Japan’s costs of trading have gone up this year, despite spreads narrowing. The answer may be down to tick size changes, and whilst it is not 100% certain, the clarity is improving.
The first tick changes took place in Japan’s markets in January, and a second round took place in July. The reduction in tick sizes has helped the Tokyo stock exchange recoup market share from proprietary trading systems. The narrowing of tick sizes in more liquid securities was an important reason to trade away from the exchange.
Effective spreads have fallen throughout this period and continued their downtrend in the third quarter of 2014. Over one year there has been a significant move downwards in Japanese spreads from 22 to 14 basis points.
However, as evidenced by the corresponding increase in average institutional trading costs during the same period, the narrower spreads are also having an effect on overall liquidity and cost. There has been no real improvement to Japanese liquidity. The existing liquidity in the book has been more fragmented and the average trade size has dropped significantly.
Japanese costs at 45 bps in the second and third quarter have dropped relative to Q1 when they stood at 50 bps, but costs are nevertheless high relative to the long term average, which used to be in the high thirties and low forties.
The change in tick sizes appears to be the main contributing factor, seemingly making it more expensive to trade institutional size orders. Institutional investors need to go deeper into the book to find liquidity and pay higher spreads, experiencing less liquidity available at each tick increment.
The narrower spread may benefit the execution of small orders and the tick sizes appear to be beneficial for the retail investor.
“I see two forces battling here: the narrower spreads should overall reduce transaction costs, but as a result of the fragmentation of liquidity in the book there is more signalling taking place which has the reverse affect and increases transaction costs,” said Ofir Gefen, managing director of ITG in Hong Kong. “There is more complex analysis that can be done here – to figure which force is winning.”
A market microstructure report sent out by a firm last week, (and was swiftly withdrawn, hence we will refrain from naming the authors), commented that tick sizes were not like party hats, that there is no one size that fits all and that it was a balancing act to find the optimal increment. It concluded that the goal should be optimisation of the quoted spread.