Noting that the SEC has made dramatic proposals to light up dark pools, Martin Wheatley, Executive Director of the Hong Kong Securities and Futures Commission said that the proposals have far-reaching implications and require careful study and thorough discussions with the industry before being adopted. While dark pool operations in Hong Kong are still relatively small, he said, the Commission has begun a study to identify the appropriate ways for alternative trading venues to develop in Hong Kong. His remarks were made at Trade Tech Asia 2009.
In an effort to increase transparency in dark pools, the SEC would require real time reporting from dark pools for their executed trades and actionable indications of interests to be displayed in the public quotation system. Dark pools in the U.S. are currently required to publicly display stock quotes if their trading volume exceeds 5 percent of the volume of a particular stock. But the new plan would reduce the threshold to 0.25 percent.
The growth of dark pools in Asia has been impeded by the fact that, unlike in the U.S. and in Europe, Asian exchanges are considered national interests and hence accorded an almost exclusive franchise to operate a stock market domestically. That said, the Executive Director believes that a case can still be made for dark pools to operate in Asia because they are not really exchanges. Dark pools can offer something exchanges cannot, that is, a wide range of order types including algorithmic trading tools. Thus, it is arguable that dark pools are not competing with exchanges, but play a complementary role in offering a different type of service or servicing a different segment of the market.
While acknowledging the benefits of anonymity and speed in dark pools, the SFC official also pointed out there are issues of best execution, price discovery, fragmentation, and transparency, 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.
Since the dark pool is an institutional market, he emphasized, regulators must 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. If the presence of dark pools has affected the ability of regulators to supervise the market, he warned, regulators must work together with the industry to identify ways to address this.
The growth of dark pools also calls for a review of the best execution policy since the fragmentation of pricing data makes 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.
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, reasoned the official, it will affect the price discovery function currently performed by the exchange market. The question is how can fair market prices be obtained if most transactions are executed on non-displayed markets.
Despite an IOSCO initiative to examine potential regulatory issues associated with dark pools, Mr. Wheatley does not anticipate the international harmonization of dark pool regulation. This is because dark pools have a different appeal to different jurisdictions and, thus, the corresponding regulatory regime will be quite different.
The world’s major financial exchanges have asked the G-20 to examine the erosion of price discovery and dark pools, arising from recent trends. The concerns were voiced in a letter to the Financial Stability Board, which the G-20 has designated as a key player in assuring the cross-border consistency of financial regulation legislation. The letter was signed by William Brodsky, CEO of the CBOE, in his role as Chair of the World Federation of Exchanges. It was endorsed by, among others, NASDAQ, NYSE Euronext, the London Stock Exchange, and the Tokyo Stock Exchange.
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