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Enoch Yiu

With the global financial crisis still a fresh memory, there has been a yearning for a return to basics in investment. Stocks, bonds and property are as exotic as most of us get.
So new investment vehicles known as 'dark pools' are bound to raise eyebrows and concerns among both the average punter and regulators. 
In the United States, the Securities and Exchange Commission is concerned about the lack of transparency about the platform.  
A dark pool is an electronic trading platform that allows investors to trade a large amount of stock without their identities and trading volume being revealed.
Although they sound like characters from a Star Wars movie, 'dark pools' are becoming increasingly popular with pension funds and asset management companies because of the confidentiality they offer. 
However, it is this very confidentiality that is posing a threat to the role of the traditional stock exchange and creating new regulatory problems.
The dozens of privately run dark pools in the city have started to get some fund houses to place orders, but local laws restricting their operations has meant they have not been run like a true stock exchange such as in the US and European markets.
But Hong Kong Exchanges and Clearing will face increasing competitive pressure from long-term rival Singapore Exchange, which last month linked up with dark pool operator Chi-X Global to introduce the first exchange-backed dark pool. This dark pool will trade Hong Kong as well as Australian, Japanese and Singaporean stocks.
A spokesman for Chi-X said: 'We hope to start operations in Australia, Hong Kong, Japan and Singapore in the first half of 2010. A project implementation team has been formed.'
The spokesman said it would first apply for a Regulated Market Operator Licence from the Monetary Authority of Singapore. It will then seek  a licence from the Hong Kong Securities and Futures Commission before starting to trade Hong Kong stocks. Another Chi-X Global official had earlier said the planned platform, after being launched, could capture between 5 and 10 per cent of Hong Kong's market liquidity.
This has raised alarms bells in the government, the stock exchange and the SFC, which want to prevent such a massive outflow of market turnover. The SFC is also  watching what the US and other international regulators do about dark pools before deciding a  course of action. 
Lee Porter, the managing director of the largest dark pool operator Liquidnet, said he hoped any new regulations would not affect the trading of institutional investors. Liquidnet last month posted a record high trading of US$$1.1 billion in equities.
'The traditional exchanges are tailor-made for retail investors,' Porter said. 'It is hard for institutional investors to trade in the retail market. This is why we have the dark pool, which is mainly for  institutional investors such as pension funds or mutual fund managers.'
Porter  said a big  disadvantage for an institutional investor such as a pension fund trading in a  traditional exchange was  transparency. 
When other retail investors see a big pension fund selling a large amount of stocks, they trade against the sellers and push the share price down further. To avoid this, Porter said, in many cases institutional investors need to break up their block lot of shares into many small trades through different brokers, increasing the costs.
Dark pools such as  Liquidnet allow institutional investors to trade large amounts of stocks  in one go through the electronic matching system, which is more convenient and cheaper than on an exchange. 
'The cost savings of trading in the dark pool would eventually be passed on to pension fund holders, who are mums  and dads on the street,' Porter said.
Porter said dark pool trading in Hong Kong and Asia represents only about 1 per cent of total market share but in Europe and the US, it makes up 16 to 20 per cent. But he argues dark pools do not compete directly  with traditional exchanges.
'Traditional exchanges are good at price discovery while the dark pools are better at volume discovery, especially on less liquid stocks,' Porter said. 
'Our system allows institutional investors to conduct block trading effectively. There is no information leakage and it does not cause any market impact.'
However, many retail brokers are complaining about that lack of transparency.
'They do not have transparency and their trading will eventually affect the traditional stock markets traded by retail investors,' said William Lee Yiu-wing, the chairman of the Hong Kong Securities Association, which represents brokers in the city.
'The SFC should follow regulators in the US and Europe, which are planning to add curbs on dark pool operations and to require them to increase transparency.'
SEC chairman Mary Schapiro said in June she was worried about the impact of dark pools on 'price discovery', particularly their use of pre-trade messages that tip off certain market participants on upcoming orders. She said such practices meant the public did not have fair access to share prices.
SFC chief executive Martin Wheatley said the commission would work closely with dark pool operators about any regulatory changes. 
'We would like to develop an appropriate regulatory structure for dark pool operators,' Wheatley said. 'The key issue is to let dark pools develop in Hong Kong under a proper regulatory framework and not to let the Hong Kong turnover flow from the city to other overseas markets.'
HKEx chairman Ronald Arculli said the financial crisis over the past 12 months had helped the exchange fend off competition from dark pools.
Arculli said a key benefit for traders in traditional exchanges was the high transparency and the lack of counterparty risk, with the exchange clearing house absorbing the risk.
As an example, the HKEx clearing house took on the HK$160 million loss following the default settlement of collapsed investment bank Lehman Brothers Holdings in September last year, with none of its counterparties suffering  losses. Had they been trading in a dark pool, the counterparty would have suffered.  
'The HKEx and other traditional exchanges have shown their strength in coping with the crisis,' Arculli said. 'When the compliance departments of the pension funds and asset management firms look at the counterparty risk issue, it is easy to see where they should trade.'
Despite the risk concerns, many fund managers are supporters of dark pools. 'We certainly look at additional options in order to improve liquidity and efficiency in our trading,' said Mark Konyn, the Asia-Pacific chief executive of RCM, part of pension and asset management provider Allianz.
Gerry Ng Joo Yeow, the managing director of Baring Asset Management's Asia division, said his company mainly traded through the stock exchange but would consider trading in dark pools as an alternative for liquidity reasons.
Timothy Lo, the managing director of French private bank CIC Investors Services, said in general private banking clients benefited more from the dark pool facility. 'Many clients of private banks or fund management companies are usually not short-term traders and they might trade large blocks of stocks,' Lo said.
But Lo concedes dark pools have minimum transparency. 'If the regulator is going to force dark pools to increase transparency, the resulting regulations should not make it hard for institutional investors to trade.'
Still a trickle
Dark pool trade in HK and Asia represents only 1 per cent of the market 
In Europe and the US, the market share can be up to: 20%
May the force be with you
Dark pools, because of their confidenctiality, are posing a threat to the role of the traditional stock exchange and creating regulatory problems
Dark pool operations represent US and Europe market turnover of: 16% to 20%
Dark pool turnover in Asia represents: 1%
Liquidnet has 154 members trading in Asia. Since its launch, Liquidnet has conducted US$11 billion in trades. On average, each trade is about: US$ 1 million
The Singapore Exchange-backed dark pool expects to capture Hong Kong market liquidity of: 5% to 10%
The settlement loss absorbed by the HKEX in the Lehman Brothers collapse: HK$160 million




Unease swirls over rising tide of dark pools