Reserve Bank of Australia Bulletin December 2001

Electronic Trading in Australian Financial Markets

derivative trading, is conducted through Introduction exchanges. Trading in foreign exchange and bonds, on the other hand, is mostly conducted in OTC markets. Within each of these two broad structures, Electronic trading of financial assets, such trading may or may not be done electronically. as bonds, equities and foreign exchange, was Equities in most countries are exchange virtually non-existent 20 years ago but has traded. In some, such as Australia, trading is grown in importance since then. Recently, the electronic but in others it still takes the form pace of development of electronic trading of open outcry. Bond markets tend to be OTC. systems has accelerated as market participants In Australia, virtually all bonds are traded by apply internet-based and other network telephone. In the United States, however, technologies to trading systems. This article around half of all bond trades are done outlines current developments in electronic electronically. trading systems in the Australian financial Across all markets, there is a distinction markets and discusses the forces behind, and between inter-dealer trading on the one hand implications of, these developments. and dealer-customer trading on the other. To date, electronic trading is much less common among the latter sort of trades than among Some Preliminaries on the former, though the growing use of internet Market Infrastructure portals – central sites through which potential parties to a trade access the sites of a number of parties simultaneously – and the electronic The trading of financial assets can occur media, is extending the use of electronic within one of two broad market structures. In trading to this market segment. an exchange-traded market, trading is Finally, it is useful to divide trading into its conducted anonymously on a centralised three component parts: – the exchange. In an over-the-counter (OTC) customer seeks quotes from a number of other market, there is no centralised exchange. traders to find the best price; order – the Rather, each trade takes the form of a bilateral customer submits a firm request to undertake arrangement between the buyer and seller. In a transaction; and execution – the buyer and Australia, almost all equity trading, and most seller commit to a contract.

7 Electronic Trading in Australian Financial Markets December 2001 over the phone. Trading in fixed-income and The Status of Electronic foreign exchange is still mostly non-electronic, Trading in Australia reflecting the value placed on personal contact in these markets. OTC derivatives trading is mostly non-electronic because of the relatively Table 1 summarises the extent to which complex and heterogeneous nature of these each of the three main steps in a trade is instruments. Table 2 summarises the history conducted electronically. Exchange-traded of electronic trading in Australia. The rest of equities and derivatives are the most highly this section provides more detail for each type automated of financial markets in Australia. of instrument broadly defined. Nonetheless, orders are typically still taken

Table1: A Typical Wholesale Market Transaction in Australia

Market Steps in trade

Price discovery Order Execution

Fixed-income (over-the-counter) Phone/electronic Phone Phone Foreign exchange (over-the-counter) Phone/electronic Electronic/phone Phone/electronic Equities (exchange-traded) Electronic Phone Electronic Derivatives (exchange-traded) Electronic Phone Electronic Derivatives (over-the-counter) Phone Phone Phone

Table2: Chronology of Developments in Electronic Trading in Australia

October 1987 ASX moved to an automated trading system (SEATS) for a limited range of ASX-listed . November 1989 SFE launched SYCOM – the world’s first after-hours electronic trading system. October 1990 Closure of trading floor at ASX and conversion of all stocks to SEATS. 1992 Foreign exchange dealing rooms started using electronic broker services such as Reuters 2000-2 and EBS. October 1997 ASX launches its electronic trading platform for trading equity options. November 1999 SYCOM became SFE’s sole trading platform. November 1999 ASX’s interest rate market started trading (retail). February 2000 Bloomberg submits proposal to ASIC to extend their Bond Trader system to offer electronic trading. April 2000 Currenex.com is launched – the world’s first internet-based multi-dealer foreign exchange service. November 2000 Australia’s four major banks announce intention to form an internet portal (AusMarkets) for online distribution of financial services. January 2001 Australian Derivatives Exchange launched. March 2001 Australian Derivatives Exchange closed. April 2001 Yieldbroker.com granted approval to offer direct trading of bonds through its internet portal. May 2001 Multi-dealer foreign exchange service FXall.com begins trading. June 2001 Multi-dealer foreign exchange service Atriax.com begins trading. November 2001 AusMarkets development put on hold.

8 Reserve Bank of Australia Bulletin December 2001 Fixed-income markets role in bringing issuers and together As noted, trading in fixed-interest is largely in the primary bond market (i.e. at the time telephone based. However, there is some that a bond is first issued). In March 2000, electronic exchange trading of fixed-interest Telstra’s A$500 million bond issue was on the ASX’s Exchange Automated marketed to institutional investors through the Trading System (SEATS). This began in internet by Westpac and Commonwealth November 1999. Recently, there have been Bank. The Commonwealth Bank also about 22 000 trades a month, for a total marketed its August 2000 bond issue through average value of around $630 million. This its website and the bond was listed on the remains only a small part of total bond market ASX’s interest-rate exchange. turnover, which typically is about The internet has, however, mainly been used $100 billion a month. Currently the ASX as a marketing tool in Australia. In the US market covers approximately 60 interest rate and Europe, various auction systems exist in products, including Commonwealth and which an issuer posts details of the security semi-government securities, corporate bonds, being offered for sale and the specific terms floating rate notes, convertible notes and of the auction. Buyers are able to submit bids hybrid securities. and the securities are awarded to the bidder In April 2001, an internet portal was that offers the highest price or lowest . established for electronic trading of Such systems are not yet used in Australia. fixed-interest securities. This portal, known as Foreign exchange yieldbroker.com, allows clients to view indicative prices, request firm quotes and execute trades In the foreign exchange market, dealers can with any of its five current members. Trading trade directly with each other or indirectly volume on yieldbroker.com has reached up to with each other in what is known as the $500 million per month. A potential brokered market. Most direct trades are still competitor to yieldbroker.com, AusMarkets, was done over the phone. In the brokered market, due to begin trading in late 2001, but put its almost all trading was done over the phone, plans on hold in November 2001. It had in what is known as voice broking, as recently aimed to provide trading facilities for as about 10 years ago. Now, almost half of -term money market and debt securities. trades in the brokered market are effected electronically, through service providers such As for electronic media, Bloomberg, which as Reuters and Electronic Broking Services has been operating an electronic bond trading (EBS). In June 2001 electronic broking system in Europe and the United States for accounted for 21 per cent of turnover in the some time, is currently seeking ASIC approval combined interbank and brokered markets to offer electronic bond trading in Australia. compared to 23 per cent for voice broking Bloomberg Bond Trader, which uses (Graph 1). When an electronic broking system Bloomberg’s communications infrastructure, is used, price discovery, order placing and acts like a bulletin board. It offers indicative trade matching are completely automated. prices on a range of Australian government, overseas government and corporate debt and, Development of electronic trading in the pending approval, will provide for direct dealer-to-customer market is less advanced. trading. By acting as a central intermediary, There are three multi-dealer internet-based Bloomberg has the potential to be more open global foreign exchange markets: Currenex, than an exchange. On the other hand, an FXall and Atriax. All three provide facilities exchange could offer anonymity, which large for trading spot, forward and swap investors like as it helps them avoid revealing transactions in a large number of currencies their financial situation. including the Australian dollar. Currenex, which began trading in April 2000, is The developments discussed above relate an independent service backed by a to electronic trading in the . predominantly non-bank consortium. It The internet has, however, already played a

9 Electronic Trading in Australian Financial Markets December 2001 Graph 1 the United States, by some 16 years, it nonetheless was a major event at the time. Inter-dealer Spot and Swaps Foreign SEATS facilitates trading between brokers Exchange Dealing Share of total turnover who are members of the exchange. A % % Voice broking significant additional development over the 25 25 past couple of years has been in the application of internet technology to provide an electronic 20 20 link between brokers and their clients. There are now 1 million customers registered with 15 15 online brokers such as CommSec and Electronic broking E*TRADE (Table 3). Online trading as a 10 10 proportion of all ASX trades is currently around 18 per cent (Graph 2). 5 5 Most of the growth in electronic broking in

0 0 Australia has occurred on the retail side of JDJDJDJD the market. While some institutional investors 1998 1999 2000 2001 Source: RBA currently has around 40 market-making Table3: Online Broking Customers member banks. FXall, which began trading June 2001 in May 2001, has a similar number of CBA 652 100 market-makers. In addition to the standard E*TRADE 82 500 foreign exchange products it also provides WBC 82 000 facilities for trading of foreign exchange Charles Schwab 50 000 options. Atriax has the largest number of NAB 48 345 dealer members (around 70). It began trading Sanford 34 817 in June this year and plans to add other foreign TD Waterhouse 30 305 exchange products and some money market HSBC 16 752 products to its site in coming months. There Quicktrade 15 017 is considerable overlap in the banks that act Total 1 011 836 as market-makers through these internet portals. Source: JP Morgan In addition to multi-dealer sites, some dealer-to-customer trading in Australia is done through the banks’ own websites. All Graph 2 banks with significant foreign exchange operations offer some kind of online trading Online Broking in Australia ’000s Proportion of ASX trades (RHS) % platform for their customers. The amount of ■ Number of trades (LHS) turnover going through these systems is in line 450 35 with global trends, i.e. 5 to 10 per cent. 400 30 Equities 350 25 The bulk of equity transactions in Australia 300 20 are conducted through organised electronic 250 15 exchanges; the ASX began screen-based trading in October 1987, when it started 200 10 trading a limited number of stocks on the 150 5 Automated Trading System 100 0 (SEATS). Although this initiative post-dated D FAJAODFAJ 1999 2000 2001 the electronically-traded , in Sources: ASX; JP Morgan

10 Reserve Bank of Australia Bulletin December 2001 have electronic links to their brokers, it is still the case that most institutional investors use Table4: Proportion of Wholesale traditional broking methods – i.e. investors Market Turnover Traded Electronically telephone the broker to submit their order. Per cent In this process, price discovery, and trade execution, which are conducted by the ASX, Market Australia US are automated. Fixed-income(a) (b) Derivatives – Inter-dealer nil 50 – Dealer/customer nil 30 In Australia, interest rate swaps and foreign exchange forwards and options, are traded Foreign exchange(b) OTC, mostly by phone. Futures, options and – Inter-dealer(c) 20 46 warrants are, however, traded on the ASX and – Dealer/customer(d) 5–10 5–10 the similarly screen-based Sydney (SFE). Equities(b) Equity options are traded on the ASX’s – Inter-exchange member 100 50 CLICK screen-trading system, which – Broker/customer(e) 10 40–45 replaced their floor-based trading system in Exchange-traded derivatives October 1997. In addition, warrants have – Inter-exchange member 100 20 been traded on the SEATS electronic trading – Broker/customer 5 na system since early 1991. The ASX has recently submitted a proposal to ASIC to reactivate Notes: the ASX Futures Exchange Limited. This (a) United States inter-dealer market data are proposal is currently being considered by from the Bond Market Association ASIC. (www.bondmkts.com); dealer-to-customer market data are from an e-Commerce survey The SFE’s SYCOM (Sydney Computerised conducted by the Greenwich Group. Market), launched in November 1989, was (b) Aggregate share across exchange-traded and the world’s first after-hours electronic trading over-the-counter trading. system. Its aim was to provide a platform for (c) Numbers for the US are from Cheung and Chinn the trading of SFE products during the (NBER Working Paper No 7416). European and North American trading day. (d) Source: Greenwich Group. A decade later, SYCOM replaced the (e) Broker estimates for Australia were obtained from open-outcry trading system, becoming the JP Morgan. US estimates were obtained from SFE’s sole trading platform. Credit Suisse Hong Kong.

Comparisons with the Exchange) still operate traditional United States open-outcry markets. In the inter-dealer foreign exchange market, there has been greater take-up of electronic It is interesting to compare the status of trading in the US. Because of well-established electronic trading in Australia to that in the relationships between the various participants United States. As shown in Table 4, a higher in the Australian dollar interbank market, proportion of equity and exchange-traded there was initially little usage of electronic derivatives are traded electronically in trading. However, of late, electronic trading Australia. While the ASX and the Sydney has been garnering an increasing share of Futures Exchange (SFE) are fully automated, Australian dollar trades. In addition, most some large US exchanges (such as the trades in which neither currency is the , the Chicago Australian dollar are now conducted Board of Trade and the Chicago Mercantile electronically.

11 Electronic Trading in Australian Financial Markets December 2001 One area where Australia has lagged well depth of a market (for example, by showing behind the US in the use of electronic trading potential supply and demand that would is the fixed-income market. While electronic transact at prices away from the current trading platforms are only just beginning to market price). be established in Australia, in the US they have Third, electronic trading facilitates made significant inroads, accounting for ‘straight-through processing’ not only around half of dealer-to-dealer transactions reducing costs of settling transactions but also and almost a third of dealer-to-customer offering better risk management. Under transactions. straight-through processing, all administration Across all markets, the dealer-to-customer of an agreed trade is done automatically. This segment of the market has not been as fast to helps to minimise the risks of fraud and adopt electronic trading methods as the human error associated with manual trade inter-dealer segment. In the inter-dealer processing. Online brokers that use fixed-income and foreign exchange markets, straight-through processing pre-validate and brokers and information services have reserve a client’s securities or funds before the provided ‘offering screens’ which display bond order is submitted to the market. If the client and foreign exchange prices for quite some does not have the stock or cash, the trade will time. Such systems were relatively easy to not proceed. extend to full trading systems. Electronic systems offer the potential for a fourth attraction to participants: anonymity. Anonymity between potential counterparties Forces for, and Implications enables participants to place big positions of, Electronic Trading without revealing their financial situation. It is possible to design electronic systems that provide complete disclosure of counterparty There are several economic factors behind details, full anonymity or anything between the push towards electronic trading: cost; these two extremes. A number of the systems transparency; risk management; and the operating overseas, however, provide a high potential for anonymity. level of anonymity and it is argued that this is The cost advantages of electronic trading are an advantage over traditional phone-based two-fold. First, electronic trading has the dealing in over-the-counter markets where potential to reduce marginal costs virtually to participants find it difficult to conduct large zero; despite relatively high initial overheads, transactions without having market prices the average cost of electronic trading becomes move against them. lower than that in traditional markets as There is, however, a tendency for trading expands. (Homogenised products institutional ‘heritage’ to affect the pace of such as foreign exchange might be expected development of electronic trading systems. to benefit most from these economies of The Australian foreign exchange market, with scale.) Second, investors can gather its longstanding relationships between information quickly, forcing greater interbank participants, seems to be a case competition among brokers. in point. The enhanced transparency afforded by Two policy concerns that arise from the electronic trading systems means that all growth in electronic trading are its impact on investors – large and small – can actively market liquidity and the risks that may follow participate and respond more quickly to from concentration of ownership of electronic changing events within the markets. Electronic trading systems. systems have the capability not just to improve The likely impact of electronic trading transparency of prevailing prices in a market, systems on liquidity is ambiguous. Other but also to provide more information on the things being equal, the lower transaction costs

12 Reserve Bank of Australia Bulletin December 2001 and greater access to market information On balance, it is difficult to predict with any associated with electronic platforms could certainty how widespread use of electronic reasonably be expected to underpin both trading systems would affect market liquidity. increased activity by existing market However, the Bank for International participants and a broadening of the market. Settlements, in their 2000 study of the In particular, the availability of electronic implications of electronic trading, found that trading platforms should encourage increased at this stage there are no clear signs that participation by retail investors. Liquidity liquidity has been adversely affected by the should also benefit from the anonymity introduction of electronic trading. provided by electronic exchanges to the extent Electronic trading systems are characterised that this feature allows market-makers to by network effects and economies of scale that manage large transactions more efficiently. create ‘first mover’ advantages. The network On the other hand, the proliferation of effects are due to the fact that the benefit of electronic trading systems should increase participating in a network, such as a financial competition among market-makers and market, increases with the number of underpin the global trend toward participants in the network. The high fixed consolidation in this sector of the industry. A costs of developing the technological decline in the number of market-makers could infrastructure accompanied by the low be expected to have a negative impact on ongoing variable costs of running a system liquidity, other things equal. In addition, there once it has been developed mean that there is some uncertainty about the performance are substantial economies of scale in electronic of electronic trading systems in times of trading systems. market stress. There are concerns that at such As a result, there may be a tendency for times, participants may be less willing to use monopolies to form in the provision of trading electronic systems and that liquidity will suffer systems and for the full cost savings from from the absence of dedicated market-makers. electronic trading to not be passed on to However, the global experience to date, albeit market participants. The potential for limited, suggests that electronic markets monopolisation also poses the risk that a perform as well in times of stress as other market’s functioning becomes heavily markets. In part this is because market-makers dependent on one computer system. For the may fail to fulfil their role in both electronic present, however, there are a variety of systems and traditional markets in times of severe in use and in development. New technologies stress. It is also possible to devise electronic also provide the scope for contestability from trading systems with strict market-making abroad. This suggests monopolistic tendencies obligations for some of the system’s will be constrained for some time. R participants.

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