The expected introduction of dark pool trading rules in Australia as part of market-wide regulatory changes should not pose major obstacles to the future development of these off-exchange liquidity venues, market participants say. However, the impact of planned regulation may depend on the kind of flow – and particularly the size – that the pool attracts.
Matthew Moore, head of Australian sales at Instinet, which has just launched its BLX liquidity pool for Australian equities, said the latter is designed to contribute positively to price discovery for block-sized trades. “In Japan, the relevance of aggregation of alternative liquidity to providing best execution has grown faster than buy-side traders had expected. In Australia, dark pools are becoming more prevalent on the street. As Chi-X becomes the alternative to the Australian Securities Exchange (ASX), smart order routing technology will become key as well. The launch of our new pool, together with our Nighthawk [liquidity aggregation] product, is an important step towards linking all those liquidity options together,” Moore added.
Will Psomadelis, head of trading, Australia at Schroder Investment Management, describes the value that dark pools can bring to the market in terms of price discovery and efficiency, as well as the reduction of both verbal and electronic information leakage. “Because the hit rate in dark pools is still relatively low, at this stage you're talking 5-7% of market volume, an urgent order with some sort of information advantage is more likely to trade through the lit market adding to price discovery and efficiency. Whereas if you have passive order flow that's more sensitive to liquidity, then you're more likely to trade through a dark pool whilst minimising market impact,” he said.
From a price discovery and market efficiency, dark pool orders can remove a lot of ”noise' from lit venues, adds Psomadelis, leaving the remaining orders, i.e. those with some form of information attached due to their urgency, to create market efficiency. “You can also argue that some broker dark pools combined with sales trader ”upstairs markets' and block crossing networks can reduce overall information leakage if used correctly as the buy-side trader is seeking to trade against natural liquidity,” he said.
The increasing fragmentation of liquidity has also led the buy-side to look for aggregation tools offering access to multiple dark pools. Psomadelis said, “In Australia, we're starting to see aggregated dark pools emerging. What we need on the buy-side is some form of transparency as to where our orders are eventually being executed and this is possible through proper use of FIX tags [on order messages]. As long as we can control the mix of execution venues that align to the urgency level of our orders, we can control the information leakage that we will suffer. This is where the trader needs to make the decision to sacrifice timing risk for market impact or vice versa depending on their objectives. Dark pools are one part of an overall strategy that we use to achieve those objectives and trading against legitimate size buyers and sellers of stocks will always be the cheapest form of trading in terms of market impact.”
Instinet's BLX, which has been available in the US since November 2009, aggregates multiple orders from both buy- and sell-side participants and consolidates them into block-sized trades. The BLX model was designed to increase trade size by appealing to an array of trading participants, including both passive block traders and those using algorithmic trading strategies. The BLX model also includes several built-in anti-gaming features, such as volume triggers and a mid-point pricing window, to prevent the system from being pinged by information-seeking traders.
Moore said the incorporation of the aggregation functionality means BLX would be adaptable to expected new regulations such as the possible introduction of minimum order value in dark pools. “One of the underlying principles of BLX is a functionality which allows us to aggregate multiple orders. That technology means we can be very flexible under the new regulations. If we have to set the aggregation at a minimum dollar value, that would be possible,” he said.
The Australian Securities and Investments Commission (ASIC) will be consulting later this year on several areas – including changes to the minimum order value in dark pools and time priority requirements of lit over dark orders; order routing, post-trade reporting and controls over DMA, volatility, algorithms and client identification – that were outlined in its initial consultation document, CP-145, Australian market structure, responses to which were submitted by 21 January.
Proposing a minimum order value of A$20,000 in CP-145, ASIC stated, “There has been growth in the use of dark pools of liquidity overseas and we believe this trend is also emerging in Australia. We are concerned this may impact the price formation process on markets.”
Moore considers that the level of dark trading in Australia is some distance from that which might begin to impact price discovery, while Lee Porter, CEO, Liquidnet Asia, which has been providing a block-crossing platform in Australia for three years, believes that the need for off-exchange trading opportunities has been made clear by buy-side firms. “The institutional investors have been very vocal in stating that their order sizes are very much larger than what is typically executed on the exchange. They need alternatives and dark pools like Liquidnet offer the ability to find additional liquidity that they may not find elsewhere,” said Porter. “There isn't any doubt from regulators that there is a need for non-displayed liquidity and the ability of institutional investors to interact with one another safely without market impact and information leakage. There are many different types of dark pools and operators; there should not be a one-size-fits-all approach.”
But there are a number of dark pools already in operation in Australia that would be impacted by a minimum order size. Broker internalisation engines, for example, typically include smaller orders routed via algorithms.
“Generally the type of crossing that goes on in the broker pools is of algorithmic orders sliced which can be very small. There's less demand for large blocks in broker pools,” says Chris Jenkins, managing director, Asia Pacific of Tora Trading, an agency broker and technology provider, whose Crosspoint dark pool, is unlikely to be launched in Australia until the regulatory environment is more settled.
Author: Jill Wong