Dark Pools in Asia Pacific â€" Watch This Space Posted by  Lee Kha Loon, CFA to CFA Institute Market Integrity Insights Dark pools have been back in the news in Asia recently. An article by Asian Investor (subscription required) on 17 August noted there is an increasing trading volume of small-cap stocks in Australia, Hong Kong, and Japan in alternative trading systems since the beginning of the year. Some 30 percent of executions in Credit Suisse’s dark pool, Crossfinder, relate to shares outside the top 200 names in Hong Kong; in comparison, such names account for only 10 percent of exchange transactions, which remain dominated by blue chips. According to the article, this trend is less pronounced in Japan: small cap trades represent 6-8 percent of Crossfinder trades, a similar proportion to on-exchange transactions. Meanwhile Liquidnet, an institutional-only dark pool platform provider, reported that trading volumes have increased in recent months in the Asia-Pacific region driven by higher market volatility.
Trading in equities in Asia is mostly done through stock exchanges with a very transparent system of price discovery. Those wanting to trade will display bids or offers to buy or sell shares at the desired quantity â€" the so called “lit†market. The opposite of lit is, of course, “darkâ€. Hence “dark pool†refers to a place where trading liquidity â€" a supply of shares â€" exists that is not displayed for all to see.
Are Institutional Investors Enjoying an Unfair Advantage?
Dark pools enable large institutional participants to move sizeable amounts of liquidity whilst minimizing intermediation costs and market impact (where the market price moves against the order upon its revelation to the market). Accordingly, they can provide investors with an efficient means of trade execution.
Some have suggested that dark pools present the risk of a two-tiered market between displayed and dark liquidity, if access is limited to only certain investors. But, to a certain extent, all markets are two-tiered, in that there are wholesale and retail channels. Same with stocks; there have always been wholesale and retail brokers, upstairs and floor trading. The bottom line is that dark pools are a natural response to meet institutional investors’ demand for low cost trading, reduced market impact, and required liquidity in today’s highly automated trading environment.
So What Are Regulators’ Concerns?
These focus around transparency and an uneven playing field. The relative opacity of dark pools can hamper price discovery if too much volume is taken away from the lit market (thankfully, we are some way off that point in Asia). However, it is important that there are consistent post-trade reporting standards for all transactions, whether they are executed on-exchange, in a dark pool, or over-the-counter, so that investors have an accurate and reliable picture of prices across the trading landscape. Moreover, this pricing information should be consolidated (in the form of a ‘consolidated tape’) so that transparency information is not diffused across a more fragmented marketplace.
On the level playing field, it is vitally important that all trading venues conducting similar types of business, and all orders of similar types and sizes, are subject to the same rules. In this context, it is important that transparent markets are not disadvantaged by a different set of rules for dark markets; otherwise, over time, we could see a larger shift in volume away from lit markets, with potential adverse consequences for public price discovery and liquidity.
So a level playing field is necessary to provide fair competition and to uphold market quality and integrity. Regulators in Asia should heed these considerations as they go about opening up their markets to greater competition so that they can avoid some of the problems we’ve seen in the U.S. and Europe.
Should Retail Investors be Given Participation in Dark Pools, and How Can It be Done Equitably?
Perhaps it is time for market participants and regulators to revisit this issue. The Australian Securities & Investments Commission (ASIC), the Australian securities regulator, published a concept paper on a regulatory framework to introduce competition in exchange markets in April. The paper recognizes that smaller trades are shifting into dark pools and the absence of pre-trade transparency will have an effect on price formation at the exchange platform. ASIC proposes to have a consolidated source of market information for both pre-trade and post-trade data, a fundamental element of a fair, orderly, and transparent market.
CFA Institute supports the move by regulators to introduce competition as that will help improve market efficiency and lower the costs for investors in the long term. In January 2011, CFA Institute released a study on the structure, regulation, and transparency of European markets under MIFID, recommending greater transparency and a level playing field. We subsequently commented on dark pools in a letter to the International Organization of Securities Commissions (IOSCO). The Australian regulators have made the first move to address this issue; others may follow. Watch this space.
Joe Biden came to China, saw, and failed to conquer the locals' ridicule. Punctuating just how "effective" Biden's visit to China was in order to "reassure that the US is solvent" (no seriously, that;s the name of the article) is a just released article in the Securities Times by Wang Tialong, member of Chinese think tank Center for International Economic Exchanges in which he went on to blatantly say that "The U.S. may be on its way to default on its debt despite the U.S. government's ability to print more money, a Chinese think tank researcher said Monday." Now this is nothing new in the escalating war of words between the two countries, although increasingly China appears to be attacking the primary loophole that defenders of the unsustainable US debt use, namely the fall back to the USD as a reserve currency. Wang went on further to implicitly accuse the US of fabricating economic data: "There is also no way to punish the issuer country if it falsifies its accounting and there is no way to restructure the issuer either, Wang said." Well, when China accuses the US of "falsifying accounting" you know you have hit rock bottom.
From Dow Jones:
The U.S. may be on its way to default on its debt despite the U.S. government's ability to print more money, a Chinese think tank researcher said Monday.
There is no guarantee for sovereign debt, which increases the risks the lenders face, said Wang Tianlong, a researcher at the China Center for International Economic Exchanges, a think tank supervised by the country's economic planner, adding that the issuer could be more careless in using the loans.
In the short term, the U.S. doesn't have much ability to reduce its deficit, Wang said in an opinion piece published in Securities Times. He added that the U.S. lacks the political system to guarantee that it will not default on its debt.
There is also no way to punish the issuer country if it falsifies its accounting and there is no way to restructure the issuer either, Wang said.
Wang's comments come after the U.S. Vice President Joe Biden said Sunday the U.S. "never will default" on its government debt and reassured Beijing that Chinese investments in the U.S. are safe.
Slowly, surely, China is realizing that the endgame is nothing short of out of control debt inflation, which is precisely what having no way to "restructure the issuer" means. That plus sending the US to bankruptcy court may be somewhat problematic. It also means that Chinese holdings of US debt will be increasingly worthless, and its population increasingly stabby as the price of hogs resumes its record climb. The only alternative is for the CNY to float and for the Chinese, Russians and Germans to say enough to this broken economic model and launch a gold (and other hard asset) backed currency. The only question is when.
News Highlights - Week of 15 - 19 August 2011
Malaysia's real GDP growth moderated to 4.0% year-on-year (y-o-y) in 2Q11 from a 4.9% expansion in the previous quarter. Private consumption increased 6.4% y-o-y in 2Q11, while public consumption growth stood at 4.0% y-o-y. Gross domestic capital formation expanded 3.2% y-o-y in 2Q11. Growth in the manufacturing and construction sectors moderated in 2Q11 to 2.1% and 0.6% y-o-y, respectively. Meanwhile, consumer price inflation in Malaysia eased slightly to 3.4% y-o-y in July from 3.5% in the previous month, with food and transport costs rising 4.9% and 4.8%, respectively. In Singapore, growth in retail sales accelerated to 10.9% y-o-y in June from 9.6% in May. Thailand's real GDP grew 2.6% y-o-y in 2Q11, compared with revised 3.2% growth in 1Q11.
* The People's Republic of China (PRC) raised a total of CNH15 billion in the Hong Kong, China offshore market last week from its sale of (i) CNH6 billion worth of 3-year bonds, (ii) CNH5 billion worth of 5-year bonds, (iii) CNH3 billion of 7-year bonds, and (iv) CNH1 billion worth of 10-year bonds. The average coupon rate of the bonds was lower by 225 basis points compared to onshore yields. Also last week, the PRC's Vice-Premier Li Keqiang visited Hong Kong, China and expressed support for the development of the CNH market.
* Japan's merchandise exports dropped 3.3% y-o-y in July amid the yen's appreciation and weak demand from the PRC and the United States. Singapore's non-oil domestic exports fell 2.8% y-o-y in the same month.
* Overseas remittances to the Philippines rose 7.0% y-o-y to USD1.7 billion in June, after climbing 6.9% in May, on the back of sustained foreign demand for Filipino workers. The Philippines posted a balance of payments surplus of USD1.3 billion in July, compared with USD222 million in June.
* Foreign direct investment (FDI) in the PRC rose 18.6% y-o-y to USD69.2 billion in the first 7 months of 2011, including a 19.8% y-o-y increase in July.
* In the PRC last week, Beijing Energy Investment raised CNY2 billion from a dual-tranche bond sale. Last week in the Republic of Korea, Shinhan Financial Group priced KRW230 billion worth of dual-tranche bonds; Hanjin Heavy Industries issued KRW200 billion worth of 3-year bonds; and Meritz Finance Holdings raised KRW200 billion from a dual-tranche bond sale. Meanwhile, the Bank of Thailand (BOT) plans to offer THB50 billion of savings bonds this month, while Indonesia mandated three banks for its planned USD-denominated global sukuk (Islamic bond), which is expected to be launched at end-September or in early October.
* Government bond yields fell last week for all tenors in Indonesia and the Philippines, and for most tenors in Malaysia, Singapore and Viet Nam. Yields rose for most tenors in Thailand while yield movements were mixed in the PRC; Hong Kong, China; and the Republic of Korea. Yield spreads between 2- and 10- year maturities widened in Indonesia, while spreads narrowed in most other emerging East Asian markets.
* Finally, some of the more interesting economic data due this week include consumer price inflation for Japan, Singapore, and Viet Nam; the 1-day repurchase rate for Thailand; exports for Hong Kong, China and Viet Nam; and the current account balance for the Republic of Korea.
Fresh trouble seems to be brewing for the UPA government, as the Comptroller and Auditor General (CAG) has completed two more high-profile audit reports that could bring attention back to political corruption and misdeeds at the highest levels.
Sources said the CAG has finalized and printed its audit reports on Air India and oil exploration contracts, including the one for Reliance's KG Basin. The reports are expected to be forwarded to the government in the next few days. It's up to the government then to table it in Parliament as the scheduling is done by it.
Whenever they are tabled, the reports are likely to draw attention to the government's decision making—by respective ministers and even an empowered group of ministers—on some of the major commitments of public funds and resources. The CAG report on AI covers, among other things, the purchase of 111 aircraft for over Rs 40,000 crore in 2006. Sources said CAG had made adverse observations on several aspects, ranging from the wisdom behind ordering so many aircraft by a financially weak body to the financing of the deal. Losses on account of what's described as wrong purchase plans, inflated loans, delay in the return of leased aircraft, etc, are estimated at over Rs 2,000 crore.
Sources said the audit report on oil exploration contracts is also ready. It has estimated direct loss at a few thousand crores because of the contract given to RIL for KG Basin, to Cairn India in Barmer district, and to a joint venture comprising RIL, British Gas and ONGC in the Panna-Mukta and Tapti gas fields.
The Air India audit covers the period of 2002 to 2010, most of which falls under the UPA, when Praful Patel was the civil aviation minister. Raising questions about the very contract for the aircraft purchase, it has said the purchases should have been executed in two phases. The original plan was to purchase 35 Boeing aircraft on firm order, with the option for adding 15 at a later stage. But the EGoM altered this to buy 50 at one go because of possible financial benefits.
The top auditor has also drawn attention to the delay in the setting up of an MRO (maintenance, repair and overhaul) facility in India by Airbus as an offset for the contract. It has examined the merger of Air India and Indian Airlines as well.
First Apple overtook Exxon as the biggest company in America, now its market cap just hit 75% of the market cap of the entire European bank stock index (that's right: one maker of phones and fads is worth almost as much as all of Europe's banks). We expect parity within a few months. Since Apple's cash generation of about $10 billion per quarter, and growing at ~100% each quarter, means that the firm will have more than a trillion in a few short years, and not a penny in debt on the other side, we are going to go ahead and say what everyone is thinking: Steve Jobs for lifetime Federal Reserve chairman.
Market cap comparison:
As corporate-politician nexus wanes, investors move away from 'well-connected' cos, which indicates a paradigm shift.
The Hyderabad Connection
In August, 2008, I found myself on a flight to Hyderabad with our infrastructure analyst. On the flight, we went through the financial statements of the said infra company, but could not make any sense of the
balance sheet. Why was the infra company making loans equivalent to almost its entire shareholders' equity? And why did the annual report say that the infra company only had minority stakes in its power plants when the investor presentations clearly suggested otherwise?
On being asked these questions, the infra CFO said, "Look, this is the way things are in India. You need to get used to it." In effect, he was trying to circumvent Accounting Standard 21 by using a clever structure, which allowed him to use his own balance sheet to flatter his own P&L. When we published our 'Sell' note on the said infra company, we were threatened by the same CFO in Bollywood-style language. And next came the investors' reaction. While some clients heeded our warnings and stayed away from the infra company, others said, "You have to accept these political connections… This company is a prime play on the 'power deficit' story in India."
These investors were right. Throughout CY09 and the first quarter of CY10, the company's stock trebled as it won more contracts and was given water and fuel linkages. And then came the scandals.
These were the defining national scandals of CY09 – CWG, Adarsh, 2G, etc. and they have had two salutary effects across a range of sectors. Firstly, they have deterred politicians from helping companies win contracts or access natural resources. Secondly, they have deterred investors from investing in companies, which are fronts for certain political godfathers. These findings are from two studies, performed over the past quarter by my colleagues.
Our Research
The first study hinges our forensic accounting model, which ranks the BSE 500 companies according to the quality of their financial statements. I remember trying to use this forensic model to make stock calls in CY08, CY09 and CY10. But it was a fruitless exercise because investors would back companies, like the infra company highlighted above, which had hopeless accounting but strong political connections. These companies would, in turn, go on to outperform the broader market. However, as the corporate-politician nexus has sought cover over the past year or so, investors have swiftly gravitated towards companies, which have strong accounting quality. So, if I break the BSE 500 into four quartiles, where quartile A has the strongest accounting quality (as per our forensic accounting model) and quartile D has the weakest, our analysis shows that over 1, 3 and 5 years, quartile A has outperformed B; this, in turn, has outperformed C, which has outperformed D. Whatever return metric is used – average returns from each quartile, median returns from each quartile, % of companies in a quartile reporting positive shareholder returns over 1/3/5 years – this pattern holds, suggesting that finally, share prices in India are being driven by fundamentals, rather than political connections.
Our second hinges around explicitly analysing the impact of political connections on shareholder returns. Within our universe of BSE500 stocks (excluding financial services stocks), we have classified the companies into 'Strong/Medium/Low,' based on the strength of their connectivity to political establishments over the past few years. Out of this universe of 360 firms, our sector leads have classified 25 (7 per cent) of these firms as having 'strong' connectivity and another 50 (14 per cent) as having 'medium' connectivity. By default, therefore, the remaining 285 (79 per cent) firms are deemed to have 'low' connectivity.
The 75 stocks with 'strong' or 'medium' connectivity came from the following sectors: Power (13 per cent), Capital Goods, Infrastructure and Construction (44 per cent), Real Estate (17 per cent), Technology (16 per cent), Metals and Mining (5 per cent), Telecom (3 per cent) and Media (1 per cent).
In the previous bull run (the period ending 2008), the 'strong connect' stocks outperformed the market substantially. However, around 2008, this outperformance peaked. Then this outperformance gave way to underperformance, which has become especially meaningful during the past one year. Over the past one year, the cumulative outperformance since 2006 has not only waned and disappeared, but has now moved into negative territory.
In particular, the 'strong connect' group has underperformed the market by 14 per cent in the past one year.
Investment Implications
It is debatable whether the pattern which has been established over the past year – of investors avoiding well-connected firms in favour of fundamentally high quality firms – is here to stay or is it a temporary reaction to the fear created by the intensity of the 2G investigation. I believe that this pattern is a positive paradigm shift and marks a watershed in the evolution of the Indian stock market. Several investment implications arise from this positive paradigm shift:
Fundamentals will become a bigger focus in sectors such as Power, Realty, Construction, Technology, Mining, Real Estate, etc., as the market forces these companies to either shape up or ship out. It won't be enough for these companies to have one or two powerful people sitting on their Boards and expect a premium valuation from investors due to the presence of these luminaries.
When the Indian market finally goes into a secular bull run, the kind of stocks which will deliver market-beating returns will be very different from the stocks which did well in the two previous bull runs (the one ending January, 2008, and the other brief blast from March, 2009-July, 2009). In particular, the high beta stocks, to the extent that they are 'strong or medium connect' companies with weak fundamentals, might not be able to outperform. In contrast, companies with clean accounting and solid franchises should be in high demand.
Investors' ability to generate market-beating performance should now become more closely aligned to their skills of spotting fundamentally high quality companies (as opposed to their skill in knowing which company is connected to which grandee).
