With Ashley Alder, CEO, Securities and Futures Commission of Hong Kong.
There’s a huge amount of work and thought being put into the regulatory approach to electronic trading internationally, and this effort has been underway for some time.
In Hong Kong, we published our new rules in March after a public consultation.
The initiatives are intended to provide much needed clarity to intermediaries and traders and, in common with much post-financial crisis regulation, are about safety, soundness and transparency. The rules are broadly in line with regulations across other major international markets and the principles published by the International Organization of Securities Commissions (IOSCO).
In essence, the rules apply to internet trading, Direct Market Access (DMA) and algorithmic trading, and are aimed at ensuring that undue risks are not borne by investors.
What are the comments of the industry on the new SFC regime of electronic trading?
Feedback was pretty open and honest. There was no significant resistance to the proposals; it is pretty evident that sensible regulation is necessarily about system safety, testing, internal controls and the risks of DMA.
Of course some comments focused on the ever present tension between the extent of safety measures required to minimise risk to an acceptable level and the costs of those measures to the industry – and to end users.
For example, smaller firms were concerned about the extent they have to employ resources to check out an electronic system that is bought off-the-shelf. The answer is that you absolutely need to check it out – because if you don’t, the risks you are taking on are unknowable; you would be flying blind.
Although the new requirements will inevitably increase operating costs, we believe that the framework will actually facilitate the long-term growth of electronic trading in our market; electronic trading is here to stay and the regime ensures that investors are informed and can be confident. One thing we are very conscious of in Hong Kong is that we deal with a vast range of financial institutions from the very big to the very small. The impact of regulation on them, including electronic trading, can therefore vary, and that’s something we have to be sensitive to. Clearly, large firms may be better able to absorb additional costs than smaller firms.
With that in mind, the new regime will become effective on 1 January 2014 to allow sufficient time for all firms to implement internal control policies and procedures, as well as to make changes to their electronic trading and record keeping systems.
How are you examining dark liquidity?
Fundamentally, with dark pools and dark liquidity, we are talking about trading off-exchange on platforms that do not offer pre-trade price transparency. Since the imposition of mandatory flagging of reported dark pool transactions by the Hong Kong stock exchange last year, the reported volume of trades executed in dark pools in Hong Kong has increased steadily, accounting for 2.2% to 2.5% of monthly turnover. This, of course, is very small compared to markets that have actively embraced alternative venues – and are now struggling with how to regulate them and find an optimal balance between the roles of “lit” and “dark” trading platforms.
We have identified a set of key issues concerning dark liquidity – clarity to users as to how a dark pool operates; involvement of retail investors; who within a financial institution can see what’s occurring in a dark pool; what ‘best execution’ means within dark pools; and proprietary orders within dark pools – e.g. the priority of proprietary orders versus genuine client orders.
So, unlike the new electronic trading rules – which are about firms operating between a trading platform and a client, this is a separate topic about the platforms themselves.
We’ve already come across some problems with existing dark pools. They have different configurations and different target clients, and of course they were originally developed to facilitate large trades by large institutions – but have moved on from this to deal with smaller trades. Those banks or brokers who operate their own “internal” dark pools tend to say that they are simply a benign electronic overlay to traditional brokerage operations. Exchanges counter this by saying that all trading needs to have pre-trade price and order book transparency and what the dark pools operators are doing is operating alternative exchanges, free riding on lit market pricing. To address these issues, we have actively discussed the situation with existing dark pool operators with a view to imposing carefully calibrated licensing conditions.
We will also consult the market later this year about codifying our stance to ensure a consistent, level playing field for all operators.
The impression that we get is that, although much has been discussed ever since the US flash crash in 2010, the jury is still out as to a) what is HFT, b) what is good HFT and c) what is bad HFT.
And you can break this down into a number of components about the “bad” side. Is HFT too unstable? Does it provide false liquidity? Does it disadvantage other investors? HFT firms tend to point to reduced spread and informal “market making” functions as the positive side of HFT.
HFT in terms of system stability and fairness is one angle. The other is the extent to which HFT can be used to commit market abuse. There are a whole list of new terms around this which mostly describe activities that are similar to market abuse in “slow” markets – spoofing, layering and so on – which often means misleading the other side of the book into believing you’re trading in one direction when in fact you’re doing the opposite. This could be manipulative. However, it is interesting that ASIC in Australia has recently concluded that HFT cannot be singled out as an unusual locus for market abuse.
We do not have any firm data on HFT activity in Hong Kong. However, according to the industry, it remains subdued. This seems largely due to the frictional cost of trading equities. Stamp duty of 0.1% of payable by the buyer and the seller can easily exceed the wafer-thin profit-per-trade that constitutes much HFT business. HKEx is in the process of upgrading its market infrastructure (including trading, the data centre and market data services) to offer enhanced services like co-location and a central gateway, so it remains to be seen whether financial costs do remain an impediment in cash markets.
Under the IOSCO umbrella and individually, how do you reconcile what other regulators are doing with the trading environment in Hong Kong?
The biggest discussion at the moment regarding cross-border regulation centres on trading in OTC derivatives.
Against this background, there is every reason to support international standard setting by the IOSCO to operate as a benchmark for cross border activity and to ensure that those standards are sufficiently detailed as to be credible.
The debate about cross-border activity focuses on how to deal with the extent to which regions such as the EU or the US apply their own laws extraterritorially and the extent they should instead refer to international standards and use other techniques to operate in a cooperative manner. The current debate is pretty central to the IOSCO because, when push comes to shove, a lot of work is being done to produce international standards, but if they’re not used at the sharp end of cross-border activity, then this begs a question as to the utility or authority of these standards.
Together with many other countries, the SFC holds a strong view that further energy should be put into the development of a common understanding amongst global regulators, as to how they will assess different jurisdictions when applying rules across borders in order to promote consistency, but without derogating from investor protection. In this connection, credible international standards should be the first port of call. The IOSCO has now set up a task force, with which the SFC is closely involved, with a mandate to identify cross border regulatory techniques and develop principles about how these techniques should be used by IOSCO members. Essentially, it’s about developing a toolbox for regulators to determine, among other things, whether or not rules of overseas jurisdictions are acceptable substitutes for their own when dealing with cross border activity. The aim of the exercise is to help achieve greater consistency of regulation globally and to avoid the possibility of fragmentation impacting on liquidity and, ultimately, reduced financing available in growth regions such as Asia.
Principles versus rules based regulation, where do you sit?
Hong Kong’s regulatory regime is a principles- or outcomes-based system, but by principles we do not mean light touch. It’s rather unfortunate that at some point there seems to have been confusion between those two phrases.
A properly regulated principles-based regime does not mean enforcement is weak – there’s no correlation between the two. The SFC’s enforcement track record over the past few years has certainly demonstrated that this is not the case.
One perceived advantage of a rules-based approach is that because a rule looks like a bright line test it’s easier to regulate and is more effective. But the problem with this is that the more detailed you get, the larger and more complex the rulebook becomes and, the easier it is to inadvertently build gaps into the system.
If you have an outcomes-based or a principles-based approach, gaps should be minimised but there is of course a large responsibility on the part of the regulator to do a good job because it’s not simply a box ticking exercise. This implies that the regulator has to exercise sensible judgements about regulatory outcomes, but also that market participants have to do the same thing. Firms sometimes come to us asking for check-lists to give them certainty. Our normal response is that this type of certainty is illusory, absent careful judgments about outcomes, and in any event check-lists are a recipe for an abdication of thought as well as loopholes.
What comes next from regulation in Hong Kong, Asia, and the rest of the world?
At the high-level, there are three areas of focus.
First, from a Hong Kong perspective, local regulations will continue to be developed to address local market characteristics; we have to be sensitive to the way that our local market is different from other markets.
For instance, while the dark pool project has an international context, it’s fundamentally a local project. Our proposal to enhance regulation of electronic trading also has an international dimension (and makes references to the IOSCO standards), but again, it’s a local project.
The second area relates to Hong Kong as a gateway with China. And that’s mainly about two things. The first is cross-border activity around listed companies and secondary market trading. The second aspect has to do with strengthening Hong Kong as an asset management centre. This means harnessing the growing pool of off-shore RMB to invest into China and encouraging Mainland investors to invest overseas via Hong Kong. This is reflected in plans to introduce a regulatory framework for the mutual recognition of Mainland and Hong Kong funds as well as encouraging the domicile of funds in Hong Kong.
Third, in the international arena, our main focus is on the IOSCO and the part we play in developing international solutions to the regulation of cross border financial activity. We are pleased to see that the IOSCO is growing in stature and is also putting plans together to develop its research, training and collaborative function for all regulators – whether for growth markets or developed economies.
With Ashley Alder, CEO, Securities and Futures Commission of Hong Kong.