On 15 May 2015, the Securities and Futures Commission (SFC) published its consultation conclusions concerning the regulation in Hong Kong of dark pools (Consultation Conclusions), largely adopting the recommendations set out in its February 2014 consultation paper (Consultation Paper).
Dark pools (also known as alternative liquidity pools or ALPs) are electronic trading systems through which the crossing / matching of orders involving listed or exchange traded securities is conducted with no pre-trade transparency.
With effect from 1 December 2015, the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct) will be amended so that (amongst other things):
- Individual investors (including individuals that are professional investors under the Securities and Futures (Professional Investor) Rules (PI Rules)) and their investment holding corporations (unless those investment holding corporations are themselves professional investors under the PI Rules) will not be allowed to trade through dark pools; and
- Orders received from the users of dark pools (ie agency orders) must be given priority over proprietary orders (including client facilitation orders) when determining order priority in dark pools.
In recent years, the global equity markets have seen a marked rise in the operation and use of alternative trading venues. Although trading through Hong Kong's dark pools is currently small in scale (and has in fact been on the decline) relative to overall market turnover, the SFC has nevertheless identified dark pools as an area in need of regulatory enhancement. Indeed, at the first ever SFC Supervisory Briefing Session held on 2 September 2014, the subject of dark pool operations was noted as a specific SFC focal point at the time. Our briefing on this session can be accessed here.
These Consultation Conclusions come on the back of a number of reforms in other jurisdictions on the way dark pools should be operated, and a number of regulatory actions in the US against dark pool operators for operational and other failings.
The new regime in Hong Kong seeks to enhance and standardise the regulatory obligations currently imposed on Hong Kong's 16 dark pool operators, and any licensed/registered persons who route client orders to dark pools for execution. This is being done through the introduction of a comprehensive set of new requirements in the Code of Conduct. The new regime draws on initiatives for the regulation of dark pools that have been developed in other major markets, and seeks to create a level playing field for all dark pool operators and users in Hong Kong. In addition, a number of the new requirements seek to codify obligations already imposed on dark pool operators on a case-by-case basis by way of conditions to their SFC licences.
The new Code of Conduct requirements will be introduced with effect from 1 December 2015, and can be found in a new Paragraph 19 and a new Schedule 8. This briefing provides a summary of some of the key requirements under the new regulatory regime.
KEY CODE OF CONDUCT REQUIREMENTS COMING INTO EFFECT ON 1 DECEMBER 2015
Management and supervision of dark pool operators
Dark pool operators will be required to effectively manage and adequately supervise the design, development, deployment and operation of their dark pool, and establish and implement relevant written internal policies and procedures to achieve this. In line with the SFC's on-going focus on senior management accountability, the SFC has confirmed in its Consultation Conclusions that while senior managers may delegate the day-to-day management and supervision of the dark pools operated by their firms, senior management remain ultimately responsible for the operation of dark pool systems and their firms' compliance with relevant regulatory standards.
Access to dark pools
The question of whether individual investors should be allowed to access dark pools generated varied responses to the Consultation Paper, with a number of individual respondents expressing unhappiness at the prospect of being excluded from participating in dark pool trading. Nevertheless, the SFC has maintained its proposal that individual investors (including individuals that are professional investors under the PI Rules and their investment holding corporations (unless those investment holding corporations are themselves professional investors under the PI Rules) should not be allowed to trade through dark pools. This is because of the complexity and opaqueness of dark pool operations and the risks associated with trading through dark pools (amongst other things). As such, only so-called "qualified investors" (as defined in the new Paragraph 19 of the Code of Conduct) will be allowed to trade through dark pools, and dark pool operators will need to establish and implement measures to ensure that only qualified investors access their dark pool.
Dark pool operators will also need to ensure that all orders placed with them by their group companies originate from qualified investors only, and will need to have systems and processes in place whereby they can ascertain from their local and/or overseas group companies the nature of the entities ultimately responsible for orders. In its Consultation Conclusions, the SFC has said that they consider this requirement to be imperative to avoid possible circumvention of the requirement that individual investors should not be allowed to access dark pools.
Similarly, licensed/registered persons who route orders to dark pools on behalf of their clients are required to introduce measures to ensure that such orders originate only from qualified investors.
One particular concern with dark pools that the SFC was keen to address was that of potential conflicts of interest by virtue of the fact that dark pool operators allow their proprietary traders to trade in their dark pools at the same time as their user clients (ie agency orders). In circumstances where the crossing / matching of orders is conducted with no pre-trade transparency as to price or volume, this creates a risk that proprietary traders might have an unfair advantage if they can access information concerning agency order flows. The SFC has therefore concluded that orders received from the users of dark pools (ie agency orders) must be given priority over proprietary orders (including client facilitation orders) when determining order priority in dark pools. In addition, proprietary traders must be restricted from having access to any information that might give them an unfair advantage over any other users of the dark pool.
Information for dark pool users and "opt-out"
Dark pool operators will need to provide users with comprehensive and accurate guidelines on the operation and risks of their dark pool, and will need to provide these guidelines to prospective users before routing any of their orders to a dark pool. These guidelines should be published on dark pool operators' websites, and provided to the SFC. Once users have been provided with these guidelines, they should then be given an option to "opt-out" of their orders being routed to a dark pool (but they will not need to "opt-in" in order for their orders to be transacted in a dark pool).
Trading in overseas securities
Dark pool operators will now be allowed to offer trading in overseas securities, as well as local securities, within their dark pools. They will also now be allowed to offer trading in local and overseas securities at any time of the day. These reforms bring the Hong Kong market in line with most other major trading jurisdictions.
Although the new Code of Conduct requirements largely codify obligations already imposed on dark pool operators on an individual basis, Hong Kong's 16 dark pool operators and any licensed/registered persons who route client orders to dark pools for execution will nevertheless need to review their existing operations to ensure that they are fully compliant with the new regime by the 1 December 2015 deadline.
Furthermore, the SFC has already signalled that additional changes in this area may be on the horizon. However, the SFC seems to adopting a wait and see strategy; first observing how relevant regulatory changes in other jurisdictions play out, before adopting those changes here. As such, the SFC has not ruled out allowing individual investors and their investment holding corporations from being eligible to participate in dark pools in the future, a step which would further bring the Hong Kong market into line with the other major overseas markets such as the US, EU, Australia and Canada.