Exchange rules limit high-frequency trading in Asia

The growth of high-frequency trading (HFT) in Asia is being slowed by a failure of exchanges to provide the technology required by the major Western funds, says Alan Donohue, chief executive of Nyenburgh, an HFT firm based in Singapore.

High-frequency trading is becoming more prevalent in Asia. The industry is well established in the United States and Europe, led by firms like Getco, Citadel, Renaissance and DE Shaw, many of which grew from options market-making firms in Chicago and the Netherlands. Although tactics diverge, often they target the tiny inefficiencies in asset prices across different exchanges, piling on huge trades over a fraction of a second, then exiting moments later.

These same funds are now providing an increasing proportion of algorithmic trading volume on Asian exchanges, attracted by wide spreads and the inefficiencies associated with retail participation.

Exchanges across the region are wooing the new participants, hungry to generate greater liquidity, the great virtuous circle of the exchange business model (greater liquidity attracting more participants, further increasing liquidity). With their deep order books and high-frequency trading strategies, the new funds are prime targets.

To attract such firms, Asian exchanges have been developing their system infrastructure, in particular upgrading matching engines. In January, the Tokyo Stock Exchange introduced the new Arrowhead platform, which claims to reduce matching time from up to 3 seconds, to as little as 5 milliseconds. The Osaka Securities Exchange intends to move its futures and options trading engine onto TSE next year to benefit from the reduced latencies.

Elsewhere, the Australian Stock Exchange recently announced its intention to introduce a platform later in the year aimed specifically at high-frequency firms. And SGX, the Singapore exchange, has licensed 12 independent software vendors to facilitate connectivity for high-frequency firms entering the market; partly as a result, foreign participation in derivatives trading grew to 26% of total volume in Q1 this year, from 15% a year earlier.

But much of Asia is still struggling to deliver the speeds high-frequency players are used to in Europe and the US. The IT infrastructures of exchanges, still relatively crude next to the cutting-edge technology applied by the leading European multilateral trading facilities like Chi-X, limit the amount of orders per second -- or 'throughput' -- a single participant can route to the matching engine. Exchanges fear engines will collapse under the flood of orders generated by high-frequency participants.

"Most Asian exchanges have severe order throughput limitations in comparison to their Western counterparts," explains Donohue. While throughputs in Western execution venues are in the thousands, most exchanges in the region offer from five to around 50 orders per second, he explains.

"On top of these physical constraints, there are the regulatory constraints that require you to have a 'responsible person' or 'designated trader' for each session," says Donohue.

If firms want to expand throughput by paying for a greater number of connections to the matching engine through which to route orders -- so-called 'sessions' -- they must employ a local participant to supervise each one. For firms keen to limit their on-the-ground presence in the region, this is a considerable expense and inconvenience. "It's not just a simple pay and play upgrade for trading firms," says Donohue.

These systemic obstacles mean that some moves by the exchanges to decrease latency -- the time it takes to complete a trade -- may not be effective.

The leading example is co-location, where exchanges offer participants the facility to co-locate their servers a few feet from the matching engine, limiting the time taken by trades to travel from trader to exchange. But other restrictions on exchange members, which may not allow direct use of co-location by the fund managers, can blunt the efficacy of server geography.

"Even with co-location, increased access sessions and a good matching engine, you may find that the regulatory barriers for specific exchanges make taking full advantage of these almost impossible," says Donohue.