Trading Places: Bringing on Stock Market Competitors

May 18, 2010

​The dominance of one of Australia’s longest surviving monopolies will be challenged later this year following the federal government’s decision to allow alternative share trading platforms to compete with the Australian Securities Exchange (ASX) in a bid to promote a more efficient stock market. Despite the ASX’s attempts to stave off competition with claims it may generate market volatility, a provisional licence has been granted to Chi-X Australia, a wholly owned subsidiary of trading platform operator and technology provider, Chi-X Global.

​A full licence will be awarded once the corporate regulator, the Australian Securities and Investments Commission (ASIC), sorts out the rules governing the new entrant. The approval of Chi-X’s application came after extensive talks with both UK and US regulators – and not long after the ASX was substantially stripped of its regulatory and oversight powers, which were transferred to ASIC.

Chi-X, controlled by the Japanese investment bank and securities firm, Nomura, is one of a small group of entrants keen to take on the ASX by creating new platforms for large wholesale trades. Although competition in equities trade execution is new to Australia, alternative trading systems have operated successfully in the US and Europe for several years. In those regions, the end of exchange monopolies has resulted in lower transaction costs and a massive increase in liquidity. New technology has facilitated high frequency trading and further boosted liquidity. These high-frequency traders pursue micro arbitrage – simultaneous buying and selling – opportunities using mathematical models and computers to execute orders in milliseconds.

Australia’s move is part of a global trend in which share trading is shifting away from the world’s long-established exchanges to bank-owned alternative platforms. Increasingly, the banks – the exchanges’ largest customers – resented the high fees paid for trades using inferior technology. Chi-X’s shareholders include banking heavyweights BNP Paribas, Citi, Credit Suisse, Goldman Sachs, Merrill Lynch, Morgan Stanley, Société Générale and UBS. Other contenders for the Australian market include US broker Liquidnet, and AXE, an electronic trading network backed by the New Zealand Exchange. A group of investment banks are adopting a wait-and-see approach to developments, but without first mover status they will need to have superior technology to make it worthwhile. Aspiring entrants were left to cool their heels as the global financial crisis focused attention on the health of the financial markets. And, at the height of the meltdown in 2008, these hopefuls were forced to take a back seat as ASIC dealt with banning, and then restricting, the practice of short selling.

Competition Cuts Costs

​It’s easy to see why Chi-X’s appearance is so welcome in Australia. According to Ronald Gould, Chi-X Asia Pacific’s Hong Kong-based chief executive, the average cost of executing a trade in Australia is almost five times higher than in Europe and North America. ASIC chairman Tony D'Aloisio – whose job is to ensure a level playing field between regulated exchanges and the newcomers – says investors will benefit from the competition due to more choice, better services and cheaper execution costs.

Chi-X offers trading in 14 markets across Europe where it has become the region’s second-largest trading platform by turnover in the 3.5 years since its launch. It has also grown a 13% market share in Canadian local stocks within 18 months. “When we first started in Europe we offered transaction costs for UK stocks that were 80% to 90% less than the London Stock Exchange’s [transaction costs]. This was a huge incentive for market participants to make the switch to an alternative platform,” says Gould. The introduction of new trading venues dramatically boosted liquidity, not least because Chi-X had a system that was faster than incumbent exchanges, such as the London Stock Exchange, and traders could arbitrage the two markets.

Traditional exchanges were forced to follow by cutting prices and upgrading technology. This was not lost on the ASX, whose lobbying to stave off competition in Australia succeeded for a time. Certainly, with more than two years to prepare, the ASX has now launched a system that it claims is as fast as those run by potential competitors. As a result, the opportunity for arbitrage between platforms may be lower in Australia than it is in Europe, although the difference in share prices will always present opportunities for high-frequency traders.

With licences pending in Hong Kong, South Korea and Japan, Chi-X’s plans to be the first truly global exchange seem to be falling into place, notes Michael Aitken, chair of capital markets technologies at the Australian School of Business and chief executive at the Capital Markets Cooperative Research Centre (CMCRC). The centre is backed by the federal government, the New South Wales government, and four Sydney-based universities, including the University of New South Wales. Aitken is also chairman of the SMARTS Group, a technology play emanating from the research centre, which provides real-time surveillance systems to more than 40 national exchange and regulatory bodies across 38 countries. Chi-X may well become the first global platform since the world’s major bourses have the difficulty of overcoming nationalistic tendencies that cause national stock exchanges to be associated with country identities. US exchange group BATS Global, another global contender, is owned by GETCO – arguably, the king of the high frequency trades and biggest market maker in the US stock market – and Credit Suisse, Morgan Stanley, Deutsche Bank and JPMorgan.

Chi-X’s expansion strategy was logical, Gould says. “We started in Europe and, when that proved to have legs, we began thinking about how we would apply our approach elsewhere. Canada gave us a chance to look closely at the US, which is an insanely competitive market, so the question of where to go next wasn’t so hard to answer.” Clearly opportunities lay in the fast-growing economies of the Asia-Pacific region. “Over time we recognised there would be an opportunity to knit those geographies together and create something larger, although that’s something for the future,” Gould says.

Aitken is quick to point out though, that while transaction costs will surely drop in Australia, they will not drop by the same amount as they did in the UK because settlement costs have to be negotiated with the ASX. “As Australia’s only clearing house, the ASX has been forced to deal with Chi-X. But there is a good chance that the ASX will be none too happy about a competitor using its systems, and will charge accordingly,” Aitken says. “If Chi-X succeeds in gaining licences in other Asian markets, its European clearing partner may see more economic benefits to come down this way – and that is when the total trading costs will really set the cat among the pigeons.”

Fears of Dark Pools

While the benefit of lower transaction costs is undeniable. ASIC – with its mandate to ensure markets are fair and efficient – is exploring whether Chi-X could damage market integrity. When a major potential change occurs, such as the arrival of new entrants, it is forced to examine the implications. This means checking that transaction costs come down and that there is no rise in prohibited trading behaviours, including insider trading, market manipulation and front running (where a broker places its own orders ahead of pending client orders). Aitken says: “Fragmentation allows market participants to split their trading across markets and avoid the scrutiny possible when you can only trade in one market. This happened in the UK. There is no coordinating regulatory authority that aggregates data across markets effectively providing cross-market surveillance, so parties intent on hiding insider trading can fly under the radar.”

The Capital Markets Cooperative Research Centre says it has supplied research evidence, consistent with Aitken’s view, to the UK regulator as well as the Committee of European Securities Regulators (CESR). In Australia, ASIC’s new market surveillance system will allow it to monitor all trading systems simultaneously. But that still leaves open issues of how a new market entrant will affect participants’ ability to engage in prohibited trading behaviours.

And, there is the question of how new entrants will affect price discovery – particularly if those new entrants facilitate what are known as “dark pools”. These are caused by the trading of large blocks of shares by off-exchange networks. Dark pools have the potential to suck liquidity from the main market because they reduce the number of share prices seen in the public markets. A major fear is the growth and size of these dark pools will encourage trading strategies that undermine transparency, price discovery and fragment liquidity leaving smaller investors disadvantaged.

“Concerns have been raised about transparency with respect to dark pools, or what are more properly called ‘non-displayed pools,’” says Gould. “A dark pool is simply an opportunity for market participants to match trades anonymously without information leakage until the trade is settled.” He understands the fear that transparency will be reduced, but points out big institutional investors have always had this internal matching opportunity available to them. And he sees that benefit being given to smaller investors. “We believe over time that medium- and smaller-sized brokers will take advantage of pooling and pass some of the benefits to their clients,” Gould says. “That has been our experience in Europe.”

Driving Efficiencies

​According to Martin Fahy, chief executive of the Financial Services Institute of Australasia (FINSIA), low-cost, high-speed, very efficient trading and settlement is imperative if Aussie capital markets are to compete with the rise of algorithmic trading, which now represents about half of all transactions. In the short term, the challenges will be not only how price discovery and quantity discovery will work, but also how the whole system will be supervised. Given the large number of equities traded by superannuation funds, the introduction of alternative trading platforms will create efficiencies in allowing price and quantity matching to take place. “It means large positions can be shifted without the distortions,” Fahy says. “The retail space will be more challenging. But we have had a lot of warning of what is required.”

This theme is taken up by Luke Randell, Citi’s co-head of global markets Australia and New Zealand, who agrees Australia has no choice but to join the technology “arms race” and move into multi-platform trading. "While Australia is leading the region in the adoption of new trading platforms, it lags the developed world, despite the demand from clients,” he says. People worry about volatility market manipulation and the impact of algorithmic trading on retail investors, but these fears have been shown to be groundless in offshore multi-platform trading environments. While heading Citi’s derivatives business in Europe, Randell watched volatility decrease and traded volume increase with the introduction of new exchanges.With the changing nature of trading, sensible regulation and market structure is required to protect investors from unusually large or drastic market moves.

Dark pools and some trading platforms can increase liquidity as they allow clients to trade at a mid price, offer smaller tick sizes (the smallest increment that can be traded) and support large parcels executed as smaller trades. “This leads to more liquidity, less impact and, ultimately, lower volatility,” Randell says. Concerns about the retail investor might be justified – they might be disadvantaged but it depends on the broker and that broker’s access to dark pools and to the various exchange venues. He points to the US where retail brokers align themselves with the big banks that have the technology and deep pockets to execute trades efficiently for their clients. 

New trading platforms have the potential to fragment markets, Randell acknowledges. But he believes regulators will solve this issue. "In Europe, legislation was introduced that requires institutional investors to obtain ‘best execution’. In turn, they require their brokers who are increasingly using smart-order routing to find the best market in which to trade each line of stock. They also provide complete transparency on settlement so the regulator can monitor the operation of the market in real time,” Randell points out. While a multi-platform trading environment is on the cards for the Australian market, everyone is watching to see what ASIC comes up with in terms of regulations.
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