Dark Pools

Recently Martin Wheatly, CEO of SFC, delivered a speech about regulating alternative trading venues, in particular dark pools and direct market access (DMA). Some major points are summarized below:

• Whatever term is used to describe them, be it dark pools or alternative trading venues, they are really just facilities that allow dealing activities outside traditional exchanges without prices being disclosed publicly.
• The proliferation of dark pools has been phenomenal during the last few years but the pace of development varies across the regions. According to US SEC, the number of active dark pools transacting in stocks that are tradedon major U.S. stock markets has increased from approximately 10 in 2002 to approximately 29 in 2009.
• In Asia, dark pools are still at an infancy stage. Some of the more prominent American and European firms have explored the prospects of setting up similar operations in the major markets in Asia, including Hong Kong. In Hong Kong, we have seen the number of dark pools, mainly brokers' internalisation pools, increased from just a handful several years ago to more than 10 currently.
• There have been discussions about the implication of dark pools for the integrity of the market. The main issue being debated is that a lack of transparency in dark pool operations deprives the public of fair access to information about the best available prices to some market participants and thus results in a two-tiered market. The dark pool is an institutional market. Regulators should carefully study the pros and cons of integrating this institutional trading venue and the trading venue offered by stock exchanges before making any policy changes. The primary focus here should be whether the two-tiered market has created difficulties for regulators to conduct market surveillance.
• Another unintended consequence of dark pools is the fragmentation of pricing data, thus making it difficult for investors to know where they are likely to get the best price for their orders. In some markets, there are rules requiring an exchange to route an order to another exchange or liquidity pool if there is a better price. But such order routing usually incurs costs to investors. The growth of dark pools calls for a review of the best execution policy.
• Price discovery is a major function of an exchange market and the efficiency with which it is carried out depends on whether orders from a diverse set of participants are properly integrated so as to achieve reasonably accurate price discovery and reasonably complete quantity discovery. Most of the dark pools determine execution prices with reference to exchange produced prices. If dark pools continue to grow and account for a significant portion of market share, it will affect the price discovery function currently performed by the exchange market.
• To bring about greater market transparency and fairness, US SEC has recently mooted three changes to enhance the transparency of dark pools: (a) dark pools in the U.S. are currently required to publicly display stock quotes if their trading volume exceeds 5% of the volume of a particular stock, but the new plan would reduce the threshold to 0.25%;(b) the second change would require actionable indications of interests to be displayed in the public quotation system; and (c) the third proposal requires real time reporting from dark pools for their executed trades, making the dark pools' identity visible to the public.
• Dark pools can offer something exchanges cannot, e.g. a wide range of order types including algorithmic trading tools. Thus, it is arguable that dark pools are not competing with the exchanges, they are in fact offering a different type of service or servicing a different segment of the market.
• Along with the emergence of dark pools or alternative trading pools, we have also seen a rapid development of advanced trading tools, in particular algorithmic trading or DMA in general. DMA allows institutional investors to trade faster and to have direct control of their order execution. The increase in trading speed can amplify any unintentional errors in the execution process. DMA also enables institutional investors to send a large amount of order flow to the market within a very short period of time, which may have a systemic impact on the market. For example, the use of DMA facilitates the automatic generation of time-sensitive orders based on the changing market conditions. In the past, we have seen a number of occasions when DMA users sent large orders to the exchanges merely based on the pre-set algorithmic formula without giving sufficient consideration to the prevailing liquidity level in the market. As a result, the stock prices fluctuated wildly triggered by the arrival of these large orders. It is therefore important that brokers who provide DMA services ensure that there is sufficient pre-trade monitoring and control of orders using DMA.
• Broker-sponsored access has raised more challenges for us to monitor DMA orders. Some brokers have offered their institutional clients direct access to the market without going through the brokers' trading systems. This kind of DMA provides market participants unfiltered access to the market and makes it difficult for brokers to conduct any meaningful pre-trade monitoring. The term "naked access" can better describe this type of trading activity. Some regulators have been looking into this issue.