. We expect exchanges to start feeling increasingly comfortable with internal crossing. Since all trades are still reported to the exchanges, the easier they make it for brokers to internalise orders, the faster orders will be completed and the sooner traders are likely to release a new order into the market. That raises the possibility of additional liquidity with the exchange benefiting from the increased flow.

Broker-dealers are competing with each other to sign up direct execution clients and all that order flow is piped directly onto the order book of the exchange. It is important therefore to foster a spirit of co-operation with the exchanges. If we are looking to maximise immediacy for a client through internalisation, we may in the process commit capital to complete the trade. This in turn creates risk that we may wish to hedge through trades on the exchange. Broker-dealers in that context are effectively the free sales and distribution arm for the exchanges.

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