Trading volumes in opaque crossing networks are increasing across Asia. This positive development must be regulated wisely to ensure that all investors can benefit, writes Lee Kha Loon of the CFA Institute*.

Dark pools, the off-market trading venues where investors can anonymously trade large volumes of listed stocks, have been back in the news in Asia recently. Media reports note an increase in trading volume of small-cap stocks in Australia, Hong Kong and Japan on alternative trading systems since the beginning of the year. Some 30 per cent of executions in Credit Suisse’s dark pool, Crossfinder, relate to shares outside the top 200 names in Hong Kong. By comparison, such names account for only 10 per cent of transactions on public exchanges, which remain dominated by blue chips. Alternative sources of liquidity can be useful for traders looking at mid- and small-cap stocks. Equity trading in Asia is mainly done through stock exchanges with a very transparent system of price discovery.

Those wanting to trade will display bids or offers to buy or sell shares in the desired quantity on the so-called ‘lit’ market. The ‘dark’ market provides access to liquidity that is not publicly visible. Dark pools enable institutional investors to move sizeable amounts of liquidity while minimising intermediation costs and market impact. They can provide investors with an efficient means of trade execution. Some have suggested that dark pools, if only accessible by certain investors, present the risk of a market divided between displayed and dark liquidity. But to a certain extent all markets are divided by wholesale and retail channels. The bottom line is that dark pools are a natural response to meet institutional investors’ demand for low-cost trading, reduced market impact and liquidity in today’s highly automated trading environment.

Market monitors Regulatory concerns focus on transparency and the possible creation of an uneven playing field. The relative opacity of dark pools can hamper price discovery if too much volume is taken away from the lit market (thankfully, this has not happened so far in Asia). But it’s important that there are consistent post-trade reporting standards for all transactions – whether they are executed on a public exchange, in a dark pool, or over-the-counter – so that investors have an accurate and reliable view of prices across the trading landscape. This pricing information should be consolidated to prevent it being diffused across a more fragmented marketplace. To create a level playing field, it is vitally important that all trading venues conducting similar types of business, and all orders of similar types and sizes, are subject to the same rules. In this context, it is important that transparent markets are not disadvantaged by a different set of rules for dark markets. Otherwise, over time, we could see a larger shift in volume away from lit markets, with potential adverse consequences for public price discovery and liquidity. A level playing field is necessary to provide fair competition and to uphold market integrity. Regulators in Asia should heed these considerations as they go about opening up their markets to more competition.

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