Sparing smalls from the dark masters

Markets live or die by confidence. There is no question that dark pools have implications for confidence in the market, given their proliferation (there are now 18 operating in Australia), the evolution of more 'market-like' characteristics attaching to them and the fact that they are regulated outside the market licensing framework.

Dark pools are generally unlicensed and non-transparent platforms for the matching of orders away from ASX and Chi-X's 'lit' markets. They have no obligation to post prices and post trades in the marketplace that other people can trade against.

Certainly, off-market trading has been a long-term feature of the market and makes sense in particular circumstances. For example, a large, institutional block trade would send a disproportionate price signal to the market and be difficult to match with the liquidity available at the time if sent to the lit market, or a large shareholder could exit their holding in a small company with an illiquid stock and the use of off-market trading can decrease disruption to the share price.

However, as dark pools have become commonplace, there has also been a reduction in the size of the trade flowing through them as brokers are able, and allowed, to match even small trades within their own broking engines rather than send them to the lit market.

Australian listed companies depend on the lit market to understand the value of their securities. But there is a lack of transparency in a dark pool, if it functions as a private exchange, as it is impossible to see which party or parties have information. This differs from the lit market where all market participants are fully and equally informed.

With dark pools facilitating a number of smaller trades, it means not all trades are being executed in the one marketplace to which everyone has equal access. With small orders not necessarily going to the lit market, it means that not all retail investors have access to the same matching process and the same commercial terms.

From the companies' and investors' perspective, therefore, the absence of the same rules of disclosure as apply to the lit market could result in an uneven playing field for investors. Moreover, dark pools can see smaller investors or fund managers acting on behalf of smaller investors affected negatively if the business of matching genuine buyers and sellers of company securities in a transparent and regulated market becomes smaller and that taking place in private exchanges becomes larger.

Any time there is a privileging of one pool of investor over another it undermines confidence in the market and undermines the principle of the market.

There is a clear solution. Small orders should not be traded in dark pools – a threshold should be implemented, below which all orders must be executed on the lit market. In fact Chartered Secretaries Australia supports the ASX proposal for a $25,000 threshold, below which all orders must be executed on the lit market. This would ensure that off-market trading is returned to the purpose for which it was intended – large transactions.

Tim Sheehy is the chief executive of Chartered Secretaries Australia.