Dancing in the dark: how dark trading has changed the financial securities market - an Australian perspective

13 April 2015

Justine Abel, Shane Barber

Investors in financial securities markets such as the Australian Securities Exchange ("ASX") should be aware of the advantages of dark trading, the effect dark trading may be having on their trading activity and its impact on the market generally.

What is dark trading?

Dark trading refers to buy and sell orders for securities that are made privately and are not visible to the "lit" market (although the trades are usually published immediately after they have completed). This is also sometimes known as dark liquidity. The venues in which the dark trades take place are known as "dark pools".

There are currently over 20 dark pools in Australia, including dark pools run by the ASX and Chi-X. As of March 2013, dark trading made up 25-35% of market turnover, and 7% of the total equity market share.

What are the advantages to investors?

Investors wishing to offload or acquire large blocks of securities may benefit from doing so in a dark pool. As the offer is not disclosed to the public, it does not create 'noise' or affect perceptions of the value of the securities6. The dark pool, therefore, may help preserve the value of the offer.

Investors may also see an advantage in making smaller, below block-size trades in the secrecy of dark pools, as they are protected from other traders getting insight into their trading plans or having their strategies leaked or imitated.

The growth in the number of trading venues in the market (which is known as market fragmentation) means that the trading venues are forced to compete with each other. The increase in competition tends to lead to lower fees, enhanced potential for innovation9 and improved tailoring of the venues to their clients' needs. 

Finally, dark pool participants have generally enjoyed lower fees and faster execution of trades than lit market participants, although this should change due to recent regulation.

How do dark pools affect the market?
Price formation

Pre-trade buy and sell orders indicate the supply of and demand for a security, as well as the market's perception of the security's value. This information contributes significantly to price-formation.

If an order is not pre-trade transparent, nobody except the person who submitted it can observe the order and none of the information contained in the order can be assimilated into share prices until after the trade occurs. If no trade occurs, the rest of the market will never know about the order. Without the contribution of the valuable pre-trade information, the price of securities becomes less reflective of their actual value.

As dark trading becomes more readily available, trade on lit markets tends to decrease; therefore the volume of pre-trade information in the market decreases. Ultimately this means that less pre-trade information is available overall and price quality tends to deteriorate further.

Volatile Prices

Sellers in lit markets may realise that their pre-trade information may be incomplete as a result of dark trades taking place in the same securities; which can cause them to become more risk-averse when they post prices. Therefore, the advertised prices for securities may not reflect the amount eventually paid by the purchasers, which results in wide bid spreads (the difference between the buy and sell prices of shares). Wider bid spreads leads to more volatile prices, which may be a disincentive to investors to trade in the market.

Conflicts of interest

Conflicts of interest can arise when the interests of a broker diverge from those of its client. Conflict of interest are likely to occur in dark pools and particularly in crossing systems. This is because brokers may trade as a principal as well as on behalf of their clients. The potential for conflict is exacerbated by information asymmetries between the Principal and the clients; as Principals receive information about the market to which their clients are not privy and they also know their clients’ trading intentions. The flow-on risks from the information imbalance are, firstly, that dark pool brokers could favour their own bids against those of their clients, and, secondly, that brokers could extract profits from their clients placing uninformed orders in the dark pool, which is a process known as 'cream skimming'.

Fairness and Investor confidence

Recent surveys undertaken by the Australian Securities and Investments Commission ("ASIC") have revealed that many investors are concerned that dark trading reduces fairness in the market. They believe that dark pools 'free ride' on the pricing and information set on exchange markets, which is unfair to those providing that pricing information. The surveys revealed that many investors feared that dark pools were offering preferential pricing to its participants. Indeed, many investors were receiving better prices on dark trades than lit trades at the time of the surveys.

The perceived fairness of the market is one of the key drivers of investor confidence, which informs investor behaviour. Investors who lack confidence in the lit system may seek to execute their trades in dark pools instead or they may conclude that they cannot compete and withdraw liquidity from the market altogether.

Liquidity

Opinions are divided as to whether dark pools help or hinder market liquidity.

On the one hand, dark pools are thought to drive liquidity, particularly for block size trades. As discussed above, trades can be executed more cheaply in dark pools and without the costs and risks (such as the risk of adverse price signalling) that occur when securities are traded on the open market. Investors are therefore encouraged to increase their trading activity and bring more liquidity into the market.

On the other hand, however, dark pools can cause a diminishment of investor confidence (as discussed above), which may cause investors to reduce their trading activity and/or withdraw from the market, causing liquidity to diminish over time.

Regulatory response

Over the past two years, ASIC has introduced a raft of new market integrity laws in order to minimise the harmful effects of dark liquidity on the market. The key focus of the rules is to improve fairness, reduce the scope for conflicts of interest, increase block-size trading and reduce below-block size trading in dark pools. ASIC reviewed the success of the rules in May 2014 and declared that the desired outcomes had been reached.

Authors

Shane Barber

Shane Barber

Managing Partner
Australia

Call me on: +61 2 9226 9888