Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
Asia-PacificApril 6 2009

Asian exchanges resist shake-up

The global financial crisis has highlighted weaknesses in equity market structures. The markets must reform if they are to attract long-term institutional liquidity. Writer Michelle Price
Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
John Fildes, managing director of Instinet, Pacific

Reservations at Yung Kee Restaurant, central Hong Kong's most popular lunch-time haunt, must normally be made two to three weeks in advance. But in recent months, the restaurant has been half full. As with Asia at large, Hong Kong has not escaped the clutches of the crisis. Hopes that the region, buoyed by the double-digit expansion of its industrial production base and a rising consumables-hungry middle class, might evade the global slump have been shattered. The news in March that China's February exports plunged by 25.7% have exposed the absurdity of these hopes.

Yet only two years ago, many regarded Asia as economically infallible. Between late 2003 and early 2008, many global long-only asset managers, sovereign wealth funds and hedge funds piled into the region – in particular to Hong Kong, Australia, Singapore and Japan. Between 2002 and 2007, the total value of hedge fund assets invested in Asia more than tripled, says Hedge Fund Research. Meanwhile, net equity inflows into a number of Asian economies continued steadily into summer 2007, according to Bloomberg, and hovered on average at about $12bn per month.

This liquidity surge prompted Asian trading volumes to soar. Between 2003 and 2007, the Hong Kong Stock Exchange (HKEx) saw its average daily cash turnover swell by more than 800%. As Eric Yip, head of the cash market department at HKEx, notes jubilantly: "In Hong Kong, we have developed beyond our imagination."

Much of this exuberance was rational. The performance of Asian equity portfolios spoke for themselves. According to US fund data provider Lipper, the performance gap between Europe and Asia for 2007 made Asian stocks highly attractive. On average, a fund invested in Asia returned a dazzling 37.7% over the year compared with a European performance of 11.6%. Even as net equity inflows began to reverse in January and February 2008, major international funds managers could be heard loudly rhapsodising that Asia was the only place to invest. Then the crisis struck. "Now everything has reversed," says one nervous head of equities at a global broker dealer. "Emerging markets mandates are dead," he observes soberly, estimating that liquidity allocated from abroad has been slashed by about 50%.

Many funds and brokerages have shut up shop and returned to Europe and the US, causing outflows to soar. During the fourth quarter of 2008, Asia-focused hedge funds declined by $16bn in assets under management, says Hedge Fund Research. The first week of March alone saw Asia (excluding Japan) equity funds withdraw some $1.09bn from the region, crowning a five-month-long retreat.

In the trading rooms, times are tough. Trading volumes have plummeted, with the average daily cash turnover of the HKEx falling 33% between the end of 2008 and January 2009. And this is better than most. Between its peak in October 2007 and the end of February 2009, the MSCI Asia-Pacific Index has dropped by 56%: the region is haemorrhageing equity.

Systemic challenges

Yet alarming as this sudden outflow is, it says almost as much about the systemic challenges facing the structure of Asia's equity markets as it does the global economy. For one thing, low liquidity is nothing new: home-grown institutional liquidity in Asia has long been in short supply. By most institutional brokers' estimates, only about a quarter of the flow they handle originates in Asia.

More problematic, however, is the predominance of the retail investor: amateur day-trading is a way of life in Asia, accounting for some 70% of liquidity across the region. This makes for sensitive markets that are both highly volatile and prone to sharp declines, says Pierre Rousseau, chief executive of BNP Paribas Securities Asia. Bad news obliterates retail flow at lightning speed, causing liquidity to evaporate.

Even in the most buoyant times, however, it is not unusual for a broker to fail to execute a client trade in certain stocks. This is not a function of poor infrastructure, however. As Gavin Williamson, head of equity execution, Asia-Pacific at HSBC, notes: "Asia is actually much further up the curve than anyone thinks it is, in terms of the infrastructure in place."

Asian diversity

Rather, the obstacles to institutional trading relate to the strong localisation of Asia's markets, regulatory idiosyncrasies and extensive bureaucracy. "Every single one of the markets in Asia presents a different challenge to effective electronic trading and most have adopted fundamentally different structures to their market counterparts in Europe," says Ian Smith, advanced execution services (AES) Asia product head at Credit Suisse. This broad diversity requires AES to be heavily customised for each market, he adds.

As such, it is not only expensive to access liquidity in Asia but the mechanisms by which liquidity is generated are highly constrained. Anonymity is major case in point. In Europe and the US, the rise of dark liquidity and anonymous order types has made trading more efficient. Anonymity also attracts incremental orders that buy-side clients would otherwise not have placed, adding further liquidity to the market, argues one major broker.

Many Asian markets, however, require the broker's name to be listed next to the bid or offer. Only in Hong Kong, Japan and South Korea are brokers permitted to operate internal crossing networks that allow them to match their own order flow. Most other markets restrict off-exchange matches to extremely large trades, meaning orders that would be executed off-exchange in Europe or the US are forced into the order book.

Even in a liquid market, such visibility vastly restricts the speed, success and efficiency of execution, proving costly for the investor. Research from agency broker ITG suggests, however, that the deepened market impact of trades executed in the volatile fourth quarter of 2008 dramatically increased the real cost of trading – a cost that would almost certainly be mitigated by greater anonymity. International brokers are working hard to persuade local regulators to relax restrictions on off-book activity. The latter remain extremely suspicious of anonymity, however, regarding it, to some extent, as a cynical attempt to conceal devious trading activity. But this complaint obscures more commercial concerns.

To reduce market impact, institutional brokers will sometimes execute large orders through local retail brokers, who are also used as alternative sources of liquidity and connectivity. By allowing greater anonymity and dark pools, market regulators would undermine the profitability of many local brokers. The issue of anonymity – like that of market access – underlines the extent to which exchanges and regulators tend to protect the interest of local players.

"One of the biggest problems Asian stock markets face is parochialism and protectionism," says John Fildes, managing director of Instinet, Pacific.

As the HKEx's Mr Yip explains, the protection of local exchanges and their local participants is regarded as prudent economic policy. "I quite strongly believe that an exchange is a unique business and it usually serves a home market in the Asia context," he says. "The exchange is viewed as a strategic asset of the economy."

Conflict of interests

It is precisely this idea that constrains the development of the Asian markets, argue many. The situation is not helped by an inherent conflict of interests that characterises the majority of Asian regulatory regimes: the regulator, exchanges and the government are all intertwined, says Philip Barnes, head of sales at trading technology provider Fidessa. "This can put a bit of a stranglehold on evolution," he adds.

Nowhere has this stranglehold been more clearly exposed than in Australia, where a number of European and US upstarts have sought to shake up the status quo and compete with the Australian Stock Exchange (ASX). European success story Chi-X, US block dark pool Liquidnet and AXE, a joint venture of the New Zealand Stock Exchange and five other banks, have all filed applications for trading licences. ITG already operates in Australia, matching trades once a day, but the latest round of contenders are effectively looking to overthrow the prevailing market structure.

They have their work cut out. Exchange fees in Asia are relatively low, meaning new venues will not be able to compete on explicit costs. BNP Paribas' Mr Rousseau also believes that low liquidity will constrain the success of new venues. In both the US and Europe, however, multiple venues have undoubtedly served to increase institutional liquidity market-wide and tighten spreads, thereby reducing implicit trading costs. The London Stock Exchange, for example, has experienced a steady rise in volumes since the emergence of competitive venues.

Robert Rooks, chief administration officer at Chi-X Asia, argues that venues such as Chi-X will offer Asian members new order types and methods of interacting with liquidity. Historically, faster venues have also attracted speed-sensitive institutional liquidity providers, such as Chicago headquartered powerhouse GETCO, which would not otherwise have been able to trade. Both buy and sell-side support for the new platform has accordingly been "huge", he adds.

Fifteen months on, however, and Chi-X and its peers are no nearer to gaining a licence. Because many of the upstart trading models technically infringe the prevailing regulatory trading rules, the Australian government has been forced to undertake a wholesale review of its regulatory regime. Despite the strong links between exchanges, governments and regulators in Asia, Mr Rooks says the Australian regulator and government have been supportive of Chi-X's application. "We are naturally frustrated but the government has been very open with us and has been very supportive. ASX is a very different matter; it is in it for profit and shareholders, it is not necessarily beneficial for the investor and as a monopoly it can charge what it likes."

Public policy

The ASX denies it is anti-competitive and maintains that the licence application is a matter of public policy. In a written statement, the exchange said: "ASX does not seek to have entry denied to potential new operators of trading venues that maintain or improve market quality and preserve market integrity. The issue for ASX has been about what needs to go in the legislative framework that would be necessary to achieve this and what market models are inconsistent with this objective and therefore should not be permitted." Mr Rooks believes Chi-X and other competitors will eventually be granted licences to trade in the Australian market. But the crisis, in so much as it provides an expedient tool with which to fend off structural change, is serving to slow the process.

AXE is less optimistic than Chi-X. Despite the significant investment made in the project, its shareholders voted to wind down the project in October 2008. But AXE has not given up entirely, says Edwin Budding, general counsel at AXE. "AXE continues to lobby the government to make a positive announcement in support of competition as soon as possible.

"Prompt action by the government would be consistent with its publicly stated goal of developing policies to establish Australia as a regional financial services hub," he adds.

Open marketplace

Besides Japan, which enjoys some competition in the form of proprietary crossing networks, Australia is regarded as the most open and electronic marketplace in Asia. For this reason, it represents something of a battleground in the fight to build out the region's market infrastructure. Market-making funds and statistical arbitrage players are present in Asia and very aggressive in certain markets, but Paul Egan, regional head of intermediaries at Citi, believes there are several major players sitting on the sidelines waiting for liquidity to grow before they enter.

GETCO, a backer of Chi-X, is one of these players, says another source. The introduction of competitive venues suited to its models would boost badly needed institutional liquidity. As such, everyone is keeping a watchful eye on the Australian market.

Back in Hong Kong, Mr Yip is acutely aware of the transformative powers of such players: at the HKEx, they already contribute a chunk of liquidity in both the cash and derivatives markets, he says. But in the cash business, a hefty stamp duty imposed on the exchange by the Chinese government prevents more such players from trading on the exchange. This levy is unlikely to be lifted any time soon, he notes.

In this regard, reflects HSBC's Mr Williamson, the aspirations of many Asian market operators are conflicted. "Markets want international investment and to be more efficient and create new products, but they are scared of fully opening up."

Asean initiative

There is some progress, however. Late February saw the Association of South-east Asian Nations (ASEAN) announce the creation of a direct market access e-trading link to the Malaysia, Indonesia, Singapore, Thailand and Philippines stock exchanges. In a move designed to attract more international funds to the region over the long-term, the exchanges plan to create a single point of access from which members will be able to trade listed securities cross-border.

Speaking at the time of the announcement, Thailand's finance minister Korn Chatikavanij said that the link-up, due to go live next year, would provide the "starting point" from which to achieve ASEAN's "2015 vision of a more integrated ASEAN capital market, with harmonised rules, regulations and practices".

Exchanges in other Asian markets are also invited to join the scheme. But scepticism abounds. Mr Yip strongly believes that good intentions will not be enough to free up the flow of liquidity across Asia.

"One principle that I observe from the US and European experience is that almost without exception regulation has to come first. There must be some kind of uniform direction from a regulatory side in order to talk about any form of [Asian] integration," he says. "I don't see the driver to come together. The idea of synchronisation and opening up of borders is almost unthinkable in this part of the world," he adds.

Furthermore, one major head of equities at an international broker believes the unfolding crisis has relegated the ASEAN initiative "to the back burner". Regulatory focus has reverted to local issues, he says, and the pressure for market reform has abated. If this proves to be the case, the Asian markets will struggle to restore historical levels of equity for several years to come.

Was this article helpful?

Thank you for your feedback!