ASIC confronts a dark pool abyss

The Australian Securities and Investments Commission has taken the first of what is likely to be a series of steps to introduce some disciplines and safeguards to the contentious development of dark pools, dark execution and algorithm-driven high-frequency trading in Australian markets.

The step taken today is a baby one, albeit an important part of the process of ensuring that Australian regulators actually regulate the development of the financial markets rather than, as has occurred in the US, allow the market participants to change their character to the point where it is too late, and the market structure has changed too significantly, to wind back the clock.

The announcement of new rules governing trading algorithms and dark pools are part of a larger review by ASIC of the framework of market regulation that is focused on the implications of the growth in dark pool and high-frequency trading activity. More broadly, ASIC and the federal government are concerned about issues of market integrity.

The specific rules introduced today imposes direct control over trading algorithms, including "kill switches" to halt aberrant trading and new extreme trading rules in the case of large price movements. There have been a number of high-profile instances in the US of algorithms creating unforseen and disruptive – and costly – gyrations in markets.

ASIC will also impose a requirement that dark pools offer meaningful price improvement over the ‘'lit'' market – the ASX – with an exemption for block trades as well as additional data reporting requirements.

There has been a concern that dark pools and dark execution are fragmenting liquidity in the lit market, which affects the efficiency of its pricing and therefore impacts investors, and that some trades that are occurring in the pools (which are effectively private unregulated exchanges) may not necessarily advantage some of the investors, particularly when retail trades are bundled together without the knowledge of the clients.

ASIC has also created two task forces that are looking more deeply at dark liquidity and high-frequency trading and the Financial Services minister, Bill Shorten, today said Treasury had been asked to conduct a review of Australia's financial market licencing regime and made specific mention of the issue of whether dark pools should be licenced.

ASX has argued that if the pools are effectively exchanges performing the same function as a lit exchange they should be regulated as exchanges and be subject to the same levies and safeguards as the lit markets. It has said the proportion of dark execution this year has ranged from about 14 per cent to 43 per cent.

The ASIC task forces are considering whether there should be minimum order thresholds for dark liquidity, better conflict management controls, rules for monitoring trading and better disclosure to clients. It is also looking at whether there should be minimum order sizes for high-frequency trades and is reviewing ‘'tick'' sizes.

It isn't the case that either dark pools or high-frequency trading are necessarily bad for the markets and investors – there was dark pool or ‘'block trading'' activity long before it was labelled dark liquidity and it makes sense for some large-scale transactions to be executed off-market before being reported to the lit-market. Some high-frequency trading may add to liquidity and market efficiency.

What shouldn't happen is that activity which would generally be expected to be put through the lit market in the interests of the investors is diverted to dark pools regardless of whether or not it is in the interests of the investor. Nor do we want to see retail flows being channelled through the dark pools and undermining liquidity in the lit markets.

There are forms of high-frequency trading that are akin to lawful front-running, with the traders using the proximity of their infrastructure to the ASX's facilities, the milliseconds of execution advantage that gives them and sophisticated algorithms to profit from, and perhaps exaggerate, relatively small price movements in the market.

The ASX has proposed that some forms of behaviour, which it regards as predatory, should attract a charge to deter the excessive orders, messages and cancellations of orders that characterise some high-frequency trading strategies.

The continuing automation of trading and the increasing ‘'sophistication'' of the trading strategies has undoubtedly changed the character of markets globally, some more than others.

US markets could be regarded as markets now dominated by traders rather than investors – by parties unconcerned about concepts of underlying value but rather focused on churning stocks for a margin.

That undermines confidence in the integrity of the market, and also explains why the bigger investors who can shift their activity away from the high-frequency traders and the lit market to dark pools have done so and in the process driven the proliferation of dark pools and the increase in dark execution.

The ASIC taskforces are due to report to the government in March next year but it is already apparent that ASIC itself is concerned about some aspects of dark pool and high-frequency activities and does want to put some rules and limits around them to protect the integrity and efficiency of the markets and investor confidence in them.