China – Uncover the New Program Trading Rules.
On June 7, 2024, the three PRC stock exchanges, i.e., the SSE, SZSE, and BSE (collectively, the “Exchanges”), issued the Detailed Implementation Rules for the Management of Program Trading (Draft) (“Implementation Rules”) for public comment. This comes after the official release on May 15, 2024, of the Administrative Rules for Program Trading in the Securities Market (Trial) (“Administration Rules”) by the China Securities Regulatory Commission (“CSRC”). The content of these Implementation Rules released by each Exchange are basically the same[1], aiming to implement the regulatory requirements in the Administration Rules. In this briefing, we focus our analysis on the key provisions of the Implementation Rules of the SSE and look at how they differ from the Administrative Rules. For other provisions that overlap between the Implementation Rules and the Administrative Rules, please refer to our Client Briefing: Observations on the Administrative Rules for Program Trading in the Securities Market (Trial).
I. Incorporates Provisions on Stock Market Program Trading Previously Adopted by the Exchanges
In February 2021 and September 2023, the SSE issued circulars on convertible corporate bonds program trading reporting and stock program trading reporting. Since then, a program trading reporting framework has been established at the SSE level. The Implementation Rules incorporate certain provisions in these circulars as well as the corresponding reporting templates (collectively, the “Circulars”) issued by the SSE, and refine and improve the specific provisions. Jointly, the Administrative Rules, the Implementation Rules, the Circulars, and other higher-level legal sources, form a comprehensive regulatory system for program trading in China.
1. Scope of Application
The Implementation Rules clarify the scope of application and state that program trading of securities, such as stocks, bonds, funds, and depositary receipts, should comply with the Implementation Rules.
The Implementation Rules define program trading and align the definition with the Circulars. Program trading refers to the act of trading securities on an Exchange through automatic generation or the delivery of trade orders by a computer program. This includes trading that follows pre-set strategies and automatically selects specific securities and timings for trading, or trading that follows pre-set algorithms and automatically executes trade orders, or any other acts with the characteristics of program trading. Our interpretation is that, even if investors make discretionary trading decisions, once they use program trading software to automatically execute orders, it is considered program trading under the Implementation Rules.
2. Management of Program Trading Reporting
In addition to program trading reporting requirements, the Implementation Rules newly require program trading investors to ensure that the program trading strategies and information technical systems they use comply with laws and regulations as well as the Exchange’s business rules.
The information to be reported under the Implementation Rules is in line with the existing Administration Rules and Circulars. Consistent with the Circulars in general, program trading investors are required to report any significant changes in the reported information to the securities company by the fifth trading day of the next calendar month. The securities company should report to the Exchange within five trading days upon receiving a significant change report submitted by a program trading investor. If a securities company finds that its client has failed to report a significant change in the reported information in a timely manner, they should urge the client to report the change as soon as possible. Significant changes include the following: (1) there are significant changes in the capital scale of the account compared to the reported information; (2) the source of leveraged funds changes, or there are significant changes in the scale of the leveraged funds compared to the reported information; (3) the contact person of the securities company or the contact person of an institutional program trading investor changes; (4) the maximum order placement/cancellation frequency or the maximum number of daily order placements/cancellations changes; (5) the primary type of trading strategies changes; (6) the information regarding the program trading software changes; (7) the account no longer engages in program trading; and (8) other significant changes recognized by the Exchange.
II. The Looking-through Requirements
The Implementation Rules propose principled provisions on the looking-through requirements for securities companies and program trading investors from different angles. Securities companies should establish program trading monitoring, identification, and reporting verification mechanisms to identify, in a timely manner, clients who are required to report program trading (or to report significant changes). They should urge them to fulfill their reporting obligations in a timely manner and conduct thorough verification of the information reported by clients. This requires securities companies to verify their client’s identities on a looking-through basis and to verify, the fund information, trading information, and program trading software information. These provisions clarify the securities companies’ verification obligations on client information on a looking-through basis. However, securities companies may need to further explore in practice how to fully discharge their verification obligations due to the vagueness of the boundaries of such responsibilities.
The Implementation Rules stipulate that program trading investors, if entering into total return swap transactions with clients and conducting program trading through their own accounts, should report the relevant client information as required by the Exchange. The specific reporting requirements will be separately stipulated by the Exchange. This is the first time when the total return swap business in the context of program trading is explicitly mentioned. From a compliance perspective, PRC regulators seem to have recognized the legality and necessity of total return swap transactions in the context of program trading, and they intend to include the reporting of total return swap transactions in the context of program trading into the existing program trading reporting regime. This demonstrates a pragmatic approach by PRC regulators to start from basic information reporting, and gradually adjust the scope of reporting according to the situation, with an aim to reduce the impact on the market. Market participants are concerned when the Exchange will clarify the reporting requirements and worry that an excessive reporting scope may add unnecessary burdens on the counterparties to a total return swap transaction. This could then cause a decrease or cessation of trading by the end clients of related total return swap transactions, thereby affecting market liquidity. In the Measures for the Supervision and Administration of Derivative Trading (Second Consultation Draft) released by the CSRC last year, derivative operation institutions are required to record the information of their counterparties, contracts, and the trading details of the derivative contracts relating to hedging transactions; Securities and futures trading venues may, based on the needs of monitoring, require derivative operation institutions to provide the foregoing information. We think that the Implementation Rules and the above proposed derivatives trading regulation are separate but echo with each other. Both leave flexibility for the Exchanges to determine the form, content, and scope of reporting based on market conditions.
III. Management of Abnormal Trading Behavior
1. Focus of Monitoring
Exchanges shall conduct real-time monitoring of program trading activities and focus on monitoring abnormal trading behavior that may affect the security of the Exchange’s systems or normal trading orders. Abnormal trading behavior includes:
(1) Abnormal instantaneous order placements, which refers to a large number of order placements within a very short time period, i.e., the number of order placements and cancellations reaches a certain standard within one second;
(2) Frequent instantaneous order cancellations, which refers to frequent occurrences of rapid order cancellations after placements within a day, with a high proportion of order cancellations throughout the day, i.e., multiple occurrences of order cancellations after placements within one second throughout a day, and the proportion of order cancellations throughout the day reaches a certain standard;
(3) Frequent lifting or suppressing, which refers to multiple occurrences of slight lifting or suppressing in the price of one or more stocks within a day, i.e., the price increase (decrease) of a single stock within one minute and the proportion of investors’ trading volume during that period reach a certain standard, which occurs multiple times within a day;
(4) Large-volume order executions within a short time period, which refers to extremely large buy (sell) amounts within a short time period, intensifying fluctuations in the main indices of the Exchange, i.e., the increase (decrease) in the Shanghai Composite Index or the STAR Market 50 Index within one minute, and the amounts and proportion of investors’ discretionary buy (sell) orders during that period reach a certain standard;
(5) Other abnormal trading behavior that the Exchange deems necessary to monitor closely.
We look forward to the Exchanges’ further clarification on the definition of “certain threshold” referred to in paragraphs (1) to (4) of this Article and “slight lifting or suppressing” in paragraph (3) (in particular how this relates to stock liquidity).
During the monitoring process of abnormal trading behavior on other securities, such as bonds, funds, and depositary receipts, that may affect the security of the Exchange’s systems or normal trading orders, the Exchanges can focus on monitoring based on the standards mentioned above and adjust the standards according to their self-disciplinary needs.
The Implementation Rules explicitly prohibit institutional program trading investors, such as public fund managers, private fund managers, and QFIs, that conduct program trading through fund products, to evade regulatory oversight of abnormal trading behavior by launching separate fund products.
If program trading causes significant abnormal fluctuations in securities trading, or if unforeseen events such as force majeure events affect normal securities trading orders, the Exchanges may take measures in accordance with their business rules, such as suspending the trading of a single stock during trading sessions, suspending the trading of a single stock for certain trading days, or closing the market temporarily.
2. Monitoring Responsibilities of Securities Companies
Pursuant to the Implementation Rules, securities companies shall (i) effectively manage their client’s program trading behavior, (ii) put program trading under abnormal trading monitoring, (iii) continuously improve the abnormal trading monitoring systems, (iv) strengthen the monitoring of orders that may seriously affect securities trading prices and liquidity, (v) identify, manage, and report clients’ suspected abnormal trading behavior in a timely manner, and (vi) actively cooperate with the Exchanges in trading behavior oversight. When a client commits the following actions, a securities company should refuse their program trading orders or cancel related orders in accordance with the agreement entered with the client:
(1) Clients refuse to fulfill the reporting obligations or the obligations to report significant changes, or fail to truthfully, accurately, completely, and timely fulfill the reporting obligations or obligations to report significant changes;
(2) Clients refuse to cooperate with the securities company in conducting due diligence on program trading, or refuse to accept the securities company’s verifications and inspections;
(3) A client’s information technical systems used for program trading experiences significant technical failures, or a client’s program trading orders experience significant abnormalities;
(4) A Client’s program trading may affect the security of the trading systems or normal trading orders;
(5) The information technical system used by clients for program trading is different from the system that has been verified, tested, and risk-assessed by the securities company;
(6) Other matters agreed upon in the relevant entrustment agreement entered between the client and the securities company.
IV. Requirements on Trading Server Co-location
Articles 27 and 28 of the Implementation Rules regulate the use of the Exchange’s trading server hosting services. Securities companies using the Exchange’s trading server hosting services should utilize the hosting resources reasonably and in compliant with the Exchange’s management rules. Securities companies should strengthen the management of their clients using the Exchange’s hosting resources for program trading and ensure the trading fairness. It requires that securities companies conduct a thorough evaluation and retain the evaluation results, which should include their clients’ trading compliance and the operation of information technical systems, before allowing their clients to use the Exchange’s hosting resources for program trading.
If the use of the Exchange’s trading server hosting services by securities companies affect the security of the Exchange’s systems or normal trading orders, the Exchange may suspend the provision of the trading server hosting services. If clients’ using the Exchange’s hosting resources for program trading experience any of the following situations, securities companies should suspend the use by the clients of the Exchange’s hosting resources:
(1) Multiple occurrences of abnormal trading behavior within one month, resulting in trading restrictions imposed by the Exchange on the investor’s accounts;
(2) Situations as stipulated in Article 22 or Article 23 of the Implementation Rules, with the relevant clients being responsible for such situations;
(3) Significant technical failures of the information technical systems used for program trading;
(4) Other situations determined by the Exchange.
V. Management of High-Frequency Trading
Both the Administrative Rules and the Circulars contain provisions on high-frequency trading. The Implementation Rules further specify the thresholds for high-frequency trading as being that, the maximum number of order placements and cancellations per second in a single account reaches 300 or more, or the maximum number of order placements and cancellations in a single account within a single day reaches 20,000 or more. The Implementation Rules also set forth a series of differentiated supervisory arrangements for high-frequency trading, including:
(1) Additional reporting requirements. High-frequency trading investors should, through their securities companies, report additional information to the Exchange, namely, (i) the location of the high-frequency trading system server; (ii) the test report of the high-frequency trading systems; (iii) emergency plans for the high-frequency trading system malfunctions; (iv) other information required by the Exchange.
The Implementation Rules exempt the following activity from the additional reporting requirements: when investors execute trade orders automatically by using pre-set order splitting algorithms for the purpose of reducing the market impact of large orders or ensuring the trade fairness across different investment portfolios, and the investors have fulfilled the basic information reporting obligations as stipulated in Article 9 of the Implementation Rules, they may be exempted from the aforementioned additional reporting requirements. These investors include public fund managers and their subsidiaries, the Exchange’s members that are engaged in asset management business, QFIs, and any other investors recognized by the Exchange, but exclude private fund managers. The reporting period is extended for these investors in the event of any significant changes in their reported fund scale of the account, the source of leveraged funds, or the scale of the leveraged funds, i.e., they are required to report these significant changes by the fifth trading day of the next quarter following the occurrence of the change.
(2) Apply stricter management of abnormal trading behavior. The Exchanges shall focus on the supervision of high-frequency trading. If investors engage in abnormal trading behavior in high-frequency trading, the Exchange may apply stricter self-disciplinary management measures in accordance with the regulations and require the securities companies to strengthen the management of the relevant client’s trading behavior. Securities companies should strengthen the real-time monitoring of high-frequency trading. If investors engaged in high-frequency trading commit abnormal trading behavior as mentioned in Section 3(1) of this briefing, securities companies should immediately take effective control and use disposal measures in accordance with the entrustment agreement to prevent the security of the Exchange’s systems or normal trading orders from being affected.
(3) Different fee standards. The Exchanges may implement different fee standards for high-frequency trading and publicize the corresponding fee standards. Securities companies should strengthen their fee management and ensure that the extra fee costs are borne by investors engaged in high-frequency trading.
VI.Management of Program Trading under the Stock Connect Regime
The Administrative Rules provide that “Investors who engage in program trading in the securities market in mainland China through the Stock Connect regime between mainland China and Hong Kong shall, in accordance with the principle of fair treatment of domestic and foreign investors, be subject to reporting management and trading monitoring regulations. Cross-border regulatory cooperation will be implemented regarding their abnormal trading behavior”. On this basis, the Implementation Rules further propose that northbound trading investors under the Stock Connect regime should be regulated by referencing the Implementation Rules in terms of, such as, the reporting obligations, trading behavior supervision and management of high-frequency trading. It further clarifies the reporting path for those northbound trading investors, i.e., they should report the required information to their Hong Kong brokers, through which the information will be submitted to the Hong Kong Stock Exchange and then to the Exchanges. If northbound trading investors fail to report as required or engage in abnormal trading behavior, the Exchanges will take measures through the regulatory cooperation with the Hong Kong counterparts in accordance with the arrangements under the Stock Connect regime.
VII. Supervision and Inspection Powers
The Administrative Rules and the Circulars have specified that the Exchanges may conduct on-site or off-site inspections of the institutions and individuals involved in program trading based on their self-disciplinary needs. The Implementation Rules detail the circumstances when the Exchanges should strengthen their on-site or off-site inspections, including (i) the program trading is inconsistent with the reported information and the investor refuses to rectify the situation; (ii) the program trading causes significant abnormal fluctuations to the securities trading; (iii) the program trading affects the normal securities trading orders or causes significant abnormalities in the results of securities trading due to unforeseen events; (iv) major technical failure in the program trading information technical systems that may affect the security of the Exchange’s systems; (v) other circumstances as determined by the Exchange.
The Implementation Rules specify that if the relevant program trading investors fail to fulfill their reporting obligations or the obligations to report significant changes as required, frequently engage in program trading inconsistent with the reported information, engage in abnormal trading behavior, or commit other violations, or if securities companies violate the provisions thereunder regarding their management responsibilities, such as the management of reporting, client program trading behavior, trading server hosting service, fees, or high-frequency trading, the Exchanges may take self-disciplinary measures or disciplinary sanctions in accordance with the regulations.
VIII. Pending Detailed Rules
According to the Implementation Rules, the Exchanges will release supporting rules in due course regarding:
(1) Specific information to be reported by program trading investors when engaging in total return swap transactions with clients;
(2) Specific management requirements and fee standards for program trading investors using the Exchanges’ value-added market data services;
(3) Specific fee standards for high-frequency trading;
(4) Specific information reporting requirements for program trading investors under the Stock Connect regime;
(5) Abnormal trading monitoring standards specifically for program trading.
In their press release, each Exchange stated that they will further update and consolidate the existing Circulars.
We will continue to monitor the progress of the Implementation Rules and their ancillary documents and share the latest developments with our clients.
[1] The Implementation Rules released by the BSE do not address trading server co-location issues. They also propose different arrangements for the management of northbound program trading investors under the Stock Connect regime.
