HK SFC Electronic Trading Rules Cut Out Brokers and ISVs
Buy-side firms are reportedly slashing their broker panels to reduce the burden of new algorithmic trading rules in Hong Kong, while technology vendors are struggling with unexpected responsibility. The special administrative region’s market regulator, the Securities and Futures Commission (SFC), introduced the rules in order to mitigate the risks of a market event due to a trading system fault or error. Although they were announced in March 2013, their true impact had not been fully realised by many market participants until recently.
“Some firms may have underestimated the scope of the rules,” says Clare Witts, a director at agency broker ITG. “At first glance they look fairly straightforward, but when you take the wording into consideration, it can capture a lot of activity.”
The rules are open because they are principles-based, which makes it hard for firms to bypass the regulator’s intent whilst being compliant at a technical level. They are intended to ensure that a system’s designers and the traders using it are ‘suitably qualified’ to deal with the technology that they are using, that the systems are properly tested and checked, and that they comply with regulations.
Any firm regulated in Hong Kong, whether buy- or sell-side has lots of work to do as a result. However firm such as independent software vendors (ISVs) that have clients regulated on either the buy- or sell-side in Hong Kong will also be under pressure, as they are asked to help their clients fulfil their own obligations.
“A vendor that isn’t regulated may not expect to be affected,” says Witts. “Then suddenly a request lands on its desk from a client, who wants it to fill in a long document detailing things like their system adequacy, and provide assurances that they can keep all records in line with the SFC requirements – for example, audit logs and documentation of system design, testing and modifications which need to be kept for at least two years after the system stops being used.”
Buy- and sell-side firms alike have been preparing for the impact for some time, working together in order to that they are fully prepared. The buy-side has groups such as the Asia TraderForum (ATF), the Hong Kong Investment Funds Association (IFA) for buy-side compliance departments and for the sell-side, trade body Asia Securities Industry & Financial Markets Association (ASIFMA). The IFA and ASIFMA have developed a four-colour coded template containing question that the buy-side intends on sending to the sell-side to fill in.
“If a broker has 700 clients there is the potential they will hear 700 different interpretations of the regulations,” says Lee Bray, head of APAC Equity Trading at JP Morgan Asset Management. “It is just not practical to do that. The idea is that the questionnaire can aid both asset management firms and brokers to create a standard frame work to begin to approach the legislation from.”
“The template was conceived of by the sell-side industry body which has taken a pragmatic approach to avoid needless work,” added one buy-side head trader who declined to be named. “It was then developed further by the industry including lawyers, compliance specialist and the buy-side, with hundreds of people’s feedback. It is a collective work and it is meant to reduce needless duplication and wasted effort, so is a fine idea.”
Slash and burn
Buy-side firms are cutting back on suppliers to cope with the rules, despite the efforts of the industry groups. Asset managers have never before had to concern themselves with the number of systems that are accessible via their trading desk. Brokers provide trading services including execution algorithms for free, knowing that they will be recompensed in trading fees.
“[Cutting back on broker lists] is a common approach; a lot of my buy-side peers have discussed it because this is all new, and if you have 40 algo providers then there are also a lot of permutations of the different algorithms in the background, so it is safer to implement a slightly smaller broker list to begin with, get comfortable with the internal processes and then once they are bedded down, expand the list out again,” Bray says. Up until now, execution and order management system providers have been able to support their system from behind a screen, in some cases using the software as a service (SaaS) model so that clients don’t even have technology installed on the hardware. Software developers who write algos but are not licensed by the SFC will note that there is a much larger onus on the buy-side to prove that the software developer has the right controls in place, which could be very difficult to get.
“Recently a lot of people have suddenly realised how broadly this affects business,” says Witts. “As soon as a regulatory obligation is put on one firm in a chain, it extends along that chain because that firm is obliged to ensure that its service providers can also comply with the relevant sections of the rules, in order for it to be able to use those providers.”
Brokers white labelling algorithms from their peers are likely to be impacted because they are an intermediary, but may not be in the best position to answer questions about algos which they do not develop themselves. It is common enough for global brokers to access a market via a local broker’s algos in Asia.
They may experience difficulties around accessing intellectual property from a potential rival, and some buy-side compliance departments may not feel comfortable getting answers back from a broker that does not develop its own algos.
Asset managers are under severe pressure to understand each of these systems and any material changes that occur in them; as algorithms can be updated fairly regularly, understanding what will trigger a requirement for relearning is causing significant concern.
“There is some debate as to what constitutes a material change,” says Bray. “It is somewhat open to interpretation but in one reading, anytime an algo gets changed on the broker side there is an obligation to notify those using that product to update their training and skills. It is not a big step from that point on to assume that the algo offering on the desk will be reduced to core set, to make this process simpler.”
Gone too far
There had been some uncertainty around how inclusive these rules they would be. It is now clear that FX and fixed income trading will not be considered covered. Dark pools are also not covered, and will fall under another upcoming regulation; the SFC and other regulatory bodies have been contacting brokers about how their dark pools work.
“It won’t be up to the buy-side to include dark pools, even if the buy-side is routing out an algo or DMA order which interact with a dark pool, that part will not be covered which is substantially good news for buy-side traders,” said the head of desk at a Hong Kong-based asset manager. One further upside, in the long term, is the potential for asset managers to examine their relationships with sell-side providers and look at unbundling their services.
“If broker lists get cut back because of concerns around execution services, it may be that we see an increase in commission sharing agreements, with some brokers selected purely for their research,” notes John Fildes, CEO of stock exchange Chi-X Australia. Whatever the upsides might be in the long-term, there are still short term pressures, notes the head of desk, “It is already coming on to October, the templates are not done yet and it will take some time for the brokers to fill then in so there is a bit of a mad ru