Compliance officers at brokerages in Hong Kong have voiced their frustrations over incoming regulations they say are hard to implement and leave them potentially liable for unforeseeable trading risks.
The city’s Securities and Futures Commission (SFC) unveiled controversial electronic trading rules this March which, among other things, will require intermediaries to carry out real-time monitoring of algorithmic trading. These rules are due to become effective from January 1 next year.
Responsibility for certifying whether clients are sophisticated enough to use algos when trading securities will lie with brokers, in other words at their discretion. The rules also require that pre-trade controls be put in place so a system can prevent orders from being sent to the market immediately, when required, and that all systems operate in the interest of market integrity.
The new regime will include mandatory system checks, reporting requirements and record keeping. By spelling out these rules, the understanding is that if market participants can be proved not to have adhered to the rules, they could be held liable for disorderly trades.
But a number of brokers argue that the new regulations are in some cases mis-directed and counterintuitive.
Speaking at the Trading Architecture Asia forum, held in Hong Kong last week, Liam Madden, Instinet’s head of legal and compliance for Asia Pacific, noted that the SFC would be using its licensing system in a unique way to determine a person’s fitness to trade.
Dealing in securities and futures contracts are regulated activities under the city’s Securities and Futures Ordinance, requiring an entity or individual to acquire Type 1 and Type 2 licences. But following a consultation process last year, the SFC has concluded that it is brokers who need to ensure clients have a good understanding of algo-trading.
The forum heard brokers state that they will find it practically difficult to know when to evaluate their clients, and would need to bring their systems technicians into the discussion.
Madden asked rhetorically: “Why do I as a supplier of an algorithm … have to second-guess whether or not [a client] knows how to use a VWAP [volume-weighted average price] algo?
“Presumably if the [licensed individual] doesn’t know how [to trade using an algo] he should not be in his job. Brokers should not be required to certify that the client of their algo is properly trained as we have no control over the hiring policies of our clients.”
He added that requirements to impose pre-trade controls when providing direct market access to clients, without mandated parameters for these controls, will force brokers to juggle reputational and compliance risks.
The SFC has said only that “specific controls may vary depending on the business model and risk tolerance of each intermediary”, leaving it open for brokers to design controls and filters to stop an order deemed manipulative or abusive from being sent electronically to exchange.
Such discretion creates a headache for legal counsel, given the difficulty of reconciling regulatory expectations about what brokers should monitor and filter, with the need to preserve clients’ trading strategies.
Under the rules the SFC will require brokers to keep records of their algo-trading systems, and be able to demonstrate to regulators how an algo places an order to market. They are also expected to give more specific information on algos to clients.
But Mark Wan, legal counsel for Société Générale, argued that brokers are faced with a dilemma: the need to balance increased disclosure of proprietary algo-trading systems (precious intellectual property) with the need to (be seen to) provide sufficient investor protection.
“One of the things we are reluctant to do is force clients who do not need the training to go through training,” Wan told the forum. “The bulk of our clients are professional investors [such as] hedge funds. Why should brokers have to explain to them how these algos work when in fact they probably know?”
Both intermediaries and buy-side traders have raised their objections to the rule changes, including at last year’s Trading Architecture Asia, as reported.
Yet after the SFC announced its conclusions this March following its consultation period, industry players say they hold little hope that the SFC will amend or redefine its requirements.