Impact of new electronic trading rules on Hong Kong asset managers
by Scott Carnachan (firstname.lastname@example.org)
The Hong Kong Securities and Futures Commission (SFC) released its consultation conclusions on the regulation of electronic trading on 22 March 2013 (Consultation Conclusions). The rules outlined in the Consultation Conclusions will affect SFC-regulated asset managers that:
- use third party trading algorithms, such as broker-provided trading algorithms; or
- use their own or their group's internally-developed trading algorithms.
This client alert includes a summary of the rules, how they impact asset managers and suggested action items to ensure compliance with the rules.
New electronic trading rules take effect on 1 January 2014
The Consultation Conclusions state the rules will become effective on 1 January 2014 and will apply to all electronic trading systems that are in use on the effective date. Asset managers need to take steps now to ensure compliance with the rules when they come into effect.
New electronic trading rules form part of SFC's Code of Conduct
The principles that will apply to electronic trading by asset managers and other SFC-regulated entities will be set out in a new paragraph 18 of the SFC's Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct), with more detailed requirements set out in Schedule 7 to the Code of Conduct. The SFC's Fund Manager Code of Conduct will also be amended to cross-refer to the Code of Conduct.
The new provisions are attached as appendices to the Consultation Conclusions. You can view the Consultation Conclusions here.
Summary of new electronic trading rules
The rules and the Consultation Conclusions give guidance on the SFC's expectations for asset managers and other regulated entities that engage in electronic trading. The rules are likely to lead to more formality around, and a need to devote more resources to, the documentation, testing and use of internal and third party electronic trading systems and related controls. It is possible practical challenges in complying with the rules may lead some asset managers to cease using third party-provided trading algorithms or to some third parties ceasing to offer their services to Hong Kong asset managers.
Definitions – scope of rules
The rules set out the SFC's requirements for "electronic trading" and "electronic trading systems". The provisions most applicable to asset managers are those relating to "algorithmic trading", which falls within the definition of "electronic trading".
"Algorithmic trading" is defined as "computer generated trading activities created by a predetermined set of rules aimed at delivering specific execution outcomes".
"Electronic trading" is defined as "the trading of securities and futures contracts electronically and includes internet trading, DMA [direct market access] and algorithmic trading".
"Electronic trading system" is defined as "the system through which electronic trading is conducted. It includes a system designed and developed in-house or by a third party service provider".
Responsibilities and obligations
Under the rules, an asset manager is responsible for the settlement and financial obligations of orders sent to the market through its electronic trading system and for implementing policies, procedures and controls to supervise those orders in accordance with applicable regulatory requirements.
An asset manager also has the following obligations:
- to effectively manage and adequately supervise the design, development, deployment and operation of the electronic trading system it uses
- to ensure the integrity of the electronic trading system it uses, as may be appropriate in the circumstances, including the system's reliability, security and capacity, and have appropriate contingency measures in place
- to keep or cause to be kept proper records on the design, development, deployment and operation of its electronic trading system
- to establish and implement effective policies and procedures to ensure that persons:
(a) involved in the design and development of, or
(b) approved to use,
its algorithmic trading system and trading algorithms are suitably qualified
- to ensure that the algorithmic trading system and trading algorithms it uses are adequately tested to ensure that they operate as designed
- to have controls that are reasonably designed to ensure:
(a) the integrity of its algorithmic trading system and trading algorithms; and
(b) its algorithmic trading system and trading algorithms operate in the interest of the integrity of the market.
Effect on asset managers that use third party trading algorithms
An asset manager will be subject to the rules when it uses third party trading algorithms. The SFC stated in the Consultation Conclusions that fund managers "are expected to comply with the requirements that are applicable to electronic trading system users. Further, where a fund manager uses an electronic trading system that is provided by a third party service provider, the fund manager should perform due diligence to ensure that it meets the requirements set out in paragraph 18 of the Code of Conduct and Schedule 7 to the Code of Conduct in its use of the system".
SFC rejected industry concerns about practicalities of compliance
Various respondents to the initial SFC consultation noted licensed entities that use third party electronic trading systems may face challenges in complying with some of the rules, particularly as such systems are by their nature specialist, third parties are likely to view information about their systems as proprietary and commercially sensitive, may be located in other regulatory jurisdictions and may be unwilling to agree to assume additional regulatory obligations (such as Hong Kong record-keeping requirements).
The SFC did not agree, and stated in the Consultation Conclusions that "once an electronic trading system from a third party is adopted by an intermediary, its use becomes part of the intermediary's business for which it is responsible, in particular with respect to its compliance with regulatory requirements".
SFC guidance on its compliance expectations
The Consultation Conclusions set out the SFC's compliance expectations where a licensed entity uses a third party electronic trading system. Asset managers that use third party electronic trading systems must:
- have a sufficient level of technical expertise to understand and explain how the system operates, including the system's scope and the nature of its functions, its work flow process, its capacity, as well as its limitations and risks, and to ensure that the system is fit for purpose, before adopting the system for use – although the SFC acknowledges that the level of understanding does not need to be as technically sophisticated as the third party's
- work with the third party to ensure that the third party understands the Hong Kong regulatory requirements and that the system provided to the asset manager meets the Hong Kong regulatory requirements, taking into account the nature, size and complexity of the asset manager's business
- assess, at least on an annual basis or when there is a material change on the third party's part, that the third party has on hand and available to the asset manager sufficient technical and manpower resources to deal with any issues or problems, including regulatory issues, when they arise
- make arrangements with the third party to ensure that records are kept in accordance with Hong Kong regulatory requirements – for proprietary information, the SFC indicated that third parties can give such information to the SFC directly as required by the SFC, rather than giving it to the asset manager.
Cooperation of third party providers needed to meet compliance expectations
Asset managers will need to engage with their third party providers to ensure they can meet the SFC's compliance expectations.
For third parties outside Hong Kong, there may be resistance to assuming additional regulatory obligations. If that is the case, the SFC strongly hints that an asset manager should stop using the third party's services – "In the event that a service provider is unwilling to provide information [for due diligence purposes] or keep records [required by the SFC], an intermediary should consider the appropriateness of using the electronic trading system provided by the service provider".
For third parties that are themselves regulated by the SFC and required to comply with the rules, the asset manager will still need to conduct due diligence and put in place appropriate information and record-keeping arrangements. It is not sufficient for the asset manager to simply rely on the regulated status of the third party.
Effect on asset managers that use internally-developed trading algorithms
Asset managers that use internally-developed trading algorithms will need to comply with the rules in full. Where a group company outside Hong Kong is responsible for developing and maintaining the trading algorithms, the asset manager will need to meet the same compliance expectations as above for third party providers in relation to its group company. In practice, there will likely be an expectation in a group context that the asset manager has greater access to information about the internal systems and less tolerance of misunderstandings / lack of knowledge of Hong Kong regulatory requirements by the group company.
Action items for asset managers
Asset managers should consider whether they engage or intend to engage in "electronic trading" as defined, and so whether the rules will be applicable to their business.
For those asset managers that engage in electronic trading, they need to review the rules carefully and develop an implementation plan to ensure they will comply with the rules on 1 January 2014.
Some action items asset managers should consider:
- Identify who has the relevant skills and expertise to assume responsibility within the asset manager for oversight of electronic trading activities and compliance with the rules; if needed, arrange for employment of relevant people or relocation of relevant people from other group companies [Note that at least one responsible officer or executive officer must be responsible for the overall management and supervision of the electronic trading system]
- Develop / enhance formal written policies and procedures for electronic trading activities that cover the areas identified in paragraph 1.1.1 of Schedule 7 to the Code of Conduct, including:
- identification of responsible officer / executive officer
- formalised governance process with input from the dealing, risk and compliance functions
- clearly identified reporting lines
- managerial and supervisory controls to manage risks relating to use of the electronic trading system
- Develop / enhance record-keeping arrangements to meet the requirements in:
- paragraph 1.3 of Schedule 7 to the Code of Conduct, which requires "comprehensive documentation" of design and development of the electronic trading system and risk management controls
- paragraph 3.4 of Schedule 7 to the Code of Conduct, which requires "proper records on the design, development, deployment and operation of its electronic trading system"
- Review current testing arrangements (for both internally-developed and externally-provided algorithmic trading systems) to determine whether they:
and, where appropriate, enhance such testing arrangements
- comply with the minimum requirements in paragraph 3.2 of Schedule 7 to the Code of Conduct, and
- are adequate and reasonable
- Review current risk management arrangements to determine whether they comply with the minimum requirements in paragraph 3.3 of Schedule 7 to the Code of Conduct and, where appropriate, enhance such risk management arrangements.
Where group companies develop / maintain trading algorithms
- Develop / enhance oversight arrangements within the fund management group where algorithmic trading systems are designed, developed and maintained by group companies outside Hong Kong; asset managers may consider:
- the documentation and records overseas affiliate(s) maintain in relation to the algorithmic trading systems
- the ability of the asset manager to access documents and other information from overseas affiliates in a timely manner
- the technical expertise of the overseas affiliate(s), and its level of staffing and resources
- how Hong Kong regulatory requirements are communicated to the overseas affiliate(s) and incorporated in the systems
- the frequency and level of formality of interactions, reviews, certifications and other actions that form part of the oversight arrangements
- how the oversight arrangements and their ongoing implementation are documented.
Where asset managers use third party-provided trading algorithms
- Determine the due diligence to be implemented on third party electronic trading systems and third party providers, both initially and on an ongoing basis, and work with third party providers to formalise and conduct such due diligence; third party providers should be obliged to notify material changes to their systems as part of the ongoing due diligence process
- Ensure there are arrangements in place with third party providers to enable the asset manager to satisfy the record-keeping requirements in paragraph 3.4 of Schedule 7 to the Code of Conduct
- Review existing documentation with third party providers and consider seeking additional representations relating to compliance with regulatory requirements, fitness for purpose and the like
- Potentially, terminate existing arrangements with third party providers where it is not possible to conduct adequate initial or ongoing due diligence, or where the third party provider is not willing to comply with Hong Kong record-keeping requirements.
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Whilst every effort has been made to ensure the accuracy of this publication, it is for general guidance only and should not be treated as a substitute for specific advice.