Investors could be disadvantaged under proposed rules for governing alternative liquidity pools (ALPs) in Hong Kong that, among other things, would give agency flows priority over proprietary orders, brokers say.

The city's Securities and Futures Commission (SFC) last week published a consultation paper that seeks to unify regulatory obligations on operators of ALPs, also known as dark pools, and which account for 2% of equity market turnover in Hong Kong. Licensing conditions are currently imposed on a case-by-case basis, but that approach would come to an end under the plans.

The SFC says giving agency flows priority would remove the risk of clients being front-run by operators trading their own orders in the same pool.

But brokers argue that the proposal would also affect 'client facilitation' orders – placed on the back of synthetic positions to provide market access without ownership of physical stocks – thereby disadvantaging investors. The proposal could mean worse execution outcomes for clients, they suggest, and would affect trading in markets to which synthetics are typically used to provide exposure. 

“There should be a distinction between true proprietary orders and those that have client flows behind them,” says one broker in Hong Kong, who asked not to be named. “These are 'risk-less principal' orders, or trade devoid of risks, whereby the orders are originated from end customers and the broker is just passing the order to the dark pool just like any agency order flow.”

In looking to impose order priority, the SFC has put dark pool orders in two categories: principal flow that mainly represents orders in which the dark pool operator has an interest; and pure client, agency flow. If a pool operator receives an order from a client and a proprietary order to trade the same securities, it would have to give priority to agency flow. Client facilitation orders would be included as principal orders.

Synthetic instruments are often used by investors trading markets with access restrictions or other operational requirements that they want brokers to fulfil on their behalf. One example is short position reporting requirements in markets such as Hong Kong.

Meanwhile, brokers say they are concerned about the proposal to restrict dark pools to institutional investors. The SFC says the lack of understanding by retail investors of how dark pools work and the risks they can pose means such investors could be at greater risk than more sophisticated ones.

But brokers say such restrictions would ignore the fact that high-net-worth individuals can be sophisticated investors and often trade in sizeable orders that could benefit from price improvement by crossing in dark pools.

HSBC had planned to roll out a dark pool, StockMax, to retail investors in 2011; but was reportedly forced to put the plan on ice due to licensing conditions imposed by the SFC.

In December the SFC reprimanded and fined HSBC Securities HK$5 million ($644,246) for misrepresenting in its licensing application that it would ask retail clients to sign 'opt-in letters' if they wanted to use the pool. It was later reported that HSBC had planned to use an 'opt out' approach instead.

Other proposals under the consultation include: enhancing the level of disclosure to ALP users; limiting the level of visibility of trading information available to the staff of ALP operators; and introducing additional control, record keeping and reporting requirements.

The deadline for submitting comments April 25. The Asia Securities Industry & Financial Markets Association is understood to be preparing a submission to the SFC.