Financial Services Quarterly Report - Fourth Quarter 2013: A New Age of Electronic Trading Regulation in Asia?

by Dechert LLP
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Hong Kong introduces a new electronic trading regulatory regime with effect from 1 January 2014, when all licensed and registered persons in Hong Kong that conduct electronic trading of securities and futures contracts listed or traded on an exchange must comply with new rules of the Securities and Futures Commission (SFC). Electronic trading is broadly defined in the Consultation Paper on Electronic Trading released by the SFC in July 2012, as the trading of securities and futures contracts electronically.

These new rules will form part of the Code of Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct) and Fund Manager Code of Conduct, and generally govern the following aspects of electronic trading:

    • Internet trading – an arrangement whereby order instructions are sent to a licensed or registered person through its internet-based trading facility (including retail internet trading where a party accesses a licensed or registered person’s brokerage services over the internet);
    • Direct market access (DMA) – the provision of direct or indirect access to a market by a licensed or registered person that transmits orders for a party and allows for execution of trades through the market’s trade matching system; and
    • Algorithmic trading – computer-generated trading activities created by a pre-determined set of rules aimed at delivering specific execution outcomes.

Obligations for Users and Providers of Electronic Trading Services

Under the new rules, an intermediary is expected to be responsible for meeting the settlement and financial obligations for orders sent to the market through the intermediary’s electronic trading system and for implementing policies, procedures and controls to supervise its own and its user’s trading as required by the Code of Conduct. An investment manager should therefore:

    • Effectively manage and adequately supervise the design, development, deployment and operation of the electronic trading system it uses;
    • Ensure, or make arrangements with its third-party service provider to ensure, that requirements regarding system controls, reliability and security are met;
    • Keep, or cause to be kept, proper records of the design, development, deployment and operation of its electronic trading system;
    • Ensure the integrity of its algorithmic trading system and that the system and trading of algorithms operate in the interest of the integrity of the market;
    • Implement policies and procedures to ensure that persons involved in the design, development and use of its algorithmic trading system and trading algorithms are suitably qualified;
    • Ensure that the design and development of its algorithmic trading system and trading algorithms are supported by suitable persons who are approved for their use; and
    • Keep or cause to be kept a complete audit trail of the design, development, record of parameters and record of reviews and tests conduct on its algorithmic trading system.

The Consultation Conclusions on the Regulation of Electronic Trading released by the SFC in March 2013 (Consultation Conclusions) clarified the position for intermediaries that are part of multi-national groups whose electronic trading system may be managed and operated abroad. The SFC confirmed that, irrespective of arrangements within the group, the onus to ensure compliance with the rules rests on the local intermediary’s responsible officer or executive officer in Hong Kong.

Third-Party Electronic Trading Service Providers

An intermediary is responsible for performing appropriate due diligence and complying with record keeping requirements where an electronic trading system is provided by a third-party service provider. The SFC expressed the view that, once an electronic trading system provided by a third party is adopted by the intermediary, the use of such system becomes part of the intermediary’s business for which the intermediary is responsible, in particular with respect to its compliance with regulatory requirements.

The SFC expects intermediaries using third-party service providers to work with those service providers to ensure that they understand the regulatory requirements and, more importantly, that the system provided to the intermediary meets the regulatory requirements, taking into account the nature, size and complexity of the intermediary’s business. The intermediary should make arrangements with its service providers to ensure that records are kept in accordance with regulatory requirements. However, the service provider will not be asked to pass proprietary information to intermediaries, but it may be requested to provide such information to the SFC directly.

Internet Trading and Direct Market Access

Any sub-delegation of DMA services by an intermediary can only be made to SFC-licensed or SFC-registered persons or overseas securities or futures dealers. The Consultation Conclusions made clear that an investment manager with discretionary power to trade on behalf of a fund or client through a written management agreement will not be regarded as sub-delegating DMA services.

In the event that the investment manager is permitted to sub-delegate its DMA services to another person, the investment manager must, itself, be a licensed overseas securities or futures dealer and must ensure that:

    • Orders of any such delegate will flow through the system of the investment manager and will be subject to appropriate risk management and supervisory controls; and
    • The delegate meets the minimum client requirements established by the intermediary and that a written agreement is in place between the investment manager and the delegate, setting out the terms of the delegation.

These imminent new measures will increase the compliance burden on investment managers, both in Hong Kong and based abroad. Investment managers are advised to review their current trading arrangements and liaise with third-party providers of electronic trading services to ensure compliance with the Code of Conduct.

Elsewhere in Asia

Apart from Hong Kong, Australia is the only other jurisdiction in the Asia region that is known to have implemented electronic trading rules. The Australian Securities and Investment Commission (ASIC) updated its Regulatory Guide on Electronic Trading (Guide), following a consultation to enhance market integrity. This Guide, which will come into effect in May 2014, provides guidance as to how participants on the different Australian stock exchanges can comply with their obligations under ASIC market integrity rules that apply to the use of automated order processing (AOP). Similar to the Hong Kong electronic trading rules, market participants in certain Australian stock exchanges should have in place appropriate automated filters for AOP, trading management arrangements, sufficient organizational and technical resources, security arrangements to prevent unauthorized access, as well as policies and procedures for appropriate system design and testing.

While no other country in Asia currently has any corresponding rules, it would not be surprising if others (in particular, Singapore) emulate the lead, as a result of global regulatory pressure and in order to keep up with Hong Kong initiatives.

*The author would like to thank Maggie Choi for her research for this article.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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