Monday, March 31, 2014

Hong Kong SFC Proposes to Restrict Dark Pools to Institutional Investors

In what appears to be a first for a major financial market, the Hong Kong Securities and Futures Commission proposed restricting dark pools to institutional investors. The Commission also proposed risk management measures for dark pools, which are electronic trading systems that do not display public quotes. In light of the lack of pre-trade transparency in dark pools and their impact on the price discovery function in the securities market, the SFC found widespread and justified concern that the dark pools, and those operating them, should be subjected to consistent, appropriate and effective levels of regulation. Ashley Alder, the SFC’s Chief Executive Officer, noted that the proposals aim to strike a balance between market development, market integrity and investor protection, taking into account the needs and circumstances of the Hong Kong market.

At least at this stage, the Commission is proposing that only institutional investors should be allowed access to dark pools. Given that some dark pools have complex execution or order processing methodologies, the SFC is concerned that retail investors might find it difficult to understand the operation of, and the risks associated with, these crossing networks. Lack of understanding by retail investors, as well as the opaqueness and potential conflicts of interest inherent in these dark pools, might well place this group at greater risk than more sophisticated investors.

Neither the E.U. nor the U.S. restrict dark pools to institutional investors. Neither does Australia, but the Australian Securities and Investment Commission imposes a meaningful price improvement rule that appears to have caused a decline in dark liquidity and to have increased the average size of trades in dark pools. Similarly, Canada does not restrict types of investors, but does impose a minimum size requirement for dark pool orders.

Given that the desired objective is to restrict participation, the Commission believes that it is preferable to specifically address this issue rather than to introduce other measures which might have this effect, but which might also give rise to other complications. For example, introducing minimum sized orders is challenging from a definitional perspective and also from the perspective of striking the correct balance when setting the minimum level.

The SFC does not rule out the future possibility of retail investors being permitted to become users of dark pools. This might be possible by treating retail and institutional investors differently. For example, retail participation might be restricted to transactions in listed or traded securities and only during exchange trading hours. This, combined with a meaningful price improvement requirement resembling that which is in place in Australia, might result in a dark pool operator being obliged to ensure that the orders of retail investors are transacted in the lit markets unless genuine price improvement can be achieved in the event of a transaction being effected in a dark pool.

The SFC recognizes that behind an institutional investor conducting transactions in a dark pool there might be retail clients for whom the institutional investor is acting. The SFC proposes to address this by imposing an obligation on dark pool operators to ensure that their clients and the clients of their group companies do not conduct transactions in dark pools unless they are institutional investors. The SFC is also aware that some dark pool operators consider this obligation to be unnecessarily onerous. While recognizing that this obligation might be inconvenient, the SFC believes that it can be met by dark pool operators, with the active assistance of their group companies.

Moreover, the SFC considers this obligation to be essential in order to prevent operators from attempting to circumvent the spirit of the proposed user restrictions by the positioning of a group company between the operator and the person ultimately responsible for the placing of an order and then treating the group company as its client and turning a blind eye to the identity of the person ultimately responsible for the order.

Risk Management. The SFC proposes that a dark pool operator should ensure that it has effective controls to monitor and prevent the crossing of orders which may be erroneous, interfere with the operation of a fair and orderly market, or be in breach of any legal or regulatory obligations. Moreover, a dark pool operator should conduct regular post-trade reviews of transactions conducted in its pool to identify any suspicious market manipulative or abusive activities, any market events or system deficiencies, such as unintended impact on the market, which call for further risk control measures, and any breaches, whether actual or potential, of any requirements relating to fair and orderly trading in its ALP or which might constitute market misconduct.