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Anchors Away! How Johannesburg switched to the fast lane and what it means

Published in Automated Trader Magazine Issue 33 Q2 2014

Sophie Lewisohn talks to the local exchange, market participants and other industry players to find out what a new co-location centre means for the South African market. Will it herald an influx of low-latency traders, new strategies and more liquidity? Is this market set to leap ahead in springbok-like fashion?

Anchors Away! How Johannesburg switched to the fast lane and what it means

Johannesburg's high speed traders have a shipping disaster off the coast of Kenya to thank.

In 2012, a captain dropped anchor in a restricted area of ocean near Mombasa and hit a bundle of fibre optic cables connecting Africa to the internet.

It was that unfortunate event, among many others of its kind, which prompted the Johannesburg Stock Exchange to move its trading system back to South Africa.

For the decade until 2012, the JSE's matching engines were located in London. "We were highly dependent on international lines to get order and trade messages from South Africa to London and back again," says Nicola Comninos, senior manager of equity market development at the exchange.

Nicola Comninos

Nicola Comninos

"From looking at other exchanges which have introduced colocation, we expect there will be an increase in liquidity - thus overall more activity for the whole market to interact with."

Orders had to make a trip across the ocean, taking 180-odd milliseconds - a serious hold up. Saving time was one reason the exchange moved its trading system from London to Sandton, the business district of Johannesburg, in July 2012.

It was also a cost-cutting exercise. "We're now managing the trading engine with local South African resources paid in rands - which is much more cost effective than hosting a trading system in the UK in pounds," says Comninos. "More importantly still, it dealt with stability issues."

International bandwidth had long been precarious, with times when the connection would cut out for no apparent reason. "There used to be just one cable which went around the west coast of Africa, round the horn and up to Europe," says Richard Bell, head of FIX Services at IRESS. "If an anchor knocked the line or a storm took out a component, it was a complete nightmare. We had to reroute our order flow through a cable which went all the way to South America, up to the States and then back to Europe."

Infrastructure companies responded by rolling out a huge cable network across the continent, with lines running along Africa's east and west coasts. "We've built a vast amount of multi-layering, so that if a particular line breaks we can switch our clients to a back-up route," says Bell. Bandwidth in South Africa is "improving", according to Comninos, but it is still expensive and not particularly fast.

The arrival of the new data centre in Sandton let investors save on their bandwidth costs and sleep easily during storms at sea. The number of trades per month has gone up by 65% since the exchange was repatriated, and the monthly traded value has increased by more than a quarter, from 264 billion rand in July 2012 to 336 billion in February 2014.

"Liquidity begets liquidity," says Bell. "It becomes a self-fulfilling prophecy." The move to Sandton also allowed the JSE to think about the next step in service provision: colocation. "There is a feeling that colocation is now an essential service for a stock exchange to offer," says Philippe Carré, global head of connectivity at SunGard.

Trading firms were buying up office space across the street from stock exchanges long before the exchanges saw the revenue opportunity and rented out space in their own buildings. Germany's XETRA became the first exchange to offer colocation in 2006. NASDAQ was next in 2007, followed by the New York Stock Exchange in 2008 and the London Stock Exchange in 2009. Since then colocation has sprung up at exchanges around the world, from Singapore to Stockholm. The Johannesburg Stock Exchange is the latest to join the club.

Members are now able to plug their trading equipment directly into the exchange's data centre - for a fee. One financial services firm told Automated Trader it has found that by moving its hosting into the JSE's colocation centre, submitting orders is seven times faster. It is also roughly three times more expensive per unit of rack space than hosting at their own data centre.

Johannesburg's new colocation building has 35 racks for clients to rent. A 3kW hosting unit goes for $4,900 a month, while a more powerful 5kW unit can be rented for $7,200 - plus electricity bills.

Inside the colocation centre, latency is estimated at 100 microseconds.

According to the JSE, an international investor who buys space in the data centre can access the market 2,100 times faster than from abroad. Trading from inside the colocation centre is 200 times faster than sending an order down the wire from Cape Town, 30 times faster than from central Johannesburg, and 24 times faster than from an office in surrounding Sandton.

Boosting liquidity

Comninos expects colocation to benefit the wider exchange. "From looking at other exchanges which have introduced colocation, we expect there will be an increase in liquidity - thus overall more activity for the whole market to interact with."

High frequency trading tends to increase on the advent of colocation, and studies have found that this is a boon to the market. "The majority of high frequency trading strategies contribute to market liquidity (market making strategies) or to price discovery and market efficiency (arbitrage strategies)," write Gomberm Arndt, Lutat and Uhle in their Goethe Institute study 'High- Frequency Trading'. However, the same study notes that "empirical research is restricted by a lack of accessible and reliable data".

One likely bet is that the volume traded on the exchange will increase. "When you put together a colocation ecosystem, you're trying to attract different players, and high frequency traders are one of them," says Carré. "These customers bring volume, and exchanges need that volume."

Another likely bet is that the gap between bid and offer prices will continue to narrow. "Spreads have gradually got narrower since the advent of electronic trading," says Bell.

At the same time, traders are seeing more volatility. "Our market is becoming increasingly volatile all the time," says Bell. "It's the same story across the world. One thinks of oneself as in a provincial environment. But the reality is, with today's electronic trading capabilities, while in some developments Johannesburg is marginally behind Europe and the US, with trading volumes and cycles we're right up there with most of the markets across the world."

Some trading firms are biding their time before signing up. "Latency is a parameter and it comes with a price and a payoff," one veteran trader at a Johannesburg firm says. "You always need to make sure that you're getting the payoff. We are not participating in colocation for now."

The exchange limited its initial offer to 20 racks so it could ensure the operational stability of the new trading environment before taking on more clients. On the day of go-live, the majority of the 20 units had been taken up, according to Comninos.

Some secrecy hangs over the occupiers of these rack spaces. "Clients are both domestic and international, and come from all trading backgrounds," says Comninos. Of the nearly 20 spaces filled, only five companies have publicly stated their presence: two exchange members, Credit Suisse Johannesburg and Peregrine Equities, and three infrastructure providers: Fixnetrix, IRESS Financial Markets and SunGard.

"Many users do not advertise that they are making use of colocation facilities," says Carré. "SunGard's clients are exchange members who want to outsource their trading architecture. They want to be in the best position to trade, with the best latency."

Another firm which has signed up to colocation is IRESS. Bell sees the exchange's introduction of colocation as an invitation to overseas investors. "Attracting those people requires a highly efficient trading system, a highly efficient settlement system, and colocation. The Johannesburg Stock Exchange has gone through and ticked all those boxes."

Another box ticked is regulation. For four years running, the JSE's regulation has been rated first in an analysis of 148 securities exchanges by the World Federation of Exchanges. As the JSE is the only exchange in South Africa, the challenges for regulators are less complex than in markets where the same stocks can be bought and sold on numerous venues and brokers are tasked with best execution.

Richard Bell

Richard Bell

"Liquidity begets liquidity. It becomes a self-fulfilling prophecy."

"I think regulation of advanced trading strategies has a way to go," says Bell. In a recent Mercatus Centre paper on global regulation of high frequency trading, Africa was conspicuously absent. "In terms of regulation, the JSE watches what's happening overseas and implements strategies to deal with particular challenges in a bid to assist the local regulator, the Financial Stability Board."

"We're following international regulatory discussions," says Comninos. "We'll be considering the concepts being proposed, although there are some we don't support, such as order resting times."

One thing the JSE might consider is kill switches. "It's not something we deem necessary at this stage, but we'll consult on it," says Comninos. "What we do have are static and dynamic circuit breakers, which seem to be sufficient at this stage."

For the JSE, circuit breakers are seen as a benefit rather than a restriction. "They give the market an opportunity to do a reality check," says Comninos. The first to be triggered is the dynamic circuit breaker. If a share price moves a certain percentage away from the previous trading price - say 5% up or down - the market enters what is known as a volatility auction. "Continuous trading is interrupted and clients have an opportunity to look at prices, reassess, and see if they really do want to execute at 5% up or down," says Comninos.

If a stock moves more than 10% or 20% from its starting price for the day (the circuit breakers are set at different points for different stocks), a static circuit breaker kicks in. "There could be a legitimate reason for the surge or fall in price, for example a CEO resigning. But it could also be fat finger trouble, or algos continuously buying and pushing prices up," says Comninos.

Critical factors

Safety mechanisms and oversight are important factors, but just as important are prospects of growth. "A lot of firms are globally connected and are looking at exchanges where they may want to build connectivity," says Carré. "The first thing they ask is, is there a growth story? They want to see new listings coming on board, and an exchange with an active strategy to attract investors."

"The second thing investors look at is the technology: how to access the market," says Carré. "The JSE is seen as very open, with top-notch trading infrastructure."

The exchange is continuously updating its technology. It recently began the process of shifting all its markets -- interest rates, equity derivatives, currency derivatives and commodity derivatives -- onto the same MillenniumIT technology that the equities market currently runs on.

"It's a big project," says Comninos. "It'll probably keep us busy for the next five years." In addition, the exchange is speeding up settlement times. Traders currently have five days to settle their trades, but the JSE is soon moving to T+3.

The third element Carré says investors consider is the wider economy. "You cannot dissociate a stock exchange from the economy it serves," he says. Sub-Saharan Africa grew 4.8% in 2013 according to the Economist Intelligence Unit, 16 times faster than western Europe's 0.3%. South Africa's GDP growth was below average for the region at 2.8%, but its equity market has performed exceptionally over the last two years.

The average value traded on the exchange in 2012 was 14 billion rand; these days it is 17 billion. In the same period, the all-share index has gained 36%. "The industrial and financial sectors have done extremely well over the last two years, and recently the resources sector is picking up again. The only downside is the volatility of the rand's exchange rate," says Comninos. "Investors are seeing great returns, but not the full 36% if they're foreign investors."

Philippe Carre

Philippe Carré

"You cannot dissociate a stock exchange from the economy it serves."

Despite media preoccupation with money flowing out of emerging markets in response to the US Federal Reserve's tapering, South Africa hasn't been particularly affected. "We haven't seen outflows to the extent one might have thought," says an emerging market equities specialist at a European bank. "People are making relative choices between South Africa and other markets. Even though a lot of markets have individual challenges, it's not as though the world doesn't have challenges collectively."

"Then, if you look at the fixed income market, there are limited yields globally. So people are willing to take on more currency risk than you perhaps might imagine, and are taking longer-term views."

The longer-term view is key when looking at the African continent. "Beyond developments on South Africa's exchange, I think the next big and exciting area is Africa," says Bell. "It's a fantastic environment in which to do business and take advantage of trading opportunities. IRESS as an organisation is putting in massive effort across the continent, specifically the markets that want to grow and bring in foreign investment, like Nigeria and Kenya."

In other words, the site of that infamous dropped anchor could be the next to benefit from the surge in connectivity and international interest in Africa.