Hong Kong clamps down on electronic trading

Author: Ashley Lee | Published: 27 Mar 2013
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KEY TAKEAWAYS

  • The Hong Kong Securities and Futures Commission’s consultation conclusions on the regulation of electronic trading incorporate limited changes from the original consultation paper;
  • Definitions in the consultation conclusions are very wide, and capture the vast majority of trades in the Hong Kong market;
  • The SFC has clarified that intermediaries are no longer ‘ultimately responsible’ for all incidents, intermediaries must conduct more due diligence on those with direct market access as well as the electronic trading systems of third-party vendors.

The Hong Kong Securities and Futures Commission’s (SFC) consultation conclusions on the regulation of electronic trading takes a broad scope, going beyond just algorithmic and high frequency trading (HFT).

But few regulatory adjustments have been made based on consultation paper responses, disappointing market participants who had hoped for greater change.

The regulations, released last Friday, are the first changes to Hong Kong’s electronic trading rules since 1999. New rules were necessary given the emergence of new technology-based trading strategies.

Dr David Donald, professor in the Faculty of Law at the Chinese University of Hong Kong and executive director for the Centre of Financial Regulation and Economic Development, generally supported the SFC’s consultation paper in his response. He even described the SFC’s proposed Schedule 7 as “perhaps too light a touch.”

He told IFLR that futures and stock exchanges should be considered public infrastructure.

“They are licensed by the government and indirectly supported by tax money, in that they benefit from governmental regulation and supervision, as well as the currency in circulation and the legal framework operating under ordinances and the courts,” he said. “Just as for all public infrastructure, it is reasonable that rules promote safe and stable use.”

While exchanges have focused on HFT in the wake of high-profile trading errors, such as Knight Capital’s erroneous algorithm in August 2012, the SFC’s consultation paper has a broader aim of properly regulating all electronic trading. It’s a practical approach, given HFT is not common in Hong Kong due to an unfavourable stamp duty.

Here are the consultation’s key outcomes, and responses, analysed in full.

Clearer definitions

A Linklaters response, on behalf of a group of 25 financial institutions and industry organisations, noted that the consultation paper’s various definitions could be subject to misinterpretation. This, it said, presented a risk of misapplication of the proposed regulation, and suggested more precise definitions as well as a frequently-asked-question section to further clarify.

Other responses, such as one by the Alternative Investment Management Association, proposed that the term ‘electronic trading’ only apply to internet trading, direct market access (DMA) and algorithmic trading.

But in its response, the SFC stressed that the definitions are intended to capture various types of trading infrastructure in which orders are inputted, generated and processed electronically, and submitted to an exchange in Hong Kong or overseas. Since the Hong Kong Exchange implemented the Automatic Order Matching and Execution System in 1993 for off-floor trading, the vast majority of trades fall under the rules’ scope.

In paragraph 13, the SFC also noted that an industry body had proposed a definition for ‘algorithmic trading’. Other responses, including Linklaters’, had also asked for a clearer definition. However the regulator clarified that does not intend to draw a distinction between simple or complex automated trading processes and strategies.

Intermediary responsibility

Another provision that concerned counsel was whether intermediaries were ‘ultimately responsible’ for orders sent to the market through its electronic trading systems. Counsel and other market participants – including a director at the Hong Kong Securities Association – were concerned about how this sort of responsibility might affect the market, especially in relation to smaller brokers.

Although the SFC amended paragraph 18.3 of the Code of Conduct to reflect that an intermediary should not be held liable for all market misconduct or other transgressions, the regulator stressed that intermediaries must implement policies, procedures and controls to supervise its own and clients’ trading. The SFC maintains that intermediaries must have at least one officer responsible for the management and supervision of the electronic trading system.

Further, the regulations require that compliance responsibilities in relation to electronic trading will fall upon executives based in Hong Kong – even if the system is managed outside of Hong Kong. Market participants agreed that this will especially affect intermediaries that are part of multinational groups.

Direct market access

The consultation conclusions limit sub-delegation of direct market access. Sources agreed that the SFC is placing a high level of responsibility on the intermediary. The SFC did not agree with the presumption that professional and institutional investors may be competent in suing an intermediary’s DMA services, and said that appropriate due diligence should be conducted on all clients.

But sources were concerned about the scope of pre-trade controls, especially because they may not provide for every eventuality that may occur when a client is utilising a DMA system.

Donald, however, agreed with the SFC, saying that automated trading and DMA are both essentially delegations of authority – one to a machine and the other to a client.

“The rules outlined in the consultation conclusions are minimal, and mostly just extend existing operational standards specifically to the situations of having either a machine or client send out orders on the licensed or registered corporation’s authority,” he said.

Due diligence

Perhaps the most difficult aspect of the SFC’s consultation paper will be the due diligence requirement for electronic trading systems provided by third party service providers.

Respondents agreed that intermediaries should, to a certain degree, keep records of the design, development, deployment and operation of electronic trading systems. But they said it would be highly impractical to try to conduct due diligence on the electronic system itself.

Newedge Financial’s comment letter stressed the practical difficulties in managing and supervising the design and development of a third-party supplied electronic system, and their vendors’ willingness to disclose their system design and operation plan to intermediaries as their users. Others highlighted the intellectual property (IP) issues related to algorithms in particular. As proprietary and highly-sensitive technology, it would be unlikely for vendors to disclose this information to intermediaries for fear of IP theft.

The consultation paper states that service providers are not required to pass proprietary information to intermediaries, as such information can be provided to the SFC directly. But the regulator questions the appropriateness of using a system in Hong Kong if service providers are not willing to cooperate in record-keeping or conducting due diligence.

What this means for the market

While the market grapples with these changes to electronic trading, the SFC has announced that it will release a separate consultation paper regarding regulations for automated trading systems and dark pools. Although these are frequently associated with HFT strategies, regulators have focused on different issues – such as transparency – when regulating off-exchange activity.

Although market participants may be disappointed by the limited changes in these conclusions from the consultation paper, they may help Hong Kong’s market mature.

Donald told IFLR that the fee structure for the exchanges in Hong Kong facilitates corporate finance. Trading costs are high, but the costs of listing and information are low. This is the opposite of New York, where fee structures tend to facilitate trading of already-listed shares, with a high cost of listing and information but a low cost of trading.

“However, it has been Hong Kong’s stamp duty that has really helped the exchange traffic to focus on corporate finance and value trades, making the high-frequency trading strategy too expensive to be successful,” said Donald. “This might make IT vendors unhappy, but it is good for Hong Kong as a financial centre.”

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