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Islands in the eastTechnology, globalization, and the future

of the financial hub in Asia

An Economist Corporate Network management brief

Insights through interaction

Islands in the eastTechnology, globalization, and the future of the financial hub in Asia

1© Economist Corporate Network 2012

Contents

Islands in the east 2

Islands in the stream 3

Between the well-lit marketplace, and the cloud 5

Speed demons 6

When to dip into the war chest—and when to just play table stakes 7

No hub is an island 8


2 © Economist Corporate Network 2012


Key thoughts:• Asian financial centres will define the future of the global financial service industry. This does not need to imply that Asia’s finance hubs will always lead in global innovation, or even be the first adopters of technology. But the gravitational pull of Asian economies (particularly, but not exclusively, the Chinese economy) will draw liquidity and trading capacity in ever greater amounts to the region for decades to come. Servicing the needs of Asia’s financial service players will become a primary goal of trading platform providers, managed network service providers, algorithmic software developers and other electronic trading ecosystem participants.

• Fit to a ‘T’. Asia’s financial hubs must become ‘T-shaped’—both broader and more focused—in order to maintain competitiveness in the region’s increasingly crowded playing field. Breadth will involve creating more diverse access to different pools of ‘smart liquidity’, including access to exchanges in the US and Europe. Depth will involve more exchanges with narrower purposes, such as specialist platforms for commodities trading.

• A long game of leapfrog ahead. Asia’s financial services industries are generally thought to be behind the curve when it comes to investment in electronic trading platforms and data centre capacity. This will not be the case for long; data centre construction to specifically serve the financial industries has become a business and a government priority in Hong Kong, and high-frequency trading is steadily becoming a large slice of trading volume in Singapore and Tokyo, especially for derivatives and other financial products with higher ‘R&D’ content. But Asian investment in capacity, platforms and solutions must keep pace with developed financial centres in the US and Europe—or rather, Asia must exceed that pace, or risk bottlenecks which could slow or derail growth in its financial service centres.

• Location, location…dislocation. The most important question raised by technology’s ceaseless march into the world of finance is: does it render the physical location of a financial hub irrelevant? The answer, this paper argues, is “It depends.” This may seem an unhelpful conclusion, but it is in what the Asian financial centre depends that their future growth rests. Growth lies with those hubs which allow market participants to capitalise on their proximity to opportunity—to pools of liquidity and market intelligence in Asian markets—while also facilitating electronic trading in all its form. Financial hubs must exist in a seemingly contradictory space: to be both a deeply and uniquely specialised marketplace, while being firmly connected to the global trading ecosystem by low latency networks. Exchange participants which are unable to do both simultaneously will be disintermediated, immediately.



Islands in the streamAsian markets will be the focal point for the next wave of innovation in financial exchanges

Asia’s capital markets are being redefined by two simultaneous, inter-related—but ultimately contradictory—forces. One is the globalisation of financial markets, underpinned by information

technology and the ever-increasing pressure on the creators, buyers and sellers of financial products to make transactions as efficient (read: fast, cheap, universally accessible) as possible. The speed and reach of machine-enabled trading platforms, and proliferation of dark pools, has had a homogenizing effect on financial markets, turning trading activity into an ‘arms race’ of technology investment for brokerages, and putting intense competitive pressure on the business models of traditional exchanges. The other trend is found in the efforts of market makers to compete through the promotion of increasingly specialised—and thus very localised—financial exchange markets. Efforts to create niches in financial markets are usually rooted in the organic assets of the place—Asia’s many examples include proximity to China in Hong Kong’s case, or depth of expertise in Islamic finance products in Kuala Lumpur.

Ironically, what links these two trends—call them, for lack of better terms, hyper-globalization and ultra-localization—is technology. Algorithmic trading now accounts for nearly two thirds of total trading of equities worldwide, and most ‘developed’ economies see no need to impede the progress of high-frequency trading (HFT), as it is believed to improve (much-needed) liquidity levels, and fosters competition. At the same time, the advent of machine-to-machine trading means that shaving nano-seconds of a trade can mean millions of dollars gained—and the distance between a trader’s servers, relative to those of the exchange, has a direct bearing on how many nano-seconds can be shaved off. Rather than portending the death of distance, then, electronic trading actually makes distance even more important to financial traders, and creates demand for IT and communications services that lower latency and otherwise speed up the pace and increase the reliability of trading.

Asia becomes the fault line against which these two tectonic trends press because it contains the largest collection of growth markets in the world—economically, for the next decade at least, Asia’s GDP (ex-Japan) will grow nearly 7% a year, more than twice the global average. The Economist Intelligence Unit estimates that China will be the world’s single largest economy by 2018, and emerging Asia will Islands in the east Technology, globalization, and the future of the financial hub in Asia account for fully half of the world’s economic output before 2050. Thus, investment flows to the region should increase in proportion, as will acquisitive capital flowing out of Asia’s increasingly wealthy financial centres into the wider world. Capital, ideas, and those that trade in them are moving to Asia with great speed, seeking yield and opportunity.

As a result, investment will increase in the underpinning technology platforms—particularly low



latency networks—applications and IT-enabled processes upon which the financial services industry now depends. In relative terms, Asia is currently underweight in the adoption of technology-enabled trading: while perhaps half of all trades are executed by software in the US today, algorithmic trading accounts for less than 20% of Asia’s volume. Moreover, there are great variances in the region’s markets: some exchanges, such as Tokyo’s, have seen HFT take up over a quarter of equity trading, and in Singapore it accounts for almost a third of all trades in derivatives, according to research from industry observers. In Hong Kong, HFT trading is estimated to only be 5% of market volume.

Asia not only lags in infrastructure and platforms that support electronic trading for historical reasons, the development of the exchanges as a ‘place-neutral’ trading environment in part runs counter to the strategies of Asian policy makers, which are keen to keep exchanges in their national competitiveness arsenal (more of this in the next section). But this is changing fast—Southeast Asia will be the fastest-expanding data centre market in the world this year, according to Datacenter Dynamics, which estimates that investment will more than double in 2012. China is ranked as the world’s third largest destination for data centre investment this year, and Australia the fifth; those two countries alone in Asia will see nearly US$5bn invested in adding capacity this year—perhaps ten percent of the world’s total.

This will, in turn have two profound impacts on Asia’s financial service markets. The first is that Asia’s financial hubs will continue to create environments that keep their market relevant – which is a challenge with policy makers increasing regulation and compliance on a global basis. The second is that while investment destinations are still relevant, the physical point of the financial transaction itself may be less so with the acceleration of machine-to-machine trading, and the steady growth of new alternative trading venues.

Yet, there are counter-points to technology’s impact on a financial hub’s competitiveness. Tax regimes and governance environments still offer Asian hubs place-specific competitive advantages. So while location still matters to the industry, Asia’s financial hubs cannot be complacent, and their future successes will in large part depend on how each responds to the continuous waves of capital, technology and innovative new trading practices that will wash upon its shores.



Between the well-lit marketplace, and the cloudThe constant pressure on Asia’s financial exchanges to innovate will both intensify consolidation—and spur more market fragmentation

An enduring argument that takes place over the future of the exchange is that it is wholly dependent on the stakeholders of an exchange. “An exchange’s role is defined by what sort of returns it has to

provide to its constituents,” observes the head of trading for an Asian bank. “This is why so many publicly listed exchanges are turning into technology providers”—and ‘national’ exchanges are becoming, in part, physical manifestations of economic policy. Some of this need for that physicality is because the exchange serves as an aggregation point for capital, of all sorts: human capital, intellectual capital, and good old-fashioned money still congregate in cities where advantage can be obtained through the acquisition of information and insight.

This argument for retaining an exchanges’ physical presence is critically important to Asian policy makers, from Singapore to Hong Kong to Korea to Japan, in their attempts to retain an edge in their respective financial service industry. It also, in turn, creates the greatest threat to the national exchange’s competitiveness, because ‘technology provider’ exchanges are fast becoming more nimble, and more able to accommodate technology-driven trading processes, and ultimately, better able to increase their market presence, either through mergers and acquisitions, or using technology to deepen their trading platforms.

At its root, an exchange must be a well-regulated, efficient place to conclude trades, and thus its utility becomes a public good, of sorts. “The fundamental purpose of an exchange is to offer protection for those who trade in it,” observes the head of infrastructure for a financial service provider. Asia’s market regulators and policy makers, especially in hub cities, are keen to make sure that this remains a primary asset, without dilution: these econo-nationalistic tendencies were certainly a contributing factor to the inability of the Singapore and Australian exchanges to execute a discussed merger last year.

However critical and enduring the utility of a financial exchange as a ‘place’ on the globe, there is some doubt as to the relevance of the actual trading floor. This can be reflected in the recent decision to trim back the lunch time break in both Hong Kong and Tokyo’s exchange, ostensibly to respond to the competitive pressure that technology-enabled trading places on it. And yet, even with the reduction, Hong Kong’s markets are still only open five and a half hours daily, making it one of Asia’s shortest trading days, which seems charmingly anachronistic for the world’s seventh-largest stock exchange and the focal point for global capital flows to the all-important China market. The resistance to change, to the always-on trading cycle that Internet-based platforms offer, will certainly render the physical exchange less relevant in global markets over time: “There is no doubt that trading floors themselves will soon become museums,” observes a Hong Kong-based trading executive. ‘Physical’ exchanges in the future thus could become objects of instruction of how the world of finance once ran, but increasingly disconnected from how stocks and financial products are traded today.



Speed demonsWhile HFT is fast becoming a staple of capital markets globally (and thus cannot be ignored by any market player anywhere), there remain concerns about the efficacy of electronic trading, which fall into two main camps, both having to do with the implied speed of HFT. The first is that electronically-fuelled trading itself creates the types of risks that expose the global economy to financial meltdowns; that the tools and practices used by HFT participants move markets too quickly for regulatory environments to protect investors. Some industry observers have gone as far as blaming HFT as being (at least part) of recent market panics, such as the so-called ‘Flash Crash’ of May 2010, when US equities markets pitched downward by 10%. While never identified as the primary cause, many in the market grow more worried about the impact of HFT-inspired sell offs, or algorithmic trading practices going buggy, or kill-switches (installed by regulators and market makers to halt such trading spirals) not functioning as intended.

The other speed-related concern is one that electronic trading proponents oversell their case for efficiency: that the increase in activity that HFT creates is simply noise, not evidence of the vaunted increased liquidity all exchanges crave. This argument posits that the number of trades that HFT platforms perform are often executed in the service of seeking pricing information, and are not actually intended to be executed; taking the argument further, that increased volume of price-seeking bids are used to actually, and/or unfairly, move markets. This concern is increasingly a minority view within the industry, for while there are clearly abuses that are perpetrated by high-speed trading, the industry is seeing more solid links between the usage of technology-enabled tools and real increases in market liquidity, as measured by the lowered bid-ask spreads that are seen where electronic trading has taken hold.

The world’s financial services and trading industries continue to favour fast-expanding economies of the emerging world. While the Asian Century is not a foregone conclusion, it is certain to be a focal point of where the world’s financial players spend the bulk of their time, and with that, there will inevitably be technology-carved inroads into these markets. Despite the regulatory and moral hazard concerns, high-speed capital will relentlessly seek to gain faster access to specific opportunities, and Asia’s financial exchanges will need to adapt to this need for speed—but while retaining the local-specific advantages of the market. Traders expect ubiquitous connectivity regardless of location, yet market-specific challenges remain: accessing market data, managing workflow and compliance to a variety of trading standards remain major obstacles in emerging and frontier markets.



When to dip into the war chest—and when to just play table stakes For trading industry players in Asia, investment in technology is a work in progress, and a process which needs work

Asia’s banking clusters, exchange platforms and capital markets are becoming more crowded playing fields—and each playing field is itself competing with others for their share of players. The Indian

regulator SEBI’s announcement of easing direct participation in Indian markets by foreign institutional investors, and HKEx announcing movement into renminbi-priced commodities are two recent cases in point. Market exchange players thus need to compete on two fronts: to be both uniquely positioned in their delivery of trading environments that service niches, and to make these platforms accessible to participants wherever they are.

This increasingly complex and interconnected global trading environment in turn means that trading electronically is no longer not an option for any financial market participant. However, this inexorable trend leads to a more fundamental question for technology decision makers in the banking, trading and finance industries: what level of technology investment is needed to create competitive advantage—and what is needed simply to maintain a position in the market? This question is particularly important for players in Asia’s markets, as the shift towards electronic transactions now gathers critical momentum. The pressure to both speed up the delivery of trades and create algorithmic tools with which to trade competitively “appears to make technology investment an unending arms race,” observes one investment banker, who notes that the decisions surrounding investing in building algorithms and related diagnostic tools, on top of the investments in the servers and processors which support them, are a constant drain on both product development budgets and strategic management time. Maintaining a competitive edge in technology-enabled trading environments, then, becomes a cycle of building up a war chest—and then spending it down.

In this environment, the other half of the technology investment equation is the one where Asia’s finance players are turning to, to free up the necessary resources to compete. “What needs to be determined at a strategic level is what technology is available as a service, or as a routine operational cost, which reduces overall management of the platform for all players equally,” according to the head of trading quoted earlier. Cloud-based solutions, or managed services for hosting platforms, “should be looked at as table stakes,” needed (but minimal) investments that must be made to stay in the game. Neither half of the IT equation—the unique solution or the on-tap commodity—will remain a fixed state, but both must be managed to increase the flexibility of the firm’s responsiveness.



No hub is an islandThe world’s financial service centres are physically disconnected from one other, and serve distinct markets for investors—or are in a continuous struggle to maintain a competitively distinguishable niche. Yet at the same time, all financial hubs are also intimately linked in the provision of an increasingly seamless global trading platform. Of course, dissymmetry exists—variance in technology platforms, liquidity levels, and availability and depth of market information. But in large part, that is the point of a market: traders will only (or should only) move when they feel that they have an advantage supplied by favourable access to asymmetric information.

In broad terms, exchange players are motivated to achieve competitive advantage either through widening the aperture to information and opportunity (if it is a marketplace provider guided by more corporate sensibilities), or by deepening it into a defined set of market experiences (if guided by more nationalistic ones). However, whether it is a private technology provider or a national exchange, both must maintain both types of service platforms in varying degrees to maintain a presence in global financial services. The opportunity for Asian financial centres is in exploiting the growing importance of Asia’s economic might, while also increasing access to the wider, deeper pools of Internet-enabled global capital.

Ironically, while Asia’s exchanges usually see their competitive differentiation in terms of their unique market positions one from another, a large part of the future success of Asian financial hubs may lie in their ability to cooperate instead: “a lesson that telecommunications service providers learned long ago, as the age of ubiquitous communications snuck up on the industry, is that a certain amount of interconnection and cooperation on service platforms with your competitions is needed to stay in the game,” says Brandon Lee, Chief Strategy Officer and Executive Vice President (Acting), Global Network Business, NTT Com Asia Limited.

The strategic imperative for trading industry participants is much the same. Localised points of presence in Asian markets will never go away, and indeed with the investment in data centres and low latency connectivity with the global market, the ‘physicality’ factor is ironically even more important. But a good deal of a financial service provider’s market presence will be defined by the non-physical, whether it is in the utility-based platforms it maintains, or the continual investment in unique trading software and applications. Navigating this tension, and maintaining depth and breadth across Asia’s financial market, will be the key to a sustained competitive advantage.

Whilst every effort has been taken to verify the accuracy of this information, neither The Economist Corporate Network, nor the sponsor of this report can accept any responsibility or liability for reliance by any person on this white paper or any of the information, opinions or conclu-sions set out in the white paper.

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Islands in the eastTechnology, globalization, and the future

of the financial hub in Asia

An Economist Corporate Network management brief

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