CSRC Consultation on Administrative Measures on Program Trading

As one of the measures to reform the market structure following the A-share market crisis, the China Securities Regulatory Commission (“CSRC”) announced the Consultation Paper for the Administrative Measures on Program Trading of the Securities and Futures Markets (“Measures”) on October 9, 2015. The Measures regulate all parties trading on the securities and futures exchanges regulated by CSRC, including clients, securities and futures brokers (collectively, “Brokers”), exchange members engaged in the proprietary trading business or asset management business, and fund management companies that lease trading units from the securities companies (the “Fund Companies”). Upon promulgation, the Measures will become the most comprehensive and highest-level regulatory rules governing program trading in the Chinese securities market and futures market, and are expected to be quite influential for a relatively long time period.
Supervisory Principles for Regulating Program Trading
CSRC expressly indicated the principles of rule-formulating in its Statement of Drafting announced simultaneously with the Measures, i.e., considering the features of the current PRC capital markets (that is, markets characterized by numerous individual investors, short-term holding of securities, and severe price volatility), program trading shall be “highly supervised, restricted for development, divided to avoid disadvantages while seeking advantages, and continuously regulated”.
Both the Statement of Drafting and the Media Q&A of CSRC mentioned the status quo of program trading in the overseas markets and the domestic markets to justify the above supervisory principles proposed by CSRC. CSRC pointed out that, the major reason for program trading being comparatively more common in the overseas markets is that the overseas markets have a market structure composed of “multiple exchanges” and are “institutional-investor-oriented”. However, it is worth noting the “dual features” of program trading; namely, on one hand, program trading improves liquidity as well as increases efficiency in terms of price discovery; on the other hand, it amplifies market volatility, jeopardizes market fairness and challenges the capacity of trading technologies. Furthermore, CSRC indicated that the overseas financial regulators are also continuously increasing their supervision over program trading.
CSRC summarized three main characteristics of the PRC capital markets: (1) the market‘s liquidity is good enough for “serving the real economy”, (2) individual investors are still major participants in the market, so aggressively promoting program trading may not be good for maintaining a fair market environment, and (3) over-speculation and hype are still serious concerns in the current market. As a result of these three characteristics, it will be a long time for the Chinese market to fully utilize program trading to improve price discovery. Meanwhile, the Statement of Drafting also indicated that, both severe market volatility caused by the technical risk of program trading as well as violations in connection with program trading have already emerged in the market. Based on the aforesaid considerations, CSRC has proposed the above supervisory principles of program trading, with an emphasis on strict restrictions.
Below is a summary of certain key points of the Measures.
Program Trading
The Measures define program trading as all trading behaviors where trade orders are automatically generated or executed via a specially designed program or dedicated software. All traders that implement program trading fall into the definition of the “program traders” under the Measures. We are of the opinion that such definition is very extensive, which embodies the regulators’ determination to comprehensively supervise program trading. The Measures authorize the exchanges to establish differentiated fee management rules based on the specific instances of trade order placement and cancellation via program trading, and to charge extra fees for program trading. These actions also embody the supervisory principle of restricting the development of program trading.
Systems of Brokers
The Measures impose several system requirements on Brokers, such as requiring Brokers to: (1) formulate special business management and risk management systems for program trading clients, (2) establish examination and inspection systems for program trading, and review the authenticity of clients’ identities and compliance in terms of sources of funds, trading accounts and trading operations, and (3) establish screening mechanisms for program trading accounts, and segregate the channels for placing orders between program trading clients and non-program trading clients, and establish separate flow controls.
Filing and Examination Prior to Trading Activity
Before starting to trade, each program trading client is required to submit (to the Broker) its identification information, information on its trading strategies, IT configuration parameters, address of its server(s), together with information on its designated contact person. The Broker shall have the obligation to examine and inspect such information and file it with the exchange thereafter. Proprietary trading members of the exchange (including those engaging in the proprietary trading business or asset management business) and the Fund Companies shall submit the relevant information directly to the exchange for examination.
Order Verification
In addition to requiring program traders to assume the obligation of prudent management for all program trade orders, the Measures require program traders to use one account to engage in program trading. The Measures also require the Broker to establish a computer verification system for program trade orders so as to automatically prevent orders with anomalous prices or quantities from being directly submitted to the exchange server(s), and to even manually verify the relevant anomalous orders. Considering that the order verification system is a new system, the Measures provide that the securities and futures industry associations shall formulate relevant guidelines for self-regulation.
CSRC expressed in the Media Q&A that, where the amount or frequency of program trading is raised to a level that may have a significant impact on market liquidity, even though the participating program traders do not have any intention to affect market prices or trading volume, such program traders shall also abide by the prudent trading obligation. It is noteworthy that the Measures emphasize the market participants’ obligation of prudence, which may imply that CSRC admits that there might be such a “constant state” where the market develops very quickly while supervisory measures are always left behind.
Functions of Trading Systems and System Access
The Measures propose requirements on the functions that a program trading system should possess. That is, the system used by a program trader must have the functions of risk control (such as capital verification, securities verification, position validation, anomaly detection and error handling) and must be used only after full testing, with the related test records kept accordingly. Where a client’s program trading system accesses the Broker’s IT system, the Broker is also required to establish an examination and inspection system for such access, and complete validation testing and risk evaluation prior to granting any access. The Broker shall bear the obligation of constant management of the client’s program trading system that accesses its IT system; and, in the event of any update of or alternation to the client’s system, the Broker shall reinitiate the validation testing and risk evaluation process. The securities and futures industry associations will formulate industry standards with respect to the requisite risk control functions of program trading and the Brokers’ system access.
Obligation of Reporting in Anomalous Situations
In the event of any anomalous situation in relation to a program trading system, the client shall immediately report to the Broker, and the Broker shall immediately report to the exchange. We recall the “Everbright Securities Fat Finger” event about two years ago. The issuance of the Measures is particularly meaningful for financial institutions engaged in program trading. In addition, for the purpose of preventing events similar to the “Everbright Securities Fat Finger” event, we note that the Measures require the securities exchanges to impose a “Daily Securities Net-Purchase Quota Control” on their proprietary trading members and Fund Companies, and also stipulate that the futures exchanges may implement an “intraday opening limit” for program traders.
Overseas Remote Control and Server Custody
The Measures prohibit the delivery of trade orders from overseas program trading systems and prohibit the connection of domestic program trading systems with overseas computers so as to be remotely controlled by overseas computers, unless otherwise stipulated by CSRC. The substance of this provision is to require all program traders to locate their trading systems within the territory of the PRC (excluding Hong Kong, Macau and Taiwan for this purpose), and such system shall not be remotely controlled by any overseas computer. In terms of the crude oil futures to be listed in the Shanghai International Energy Exchange, which will be opened to all foreign investors directly, it is still unclear at this stage whether or not CSRC will grant an exception for such trades.
In addition, the Measures require the exchanges to provide cabinet custody services (i.e., co-location of servers through leasing spaces offered by the exchanges) and the Brokers to allocate trading units or seats and flows in accordance with the principle of fairness. The Measures also prohibit Brokers from discriminating amongst their clients in terms of offering apparent differentiation of order placement speed; however, it is also unclear whether the last point actually prohibits low latency trade placement.
Prohibited Behaviors
The Measures expressly enumerate the following prohibited behaviors for program trading and the relevant penalties, and require exchanges to enhance their real-time monitoring: (1) trading of the same securities between accounts of the same body, accounts controlled by the same body, or suspected affiliated accounts, (2) cross-trading of futures contracts between the accounts of the same body, or accounts de facto controlled by the same client, (3) frequent placement and frequent cancellation of orders, where the order filled/placed ratio is significantly lower than the normal level, (4) conducting a high volume of and consecutive trades by utilizing programs during the period immediately prior to closing, which affects the closing price, (5) conducting large-value order placement, the price of which consistently deviates from the market settlement price at the time of such placement so as to mislead other investors’ decisions, in the meantime conducting multiple small-value reverse buy or sell trades and then settling, (6) consistently placing buying orders at a price higher than the most recent settlement price, or consistently placing selling orders at a price lower that the most recent settlement price, which gives rise to rapid push-up or push-down of price, and then conducting numerous reverse buy or sell order placements and settling after leading or strengthening the price tendency, or (7) other program trading behaviors that violate the laws and regulations and jeopardize the normal trading order of the securities and futures markets.
The Measures also confer on CSRC the power to require program traders to provide the source codes of their trading programs and detailed information on their trading strategies, depending on the needs of regulatory enforcement.
CSRC expressly pointed out in the Media Q&A that the aforesaid prohibited behaviors shall be distinguished from abnormal trading behaviors determined by the exchanges, and also shall not be directly labeled “market manipulation” solely by virtue of being a “program trading prohibited behavior”.
CSRC believes that there may be some connections among abnormal trading, program trading prohibited behaviors and market manipulation, and that such behaviors might also be transformed into each other in some cases. Different treatments of such conduct, therefore, will be advantageous to protect investors’ interests and maintain the normal trading order of the market from multiple angles and levels through self-discipline supervision, administrative supervision and/or criminal laws.