Are you on the hook?
Is the Hong Kong regulator going to come knocking on your door?
With the release of the Hong Kong Regulator’s (the Securities and Futures Commission) conclusions on its recent consultation paper on the regulation of electronic trading, the institutional trading community in Hong Kong, and those who trade into Hong Kong from abroad, began to look at their new obligations. A principal area for concern are the new efforts by the SFC to have buy-side users of algorithmic trading strategies, and the brokers who route those strategies, to have documented due diligence and training on the use of those algos, including areas such as responsibility for orders, a dequacy of systems, risk management (internet trading and DMA), qualification, testing, and risk management (algorithmic trading), for when the regulations come into effect in January 2014. As Robert Laible, Division Director at Macquarie and Co-chair of the FPL Asia Pacific Exchanges and Regulatory Working Group says “users need to understand exactly how [their alogs] perform and what they should be used for. I don’t think you can say “I relied on my broker-dealer and he told me it was a good algo” anymore; those days are gone.”
Jessica Morrison, Head of Market Structure APAC at Deutsche Bank, and also Co-chair of the FPL Asia Pacific Exchanges and Regulatory Working Group adds “the SFC has come to focus on the risk controls, testing process, documentation and audit trail, including looking to assign responsibility to people in a more defined way. The SFC basically want to make sure that algos are being rolled out in a thoughtful manner and have been tested properly, and if they do have a negative impact on the market, who is responsible?”
As with all new regulation, there is an inevitable burden to be placed on market participants, and as is often the case, much of this burden will sit with the sell-side. But, as Ashley Alder, CEO of the SFC said in a recent interview with GlobalTrading “The answer is that you absolutely need to check out [the system you use] – because if you don’t, the risks you are taking on are unknowable; you would be flying blind.”
However, Rob Laible contests, “most firms have been doing this to a large extent, but it may not have been a formalised written policy. Now things are going to have to be much more formal and there is a greater element of record keeping, implying there will be added cost.” The difficulty for sell-side firms is the control of what comes through their infrastructure, especially if they didn’t write the algorithms in use themselves, and doubly so if the buy-side firms employing these algos are based outside of Hong Kong. Jessica Morrison explains, “Where the client writes their own algo, the broker is expected to have a good understanding of the electronic trading systems and algos the clients use. This will get quite hard for the brokeragecommunity, particularly where those clients are offshore. With some offshore traders that have sophisticated strategies not being directly regulated by the SFC, How willing will they be to attest to their broker on how their algos have been developed and tested? A concern for the brokerage community is that there could be brokers willing to take on those clients without proper due diligence, and this could put pressure on others to also lower the standards bar as no one wants to lose a client. But you also don’t want a client that puts you at regulatory risk, so the brokers have to consider the balance very carefully.”
One practical aspect being closely examined by market participants is the need for a suitable testing environment at the Hong Kong Stock Exchange to allow for rigorous testing of new algos. Jessica specifies that “We want the exchange to offer a rich enough environment that we can try to break our own controls, to ensure that they work. We need that environment to be as close to a live environment as possible – it is difficult to get confident that your testing was good enough, if it was only in a very simple stable low volume market environment.” But there are signs of progress being made in this area, as Rob reflects “The fact that the exchange has become more sensitive to our needs, and is offering up a potential opportunity to use some infrastructure that would be as close as possible to production, is a good thing.”
Industry body collaboration
Currently leading industry groups are working on a consolidated industry approach to the SFC regulations on electronic trading to ensure that there is ample education for firms both based in Hong Kong, and those that the new regulations affect based elsewhere in the world. Jessica elaborates further, “The collaboration between industry groups started off as FPL, AIMA, ASIFMA and ATF and it is hopefully growing. We are keen to expand to as many as groups as possible. We are focusing on the process of attestation between the various interested parties. This industry group is working on a set of documents that are relatively standardised so that firms can use a template rather than having to respond to potentially hundreds of different enquiries, and that will minimise the practical workload that will come along with this. The interesting thing about standardisation is that is also allows the buy-side to compare various brokers on their diligence.”
Nick Ronalds, Managing Director of ASIFMA concludes that “the new regulations broaden the scope and rigour of due diligence requirements on a range of fronts. If every broker adopts a different set of standards and requirements it will lead to greater complexity, higher costs, and potential confusion among clients. We think a collaborative industry approach is crucial so that all participants can adopt common standards, protocols, and procedures.”
The buy-side’s involvement in the broader conversation is also paramount, as Matthew Saul, Head of Trading Asia ex Japan at Fidelity, and Chair of the Asia Trader Forum noted “ATF is glad to see the sell-side approaching this in a co-operative manner. However, it will be ascramble for many buy-sides to have the levels of formalised process in place that the SFC regulations might require by January 1st [the SFC’s implementation deadline], but certainly everyone in the ATF group will be heading in the right direction.”
As APAC Regional Director of the FIX Protocol industry standards organisation, Edward Mangles adds “a natural role for us is to work alongside other industry organisations to create practical solutions, and this current collaboration is moving the industry towards a set of robust best practice guidelines.”
The point of principles-based regulation is that firms have to collectively and independently exercise judgement and implement the appropriate level of diligence.
As Rob Laible states, “The SFC is saying that they’re not going to tell you how to pass any test – they want to make sure you have appropriate procedures, and that they achieve what they are supposed to do, and if the SFC come knocking, firms must be able to explain their procedures in an intelligent, meaningful way, and demonstrate how they work.”