Australian dark pool rules shift liquidity back to the lit market

Decline in broker-dealer dark pool volumes after Asic introduces requirements for price improvement

The implementation of dark pool and market integrity rules by the Australian Securities and Investments Commission (Asic) last year has resulted in a significant decline in the number of trades executed off exchange on broker-dealer dark pools, say market participants.

While dark pool flows have remained at around 25–30% of the total market flows, (28.1% according to the ASX's latest report on February 7), the Australian regulator had become increasingly concerned with flows driven by large broker-dealer internalisation engines that accounted for up to 12% of overall market volume.

This has fallen to around 4% following the introduction of rules that require price improvement for trades to be executed in dark pools.

Dark pools were originally created to help institutions move large transactions without any information leakage, market impact and with some price improvement.

However, often the trades executed on broker-dealer dark pools were small sized and did not offer price improvement, says Lee Porter, head of Liquidnet Asia-Pacific in Hong Kong.

"These types of transactions that were being executed in the dark should really be happening on exchange and assisting with the price formation process," he says.

Historically, within the Australian market, large or block trades – defined as trades over $1 million – could be executed in a dark pool without the need for price improvement. This changed in May 2013 with the introduction of three different block trade thresholds based on the liquidity of the stock ranging from A$1 million down to A$200,000.

"What Asic found was that a lot of transactions were going off at the bid or offer and there was no price improvement and the execution size was often smaller than what you would find on the ASX or Chi-X. The introduction of a tier system meant that if there was no price improvement these trades had to be executed in the lit market," says Porter.

"The introduction of tiers meant that the percentage of transactions being executed in broker-dealer dark pools went from 12% to 4%. So it had a very specific effect and the lit market has also seen increased liquidity a result," he adds.

The implementation of Asic's rules has led to a rise in liquidity on the ASX, says chief executive Elmer Funke Kupper, speaking at an event to announce the exchange's half-year results on February 13.

"Dark pools have come back a bit because of Asic's implementation of new controls called 'meaningful price improvement'. This has pushed some liquidity back onto the lit market, particularly in the retail sector," he says.

The approach undertaken by the Australian regulator on dark pool regulation is something other regulators in the region should be following, says Porter.

"What Asic has done should be a template for each regulator in Asia to follow when looking at how dark pools operate in their market," he says.

Hong Kong's securities regulator, the Securities and Futures Commission (SFC), was due to release a consultation paper on dark pools in the third quarter of 2013, but that was postponed and is expected to be released shortly.

From April 2012 to March 2013, dark pool trades accounted for about 2.2% of the total turnover in the Hong Kong securities market, according to figures from the SFC.

The head of an agency broker-dealer in Hong Kong says the small size of the dark pool sector in the city's markets means the regulator's concern is overstated.

"Dark pool trading makes up such a minimal part of the market, so I wonder what is the problem that they are trying to solve."

According to the broker-dealer, the structure of the Hong Kong market means dark pools are unlikely to ever form a significant source of activity.

"Dark pools in Hong Kong will never get to the point of other markets simply because there are no real market-makers here such as Getco and other high-frequency traders due to the transaction costs.

"So there is no liquidity off-market other than natural liquidity at the brokers. There is also a huge amount of retail flows that does not hit the pools so if you take that into account there is a very small amount of trading that is done off the market," he says.