Small- and mid-cap trading flourishing in dark pools

Alternative trading systems (ATSs) – particularly non-displayed venues or 'dark pools' – promote themselves as useful platforms for executing less liquid stocks. Figures from Credit Suisse and other brokers show that clients seem to concur with this view.

The Swiss firm’s Crossfinder dark pool sees a significantly higher proportion of small-cap stock trades than are done on the main exchanges in Hong Kong and Australia and on proprietary trading systems (PTSs) in Japan.

Some 30% of Crossfinder executions are done in shares outside the top 200 names in Hong Kong, compared with around 10% on the exchange, according to research covering January 2010 to July 2011.

The difference is even more pronounced in Australia, where around half the number of executions are done outside the top 100 names, compared with around 10% on the exchange.

In Japan, small-cap executions (Topix 1,000 or smaller) represent around 6-8% of the total in Crossfinder, in line with volumes on Tokyo Stock Exchange. But Japanese small-cap trading on PTSs is less substantial, with 98% of volume on SBI Japannext and 99% on Chi-X Japan done in large-caps. This is due to market-maker incentives, meaning market-makers favour large-caps over less liquid names, says the bank.

High small- and mid-cap trading volumes reflect Credit Suisse Crossfinder clients’ execution profile, says Murat Atamer, Asia-Pacific head of product in the advanced execution services unit in Hong Kong. Market-makers are incentivised to provide liquidity on ATSs like Japanese PTSs, he notes. They take risk by making markets in names; hence they mainly focus on large-cap names to provide liquidity.

Moreover, bid-offer spreads on small- or mid-cap trades will often be very wide on the exchange, so investors can get a better price on a dark pool, saving them half the spread, says Atamer. “Why pay 80 basis points in spread when you can get the mid-price?” he adds. “It’s on those wide-spread names that you get the most from your crossing engine."

Credit Suisse will hope to see even greater volumes when it starts supplying its full ‘alpha scorecard’ by early September, as part of the counterparty-selection tool it started rolling out in Asia this year. Clients will receive detailed information about on Crossfinder executions as well as on those done on other alternative venues.

It's a similar story around less liquid stocks for other dark pool providers. Citi has seen rising liquidity across Asia-Pacific names – particularly small- and mid-caps – over the past six months, and especially the past two months, says Ben Valentine, Asia-Pacific head of electronic execution sales at Citi in Hong Kong.

For example, there’s been an 8.5-fold increase on the Citi Match crossing platform in ASX200 trading volume outside the top 50 stocks. Top 50 trading volume growth has been substantial, adds Valentine, but hasn't grown at the same pace as small- and mid-caps.

There are a number of reasons for this, says Ian Smith, head of electronic execution at Citi in Hong Kong. Trading algorithms are getting smarter and better able to incorporate small- and mid-caps. Clients are also taking a more coherent and consistent approach to dark pool liquidity and using it more rigorously to get trades done. In addition, interest is rising in using transaction cost analysis to help identify the venues with the best liquidity and execution.

UBS, too, finds that small- and mid-caps seem to have higher crossing rates than the large-caps in its dark pool, especially in Australia, says Xia Yang, Asia-Pacific head of execution services at the bank in Hong Kong.

Data from agency broker ITG, which runs the Posit Marketplace dark pool aggregator, also supports Credit Suisse’s findings. The platform connects to eight large crossing networks and broker internalisation pools in Asia-Pacific.

Analysis of market-cap trends across the trades done in the different pools in Posit Marketplace in the year to date shows a higher percentage of mid- and small-cap shares traded in the alternative liquidity pools than the corresponding percentage traded in the lit markets. In Hong Kong for example, around 30-40% of Posit Marketplace trades are in mid-and small-cap stocks, and in Australia this number rises to over 40%. 

Ofir Gefen, head of Asia-Pacific research for ITG, says: “Finding liquidity is a key challenge when trading Asia and Australia. There may be plenty of liquidity in large-cap names on the exchange or in lit markets, but alternative sources of liquidity can be particularly helpful to traders looking for liquidity in mid- and small-caps."

Indeed, some 30-50% of traded volume on institutional-only dark pool Liquidnet (in dollar terms) is in the small- and mid-cap market. The venue sees average execution size in mid-caps of close to $1 million.

Lee Porter, Asia-Pacific managing director of Liquidnet, says: “We have always been successful in the small- and mid-cap space, as it is the higher ADV [average daily volume] names and not the higher value names in dollar terms that are often the most difficult to trade and difficult to find liquidity in.”

That said, Liquidnet still sees a significant proportion of its trading in large-caps. “In Asia the free-float of a large-cap is not always that significant, so there can still be liquidity challenges for a trader in these names,” says Porter. “Also, the spreads can still be wide, so trading at the mid price in a large-cap in size can be meaningful to traders in terms of liquidity and price improvement."