THE quality of Australia's sharemarket could be severely damaged if the volume of trading in so-called "dark pools" grew to a similar size to markets in the US or Japan, a think tank has warned.
It comes as the corporate regulator releases its draft new rules for market integrity, including plans to introduce protections for people who wish to report suspicious trading activity on the ASX and Chi-X markets.
Professor Alex Frino, chief executive of the Capital Markets Co-operative Research Centre, said sharemarket trading costs would increase and price discovery would be harmed if the value of shares traded in private exchange areas, called "dark pools," became too large in Australia.
Dark pools are areas away from the main exchange where traders go to anonymously trade large blocks of shares. They do so to avoid exchange fees, and to prevent unfavourable price movements on large orders.
Professor Frino, of The University of Sydney business school, has released new research indicating that Australia's market would be too small to handle the volume of dark trading that occurs in larger markets such as the US, and that if dark trading continued to grow it could severely damage market quality, while raising the cost of trading.
"If 20 per cent of our trading activity went dark, the increase in the cost of trading [on the main exchange] would be about 1 basis point, which doesn't sound like a lot, but it's three times the ASX exchange fee," he said.
"[But] the dark liquidity that's occurring in our marketplace is already impairing the cost of trading in the lit market."
At the moment, Australia's lit market accounts for about 70 per cent of turnover while 30 per cent passes through off-market exchanges, according to the ASX.
About 5 per cent of off-market trading goes into dark pools.
The warning comes as the Australian Securities and Investments Commission released its draft market integrity rules this week, the next stage of an industry consultation process that began in November 2010.
Greg Yanco, ASIC's senior executive leader of market and participant supervision, said the corporate regulator would make no new rules on algorithm testing, nor any new rule on the minimum order size required for trades undertaken in dark pools.
But he said it would push ahead with plans to restrict the ability of traders to trade in dark areas unless they could prove that, by doing so, they would make meaningful price improvements.
"We can see signs that our market may go the way of other markets, where it would deteriorate if there's too much business done in the dark," he said.
"So we're saying that business done in the dark, unless it's a large special size, needs to have meaningful price improvement.
But the executive director of the Australian Financial Markets Association, David Lynch, said he was concerned ASIC's proposal would interfere unnecessarily in the price bargaining process, particularly for stocks whose price formation process "is not at any risk from dark liquidity".
Frequently Asked Questions about this Article…
What are dark pools and how do they work in sharemarket trading?
Dark pools are private or off-market trading venues where traders anonymously buy and sell large blocks of shares away from the main exchange to avoid exchange fees and reduce the risk of unfavourable price movements on big orders.
Why are dark pools a concern for everyday investors and market quality?
Professor Alex Frino and other commentators warn that if dark trading grows too large it can harm price discovery and raise the cost of trading on the lit market, potentially damaging overall market quality for investors.
How much of Australia’s trading currently happens on the lit market, off-market exchanges and dark pools?
According to the ASX, about 70% of turnover is on Australia’s lit market, roughly 30% passes through off-market exchanges, and around 5% of that off-market trading goes into dark pools.
Could more dark trading raise trading costs on the ASX?
Yes. Professor Frino says if 20% of trading went dark the increase in the cost of trading on the main exchange would be about 1 basis point — which he notes is roughly three times the ASX exchange fee — meaning dark liquidity can impair costs in the lit market.
What steps is ASIC proposing in its draft market integrity rules to address dark trading?
ASIC’s draft rules include protections for people who report suspicious trading on ASX and Chi‑X, and propose restricting traders’ ability to use dark venues unless they can show their trades deliver meaningful price improvement; large special‑size trades may be treated differently.
Will ASIC introduce new rules on algorithm testing or minimum order sizes for dark pools?
No. Greg Yanco from ASIC said the regulator would not introduce new rules on algorithm testing or set a new minimum order size for trades in dark pools as part of this consultation.
What do industry groups say about ASIC’s proposed limits on dark trading?
David Lynch of the Australian Financial Markets Association expressed concern that ASIC’s proposal to require price improvement proof could unnecessarily interfere with the price bargaining process, especially for stocks whose price formation isn’t seen to be at risk from dark liquidity.
What could happen to Australia’s market if dark pools grew to the size seen in the US or Japan?
The research cited by Professor Frino warns that Australia’s market would be too small to cope with dark‑pool volumes at the scale of larger markets, and that such growth could severely damage market quality and increase trading costs for investors.
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