A complex game of hide and seek

As asset managers lead the charge into Asia, buy-side traders are left grappling with the dual challenge of finding liquidity and disguising their intentions in markets that are not geared to accommodate large institutional orders.

Ben Dyson

Given the choice of the latest ‘covert’ algorithm designed to slice up an order or the means to trade a block of shares, most buy-side traders in Asia may well opt for the latter. “Time and time again, head traders would tell me: ‘These algorithms are good, but if you could find me a way to trade a block of stock you are going to add a lot more value’,” recalls David Klinger, head of Asia ex- Japan at Liquidnet, and a former head of AES Asia- Pacific at Credit Suisse.

Difficulties dealing in size are common. “For big institutional players or anyone who is trying to move large volumes of stock or implement a very aggressive investment call, Asia is a difficult place to find liquidity,” says Gabriel Butler, director of sales and trading at ITG in Hong Kong.

Consistently finding liquidity in Asia’s disparate markets has always been a challenge for traders. In a Tabb Group report, ‘Global equity trading: the buy-side perspective from connectivity to TCR’, published in February 2006, some 60% of Asian respondents cited finding liquidity as a major problem. The study may be almost two years old, but pinning down sufficient liquidity remains the overriding concern of traders. “It is a big issue,” says Klinger. “You speak to some traders and they have orders that sit on their blotter for weeks or months because they just can’t find the liquidity to sell it.”

 “The liquidity curve is certainly different in Asia,” says Matt McKeith, head of equity dealing, First State Investments in Hong Kong. Whereas liquidity in largecap stocks can be plentiful, even allowing a $100 million order to be traded over the course of the day, the lack of market depth soon becomes apparent once traders start dealing in mid-cap stocks. Liquidity simply “peters out,” says McKeith.

The issue does not equate to market cap alone. Traders can find themselves swimming in shallow waters, trading names with high market cap that are disproportionately low in turnover.

The lack of liquidity in Asia can sometimes be overstated, according to Andrew Freyre-Sanders, head of algorithmic trading at JPMorgan Securities (Asia- Pacific). “There has been plenty of liquidity over the past couple of years,” he notes. However, he concedes that certain features and regulations make trading difficult, which in turn could dampen liquidity. “The reality is that spreads are high, volatility is high, and the liquidity has a habit of vanishing,” he observes. “There are microstructures in many Asian markets that can be friction points to getting in and out of stocks, which ultimately will attract cost and reduce liquidity.”

Spreads at fault
Part of the problem is the wide bid/offer spreads in many markets. “The cost of crossing a spread is much higher than in most other markets around the world,” says Klinger, with the average spread in Singapore around 65bps, many of the ‘H’ shares in Hong Kong over 90bps, and Japanese banks in the same range. This makes it relatively expensive to trade compared with other regions around the world, and can put off traders who are unaccustomed to paying such high transaction costs.

In contrast, traders in the US have seen average spreads fall over the past five years from around 125bps to 38bps. In Asia – outside of Japan – transaction costs are generally within an 80bps to 90bps band, according to TCA data from ITG. “It costs more than twice as much to implement an order in Asia compared to the US, and obviously those costs bal- loon when the order sizes grow,” says Butler at ITG.

In Hong Kong there has been a phased reduction in minimum trading spreads. In July 2005, Hong Kong Exchanges and Clearing (HKEx) reduced the minimum spreads for all shares priced above HK$30. At the time, this change affected 29 stocks. This was followed in July 2006 with a spread reduction for securities trading between HK$2 and HK$10. HKEx is not the only exchange to see the value in narrowing spreads. The Singapore Exchange plans to reduce minimum bid sizes for securities priced above S$3 in January 2008.

Exchanges may be happy to make some changes to narrow spreads and improve liquidity, but it seems they can only go so far. In February 2007, the HKEx announced it would not be going ahead with the final stage of its spread-narrowing project – the reduction of spreads for securities trading between HK$0.25 and HK$2. In a statement, HKEx said it chose to abandon the plans following a review of market data for the first six months after the previous spread change in July 2006, and in response to comments it received from the market.

Visible differences
When asked whether information leakage caused him to lose sleep at night, Mark Mobius, president of the Templeton Emerging Markets Fund, famously told The TRADE, “No”, because if it did he would never get any sleep. “We see evidence of information leakage every time we trade,” says McKeith. “This is an issue that many players in the region will be looking to the exchanges and the regulators to tighten up on, because it is a real problem,” he adds.

Concealing a trade on the public order book, essential for large institutional orders, is a big challenge. In Hong Kong and Korea, for example, brokers’ identification codes are displayed alongside trades in the central order book.

The most extreme example is in Korea, where visible to everybody – even retail investors – the cumulative buy and sell volumes for a broker in a stock are displayed. This makes it possible to rank brokers by trading volumes in a particular stock over a day or a month, explains Freyre- Sanders. As a result, institutional orders are open to detection. These orders tend to be the preserve of the large global brokers, with the smaller regional firms handling retail orders. When people see the ID codes for big names such as Goldman Sachs, Merrill Lynch, Credit Suisse or JPMorgan appear on the public order book, it is often fair to assume they are trading on behalf of an institution.

No trade remains secret for long. “The only way to get set in a decent line of stock is by giving an order to a broker and sending out an indication of interest,” says Klinger. “But the moment you do that you are effectively advertising the fact that you are large in a name to the whole community. Because it is a pretty small community, if there is a big order out there in a stock, it gets around very quickly.”

Front-running
Market visibility gives retail investors the opportunity to jump in front of institutional orders, ensuring a cheap price for themselves but resulting in an increased price for the retail order when it is executed. “A huge amount of front-running goes on in the market,” says Klinger. “There is very high retail participation [in many markets] and a lot of the retail investors make their money out of front-running institutional-size orders.”

The prominence of retail investors presents other challenges. In many Asian markets outside Japan, retail trades can make up as much as 50-60% of total volume. In these markets, available liquidity is hostage to retail investor sentiment.

While liquidity is generally easy to come by, comments a trader at one specialist Asia fund, particularly given current bullish sentiment, this can change quickly in retail-dominated markets. “Even though Asia has developed and the markets have become bigger, the retail segment is still a significant provider of liquidity,” he says. “This means that liquidity can be far less longterm and more flighty than institutional money, which works on different time horizons and with different parameters.”

Market depth
Work is underway to deepen the liquidity pools in many markets and remove some of the obstacles to trading. Since November, Liquidnet’s buy-side crossing network has been available in five markets – Japan, Hong Kong, Singapore, Korea and Australia.

Liquidnet’s business model appears to have found favour with some members of the buy-side, who believe the firm will improve access to liquidity. “We certainly favour Liquidnet as a buy-side to buy-side transaction system, and we believe genuinely that that is potentially a source of greater liquidity,” says McKeith at First State Investments. “Liquidnet’s system has an advantage because it scans the order blotters of buy-side houses, so it is scanning for latent liquidity that wants to be in the market but isn’t advertised.”

A number of the large global brokers, such as Credit Suisse and Morgan Stanley, now offer access to their non-displayed liquidity and crossing engines in Asia – and several more plan to. Some are trying to make access to their dark pools and crossing networks easier. In May 2007, Credit Suisse and Instinet agreed to provide access to each other’s dark pools of liquidity – Crossfinder and CBX respectively – in Japan. Instinet also operates JapanCrossing, a three-times-a-day crossing engine that does not have to report to the Tokyo Stock Exchange.

“Dark liquidity has a tremendous role to play,” says Butler at ITG. “Over the next year or two we should see an increase in volumes at these venues.” Liquidity is also being boosted as a direct result of the growing global interest in trading Asian stocks.

Hong Kong in particular is benefiting from the flow of foreign investment thanks to its links with China. “There is a lot of interest in investing in China, where it is difficult to get money into,” says Butler. “There are a lot of shares of Chinese companies listed in Hong Kong, so there has been a knock-on effect of people riding the China wave in Hong Kong.” Hong Kong is also benefiting from a growing number of firms wanting to float on its stock exchange. “Listings have been going through the roof in Hong Kong. This has drawn a lot of interest,” says Butler. This, combined with mounting interest in Chinese stocks, has had a positive impact. “Volume is up. Liquidity has improved,” he states.

Liquidity is becoming easier to find, according to Larry Tabb, CEO of research and advisory firm Tabb Group. “The markets are getting deeper and more interesting. The more people there are in the markets, the easier it is to trade,” he observes. “Markets are also becoming more electronic, so that makes liquidity easier to access and gives the buyside, and the sell-side for that matter, more control over execution.”

Are we there yet?
Despite an improving scenario, there is a sense that there is still some way to go before access to liquidity is easy enough to satisfy all market participants. While acknowledging that the markets have become more liquid, Tabb asks: “Are we there yet?” His answer: “No.”

There are a number of changes, some small, that market participants believe could improve access to liquidity. Structures and mechanisms to aid anonymity are high on the ‘wish list’. “The ability to hide your orders on exchanges or even electronic communications networks (ECNs) is pretty much non-existent in most Asian markets,” observes Butler. In what would amount to an “incremental change” – introducing the necessary technology to conceal orders on the main market – the trading environment could be improved substantially, he suggests, in turn having “a dramatic effect on the amount of liquidity in the market.”

The development of offexchange crossing networks could play a major role in helping traders hide orders. McKeith at First State Investments sees scope for alternative trading venues – free from the ID stipulations governing central order books – to offer ‘undisclosed’ access to ID markets.

Others agree that offexchange sources of liquidity could improve trading conditions. “The development of alternative liquidity pools – either multilateral trading facilities, ECNs or alternative trading systems – will start forcing exchanges to open up, as well as creating larger liquidity pools, making it more attractive for global players to become more involved,” says Tabb. But he acknowledges that such changes will not be quick or easy to implement. “To an extent, it will require changes in regulation and market structure,” he adds.

Slowly but surely
There are several reasons why progress could be slow. First, Asia has long been an exchange-driven environment and it seems likely that the established trading venues will fiercely defend their territory, hampering the progress of alternative trading platforms. And while regulators may be looking to make their markets more competitive, they are unlikely to do so at the expense of the existing exchanges. This could make it tough going for firms to set up dark pools and crossing networks, which are likely to divert order flow from the main exchanges.

Even if more dark pools can get off the ground, it is only part of the battle. While Butler at ITG sees dark pools playing a big role in Asia, they face challenges. “The main hurdle is going to be connectivity,” he says. “You have so many different players in so many different markets trying to access liquidity in other markets, and getting them all hooked into these alternative venues is obviously a lot harder than if the exchanges were to provide some enhanced functionality with everyone already linked into them. So it will take some time.”

And although some feel crossing networks and dark pools will help deepen liquidity, there is a certain amount of scepticism about them in the market. Favouring Liquidnet’s ‘buyside only’ approach, McKeith is more critical when it comes to brokercontrolled dark pools. “You have to wonder whose benefit firms are serving by setting these things up, especially when you start having inter-bank agreements linking liquidity pools together.” Buy-side firms stand to benefit from lower commission costs and increased competition, he concedes, but questions remain concerning transparency and how dark pools will be used.

Pressure from outside
While barriers to change remain, pressure to make trading easier continues to mount. The major global investment houses – both buy-side and sell-side – are adding to their presence in Asia. They are bringing with them practices, standards and expectations from the US and Europe. A global broker or asset manager will want to ensure best execution for a client in Asia as much as for a client in the US or Europe, whether regulations demand it or not. “By upping their presence, they are naturally importing global standards,” says McKeith and, almost by default, “fostering change in the mindsets of regulators and exchanges.”