Much has been said and written in recent months about dark pools, and on Wednesday the chairman of Hong Kong Exchanges and Clearing threw his hat into the ring. Ronald Arculli is not in favour of such trading platforms, which only require prices to be published after a transaction is complete.
He set out his stall in a speech at the Foreign Correspondents' Club in Hong Kong titled 'Roles and Challenges of Stock Exchanges' (click here for the full text). Highlighting the benefits of exchanges (good risk management, transparency, liquidity fairness, a reliable infrastructure and central counterparty services, among other things), he said they demonstrated their worth during the crisis: "Almost all exchanges continued to function normally and remained open during the turmoil."
Arculli also remarked that governments worldwide have recognised the "unique value" of exchanges, with a number of moves afoot to standardise over-the-counter contracts and move them onto exchanges. This is in stark contrast to well publicised concerns of regulators, such as the US Securities and Exchange Commission, as to whether dark pools create unfair advantages for some in the market. Arculli believes they do and clearly outlined his concerns.
Firstly, these platforms lack transparency, as they show buy and sell orders and deals that are not transparent or available to the general investing public, he argued, effectively creating a two-tiered market. They are typically run by broker-dealers and large market-makers looking to save on transaction costs and fees, and do not alert the broader market of impending deals which could affect a stock's equilibrium.
Powerful technology can be used to conduct high-frequency algorithmic trading in dark pools through both on- and off-exchange platforms to profit or arbitrage on small price differences, said Arculli. This has resulted in dark pools accounting for 12% of market trades in the US now, up from 1.5% just five years ago, while in Europe they account for some 4% of equity trades. In Asia, these venues make up a much smaller percentage of the average daily turnover, he added, but in a globalised marketplace, they still raise significant concerns.
Besides transparency, another issue is that the proliferation of alternative platforms means liquidity is increasingly fragmented, diverting volumes away from publicly traded exchanges, he said. Smaller companies may suffer as high-frequency traders tend to prefer larger, more liquid shares. Such fragmentation not only affects effective price discovery, said Arculli, but also increases price volatility and adds to surveillance difficulties.
Moreover, the lack of regulation and transparency of dark pools could result in notable systemic risk, he said, citing the problems surrounding Lehman Brothers and AIG last year. "As dark pools typically lack a central counterparty, the default of a large participant could have severe consequences on market stability," he said.
In addition, these platforms raise concerns over company ownership. "Arguably when shares are held only for fractions of a second, it is no longer about participating in the ownership of a company or ensuring it is well run," he said. "The opaqueness of trading, and its fragmentation have negative implications for effective corporate governance."
Arculli suggests the rise of such platforms set up by investment banks might indicate a trend towards the re-mutualisation of stock trading. Originally stock exchanges tended to be set up as associations by their trading members, he said, but have since de-mutualised and become commercial, often listed, corporate entities to better serve their stakeholders.
"Now as the bigger trading participants are getting together again to create their own networks, is the trend reversing?" said Arculli. "Complicating matters even further, some exchanges have decided to join the fray and team up with large institutions to set up their own dark pools." Singapore Exchange's recent tie-up with Chi-X is one such example. Other trading platform providers, such as Liquidnet, are also working on expanding into Asia.
Arculli went on to say that regulators in the EU and the US have been reviewing dark pools and considering stricter measures to ensure a fair and stable trading environment. Investors -- especially institutional ones -- are seeking better, faster and cheaper services for more computerised methods of trading. Hence, he added, exchanges must continue to offer better execution and more efficient pre- and post-trade services to stay competitive, while protecting investors.
Despite his worries, Arculli, said, competition is welcome. China, for example, has the capacity and the need for more than one successful financial centre. But he added a caveat.
"We welcome challenges that strengthen our markets and make them more effective and efficient," said Arculli. "But we are concerned by those that increase systemic risk or disadvantage a certain segment of investors to the benefit of others."