Long-awaited competition in the Australian equities market will finally arrive later this year. After a two-year delay caused by the global financial crisis and transformation in the Australian securities regulatory landscape, Chi-X, the alternative trading venue that has had such success in both Canada and Europe, was given approval in principle for its market licence application in March. And providing it can overcome the final hurdle of negotiating access to the country's sole equities clearing and settlement facility, which is operated by the Australian Securities Exchange (ASX), it plans to launch its displayed alternative trading system in October.
Meanwhile, the new Australian market regulator, Australian Securities and Investment Commission (ASIC), has opened the door for foreign clearing and settlement providers to consider setting up in Australia. The regulator published new regulatory guidance in late April, spelling out its processes and conditions for licensing any organisation that wants to compete with the clearing house electronic sub-register system (Chess, the Australian equities clearing and settlement system). This is operated by the ASX Settlement and Transfer Corporation, a wholly owned subsidiary of the incumbent exchange.
A matter of negotiation
But there is a major stumbling block. Amid Chi-X's negotiations with ASX over clearing access, the exchange is requesting A$450,000 ($400,000) annual access fee in the Trade Acceptance Service documentation that ASX unilaterally published in December. According to one source, negotiations on this issue have been tense.
When Australian minister for financial services Chris Bowen announced the in-principle approval for Chi-X's market licence, he said the government would ensure ASX gives access to new operators, but also that access should be available at a reasonable price. And if negotiations were not fruitful he reserved the right to draw on regulatory powers such as the Trade Practices Act to force a resolution.
But the parties involved say this will probably be unnecessary. "In fact, ASX is keen to negotiate commercially with Chi-X, and any other entity that wishes to use ASX's clearing and settlement services," says Matthew Gibbs, corporate relations manager at ASX.
"No government encouragement is needed. We are currently working hard to come to an agreement to provide access to ASX's clearing and settlement facilities. And why wouldn't we? Unlike trade execution, where Chi-X would be a competitor, there is a commercial benefit for ASX in making its clearing and settlement services available to other users."
This is the root of one of the major differences of opinion between the two companies. Chi-X feels that if it is bringing business to ASX it shouldn't be charged a fee for the privilege. When it set up in Europe, it first arranged clearing through the European Multilateral Clearing Facility, a new clearing and settlement joint venture between Fortis and Nasdaq OMX. In Canada, it clears trades through the national clearing organisation CDS Clearing and Depository Services. And in Japan, where Chi-X also plans to begin operations in July, it has secured a clearing arrangement with the Japan Securities Clearing Corporation (JSCC), which is 86% owned by the Tokyo Stock Exchange (TSE).
Chi-X says that in none of these markets is it charged a large annual access fee on top of volume-based pricing. "We approached the JSCC and found it was really interested in engaging with us. It knew competition in trade execution was going to happen," says Ron Gould, CEO of Chi-X Asia-Pacific.
"It said: 'You're going to be an exchange, not a broker. So we'll treat you like an exchange.' The TSE has embraced the prospect of change in a broad way - it knows that it may have less market share, but it will be a much bigger market thanks to competition and innovation."
Mr Gibbs at the ASX says the proposed annual access fee reflects the provision of a commercial service. "It takes into account the costs to ASX of modifying technology systems to develop the service, maintaining it and meeting ongoing service level obligation," he says. "Interestingly, ASX knows of no other example anywhere in the world of a vertically integrated exchange group - offering trading, clearing and settlement services - that is making its clearing and settlement facilities available to a trade execution competitor. That's not to say it shouldn't happen, but rather that there's no existing model to adopt or from which to learn. It's a first."
At the time of writing, negotiations were getting down to finer points and drafting of an agreement, and both sides were optimistic. But if Chi-X cannot agree an access deal with ASX by the end of June, this may affect its ability to launch in October. Furthermore, at present there are no other options available for domestic equities clearing in Australia. This is something that could change in the medium-term, though not soon enough to give Chi-X an alternative in the near future.
Ron Gould, CEO of Chi-X Asia-Pacific
Foreign operators
ASIC has released regulatory guidance (RG211) in anticipation of more clearing and settlement facilities seeking to operate in Australia. It responds in particular to international regulatory developments promoting the use of central counterparty (CCP) clearing and settlement of over-the-counter (OTC) derivative transactions. Some market participants have questioned whether Australia has enough volume in OTC derivatives trading to warrant a CCP clearing and settlement facility. But the regulatory guidance also opens the door to organisations such as the UK's LCH.Clearnet, which may want to establish a domestic equities clearing presence in the Australian market. And as trading volume in Australian equities continues to grow, this would be a much more attractive proposition for a foreign operator.
LCH.Clearnet is already working with Chi-X APAC on its Chi-East dark pool joint venture with the Singapore Exchange, which goes into soft launch in June. Chi-East will offer non-displayed trading in stocks listed in four markets - Singapore, Hong Kong, Japan and Australia.
LCH.Clearnet is providing a multi-market CCP clearing solution in the non-Singapore markets, with Citi acting as LCH's settlement agent, connecting it to the relevant securities depositories.
Mr Gould says the Australian government is right to also promote competition in clearing if it is serious about bringing overall benefits to end investors.
"Our experience in Europe has been that for investors it's extremely good to have competition in clearing and settlement. The reality is that roughly half the benefits of potential cost reduction relate to post trade rather than the trade side, so there's a huge missed opportunity if you don't have any competition," he says. "When we started in Europe we did so with a new clearing house that came in with much lower costs and investors benefited dramatically."
Meanwhile, ASX has not been sitting idly by in the two years since Chi-X and others first applied to operate market licences in Australia. While the regulatory reform process that moved market supervision responsibilities from ASX to ASIC was under way, ASX has been developing new products to respond to the introduction of alternative trading systems.
In November, ASX will operate a new matching engine based on global exchange group Nasdaq OMX's Genium INET technology, upgrading from its current system, also provided by Nasdaq OMX. This will cut latency to an impressive 250 microseconds from the current two to three milliseconds and boost capacity five-fold to exceed 5 million trades and 500 million order book changes per day.
Stephen Zilioli, joint head of Liquidnet Australia
Incumbent fight-back
On top of this, ASX will launch new platforms this year and next for its traditional cash equities business, for high-frequency trading and for block trading. The exchange's VolumeMatch anonymous block trading facility will be the first to go live in July this year before moving onto the new matching engine in November. The new traditional cash equities platform TradeMatch will launch with the new matching engine in November. And PureMatch, a parallel central limit order book aimed at high-frequency traders in the ASX 200's most liquid stocks, will launch in early 2011.
A number of other new order types and a nascent smart order routing service - initially just routing between ASX order books, but potentially external liquidity pools too - are also on the cards at ASX.
Roughly a third of ASX's revenue comes from trade execution, and the bulk of this is not in cash equities. Nonetheless, to protect its position the ASX has designed these new products to closely match Chi-X's own business model and services. When ASX makes its pricing announcement on the new products in the coming months they are expected to include significant discounts and rebates to counter Chi-X's launch.
But Mr Gould says the two-year grace period enjoyed by the ASX to develop its competitive response will not have much bearing on Chi-X's results. "In Europe, when Chi-X Europe was established we were a first mover. There were no other multilateral trading facilities (MTFs). And it is the biggest by far today. But in Canada we were the seventh in a much smaller market environment with a more energetic mainstream exchange. Yet the pattern of our development in Canada has been very similar to the pattern of development in Europe," he says. "The growth trajectory has been very similar. So clearly there are some underlying dynamics of our business model that are just not about when we start in a particular market."
Chi-X wasn't the only organisation to apply for a market licence in 2008. Institutional broker Liquidnet, and AXE - a consortium of the New Zealand Stock Exchange and large Australian market participants Citigroup, CommSec, Goldman Sachs JBWere, Macquarie Bank and Merrill Lynch - also submitted applications.
Mr Gould is not sure the Australian market can support a large number of new market entrants as well as Chi-X. "I suspect that there is some room for another specialist niche player. I also suspect that it would be tough to support a lot more than that," he says.
And it seems, for now at least, that other prospective market entrants agree. Neither AXE nor Liquidnet are pushing forward their applications with ASIC.
The market participants in AXE may have gotten cold feet after seeing the fate of a similar consortium, Turquoise, in Europe, which was formed to put pressure on the London Stock Exchange (LSE) to innovate and reduce prices. After incurring significant setting-up costs and running at a loss for several years, the Turquoise backers ended up selling the platform to LSE, while remaining as co-investors.
But with their presence, and that of other MTFs in Europe, the initial goal of reducing the cost of execution and fostering innovation was still met. If Chi-X can be a catalyst for these changes on its own, the AXE backers may not feel the need to proceed.
Second thoughts
Liquidnet, too, has had second thoughts about running an alternative trading system in Australia, particularly given that its Asian institutional brokerage business, including Australian operations launched in 2008, has already proven successful.
Liquidnet says the decision not to proceed is partly to do with the lack of clarity about clearing arrangements, but also the expected cost of complying with licence conditions from ASIC.
"This could be in the form of human capital costs for compliance and reporting as well as a fee structure," says Stephen Zilioli, joint head of Liquidnet Australia.
But the main reason for not pursuing a market licence, for now at least, is its original motivation is no longer as relevant. Liquidnet initially submitted a market licence application because of the inefficiencies of the ASX crossing rule.
"But we found our initial estimates of the impact of those rules on our business were a bit high," says Mr Zilioli. "It was less costly to report to the ASX than expected. But also we modified our own model a bit to fit with the ASX, and it did away with the 10-second delay that was initially part of its crossing rules."
Liquidnet's business in Australia for its anonymous block trading has already grown substantially. It has gone from nine domestic institutional investor members at launch to 40. Across its five Asian markets (it also operates in Hong Kong, Singapore, Japan and South Korea) it has gone from 50 to 150.
"Compared with the US, Europe and some Asian countries such as Japan, Australia has a very one-size-fits-all approach to innovative trading models," says Mr Zilioli.
"Fragmentation is coming. The time for debate about whether it's good or bad has passed. The challenge for Australian institutions is how they position themselves to take advantage, or at least to minimise the negative impacts."
