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Dark pools undermine confidence in equities market - researchers

30 Jul 2013

Research undertaken by the University of Sydney Business School and the Capital Markets CRC has found that the recent growth in dark pools share trading in the U.S. is severely damaging equity markets.

Dr Hui Zheng, a Senior Lecturer in the Business School's Discipline of Finance, says this market fragmentation could have serious implications for Australians who invest their superannuation savings in global equities.

"I am also concerned that the Australian market is moving in a similar direction," Dr Zheng said.

Off-exchange trading venues, known as "dark pools", lack the transparency of established exchanges. They are favoured by financial institutions and brokers who are able to make large and anonymous trades without public market scrutiny.

Describing the rapid increase in dark pool as "profound and negative", Dr Zheng said that a deterioration in the quality of equity markets would have a flow-on effect to the broader community. "This will reduce investor confidence in the financial markets which is the least desired under the current economic conditions," he said.

"This research is not only important for the U.S. market regulators but also of particular importance for many Australians who have large quantities of their superannuation invested on their behalf in equity markets around the world," he said.

While Dr Zheng's research focused on the United States, he believes the results "provide the clearest set of signposts to date of the pitfalls that our domestic markets need to avoid."

"It is well-known that the US markets are leading the way, in terms of market development and innovations," he said. "However, European markets shadow the US quite closely, with the Australian markets following behind."

"In the U.S. dark pools lack transparency and are not subject to the same regulations as the public exchanges," said Dr Zheng. "Our study found that these features allow dark pools to actively entice orders, unrelated to the short-term directions of future price movements, away from primary markets and that this activity is harmful to the overall market quality.

"Market fragmentation is not a new phenomenon in US markets but based on our research the speed at which dark pools are springing up is a major concern for market regulators."

Recently, ASIC in Australia and the Investment Industry Regulatory Organization of Canada (IIROC) instituted market regulation changes to constrain trading in dark pools.

Similar policy initiatives are also currently circulated among market regulators and practitioners in the European Union. The U.S. recently launched an investigation into dark pool trading, and is reported to be considering a ban on the practice.

The study has been accepted for presentation at the 9th European Central Bank Annual Workshop on the Microstructure of Financial Markets, to be held in Frankfurt, Germany, in September.