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Get ready to implement Hong Kong electronic trading rules

By Scott Carnachan, Consultant

Deacons

Q4 2013

 

The electronic trading rules (“Rules”) set out in paragraph 18 and Schedule 7 to the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (SFC) come into effect on 1 January 2014.

 

Prior to 1 January 2014, Hong Kong regulated asset managers and other Hong Kong licensed corporations need to:

  1. Determine whether the Rules apply to any of their activities.

If yes:

 

  1. Review their internal systems, policies and procedures for compliance with the Rules, and update those systems, policies and procedures as appropriate;
  2. Identify third party providers of electronic trading systems, algorithmic trading systems and trading algorithms they use and conduct due diligence on those  third party providers; and
  3. Update relevant documentation, including their compliance manuals and agreements with third party providers.

Who is subject to the Rules

The Rules apply to entities licensed by or registered with the SFC (licensed corporations) that conduct electronic trading of securities and futures contracts that are listed or traded on an exchange. The Rules also apply to licensed corporations that provide trading of leveraged foreign exchange contracts electronically by means of internet trading. The SFC has stated that, in the normal course, asset managers will not be providing internet trading services for the purposes of the Rules.

“Electronic trading” is defined broadly to include the electronic systems the licensed corporation uses to input orders, to process those orders and to execute those orders. A licensed corporation’s electronic trading systems include systems developed by the licensed corporation and systems developed by third parties (including affiliates of the licensed corporation) that the licensed corporation uses.

 

The Rules do not apply to:

(i) electronic trading of instruments that are not securities or futures contracts (such as swaps, FX forwards and other over-the-counter derivatives);

(ii) electronic trading of securities or futures contracts that are not listed or traded on an exchange.

 

Certain obligations under the Rules only apply where the licensed corporation provides an electronic trading system to clients for their use.

 

Responsibilities and obligations under the Rules

Under the Rules, a licensed corporation 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. A licensed corporation 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 placeto 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,

(c) 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.

 

Review internal systems, policies and procedures for compliance

A licensed corporation that is subject to the Rules will need to identify any gaps in its internal systems, policies and procedures, and any enhancements necessary for it to comply with the Rules.

To assist its members with this review, AIMA has prepared a “User Template – SFC Regulation of Electronic Trading” that contains sample questions based on the requirements of the Rules for asset managers to ask themselves. The questions are grouped under management and supervision, adequacy of systems, record keeping and systems documentation, qualifications and training for staff, testing and risk management.

 

Conduct due diligence on affiliates, brokers and other third party providers

The Rules require that a licensed corporation conduct "appropriate due diligence" on third party-provided electronic trading systems, algorithmic trading systems and trading algorithms it uses. The purpose of the due diligence is to enable the licensed corporation to assess whether it will comply with Rules when it uses the third party systems (not that the third party complies with the Rules).

Note that “third parties” include affiliates of the licensed corporation. So, where for example an overseas affiliate is responsible for the design, development and maintenance of trading algorithms the licensed corporation uses, the licensed corporation will need to conduct appropriate due diligence on its affiliate and the trading algorithms.

To help meet this due diligence requirement and to provide a level of consistency across the market, various industry associations in Hong Kong (including AIMA) have collaborated on an Electronic Trading Information Template that licensed corporations can give third party providers. The Template includes a summary of the Rules and illustrative questions to ask third party providers as part of the due diligence process.

Ultimately, the level of due diligence that is “appropriate” will vary from licensed corporation to licensed corporation, and will depend on the nature of the licensed corporation’s business, the types of electronic trading systems it uses and the purposes for which it uses those systems.

 

SFC guidance on its compliance expectations

The SFC has indicated it expects licensed corporations that use third party electronic trading systems to:

  • 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 licensed corporation meets the Hong Kong regulatory requirements, taking into account the nature, size and complexity of the licensed corporation’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 licensed corporation 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 licensed corporation

Cooperation of third party providers needed to meet compliance expectations

Licensed corporations will need to engage with their third party providers to ensure the licensed corporations can meet the SFC’s compliance expectations.

For third parties outside Hong Kong, there may be resistance to assuming additional regulatory obligations.

For third parties that are themselves regulated by the SFC and required to comply with the Rules, a licensed corporation will still need to conduct due diligence and put in place appropriate information and record-keeping arrangements. It is not sufficient for the licensed corporation to simply rely on the regulated status of the third party.

 

Update documentation

Licensed corporations will need to update their compliance manuals, policies and procedures to reflect the requirements of the Rules.

In addition, licensed corporations will need to review and potentially revise their existing contractual relationships with third party providers to ensure compliance with record keeping requirements under the Rules and to ensure the licensed corporations receive sufficient information (in relation to system updates, capacity, testing and the like) to satisfy themselves of the ongoing suitability of the third party systems.

 

Be prepared

The effective date for the Rules is fast approaching. Licensed corporations need to be preparing now so they will be able to comply when the Rules come into effect on 1 January 2014.

 

scott.carnachan@deacons.com.hk

www.deacons.com.hk

 

 

 

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