Between Hillary Clinton's war on "quarterly capitalism" or the religious fervor surrounding the mythical Dodd-Frank and Glass-Steagall regulations, there seems to be no lessening of the trend of anti-"Wall St." political hysteria in the United States. One would be inclined to think the Japanese would be less driven by emotional appeals and more focused on the long-term structural problems of their markets, but unfortunately, you would be wrong. Japan seems intent on following the rest of the world, if not leading it in this latest flashpoint - conquering the HFT boogeyman.
Japan's Financial Services Agency has formally indicated that it can "no longer ignore the concerns [surrounding high-frequency trading]" and is already engaging in official talks to "figure out what is going on." The target is the Japan Exchange Group ((OTCPK:JPXGY; TYO:8697) ("JPX"); Osaka Securities Exchange Corp. (OTCPK:OSCUF)), which owns the Tokyo Stock Exchange and Osaka Stock Exchange, in addition to the Japan Securities Clearing Corporation. JPX has grown significantly from the revenue generated by its business with HFTs, so any vague talk of "Western-style regulation" naturally has the exchange group highly concerned.
The cold reality is that according to many empirical studies of those markets in the U.S. and Europe, in addition to a recent 2014 study of Japanese markets by the TSE, HFT actually provides much-needed liquidity and price discovery - hence why exchanges allow HFT firms to plant themselves in their buildings and pay them liquidity premiums. We will explore the results of this study here to try to clear the air about high-frequency trading once and for all. Regardless of whether or not the council decides to pursue regulatory measures, I maintain a Buy/Hold on JPX, as the dealer group has disproportionately suffered considering growing revenue and limited impact of NIRP on trading activity.
|YTD Price Performance||-30.47%|
|Working Capital Ratio||1.00|
|Dividend Payout Ratio||61.20%|
|Dividend Gross Yield||3.16%|
High-frequency trading has been thrown more and more into the spotlight as it has grown to compromise a larger share of the overall securities markets around the world. Modern-day estimates typically claim that around 70% of U.S. securities market activity, for example, is conducted purely by HFT firms. Despite this immense growth over the past several decades, very few people actually know what HFT actually is, and thus, negative perceptions have been able to easily take hold in the minds of many politicians, traders, and journalists.
Generally, HFT is categorised by the following characteristics:
- Utilises co-location/proximity services
- No significant positions at end of day; daily trading value at least 50% of portfolio
- Extracts extremely small margins per trade (within 4 ticks of the BBO)
- Rapid order cancellation; order cancellation rate >20%
- Receives rebates on more than 50% of transactions or orders
Essentially, HFT firms engage in traditional statistical arbitrage, albeit on a massive scale, by utilising the most advanced technology/algorithms available and by setting up shop in or extremely close to the trading houses.
Empirical Analysis of HFT Impact in Japan
Many studies have already been done in the U.S. and Europe regarding the impact of high-frequency trading on their securities markets.
- High Frequency Trading and Price Discovery (Brogaard, Hendershott, and Riordan)  ECB Working Paper
- Low-Latency Trading (Hasbrouck, Saar)  NYU Stern Working Paper
- Does Algorithmic Trading Improve Liquidity? (Hendershott, Menkveld)  Journal of Finance
These various studies have generally come to similar conclusions: that HFT contributes to improved price discovery, liquidity, and market efficiency. However, very little research has been done on the HFT industry in Japan despite its growing prevalence. This is why the TSE commissioned VP Go Hosaka in 2014 to conduct an empirical analysis of HFT in Japan.
373 TSE-listed stocks were selected for analysis, which recorded HFT daily trading value more than ¥50 million for each day during the analysis. To identify which order originators were from HFT firms, the following criteria had to be met:
- Orders placed via virtual servers
- Order cancellation rate >20%
- Order execution rate <25%
By observing the order time periods, order types, and order prices, Hosaka attempted to discern whether HFT orders were actually providing liquidity to the market. Hosaka found that most HFT orders were placed within traditional auction hours with very few market orders and, based on order price, did indeed provide liquidity. At least 60% of HFT orders were found to be placed within 4 ticks of the best bid offer - a higher proportion than conventional orders.
Next, by analysing orders' resting time in the order book, Hosaka found that most market-to-limit orders (BID < PRICE < ASK) (PRICE = ASK and PRICE = BID) tended to be cancelled soon after placement. Perhaps most interesting is that by classifying order types as "taking" or "making" liquidity and the subsequent price movement trends, HFT orders tended to not only provide more liquidity than conventional orders, but also contributed to a higher proportion of orders opposing price trends, making HFT orders more price neutral than conventional orders.
Incredibly, this study not only debunks that claims that HFTs "steal" value and manipulate the market, but that, in reality, HFTs actually are more price neutral and, by virtue of their order type, prices, and value, provide more liquidity and market efficiency than conventional trading. The share of orders opposing market moves was actually higher for HFT, meaning that, if anything, HFTs are the ones suffering to provide liquidity.
Now, of course, there are understandable criticisms of high-frequency trading. The traditional perspective is that HFT firms have a statistical advantage in speed via their proximity to trading houses, and thus, can act on new information far faster than the average investor, who often takes days to receive, compile, and process new information - such as a quarterly report - about a company. In the case of Japan, 70% of all HFT trades occur within the TSE building itself. This common critique is that this advantage allows HFT firms to benefit at the expense of ordinary traders. However, I would suggest that this is the furthest from the truth because, in reality, not only do most HFT trades occur with each other, but as shown above, HFT trades do not hold significant positions (long or short) on any particular security and, if anything, often trade against the actual price momentum of a particular stock.
This is a highly pernicious misconception that even the supposed financial regulatory experts in Japan have fallen prey to.
The agency put high-speed transactions on the agenda not just because the trades are nebulous, but also because the stock market - which used to be a forum for traders to test their discernment of companies' growth potential - has turned into a racecourse pitting one computer's processing speed against another's, said a senior FSA official.
- Nikkei Asian Review
In reality, what is truly nebulous is to disregard the entire history of trading, which has always revolved around who has the faster horse or, in today's era, the faster fiber optic network. It is reminiscent of the age-old Rothschild tall tale, which claimed that Nathan Rothschild had amassed his wealth by exploiting his advanced knowledge of the result of the Battle of Waterloo to rush to London and make a killing at the Stock Exchange.
Just as with the falsified Rothschild tale, the accusations of front-running and insider trading are typically falsified, conjured out of thin air. Even if HFT firms are the evil arbitragers gaming the system for their own benefit, which it is proven they are not, this would be the reality of the system anyway - it is the nature of the game, and always has been. To attempt to conquer this non-existent boogeyman via regulation, as with the result of most other regulatory crusades, would only further consolidate the "winners" and "losers" of the exchange dealers and destroy what little competition there is left. If companies and firms thought it such a problem anyway, they would simply not do business with the Japan Exchange Group or any of the other major international exchanges that accept and often subsidy HFT; of course, the opposite is true, as added liquidity equals added business.
Hopefully, the FSA will not go through with attempting to stymie the growth of HFT because of popular misconceptions or the public mood. Because actually, JPX is providing a stellar example of regulatory voluntarism. Japan has always lacked fair disclosure laws like those in the U.S. which prevent companies from selectively leaking quarterly results to the nonpublic, meaning companies would often issue "sneak peeks" of their earnings to brokerages. However, realising that the regulatory environment has been becoming more stringent as of late, the TSE and JPX have condemned the practice of selective disclosure, and major brokerages such as Nomura (NYSE:NMR) and Daiwa Securities (OTCPK:DSECF, OTCPK:DSEEY) are already following suit, banning their analysts from interviewing with companies in the run-up to earnings releases.
As for JPX financials, despite a decrease in revenue associated with trading of JGBs due to the introduction of NIRP, trading services revenue, along with all other sources of revenue for JPX, has increased significantly.
|Operating Revenue (millions of yen)||FY ended March 31, 2015||FY ended March 31, 2016|
|Trading Services Revenue||48,698||52,471|
|Clearing Services Revenue||20,092||23,140|
|Listing Services Revenue||12,249||13,250|
|Information Services Revenue||16,311||17,706|
This is likely due to the consistent innovation at JPX, such as erecting new trading systems, extending trading hours, creating new derivatives products, and much more. Some of the upcoming derivative products that JPX has created are sure to attract more trading revenue:
- TSE Mothers (Emerging Companies) Index Futures
- TAIEX (Taiwan Stock Index) Futures
- FTSE China 50 Index Futures
- JPX-Nikkei 400 Options
Ultimately, whatever regulatory measures that the FSA tries to enact, such as "monitoring" or "registering with authorities," will be useless, because clearly, the regulators do not or refuse to understand the true nature of high-frequency trading. Any impact of regulation will be very limited, and JPX investors need not worry - after the Tokyo-Osaka merger, the Japan Exchange Group has quickly been trying to become one of the most innovative exchange dealers in the world. Not only will JPX be able to surpass its financial colleagues in Japan, such as Mitsubishi UFJ (NYSE:MTU), thanks to its focus on derivative products as opposed to traditional income investment (i.e., the bond market), but if all this regulatory nonsense continues to engulf the U.S. and Europe, then JPX will be able to surpass companies like JPMorgan (NYSE:JPM) in technology and revenue growth.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.