Why Asia must see the light in dark trading

WITHOUT a doubt, some issues in finance such as bank balance sheets, contagion risks and dangerously indebted sovereign nations, demand urgent action from authorities. But as the economist Milton Friedman once stated: “The one responsibility of business is to engage in activities designed to increase its profits, while also staying within the rules of the game.” In other words, businesses should engage in open and free competition without deception or fraud.

It is therefore perplexing why innovations in the cash equity markets, designed to help asset managers reduce costs and increase investor returns, have seen the ire of European Union policymakers.

Take dark pools as a prime example. Private exchanges, designed to help asset managers trade equities in large quantities at a fair price, have reduced the cost of trading shares and increased choice for asset managers. Many studies demonstrate the efficiency of executing large blocks of stock without having to show the market in advance, particularly in small and mid-cap stocks. So why have European regulators limited dark trading to only 8 per cent of market turnover – and more importantly, why should Asian rule makers not follow suit?

Inaccurate views that off-exchange trading is secretive and risky have led EU policymakers to a predictable reaction. It is essential that Asian regulations reject these pre-conceived ideas. Firstly, there is the popular misconception that dark venues hide prices. They do not. Almost all dark venues use a widely known mid-point reference price, obtained from the broader market. Only the liquidity (buy and sell orders) is hidden from view. Furthermore, most venues publish trades immediately after execution, so the market is never blind to their activity. These real-time trade publications provide the “pre-trade” information for the next trades in the market, either in dark pools or on national exchanges.

Fund owners benefit from dark pools by not alerting the market to their intentions when trading large blocks of stock. When buying or selling large blocks of shares, the market will move against you if you display your trading intentions. Transaction costs surveys measure this impact cost at roughly 0.4 per cent for trades by various institutional funds across UK equities. Measuring and reducing this impact is key for traders, as they seek to preserve value for savers. Using dark pools is an important tool in the effort to reduce these costs.

The good news is that across Asia, there is no pan-Asian regulation, unlike the EU with its heavy single market rulebook. There are 14 different developed and emerging markets across Asia, all of which act as their own regulators. In Asia-Pacific developed markets, both institutional investors and retail clients already have access to dark liquidity. Across the emerging markets in the region, however, there is a focus on retail clients, who currently do not have access to dark liquidity. The focus should be on growing the institutional marketplace, and regulators must work to define a better outcome for usage of dark pools within those markets. Only then will this style of trading become more prevalent among asset managers.

Rule makers across Asia have a duty to explain to investors across the region what a more draconian approach to dark trading really means. Simply put, the added market impact from trading an equity fund without dark pools means ordinary investors will be retiring later due to the additional costs incurred by pension savings.

The writer is head of South-east Asia at Aspectus Group