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Wise Guidance: Sound practices for algorithmic trading from HKMA

Wise Guidance: Sound practices for algorithmic trading from HKMA

As markets have evolved rapidly over the past two decades, regulators have faced the difficult task of adapting to the new realities brought about by the emergence of electronic trading. New trading practices, particularly with algorithmic trading, have dramatically altered the structure of the market and introduced new risk factors that were never envisioned when market rules were first established. At times the results have been catastrophic, as with the quick demise of Knight Capital Group in 2012 when a rogue algorithm led to over $440 million in losses in less than an hours time. However, regulators have generally responded to these new challenges in helpful and constructive ways. The latest example of this comes from the Hong Kong Monetary Authority (HKMA) in an advisory letter that details best practices along with areas of concern with regard to algorithmic trading.

 

HKMA sound risk management practices for algorithmic trading

 

The HKMA released their letter and guidance on March 6 following “a round of thematic on-site examinations focused on algo-trading” conducted in 2019. These examinations were a follow-on from a survey of market participants in 2018 on the topic and it was determined that more guidance was needed. The on-site examinations were conducted at seven firms and the guiding principles that were gleaned from these examinations were broken down into four broad categories:

  1. Governance and oversight
  2. Development, testing and approval
  3. Risk monitoring and controls
  4. Documentation

 

Key takeaways from the HKMA research

 

Several key takeaways emerged from the letter and annex published by HKMA:

  • This is an excellent example of thoughtful and progressive regulation that carefully studies the situation and adopts the best practices as exhibited by leading practitioners.
  • Importantly, HKMA offers thorough guidance without being overly prescriptive. Rules-based regulation often has unintended negative consequences as adherence to strict rules leaves gray areas that harbor risk. Principles based regulation, on the other hand, encourages a healthy dialogue and produces outcomes that evolve along with market circumstances.
  • The Annex offers many good, practical suggestions, such as establishing alerts at 80% of thresholds or limits to act as early warnings. 
  • One area of concern is kill functionality. HKMA makes no mention of concern for the market impact that a blanket or wholesale kill function can have, an area that regulators such as the CFTC and SEC have stressed recently. Kill functionality can be problematic as exchanges and regulators are increasingly concerned that all activity must take into effect the market impact it will have.

 

A shining example of regulatory excellence

 

The changes that accompanied the emergence of new forms of trading in the electronic era have been profound and this change dynamic is ongoing. It has not been easy for regulators to adapt and the best examples of regulators evolving to meet new conditions involve a willingness to listen and an approach that stresses communication, flexibility and shared responsibility. On all of these counts, the recent guidance regarding algorithmic trading from HKMA is a shining example of regulation done right.

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