A Brand New Game in Electronic Trading?
On July 24, 2012, the Securities and Futures Commission (SFC) of Hong Kong SAR published its “Consultation Paper on the Regulation of Electronic Trading”. In the paper, while acknowledging that “[technological developments] are welcomed as they increase the efficiency of our markets and provide options for investors who participate in our markets”, the SFC also commented that “… effort is required to ensure the integrity of the market and that trading via direct market access or by the use of trading algorithms are conducted in a fair and orderly manner.”
The publication of the consultation paper coincided with a series of high-profile incidents that have led to debates on the merits of algorithmic trading and high-frequency trading on both market efficiency and market operation effectiveness under the current design of market structures. Although the debates have been more centered on U.S. markets than other regions, as a financial center in the Asia-Pacific region that has seen a significant increase in trading volume via electronic means (such as DMA and sophisticated trading algorithms), Hong Kong definitely considers proper regulatory requirements necessary for the healthy functioning of its markets.
In fact, at least to our knowledge as practitioners in the electronic trading field, many of the items in the paper – such as pre-trade management and post-trade monitoring procedures – have been discussed, developed and implemented by many firms on both the Buy side and the Sell side. Some implementations were specifically under the suggestions from regulatory bodies such as the SFC. What is different now is that all such suggestions from different regulatory bodies to different trading firms over the past many years are formally proposed and will likely be implemented as regulatory requirements that have to be followed by many market participants and service providers. The compliance and legal gravity is definitely more significantly felt by many people.
We believe that potential impacts on electronic trading will be on three fronts: first, key operation steps in electronic trading will be formalized and followed by market participants and service providers; secondly, quality assurance of trading technologies for both trading systems and trading algorithms will be gradually standardized; thirdly, the economics of electronic trading as a business will be modified. We will elaborate on these three points below, with a few suggestions for market participants and service providers on how to position themselves in a likely new regulatory landscape that affects their business operations.
Key operation steps in electronic trading will be formalized: As a relatively new means of execution, electronic trading has a high degree of automation in trading process. An issue that the industry has been facing is how much automation the industry should give to electronic trading. On the Sell side, traditional human intervention by sales traders has been considered valuable when managing execution risk, especially for illiquid instruments. However, in recent years such value as perceived by the Buy side has been diminishing as trading volume remains low historically and trading algorithms are becoming more intelligent in risk management. As a result, the basic practice in traditional Sell side sales trading business is evolving toward the role of “trading process manager”, which should be given a set of operation guidelines to ensure the smooth flow of operations to avoid disruption to the process. The SFC consultation paper formalizes such operation guidelines in the following areas: (1) training and certification of electronic trading professionals playing the role of “trading process managers”, especially for relatively sophisticated processes such as algorithmic trading; (2) pre-trade risk management and post-trade monitoring as required operations that electronic trading professionals have to conduct; and (3) responsibility for certifying in-house or third-party technology solutions in terms of product capabilities and technology stabilities. All such requirements may indicate that the traditional role of a sales trader on the Sell side will potentially be replaced by that of a manager of electronic trading products and that of execution consultants, who will be responsible for their clients’ execution performance.
Quality assurance of trading technologies for both trading systems and trading algorithms will be gradually standardized: Standardizing both the development and the quality control of electronic trading products is not only the result of recent development of trading technologies and algorithmic trading software, but also the natural evolution of industry regulations to ensure orderly operation of the markets. Although nobody can ensure perfect stability of trading software, some market participants have already started asking if traditional Sell side brokers, which themselves are not technology specialists, are fully capable of managing highly automated trading systems. The fact that Knight Capital was reported to seek advice from IBM after losing 440 million USD due to trading software error indicates that both rigorous quality assurance and control procedures and outside professional advices and certifications may be needed by Sell side firms who want to provide electronic trading services to their clients, as well as by specialized trading firms whose businesses depend on trading technologies. It seems that the SFC has this in mind when the consultation paper was drafted. The paper suggests key quality assurance steps such as: (1) stress testing of the trading system, (2) testing of trading algorithms in their responses to sudden market dislocations (likely using sophisticated exchange simulators that take into account market participants’ behaviors under stress), (3) safety checks in trading systems due to erroneous trading behaviors such as too many orders in a short period of time or too large orders submitted to the market, etc. The key difference between the current paper and previous case-by-case requirements on individual firms is that such quality assurance requirements will likely have to be both systematically implemented as testing procedures and standardized across different firms, and electronic evidences of meeting such requirements may have to be documented, presented to and filed by regulatory bodies.
The economics of electronic trading as a business will be modified: As stated by the SFC consultation paper, proposals set out in the paper should “…build on the existing regulatory requirements by providing a more coherent and comprehensive set of regulatory framework for electronic trading.” This
means that many market participants should already have frameworks in place to cope with basic regulatory guidelines. However, it is our belief that extra work has to be performed by many (if not all) firms who provide electronic trading services to their clients in order to comply with these new requirements – assuming these new requirements will eventually be put into law. Extra investment in trading software, hardware and external consulting services may be needed, especially for operation flow design and trading system testing and certification. For the near term, this may lead to elevated cost base for business operations of many firms. To certain degree, the whole market may have to pay such extra price in order to manage the potential downside risk of disorderly market operations. As a result of that, it may alter the business of electronic trading. Firms who cannot afford the extra cost to ensure complete compliance with the new regulations may have to outsource electronic trading services to other firms who can and want to afford. There may be new specialized trading firms who are also technology professionals that can provide products by not only complying with the new requirements but also competing in terms of good execution performance. In recent years, trading cost has been coming down due to increased usage in electronic trading. It may be the case that the downward trend of trading cost will gradually stabilize and even go slightly higher, providing enough incentive for firms to develop more stable and better performing products that have very low probability of dislocating the market. If that is the end result, it will be a “win-win-win” situation for market participants, execution service providers, and the SFC altogether.
Acknowledgement: The author thanks Mr. Kun Zhu and Mr. Song Gu for insightful comments and suggestions for this article.
Hongsong Chou is Managing Director and CEO of Charles River Advisors Ltd., a Hong Kong-based advisory firm specialized in algorithmic trading, high-frequency trading and quantitative investment strategies.