Shedding light on the ASX's dark pools

Elmer Funke Kupper asked himself a loaded rhetorical question today. After eight months as chief executive of the ASX, who are the winners from the new competitive securities market structure that has been created by Chi-X's cracking of ASX's traditional monopoly?

Funke Kupper said that he had been unable to find people prepared to say they were significantly better off under the new structure, despite the fact that ASX had reduced its trading fees, improved its product range, built a new data centre and was becoming more externally-focused in response to the competition.

The answer to that question of where the benefits of the competition were flowing, he said, could be found in the US. He used a dissection of the business model of the third-largest US exchange BATS. BATS, after merging with Chi-X Europe last year, also accounts for about 25 per cent of trading in Europe.

BATS was founded in 2005 in response to the mergers of the New York Stock Exchange with electronic communications network, Archipelago Holdings in preparation for the NYSE's own IPO and the NASDAQ acquisition of Inet ECN.

BATS was designed to meet the needs of high-frequency traders and among its backers were a number of those traders, including Getco, a top five trader in the US and Europe. High-frequency trading is thought to account for more than 70 per cent of US trading volumes.

According to Funke Kupper, BATS made a profit of $US38 million in 2011 which, as he said, wasn't a lot of money for such a major exchange. (The ASX had underlying earnings of $261.6 million in the nine months to March). Of more interest to the ASX, however, is how it made that money and the nature of the flows across its platform.

In the US companies choose the exchange they list on but are traded on any and all of the three major exchanges. The exchanges pool the data of their trading within a utility that sells the data to users – brokers, banks and fund managers – with the revenue split between the exchanges according to their market share. That structure, which is unique to the US, and the high-volume nature of its core client base generated $US55 million of revenue for BATS.

Another unusual feature of the US markets is that the exchanges operate under a "maker-taker" model, where they charge price-takers and pay price makers, unlike the ASX model where both sides of a trade pay to trade. The price takers are retail and institutional investors, the price makers are mainly high-frequency traders.

Last year the price takeovers on the BATS platform paid it $US695 million while the price makers received $US566 million. As Funke Kupper said, there was a $566 million transfer of value between the investors and the traders. The ASX estimated that across the entire US industry the value transfer amounts to more than $US3 billion.

Given that BATS does have high-frequency traders as shareholders – Getco being its largest – they also get access to the revenue it generates from their volumes.

There is an argument that high frequency adds liquidity to markets, making them more efficient. Equally there is a view that their growing levels of activity means securities markets are increasingly markets that favour traders rather than investors and some sophisticated institutions rather than traditional institutional and retail investors.

The institutions have responded to the change in the markets – and the sophisticated algorithms the high-frequency traders use to "front run" their trades – by shifting their activity into the so-called "dark pools" where they can internalise matching transactions or deal directly with other institutions away from the transparency of the traditional regulated exchanges (and away from the high-frequency traders).

That clearly isn't helpful to liquidity and transaction costs on the "lit" exchanges, nor for the transparency of trading. Funke Kupper said nearly 30 per cent of Australian market activity was "dark" already. Getco, incidentally, is a shareholder in Chi-X Australia and a registered participant on the Chi-X platform. In the US, at least, it also operates a dark pool.

Funke Kupper, perhaps not surprisingly, doesn't appear to like dark pools, which he says are effectively private exchanges that aren't operating under the same obligations as the regulated exchanges and which aren't accessible to everyone, have no published rules or commercial terms and only benefit some parties.

While he says there are legitimate roles for dark pools and high-frequency traders, he also said their existence could have serious implications for the ASX and Chi-X "lit" markets in the medium terms "and need to be managed now."

Only yesterday the Australian Securities and Investment Commission's deputy chairman, Belinda Gibson, announced that it is setting up a taskforce to investigate how dark pools operate and to determine whether the commission's "light touch" approach to regulating them remained appropriate. ASIC was concerned, she said, about the implications of the growth in dark pool activity for retail investors.

The embarrassingly bungled Facebook listing, where NASDAQ's systems were sent into a loop by an avalanche of automated trades, and the 2010 "flash crash" in the US where the interaction between automated algorithmic trading and high frequency trading sent the US markets into a tailspin, are examples of some of the risks created by the increase and rise of the new mechanisms for trading, where everything happens in pre-programmed milliseconds.

Funke Kupper, however, was pointing less to the technology than to public benefit, or harm, in high-frequency trading and dark pools. Do we want markets run for the benefit of a particular type of trading and trader, with the interests of just about everyone else, including the exchange operators, rendered secondary?

During the early phase of the global financial crisis there were lots of dark mutterings about the revealed and potential threats to global financial stability within the opaque and largely unregulated shadow banking system.

It would appear until relatively recently regulators have failed to make a distinction between different types of turnover in securities markets or properly recognise the emerging threats to liquidity, equity and stability created by high-frequency trading and dark pools and the exchanges structures that facilitate them and encourage their growth.