Beyond HFT

Last week I attended the Tokyo Financial Information Summit, put on by Interactive Media. The event was interesting from a number of perspectives. This event focuses on the capital markets; attendees are usually domestic sell side and buy side firms and vendors, including global firms active in Japan. This year there was good representation from around Asia ex-Japan as well; possibly attracted by the new volatility in Japan’s stock market. The new activity in the market was set off by the government’s Abenomics policies aimed at reinvigorating the Japanese economy. But I suspect the fact that Japan’s stock market is traded on an increasingly low latency and fragmented market structure gives some extra juice to the engine. Speaking of high frequency trading, Celent’s presentation at the event pointed out that HFT volumes have fallen from their peak (at the time of the financial crisis) and that HFT revenues have fallen drastically from this peak. In response to this trend, as well as the severe cost pressures in the post-GFC period, cutting-edge firms seeking to maintain profitable trading operations are removing themselves from the low latency arms race. Instead, firms are seeking to maximize the potential of their existing low-latency infrastructures by investing in real-time analytics and other new capabilities to support smarter trading. HFT is not dead, but firms are moving beyond pure horsepower to more nuanced strategies. Interestingly, this theme was echoed by the buy and sell side participants in a panel at the event moderated by my colleague, Celent Senior Analyst Eiichiro Yanagawa. Even though HFT levels in Japan, at around 25 – 35% of trading, have probably not reached their peak, firms are already pulling out of the ultra-low latency arms race–or deciding not to enter it in the first place. The message was that for many firms it is not advisable to enter a race where they are already outgunned. Instead they should focus on smarter trading that may leverage the exchanges’ low latency environment, but rely on the specific capabilities and strategies of a firm and its traders. Looking at this discussion in a global context, it seems interesting and not a little ironic that just as regulators are preparing to strike against HFT, the industry has in some sense already started to move beyond it.

The State of the Indian Capital Market

There are fundamental problems in the Indian capital market structure, such as lack of liquidity and limited depth and breadth. Many listed securities on stock exchanges are not traded; among the traded securities, not many are traded actively. The market is highly concentrated; a few companies dominate trading at the exchanges. This clearly narrows the breadth of the market, giving rise to liquidity problems for many stocks. Geographic breadth is another problem for Indian markets. Around 80% to 90% of total cash trading and 70% to 80% of mutual fund ownership come from the top 10 cities, with the top two cities (Mumbai and Delhi) accounting for about 60% in each segment.. These shortcomings can be addressed by technology development, better regulations, and focus on financial inclusion. India’s capital market regulator, Securities and Exchange Board of India (SEBI), has been addressing many of these issues. Although the equity market in India is relatively well developed, the debt market is lagging by some distance. The debt market is dominated by government securities. The corporate bond market is very small for a number of reasons, including lack of market infrastructure and adequate regulatory framework, low liquidity, lack of investor interest, etc. Efforts are being made to develop the corporate bond market. Some of the measures include increasing the limit for foreign participation, reducing issuance and transaction costs for corporate bonds, applying similar mark to market accounting requirements for loan and corporate bonds to discourage banks from relying heavily on loans, and setting up a basic framework of credit default swaps on corporate bonds in the country. Some positive results have been observed in recent years, but debt market development will require long-term efforts and commitment. By contrast, India has a healthy exchange-traded derivatives market. India started off with trading in derivatives in the early 2000s, initially allowing trading in index futures (2000) and index options (2001). Options and futures on stocks were allowed in 2001. Since then the product universe has expanded, as has the investor base, resulting in higher volumes and a robust trading platform with sound risk management practices. Index futures and options and stocks futures dominate derivative contracts traded at Indian exchanges. The investor segment is broadly classified into retail and institutional segments. The retail segment brings in the volume, but its trades are essentially low value. A key concern has been this segment’s drop in participation in the secondary market and also in IPOs. This decline began with the crisis in 2008, but the lackluster performance of most IPOs has contributed to what has become an alarming drop. Foreign institutional investors (FIIs) have been a dominant contributor to Indian markets. Since economic reforms started in 1991, India has focused on attracting foreign investment flows by relaxing eligibility conditions for FIIs, relaxing investment limits, and expanding investment instruments. The intermediaries in the market include the exchanges and brokerages. India has 22 stock exchanges registered with SEBI, with over 8,000 registered brokers and over 60,000 registered subbrokers. However, most of the trading takes place at the two major pan-Indian exchanges, National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). NSE is the largest exchange in the country, with around 70% of the equity volumes, while BSE is the second largest. A lot of revamp is happening within exchanges as they turn more competitive to gain market share. Brokers, both domestic and international, are competing in a highly fragmented market. The next wave of growth will probably arise out of technological capabilities, and hence brokerages are trying to outdo each other by providing advanced trading tools like Direct Market Access (DMA) support and algorithmic trading solutions. India has been an early adopter of the various technological changes occurring in the capital markets. With electronic trading picking up along with the adoption of the internet, booming retail equity business evolved in the last 10 years. Surprisingly, due to the market boom and IPO bonanza, retail adoption of technology initially outgrew technology adoption on the institutional side, where voice brokers still played a large part. As foreign participation in the Indian markets picked up, it brought in a rigor and technological requirement essential for international competition leading to adoption of the latest technologies by domestic market participants. A key reason for the success of the Indian capital markets has been the efficiency of SEBI, the capital market regulator. Four regulators control the participants in the securities market. There have been turf wars, and the future might see a super-regulator. India has a good regulatory environment regulating the capital markets, which shielded the economy, to some extent, from larger negative impacts of the global financial crisis and helped it regain its mark quickly afterwards. The regulator has been cautious in expanding the market, and transparency and investor protection have always been high on its agenda. This has sometimes created conflicts with industries as well as among regulators, but it has taken the markets along the right path of development.

Putting the best foot forward, by choice

The recent City Day organized by SunGard in Mumbai provided interesting insights into India’s equity trading industry. Mr. Damodaran, ex-head of SEBI, the capital market regulator put India’s liberalization and globalization into perspective by pointing out that often in its recent history India has been forced to take actions that are seen to be desirable in hindsight. In 1990-91, it was the precarious forex reserves situation that forced India to open up its economy. Moving on two decades down the line, one hopes that electronic trading in the form of Direct Market Access (DMA), Smart Order Routing (SOR) and algorithmic trading would be something that our capital markets adopt out of choice and because they see the merit in doing so, as opposed to either being forced to do it, or even worse, not doing it at all and facing the possibility of extinction once the global broker-dealers enter the market in a big way. A trend that usually follows the widespread adoption of electronic trading is the concentration of trading, especially in one financial center across a region. In Europe, London happened to be the center that benefited most from the introduction of these technologies. Similarly, markets such as Japan, Korea, Taiwan, Singapore and Hong Kong are adopting high frequency trading in a big way. India cannot afford to be left behind in this context. The same goes for the leading brokerages in the Indian markets. It takes a trading desk between six months to a year to fine-tune its electronic trading capabilities. The longer the delay in getting the buy-in to do so, the lower the chance of success and indeed survival. The buy-side also has to be decisive and quick in its approach. Moving on to some of the other presentations in the event, there were useful inputs given into the issues that are cropping up in terms of the infrastructure for electronic trading. While NSE has a fast matching engine, the rest of the infrastructure has a long way to go. As pointed out, in Indian centers outside Mumbai the contrast between Indian and international capabilities is even more stark and communication networks have been found lacking. Data quality is also something that brokers, especially the smaller ones are struggling with. In this scenario, it is important that India opens up its markets to globally renowned vendors, while at the same time encouraging its local IT firms to also compete in the market. The Indian market is large enough for a number of firms to participate and be able to meet the various requirements for electronic trading.

Accepting the need for Electronic Trading

In its recent history,the Asian market has been characterized by the adoption of technology in a much more compressed time-frame as compared to its counterparts in the western world. This has been true of the industrial as well as the services sector, where it is also holds true for electronic equity trading. Asia is well poised for a rise in the share of electronic trading in the next few years. Markets such as Japan, Australia, Singapore, Hong Kong and India are seeing a lot of investment happening that is related to Direct Market Access (DMA), Smart Order Routing (SOR) and High Frequency Trading (HFT). The associated infrastructure such as market data services, co-location and so on are also being paid attention to, as is the requirement for helpful regulation. However, in some markets, the regulators are not very confident about and supportive of the needs of greater electronic trading. This is partly because of the financial crisis and rising requirements for risk management, and also due to the flash crashes that have occurred in the NYSE and OSE markets. We expect the regulatory framework to become more flexible in most markets, but there is still an important element that needs to be addressed across the board in the Asia-Pacific. That is the role of smaller brokerages and the buy-side. Unlike larger brokerages, these are still reluctant to adopt electronic trading and to make the investments required to have the same. While attitudes and capabilities do not change overnight, I believe that market investors in Asia need to be made aware of some harsh realities. To start with, the way HFT and algorithmic trading evolved in the US and European markets, there was very little time for market participants to react to and adopt such trading. The change happened so quickly that a number of brokerages and buy-side firms were unable to cope and had to operate in a more constrained fashion or even shut down. The incentive that HFT provides for those trading larger volumes means that the smaller players are at a relative disadvantage. This increases even more if they are slow to react and do not adopt electronic trading. So it is not just the speed of trading that is important to succeed, it is also the speed of thought. Hence, smaller brokerages and buy-side firms in Asia should be more positive and not be afraid of investing in DMA, SOR or HFT. The gains from these might not be apparent immediately, but if the lessons from the western markets teach us anything, it is that the quick and nimble-footed firms were the most successful during the rise of electronic trading. With the trading infrastructure in Asia changing so rapidly, there is little reason to believe things are going to be different here.