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Enhancing the Competitiveness of Korea’s Securities Exchanges. Hana Institute of Finance President Heungsik Choe. Table of Contents. I. Overview of Securities Exchanges and Alternative Trading Systems. II. How Conventional Exchanges Are Responding to the Rise of ATSs.

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Hana Institute of Finance

President

Heungsik Choe


Table of contents
Table of Contents

I. Overview of Securities Exchanges and Alternative Trading Systems

II. How Conventional Exchanges Are Responding to the Rise of ATSs

III. How ATSs Are Responding to the Evolving Exchange Sector

IV. Growing Competition Between Exchanges and ATSs

V. How Korea’s Exchange Sector Can Stay Competitive


Overview of Securities Exchanges

Purpose

Purpose

  • Provide markets for securities trading

  • Enable efficient price discovery

  • Establish rules for fair trading practices

  • Regulate the trading activities of members

Functions

Functions

Exchanges ensure that orders are executed and transactions

settled in the fastest possible way.

Efficiency

Transparency

Exchanges help investors make informed, intelligent decisions

by ensuring that information is disclosed in a timely, complete

and accurate manner.

Exchanges ensure that no investor has an unfair advantage

over other market participants.

Fairness

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Demutualization and Listing of Numerous Exchanges

Late-1990s to Mid-2000’s: Developments in the Exchange Sector Set the Stage for Key Regulatory Changes in 2007

Demutualization and Listing

  • Separates ownership and membership

    • Makes it easier to provide optimal services

    • Paves the way for exchange consolidation

Gradual Progression

M&A, Strategic Alliances and Partial Acquisitions

  • Helps achieve economies of scale and scope

    • Creates financial, operational and managerial synergies

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Major Forces of Change in the Exchange Industry

  • Enabled the emergence of

  • new low-cost entrants:

Globalization

  • ATSs (MTFs)

  • I-Bank Internalizers (SIs)

Liberalization

of capital flows

  • Low Trading Costs

  • Low Latency

Regulatory Reform

IT

  • Falling Market Shares

  • Falling Margins

  • US: Reg NMS

  • EU: MiFID

Technological Innovation

Increased need for conventional exchanges to restructure

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Regulatory Reforms Level the Playing Field

Reg NMS

(Regulation National Market System)

MiFID

(Markets in Financial Instrument Directive)

  • Established in 2007 by the SEC

  • A series of initiatives designed to modernize and strengthen the national market system for equity securities.

  • Europe’s analogue to Reg NMS; Effective starting in Nov 2007

  • Cornerstone of the EC’s Financial Services Action Plan aimed at increasing competition and consumer protection in investment services

  • Harmonizes regulations of member states to better protect investors

    • Client categorization and client order handling

  • Enhances transparency by requiring the provision of sufficient trading data

  • Pre and post-trade transparency

  • Requires best execution

    • Assuring the best possible result including cost, spread and likelihood of execution as well as execution price

  • Treats Systematic Internalizers (SIs) as mini-exchanges

  • Order Protection (or Trade Through) Rule

    • Aims to guarantee best price execution

  • Access Rule

    • Addresses fair and nondiscriminatory access to price quotations

  • Sub-Penny Rule

    • Establishes minimum pricing increments to address the practice of “stepping ahead”

  • Market Data Rule

    • Promoting the wide availability of market data and allocating revenues to the most useful data

  • Alternative Trading Systems (ATS)

  • Systematic Internalizers (SI)

  • Multilateral Trading Facilities(MTF)

  • Systematic Internalizers (SI)

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Overview of Alternative Trading Systems

Characteristics

  • Various non-exchange trading venues have been launched as alternatives to conventional exchanges; their predominant function is the matching of transaction counterparties.

  • ATS (US), MTF (Europe), PTS (Proprietary Trading Systems: Japan), Dark Pools, etc.

    • As of 2010, approximately 120 ATS were in operation.

Strengths

  • Rapid order execution

  • Require few personnel but high-performance computing systems

  • Low costs of trading

    • Explicit costs: fees

    • Implicit costs: market timing costs and market impact costs

Competition

Complement

Exchange

ATS

Listing & disclosure

Reduced impact of block trades

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Algorithmic Trading and HFT (Appendix)

HFT (High Frequency Trading)

Algorithmic Trading

A type of automated trading that breaks up large blocks of shares into smaller ones to manage risk and reduce the market impact of large trades

A sophisticated program trading platform that uses powerful computers to transact a large number of orders, a special class of algorithmic trading

  • Also known as algo trading, black box trading or robo trading

  • Use of electronic platforms with an algorithm deciding on timing, price, or quantity

  • Widely used by pension funds, mutual funds, and other buy side institutional traders and sell-side traders such as market-makers providing liquidity

  • Can be utilized in a variety of investment strategies, including market-making, arbitrage, or trend following pure speculation

  • Highly quantitative, uses computerized algorithms to analyze multiple markets and place orders based on market conditions

  • More sensitive to the execution speeds of markets

  • Positions held for a relatively short time and orders are often executed tens of thousands of times per day

    • According to the Aite Group, HFT accounted for 73% of all US equity trading volume in 2009

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Ongoing Battle to Attract Heavy Trading Volume

ATS

Conventional

Exchanges

Asia

US

Europe

  • Chi-X Europe

  • BATS-Europe

  • Turquoise

  • Chi-X Japan

  • Chi-X East

  • BATS

  • Direct Edge

  • Consolidation

  • System enhancements

  • Diversification

  • New Offerings

Competition

for

Survival

Algo Trading

HFT

Market Making

Statistical Arbitrage

Event Arbitrage

Technological Innovation

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Major Changes in Markets (2000~2009)

Total number of trades in equity shares ⇒ +700%

Weighted average value of trades ⇒ -85%

  • While the number of trades has exploded, the average value of trades has dropped significantly.

  • These phenomena have been largely due to the proliferation of HFT and algorithmic trading.

Source : WFE

* This average, computed on WFE members, has been weighted by the share of each member in the total value share trading.

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Table of contents1
Table of Contents

I. Overview of Securities Exchanges and Alternative Trading Systems

II. How Conventional Exchanges Are Responding to the Rise of ATSs

III. How ATSs Are Responding to the Evolving Exchange Sector

IV. Growing Competition Between Exchanges and ATSs

V. How Korea’s Exchange Sector Can Stay Competitive


How Conventional Exchanges Are Responding

  • M&A, Strategic Alliances and Partial Acquisitions

  • Acquisition and/or Establishment of ATS

  • Improvement of Trading Systems

  • Diversification of Business Models

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1. M&A, Strategic Alliances and Partial Acquisitions

As of 2011, most larger exchanges have been listed except for several Asian ones.

Ongoing Demutualization and

Public Listings

Benefits of Consolidation

From 2000 to 2009, securities exchanges have engaged in 73 M&A’s, 237 strategic alliances and 68 partial acquisitions across the globe.

  • Achieve economies of scale and scope

  • Better utilize network externalities

    → Enhanced market power

  • Adapt to economic disturbances

  • Since 2006, the spread of M&A has accelerated, with 80% of exchange M&A activity concentrated in the period since then

    • Such activity has coincided with the rapid expansion of ATS and HFT

    • A majority of activity has been between stock exchanges and trading technology companies

  • M&A has been more active in Europe and North America than in Asia

    • Asia’s capital markets are at differing stages of development

    • Efforts to build an economic bloc in Asia have been slow

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Exchange M&A Activity Between 2000 and 2009

Type and Number of Mergers Between Exchanges

  • Horizontal

    - Two Stock exchanges (22)

    - Two Derivatives, Fixed Income and Commodities

    exchanges (8)

    - Stock exchange + Derivatives, Fixed Income and

    Commodities exchange (8)

    - Two Clearing and Settlement Organizations (5)

  • Vertical

    - Stock exchange + Clearing and Settlement

    Organization (5)

    - Stock exchanges + Trading Solutions Provider (18)

    - Derivatives, Fixed Income and Commodities

    exchanges + Trading Solutions Provider (5)

By Economic Area

  • Intra-Regional

    - Europe (25)

    - North America (23)

    - South America (2)

    - Asia (15)

    - Africa (2)

  • Inter-Regional

    - Europe and North America (5)

    - Europe and Asia (1)

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Ten Largest Deals in the Exchange Sector in Europe and North America

(Mar. 06 ~ Mar. 11)

Source : “Trading blocs”, PWC, Aug. 2011

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2. Acquisition and/or Establishment of ATS America

  • Carried Out in Response to Fragmentation or Decreasing Market Share

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3. Improvement of Trading Systems America

Aims to achieve ultra-low latency and high levels of reliability and capacity

  • NYSE Euronext’s UTP (Universal Trading Platform)

    • Connectivity to all the NYSE Euronext markets through low latency global network

    • 150-400 microseconds per roundtrip and 100,000 orders per second

  • Nasdaq OMX’s INET trading system

    • Used across its US and European markets including equities and derivatives

    • 1 million messages per second at an average speed of sub-250 microseconds

  • LSE’s Millennium Exchange

    • Abandoned the troubled TradElect system after a full day outage in 2007

    • An average latency of less than 120 microseconds, making the LSE one of the fastest venues

  • ASX’s PureMatch and VolumeMatch

    • Adopting the Nasdaq OMX’s INET technology in response to Chi-X Australia’s entrance

    • PureMatch is primarily for HFT while VolumeMatch is for bulk order execution service.

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4. Diversification of Business Models America

Selling Exchange Technology and Market Services

  • Incumbent exchanges have tried to diversify revenues by exporting their trading platforms and IT systems to emerging markets.

    • NYSE Technologies, the IT services arm of NYSE Euronext, has provided trading platforms to emerging markets such as Warsaw and Qatar.

    • Nasdaq OMX’s trading platforms have powered many markets including SGX and ASX.

    • The ASEAN Trading Link, a venture between 6 Asian exchanges, was designed with assistance from NYSE Euronext.

    • LSE’s technology will be adopted for upgrades in South Africa and Mongolia.

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Table of contents2
Table of Contents America

I. Overview of Securities Exchanges and Alternative Trading Systems

II. How Conventional Exchanges Are Responding to the Rise of ATSs

III. How ATSs Are Responding to the Evolving Exchange Sector

IV. Growing Competition Between Exchanges and ATSs

V. How Korea’s Exchange Sector Can Stay Competitive


How ATSs Are Responding America

  • Transformation Into an Exchange

  • Acquisitions

  • Provision of New Services

  • Entry Into Asian markets

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1. Transformation Into an Exchange America

  • Develop new revenue streams through the provision of various services such as listing

    • In Aug. 2008, BATS transformed itself into an exchange and became the third largest in Jan. 2009 in terms of turnover value. Moreover, it has advanced into listing new indexes like BATS 1000.

    • In March 2010, Direct Edge received approval to convert into two separate exchanges: EDGA and EDGX

    • Alpha Trading Systems, the largest ATS in Canada, received approval to transform from an ATS to Alpha Exchange.

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2. Acquisitions America

  • Due to the increasing number of ATS firms, competition has intensified, resulting in liquidation or acquisition by other exchanges and ATS

    • In July 2010, NASDAQ OMX Europe, the MTF of NASDAQ OMX, ceased operations.

    • In Feb. 2010, Turquoise, the well-known European MTF, was acquired by LSE.

    • In Nov. 2011, BATS Global completed acquisition of Chi-X Europe, the largest pan European trading venue.

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3. Provision of New Services America

  • Operate multiple trading systems with different fee structures and pricing models

    • Direct Edge: EDGX is charging for removing liquidity

      EDGA does not charge to provide or take liquidity

    • BATS: BZX applies a “taker-maker” model, but BYX applies

      a “maker-taker” model

  • Offer smart order routing

  • Provide clients a choice among multiple CCP’s

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4. Entry Into Asian Markets America

  • In Jul. 2010, Chi-X Japan launched PTS to trade Japanese-listed securities. Chi-X Japan is owned by Chi-X Global, a wholly-owned subsidiary of the Nomura Group.

  • In Oct. 2011, the monopolistic position of ASX was broken by the launch of Chi-X Australia, a subsidiary of Chi-X Global.

  • From Nov. 2008, a variety of darkpools such as Liquidnet, CLSA’s Bolcsec, and Goldman Sachs’ Sigma-X have been launched in Hong Kong.

  • Chi-East, the joint venture between Chi-X Global and SGX, commenced operations in Nov 2010 for the trading of selected securities listed in Singapore, Hong Kong, Australia, and Japan.

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Table of contents3
Table of Contents America

I. Overview of Securities Exchanges and Alternative Trading Systems

II. How Conventional Exchanges Are Responding to the Rise of ATSs

III. How ATSs Are Responding to the Evolving Exchange Sector

IV. Growing Competition Between Exchanges and ATSs

V. How Korea’s Exchange Sector Can Stay Competitive


Fierce Competition Between Exchanges and ATSs America

  • There is a large difference in market share between the largest exchange groups and the others, and the growth of ATS’s has been conspicuous.

  • When they announced their merger in Feb 2011, the combined market share of Chi-X and Bats Europe in European share trading exceeded 20%.

  • By end of 2010, BATS Global and Direct Edge had captured 21% of US equity market trading volume, placing them at number 3 and 4, respectively.

Electronic Trading Order Book Value Traded in 2010

Source: “Trading blocs”, PWC, Aug. 2011

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10 Years in Review (2000~2009) America

Market Capitalization ⇒ +33%

  • Though the Americas has the largest market cap, Asia-Pacific’s share has grown significantly.

Total Value of Sharing Trading ⇒ +61%

  • While the Americas remains dominant in total trading, the Asia-Pacific’s share has more than doubled.

Source: WFE

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Monopoly America

of conventional exchange

Fragmentation

by ATS & MTF

Consolidation

through M&A among

exchanges and/or ATS

…..

Cyclical Trends in the Exchange Sector

Repeating Cycle of Centralization and Fragmentation

Interestingly, consolidation and liquidity aggregation are not good for HFTs, as they benefit from highly fragmented markets that provide more arbitrage opportunities.

Ironically, regulators’ intention to break up the monopolies of exchanges has created larger global ones.

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KRX’s Position in Cash Markets America

Largest Exchanges by Value of Share Trading in the Electronic Order Book in 2011

Largest Exchanges by Total Value of Bonds Traded in 2011

Source: WFE

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KRX’s Position in Derivatives Markets America

Stock Index Options (2011)

(millions of contracts,%)

Total Equity Derivates (2011)

(millions of contracts,%)

Securitized Derivatives (2011)

(value of trading)

Source: WFE

| 29


Table of contents4
Table of Contents America

I. Overview of Securities Exchanges and Alternative Trading Systems

II. How Conventional Exchanges Are Responding to the Rise of ATSs

III. How ATSs Are Responding to the Evolving Exchange Sector

IV. Growing Competition Between Exchanges and ATSs

V. How Korea’s Exchange Sector Can Stay Competitive


A Proposed Future for Korea’s Exchange Sector America

Extend global networks

Rational Regulatory Reforms

Reduce technology gap

  • Fair competition

  • Mutual Support

Exchange

Strategic

Alliance

US · Europe

“Slow and Steady”

Consolidation

Asia-Pacific

ATS

Collaborate in trading systems development

HFT

Strengthening of Infrastructure

Enhance mutual accessibility to markets

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Recommendations for korea s exchange sector
Recommendations for Korea’s Exchange Sector America

  • Invest in and Jointly Develop IT System

  • Pave the Way for the Successful Introduction of ATSs

  • Devise New Products Within the Asia-Pacific

  • Offer a Variety of Services to Participants

  • Improve Derivatives Trading Platforms and Clearing & Settlement

  • Strengthen Strategic Alliances with the US and Europe

  • Encourage Consolidation Within the Asia-Pacific


1. Invest in and Jointly Develop IT Systems America

  • Continue to invest substantial sums in IT systems

    • Work constantly to fulfill the demand for faster and more sophisticated trading technology

    • Enhance and reinforce the stability of the system to prevent market accidents such as the “flash crash” of May 2010

    • Improve capacity and technology to attract large volumes of algorithmic traders, especially HFTs

  • Work with Asian partners to jointly develop trading platforms

    • Seek new revenue streams, for example, by exporting IT systems or providing assistance in the opening of securities exchanges in Asian emerging markets

    • The future consolidation of Asian exchanges will be easier and more efficient if common trading platforms are used.

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2. Pave the Way for the Successful Introduction of ATS America

  • Ensure that ATSs are launched successfully to build up internal competitiveness

    • There is a need to prepare ATSs for successful launching before the amendment to the “Financial Investment Services and Capital Market Act” is ratified.

    • It is advisable to establish holding companies owned by Asian financial institutions thatcan own and operate ATSs in the Asia-Pacific.

      * Large Asian investment banks and brokerage firms may be good candidates.

  • Learn how to manage ATSs through alliances

    • Strengthen ties with larger exchanges, especially ones having significant experience operating an ATS

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3. Devise New Products Within the Asia-Pacific America

  • Encourage Asia-Pacific countries to cross-list securities and trade a range of products

    • As a first step, the representative stocks of each country should be considered for dual-listing and/or cross-trading.

      * KRX has proposed dual-listings with China and Honk Kong, and has entered a cross-trading agreement with Japan that covers all stocks and is set to commence in November 2012.

    • Create a combined ETF that incorporates similar sectors from each exchange, as the listing criteria are easier to meet in spite of differing regulations and cultures

    • Take advantage of the rapid growth of derivatives in the region to devise new derivative products that can attract the attention of multiple countries

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4. Offer a Variety of Services to Participants America

  • Accept various types of orders from large participants

    • Diversify the types of orders accepted, especially for large-volume traders such as algorithmic traders

    • A good example might be iceberg orders, which help to mitigate market impact.

  • Offer services aimed at enhancing the speed of order execution

    • The popularity of low latency trading has been giving a good chance for growth of exchanges offering co-location services.

    • DMA (Direct Market Access) might be a service offered that enables sophisticated investors to place orders directly on the exchange order book for high speed execution.

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5. Improve Derivatives Trading Platforms and Clearing & Settlement

  • Prepare for standardization and centralization of OTC derivatives and their trading

    platforms

    - In accordance with the US Dodd-Frank Act and MiFID, many derivative products will be

    traded through exchanges and cleared through clearing houses.

    - This will provide a great opportunity for exchange groups that focus primarily on equities.

    - Also, attention should be paid to OTFs (Organised Trading Facilities) and SEFs (Swap

    Executive Facilities), the mirror images of MTF and ATS in cash market, respectively,

    as potential rivals to exchanges.

  • Enhance systems for clearing and settlement, as these might provide an important competitive edge in the near future

    • In Sep. 2010, the EC published the European Market Infrastructure Regulation (EMIR), which aims to increase stability in OTC derivative markets.

      * It aims to ensure that OTC contracts are centrally cleared and trading parties able to select among a variety of clearing houses.

    • If clearing platforms are more open, it may be easier for specialist clearers to carve out a competitive position.

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6. Strengthen Strategic Alliances with the US and Europe Settlement

  • Extend global networks through strategic alliances with US and Europe trading venues

    • Construct 24-hour trading systems through network linkages

      * At present, KRX, CME(US), and Eurex (Europe) are offering 24-hour trading of KOSPI 200 futures

    • Strengthen strategic alliances through cross-listings and cross-trading

  • Actively embrace advanced systems and trading technologies

    -To shorten the time required to develop systems and technology, it is advisable to learn from the experiences of the advanced systems.

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7. Encourage Consolidation Within the Asia-Pacific Settlement

  • Push ahead toward gradual consolidation of trading venues in Asia-Pacific

    • The countries of the Asia-Pacific differ widely not only in terms of language and cultures, but also in terms of their capital markets and regulatory environments.

    • Nevertheless, the trend toward integration seems to be established and may even accelerate in the near future.

      * ASEAN is promoting cross-border collaboration through its upcoming “ASEAN Trading Link,” which is made-up of seven stock exchanges from Indonesia, Malaysia, the Philippines, Singapore, Thailand and Vietnam (2). The 210 stocks representing the 30 blue chips from each exchange will be available for trading on a common platform.

      * The BRICS and Hong Kong will start to cross list their derivatives indices from Mar. 2012 in a bid to expand their product offerings.

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