Market hits back at Hong Kong plans to bar retail access to dark pools

Securities and Futures Commission move puts Hong Kong at odds with other Asian regulators

The suggestion by the Securities and Futures Commission (SFC) that it might limit access to alternative liquidity, or dark pools, to institutional investors only has been criticised by market participants in Hong Kong who say that a greater diversity of investors aids price discovery.

On February 27 the Hong Kong securities regulator released a consultation paper on the regulation of dark pools within Hong Kong which included the suggestion to put a block on retail participation.

Proposals from the SFC include restricting access to institutional investors, enhancing the level of disclosure to dark pool users and ensuring the priority of agency orders over proprietary orders initiated by dark pool operators, which currently account for 2% of the total turnover in the Hong Kong securities market, according to the regulator.

While most of the measures have been welcomed by market participants, the restriction to institutional investors and the exclusion of retail participation has come in for criticism. Hong Kong is the only jurisdiction looking to restrict retail flows with regulators in the US, Europe, Canada, Australia and Japan all currently allowing retail access to dark pools. In Singapore, access is only restricted by minimum order size and not the category of investor.

Market participants argue that retail participation enhances price discovery and liquidity in dark pools.

"I am not sure why the regulators have considered that retail investors are not sophisticated enough to participate in these pools because all you are doing is preventing them from getting a better price. Ultimately that is what a dark pool does, it gives you a price within a spread, at the midpoint of the bid and offer and you are now preventing that, so an individual will only get the best bid or offer on the market," says the head of an agency broker-dealer.

Rob Laible, ‎head of electronic and program trading for Asia at Macquarie in Hong Kong, says that while he understands the regulator's concerns over retail investors, dark pools are a simple concept.

"It could be relatively straightforward for retail investors to understand dark pools given what retail investors have been given access to in the past including pretty sophisticated shadow banking-type products. Being able to trade an equity that is listed where the bid and offer is quoted and knowing that you could execute the trade at the midpoint to gain price improvement – to me that seems a pretty easy concept to understand," he says.

Laible adds that in order to create liquidity, a variety of participants should be allowed to participate in a market.

"Retail investors have different motivations than institutional investors and if you want to create more liquidity and volume you want as many types of participants that have different motivations and time horizons interacting with each other in one place in a given market. Retail investors, who make up 24% of the Hong Kong market, are an important part of that," he says.

This view is shared by Emma Quinn, head of Asia-Pacific trading at AllianceBernstein in Hong Kong.

"Dark pools when used in the right manner are good for any investor as you are getting price improvement so I would like to have seen retail investors included both for their benefit and for the benefit of institutional traders trading against that flow and the price improvement that it offers both parties by trading at the midpoint rather than the crossing spread," she says.

Chris Jenkins, head of sales and operations, Asia-Pacific at Tora in Hong Kong, says the limitation of retail flow could also present some logistical issues.

"How does one guarantee that your end-client isn't a retail client? Certain brokers may have other broker-dealer clients whose end-clients may be classed as retail. For example if a Hong Kong broker has a US broker-dealer client, there will have to be some form of guarantee that those end retail clients won't have access to the dealer's Hong Kong liquidity pool," he says.

And while market participants agree with the proposals to ensure the priority of agency orders over a bank's own proprietary orders within a dark pool operator, there are some proprietary orders that buy-side institutions would like to access which would lose priority under the proposed rules, says AllianceBernstein's Quinn.

"When you label everything done by a bank as being proprietary flow because it is being done by an affiliated entity, this can limit the amount of liquidity that is offered. As an institutional investor, we may want to interact with some bank flow which we wouldn't necessarily think falls under a proprietary tag.

"For example the unwinding of a warrant hedge – that to me is good flow that I would want to interact with as opposed to trading against a proprietary trader on behalf of a bank with a mandate to make money for a bank. Under the definition of proprietary trading in this consultation paper they are all lumped together and I would have liked the ability to differentiate the different types of proprietary trading," says Quinn.

Macquarie's Laible also believes that there should be a distinction in the types of principal flow. For example, under the current proposals, the facilitation desks of broker-dealers that often unwind client portfolios will also be classified as proprietary flow.

"If a facilitation desk is guaranteeing volume weighted average price (VWAP) for somebody and you have an algo that is unwinding those trades and it is already going to be trading in the market, why not be able to send that into the dark pool where potentially it could be crossed and both buyer and seller could enjoy trading at a lower cost and saving half the spread," he says.

"I would define proprietary trading as alpha-oriented whereas facilitation tends to be an unwind of an order they already have," he adds.

The SFC's move makes it the latest regulator in Asia to look at reforming dark pool trading activity, following similar moves by Australian and Singaporean regulators.

In Singapore, in addition to reporting to the local exchange, the Monetary Authority of Singapore has stated that the minimum order size that can be executed off the Singapore Exchange (SGX) is S$150,000 or 50,000 shares.

This is in contrast to the approach taken by the Australian Securities and Investments Commission, which has refused to impose a minimum size threshold for dark orders, opting instead to require dark traders to obtain ‘'meaningfully'' better pricing than is available in the lit market.