2019.02.28 XIE, Qing (Natasha)、WU, Man、YANG, Yuxiaoxiao
In the run up to the Chinese Lunar Year, the China Securities Regulatory Commission (“CSRC”) released its Consultation Paper on the Administration of Securities Brokers’ Electronic Connections with Clients’ External Trading System (“Consultation Paper”) for public comment.
The Consultation Paper focuses on the regulation of electronic connections between securities brokers and their external clients’ trading systems (“external connections”). It is not unusual for securities brokers to allow their clients to use client-owned proprietary automatic trading systems to place orders in order that the clients may implement their own algorithm strategies, rather than relying on trading systems provided by their securities brokers. In this context, “external connections” can be taken to mean the information system interfaces or other information technology methods used by securities brokers to connect with their clients’ trading systems in order to receive trading and enquiry instructions from such clients.
The evolution of the CSRC’s regulation of external connections used by securities brokers started following the 2015 A-share abnormal fluctuations. In July 2015, as it became apparent that non-licensed institutions had been using information systems to open virtual stock accounts for their clients and to trade stocks on behalf of these clients, the CSRC ordered brokers to call a halt on the opening of any new business that involved external connections, and to clean up their existing business. There was subsequently further strengthening, with the CSRC taking a series of regulatory actions and imposing penalties for activities that used information systems to illegally engage in the securities brokerage business.
The release of the 2019 Consultation Paper on external connections marks the end of three and half years of radical clearing-out by the CSRC, and a return to a more stable approach.
The Draft Statement of the CSRC on the Consultation Paper (“Draft Statement”) acknowledges that some professional institutional investors do actually need to use external connections for the purposes, for example, of allocating trades among different portfolios, applying risk control measures universally, and/or executing certain trading strategies.
In its Draft Statement, the CSRC lists three major risks or concerns associated with such external connections:
(i) compliance risk: where unlicensed institutions use external connections to engage in securities brokerage or other types of securities activities that are only allowed to be conducted by licensed financial institutions;
(ii) information security risk: those risks associated with information technology of external systems that could be spread to securities brokers; and
(iii) market risk: primarily refers to issues that arise in securities companies due to inadequate risk control, such as “fat finger-errors.”
Generally speaking, when compared with the response in 2015, the three major risks identified in the Draft Statement suggest that the CSRC recognizes that external connections are just a tool rather than an illegal activity that should be banned, and that forbidding their use is a short-term measure that may not support the CSRC’s longer-term goal of preventing risk in financial markets. With the release of the Consultation Paper, it appears that the focus of regulation is shifting from banning technical tools, and is instead moving towards increasing the supervisory requirements on securities brokers themselves, including defining the requirements of investor suitability before they use the tools.
Our reading of the Consultation Paper identifies two key strands.
Firstly, securities brokers shall provide services according to the reasonable business needs of the investors on the condition that provision of such services proves to be safe and should be in full compliance with the relevant laws and regulations. Securities brokers shall direct investors to use, in the first instance, the trading terminals provided by such securities broker. Use of external connections is allowed only in exceptional circumstances, and in order to provide a reasonable supplementary service to the standard services provided by securities brokers.
Securities brokers can only provide external connection services to those professional investors prescribed in Item 1 or Item 3 of Article 8 of the Measures for the Eligibility Management of Securities and Futures Investors and who have reasonable needs. Among professional investors, in order to qualify, a private fund manager of securities investment fund is required to have assets under management (AUM) over the last year no less than RMB 500,000,000, and the relevant private fund shall have been filed with the Asset Management Association of China.
Secondly, there has been a strengthening of the supervisory obligations of securities brokers. It is expressly indicated that securities brokers shall bear primary responsibility for the management of external connection activities, and shall be held liable for violations of such management responsibilities.
There are three key principles with which securities brokers should comply when they engage in relevant activities: compliance and prudence, risk control and whole process management.
The compliance and prudence principle means that securities brokers should evaluate whether the trading needs of investors are reasonable, and provide their external connection services prudently.
The risk control principle refers to the need for securities brokers to identify, monitor and prevent any potential risks arising from their external connection activities.
The whole process management principle means that securities brokers shall conduct coordinated management of their external connection activities, and establish clearly articulated management mechanisms to address the full process, including but not limited to due diligence, pre-review, trading monitoring, abnormal event handling, emergency response, and exit mechanism.
The Consultation Paper sets out a higher entry threshold for qualified securities brokers, such as having an A-class rating or higher for at least one year within the past three years. This requirement means that almost all foreign brokers are currently excluded from qualifying.
It is significant that, for the first time, the Consultation Paper provides a definition of “automatic trading”, that is trading activity in which trading orders are automatically generated and executed through established programs or specific software, and stipulates that securities brokers providing trading information systems or relevant strategies to investors for the purpose of engaging in automatic trading activities or who engage in automatic trading in their proprietary business or assets management business shall be governed by reference to the Consultation Paper. This means that the compliance principles established in the Consultation Paper shall effectively apply to all automatic stock trading activities undertaken by securities brokers.
We will continue to pay close attention and will share the latest developments with our clients.