Give public access to ALPs
15 April 2014
On 27-Feb-2014, the SFC launched a consultation paper on the regulation of Alternative Liquidity Pools (ALPs), also known as Alternative Trading Systems and "dark pools". As we will explain, the proposals would eliminate the possibility of public (retail) access to faster and better order-execution that ALPs can provide. Now is your chance to help oppose this by submitting your view to the SFC.
Background
The SFC defines ALPs as:
"electronic systems through which the crossing or matching of orders involving listed or exchange-traded securities are conducted with no pre-trade transparency."
The SFC doesn't define "pre-trade transparency" but we take that to mean that no bids or offers are displayed to users. ALPs are operated under a "Type 7" SFC licence for Automated Trading Services (ATS). At 31-Dec-2013 there were 25 corporations with an ATS licence, but only 16 of them operated ALPs. Others may operate lit venues, or Electronic Communication Networks (ECNs) which display orders (whether anonymised or not) to clients. In essence the biggest ECN is the AMS/3 trading system operated by The Stock Exchange of Hong Kong Ltd (SEHK), although it does so as a statutory monopoly "stock market" to which all other ECNs must report trades and pay tolls.
The stated objective
The stated objective of the SFC consultation is to enhance and standardize the regulatory obligations on ALPs operators in HK, which until now have been dealt with by imposing conditions on the ATS licence. The licence conditions of ALPs are inconsistent between operators. For example, currently the SFC restricts new ALPs to securities listed on SEHK and restricts operation to the same trading hours as SEHK, but that doesn't apply to ALPs which were licensed "some years ago". The SFC proposes bringing them all to a common standard by putting that standard into the omnibus Code of Conduct, and asks what that standard should be.
The SFC proposes allowing ALPs to operate at any hours they choose, and to transact in any securities they choose, whether listed on SEHK or overseas. On trading hours, they state:
"allowing transactions in securities that are traded on SEHK to be effected outside SEHK trading hours would merely recognize and sanction the practice that has long existed, albeit without the involvement of electronic crossing or matching systems, of transactions being entered into after normal trading hours and reported to SEHK the following day."
Webb-site agrees that investors should be free to trade when they want, and that allowing ALPs and ECNs to choose their own hours of operation will facilitate this and enhance competition. If there is enough demand for trading outside the 5.5 hours per day of SEHK, then it sends a clear signal that they should consider lengthening their own hours, possibly including the 12-1pm lunch break.
It is also a reality that through various online brokers with a HK presence, the public can already trade in securities in multiple overseas markets, and institutions certainly can, so we see no reason in principle why we should not allow ALPs to facilitate onshore trading in overseas stocks.
The unstated objective: locking out the public
What the SFC does not mention, though, is that this paper comes in the aftermath of a crackdown on a proposal from HSBC to allow its retail clients to use StockMax, an ALP that could have provided price improvement and faster execution for clients by allowing them to deal inside the often wide minimum bid-offer spread on SEHK and to at least bypass the SEHK queue. At the last minute, the SFC revoked its approval for retail access, and it was only 16 months later that it indirectly explained why; HSBC had proposed StockMax as an opt-in service but had then changed its mind to make it an opt-out service, and the SFC had not been updated.
But if that was the only concern, then HSBC could have proceeded with an opt-in service. What this was really about, in our view, was political pressure, including from small brokers, not to allow competition outside SEHK's trading engine, because small brokers do not have enough order flow to provide such services individually (although they could pool their efforts).
So now, in this paper, the SFC proposes to eliminate the possibility of StockMax, or systems like it, providing retail access to competing trading venues. The SFC proposes that only "institutional investors" should be allowed access to ALPs. They don't use small brokers anyway. The SFC then goes on to admit that some larger financial services groups have both fund management arms and private banking/ retail broking arms, so it proposes to require ALPs operators to ensure that their clients, and the clients of their group companies, do not conduct transactions unless they are institutional investors, to prevent them "attempting to circumvent the spirit" of the ban. All very cumbersome.
The reason given for banning retail investors from ALPs is that investors "might find it difficult to understand the operation of, and the risks associated with, these crossing networks". This is frankly rather patronising. It doesn't take a rocket scientist to understand that sooner is better, and that being offered a better price is better. This is the same regulator which has no problem with allowing retail investors to trade exotic products such as proprietary derivative warrants and bull-bear certificates issued by investment banks when there is no fungibility between them and only the issuing bank can go short by printing more. If those risks are acceptable then surely ALPs are.
The SFC suggests that ALPs provide a "promise of price improvement" that may mislead retail investors. They don't. They provide a possibility of price improvement, which is better than no possibility. ALPs will not always improve on the speed of execution or the price you are willing to pay or receive relative to the exchange, but they won't do any worse, because the broker-dealers are always under an obligation to provide "best execution" - that is, if they can get a better price on SEHK, or if they don't have a matching order immediately available, then they must send the order to SEHK.
The HKEx monopoly
As an unelected director and CEO of Hong Kong Exchanges and Clearing Ltd (HKEx, 0388, the owner of SEHK), Charles Li Xiao Jia, pointed out last week (much to the chagrin of the Government, which likes to pretend otherwise), HKEx is a government-controlled company, and its shareholders (on a 1-share-1-vote basis, by the way) can only elect 6 out of its 13 directors. The SFC's paper adopts the unstated assumption that this state-controlled monopoly should remain the default venue for trading securities, rather than opening up competition and innovation. As a result, we are stuck with the wide spread table (as much as 2% at 50 cents) and rigid trading hours.
The USA and Europe, by comparison, have multiple competing trading venues. Even Australia has two. Whilst this does present its own challenges for regulation, it is an organic, competitive market which has produced far narrower bid-offer trading spreads and lower transaction fees than the HKEx monopoly. The recent hubbub over Michael Lewis' latest book on the US market tends to overlook that. Yes, there are some clever people who arbitrage between the venues, and yes, there have been some unfair practices by trading venues, which in essence have been sharing the fruits of front-running some clients with others. The SEC should crack down on these practices, but that doesn't mean they are going to turn the US market into a state-controlled monopoly exchange like SEHK.
At the very least, the SFC should allow "informed consent". That is, they should allow retail investors to opt in to the use of ALPs and ECNs in their orders, either on a per-order basis or an all-order basis. That's the basis on which the SFC originally approved Stockmax. This would allow for more competition, which would force SEHK to overhaul its archaic practices. Secondly, now that we do have a Competition Ordinance, the Government should remove the statutory monopoly of SEHK and allow for a level playing field of properly licensed competing exchanges, without all the competing venues (ALPs and ECNs) having to pay a toll to SEHK.
Competing exchanges would of course mean additional regulatory workload - it is undoubtedly easier to regulate one exchange than several. The SFC would need to oversee a consolidated reporting and quotation system similar to that provided by Regulation NMS (National Market System) in the USA. But it would be better than the current monopoly mono-pool.
Submit your views to SFC
Should retail investors have access to Alternative Liquidity Pools, with the opportunity for faster and better execution of orders? You can submit your views, however brief, directly to the SFC using this form on their site. If you agree with Webb-site, then you could just submit along the following lines "I am a retail investor and I want access to ALPs". Variations are better, to avoid the risk of being aggregated and treated as a single submission.
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