Japan: Regulatory Trends In Japan On High-Speed Algorithmic Trading

Last Updated: 10 February 2017
Article by Mitsutoshi Uchida and Daisuke Niwa

INTRODUCTION

On December 22, 2016, the Financial Services Agency of Japan (the "FSA") published a report summarized by the Working Group on Financial Markets of the Financial System Council, titled "Report of Working Group on Financial Markets – Promotion of Stable Asset Formation by Japanese Citizens and Development of Market / Exchange Systems" (the "Report"), and indicated its policy to introduce a registration system for investors who conduct "high-speed algorithmic trading". The bill for amendment of the Financial Instruments and Exchange Act (the "Act") incorporating such policy is expected to be submitted to the Diet at the current ordinary session, which convened on January 20, 2017.

REGULATORY TRENDS IN JAPAN

Based on the market situation of high-speed algorithmic trading and trends in Europe and the United States, the Report recommends developing various frameworks of rules in connection with high-speed algorithmic trading.

Introduction of Registration System & Various Measures

The Report first recommends introducing a registration system for investors who conduct high-speed algorithmic trading and, after imposing a duty to develop necessary systems and manage risks, developing the framework as shown below to enable the regulators to verify their actual trading conditions and strategies.

In light of details of the discussions in the Working Group on Financial Markets, the specific content of the framework to be developed is expected to be as follows:

Of "1. Measures for System Development and Risk Management" listed above, as "(i) Proper management and operation of trading system," for example, it would likely be required that the trading system have an adequate processing capacity, that the trading system be tested and monitored, and that measures be taken to prevent erroneous orders. Further, of "(ii) Appropriate operation system and sound financial basis," as "appropriate operation system," it would likely be required that personnel structure be secured by having persons with knowledge, etc., necessary to conduct high-speed algorithmic trading and hiring persons responsible for compliance, and that internal control be secured by formulating internal rules and implementing trainings for employees. Likewise, as for "sound financial basis," it would likely be required that some sort of financial restrictions and measures to secure eligibility of major shareholders are respectively put in place.

Of "2. Measures for Notification and Provision of Information" listed above, it is not clear how detailed in "(iii) Filing of algorithm trading strategy" the regulators must be apprised of trading strategies. We would need to wait for further announcements of bills, etc., to determine, for example, whether it is sufficient to simply file a notification of "market making," "arbitrage," "discretional," etc., or whether a more detailed explanation of strategy would be required, such as in the case of "arbitrage," what kind of price difference are being sought as arbitrage, or in the case of "discretional," what type of stock price fluctuations is predicted and observed for profit-making.

Measures to Ensure the Effective Enforcement of the Regulations on Overseas Investors

The Report also recommends that, in introducing rules for investors engaged in high-speed algorithmic trading, the following measures should be implemented, noting that it is necessary to ensure the effective enforcement of the rules on investors based overseas.

In light of the background to the argument in the Working Group on Financial Markets, we can say as follows with regard to the specific details of the measures to be implemented.

In "1. Measures regarding securities brokerage firms" listed above, securities firms will be prohibited from undertaking high-speed algorithmic trading for certain investors. While it will be relatively easy for securities firms to get to know who is an unregistered investor engaged in high-speed algorithmic trading, their burden is expected to increase in checking whether or not their customers have in place appropriate systems and risk controls for high-speed algorithmic trading. Meanwhile, it is unlikely that criminal penalties against unregistered investors engaged in high-speed algorithmic trading will be introduced.

One option discussed in "2. Measures regarding investors based overseas" listed above was for these investors to be required to establish a domestic base within Japan. There were, however, opinions that while securities markets in the world are already conducting operations in three major time zones—Singapore, London, and New York—the burden would be too heavy if investors were required to set up another base in Asia, which, as a result, may keep investors out of Japanese securities market. Eventually, it was decided merely to require that investors place a representative / agent in Japan.

Grant of Investigative Authority to Exchanges

Furthermore, the Report found that in order to ensure the effective enforcement of the rules, it would be appropriate to enable exchanges, who are closest to the markets as the operators of the trading system, to investigate investors engaged in high-speed algorithmic trading.

In general, institutional investors, including HFT (high frequency trading) firms, place orders with multiple securities firms for many purposes, such as increasing potential allocation, paying commissions fairly, and avoiding operational risks due to system failures. As such, it is difficult for a single securities firm to get a complete view of those orders. After the amendment of the Act this time, it is hoped that the exchanges would learn the identity of the firms based on their allocated IDs and also promptly get a full picture of the orders, which would hopefully increase the transparency of the trading activities.

ASSESSMENT

Foreign government authorities are developing new regulations as HFT firms dominate securities markets around the world. If against this backdrop only Japan does nothing, bad faith investors may exploit the regulatory loopholes, which as a result may inhibit sound asset formation of general investors, pension funds, and others. The measures to be taken by the amendment of the Act this time are expected to serve as equivalent to regulations that are scheduled to take effect in Europe and the United States. We think that the FSA's prompt action this time deserves recognition, especially from the standpoint of securing a level playing field.

The greatest challenge in the recommendations in the Report would be the fact that the definition of the term "high-speed algorithmic trading" is not necessarily clarified in the first place, and so it is not clear who will be subject to the regulations, including the introduction of the registration system—would all investors placing orders from a collocation area in an exchange as a rule be subject to the regulations; would such regulations only target investors engaged in trading of a certain quantity, frequency, volume, and the like; and would the duty to register be imposed upon investors not placing orders from such collocation area but who are engaged in trading using algorithms? HFT firms should, without delay, make preparations to apply for registration, keeping a close eye on future law amendments and trends in implementation of procedures regarding public comments.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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