China proposes new scheme regulating automated trading of securities and futures
On 9 October 2015, the China Securities Regulatory Commission (the “CSRC”) released details of a proposed new regime that will impose new operational and risk management requirements on parties seeking to use pre-designed procedures or special software to automatically conclude or execute trades in both the securities market and the futures market in mainland China (“programme trading”). This was followed by more detailed draft implementing rules released by each of the stock exchanges and futures exchanges in mainland China. The consultation periods end on 8 November 2015. The new regime, once implemented, will replace the current disparate, high-level requirements adopted by each of the above exchanges regarding programme trading.
Key features of the proposed new regime include:
Definition of programme trading. Programme trading is broadly defined to cover all trading activities conducted by using pre-designed procedures or special software which enables automatic conclusion or execution of trades. Notably, this definition does not distinguish automated trading from high-frequency trading, nor does it specify which software falls within “specific software”, thus potentially covering trading activities using all types of pre-set programmes or software.
Prior reporting and system verification. Where a client of a securities or futures broker seeks to conduct programme trading, it must provide its broker with details including its identity, its trading account and the developer of its programme trading system, description of its trading strategy, source of funds, IT system parameters and location of its server. The broker must consolidate all information received from different clients and file it with the exchange, on a daily basis. Until the required information is verified by the broker and filed with the exchange, no programme trading by the client can commence. Similar reporting and verification requirements apply to brokers or fund management companies when they conduct proprietary trading or asset management activities (the draft rules do not specify the standards and process of verification, thus creating uncertainty as to how the set-up procedures ought to be completed before programme trading can commence). Note that CSRC is also empowered under the draft rules to request for specific details of the trading strategies and the source codes of the trading programmes.
System conditions. Programme trading systems must embody prescribed functions including, amongst others, verification of funds and securities/positions, detection of anomalies and error processing. Brokers must undertake testing and reviewing of any clients’ programme trading systems that are sought to be linked up with their own systems, and must carry out the required risk assessments before allowing such connections. Brokers must also enter into interconnection agreements with the relevant clients to prescribe, amongst others, the allocation of parties’ responsibilities and liabilities on the continuous monitoring of the programme trading systems and prohibitions against clients carrying out programme trading on behalf of others.
Controls over how trades are executed. The draft rules impose various requirements on the brokers in relation to trades control, including: (i) establishing automated systems to prevent abnormal trades directly entering the exchanges’ servers; (ii) manually verifying and rectifying abnormal trade orders as appropriate; and (iii) establishing separate order placement channels for trades conducted through programme trading and non-programme trading systems to enable better control of orders originating from the different types of system. In particular, orders for programme trades cannot originate from, or be controlled remotely by, a programme trading system located outside the PRC.
Prohibited trades. The following programme trading activities are prohibited: (i) trading in the same security through commonly owned, commonly controlled or associated accounts; (ii) countervailing buying and selling of futures contracts, either in the same account or among different accounts subject to common control; (iii) frequently placing and withdrawing orders where the ratio of trades concluded is abnormally low; (iv) placing large volumes of continuous programme trading when a trade is being closed, resulting in impact upon the closing price level; (v) placing misleading orders at prices fundamentally diverging from market price whilst simultaneously placing and concluding numerous small counter-trades; and (vi) placing purchase orders significantly in excess of market price, or sale orders significantly below market price, thus causing substantial price movements, followed by the placing and conclusion of large numbers of counter-trades.
Position limits. Under the proposed new regime, the stock exchanges are authorised to set up daily net purchase position controls over programme trading by securities companies (for their proprietary trading and asset management activities) and asset management companies who trade using securities companies’ trading units. The securities companies and asset management companies concerned must accordingly set their own position limits for their trading units, which will be filed with the stock exchanges and updated as needed. These limits may be adjusted by the stock exchanges. The futures exchanges, on the other hand, are authorised to put in place daily limits on the positions that may be opened through programme trading activities.
According to the CSRC, the purpose of the proposed new regime is to address perceived unfair treatment of small investors, and reduce market turbulence, resulting from speculative, liquidity-fuelled trades placed through automated, high-frequency and other similar trading strategies. While the need to regulate against risk of excessive volatility in China’s financial markets is understandable in this regard, the authorities will need to strike a delicate balance to avoid creating undue interference in the operation of the market through new reporting requirements and monitoring powers.
ReferenceAdministrative Regulations for Programme Trading in the Securities and Futures Markets (Draft for Comments), China Securities Regulatory Commission (“CSRC”), and related exchange rules