United States
Hong KongElectronic trading and alternative liquidity pools
A firm that uses or provides an electronic trading system stays fully responsible for the orders it sends, whoever built the system. The SFC requires testing, capacity, reliability, security and contingency arrangements, controls over direct market access, and specific disclosure and record-keeping for alternative liquidity pools.
Outsource the technology, keep the obligation. That sentence answers a surprising proportion of the questions on this heading, and it is the reason the SFC wrote the requirements the way it did.
- Source
- SFC Code of Conduct and its schedules on electronic trading
- Core rule
- The firm remains responsible for its orders, including those generated automatically
- System expectations
- Tested, adequate capacity, reliable, secure, with contingency arrangements
- Direct market access
- Pre-trade controls, client suitability for DMA, and the ability to intervene
- Alternative liquidity pools
- Client disclosure, a user register, and restrictions on participation
What counts as electronic trading?
Broadly, any system that transmits orders electronically on the firm's behalf or on behalf of its clients. Internet trading platforms. Order management systems. Algorithmic trading engines. Direct market access arrangements where a client's order reaches the exchange through the firm's infrastructure. The regulator treats them as one family because they raise the same question: who is answerable for an order that no human individually approved?
The answer is the licensed firm. Always.
What must a firm do before switching a system on?
- Test it adequately, including before any material change, and keep records of the testing.
- Size it properly, so that capacity is sufficient for expected and reasonably foreseeable peak volumes.
- Secure it, with controls against unauthorised access and against the integrity of orders being compromised.
- Plan for failure, with contingency arrangements that let the business continue or wind down safely when the system does not.
- Keep effective records of the design, the changes and the operation of the system.
Where the system is supplied by a vendor, the firm still has to satisfy itself on each of those points. Buying software from a reputable provider is not diligence, it is procurement.
What controls does direct market access require?
Direct market access lets a client send orders to the market through the firm's connection, at speed, with no human at the broker looking at each one. The firm therefore needs controls that operate automatically and in advance.
| Control | Purpose |
|---|---|
| Client assessment | Satisfy itself the client has the knowledge and systems to use DMA responsibly |
| Pre-trade risk limits | Automated checks on order size, value, price and exposure before the order leaves |
| Filters against erroneous orders | Stop fat-finger and runaway algorithm orders reaching the market |
| Immediate intervention | The ability to suspend or cancel a client's access without delay |
| Monitoring | Real-time surveillance of order flow for market misconduct and rule breaches |
| Written agreement | Terms with the DMA client covering the firm's rights and the client's obligations |
Sub-delegation of access, where a DMA client passes the connection to its own clients, is the scenario examiners like. The firm's responsibility does not thin out as the chain gets longer, and it must know who is actually sending the orders.
What is an alternative liquidity pool?
A trading facility that matches orders away from the exchange's order book, sometimes called a dark pool because pre-trade prices are not displayed. Institutions use them to move large blocks without signalling their intentions to the wider market. The trade-off is opacity, and the SFC's requirements are aimed squarely at that.
- Tell clients that their orders may be routed to an alternative liquidity pool, and obtain their agreement.
- Maintain a user register, so the operator knows who is trading in the pool.
- Restrict participation in line with the regulatory limits on who may use these facilities.
- Give priority appropriately, without allowing proprietary flow to be advantaged over client orders.
- Keep records of orders and transactions in the pool, and report as required.
The exam-relevant contrast is with the exchange order book, where price and time priority is public and visible. Our guide to dealing in securities on SEHK covers that side.
When a stem describes a technology failure, ask who was licensed. The vendor was not. The client was not. The firm was, so the firm answers for the order. That reasoning gets you to the right option in most electronic trading questions without recalling a specific requirement.
A worked question
A licensed corporation provides direct market access to an institutional client. The client's algorithm malfunctions and floods the market with erroneous orders. Which statement is correct?
- The client is solely responsible, because it wrote and operated the algorithm
- The vendor of the firm's order management system is responsible for the failure
- The firm remains responsible for the orders and should have had pre-trade controls and the ability to intervene
- No one is responsible, provided the orders are cancelled by the exchange
How much of this is worth learning?
Less than the length of this page suggests. On our estimated split, the whole of Topic 6 is about 10 of 60 questions, and electronic trading is one heading of six within it. One careful pass, and the shortcut in the callout above, is a proportionate investment.
Where I would push back on the usual advice: this heading is often dismissed as niche, and it is not. Retail internet trading is electronic trading, so the requirements touch nearly every firm rather than only the algorithmic desks. That makes the material more intuitive than candidates expect once they stop picturing high-frequency traders and start picturing their own brokerage app. Test it in Topic 6 questions.
Common questions
Who is responsible when an electronic trading system fails?
The licensed firm. Responsibility for orders sent through its systems cannot be outsourced to a technology vendor or transferred to a client by contract. The firm must be satisfied the system is tested, has adequate capacity, is reliable and secure, and has contingency arrangements.
What is direct market access?
An arrangement letting a client send orders to the market through the firm's connection without individual manual handling. The firm must assess the client, apply automated pre-trade risk limits and error filters, monitor the order flow, and be able to suspend access immediately.
What is an alternative liquidity pool?
A facility matching orders away from the exchange order book, without displaying pre-trade prices, often called a dark pool. Operators must disclose to clients that orders may be routed there, maintain a user register, restrict who may participate, and keep proper records.
Do these requirements apply to ordinary internet trading platforms?
Yes. Any system transmitting orders electronically for the firm or its clients falls within the electronic trading requirements, so a retail online brokerage platform is covered as much as an algorithmic trading engine.
Can a firm rely on a vendor's assurance that a system is adequate?
Not on its own. The firm must satisfy itself that testing, capacity, reliability, security and contingency arrangements are adequate, and keep records showing it did. Purchasing from a reputable vendor does not discharge the obligation.