On the cusp: regional integration in Asia

It’s 2015, the mid-point of the decade and a good time to start looking at major trends in Asian financial services over the next five to ten years. One of the major themes will be regional integration, which is another way of saying the development of cross-border markets. There are at least two important threads here: the ongoing internationalization of China’s currency, and the development of the ASEAN Economic Community (AEC) in Southeast Asia. RMB internalization is really about the loosening of China’s capital controls and its full-fledged integration into the world economy. And everyone seems to want a piece of this action, including near neighbors such as Singapore who are vying with Hong Kong to be the world’s financial gateway to China. The AEC is well on its way to becoming a reality in 2015, with far-reaching trade agreements designed to facilitate cross-border expansion of dozens of services industries, including financial sectors. While AEC is not grabbing global headlines the way China does, we see increasing interest in Southeast Asia among our FSI and technology vendor clients. From Celent’s point of view, both trends will open significant opportunities across financial services. In banking, common payments platforms and cross-border clearing. In capital markets, cross-border trading platforms for listed and even OTC products. In insurance, the continued development of regional markets. Financial institutions will be challenged to create new business models and technology strategies to extract the opportunities offered by regional integration. It’s the mid-point of the decade, and the beginning of something very big.

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 Market structure debate in Asian context

The recent debate about the impact of High Frequency Trading (HFT) and on the issue of market structure in general is no more confined within the US market. Regulators and market participants worldwide are discussing this issue seriously. The chairman of the Australian Securities and Investment Commission (ASIC) recently detailed the position of the Australian authorities in this regard. Incidentally Australia, along with Japan, is one of the few Asian countries that have multiple trading venues, a necessary condition for the growth of advanced trading and order routing capabilities, including HFT. It is worthwhile to look at the state of adoption of the Asian region in terms of adoption of advanced trading tools, and the role of the Asian exchanges in that regard. The different Asian markets are at different levels of maturity, and therefore it is difficult to analyse the region as a single homogenous entity; rather the Asian markets can be grouped into two broad categories. The first category belongs to the advanced economies like Australia, Hong Kong, Japan and Singapore which have well developed capital markets. Exchanges in these countries are at par with western competitors in terms of latency and adoption of advanced trading technologies. The second category consists of exchanges in emerging economies like India, China, Malaysia, Korea which are somewhat lagging their Asian counterparts in the first category. However, there is a common factor that runs across the two categories of exchanges – lack of competition from alternative trading venues. This means that most of the Asian exchanges are largely national monopolies without significant competition from alternative providers, though the situation is slowly changing in some markets (e.g., Australia, Japan). This is one aspect which distinguishes Asia from the western markets where the competition among exchanges and alternative trading venues is severe. Another key challenge in Asia is the fragmentation of markets and lack of harmonization – regulatory, economic, monetary and technological – in trading and settlement practices. This restricts the growth of cross border trading volumes and greater regional integration at an Asian level. The ASEAN initiative is a move in that direction, but it is still early days to judge its potential for achieving regional integration. Asia has also lagged the western markets in terms of adoption of advanced trading tools and technologies (like DMA, algorithmic trading, high frequency trading etc). Some of the Asian exchanges, particularly the ones in the advanced economies, have adopted latest technologies with low latency and colocation offerings, but some of the above mentioned factors still present challenges. For example, lack of multiple trading venues limits arbitrage opportunities. Lack of regional integration means cross border flows have yet to realize its full potential. These prevent growth of trading volumes, need for advanced trading tools and technologies, and participation of foreign players in domestic markets. Regulators in Asia are traditionally very conservative. Therefore decision making for significant changes in market structure and practices takes time. In a rapidly evolving trading world, this means Asian exchanges find hard to stay abreast with global trends. Also because domestic exchanges are perceived more as national utilities, any proposal that threatens the position of incumbent exchanges is met with resistance and difficult to implement. Some of the Asian exchanges have been very aggressive in exploring newer avenues beyond the traditional revenue sources. The Singapore exchange is a good example of that. It started offering clearing services for commodity derivatives through its AsiaClear offering a few years ago. In addition to providing CCP services as mandated for OTC derivatives under the proposed reforms, the SGX is collaborating with the Korea Exchange to develop the latters’ OTC clearing capabilities. Therefore in some markets (like Singapore) the incumbent exchanges are taking a leading role in clearing of OTC derivatives as proposed by new regulations. It will be interesting to see if new players will be able to enter and succeed in this business. Low volumes in the Asian markets, proliferation of CCPs, and competition from international ones may result in each CCP specializing in specific niches along product lines or local currency instruments.

Indian exchanges prepare for greater competition

The Indian capital markets regulator, SEBI, is talking reforms as it recently announced a blueprint that is potentially set to increase competition among exchanges. The regulator’s stance on increasing competition and allowing foreign investment in exchanges was closely anticipated in recent months, especially among large global banks. SEBI had to address pressing concerns on attracting foreign investment (Figure indicates the drastic fall in FII inflows into India in 2011) and failing to keep pace with developments in global capital markets. The new move by SEBI has cleared the way for listing of stock exchanges. This decision comes after an expert committee headed by former Reserve Bank Governor Bimal Jalan submitted its report in 2010 on governance and ownership issues relating to market infrastructure institutions. While SEBI has broadly accepted the recommendations, it has gone ahead with the move to allow public listing of exchanges despite the committee recommending against such a move on ‘conflict of interest’ grounds. The blueprint indicates that public holding of exchanges should be at least 51%, while exchange operator, banks and insurance companies are allowed to hold up to 15%. Foreign investors are allowed to hold up to 5%. Exchange operators, however, would not be allowed to list on their own exchanges. SEBI is watching developments in global capital markets closely. The developed markets in US and Europe are far ahead in terms of maturity of market infrastructure, while India is yet to reach a stage where alternative trading venues can compete with incumbent exchanges. The NSE started in 1994 to compete with the then singly dominant exchange, BSE. But ironically the NSE has today itself become what it set out to defeat, accounting for close to 75% of equity volumes. The attention is on regional exchanges to play more aggressively. With an intention to infuse more competition, the regulator has warned that dormant exchanges that are not attracting liquidity would have to be wound up. SEBI has stipulated a minimum annual trading volume of INR 1000 crores for exchanges to continue operating and the same would be reviewed after 3 years. While we see it as a timely warning bell, it is not enough. We have to wait and see how SEBI looks to empower and encourage regional exchanges. The Delhi Stock Exchange has already woken up to the competition by following in the footsteps of LSE in upgrading its IT infrastructure by partnering with MilleniumIT, a technology player which provides ultra-low latency trading solutions. The debate in ongoing in the case of clearing houses and the regulator is expected to come out with its view soon on having a single clearing house versus introducing interoperability. Although it appears that policy challenges facing SEBI are similar to those faced by regulators in developed markets in the past, and despite indications that SEBI is trying to align with developed markets, we should be careful while concluding that the Indian regulator would eventually follow in the footsteps of US and Europe.

Observations on HFT

High frequency trading (HFT) has been in news recently, especially after the US stock market crash, also called ‘Flash Crash’ of May 6, 2010 which created sudden panic in the market for a few minutes. Many have blamed high frequency traders and rogue algorithms for suddenly pulling out liquidity, reacting to uncertainty in the market. “Quote-stuffing”, a phenomenon where traders place large rapid-fire orders and cancel them immediately, was highly criticized as a major factor. The debate over the impact of high frequency trading on market stability has invited the attention of the regulators, who are currently assessing the impact of HFT on the market microstructure and gathering opinions of industry participants. Academic research investigating the role of HFT has not clearly reached a conclusion on whether HFT is good or bad for the markets, and there are arguments on either sides of the table. Those in favour of HFT say that it adds liquidity to the market, reduces spread and helps in ironing out price inefficiencies. Those taking the counterview say that HFT reduces book depth, it is unfair to market participants who cannot invest heavily in sophisticated technology, and it contributes to increased volatility. Notwithstanding the arguments over curtailing the freedom of HFT traders and asking for mandatory reporting among other measures, HFT as a trading paradigm has evolved during the last five years, with adoption rates constantly going up. Celent estimates that about 55% of all equities volumes are driven by HFT in US, the number is around 35% in Europe and around 5% in Asia, as shown in Figure. The rise of HFT in US and Europe was driven by regulations such as RegATS and RegNMS in US, and MiFID in Europe which spurred greater innovation in technology. Asia is now being touted as the next growth driver for HFT. Asia has taken to the adoption of HFT rather slowly, much of which can be attributed to the regulatory environment. Japan is an exception, however. Celent estimates that the percentage of equities volumes driven by HFT in Japan is around 30%. The reason is increased fragmentation in the Japanese equities market, coupled with adoption of sophisticated technology. Tokyo Stock Exchange’s adoption of high-speed Arrowhead trading system is a case in point. Japan is an interesting case, because the increase in HFT adoption coincides with increasing spreads and increasing volatility. However, this should not be understood as an insight about how HFT will unfold in the rest of Asia. The market for HFT in US is maturing, and Europe is also headed in that direction, which is why investors could look towards Asia and emerging markets for future growth opportunities. Added to this is also the concern about over-regulation in the Western markets. By maturity, we mean the increased standardization in HFT techniques and reduced diversity in trading strategies to capture unique trading opportunities. Trading firms and even trading venues are dealing with this by adopting sophisticated technology which may be cost intensive, such as upgrading hardware and software for achieving the least latency, for instance. This battle to achieve near-zero latency is not a feasible method for winning the market because of the costs involved. Therefore, the strategy for winning the market in the matured Western markets is moving towards “effective trading strategy generation”, and development of proprietary trading strategies which can be implemented with the existing trading and connectivity infrastructure. Japan and Australia are leading the trend in APAC, followed by Singapore, Hong Kong and Taiwan. China and India are important markets for HFT in Asia, but success will depend on how trading firms find their ways in dealing with the regulatory environment in both countries. Last year, China toughened its regulatory stance on speculation on futures exchanges. The exchanges have increased monitoring of “quote-stuffing”, which was mentioned earlier, and keeping a close watch on investors trading between their own accounts. In India, there have been some healthy signs for HFT. Both the BSE and the NSE have installed new co-location centers, and regulators have allowed ‘smart order routing’ paving the way for increased automated trading. Celent estimates that the percentage of cash equities volumes driven by HFT in India is around 5%. Another encouraging sign is the setting up of a cloud model which offers shared IT infrastructure by NSE. This is a boon to smaller players who do not have the capability to invest in private infrastructure. Instead, they can now plug into the infrastructure provided by NSE and get onto the HFT highway by paying a fee for the services availed. Overall, the signs for growth of HFT in India are positive. There is an interesting pattern that is emerging in relation to cross-asset correlations between asset classes over the last five years. Cross-asset correlations, especially in the developed markets have increased at an alarming rate. What this effectively means is that, portfolio diversification and other hedging techniques are way less effective today in protecting from unexpected price movements, than they were five years ago. There is a peculiar relationship between the increase in multi-asset trading and high frequency trading with increase in cross-asset correlations, which is being investigated. Consequently, alpha generating opportunities in the developed markets have dwindled. Despite the heterogeneity in Asian markets and the several challenges such as regulation, cost of borrowing and liquidity, there is more reason for investors to look towards Asia for future growth opportunities in HFT.

Private Equity in India: Poised for growth

The year 2010 was a good one for PE in India. India posted the highest growth rate in PE deal value among all major economies in Asia-Pacific, clocking 111% growth, ahead of China’s 56% growth. The deal activity in India doubled to about US$7.4 billion, compared to US$3.5 billion in 2009. The past decade saw enormous growth in PE investments, which increased from US$1.2 billion in 2000 to US$7.4 billion in 2010, registering a CAGR of 20% during this period. However, the credit crisis of 2008 threatened to stall the growth in deal activity, because the crisis had a clear impact on PE activity in India. Deal values dropped considerably starting Q4, 2008. The lull lasted five quarters before the deal values were restored to pre-crisis levels in Q1 2010. The total deal value in Q1 2011 has shot up to US$3.3 billion from US$1.4 billion in the previous quarter, a 142% rise. With the economy poised to grow at around 9%, and the IMF providing a close growth forecast figure of 8.3% for 2011, investors are upbeat about growth prospects. The year 2011 has clearly begun well, and the deal activity is expected to continue into the next quarters. According to industry estimates, there is US$20 billion of committed, unused capital yet to be deployed in the Indian market, which already makes supply constraint a non-obstacle. The PE landscape in India is highly dynamic, and more often than not, it systematically responds to macroeconomic cues, domestic and global, and indicators such as interest rate and inflation. It is interesting to note that in spite of its dynamic nature, there is a striking characteristic that continues to persist. The average deal size has mostly flickered around US$25 million since 2004. The quarter-on-quarter figures since Q3, 2008, as shown in the Figure, do not show much variation in average deal size. It suggests a mindset that a majority of PE deals target minority positions. Tighter regulation on buying large positions in publicly listed companies could be one factor that is keeping the average deal size low.

Infrastructure was the star sector for PE investments in 2010. The aggregate deal value in infrastructure stood at US$2.3 billion, accounting for 32% of the announced deal value. The power sector is emerging as an attractive segment within infrastructure, with PE funds looking to capitalize on the demand-supply gap. India is currently power starved; industry estimates suggest that the energy availability of 750,000 million units (MU) fell significantly short of the demand of 830,000 MU during 2010. PE firms are chasing investment opportunities as India expands its power generation capacity. Infrastructure is followed by telecommunications, where the aggregate deal value stood at US$823 million. A close third position was taken by the financial services sector, which registered an aggregate deal value of US$820 million. In terms of volumes, technology sector saw the largest number of PE deals. Q4 2010 was particularly favourable to the technology sector, with the total deal value more than trebling when compared to Q4 2009. Technology is expected to continue leading PE deal volumes in 2011 as well. There are several challenges facing the PE industry. The regulatory challenge is foremost, followed by political pressures (especially in infrastructure sector) and volatile macroeconomic factors such as high inflation. The current regulation is particularly unfavourable for picking up large equity (over 15%) in publicly listed companies. Moreover, private equity is not treated as a separate asset class, which makes its treatment under securities and tax laws complex. Lack of meaningful exits was criticized as an impediment, but 2010 has proved it wrong. PE exits in 2010 stood at US$5.3 billion, and the exit volume registered at record high of 120 exits during the year. Strategic sales emerged as an important exit mode, with 26 deals choosing this route. The strong record of exits should boost investor confidence and fuel the next round of growth in 2011. The Indian PE industry is maturing. The attitude of promoters towards PE/VCs is changing, and there is greater recognition of the value that PE/VCs bring to the business. Although obstacles such as divergence on valuation expectations between promoters and investors, a tough regulatory environment, and inflation concerns remain, the fundamentals are intact. The PE industry is set for aggressive growth in 2011.

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.

Financial inclusion in India and micro-insurance, the new buzz word

‘Greater financial inclusion’ figures prominently on the economic development agenda set by the Indian government in recent times. The much-talked-about UID project which aims to provide unique identity numbers to all Indian citizens, and links the number up with a compulsory bank account is indeed a bold step towards realizing that goal. The recent buzz word, however, in discussions on financial inclusion seems to be micro-insurance. The Finance Minister, in his recent address at the Global Insurance Summit, stressed on the need for popularizing micro-insurance in semi-urban and rural areas of the country. The attention on micro-insurance seems to have come at a right time, when the success of several government sponsored welfare schemes for the rural poor in India like the National Rural Employment Guarantee Scheme (NREGS) depends quite a lot on the ability of the financial system to mitigate the risks arising out of unforeseeable natural calamities and other disasters. In this context, the increasing efforts of insurance companies in tapping semi-urban and rural markets are an encouraging sign. Insuring the vast rural population against losses from disasters is indeed a big challenge for the Indian insurance industry, when at the same time it is important to ensure that premiums remain affordable. IRDA, the Indian insurance regulator, has in a recent exposure draft on a standard insurance product suggested that the premiums will be decided by the regulator and insurers might not get any leeway in this regard. The regulator’s goal of promoting financial inclusion is laudable, but greater freedom to insurance companies to design products and price them might be more desirable. The regulator has also proposed that insurers will have to mandatorily offer the standard product. The draft also talks about placing restrictions on selling other products with higher premium and lower benefits. Overall, it could be surmised that the regulator is concerned about insurance agents pushing expensive endowment products to the poor, which is a very valid concern. It would be interesting to monitor developments in this area for the next few months, as IRDA is also considering a proposal to allow cross-selling of micro-insurance products which would essentially provide insurance companies access to the large network of public sector banks for selling their products. The banks would benefit too as it would enable them to enlarge their portfolio of products.

25% Public Float in India : Is the timing right ?

The Securities Contracts (Regulation) Rules (SCRR), 1957 was recently amended to incorporate a minimum 25% public float for all listed companies – private and public. The amendment also applies to listed statutory corporations. Public float is defined as that part of a listed company’s shares that are not held by the promoter. The proposal to push for a 25% public float had been around for some time now, and it has finally seen the light of the day, with the proposal turning into a law with a strong push from the Finance Ministry. There is little doubt about the objectives of the amended law – greater public float creates deeper public markets, making the markets more efficient, thereby reducing the cost of raising funds. However, the crucial question that is being asked now is about the timing of the amendment, and about the time-frame given to companies to comply with the new law. While equity markets all around the world still appear shaky and offer no compelling signs of recovery from the financial crisis, it appears that the amendment is a tad hasty. It is not very convincing that the next 2-3 years is the best time to dilute shareholding, especially given the volatility and the subdued valuations. The criticism is equally about the short time-frame (2-3 years on average) given to the companies to comply. This compliance is estimated to raise money in excess of Rs. 1.6 trillion. Companies might be unable to put the forcefully raised money to any better use. The premise that ‘greater public float results in greater liquidity’ also appears shaky. Higher public float might discourage many companies which are more comfortable with smaller divestment from listing. Also, listed companies which do not want to divest at the moment, might rather prefer to delist than comply with the new law. This might in fact result in lower liquidity. While the objectives of the amendment are noble, and definitely in the right direction towards creating more mature equity markets, the government should have waited for more convincing signs of global economic recovery before making the law.

Electronic and cross-border trading in Asia

I recently participated as a moderator in two panel discussions on the South East Asian markets in the SunGard City Day held in Singapore on 14th July, the topics being electronic trading and cross-border trading respectively. An important point that came out of the discussions was that Asia-Pacific cannot be seen as one market, unlike the European Union. It comprises of various national markets at different stages of development. Japan, Australia, Singapore and Hong Kong are the leading markets in the region. By comparison, markets such as Indonesia, Malaysia and China are lagging behind. The difference can be seen in terms of infrastructure, e.g., the differences in the latency of the exchanges, as well as the number of products that can be traded on them. In the leading markets, the circumstances are becoming more conducive to high-frequency trading and the operation of alternative trading systems, including dark pools. Co-location services are being provided by the exchanges and the regulators are reducing the barriers on off-exchange transactions, such as the limits on the size of transactions and the time limit within which a transaction has to be reported. A crucial factor in the adoption of greater electronic and algorithmic trading will be the willingness of the buy-side to develop the infrastructure for the same. An interesting example that was quoted in the event was that a buy-side trading desk took three months just to fine-tune the latency of their connectivity to the exchange. What this highlights is the fact that while many in the local sell-side and increasingly the buy-side are convinced of the need to have algorithmic trading, it will take time to put the necessary systems in place. Also, the local players are not sure about whether they can afford the level of investment (and the time taken) required to create the trading infrastructure. Hence, the barriers to adoption of technology are more practical than theoretical, unlike earlier. In fact, most of the panelists stressed that there has been a sea-change in the mindset of the domestic market participants in the last 2-3 years and they are much more open to having algorithmic trading and dark pools now. It is further expected that once ADR/GDRs can be traded in these exchanges, the level of algorithmic trading will go up, with the greater presence of exchange-traded funds also playing a similar role. However, the level of off-exchange trading in the next 3-4 years is expected to go up to 5% at the most, up from the current 1% but much below the 30% levels seen in Europe. Cross-border trading in the ASEAN region has picked up in the last few years. Regulation has also paved the way for this, e.g., in Malaysia, regulation has recently allowed up to 30% of the NAV of a firm to be used in trading assets abroad. Even before the recent ASEAN linkage between six countries was announced, cross-border trading was a prevalent phenomenon. The linkage is expected to increase the level of electronic trading and also make it cheaper and more efficient. The next step should be to develop the post-trading infrastructure and linkages between the central securities depositories.