High frequency (HF) and algorithmic (algo) trading1 has attracted regulators’ attention for some time. Following global initiatives to regulate HF and algo trading, the Hong Kong Securities and Futures Commission (SFC) will launch new requirements, under the Code of Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct) and Fund Manager Code of Conduct, to regulate algo traders, in addition to the service providers of internet trading2 and direct market access3 (DMA) on 1 January 2014. This client alert looks at the new regulatory framework and suggests a road map to prepare for compliance with it. Introduction
At the end of March 2013, the SFC published its consultation conclusions on the regulation of electronic trading4 (http://www.sfc.hk/edistributionWeb/gateway/EN/consultation/). It intends to implement the new requirements on electronic trading on 1 January 2014, by way of amendments to the Code of Conduct and the Fund Manager of Conduct.
Are you the new targets?
The new requirements capture electronic trading of securities and futures contracts traded on exchanges, as well as leveraged foreign exchange trading5 off the exchanges. They target 2 categories of SFC licensees and registrants:
- Services providers of internet-based trading facility and DMA, which include:
- banks6 and brokerage firms providing online trading facilities (e.g. order routing system and pre-installed apps) where clients can place buy and sell orders to them; and
- operators of dark pools and automated trading platforms (ATP) where clients’ orders are matched and executed under the operators’ identifiers.
Dark pool and ATP operators in Hong Kong are usually licensed for Type 7 regulated activity (i.e. providing automated trading services) and subject to various licensing conditions restricting the operation of their dark pools and ATPs. As some of the licensing conditions are similar to the new requirements, such operators may already be in significant compliance. However, it will be worthwhile to conduct a gap analysis to assess if this is the case. It is also likely that the SFC will revisit the current licensing conditions in the near future.
Overseas operators of dark pools and ATPs authorized under Part III of the Securities and Futures Ordinance are excused from complying with the new Code of Conduct. However, they are likely to be affected by another SFC policy initiative on dark pools and automated trading services intended for public consultation later this year.
- Users of algo trading systems, which include:
- HF traders and market makers trading through computer algorithms; and
- asset managers and hedge funds managers using computer algorithms as their investment or trading strategies.
HF traders and market makers trading securities on their own accounts with professional investors in Hong Kong are generally exempted from licensing with the SFC. Interestingly, if they want to have direct trading rights in the Stock Exchanges of Hong Kong Limited (SEHK), they must first be licensed for Type 1 regulated activity (i.e. dealing in securities) before becoming exchange participants. That means, they will be subject to the amended Code of Conduct.
Overview of the new requirements
In general, the amended Code of Conduct and Fund Manager Code of Conduct create new obligations relating to:
- Responsibility for orders sent to the market through an electronic trading system, including responsibility for settlement, financial obligations, as well as implementation of policies and procedures to control and supervise the orders
- Management and supervision of the design, development, deployment and operation of the electronic trading system
- Adequacy of system, including the reliability, security and capacity, and contingency of the electronic trading system
- Record keeping, including the design, development, testing, reviews, modifications, upgrades, rectifications, risk management documentation, audit logs and incident reports of the electronic trading system
Some requirements are specifically imposed on service providers and users:
Click here to view table.
What do you need to do? Take some action now.
The regulatory reach of the SFC is expanding beyond licensed players (for example, your clients and system developers) in the electronic trading world. It requires its licensees and registrants to monitor and supervise their clients’ trading activities as well as the electronic platforms themselves. This can make compliance of the amended Code of Conduct and Fund Manager Code of Conduct difficult because licensees and registrants, in practice, may not have full access to and control of their clients and trading systems.
It is important to manage your risk in this area, as the regulators will penalise non-compliance and both your organisation and senior management are at risk. Here are some steps you should be taking now.
Do a holistic overview of your systems
One, if not the primary, impetus for these regulations is to preserve the integrity of Hong Kong’s markets. Unscrupulous or undisciplined users of automated trading systems are potentially disruptive influences and undermine such integrity. Therefore, if, in the past, your systems were designed with primarily commercial requirements in mind, do review them with this in mind. Now such systems are specifically expected to operate in the interests of the integrity of the market7 and prevent manipulative or abusive trading activities8.
Review your agreements
You can build in some self-protection through contractual provisions (albeit this is not a complete solution) with your clients and system developers. For example, where you provide DMA to institutional clients, you may restrict the scope of sub-delegation and seek remedies for use by unlicensed persons in your client agreements.
Know your clients
Good knowledge about your clients and their trading activities helps you design your pre-trade controls. In your client due diligence questionnaire, you may set some new trading options to test a client’s trading pattern, and thereafter use this information to formulate your pre-trade monitoring system.
Talk to your system developers
The electronic trading system that you are providing to clients or, using, may not be owned by you. In most cases, you only have a licence to use the system and have no access to technical information about the system. If this is the case, now is the time to initiate a dialogue with your system developers so that key features are transparent to you. Where appropriate, you may also consider changing your arrangements to enable you to maintain audit logs and keep system records.
Enhance your internal controls
To prepare for the new requirements, you may now start updating your electronic trading system and compliance policies and procedures. Training to staff is also important, so that they will be aware of the new operating risks.