From December 1, Hong Kong’s Securities and Futures Commission will ban retail investors from trading in dark pools. Only institutional investors such as pension funds, portfolio managers or professional investors with minimum portfolios of HK$8m (about $1m) will be allowed in.
“Dark pools are not meant for retail investors, they’re meant for institutional investors,” said Seth Merrin, CEO of US-based Liquidnet, who spoke to FSA on a recent trip to Hong Kong.
Liquidnet runs an “independent alternative trading platform”, better known as a “dark pool”, in 11 markets in Asia.
“Regulators all over the world are sounding the alarm and focusing on high frequency traders and dark pools. The regulators are saying `if you’re providing value above and beyond what exchanges don’t provide, then continue. If not, they’re shining a light on dark pools."
A dark pool operates within the broader stock market. It allows buying and selling without public disclosure.
Merrin said Liquidnet was created because the trading of institutional investors’ large assets have outpaced the ability of the traditional exchange to handle those transactions efficiently. In Asia, for example, the average size of a trade in Liquidnet’s dark pool is $1.1m, while on the exchange the average trade is single digit thousands, he said.
“So every time [institutional investors] go into the market, they move the market.”
The dark pool provides liquidity by matching buyers and sellers who wish to engage in large transactions.
A question of transparency
Hong Kong had 16 dark pools as of June 30, the SFC said. Lee Porter, head of Asia-Pacific at Liquidnet, estimates there are 40 across Asia.
However, dark pools are coming under increasing regulatory scrutiny globally.
Earlier this year, the SFC fined BNP Paribas Securities $15m for “failures in relation to its dark liquidity pool trading services”.
In the US, dark pools have been under fire for lack of transparency. In particular, high frequency traders have been allowed in some dark pools, and they have used their technology to gain an unfair trading advantage compared to the broader market.
However, Merrin said that Liquidnet does not allow high frequency traders into its dark pool and has strict rules to vet new users.
Porter added that one fallacy about dark pools is that buying and selling is done away from the exchange so no one can see the activity.
“Every trade executed in Hong Kong is tagged and the regulator knows who did it and what the volume was,” he said.
However, the regulator does not publicly disclose the information.
Moreover, Porter said it is untrue that dark pool transactions are done at “weird and wonderful prices” away from the market.
By his estimation, 99.9% of transactions happen within the current bid offer.
Asia record year
The firm expects a record year for its hosted transactions in Asia. Last year, Liquidnet had $22bn in regional transactions, which has already been exceeded in 2015, Porter said.
Large institutional investors such as pension funds and sovereign wealth funds have been particularly active this year in Japan, where he expects a record year for the firm, and in Europe.
Asia and Europe together will represent 50% of the firm’s global revenue by years’ end.
Still, dark pool volume in Asia’s markets is only one-quarter of the US volume.
In Hong Kong, about 2% of all stock exchange transactions go through dark pools. In the US, the figure is about 12%, Merrin estimated.