Few debates are more important for institutional investors than that surrounding the issue of rapid growth in so-called 'dark pools', which are mostly unlicensed and non-transparent markets for securities trading, away from 'lit' markets, such as the Australian Securities Exchange (ASX) and Chi-X.

The ASX this week released a comprehensive submission to ASIC's consultation process for new market integrity rules and guidance.

ASX chief executive Elmer Funke Kupper has argued publicly in recent months about the dangers of dark pools.

The ASX estimates dark execution (transactions not on the lit markets) has varied between 14 per cent and 43 per cent this calendar year, and averaged 25 per cent from January to June.

This means a large amount of trading is occurring through operators without a market licence that are not subject to the same regulatory standards or disclosure requirements as lit markets.

The percentage of trades exchanged in dark pools in the United States has increased twofold between 2008 and 2010, according to ASX figures, and in some instances led to a deterioration of market quality.

The ASX said: "There is clear evidence, both in Australia and overseas, that an increase in dark execution results in widening spreads, higher costs for investors and a negative impact on price discovery.

"New Australian research demonstrates that fragmentation of the lit market has a major impact on transaction costs in the Australian market, where volume and liquidity are low relative to larger markets such as the US. This reduction in quality of the lit market also undermines the important role of the lit market as a reference point for the broader market.

"Moreover, the proliferation of trading venues and algorithmic trading significantly increases the risk of unexpected market movements or disruptions, which can undermine investor confidence. There are now numerous examples of this in the United States, which today is one of the most fragmented markets in the world."

Although dark pools have been demonised, they have a role in well-regulated markets and are important when institutional investors buy or sell large parcels of securities.

Even the ASX accepts that block orders above $200,000 (depending on a company's market capitalisation) should be allowed away from lit markets, without any changes (unless there is systematic order matching), to avoid price distortions.

Problems occur when dark pools are used to trade much smaller amounts on unlicensed markets.

The use of dark pools to execute trades is growing in response to algorithmic share-market trading, which is flourishing worldwide.

Many institutional investors believe high-frequency traders gain an unfair advantage over other investors by using high-speed computer programs and data.

The ASX submission refers to US research by Pragama Securities that shows that in even the most liquid stocks, the profitable trading by high-frequency traders has come at the expense of more traditional investors, such as fund managers.

Research by Professor Alex Frino, chief executive of the Capital Markets Co-Operative Research Centre, estimates trading costs on lit markets will rise by almost one basis point if 20 per cent of trading in the top 200 ASX-listed securities moves to dark pools.

"When trading moves off-exchange, trading costs on the lit exchange rise and it becomes more costly for buyers and sellers to find each other," Frino says.

"This implies that dark liquidity has a significant negative impact on liquidity and on price discovery."

The problem of dark pools could be amplified in markets such as Australia, which have less volume and liquidity compared to those in the US.

The ASX also argues that, by disclosing price and volume before a trade, the lit markets provide an important reference point for the broader market in terms of a security's supply and demand.

Its submission said: "If a significant amount of informed liquidity is being transacted other than on the lit markets, this will limit the ability of all investors to fully assess the price at which they can trade securities, as there is no reference point in which the market can have confidence. This will undermine the broader market. There need to be good reasons for orders to be executed away from lit markets."

The other problem is dark pools operating under a different regulatory standard to lit markets.

The ASX argues that dark pools that operate without a market licence should be subject to the same requirements as licensed markets to publish their rules, and have the same ASIC surveillance requirements and supervision levy.

It is hard to disagree with most of these arguments.

But until regulators find a way to better deal with high-frequency trading - and make markets fairer for all investors - growth in dark pools will continue because they provide a service some institutional investors want.

Tony Featherstone is consulting editor for the ASX Investor Update e-newsletter.