Published On: Tue, Dec 21st, 2010

HK To Gather More Data On Dark Pool Operators

Hong Kong’s alternative liquidity pool operators earlier this month received a letter from the city’s exchange operator advising them they will have to start reporting their trades using a new transaction code, in a move that could shed more light on the developing and inherently opaque business.

Though operators of dark pools, a type of alternative liquidity pool that doesn’t display quotes publicly, already report their trades to Hong Kong Exchanges & Clearing Ltd. (0388.HK), the new requirement will segregate their activity from other off-market transactions, better enabling regulators to gauge the size of the market.

Current market estimates indicate dark pools account for 1%-3% of the value of trades in Hong Kong, but the actual size of the business and how fast it is growing are unknown.
Dark pool transactions account for about 2.3% of traded value in Europe and 12.6% of trading volume in the U.S., according to Rosenblatt Securities Inc. The transactions are typically measures by traded value in Europe and Asia and by volume in the U.S.

The pools let customers anonymously execute large block trades, reducing the risk information leakage could affect prices as orders are processed. They can also save end-users money by enabling them to negotiate narrower spreads between bid and offer prices than those regulated by Hong Kong Exchanges, which are on average 23 basis points, said Ian Lombard, chief operating officer at Tora. Spreads are typically just four to five basis points in the U.S., he said.

Lorraine Chan, spokeswoman for HK Exchanges, said Tuesday the regulation will take effect Feb. 1 and that information will be collated and shared with Hong Kong’s securities regulator.

Alternative liquidity pool operators in Hong Kong such as Liquidnet Asia Ltd., Instinet Pacific Ltd. and Tora said they are happy about the new regulation, as they believe the increased transparency could help drive their business, which has been vilified by the chairman of Hong Kong Exchanges–the city’s monopoly bourse operator–in the past.
“The new rules should help people better understand dark pools, which have had some public relations issues in the past,” said Joel Hurewitz, head of sales for broker dealers and liquidity at Instinet Pacific.

Lombard said: “Any legitimate dark pool operator in Hong Kong or Asia would encourage this type of transparency.”

HK Exchanges Chairman Ronald Arculli said in a speech in Shanghai in July that the proliferation of alternative trading venues posed “challenges to regulators and regulated exchanges. There is unequal access to markets and the fair price discovery process is impeded because a portion of demand and supply for a stock is effectively concealed,” he said.

David Webb, a shareholder activist and former director of the exchange, criticized the speech in an article on his website as a “thinly-disguised and factually flawed rant against the competition that investors in less-protected markets enjoy from competing exchanges and alternative trading systems.”

The stance of the chief executive of Hong Kong’s Securities and Futures Commission on the emergence of alternative liquidity providers has appeared more moderate than Arculli’s view. In a November 2009 speech in Singapore its chief executive, Martin Wheatley, said that though the spread of dark pools has raised concerns about the transparency and fairness of alternative institutional trading venues, and created potential difficulties for regulators, overseas experience has shown that such venues also provide benefits to the market such as reducing trading costs, enhancing liquidity and allowing faster execution.
In Europe the advent of the Markets in Financial Instruments Directive regulations, which sought to integrate the European Union’s financial markets, drove down trading costs dramatically. The rules paved the way for alternative trading systems and clearing platforms and allowed trading venues to report their activity to specialized reporting platforms that charge less than traditional exchanges.

But the emergence of alternative liquidity providers hasn’t yet lowered trading costs much in Asia, where the venue operators are typically hamstrung by rules requiring them to pay traditional exchanges for their trades even though the exchanges haven’t participated in the transaction.

Hong Kong charges 10.8 basis points per trade including a 10 basis point stamp duty–whether the trade is done via a dark pool or through the exchange–while in Europe the London Stock Exchange charges 0.45 basis point per trade and dark pools charge a maximum of 0.3 basis point.

While this high cost of trade hasn’t deterred dark pool operators, who can charge high margins for their services that historically haven’t been offered by conventional exchanges, it has made it impossible for those operating “lit” alternative trading systems, which function more like traditional exchanges, to set up shop in Hong Kong. But alternative display market venues, which are a low margin, high volume business, are popular in Europe and the U.S.

“The display market business is non-existent in Hong Kong because the cost is prohibitive. It’d be like trying to run a Burger King if you had to buy all of your burgers pre-made from McDonald’s,” said Glenn Lesko, Asia-Pacific chief executive of Instinet Pacific.

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