The regulatory climate has become distinctly cooler for dark pools over the last 12 months, with Hong Kong the latest market in which off-exchange trading is being regarded with more suspicion.
A number of brokers holding automated trading service (ATS) licences from Hong Kong's Securities and Futures Commission (SFC) are apparently having to deal with "wave after wave" of questions from the regulator in response to any request for a change to the terms of their licence, for example to upgrade the matching service they offer to clients, primarily institutional investors.
The regulator's approach is seen by some as "stifling innovation" and reducing the value of off-exchange liquidity pools to the buy-side.
Hong Kong is far from the only jurisdiction in which regulators have been paying increasingly close attention to the role of dark pools. In Europe, MiFID II may yet ban broker crossing networks. Next month, Australia is expected to announce a requirement for dark pools to guarantee minimum levels of price improvement. Across Asia, regulators are nervously considering whether to open up their markets to alternative venues - lit or dark.
Some see the hand of Hong Kong Exchanges and Clearing (HKEx) behind the actions of the regulator. Although off-exchange trading volumes remain low compared to other markets, HKEx has maintained a hostile attitude. Former chairman Ron Arculli went so far as to claim dark pools has contributed to the financial crisis, while current CEO Charles Li has made it clear he regards ATSs - which must report all transaction to the primary exchange - as a competitive threat.
HKEx holds a privileged position under Hong Kong's Securities and Futures Ordinance, the core legislation governing the activities of financial institutions regulated by the SFC, but there are other likely factors behind the regulator's seemingly heavy-handed tactics.
Like many other regulators around the world, it's highly likely the SFC simply doesn't quite 'get' dark pools, the benefits to market participants or their interaction with liquidity on primary exchanges. It's understandable that brokers become frustrated at the confusion caused by the automation of the age-old practice of client matching or the failure of many watchdogs to firmly grasp the difference between the trading needs of wholesale and retail financial market participants.
But in Hong Kong's case, there has been an explosion in the number of ATSs in recent years. Perhaps it is to be expected that the SFC should want to collect as much information as possible, with a view to creating a more coherent framework for off-exchange trading.
According to sources, the information that the SFC is most interested in is the identity of counterparties to transactions executed in their dark pools. This suggests that a key concern of the regulator is to ensure no retail flow is ever allowed into a dark pool, which could potentially undermine the business models of retail brokers, an extremely influential lobby in Hong Kong. After all, the SFC insisted that HSBC reverse its plans to launch a dark pool in Hong Kong that mixed retail and institutional flow.
Some have dismissed the SFC's questions as an inevitable administrative overhead, while others see them as obstructing sell-side efforts to add value to clients and minimise exchange fees, both important issues in these resource-constrained times.
Whatever the watchdog's motives, it is collecting a lot of data that could well inform a new regulatory framework. As such it might be as well for the buy- and the sell-side to engage with the SFC in anticipation, rather than reacting to a set of rules that misunderstand the increasingly important role that dark pools are playing in the pursuit of liquidity.