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Dark pools can benefit small, mid-cap stocks in Singapore: study

Such stocks are often less liquid, so positive effects of dark trading on lit liquidity would be amplified, but up to a point

There's room for a more calibrated approach to dark trading in Singapore's equity markets than the current regime which imposes a blanket minimum threshold on all block trades, say the study's authors.


DARK trading, which often comes with a negative connotation as investors trade shares anonymously, can actually improve market liquidity for illiquid, as well as small and mid-market capitalisation stocks on the Singapore Exchange (SGX), a staff paper from the Monetary Authority of Singapore (MAS) said on Thursday.

The research, conducted using a quantitative approach based on predictive models and empirical data from 2016, showed that despite concerns that dark-pool trading erodes market transparency, it can be positive for the liquidity of a public or lit exchange, but only up to a certain point.

The positive effects are particularly pronounced for small and mid-valued stocks. Lit exchange liquidity starts to worsen when the proportion of dark trading increases to 25-30 per cent of the total market value.

"For small to mid-market capitalisation stocks, which tend to be more illiquid than large market capitalisation stocks, our agent-based models suggest that dark trading is beneficial to such illiquid stocks even at relatively high proportions of dark trading," according to the paper, which does not reflect MAS' views.

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Perfectly legal, dark trading - also known as "black pools", "dark liquidity" and "upstairs markets" - are controversial alternative private trading platforms that allow investors to make large trades anonymously unlike in a lit exchange where traders can see a large order going through and can move the price against the investor executing the order.

In Singapore, dark trading accounts for about eight per cent of total traded value, compared to other countries like the US, where dark trading accounts for 25-30 per cent; United Kingdom, 20 per cent; and Australia 25-26 per cent.

The SGX tried to get in on the act in 2010, starting Chi-East with Nomura's Chi-X Global. But Chi-East was shut in 2012 due to a lack of activity. Feedback for broker-dealer-run dark pools in Singapore in the past has been they cannot reach "critical mass" by targeting the sell side, and so struggle to jump over minimum crossing size hurdles of at least 50,000 units or S$150,000 in terms of value.

Currently, there are only two dark pool operators here - LiquidNet and Credit Suisse. Both target institutional investors, and have a larger average execution size. So they do not face this problem.

The authors - Chioh Wenn Sheng, Chua Bing Kiat, Andrew Ang, Fan Jia Rong and Brandon Sim - noted that the presence of dark pools encourages the entry of participants who would otherwise not be willing to trade on traditional exchanges, perhaps due to the price impact of their large trades. It could result in a case where liquidity begets liquidity.

"The effects of liquidity externalities could be especially strong in market structures such as that of the SGX where dark (block) trades and lit trades on its listed securities are aggregated and disseminated in a single market data feed. As information is disseminated, market participants will thus become aware that there is trading interest in those securities, and such increased trading volume may generate further trading interest,'' they said.

The study found that smaller market capitalisation stocks experience, on average, larger increases in lit liquidity than those for larger market capitalisation stocks as dark trading increases. Small market value stocks are generally less liquid than the large market value ones. Hence, any positive effect of dark trading on lit liquidity would be amplified for small market capitalisation stocks.

It also suggests that when dark trading accounts for more than 25 per cent of total trades in a single stock, liquidity fragmentation sets in as trades migrate from the lit exchange order book to off-exchange negotiated block trades. Similarly, market depth improves as long as dark trading proportion is below 30 per cent; after which, market depth deteriorates.

"From a policy perspective, these findings suggest that there is room for a more calibrated and differentiated approach towards dark trading in Singapore's equity markets than the current regime which imposes a blanket minimum threshold on all block trades,'' the authors concluded.

Jason Yates, managing director and Head of Asia Execution Services, Morgan Stanley, welcomed the report and its findings.

"If the report's conclusions lead to a change in policy, we believe any resulting improvement in transparency and liquidity could benefit the full spectrum of Singapore market investors," he said.

One institutional broker said, "Removing the minimum threshold will bring offshore liquidity onshore as well as increase the percentage of real time crossings that currently happen after the market closes."

Another concurred with the study and believes liquidity in the small and mid-cap space would benefit by the removal of the minimum threshold, and "this would increase the number of stocks institutional investors see as eligible to invest".

Lee Porter, Asia Pacific head and managing director for Liquidnet, suggested that Singapore should study the Australian model which has a tiered approach based on market capitalisation because it provides "a thoughtful and sensible approach" without interfering with price formation on the lit market.

Asked if SGX is considering resurrecting its dark pool, the exchange said: "We continually engage our intermediary partners to identify new ways to enhance our markets for investors and issuers."

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