As you can see below, it was especially useful last Tuesday when Deutsche Börse had a hiccup and delayed its opening by 80 mins.

The absence of trading during the outage proved, yet again, that the market is still overly dependent upon the primaries for price formation. The irony of this was highlighted as well by NYSE Euronext’s Duncan Niederauer who believes that exchanges risk becoming mere show rooms for prices and that all the real trading might end up taking place on alternative lit and dark venues.

Some of you have been kind enough to let us know that you’ve found Fragulator Live useful in a number of ways, including for observing how fragmentation varies during the trading day as liquidity shifts across venues; discovering which European venues benefit the most from the US market opening; checking how SORs behave when the LSE goes into auction mode; and comparing indices and stocks across different geographic regions.

Anyway, enjoy the Fragulator Live – let us know what interesting things you discover and what else you’d like to see.

A number of new dark pools are emerging that are specifically geared around allowing institutions to find natural liquidity between themselves. BLINK from Cheuvreux is just the latest example, and let’s not forget LiquidNet that pioneered the whole concept of buy-side crossing in the first place. For folks that don’t want to trade in size (such as the retail punters) then the narrower bid/offer spreads offered by electronic market makers look attractive. This has become the model adopted by MTFs such a TOM and Equiduct, powered by Optiver and Knight/Citadel, respectively.

Taken to its extreme then, you might end up with a separation of trading, with institutions placing more and more of their liquidity into broker dark pools and crossing networks whilst the retail community interacts with the HFT guys. But the real point is that, in any industry, market forces will always mean that different suppliers will shape their offerings in order to service distinct customer segments with similar needs. With this in mind, maybe the regulators should stop meddling and simply ensure that the depth, type and longevity of liquidity available at a venue is made clear to anyone that wishes to play there. The alternative is an endless array of corrections and counter-corrections from the regulators, just like a golfer having a really bad day on the course of unintended consequences.

Despite all the noise and hoopla, market participants seem to be huddled together at the top of the diving board waiting for someone else to take the plunge first. Regulatory uncertainty is definitely one reason, but there is also a real sense that there will be far more of these things than the actual trading volume (as opposed to notional outstanding) will be able to support. Maybe a better option then is to be the guy offering the aggregation layer that allows traders to smartly scan the total liquidity across all the different platforms. By combining the available liquidity into a single virtual display, all sorts of further revenue generating opportunities start to become apparent, so maybe it’s a case of first mover disadvantage on this one.

But just as in equities, the real prize is in clearing and the ability to offer margin or position offsets between different but related instruments. The LSE’s acquisition of LCH.Clearnet looks like a great move as it will enable it to leverage the mighty OTC SwapClear franchise. On the other hand, the mountains of ETD open interest held at EUREX Clearing, CME Clearing and others provide different starting points for portfolio margining. The question then is: which will prove to be the strongest magnet?

It’s been a hard slog for the alternative trading community in Japan, however, as they have had to battle without the assistance of a formal concept of best execution as enshrined by America’s trade through rule or MiFID’s principles based approach. On top of this, the PTS community also has to negotiate some tricky Financial Services Agency regulation. The first is known as the 5% TOB rule which basically states that any investor that amasses 5% of a firm’s stock through OTC trading must then mount a full takeover bid for that firm. On the face of it, this is a sensible attempt to ensure that corporate takeovers are undertaken in the full light of day. The problem is that when the PTS concept was originally formulated, the new venues were designated as OTC venues. The net effect of this is that many Japanese investment firms are reluctant to buy stock on PTSs just in case they might trigger the takeover rule. On top of this, any PTS that amasses 10% market share must automatically apply for full exchange status.

Despite this, as the chart below shows, the combined share of Chi-X Japan and SBI Japannext in the Nikkei 225 hovers around 6-7%.

This is usually enough to ignite the fragmentation touchpaper, as a critical mass of brokers then invests in the appropriate smart-routing technology. A further stamp on their growing legitimacy is the fact that the JSDA has rescinded earlier restrictions that prohibited participants from using PTS venues in the event of the primary market failing.

If they are to really grow, however, Chi-X Japan and SBI Japannext still have some politicking to do. They should be helped in this by the fact that the OSE/TSE deal looks (almost) certain to go ahead and so the market will be even more wary of the monopoly power of the combined Japan Exchange Group.

So maybe, at long last, things are really changing and Japan will become the land of the rising sun for alternative venues.

As always my thanks to the management and staff at Fidessa kk for all their kind hospitality during my stay last week.

Part of the problem lies in coming up with a definition of HFT that everyone agrees upon, but the real problem lies with the regulators themselves. When they were busy introducing multi-market structures, why didn’t they think that this would lead to a huge increase in HFT? Splitting liquidity over multiple destinations and the subsequent introduction of maker taker pricing provides the ideal breeding ground for arbitrage. And, of course, exchanges around the world have been busy building the fastest race tracks they can in order to attract the same HFT players too.

Maybe it’s because HFT is such a nebulous concept that it becomes such an easy scapegoat. Firms can always claim that any sanctions aren’t really directed at them but, just like Greece, I guess the debate will go on forever.

That is not to say that the decision was necessarily wrong, but the reasoning behind it doesn’t seem to stack up. As one of our previous polls showed, the market was pretty evenly divided on the issue but with a significant number of “don’t knows”.

For these swing voters, maybe it’s all about capital efficiency. Ever since the financial crisis, capital has become an increasingly valuable commodity as market regulators around the world are steadily upping the requirements. Would a combined entity have been able to offer more efficient use of capital through margin offsets or otherwise netting positions for traders? Or, would a combined entity have been able to drive up prices and exploit its position without exchanges like the CME or NASDAQ  jumping in?

Personally, I think Brussels might end up adding this decision to the “Not sure we got it right” pile.

Even if the idea of such a tax were a good one, have they thought through how it will work in practice in the equity markets (let alone other asset classes)? Reports suggest that France will go it alone even if it cannot co-opt Germany into its plan. But, around 40% of the trading in the CAC 40 and DAX now occurs outside of Paris and Frankfurt (as the charts below show) with most of this liquidity residing on London-based (and FSA-regulated) MTFs such Bats/Chi-X and Turquoise.

So, even if the French can extend their jurisdiction, it seems unlikely that the City of London will support such a tax, especially as any revenue raised will stay in French (and possibly German) pockets.

Looks like it’s time that European governments recognised that, in equities trading at least, the go it alone nationalistic approach went on the scrapheap the moment the chaps at MiFID mansions first got their pens out. Maybe I should drop a note directly to Monsieur Baroin at the French Finance Ministry …

The video shows end of day trading in Mizuho stock on 26th September 2011 and you can clearly see that SBI trades inside the TSE spread nearly all the time. The benefit is that price improvement is delivered nearly 80% of the time for both sides of the trade and, in this case, was around 10-11 bps.

Tick sizes in Japan vary considerably between the incumbent (1 to 100,000 JPY) and the PTS folks which begin at 0.1 and are capped at 10 and 100 at Chi-X and SBI respectively. Smaller tick sizes are only part of the game, though, as alternative venues need to provide low latency platforms and other incentives so as to encourage liquidity providers to step up and make prices in these smaller increments. And, for their part, these providers need to operate at sufficient frequency on and between venues so as to achieve an acceptable balance of profit and risk. The resultant liquidity, typified by smaller trade sizes and narrower spreads, isn’t always good news for institutional investors that want to trade in larger size. But, then again, maybe that’s what dark liquidity is supposed to be all about.

The Japanese situation can be contrasted with Europe where combatants have grudgingly agreed a scheduled process for tick size reductions, and with the US and Australia where tick sizes are standardised. It’s not all peaches and cream for alternative Japanese venues, however. Until recently they have had to contend with prohibition of maker taker pricing and a unilateral short selling ban.

Anyway, this all got me thinking about what the right ingredients really are for alternative venues to prosper and I thought it would make an interesting topic for the first poll of 2012. As always, I’d be interested to hear your views.

Thanks to everyone for their comments on the last blog and thanks to Chuck Chon of SBI Japannext for pointing me to the video in the first place.

As always, feel free to comment.

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Also, I imagine that most regulators would see themselves as gamekeepers rather than poachers but this does help highlight the fundamental problem our industry faces. The minute you interfere in any ecosystem and try to protect one species or another you invariably invoke the law of unintended consequences. This is especially true in financial markets that are going through a rapid period of evolution driven by a technology-inspired natural selection process. The tendency then is to try and adjust for these consequences with yet more regulation and so the vicious cycle continues. This is confirmed by the fact that it was the regulators themselves that inadvertently fuelled the HFT boom by breaking up the national (natural?) monopolies of stock exchanges in the first place.

We begin 2012 much as we left 2011 with fear, uncertainty and doubt being the prevailing sentiments, so maybe regulators on both sides of the Atlantic should take a second look at their groaning inboxes. Perhaps a return to lighter touch regulation is the lesser of two evils. Why not let the natural evolution of financial markets play itself out. Of course, there will be individual winners and losers but the overall ecosystem will emerge stronger to the benefit of everybody who is either directly or indirectly affected by capital markets. The alternative will be ever-growing mountains of retrospective regulation that will be arbitraged, hidden behind or simply never understood.