In recent months, dark pool operators could be excused for feeling they were being attacked on both flanks. But that was before Ronald Arculli came along and opened up another front.
With plans afoot in both Europe and the US to redefine the scope of dark pools and off-exchange trading, the chairman of the Hong Kong Exchange has weighed in with an attack of his own.
In a speech to the Hong Kong Foreign Correspondents’ Club last week, Arculli went beyond his prepared script in his criticism of dark pools. Arculli, who has chaired the exchange since April 2006, had planned to outline the perceived threat of dark pool trading to price discovery among retail investors as well as the systemic risks that large volumes of non-displayed trading pose, on the basis that “dark pools typically lack a central counterparty”, much like over-the-counter derivatives markets.
But he went further, asserting, “I think, to some extent, the woes that were felt by firms like Lehman Brothers, Merrill Lynch and AIG might have been contributed to by the volume of trading [on] dark pools.”
It is generally accepted that high volumes of off-exchange trading may compromise effective price discovery in the cash equity markets. But dark pool operators also have to get used to being associated with all the failings of the financial sector, regardless of proximity. In his speech, Arculli suggested dark pool volumes had grown “in tandem” with high-frequency trading, an activity also viewed with suspicion by non-market professionals on the largely unproven basis that it damages the interests of the smaller investor.
Tighter dark pool regulations in the US and Europe are by no means a certainty, but both the Committee of European Securities Regulators (CESR) and the US Securities and Exchange Commission (SEC) are currently reviewing the available evidence. In October, the SEC proposed three changes aimed at increasing transparency in US dark pools: requiring ‘actionable’ indications of interest (IOIs) to be published as quotes; lowering the level at which dark pools must make quotes public to 0.25% of a stock’s average daily traded volume from 5%; and obliging dark pools to report trading volumes individually on the US’s consolidated tape. Market participants have 90 days to respond to the proposals. In Europe, CESR is collating information on the proportion of overall equity trading is currently conducted on Europe’s dark pools, including broker’s internal crossing engines that are not registered as a multilateral trading facility or a systematic internaliser and as such do not publish volumes. CESR will recommend intervention to new internal market commissioner Michel Barnier if it considers dark volumes a threat to market transparency and price formation.
Worries about systematic risk and market opacity are downplayed by dark pool operators of all stripes, emphasising instead the reductions in trading costs that asset managers can hand to end-investors in the retail market by trading on non-displayed crossing networks and dark pools.
“Alternative trading platforms provide enormous value to institutional investors by allowing them to trade without fear of market impact or information leakage,” says Lee Porter, managing director, Asia-Pacific, Liquidnet, a buy-side-focused, non-displayed crossing network that allows users to negotiate on price. “Both affect price of their executions and returns, which are ultimately passed on to retail investors through their pension and mutual funds.”
Brokers often point out that their dark pools are, in essence, little more than the automation of the age-old service of crossing trades internally when clients’ buying and selling intentions coincide to save exchange fees. For this type of service, the broker has always been the de facto counterparty to the trade. Nomura’s NX dark pool, for example, currently deploys no external central counterparty (CCP) and is in no hurry to appoint one even though it recently announced its intention to register as an MTF. “Most of the flow in NX is buy-side directed and they want to face us as the counterparty. A CCP really only adds value where there is a lot of sell-side activity,” says Andrew Bowley, head of electronic trading product management, EMEA, Nomura.
Bowley accepts that there could be a threat to price formation if dark pools were to attract liquidity that would otherwise be posted on a lit venue. But with dark pools accounting for perhaps 3-4% of European liquidity, that remains a very distant prospect. “Even at levels of around 9% in the US, they are nowhere near reaching saturation point,” says Bowley.
In Bowley’s view, the key value of dark pools is that they provide an opportunity to activate flow that would otherwise remain untradable. A buy-side trader with a large order would rather keep a proportion of his order on his blotter than place it all on a lit venue and risk the market moving against him. Having access to dark pools gives him the opportunity to trade that otherwise inactive portion of the trade at the mid-point or better. In a period where volumes remains constrained, dark trading could be said to be one of the few bright spots in equity trading during 2009.
Arculli has form in launching assaults of dark pools. In September, he told the South China Morning Post that traditional exchanges offered market participants greater protection in the event of Lehman-style implosion. “When the compliance departments of the pension funds and asset management firms look at the counterparty risk issue, it is easy to see where they should trade,” he said.
Hong Kong’s regulator, however, has taken a slightly more conciliatory tone. Martin Wheatley, CEO of the Securities and Futures Commission of Hong Kong has gone on record as saying he wants to develop “an appropriate regulatory structure” for dark pool operators. The dark pool debate, it seems, now rages across the globe.
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