Hong Kong Securities and Futures Commissions
consultation conclusions on the regulation of electronic
trading incorporate limited changes from the original
in the consultation conclusions are very wide, and capture
the vast majority of trades in the Hong Kong
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 Commissions (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 Kongs 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
SFCs consultation paper in his response. He even
described the SFCs 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
While exchanges have focused on HFT in the wake of
high-profile trading errors, such as Knight Capitals
erroneous algorithm in August 2012, the SFCs consultation
paper has a broader aim of properly regulating all electronic
trading. Its a practical approach, given HFT is not
common in Hong Kong due to an unfavourable stamp duty.
Here are the consultations key outcomes, and
responses, analysed in full.
A Linklaters response, on behalf of a group of 25 financial
institutions and industry organisations, noted that the
consultation papers 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
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
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.
Another provision that concerned counsel was whether
intermediaries were ultimately responsible for
orders sent to the market through its electronic trading
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
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 intermediarys 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
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
corporations authority, he said.
Perhaps the most difficult aspect of the SFCs
consultation paper will be the due diligence requirement for
electronic trading systems provided by third party service
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 Financials 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
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 Kongs 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
However, it has been Hong Kongs 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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