The ASX's attempt to clean up dark pools

The ASX's Elmer Funke Kupper has made no secret of his dislike for high-frequency trading and dark pools, even though ASX garners a tidy amount of income from giving high-frequency traders preferential access to its data.

ASX's submission to an Australian Securities and Investments Commission consultation on proposed new rules for the Australian market reflects his concerns and is likely to fall on sympathetic ears because ASIC has made it clear in recent times it shares Funke Kupper's reservations.

Dark pools – generally unlicensed and non-transparent platforms for matching of orders away from ASX and Chi-X's "lit" markets – were created in response to the emergence of high-frequency trading in the US and elsewhere.

Institutional investors became concerned about the impact of high-frequency trading on the volatility and the cost of their trading in lit markets, where the traders use highly-sophisticated algorithms and their direct access to exchange data to place and withdraw multiple bids and offers that, in effect, enable them to legally "front run" traditional trading.

They believed that the impact of the high-frequency trading was increasing market volatility, pushing up the cost of their buying orders, pushing down the price of their sales and, as we saw in the US last week, creating the potential for aberrational trading and disruptive "flash crashes".

Their response has been to increasingly resort to dark pools.

The concern of ASX and ASIC is that while there might be benefit for particular investors from trading outside the lit markets the emergence of multiple pools of liquidity and non-transparent trading could, because trading in the dark pools, crossings and internalisation of trades are priced by reference to the lit markets, result in lower liquidity in those markets and wider spreads and damage the interests of the vast majority of investors.

It should be noted that ASX isn't arguing that dark pools or dark execution should be prohibited (which would be self-harming, given that it conducts some dark execution itself) but rather that they should be better regulated and more transparent.

There has been a sense of complacency in this market about the emergence of high-frequency trading and dark pools – which now dominate trading in the US – but there is no complacency in the ASX submission, which includes an analysis of this year's dark pool execution which it says shows that the proportion of "dark executions" has ranged between 14 per cent and 43 per cent this year.

At the upper end of that range trading in dark pools would be having a material impact on the liquidity of the lit markets.

ASX says there is evidence that shows there is a significant cost – which it says is three times its transaction fee – if trading in the top 200 ASX-listed securities falls by 20 per cent as a result of fragmentation of liquidity.

ASIC has proposed, and ASX supports, some controls over the use of dark pools. ASIC has proposed that trades have to be disclosed to the pre-trade market unless there is a meaningful price improvement from executing the trade within a dark pool. Unless there were a materially better price available it is unclear why a trade could be executed outside the lit markets without disadvantaging the interests of the investor.

Both ASIC and ASX are also interested in imposing order size thresholds for dark orders – ASX suggests $25,000 – below which the orders would have to be executed in a lit market. It is proposing different treatment for larger transactions.

They are also interested in extending regulation of securities markets from the lit markets to the dark, with ASX arguing that the dark pools are effectively private exchanges that involve the systematic matching of orders that should be regulated in the same way as public markets that perform the same function, with ASIC surveillance and subject to the same supervision levy and similar integrity safeguards as the lit markets.

ASX also makes the point that trades on dark pools, unlike the lit markets, aren't settled within the licensed clearing and settlement regulatory framework (and on ASX's clearing and settlement platform), exposing participants to counterparty settlement risk. It wants disclosure of the clearing and settlement risks for clients of executing transactions via dark pools to be made to the clients.

ASX is, in the submission, obviously arguing its own self-interest, as one would expect. There is real validity, however, in its questioning of the public benefit in high-frequency trading and dark pools and the impact of those activities on lit and highly-regulated markets.

If they fragment liquidity, increase spreads and transaction costs and drive activity and price discovery out of transparent markets, where's the public good?