Gone to the Dark Side

For good reasons, institutional investors in Australia are tapping into dark liquidity. But as more dark pools appear, new regulatory proposals to protect price formation on the open market and define which trades can be executed in the dark have been made. SIMON MUMME talks to dark liquidity vendors about the state of play in block trading.

Originating in the US at the turn of the century, dark liquidity arrived in Australia only a few years ago. It enables investors to anonymously execute million-dollar trades away from public exchanges, minimising the chance that prices will move against them. It has become more popular as, more recently, major brokers and the Australian Stock Exchange (ASX) itself joined the niche providers in sourcing off-market liquidity from investors.  In August, off-market block trades, which are usually one or more millions in volume, accounted for 19 per cent of total trading, while on-market crossings below block size made up 13 per cent of trading, according to the Australian Securities and Investments Commission (ASIC).

While the non-block volume of trading has remained steady, the block volume has fluctuated. In a consultation paper on the structure of the Australian equity market, released in late October, ASIC also observed that partially undisclosed orders – such as ‘icebergs’, which show only part of an order – were put onto the open market, or the central limit order book (CLOB) of the ASX. But more recently, some have lodged completely undisclosed orders. These more opaque orders are allowed by an order type offered by the ASX. Rather than providing a quantity and a price, these orders display a ‘U’, and the market doesn’t know if the order will be for 5,000, 5 million or 20 million securities. But in an ASX update to its product range, scheduled to be completed by the end of November (before this issue of Investment Magazine went to press), it is understood that undisclosed orders would no longer be supported.

The regulator notes that it’s easier for traders to put undisclosed orders on the order book than to access dark pools, which impose restrictions about the types of investors that can participate, although transparent orders have greater precedence on the market. ASIC’s concern about dark liquidity and undisclosed orders is the potential impacts they can exert on the “price formation” of securities. If more trades are executed away from the CLOB, or prices on the order book are invisible to the market, the more difficult it is for the market to efficiently price securities. There is an “inherent tension” between the advantages gained by investors trading in the dark, and the long-term “public good” of price formation, ASIC notes.

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