Eye On Australia

Eye On

FIXGlobalTrading

Australia October 2012

Regulation Algorithms ETFs Liquidity Fragmentation

www.fixglobal.com

Editor’s note

Dear readers,

Welcome to the FIXGlobalTrading Australian supplement. As we head towards the end of 2012, and with the Sydney FPL Conference sure to spark both reflection and speculation, we thought it would be timely to have a series of articles purely focused on the Australian market. In this supplement we look at its wider landscape, and major trends, both regulatory and technological.

The topic on everyone’s mind at the moment is the changing regulatory environment, and how recent much publicised trading incidents are influencing attitudes towards electronic, and specifically algorithmic, trading.

FIXGlobal Publisher

The regulators, the sell-side and the vendors all have an opportunity in this supplement to provide their own views on the evolution of the multi-venue market in Australia.

Editor

Edward Mangles

Managing Director Stephanie Lawton Peter Waters

Global Sales and Marketing Yulia Kuksina

However as is often the case, the past is just as important as the future, and it is a matter of defining that which is to be examined, before examination can really begin. Our contributor’s each offer their own definitions of dark liquidity, dark pools, electronic and algorithmic trading, and each use their unique insights to look at where the market could progress further.

Sales and Marketing - EMEA Rebecca Trant

Operations Manager Tammy Fung

Design & Layout Bobo Chan

On a broader theme, we also take a look at the burgeoning ETF market in Australia, and the potential growth and value of this asset class for portfolio divestment and institutional investors.

As I begin my tenure as Editor of the FIXGlobalTrading journal, I would just like to take this opportunity to express my hope that you will enjoy this supplement, and future editions of the journal to come.

Best, Peter Waters Editor FIXGlobalTrading

FPL Australia Working Group I would also like to introduce the Co-Chairs of the Australia FPL Working Group, James Hardcastle of Fidessa and Yemi Oluwi of Ullink. Please get in touch.

Yemi Oluwi

yemi.oluwi@ullink.com

James Hardcastle

james.hardcastle@fidessa.com.au

General Enquires info@fixglobal.com

Advertising

Companies interested in discussing sponsorship and/or advertising opportunities please contact your regional editorial representative or sales@fixglobal.com.

Publisher

HM Publishing 2802, 28/F Lippo Centre Tower Two 89 Queensway, Admiralty, Hong Kong Tel: 852 2121 1566 Fax: 852 3007 3821

Publishers’ Note The opinions expressed in this publication are not necessarily those of the publishers or of the institutions of the contributing author. Although care has been taken to ensure the accuracy of the information contained within the publication, neither the publishers, authors nor their employers can be held liable for any inaccuracies, errors or omissions; nor held liable for any actions taken on the basis of the views expressed, of information provided within this publication.

No part of this publication covered by the publisher’s copyright may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, be they graphic, electronic or mechanical, including photocoping, without the written permission of the publisher. Any unauthorised use of this publication will result in immediate legal proceedings.

All Rights Reserved © 2012

Eye on Australia

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Contents Australian ETF Market Poised For Growth

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Ilan Israelstam, Head of Strategy at BetaShares, looks at the past, present, and future, of ETFs on the Australian market.

Algorithmic Attitudes

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In the ever-changing world of algorithmic trading, Ben Read, Electronic Sales, Bank of America Merrill Lynch Australia, examines the ongoing trends and potential pitfalls of electronic trading in Australia.

Taking Aim At Misconduct

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Greg Yanco, Senior ExecutiveLeader of Market and Participant Supervision, ASIC investigates the electronic trading environment in Australia, and where regulation can play a role.

Dark Horses Down Under

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As the issues surrounding dark liquidity grow more and more contentious, Steve Grob, Fidessa’s Director of Group Strategy, looks at the Australian trading landscape, how this type of trading has evolved and what the dark future holds.

Australia’s Multi-Market Landscape

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As the multi-market environment in Australia celebrates its first birthday, Ben Jefferys, Head of Trading Solutions, IRESS, reviews market structure evolution, and considers future growth potential.

• Liquidity analysis & benchmarking • Multi-market execution • Liquidity seeking algorithms for dark & lit venues • Maximising internalisation of order flow • Best-ex compliance, simulation & reporting

Australian ETF Market Poised For Growth Ilan Israelstam, Head of Strategy at BetaShares, looks at the past, present, and future, of ETFs on the Australian market.

The first exchange traded fund (ETF) was quoted on the Australian Securities Exchange (ASX) on 27 August 2001, and while growth was slow in the early days, since 2009, assets under management of Australian Exchange Traded Products (ETP) have doubled, with approximately $5.5 billion invested as of August 2012.

The last 12 months in particular have been significant in terms of the development of the Australian ETF industry, with all major asset classes now available for investors in ETF form. In addition, new money into the industry was significantly positive – with over $200m of net net inflows in the last 6 months alone.

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Additionally, the number of products and exposures now available on the ASX has increased substantially, with 26 new ETPs listed since June 2011. To put this number in context, in July 2010, almost nine years after the first ETF was launched in Australia, there were only 37 ETPs quoted on the ASX, and in the last two years, we have seen this number more than double. Of the 26 new ETPs listed on the ASX since July 2011, investors now have exposure to a range of currencies, fixed income, cash and commodities such as agriculture and oil. With all these asset classes now available,

Ilan Israelstam, Head of Strategy, BetaShares we are also beginning to see greater interest and some investment in ETFs by institutional investors.

Institutional Investors’ Usage Still Limited – but Significant Upside Available While there has been plenty of interest in ETFs by Australian institutions, uptake has been limited to date. However, despite this, activity has definitely picked up in the last 12 months including initial ETF investments by SunSuper, a major Australian pension fund, and van Eyk, a multi-manager, both allocating to emerging markets through ETFs. Recently, there has also been institutional use of the US dollar ETF (which aims to profit from a fall in the Australian dollar against the US dollar), as well as in the high interest cash ETF (which aims to provide returns greater than the Reserve Bank of Australia cash rate).

Just recently, a resources sector ETF experienced some block trading as institutional investors looked to obtain tactical tilts to Australia’s largest sector of the economy.

The above progress notwithstanding, there is still a long way to go. In other markets such as Europe or the US, up to 50% of ETF assets under management are institutional and ETFs are almost always in the top 10 securities traded in terms of exchange turnover. Compare this with Australia, where ETFs only make up a small portion of the total trading value, with a majority of the money retail based.

It appears as though significant upside still exists for institutional usage of ETFs in Australia.

The Attractiveness of the Australian ETF Market Despite not being as advanced as other ETF markets, there are some characteristics for Australian ETF issuers which make the local market attractive. First off, by sheer virtue of being a laggard market, local

“Outside of core Australian equities exposures, investors can now access fixed income, cash, commodities such as oil and agriculture, as well as precious metals such as gold, on the ASX.” ETF issuers and regulators can learn from the scrutiny of ETFs that occurs in more developed markets, especially when it comes to regulatory issues.

As an example, Australian ETF structures benefit from ‘best practice’ in existence around the globe. To illustrate this, currently all ‘synthetic’ ETFs listed in Australia are backed by cash held in a depositary account. Such a structure avoids some of the controversy that occurred when similar ETFs quoted in overseas markets utilised alternative forms of collateral in their structures.

The second point is that the Australian ETF market has a lot of room to grow. If we compare Australia to Canada, there are a lot of similarities in terms of GDP, population size and being a resources driven economy. However, there is a huge difference in terms of size of the ETF market with the Canadian industry being approximately C$40 billion compared with just over A$5 billion locally. The size of the potential is particularly striking when one notes that Australia has the fourth largest pension pool in the world, just having tipped A$1.4 trillion. This clearly presents strong growth opportunities for ETFs as retail and institutional investors continue adopting ETFs in portfolios.

Depending on market conditions, we believe the Australian ETF market has potential to grow exponentially over the next three years reaching up to A$15 billion by 2015.

Alternative Asset Classes ETFs are access vehicles for investors providing the opportunity to gain exposure to a variety of asset classes in a simple, transparent and liquid manner.

Outside of core Australian equities exposures, investors can now access fixed income, cash, commodities such as oil and agriculture, as well as precious metals such as gold, on the ASX. Eye on Australia

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Australian ETF market poised for growth Traditionally, Australian investors are more heavily weighted towards domestic equities compared with global counterparts. Most Australian superannuation funds can allocate anywhere between 30% - 40% of portfolios to Australian equities, a very high level when compared with overseas pension markets.

Now that there exists direct access to fixed income, commodities and previously available asset classes of domestic and global equities, investors can now access all the asset classes of a balanced portfolio and tailor their exposure depending on their risk profile. As an example of further access made available via ETPs, in July the first “bear fund� was launched in Australia. As the product is designed to go up when the sharemarket falls (and vice versa), it allows investors to profit from or hedge against a decline in Australian shares.

Future of ETFs in Australia ETFs on global exchanges provide a reflection of investor sentiment, and fund flows of larger ETFs are actually a gauge of the risk appetite of the market. Although Australian ETFs have not reached this size, local products do provide a barometer for risk appetite. Currently the flows indicate that risk appetite is subdued resulting in very little inflows to Australian equities based products. Despite this, Australian investors may have finally turned the corner with renewed interest in Australian equities during July, with 6 of the top 10 funds by inflows being Australian equities based.

The other continuing trend is dividend and yield based strategies which are continuing to prove popular among investors. With capital return expectations

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low and investors looking to yields for returns, they now have the option of fixed income ETFs, and recently the first cash ETF, available on the ASX. While fixed income ETFs have been popular overseas, the market in Australia is still in its infancy and has not yet enjoyed the same success compared with overseas markets. During the first half of 2012, fixed income ETFs attracted just over $40 billion in new assets globally, which accounted for approximately 40% of all global inflows.

Also, lack of investor conviction has resulted in lower trading volumes on the Australian Securities Exchange but the various ETFs which track Australian equities indices have continued to prove popular as both trading instruments and longer term buys.

Innovation can sometimes be dependent on the market and in the case of Australia, the first cash ETF to be quoted has grown strongly due to the market dynamics. With one of the highest interest rates in the developed world, investors can now access high Australian interest rates through the cash ETF in a simple, transparent and liquid manner on the ASX. Notwithstanding a great deal of product innovation, by global standards, the range of listed exposures available to Australian investors is still very narrow. As such, we expect there to be continued product innovation over the coming year. Such innovation could include more thematic and strategy based ETFs. As the menu of products continues to fill out, we expect further adoption, both retail and institutional, as the ETF market continues its growth trajectory.

Algorithmic Attitudes Ben Read, Electronic Sales, Merrill Lynch, examines the ongoing trends and potential pitfalls in electronic trading in Australia.

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To the year ended July 31, turnover on the ASX had fallen 46% over the previous year on year, with eight down months out of the 12. (Please see diagram1 on next page). August provided some relief, with turnover up 23%, but globally equity volumes continue to decline through the seasonally quiet summer months; driven by a continued rotation out of equities amidst global economic uncertainty – the European Sovereign Debt Crisis, the US election and “Fiscal Cliff”, and Chinese growth moderation at the same time as a once-in-a-decade leadership change, all weigh heavily.

Beyond the macroeconomic (cyclical) challenges over the past 18 months, there has been a significant structural shift in the Australian market. Most significantly, in executing orders on behalf of investors, participants now have two public, or lit, venues and exchange-run/broker dark pools to consider. Best execution obligations set out in the corresponding ASIC Market Integrity Rules have introduced a new set of market integrity rules, which bear resemblance to the European Union’s Markets in Financial Instruments Directive (MiFID). Each require every market participant to now have a policy in place which sets out the framework in which it will meet its best execution obligations to its clients.

The similarity to MiFID is its principles-based nature of this best execution requirement, which allows each broker to decide how it determines the best outcome for clients.

This is driving electronic trading/execution to become a more significant part of how Australian markets trade. Globally, we have witnessed this over the past decade and recent data estimates that 75% of US and 55% of European volumes are

now being executed electronically. In Australia, we estimate this figure to be closer to 35%; up significantly over the past 2-3 years, but still very low by global standards, which, to us, implies that there is still substantial growth ahead. ASIC has been following this shift towards electronic, or direct, execution and in its recent consultation paper (CP184) provided guidance and rules on automated trading. One point was to ensure that all participants maintain robust filters and controls across all platforms that access the market, with a key requirement to have a kill switch in place that can shut down parts of the execution infrastructure when behaviour outside accepted patterns is detected.

A kill switch can take two forms: it can either be software coded, or hardware-based. The former is a functionality that exists across the execution platform. It allows the trading desk, in combination with oversight functions, to quickly shut down either flow from a particular client, or a particular algorithm, that they believe is not behaving correctly. A hardware-based solution is more complex and involves the physical disconnection of parts of a market participant’s order routing platform from the exchange infrastructure. This is typically accomplished by closing or blocking network switches that exist between the two.

Also vitally important is the real-time monitoring that alerts trading desks to any form of execution that is occurring outside acceptable parameters. Most market participants with established electronic trading platforms have pre-trade filters based on a percentage of ADV, value of single orders, total notional and net delta.

Taking this further is the implementation of systems that can alert on abnormal patterns of messages, trades and realised profit and loss. Significant deviations from historical patterns can significantly speed up decision making in whether to involve a kill switch.

After the recent events in the US involving Knight Securities, SEC Chairman, Mary Schapiro commented that “when broker-dealers with access to markets use computers to trade, trade fast, or trade frequently, they must check those systems to ensure they are operating properly.1 ” In Australia, the investment community is supportive of such initiatives to ensure that overall market integrity and confidence is maintained and that investors and participants are protected from similar events occurring. In the immediate aftermath of Knight Capital, sell-side lines of business right across the industry conducted thorough reviews of their internal risk frameworks and there was plenty of dialogue with clients on what their trading limits were with different trading desks they faced. The majority of this work started before ASIC formally published CP184.

Eye on Australia

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Algorithmic Attitudes Algos: Definitions Matter We think it is also important to distinguish between the different types of “algorithmic trading� given the air-time this contentious issue has received over the last 12 months. Benchmark execution algorithms used by sell-side trading desks and accessed directly by the buy-side are for the most part relatively safe.

They execute a specified number of shares in a single or basket of stocks, governed by a framework of parameters that controls how they post and take liquidity from lit and dark venues. Typical algorithms of this type are Implementation Shortfall, VWAP, Percentage of Volume and Market on Close. They are some of the tools used by many participants to help achieve the best execution outcomes for clients.

The algorithms or automated strategies run by proprietary trading organisations and high frequency trading (HFT) firms have more discretion in what they buy or sell based on the market conditions they encounter.

They can generate orders without the direct oversight of a portfolio manager or any human intervention at all. For example, a market making strategy can trade across a whole index of stocks, generating orders to both buy and sell the same stock concurrently and auto executing futures contracts to manage risk.

Australian market from the systemic risk that may be posed by the combination of algorithms operating on a daily basis.

The volume of orders and turnover generated by a high frequency trading strategy is likely to be significantly higher than a regular execution algorithm. However, the right risk and control framework at the exchange and participant levels, can offer significant protection to the

Finally, a lot has been spoken about HFT algorithms that are deliberately setup to manipulate or game other investors.

We do not believe that the majority of HFT strategies behave in this way; they operate legitimate business models, which are fully compliant with ASIC market integrity rules.

Ben Read, Electronic Sales, Merrill Lynch

Monthly Australian Equity Market Turnover $180 $160 $140

Billions

$120 $100 $80 $60 $40 $20

Data: BofAML

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Diagram 1

Australian Equity Market Liquidity Fragmentation 100% 90% 80% 70% 60% 50%

Dark Total

40%

Off-mkt Total

30%

Lit Market Total

20% 10%

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Data: BofAML

Pooling Liquidity Dark pools are currently a focus and there has been much discussion on how much of market turnover is getting transacted within them. Our research shows that the percentage of total turnover that has been transacted in dark has remained relatively stable at 11-15% in 2012. For the purpose of our research, we have designated volume executed in Centrepoint, priority crossed or National Best Bid and Offer (NBBO) trades as dark. We think the right metric for the Australian market is the amount of volume that’s getting executed within ASX’s Centrepoint, and the crossing mechanisms that report to market. Block trades negotiated in the upstairs market have been classified as offmarket volume for many years and should continue to be so.

The key is finding the right balance that protects price discovery and liquidity in the lit market, but still affords investors the ability to keep their footprint minimal. The majority of investors are focused on minimising their overall market impact. Hence, it is important that the market structure moves towards an equilibrium with an appropriate balance between the protection of price discovery and liquidity in the lit market on one hand, and the ability of investors to minimise their footprint via the dark pools on the other. A quality independent research on the links between the quality (price discovery and liquidity) of the lit markets and the growth in dark pool activity would be a welcomed addition to the current debates.

1

If ASIC were to impose minimum sizes for dark pool crossings, as the ASX is campaigning for, then we believe something is needed that is a more flexible than an arbitrary dollar value. As turnover increases or decreases and the price of individual stocks moves then a single value can go from being appropriate to inappropriate very quickly.

One suggested solution is a value that is a function of the stock’s liquidity. For example, five times the average trade size based on the previous 20 trading days.

Global regulators are certainly aware that that every round of wholesale regulatory change adds a significant cost burden to market stakeholders both on the buy- and sellsides. The majority of resources are going into technology, compliance and legal functions. What the industry globally is still trying to evaluate is whether the more stringent regulatory requirements and all of the investment made has yet led to both the buy- and sell-side being able to offer a better product or service to their clients.

As a final point, the majority of Australian participants are global firms where Australia is just one of many territories they operate within. If the cost of running an equities business within Australia becomes prohibitively high then there is a danger that, in an environment of reduced activity, focus and resources are pulled back in favour of other regional markets. This in turn could reduce the breadth of services that are available to our domestic managers.

http://www.sec.gov/news/press/2012/2012-151.htm Eye on Australia

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Taking Aim At

Misconduct Greg Yanco, Senior Executive Leader of Market and Participant Supervision, ASIC looks at the electronic trading environment in Australia and where regulation can play a role.

ASIC is Australia’s corporate, markets and financial services regulator. In relation to its responsibilities supervising markets, ASIC believes that well-regulated, transparent and well-functioning capital markets are the engine room for economic growth: matching companies that wish to raise capital to grow their businesses, with investors that wish to place their funds for a return in a liquid market.

ASIC constantly monitors changes in global equity markets and draws on the surveillance experience of other regulators. It is clear that technology has increased the speed, capacity and sophistication of trading. Along with the new opportunities that this presents for participants, it also poses new regulatory challenges for ASIC. Flexible Advanced Surveillance Technologies (FAST) In the May federal budget, the Australian Government announced a commitment to invest in new technologies to enhance ASIC’s capabilities in market surveillance and enforcement. The $43.7 million over four years will allow ASIC to plan for a future that includes greatly increased message traffic, new trading technologies and techniques, increased competition between trading venues, and the increasing globalisation of capital markets.

The funding allows ASIC to provide four key deliverables. Firstly, it allows for the replacement of ASIC’s market surveillance system – a system which was originally designed for a single market and for which the contract expires in 2013. ASIC’s new system will continue to use the existing FIX specification.

The upgrade will add capacity and capability, and enable the system to cope with both a multi-market environment and the increase in high frequency trading (HFT) and algorithmic trading. It will also allow for real-time surveillance of futures markets, which is currently post-trade. The new system will provide the capacity to handle the dramatic increase in messaging, with the ability to handle up to one billion messages per day.

Secondly, the system will allow for advanced analytics; for analysts to search data records and identify suspicious trading by connecting patterns and relationships. This will be crucial for greater levels of detection of insider relationships, and will also allow for the development of post-trade surveillance capabilities to identify market trends, patterns of trading behavior and repeated or systemic behavior. These capabilities are common in other comparable markets.

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Thirdly, the new system will also include a portal for market participants to connect with ASIC. This will allow for the enhancement of efficiencies in dealing with ASIC, and enable participants to electronically lodge certain material in accordance with their obligations. Fourth, the development of a workflow system will help ASIC improve the management of cases from the moment ASIC receives an alert, complaint or enquiry, to the end of an enforcement action.

With Australia having some of the highest levels of share ownership globally, this funding is crucial in allowing ASIC to strive towards one of its strategic priorities of confident and informed investors and financial consumers. This is achieved through markets operating with integrity and efficiency which, in turn, helps to achieve another strategic priority: fair and efficient financial markets.

The funding costs will be smoothed and recovered over 10 years to minimise impact. In our view, the cost will be outweighed by the medium to long-term benefits of competition and of well regulated, fair and efficient markets. These costs also reflect the additional costs of supervision due to the increased speed and complexity of trading and dispersed trading venues, including dark pools. As a percentage of market turnover, the cost of market supervision remains favourable to comparable jurisdictions.

ASIC is committed to the project representing value for money, which means the process needs to be thorough. We will put in place strict evaluation procedures and will ask vendors to demonstrate competency in a range of functionalities important to ASIC and the market.

ASIC is acutely aware of the size of the IT project and build, and has hired experienced technical staff that have the requisite skills.

Electronic and Automated Trading Technology has increased the speed, capacity and sophistication of trading. This has opened the door for new types of market participants that bring innovative trading strategies and an increase in platforms where orders can be matched.

Two regulatory challenges that ASIC is particularly interested in relate to the increased use of dark liquidity and HFT. ASIC has recently established internal taskforces to specifically consider these areas.

Greg Yanco, Senior Executive Leader of Market and Participant Supervision, ASIC Dark liquidity As many of you will know, a ‘lit’ market, like the ASX and Chi-X, allows orders to be seen before the market matches them. Dark liquidity however, has no or little pre-trade transparency. On current estimates, dark liquidity may account for as much as 30% of market turnover. There are independent dark markets and also ‘crossings’ markets, which while originally operated by the major investment banks for their institutional clients’ large order flows, are now open to a broader range of market users.

Dark pools, which are a subset of dark liquidity, are now required to register with ASIC and provide monthly statistics of their activity.

The number of dark pools has increased almost fourfold since 2009. Given this growth, the changing nature of dark liquidity, as well as new forms of activity that challenge the boundaries of what we have traditionally considered to be manipulation, ASIC’s dark liquidity taskforce will consider how these dark pools are impacting the market in Australia, and whether our historically light-touch approach needs to be reconsidered.

As ASIC only sees the final trades when they are posted to the lit market, the taskforce will also look at how dark pools are supervised. We will consider whether a pool is truly dark to everyone, or whether an information asymmetry exists. We will also look at whether the dark market operator’s proprietary desk, or even a favoured client, is able to see orders coming through and pick the best ones.

The taskforce will review conduct in dark pools and other trading done off-market. This review will look at compliance with market integrity rules, and review Eye on Australia

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Taking Aim At Misconduct conduct in dark pools and other trading done offmarket for compliance with the Corporations Act and market integrity rule obligations. This will focus on market manipulation, insider trading, handling of client money, conflicts, records and disclosure. ASIC will take enforcement action for non-compliance where appropriate. The taskforce will also consider the nature of trading by high frequency traders in dark pools and whether certain behaviour should be discouraged.

We will propose new rules where necessary.

The taskforce will also consider more “market operator-like” obligations for dark pools (e.g. conflict management; monitoring; information dissemination; transparency of access, pricing, operations) and review the extent of payment for order flow and facilitation in our market and the impact on outcomes for client.

It will also consider whether incentives beyond our meaningful price improvement proposal are required to foster price discovery, for example, amending tick sizes.

All up, we are confident that the taskforce will provide the means for further promotion of market quality for delivering efficient price formation, informing investors about how their orders are executed, and overall confidence in the integrity of the market.

High frequency trading HFT is generally considered to be trading characterized by the automatic generation of large numbers of trades based on price movements and market information, with traders holding positions for a very short time. While not as prevalent in Australia as it is overseas, HFT is growing. Industry feedback suggests it may now account for 15-25% of equity market turnover. This is up from 3-4% which was estimated by the industry in February 2010.

ASIC acknowledges the increased role of technology and the efficiency benefits it brings, particularly from greater liquidity. However, we are also aware that it brings with it new regulatory risks. ASIC has no tolerance for any form of market misconduct, whether it originates from high frequency traders or other participants. We expect the taskforce to provide us with a better understanding of how HFT operates in this market, and whether there are any abusive practices or inadequate filtering trends emerging.

ASIC already monitors HFT and algorithmic trading as part of its ongoing supervisory function. We use the current rules that are in place to mitigate some of

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the regulatory concerns about electronic trading, including HFT. Participants are already required to have controls in place, and unfiltered DMA is prohibited under existing market integrity rules.

The taskforce will go further and consider whether the current framework is equipped to deal with the continued expansion of HFT. The taskforce will analyse the prevalence, nature and impact of HFT in our market (and abroad) as well as consider the drivers for growth. It will conduct surveillances examining the conduct of HFTs for non-compliance with the market integrity rules and the Corporations Act, and will take enforcement action for non-compliance where appropriate. It

“ASIC acknowledges the increased role of technology and the efficiency benefits it brings, particularly from greater liquidity.

However, we are also aware that it brings with it new regulatory risks.” will assess algorithms employed by high frequency traders and whether certain types of trading or strategies that are disruptive should be prohibited.

The taskforce will also consider the nature of trading by high frequency traders and on which markets they are most prevalent, and whether there is a positive correlation between speed to market and profitability.

As always, ASIC is looking forward to engaging with the industry and the markets in considering the issues discussed above. If we believe there should be changes to the current rules, we will consult and work closely with the industry on implementation.

The responsibility in working to ensure our markets are fair and efficient, and investors retain their confidence in the markets is a collective one, and one that we should all contribute towards.

Dark Horses Down Under As the issues surrounding dark liquidity grow more and more contentious, Steve Grob, Fidessa’s Director of Group Strategy, looks at the Australian trading landscape, how this type of trading has evolved and what the dark future holds.

Over the past few years, much attention in Australia has focused on the competition between ASX and Chi-X. But, in fact, multi-venue trading (via dark pools) was available to Australian investors long before Chi-X ever opened its doors back in November 2011. The term ‘dark pool’, however, has now become a catch-all phrase that describes a variety of activities that match trades but do not distribute pre-trade prices. Partly because of their name and partly because they are misunderstood, dark pools have attracted great controversy worldwide, and Australia has been no exception to this. So, what does the Australian dark landscape really look like, who is in it and what value does dark trading really bring to the market?

In 1997, ITG launched POSIT, a pre-market VWAP cross, Australia’s first alternative venue. However, it wasn’t until 2008 – anticipating the end of the ten-second rule1 – that Liquidnet followed with its buy-side crossing network, and finally Instinet with its BLX crossing network in 2011.

Likewise, broker dark pools were also around before Chi-X was born. UBS PIN (Price Improvement Network) launched in 2009 with other major brokers quickly following.

These days most of the big brokers in Australia operate dark pools, although UBS PIN remains the biggest.

Finally, ASX’s own dark pool, Centre Point, was launched with much fanfare in 2010, and it is thriving (see diagram 1); it in fact has greater market share than Chi-X. To illustrate the complexity of these issues though, at a conference in Melbourne in May 2012 ASX chief Elmer Funke Kupper warned of the dangers dark pools presented to the Australian trading landscape, even though ASX earns 0.5bps on the AU$100 million-odd worth of trades executed on its venue every day.2

Eye on Australia

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Dark Horses Down Under Genesis of Dark Pool Trading Institutional buy-sides have always preferred to cross their order flow with other buy-sides that have the ‘natural’ other side in the stock they are looking to buy or sell. The reason for this is anonymity, or not divulging their trading intention to the market at large. The larger the order size the greater the value placed on this anonymity. Dark pools provide exactly this – but have they always been available or are they a new luxury brought about by the wonders of electronic trading?

In the days before widespread computer usage, if an institution wanted to move a big line of stock, and didn’t want to send it down to the exchange for fear of moving the market, they’d call their broker. Often the broker would call their internal counterparts to see whether they, or a client, was buying or selling a similar block and would execute an ‘upstairs’ trade at an internally negotiated price. Depending upon the skill of the broker, this provided a high degree of anonymity and certainly more than would be achieved by just dumping the order on a lit market for all to see.

It was a natural step then for brokers to employ computers to automate this upstairs activity so as to increase its effectiveness and reduce their reliance on human memory.

The result was a dark pool that matched different client orders away from the public gaze of the lit markets.

When is a Dark Pool not a Dark Pool?

The terms ‘internaliser’ and ‘dark pool’ are often thrown around synonymously when talking about non-lit trading, particularly in the Australian media. Correctly speaking, however, an internaliser describes a firm conducting a specific activity where Steve Grob, Director of Group the broker is looking at Strategy, Fidessa incoming client orders and choosing to cross them against its own book. This can be contrasted with a broker crossing network, which is anonymous to both the clients and the broker – neither can see the orders inside the pool until they have been executed.

A third category of non-lit activity includes dark books operated by venues that provide a similar service. And, finally, some venues permit dark order types (where part of the order is hidden) to intermingle with their lit liquidity.

Not only are there many types of non-lit or dark venues but, to make matters worse, each is defined and treated

Note 1 Under ASX regulation, trades had to be displayed on the ASX for ten seconds before they could be crossed.

2 Based on AU$2.425bn worth of trades executed in May 2012.

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differently by various regulators around the globe.

No wonder then that dark pools tend to be perceived suspiciously (see diagram 2, on previous page).

The Dark Side of Australia Dark pool operators would, of course, argue that dark pools make the world a great deal better for Australian institutions. They facilitate anonymous trading in a way that was never possible before they arrived, and allow price improvement (as trades may be executed at prices better than those available on the exchange).

If lit markets are all about price discovery, then dark markets could be seen as being all about size discovery.

Enter the regulators. While many have accused dark pools of being unregulated, this is far from the truth. The firms that run dark pools are heavily regulated, as are the dark pool structures themselves; but just how to do that has been, and continues to be, a thorn in the regulators’ sides.

While ASIC certainly doesn’t want to see prices moving around as institutions throw huge blocks of stock on to the ASX, they also take their lead on dark pool regulation from IOSCO, which says that national regulators should try to preference lit venues over dark ones in their thinking.

This has led to an uneasy relationship between dark pool operators and ASIC in Australia. ASIC said in 2012 that it would not impose a proposed minimum value for dark transactions and indeed would allow trades below block size, as long as they were executed within the national best bid and offer. The media squealed that the big institutions had forced ASIC out of a rule that would protect retail investors, conveniently ignoring the fact that many big buy-side institutions are aggregators of retail money anyway.

The problem now troubling regulators and market participants is that the average trade size in dark pools is shrinking. These venues were created, so we are told, to allow institutions to trade big blocks of stock.

Yet the average trade size in Australia is consistently falling. However, the average trade size on the lit market is falling too, not just in Australia, but around the world. Most likely this is a result of two things: smarter algorithmic trading, chopping large trades into smaller chunks to aid the hunt for liquidity; and high frequency trading, which is the other bane of the regulators.

ASIC still maintains its right to insist upon a minimum trade size and is making the operators of non-lit venues provide it with monthly statistics on their volumes.

Unfortunately for ASIC there is little hard information available from abroad. Anecdotally, however, European and US buy-sides moan that the sheer number of dark

pools makes it less and less likely they will find the other side to their block orders without lifting the lid on each and every one of them. This takes both time and money and so the dark pool phenomenon risks becoming a vicious circle. More dark venues mean that firms are increasingly tempted to ping them with small orders to see if there is any relevant liquidity there. This then decreases dark trade size further and sets the alarm bells ringing with regulators (see diagrams 3 and 4).

Nevertheless, the fact remains that market ecosystems have evolved and now there is no turning back. As each country-specific or regional regulator grapples with the issue, they run the risk of encouraging regulatory arbitrage, where firms will simply move out of markets where regulation is too prescriptive and set up shop in the places they can most easily do business.

Until (if ever) a harmonised approach arrives to address what is a global phenomenon, regulators and trading institutions will need to deal with dark liquidity in their own backyards. Technology exists to piece the liquidity landscape – lit and dark – back together, and while the rulebook is being written and re-written, those who focus on simply getting the best trading results possible will, as always, come out ahead.

Eye on Australia

17

Australia’s Multi-Market Landscape Ben Jefferys, Head of Trading Solutions, IRESS, looks back at a year of the multi-market environment, and the future growth potential.

With almost a year of a multi-market environment in Australia, it’s time to stop and reflect on the year that has just passed. The question often talked about town is whether expectations have been met; but depending on who you are or who you talk to those expectations were very different things, if anything at all.

As Australia anticipated the launch of Chi-X and its rival ASX PureMatch we looked abroad to get a sense of what to expect. It didn’t take long to realise that the legislative framework and market structure within Australia was different to other countries and regions in the world.

Many felt that the Canadian experience would be the closest, but still there were enough significant differences to ensure that Australia’s journey was a unique one.

The most relevant point of difference between Australia and other parts of the world was just what happens when there is a better price on one market compared to another. In Australia there are no hard and fast rules about having to solely execute at the better price. It comes down to the market participant (i.e. the broker) and their respective best execution policies. The latest guidance from the regulator, ASIC, says that a broker needs to make a decision on whether to trade on markets other than the ASX if outcomes, including all costs involved, are consistently delivering better results for clients.

In Europe where the European Union’s Markets in Financial Instruments Directive (MiFID) applies, best execution is “principles based” where the premise lies in achieving the best outcome for the client. It is important to note that it states best outcome and not just best price.

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The US and Canada have what are known as trade-through protection rules but then the definition in each country differs. For the US, if there is a better quoted price on another exchange, then the order must be forwarded by the receiving exchange to the exchange with a better price. In Canada it is similar but not quite the same. If there is a better price elsewhere, then the exchange must reject the order and the broker must then try again and send it to the exchange where the better price exists.

Delving into the detail of how each market is structured and how their respective legislative frameworks operate one would have found it increasingly difficult to predict just what might happen in Australia in a multi-market environment.

Depending on what side of the fence you sat those expectations ranged from cheaper transaction costs through to tighter spreads and everything in between. If you went and asked the industry as to whether these last 12 months constituted success for multi-markets in Australia, sadly the response is most likely to be one of indifference.

The Arrival of Fragmentation But a lot has been achieved in the last two years by exchanges, market participants, regulators and vendors. The change has been immense. If we focus just on innovation around the fragmentation of the Australian marketplace most people would be surprised at just how long this change has been in motion. It was back in June 2010 when the ASX fragmented its own market with the CentrePoint and VolumeMatch

products. The latter traded once and has not since, whilst CentrePoint has developed into a successful alternative market where price improvements can be realised by trading at the mid-point of the spread.

Then on 31 October 2011 Chi-X Australia commenced trading on a small number of stocks and was in full swing by 9 November 2011 trading all ASX 200 stocks plus ETFs. Similarly, the ASX soft-launched its competing PureMatch product a month later on 28 November 2011.

Fragmentation had officially arrived and a survival of the fittest began. Market participants were now spoilt for choice. There were the lit markets ASX TradeMatch, ASX PureMatch and Chi-X along with the dark ASX CentrePoint market and ASX VolumeMatch sitting somewhere in between. Hidden orders could also be pegged within the spread on Chi-X. When it came to the lit markets it didn’t take long for there to be only one alternate exchange left competing with ASX TradeMatch. ASX PureMatch traded upon its launch but has been dormant ever since. The regulator, ASIC, finally confirmed the fate of PureMatch when on 23 February 2012 it indefinitely extended its waiver that PureMatch bid/offer quotes are not required to be included in National Best Bid Offer (NBBO) calculations until it reached a liquidity level on average over 10 consecutive trading days of 0.2%.

Gaining Ground Chi-X however has been slowly gaining ground since its launch – but is it the success that everyone expected? How did it compare to what was seen in other markets around the world?

Looking at what happened in Canada in terms of market share we can directly compare just how the

Australian foray into multi-markets stacks up. Markets first fragmented in Canada back in 2007 when a market called Pure launched, which in all respects never gained significant market share. But a more realistic comparison can be made by benchmarking against Chi-X Canada and another called Alpha which is owned by Canada’s biggest banks. After six months of trading, Chi-X Australia’s overall market share sat at approximately 1.9% and at the time of writing and after 11 months market share had risen to 4.6%. Comparing this to the two successful alternative exchanges in Canada we can see that Chi-X Australia is tracking well. Out of interest, the most recent market share statistics for these markets see Chi-X Canada and Alpha with approximately 9% and 19% respectively.

Exchange After 6m Chi-X 1.9% AU

After 11m 4.6%

Chi-X CA Alpha

0.2%

2.7%

5.5%

12.6%

The following chart helps visualise this comparison over a longer period. It shows the first 24 months of multi markets in Canada and overlays what we have seen to date in Australia. Within that 24 month period in Canada four separate exchanges launched; Pure in September 2007, Omega in December 2007, Chi-X in February 2008 and Alpha in November 2008.

Momentum gathered pace once volumes got past 2-3% and within 18 months close to 10% of volume in Canada was traded on alternative markets. Within two years it was pushing 20%. Whether Australia follows is anyone’s guess but looking at the numbers so far it appears that things are heading in the same direction.

Eye on Australia

19

AUSTRALIA’s Multi-Market Landscape

*CDX is a Canadian collective of Chi-X, Alfa, Pure and Omega exchanges. CXA is Chi-X Australia.

Trading volumes and market share are simple measures but buy- and sell-sides must find more comprehensive ways of determining how multi-markets can possibly benefit their business. As discussed earlier, best execution in Australia doesn’t just have to mean the best price, and as ASIC states, we should be looking for a consistently better outcome for the client. For a private client it is likely to be driven on best price, whilst an institutional buy-side client needs the best price considering depth and availability of liquidity to the stocks they are trading, whilst accounting for latency and minimising market impact.

Analysing the Change New suites of tools are evolving to help with the necessary analysis to seek liquidity at the best price possible. The emphasis for the buy-side on transactional costs analysis (TCA) is heightened since liquidity is split across more exchanges and dark pools making it more complex to minimise market impact. As the marketplace fragmented, the buy-side would often express that it becomes harder to trade stock in size, whilst at the same time proponents of HFT and market makers on alternative exchanges claim that they are adding liquidity to these markets and offering tighter spreads. Whatever the outcome this reiterates the need for tools to monitor the quality and cost of execution, whether it is on one or multiple exchanges.

Similarly, whether you are trading on one or multiple exchanges there is now a need to monitor what are known as “trade-throughs”. A trade-through occurs when there was a better price available on a different exchange compared with the price on the exchange that you traded at. To date in Australia the monitoring of trade-throughs has been a function of a select number of brokers using smart order routers. Trade-through analysis (TTA) is a good way to measure the effectiveness of a

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Ben Jefferys, Head of Trading Solutions, IRESS smart order router but as awareness grows along with the market share of alternative exchanges we are now seeing greater interest in TTA. In Australia the brokers to a trade become publicly disclosed on T+3 and this is incorporated within TTA tools. One broker can compare their trade throughs with the next and the same applies for the buy-side who can look across all brokers and rank them according to the number and value of trade throughs. As volume on alternative exchanges increases then so does the likelihood of a trade through.

So it is no wonder that the expectation of multi markets in Australia is varied if not distorted. We have a marketplace that has dramatically changed with the introduction of alternative exchanges, suites of new tools and data to monitor execution quality and two exchanges competing in an arms race for liquidity with an almost constant stream of innovation. All in all it is a difficult path to navigate but spending the time to understand the change is advantageous. Whether the outcome is one of realising a better price or not it is certainly worth understanding the new structure to help uncover ways of extracting the best and most efficient means of getting the desired result. Only then can a true expectation be set and then later evaluated.

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