Asia’s Alternatives

In many respects, Asia has been following the U.S. and European lead on matters of market structure and regulation as Asian laws and technologies steadily edge closer to the world standards developed elsewhere. With the recent spate of memorandums of understanding among Asian exchanges, not to mention those between these regional markets and others in the West, Asia may be following a similar path of exchange consolidation as well.
According to Neil Katkov, a Tokyo-based analyst with research firm Celent, the exchange consolidation trend is truly global, and understandably extending to Asia. “There is a competitive need to stay ahead of the game in the global exchange market,” he says.

It looks to some experts like a game of musical chairs, with the player standing alone at the end seen as the loser. “This is very much a network business,” says Benn Steil, director of international economics at the Council on Foreign Relations in New York. “The larger you are, the more money you make, and the more people trading on the platform, the more benefit for the traders. If you don’t achieve a large size, you’re at a competitive disadvantage.”

But there are rules of the U.S. and European exchange game that don’t apply in Asia. For one thing, U.S. exchanges operate with a single legal framework, a common language and currency. Europe, though not entirely unified on the euro, has a far more manageable currency structure than Asia and has coalesced on a common legal framework that is continuously bringing more countries into the fold. In addition, English has become the de facto language of the securities industry, which makes it compatible with the U.S. but not with all Asian markets.

Thomas Kloet, a former CEO of the Singapore Exchange who is now senior executive vice president and COO of Fimat USA, a U.S. brokerage unit of Societe Generale, sees Asia as by far the most complicated area for a cross-continental exchange merger. Besides the currency, language and jurisdictional inconsistencies, he says, stock exchanges are matters of national pride.

The Tokyo Stock Exchange (TSE), notes Celent’s Katkov, is “marginalized by design. Its strategy is to maintain itself as a single important market. I don’t think it’s interested in a regional merger.”

In Hong Kong too there is a strong nationalist orientation. The board of the stock exchange is appointed by the Hong Kong government, says Simon Luk, partner and head of the Hong Kong practice of Heller Ehrman, which is headquartered in San Francisco. “It is unlikely that a government-appointed board of the Stock Exchange of Hong Kong will offer itself up for sale and engage in merger activities,” he says.

Intra-country Action First

The result, experts say, is that while cross-border exchange consolidation may come to Asia within a generation, the near term is more likely to see consolidation within countries, arm’s length exchange linkages rather than full mergers, and the rise of alternative trading systems (ATSs).

Japanese regulators have already set in motion a merger of TSE with three smaller commodities exchanges there. In-country mergers could result in economies of scale, operational efficiencies and increased liquidity. They also avoid having to deal with the complexities of cross-border tie-ups, while also strengthening the merging markets for when those bigger deals begin to take place.

In Asia, according to analyst Bob McDowall of Needham, Mass.-based research firm TowerGroup, the cross-border-deal risks include integration, branding, culture and regulatory conflict.

“It is in everybody’s ultimate interest to cooperate and move toward an integrated global securities trading system,” says Raj Aggarwal, Sullivan professor of international business and finance and dean of the College of Business Administration of the University of Akron in Ohio. “The operative word here is ultimate,’ as there are numerous obstacles to be overcome before we get there–if ever.” He predicts that Asia will move toward consolidation only haltingly, and in stages.
“Foreign markets tend to follow developments in U.S. market structure and regulation, and Asia will likely follow suit,” says veteran securities industry attorney Paul Merolla, a partner of LeClair Ryan and leader of its New York office. However, longer geographic distances and different cultures will slow the rate at which Asian exchanges consolidate, he says. “Accordingly, more alternative or electronic trading platforms, like the private trading system in Japan, will develop in the Asian markets,” he notes.

According to William Cline, managing partner of New York-based financial industry consulting firm Acai Solutions, Asian exchanges will face the same competition from alternative trading networks for order flow and liquidity as U.S. exchanges already do. “Super fast electronic order and execution management systems and smart routing were innovations created outside of traditional exchanges,” he says. “And the well-publicized trading system challenges at [Asia-Pacific] exchanges such as the TSE suggest there is room for improvement and innovation in IT and market structure there as well.” Added Cline, “This fragmentation of liquidity and competition for order flow … represents a real challenge to the traditional exchange as a large, centralized hub of liquidity.”

This summer, Australia will see the launch of an electronic communications network (ECN) called AXE, operated by the New Zealand Exchange (NZX). “There has been solid progress on the AXE ECN Australian market license application,” NZX said in an April 27 statement. The launch is expected in late June or early July.

Meanwhile, two prominent New York-based ATS operators, Liquidnet and Nomura Holdings subsidiary Instinet, have big plans for Asia.

Nick McDonald, head of Asian equities for Instinet, says the company has had a presence in Asia since the mid-1990s: It opened a Hong Kong office in 1994, Tokyo in 1995. Instinet received its Japanese proprietary trading system license in 2002. Now, the agency brokerage plans to set up a crossing system in South Korea. It just opened an office in Singapore, is working on a direct market link to India, and is keeping a close eye on Australia.
“We are just about to get our remote membership to the Australian Stock Exchange and looking closely at what happens there,” McDonald says. “We’re happy to see the AXE group push their ECN through the regulatory channels.”

Cost Motivation

Among the factors driving ATSs in Asia, McDonald says, are high spreads set by the exchanges, expensive brokerage commissions, the bundling of trade execution and research, and the fact that buy-side firms are reluctant to place large orders on the exchanges for fear of moving the markets.

For Instinet, which has introduced in Europe the Chi-X trading system, a new matching system that is similar in pricing and technology approach to Instinet’s former Inet ECN, “if there is a need for a pan-Asian crossing network, we would certainly look at dong something like that,” McDonald says. “At Instinet, we see ourselves as a solution provider–giving better access to clients to the exchange, creating the alternative trading platforms.”

In Japan, Instinet acts as a broker that passes client trades on to exchanges. It can also match, or cross, trades within its own order book, either on a real-time basis or at three fixed times during the day. Its order book is transparent to clients but not visible to outsiders. Instinet has 3 percent of the Japanese order flow. In Hong Kong it’s up to 1 percent “on a good day,” McDonald says.

“At the moment, in Japan, there are no alternative trading systems,” says McDonald. “In Japan, you’re just starting to get dark liquidity pools operated by various brokers.” Instinet has really started to take off in Japan during the last year, he says.

Technology problems at TSE added some urgency for traders looking to alternatives to traditional trading channels. “In Japan at the moment, the [Tokyo] exchange is suffering very badly from latency and bad legacy systems,” McDonald says. “TSE is going to invest $500 million and only start talking about this issue and addressing this issue in 2009.” By then, there will be a lot of ECNs around, he predicts.

Instinet may be helped by the fact that its parent, Nomura Holdings, owns Japan’s largest brokerage, and its $1.2 billion acquisition of Instinet in February is a sign that Japan is starting to take ATSs seriously. “We’re leveraging that relationship to help promote Instinet,” McDonald says.

However, most Japanese clients of Instinet aren’t taking advantage of the platform’s crossing system, using it mostly as a low-cost broker to execute orders on the exchanges, McDonald says. He adds that comparing the Japanese financial markets to those of the more-developed U.S. “is like comparing a bullet train and the steam engine. [The Japanese] have a lot of catching up to do.”

Liquidnet, the anonymous block-trading venue for the buy side, is taking that U.S.-proven approach to Asia. “That’s been a very successful model for us, and we’re in the process of rolling that model out in the Asian market,” says David Klinger, Hong Kong-based managing director for Liquidnet Asia.

Klinger said that Liquidnet hopes to go live there this summer. It has more than 100 institutional clients signed up. Most are Asian buy-side firms that have become comfortable using Liquidnet through their offices in the U.S. and Europe. Forty percent are U.S. and European institutions with a presence in Asia.

The company plans to be in five Asian countries–Japan, Hong Kong, Australia, Singapore and South Korea–and has received regulatory approval in Japan. “Because our model is a little different,” says Klinger, “and there aren’t any other alternative trading systems in the region, the regulators are taking a little longer to figure out how the model fits into the regulations.”

Article originally appeared in Securities Industry News, which has since closed down.