* PTS share of equity trading tiny but rising fast
* TSE launching new system in January to counter rivals
* Unbundling regulation could determine fate of PTS
By Nathan Layne
TOKYO, July 17 (Reuters) - The Tokyo Stock Exchange is facing a big challenge to its iron-grip hold on cash equities trading in Japan as alternative trading systems gain traction with faster trades at better prices.
Asia's largest bourse is not sitting still, however, investing about $140 million on a new system due to launch in January that will address its weak points of capacity and speed. It is also planning to cut tick sizes to narrow its bid and ask spreads in an effort to protect its 96 percent market share.
But with fund managers showing an interest in tapping new liquidity pools, trading in Japan's markets will likely fragment, as it did in Europe and the U.S. where alternative platforms have siphoned significant business off incumbent exchanges.
The growth of proprietary trading systems (PTS), as the alternative platforms are called, is part of a larger trend of increased use of electronic trading and broker-run dark pools that allow for anonymous order matching.
"I see a gradual evolution towards off-exchange trading," said Neil Katkov, head of Asia research for financial services consultancy Celent. "I would say the TSE might lose 10 to 15 percent of its trading in the next 3 to 5 years."
There are six operators of PTS in Japan. The biggest are run by Nomura Holdings unit Instinet, financial services conglomerate SBI Holdings and online broker kabu.com Securities Co Ltd
Collectively 226 billion yen ($2.4 billion) worth of shares traded on PTS in May, accounting for just 0.7 percent of overall volumes and dwarfed by the TSE's 30 trillion yen.
But that still marks a doubling of market share in the past year, driven by the start of daytime trading at the platforms run by SBI and kabu.com, whose initial strategy of targeting retail investors looking to trade at night never took off.
And further growth is expected as brokers roll out so-called smart order routing systems that can ping the various pools for the best price.
Turnover on SBI's Japannext, which is more than a third owned by Goldman Sachs, hit a record 149 billion yen last month, and on some days has topped the Jasdaq market for start-up firms.
"We are going to get to the tipping point where you can't ignore it anymore," said Olivier Thiriet, managing director and head of client trading & execution in Asia Pacific at Credit Suisse, which has launched a smart order router to sweep the PTS, its own dark pool and the TSE.
"Aside from the regulatory environment, why would Japan be different than Europe and the U.S.?"
BEST EXECUTION
PTS can execute trades in milliseconds against what can sometimes take a few seconds on the TSE. They also have finer tick sizes, giving investors the chance of buying or selling shares at a more favourable price.
For example, someone looking to buy Toyota Motor on the TSE could do so at 3,500 yen, 3,510 yen or 3,520 yen but not in between those 10 yen tick intervals set by the exchange. On the PTS the tick interval is 1 yen.
A recent survey by Nomura Research Institute of major asset managers showed that while only a quarter were using alternative trading venues some 80 percent expect the use of them to grow.
"Until now there has simply not been enough competition," said Tomoatsu Yamamuro, managing director and head of dealing at BlackRock Japan. "And if the TSE can't address our needs then we'll actively use crossing networks and the PTS."
Alternative trading systems and dark pools accounted for 40 percent of U.S. equities volumes and about 9 percent in Europe last year, according to Celent. The largest players include Direct Edge and Chi-X, which is controlled by Instinet.
But not everyone believes the systems will grow significantly or that their development is even healthy for markets in Japan.
Electronic communications networks and multilateral trading facilities, as alternative venues are known in the U.S. and Europe, were both able to grow in large measure because there was plenty of room for fees to come down.
In contrast the TSE's exchange fees are relatively low, leaving one less area for PTS to exploit.
Executives at UBS in Tokyo argue that the TSE's new system, called "Arrowhead", may snuff out any other competitive advantage held by PTS. They also point to the potential downside to fragmentation, which can make it more difficult to find and document best price.
"As with any shopping trip, it is preferable if you can get it all done in one place for the right price and in the right amount of time," said Trevor Hill, managing director and deputy head of Japanese equities at UBS.
"With Arrowhead you can probably create the mega-mall and you could see market-hour PTS's fade away in Japan."
While sceptical of their growth potential, UBS is among the top suppliers of liquidity to the PTS and said it would continue routing orders their way in search of price improvement.
The fate of PTS could hinge in part on whether the financial regulator introduces new rules allowing fund managers to separate the payment of research and execution fees. It said last month it was considering such a move.
The practice, known as unbundling and already widely used in Europe and the U.S., would encourage investors to trade with the broker most adept at execution, which in turn could drive more orders to the PTS.
Some market participants say the TSE stands to benefit as long as changes make for a more dynamic trading environment.
The TSE says its new system will be able to process trades in 10 milliseconds or less, which should be fast enough for statistical arbitrage and other high-frequency traders that may have otherwise overlooked Japan.
"These guys are going to start to come to the market and that's going to be additional liquidity that the TSE has never seen before," said Nick McDonald, co-head of equities for Asia-Pacific and Japan at Instinet. ($1=93.63 Yen) (Editing by Lincoln Feast)