Despite the uncertain outlook for Japanese equity values and volumes, 2010 may yet be seen as a watershed among Tokyo's trading community, says Mark Wheatley, head of electronic trading, Asia Pacific, and head of Japan equities, Bank of America Merrill Lynch (BAML).
The TOPIX index reached a new low for 2010 at the end of August, 804.67, having reached a high of 998.90 on 15 April. On 1 September, the Nikkei 225 blue-chip index fell to 8,796.45, its lowest level since April 2009. Average daily trading value on the Tokyo Stock Exchange (TSE) dropped 5% in August from July's levels. Prospects for a rally before the end of the year are muted, but changes to the trading infrastructure are continuing apace.
The most obvious agent of change has been Arrowhead, the TSE trading platform that went live on 4 January and has so far proved as fast and reliable as the exchange had hoped. Arrowhead has cut the TSE's order response time to five milliseconds and data distribution to three milliseconds; the system has also boosted the exchange's order capacity to 46 million from 28 million previously. Wheatley notes that disappointing trading volumes mean that the system has not been fully stress tested, but says the impact has been significant. While many expected that reduced round trip times would have a beneficial impact on electronic trading volumes, Wheatley points out that Arrowhead has benefited the high-touch trading environment too. “At busy periods, such as the AM and PM market openings and closes, a dealer or sales trader might have had to wait 5-10 seconds between punching the stock code in and getting the market data. The ability to see market depth instantly and trade on it, for example, has had a big positive effect.”
As well as stimulating volumes, part of the rationale for introducing Arrowhead was to fend of competition from faster, technology-led trading venues. Proprietary trading systems (PTSs) still account for barely 1% of volumes, so the TSE may appear to be under little threat. But with Chi-X Japan entering the market in July and PTSs finally permitted to clear via the Japan Securities Clearing Corporation, the incumbent should not rest on its laurels. Wheatley suggests that continued pressure from overseas investors on brokers in Japan to be able to split an order across multiple venues has had a knock-on effect on domestic firms. “The pressure from international accounts to deal only with sell-side firms that can offer them best execution has forced domestic sell-side institutions to come up with new solutions,” he says. “The domestic buy-side, meanwhile, may have been shamed into action by competitors getting better executions through trading on all available venues. In the current macro economic environment it's hard to attract money to Japan, so ensuring you are focused on getting the best execution can be a significant factor in the competition to keep and grow assets.”
This combination of pressures has brought about a change in the trading mindset of Japan's domestic institutional investors, says Wheatley. “Some buy-side firms had shied away from trading on other venues to mask their lack of technology investment and avoid the changes it would entail to their best execution policies. But now a lot of the domestic institutions that previously just wanted to trade on the TSE do want to trade on PTSs and in dark pools. I think we've seen a definitive shift in understanding the different types of liquidity that multiple venues can offer,” he notes.
PTSs could soon receive a further boost to volumes, according to Wheatley, that could cement their place as true competitors to the TSE. Around 10% of all equity trading volumes in Japan are short sales, but PTSs do not currently support the uptick rule imposed by Japan's regulator, the Financial Services Agency (FSA) – which prohibits short selling “at prices no higher than the latest market price” – and so cannot execute this business. The FSA has yet to confirm whether it requires the PTSs to implement the uptick rule in accordance with their own smaller tick sizes and bid-offer spreads or in line with the TSE. If the PTSs are allowed to implement the uptick rule using their own tick sizes, there could be a significant advantage over the TSE and all short sales could potentially migrate to the PTSs.
“If, following the clearing change and the launch of Chi-X Japan, the PTSs' market share collectively rises to 5-10% of total TSE volume, they become very relevant and everyone has to have a solution in place to accommodate them,” says Wheatley. “Otherwise best execution just flies out of the window.”
In days past, the TSE could be relied on to respond slowly to such a competitive threat, but Wheatley believes Arrowhead might represent more than an overhaul of the exchange's technology.
“The TSE could potentially address some of the threat by cutting its bid-offer spread to match the PTSs,” he observes. “It has not been known for reacting quickly to change in the past, but then again it has been making some good long-term strategic decisions in terms of technology and rules changes. You can't say they've got their head in their sand any more.”
But while Arrowhead has stimulated competition between foreign and domestic brokers to supply more effective electronic trading services, some aspects of the Japanese trading environment are proving resistant to change, with low volumes adding to the sense of inertia. Commission sharing agreements (CSAs) are not recognised by the FSA and as such the practice of many Japanese domestic firms sharing business across a large number of brokers has the tendency to support sell-side firms that cannot compete on a best execution basis. With volumes falling, commission rates are rising in some cases in recognition of the need to maintain access to a suite of broker services. In such circumstances it becomes difficult to meet payment obligations to the sell-side and best execution obligations to clients. “Without CSAs, many of the buy-side dealing desks trading in Japan operate to match a broker vote with a best execution overlay. It can clearly be a very difficult balance if half the firms on the broker list simply cannot meet best execution requirements across multiple venues,” says Wheatley.
A change in the regulator's stance on CSAs is unlikely this year, but a sea change in domestic institutions' execution expectations may achieve similar benefits at time when brokers are having to work harder for their money. “In a low-volume environment, sell-side firms are being much more competitive in facilitating client business. If you tell a client, we can do your high touch, but can't do portfolio or electronic, that could be 50-60% of the Japanese or total business you're not going to have a chance of winning from a large global buy-side firm especially if it has a centralised trading desk.”