Dark Pools in Asia Pacific — Watch This Space

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 — the so called “lit” market. The opposite of lit is, of course, “dark”. Hence “dark pool” refers to a place where trading liquidity — a supply of shares — 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.