The volatile market conditions that caused higher trading costs and wider spreads in Q4 2008 did not result in a shift away from execution algorithms by Asia’s buy-side traders, according to Glen Gee, head of analytical products and research, Asia at agency broker ITG.
“Many thought increased volatility would drive Asian traders away from algorithms, which are still seen as relatively new technology for the region,” said Gee. “However, we have seen increased use of algorithms, not least because many traders are covering multiple Asia-Pacific markets with different market times, characteristics, currencies and trading constraints.” As traders tried to cope with high levels of volatility, rapidly changing prices and widening spreads across multiple markets, Gee asserts that increasing sophistication in the execution algorithms available in Asia provided much-needed support. “Now algorithms and systems are specifically suited to these kinds of conditions and can help a trader to monitor and respond to fast-moving markets, trade more aggressively when prices move to reduce delay costs, and alert the trader when performance of a specific trade is deviating from the given benchmark,” he said.
A recent ITG report analysing trading costs across Asia for the two years to December 2008 revealed the extent of the unprecedented conditions faced by buy-side traders toward the end of last year. Equity trading costs in developed Asian markets increased by around 100% over the period of the study and rose by more than 200% in certain other of the region’s less developed markets. Moreover, ITG reported rises of up to 350% in the standard deviation of trading costs – the number of trades whose costs are far removed from the average – since the start of 2007.
Gee said that widening spreads accounted for the vast majority of increased trading costs as liquidity drained from Asia’s equity markets. As elsewhere, falling liquidity levels in the region were attributed to a combination of large-scale sell-offs by global institutional investors, deleveraging and liquidation of equity assets by hedge funds suffering high redemption levels, and a severe reduction in trading activity both by proprietary desks and stat arb hedge funds that had previously helped to keep a lid on spreads by acting as market-makers. “With the balance tipping firmly towards sells rather than buys, and tumbling markets keeping risk averse investors away, liquidity was sucked out of the markets, widening spreads and having a proportional increase on the expected costs of trading,” observed Gee.
Although all markets felt the impact on trading costs of falling liquidity levels and high volatility, local factors left some markets harder hit than others. New Zealand and Japan suffered more from the loss of liquidity than Hong Kong, Singapore and Australia, according to Gee. While New Zealand’s limited number of stocks and generally low turnover was accentuated in Q4 2008, Japan witnessed a significant exodus. Cautious domestic investors, including Japan’s large retail investment community, withdrew rapidly as the scale of the global financial crisis emerged. International market participants also fled. “As the largest Asian equity market, Japan has had a higher proportion of overseas investors including a large number of high-frequency hedge funds and also prop trading – both businesses that in Q4 almost shut down,” said Gee.
Asia’s trading costs are likely to remain closely correlated with volatility and will keep to current levels as long as liquidity continues to be scarce. Gee said historical analysis shows that use of advanced trading tools by the buy-side, such as DMA and execution algorithms, has had a beneficial impact on spreads and hence trading costs, in the region. Research published by the firm last year showed that median spreads for stocks in Australia’s S&P/ASX200 index fell to 26.41 basis points in 2007 from 51.74 basis points in 2004.
“It’s clear from the research though, that although advanced electronic trading tools can help to mitigate some of the risks and manage trading performance in volatile conditions, a general widening of spreads and loss of liquidity is still the most significant factor on costs,” said Gee.