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Asia-PacificNovember 24 2010

The emergence of Asia's dark pools

Alternative liquidity is surging in Asia, and dark pools are now leading this assault. However, some major market participants are lagging behind. Writer Michelle Price
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The emergence of Asia's dark poolsLee Porter, managing director of Liquidnet Asia

Alternative liquidity, the likes of which have served to fundamentally transform both the US and European equity trading landscape, is growing rapidly in Asia. But no form of alternative liquidity is growing faster than that of 'dark pools' - a type of off-exchange non-displayed liquidity that has already sparked much controversy among regulators and practitioners in both the US and Europe.

As in the US and Europe, Asian dark pools are being pioneered for the most part by broker dealers and agency brokers, while a number of major Asian exchanges - notably Australia and Singapore - are also poised to launch their own dark offerings in due course. Not all of Asia's major exchanges are embracing dark liquidity however, with the Hong Kong Stock Exchange (HKEx) remaining strongly and loudly sceptical about the phenomenon.

A global influence

The rise of dark electronic liquidity is a testament to just how fast the Asian equity trading landscape is evolving. It also serves to underline how influential global brokers have been in driving that transformation. For the most part, these dark pools are not home-grown but provided by foreign broker dealers and agency brokers.

Take Hong Kong for example, where the local regulator, the Securities and Futures Commission (SFC), has granted 12 Alternative Trading System (ATS) licences for dark pools trading in Hong Kong equities. Credit Suisse, Citi, UBS, BNP Paribas, Goldman Sachs, Morgan Stanley, Merrill Lynch and agency brokers ITG and Instinet all operate internal crossing networks in Hong Kong, while buy-side block crossing network Liquidnet Asia, which is also based in Hong Kong, offers dark liquidity in Hong Kong, Australian, Japanese, Singapore and South Korea-listed stocks.

In late May, Nomura rolled out its NX (NomuraCross) dark pool in Hong Kong, following the launch of a similar venue in Japan in late 2009. Germany's Deutsche Bank, meanwhile, added its name to the growing list of broker-owned dark pools in August, when it unveiled its Hong-Kong-based Deutsche Bank Automated Trading System.

And Hong Kong is not the only marketplace embracing dark liquidity. For a long time one of Asia's most structurally progressive markets, Tokyo has also seen a surge in dark trading in recent months. In late September, for example, agency-only broker Instinet announced that its Instinet Japan Limited subsidiary has added dark order types to its Japan share-trading platform CBX Asia, which had previously been a fully lit venue.

Citigroup is also getting involved, having launched a Tokyo-based dark pool offering in conjunction with Japanese online broker Kabu.com earlier this year. The US broker is also set to expand its dark liquidity footprint throughout Asia, with plans to launch a dark pool in Singapore next year after the value of its off-exchange trading in Australia increased to a record $1.3bn in June this year, according to Bloomberg. "Dark liquidity is no longer scary," says Lee Porter, managing director of Liquidnet Asia. "People understand dark liquidity and its benefits a bit more now. It's a bigger part of their daily workflow."

A long lament

Brokers have long lamented the lack of anonymity that characterises trading on Asian exchanges, where liquidity is often scarce, spreads are wide, and trading costs can be as much as 60% higher than in the US - particularly in markets such as Hong Kong, where the stamp duty prevails.

Transacting in dark pools offers institutional traders a deeper and cheaper venue in which to execute trades anonymously. Demand for dark liquidity among fund managers trading in Asian stocks is growing.

"People want it very badly. The biggest buy-side firms out here are outsizing the market every time," says Glenn Lesko, managing director of Instinet Asia Pacific. "They cannot get the liquidity that they want on the exchange and they don't want to have to open up their order flow to broker sales traders every time they want liquidity."

New York-based Greenwich Associates estimates that, at the present rate of growth, the proportion of all Asian trades executed off-exchange will rise to 3% by 2013. Although on an absolute basis this sounds small, it would put Asia-Pacific, as a much less developed region, just three years behind Europe in terms of dark liquidity volumes.

But if dark execution venues are growing and are, in turn, serving to boost the absolute volume of Asian liquidity, this liquidity is not all available in one place. This problem is rapidly making liquidity aggregation the next critical structural development in both Hong Kong and beyond. "The aggregators are the newest and a very important building block of mature market structure," says Neil Katkov, managing director of research group Celent in Asia.

Several brokers are now vying to provide a liquidity aggregation service that will link their internal networks with other regional dark pools, thereby providing their clients with a single point of access to a large chunk of Asian dark liquidity. Both Instinet and ITG are pushing out Asian aggregation services, while Deutsche Bank's new dark pool also has an additional liquidity-seeking algorithm which will give Deutsche Bank's clients access to other Asian dark pools.

"The interesting thing about dark pool and alternative trading systems in Asia is that already, from a business model point of view, there is a full set of initiatives - there are as many models conceptually as there are in Europe or the US," says Mr Katkov.

The pan-Asian vision

Another player offering a dark liquidity aggregation service is Tora, a Hong Kong-based technology vendor in which Goldman Sachs made a minority investment this year. Tora's first dark pool, launched in Japan in February, offers clients access to both Tora's own crossing network and aggregated liquidity from other venues such as Kabu.com. The Tora platform, known as Crosspoint, has stolen about 4% of total trading volume on the Tokyo Stock Exchange.

But Japan is just the start for Tora. The company plans to roll out the dark pool across Asia's major markets, with Hong Kong, Singapore and Australia to go live later this year. By aggregating liquidity across all of these markets, Tora plans to crack the problem of regional liquidity fragmentation by creating a pan-Asian dark pool. "The tricky bit is that liquidity has always been scarce in Asia and in recent years it has got scarcer, so we're doing the heavy lifting to bring that liquidity together," says Chris Jenkins, managing director of the Asia-Pacific region for Tora.

Rival brokers claim that Tora's aggregation model is no different from theirs, but Mr Jenkins argues that Tora's status as a native Asian platform will mark it out from the competition. Unlike other brokers, the Tora software has been built specifically to manage Asian order types, exchange rules and market practices. "All these things make a difference in terms of the functionality of the trading platform," says Mr Jenkins. "The clients want you here. With other firms you don't get the client support and the clients feel that Asia is an afterthought."

Aggregating liquidity within a domestic market is one thing, but aggregating dark liquidity pan-Asia is an altogether trickier proposition, say market-watchers. "Tora has been very, very successful as an aggregator in the Japanese market, but it will be interesting to see how successful it is in positioning itself as that central entity in cross-border trading," says Mr Katkov.

Indeed, success is not a foregone conclusion for dark pool providers in Asia, and some broker dark pools have struggled to attract flow. Market-watchers can expect a slew of announcements in coming months outlining co-operation between Asia's dark liquidity providers, as each pool battles to accrue aggregate liquidity volumes. Indeed, the announcement in mid-September that Instinet and Tora will allow mutual access to their liquidity pools in Japan is just the start of the next phase of major structural transformation in the Asian equities markets. Instinet, for example, plans to connect to at least 10 broker dark pools, says Mr Lesko.

Regulatory shift

But it is not just the brokers that are pioneering structural change. Chi-East, the Singapore Stock Exchange's (SGX) much-feted joint venture with Chi-X Global, will provide dark trading in Hong Kong, Singapore, Australia and Japan stocks.

According to Ned Philips, CEO of Chi-East, the platform will begin trading in a handful of very liquid stocks in each market from the outset. While liquidity aggregators are looking to source liquidity from a variety of fragmented private dark pools, Chi-East is a centralised dark trading venue to which all brokers enjoy unrestricted access.

"Everyone has their own means of trading orders. We're sitting in the middle of the table and saying 'we're willing to accept all of your relevant order flows', and this will come from different sources," says Mr Philips.

For many market-watchers, Chi-East - which is due to go live around the time of writing - marks a seminal development in the Asian equities landscape, if only for its exchange-backed status. In the view of analysts such as Mr Katkov, the SGX's partnership in the project demonstrates a broader softening towards alternative liquidity among Asia's regulators.

Other exchanges are falling in line. Even the Australian Stock Exchange (ASX), for example, which last year submitted to a regulatory overhaul that deprived the exchange of both its supervisory status and de facto monopoly, is undertaking to renovate its secondary markets. In June, the exchange unveiled plans to slash trading fees, upgrade its trading platform, and launch two new mechanisms for trading stocks.

But there is one major exchange lagging behind. Although the Hong Kong marketplace now boasts 12 crossing networks, the HKEx itself has been less than enthusiastic on the subject of alternative liquidity. Appropriating a buzzword now well established in Europe, Ronald Arculli, chairman of the HKEx and a highly vocal critic of alternative liquidity, has publicly lamented the rise of liquidity fragmentation.

In July this year, Mr Arculli told an audience at the Shanghai Finance Forum that fragmentation of liquidity makes the best prices inaccessible to retail investors. He went on to add that it has negative implications for effective corporate governance. But his remarks appear to find little sympathy among those at the vanguard of the phenomenon. "Fragmentation is a problem in Asia: we don't have enough of it," says Chi-East's Mr Philips. "We want alternative venues in Asia so that investors have more choice. The market needs it."

Late to the party

Mr Arculli is hardly the first exchange grandee to voice fears regarding dark liquidity but his remarks are arguably the most extreme. In a separate December speech that is now notorious among the local Hong Kong trading community, Mr Arculli told an audience at the Foreign Correspondents Club that it is possible to link the rise of dark liquidity to the collapse of Lehman Brothers.

Hong Kong brokers are apparently too polite to speak out publicly against Mr Arculli's characterisation of dark liquidity, but privately many despair at what they feel is a retrograde and flagrantly self-serving position on the subject. "Among institutional and knowledgeable investors, dark liquidity is not controversial at all," says one Hong-Kong based broker. "I think Mr Arculli wants to make it controversial because the exchange potentially has a lot to lose."

Unlike the SGX, the ASX or the Tokyo Stock Exchange, the HKEx is doing little in its secondary market to acknowledge - or indeed exploit - structural change, of which dark liquidity is merely one form. There is a growing feeling among Hong Kong brokers that the HKEx's privileged position as the de facto international market for Chinese listings has led it to neglect its secondary market. The HKEx's attempt to exempt itself from a new Competition Bill unveiled by the Hong Kong government in July, which would not only open the exchange up to head-on competition from the likes of Chi-X but would deprive it of its monopoly on clearing too, has done little to dispel this perception.

But the exchange's position on alternative liquidity poses other risks. Some market-watchers have warned that by eschewing its own dark liquidity initiatives, the HKEx is potentially opening up opportunities for other regional exchanges to develop a dark market in Hong Kong-listed stocks.

According to some brokers, the SFC is less obdurate on the issue and is exploring how to develop a regulatory structure for dark liquidity. "The SFC understands dark liquidity," says Mr Porter. "The regulators here are keeping a very keen eye on dark liquidity to see what works."

As such, HKEx may yet be compelled to explore dark liquidity in its own business. But when it does, it may find itself a little late to the party.

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