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“A Capital Market Partner Adding to Customer Value”

Comprehensive Management Plan for

Algorithmic Trading in the KRX Derivatives

Market

7.12.2013

Korea Exchange

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“A Capital Market Partner Adding to Customer Value”

I. In progress

Korea Exchange (Derivatives Development & Regulations of the Derivatives Market

Division) is opening a briefing today in order to provide its members with the latest

updates in regard to the management of algorithmic trading. It is also to avoid negative

market impacts generated by algorithmic trading errors and secure both effectiveness

and safety of the derivatives market with the comprehensive management plan designed

to prevent such abnormalities.

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“A Capital Market Partner Adding to Customer Value”

II. Summary of the comprehensive management plan

Assortment Detail Anticipated Outcome

Risk

management

of algorithmic

trading

- Register algorithmic trading

accounts to KRX

- Minimize negative market

impacts caused by abnormal

transactions due to algorithmic

trading errors

- Set the cumulative order quantity

limit

- Take advantage of ‘Kill Switch’

- Set up the automated order

cancellation system

Excessive

order

management

- Restrict receiving excessive orders - Secure stability of the exchange

derivatives system - Impose a surcharge for excessive

orders

Risk

management

of the ex-post

customer

margin

account

- Increase the management level of

risk exposure amount

- Reduce the risk that institutional

investors fail to fulfill their

settlement obligation to maintain

the ex-post customer margin

- Abolish the obligation that requires

maintenance customer margin in ex-

post customer margin accounts

※ This booklet is prepared only to assist the understanding of members on

matters related to order receipt and submission. It should be kept in mind that the

contents herein are subject to changes when the Business Regulations of KRX

Markets are amended.

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A. Risk management of algorithmic trading

1. Obligation to register algorithmic trading accounts to KRX

a. Current problem: It is nearly impossible for KRX to perform real-time monitoring

on every single automated transaction or to detect a trace of abnormal transactions in

absence of information, the account information of its members in algorithmic trading.

Currently, it is mandatory to register only market making accounts of members and ex-

post customer margin accounts to KRX.

b. Improvement: KRX becomes capable of protecting the market against negative

market impacts, such as technical glitch generated by abnormal orders due to the

algorithmic trading errors, by making use of member-submitted account information in

algorithmic trading.

Definition of ‘algorithmic trade’: ‘algorithmic trade’ is the use of electronic platforms for

entering trading orders with an algorithm which executes pre-programmed trading

instructions whose variables may include timing, price, or quantity of the order, or in

many cases initiating the order without human intervention.

Members are obliged to register algorithmic trading accounts of their own and their

customers to KRX ahead of placing an order.

* In regard to investors who trade on algorithms and manually at the same time, they are

also on the obligation to register their algorithmic trading accounts in advance.

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* Members are asked to fill in extra information such as ‘process ID’ and ‘contact

information’ for emergency use in the registration process.

Within the range of registered algorithmic trading accounts, KRX supervises all

transaction records to detect signs of abnormal orders through the monitoring system

under development.

In regard to members with unregistered algorithmic trading accounts with over 20,000

daily orders, they are required to submit a statement to prove their non-algorithmic

trading intention by the market closing time of the following day.

<Guideline for registering the algorithmic trading accounts>

Assortment Details

Applicant - Members

Object to

register

- All derivatives accounts in use for algorithmic trading (Both members’

and their customers’)

* According to the definition of ‘algorithmic trade’- ‘algorithmic trade’ is

the use of electronic platforms for entering trading orders with an

algorithm which executes pre-programmed trading instructions whose

variables may include timing, price, or quantity of the order, or in many

cases initiating the order without human intervention.

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When to

report

- It is an obligation to report to KRX in no delay whenever any change

arises regarding the status of algorithmic trading accounts as long as those

accounts are registered and valid for use.

* Members should report to KRX especially when they permanently close their

algorithmic trading accounts. By doing so the exchange derivatives system can be

relieved from burden of unnecessary workload.

How to

register

- It is required to type in the information into the exchange derivatives

system via the member derivatives system (API method)

Registration

in details

Item to register Details

Account No. of algorithmic

trade accounts

-To provide members with ‘Kill

Switch*’

Order process ID

in use for

algorithmic

trading accounts

-To provide a function called ‘Cancel on

Disconnect**’

- Provided only if it is identified as an

exclusive process

Contact Information of

a representative in charge of

algorithmic trading

- To make contact with a

representative without delay in case of

emergency

* Kill Switch: allocated to the account No. of the registered account

** Cancel on Disconnect: allocated to a registered order process ID (Introduction

of this function is subject to the test result from the Exture+ system under

development)

- An additional account code for algorithmic trading will be added to the

existing account code types.

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Account code * Current account code types

→ Customer: 31, Member: 41,

Market Making: 42, Arbitrage& Hedge: 51

How to manage

the code from

unregistered

accounts

- When the algorithmic trading account code appears from unregistered

accounts while receiving orders, it is mandated to make confirmation with

corresponding members.

→ It is not to be processed until members confirm.

- When the non-algorithmic trading account code appears from registered

accounts while receiving orders, it is mandated to make confirmation with

corresponding members.

→ Registered accounts continue to remain as algorithmic to KRX until

they are reported as permanently closed to KRX.

Statement

submission

to verify

non-algorithmic

trading intention

- KRX gives a notification to members who hold unregistered accounts

with over 20,000 daily orders (except for “trade on CME Globex” and

“negotiated trade”) after the closing of trade.

- Members are required to submit a statement to verify their non-

algorithmic trading intention until the market closing time of the

following day.

→ Members should check with their customers from the very start to see

if those customers’ intention of opening an account accords with

requirements of algorithmic trading accounts

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2. Introduction of the cumulative order quantity limit

a. Current Problem: There exists the order quantity limit now, but not enough to put

a limit on heavily accumulated orders caused by irregular duplication of individual

orders which comply with the current quantity limit per contract. (January 7th, 2013).

* Ex) the order quantity limit for KOSPI 200 futures: 1,000 contracts

b. Improvement: Members should estimate and set the cumulative order quantity

limit for their own and their customers’ ex-post margin accounts to curb orders beyond

the limit.

* Upfront initial customer margin accounts, quantities of which are already ceiled due to

adoption of the upfront initial customer margin, are exempted from adopting the

cumulative order quantity limit.

* An additional step for verifying the cumulative order quantity limit is newly added to

the existing steps for the verification by members (Regulation 65) and it applies equally

for both members and their customers.

* Members are strongly advised to set their own cumulative order quantity limit within

the scope of fixed figures** to the bid/offer* as KRX stipulates.

* It is not easy to detect irregular repetition of the bid/offer orders solely under the net cumulative

limit (Ex: 10,000 contracts of short futures + 10,000 contracts of long futures= 0)

** The cumulative order quantity limit is 7,500 Delta to the bid/offer for ex-post customer margin

accounts of algorithmic trading accounts, whereas it is 15,000 Delta to the bid/offer for ex-post

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customer margin accounts which are not in the category of algorithmic trading accounts.

* Investors, including members, are temporarily allowed to place mass orders beyond

the cumulative order quantity limit if they acquire authorization from their department

of risk management to raise the limit for a limited time.

* All records relevant to the case above should be kept in a secured storage.

<Guideline for the cumulative order quantity limit>

Assortment Details

Applicant

- Members

* It is way beyond capability of the exchange derivatives system to estimate every

cumulative order quantity limit for all derivatives accounts → individual

member systems can share the burden

Applicable

product

- KOSPI 200 Futures (incl. spread), KOSPI 200 Options

* Expected to gradually expand to all products.

Object

to verify

- Members’ own accounts and ex-post customer margin accounts

* Upfront initial customer margin accounts, quantities of which are already ceiled

due to adoption of upfront initial customer margin, are exempted from adopting

the cumulative order quantity limit.

- It is intended to check order quantities submitted to the exchange during the

order receiving hours of the regular session

* “Trade on CME Globex” and “negotiated trade” are not counted

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How to

verify

- It is newly added to the existing verification by members

- Excessive orders over the cumulative order quantity limit will be

automatically dropped off

- Members are strongly advised to set their own cumulative order quantity

limit within the scope of fixed figures to the bid/offer as KRX stipulates

- The cumulative order quantity limit is 7,500 Delta to the bid/offer for ex-post

customer margin accounts of algorithmic trading accounts

- The cumulative order quantity limit is 15,000 Delta to the bid/offer for ex-

post customer margin accounts which are not in the category of algorithmic

trading accounts.

- Investors, including members, are temporarily allowed to place mass orders

beyond the cumulative order quantity limit if they acquire authorization from

their department of risk management to raise the limit for a limited time.

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<Formula to calculate cumulative order quantities>

Assortment Remarks

Bid

∑(Order quantities from buying futures contracts +

Quantities of unmatched orders from buying futures

contracts)+

∑(Order quantities from futures SP + Quantities of

unmatched orders from futures SP)+

∑|(Order quantities of orders from buying call option +

Quantities of unmatched orders from buying call option)*

delta * the multiplier ratio|+

∑|(Order quantities from selling put option + Quantities of

unmatched orders from selling put option)* delta * the

multiplier ratio|

Offer

∑(Order quantities from selling futures contracts +

Quantities of unmatched orders from selling futures

contracts)+

∑(Order quantities from futures SP + Quantities of

unmatched orders from futures SP)+

∑|(Order quantities from selling call option + Quantities of

unmatched orders from selling call option)* delta * the

multiplier ratio|+

∑|(Order quantities from buying put option + Quantities of

unmatched orders from buying put option)* delta * the

multiplier ratio|

* KRX provides “Delta” from the previous day for the use of managing the open

interest limit

* The multiplier ratio= option trade multiplier/ futures trade multiplier

→ 1 for KOSPI 200 Products

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3. Introduction of Kill Switch

a. Current problem: The existing Exchange derivatives system does not allow

members to cancel a batch of unmatched orders or to shut down receiving orders for

each account by one click. As a consequence, the system is potentially exposed to a

huge risk of the failure to fulfill settlement because there is no safety bar to stay away

from algorithmic and systematic errors.

Assortment Current situation Problem

Order

cancellation

- Inconvenience to cancel* each

order in a separate way, not

allowing to cancel a batch of orders

at once

* The individual order No. is

required to cancel each order.

- The existing cancellation method

takes too long to cancel entire

unmatched orders if algorithmic traders

hold a multiple number of them.

Order

shut down

- The exchange is not capable of

shutting down receiving orders

from a particular account

* Yet, there is a way to block

receiving orders from a particular

member

- Unless abnormal orders are

immediately detected and properly

taken care of, it may seem unlikely to

manage the increasing size of the loss

due to algorithmic trading errors.

b. Improvement: ‘Kill Switch’ is set up for use to enable members to cancel a batch

of orders by one-click and to shut down additional orders afterwards.

* Taking advantage of ‘Kill Switch,’ members can make a quick response to an unintentional,

abnormal order by algorithmic trading errors and prepare not to repeat the unfortunate accident

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that recently happened in January 7th, 2013.

<Guideline for Kill Switch>

Assortment Details

Applicant

- Members should pass through the user-authentication process to access to the

application section for Kill Switch

- KRX cannot initiate Kill Switch without a request from its members

* It is very unlikely to discover irregular orders only with the partial information on

orders/ transactions

Applicable

object

- Algorithmic trading accounts in which an irregular activity, such as technical

glitch or error, arises.

- It cannot be initiated to unregistered algorithmic trading accounts*

* Considering the way the Kill Switch operates in the exchange system, it is strongly

advised to register to KRX in advance.

- If Kill Switch runs for every account, there arises risk to burden the exchange

system, in forms of system overload or system lag. That being said, only

registered algorithmic trading accounts to KRX are covered for operation

of Kill Switch.

* Total No. of algorithmic trading accounts: approx. 50 to 100

Total No. of entire trade accounts: approx. 30,000 to 40,000

Operating

hour

During the order receiving hours of the regular session(08:00-15:15)

How to

apply

- Apply via the Member Derivatives System (API method) or the member

derivatives terminal

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Application

process

details

- When members type in the account no. of their algorithmic trading accounts on

the system, the registration process for Kill Switch is completed.

- It is irrevocable once the application process has been completed.

* Members are responsible for initiating kill switch, therefore should be careful

enough not to freeze the well-functioning accounts by mistakes

Operation

process of

Kill

Switch

- One stop process(①+②)

① Cancel a batch of unmatched orders from the account by one click

② Automatically shut down receiving orders from the account

* It saves unnecessary inconvenience to cancel each unmatched order separately.

- It might look quite identical with the existing process to cancel an order when

it comes down to the entity who decides and proceeds the operation, but the

newly devised Kill Switch distinguishes itself from the existing as it cancels a

batch of orders at one time, not each order in a separate way.

Release of

Kill

Switch

Operation

- It is possible to stop* Kill Switch operation in 10 minutes from initiation.

* ‘Stop’ means to release an action of blocking receiving orders from the

corresponding account, reinstating the account back to the normal state.

- Initiating Kill Switch should not be abused for investment strategies. To

prevent such kind of abusive usage, it goes on to stay active at least 10

minutes for each time.

- Kill Switch operation continues to stay effecive unless there is an official

request from members.(It goes on the following day and after if not)

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4. Obligation to set up the automated order cancellation system

a. Current Problem: According to the regulations of Korea Exchange, it states no

clause mandating to set up the automated order cancellation system* in requirements**

for the member derivatives system.

* The system serves to cancel each unmatched order automatically.

→ It is not yet mandatory to serve for the purpose above although there are some members,

systems of whom are set to operate for that purpose above.

** Requirements of the member derivatives system

(Enforcement rule 117-3, Regulation 65, in the guidelines related to connection to

member derivatives system)

: It should serve to process the user authentication, protect customer’s information from

abuse, and confirm order details without delay, review order/transaction details, record

order history, reject to receive orders if necessary, verify suitability of an order, use a

separate and exclusive security device, and manage the member system directly, and so

on.

It gets to the first priority to come up with a contingency plan to cope with abnormal

orders for the time until the next generation system ‘Exture+’ debuts.

* It is on schedule to introduce ‘Exture+’ in 1st half, 2014

b. Improvement: KRX mandates each member to set up the automated order

cancellation system*.

* It will be added to the requirements for the member derivatives system

(Enforcement Rules 117-3)

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It is anticipated that it gets possible to take care of abnormal orders from members’

accounts promptly by activating Kill Switch* in cooperation with the automated order

cancellation system

* It will be provided around the time when the next generation system ‘Exture+’ comes out in

1st half, 2014

※ Comparison between the two systems

Assortment The automated order cancellation system Kill Switch

From

member to

KRX

- Automate the existing process

- Type in the order No. for cancellation

- Initiate Kill Switch on a

particular account

- Type in the account No.

Out of the

exchange

- Process each cancellation separately

(current method to cancel an order)

- Process order cancellation in

a batch by one click

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B. Excessive Order Management

1. Restriction on receiving excessive orders

a. Current problem: There exists no safety bar to restrict on receiving excessive

orders, thus undermining the potential risk that the exchange derivatives system

goes through critical technical glitch by accidentally submitted excessive orders

due to algorithmic trading errors.

* It is currently applied to the night session of the KOSPI 200 futures

“Regulation 156-2, enforcement rules 164-2”: In case where the exchange derivatives

system has failed or is expected to fail due to influx of excessive orders or it is

necessary for the market management, the Exchange may not accept a part or all orders

placed by the concerned member

AVG No. of orders for the previous 3 seconds > 750 orders

- Refuse to receive orders except those for cancellation

AVG No. of orders for the previous 3 seconds > 1,000 orders

- Refuse to receive all orders without exception

* It raises a concern about the system break-down due to influx of excessive orders under

the asynchronous Exture+ system which processes higher volume of orders than the

current system does.

b. Improvement: It gets to refuse acceptance of excessive orders in case of system

break-down or errors due to influx of excessive orders.

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< Guideline for refusal to receive excessive orders>

Step Details

1

In case where it comes to go beyond the excessive order quantity limit

→ Members are obliged to control the interval of order submission immediately after

the exchange’s notification

2 In case where it exceeds the excessive order quantity limit

→ The exchange refuse to receive orders from the corresponding account

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In case where it comes to exceed the maximum order receipt limit of the entire exchange

derivatives system

→ The exchange immediately shuts down the whole trade operation of a particular

product for which excessive orders are submitted. (Ex: Index option)

→ Operation designed for the trading safety of members is scheduled to be in enforcement by the time

the development of the ‘Exture+’ system is completed.

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2. Impose a surcharge for excessive orders

a. Current Problem: A large number of orders by algorithmic trading continuously

burden the exchange derivatives system, generating an increasing number of unmatched

orders as a consequence. Therefore, It is essential to avoid such ineffectiveness and to

impose* a surcharge on excessive orders.

* It seems more reasonable that a member, who trades more on a frequent basis within the

exchange derivatives system, pays more for maintenance of the system.

b. Improvement: KRX imposes a surcharge on accounts where appear to put out

excessive orders for KOSPI 200 futures/ option products depending on a degree of

contribution to the exchange derivatives system.

<Brief guideline for imposing a surcharge for excessive orders>

Assortment Details

Object

KOSPI 200 futures (incl. futures spread)/ option product

* except for “trade on CME Globex” and “negotiated trade”

The market making accounts are exempted if they belong to market making

products

* It is not applicable for KOSPI 200 futures/ option products since they are not in

the category of market making products.

All accounts meeting the standards in both quantity and quality

① Quantity Standard: Total No. of orders per day≥ 20,000

② Quality Standard: The ratio, No. of orders to Trading Volume of orders, is

higher than 20:1 or 10:1 depending on the No. of orders

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Imposing

standard

◆ Accounts with No. of orders < 20,000 – Not Applied

◆ Accounts with No. of orders ≥ 20,000

< 100,000

→ The ratio of the accounts ≥ 20:1 – Applied

◆ Account with orders ≥ 100,000

→ The ratio of the accounts ≥ 10:1 – Applied

Assortment

No. of orders

Trading Volume of orders (Quality)

<10:1 10:1-20:1 ≥ 20:1 ∞

No. of

Orders

(Quantity)

<20,000 N/A N/A N/A N/A

20,000-

100,000

N/A N/A Applied Applied

≥100,000 N/A Applied Applied Applied

FEE Amount Flat Fee, KRW 1,000,000 per day* for each product

* Fee waivers up to two times a month may be applicable unless the ratio

(No. of orders to Trading Volume of orders) doesn’t exceed five times the

applicable standard ratio (thus, less than either 100:1 or 50:1)

Purpose Only for the purpose of contribution to improve of the exchange derivatives

system

Payment A member, who receives a bill from the exchange on the transaction date (T-

day), should make payment within 2days (T+2) from the day.

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C. Risk Management of the ex-post customer margin account

1. Increase the management level for risk exposure amount

a. Current problem: It is urgent to fortify management level for risk exposure

amount of ex-post customer margin accounts, not to repeat committing the very

same accident caused by algorithmic trading errors in January 7th, 2013

* Originally, management for risk exposure amount of the ex-post customer margin account

was first introduced in March 28th, 2011 to protect a member from a risk of the failure to

fulfill the settlement obligation after the option shock (November 11th, 2010) arose.

Assortment Status Problem

Limit on

risk exposure

amount

- Members are required to set the

risk exposure limit lower than 10

times of the total depository.

- The current level of the limit is too

high and broad to prevent a risk of

the failure to fulfill the settlement

obligation when the algorithmic

trading errors arise.

Measurement

Over the limit

- Within an hour members should

request their customers to lower

risk exposure amount voluntarily.

- If it is not resolved yet, members

should balance the exceeding

amount by either applying upfront

- It is currently given a certain

duration of time to resolve a problem

on their own for the convenience of

qualified institutional investors.

- However, it turns out ineffective in

dealing with emergency quickly

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initial margin or performing an

opposite transaction.

because of the risks of delay and

abusive usage by some institutional

investors

b. Improvement: It gets to increase the management level of risk exposure amount in

ex-post customer margin accounts by lowering and narrowing its risk exposure

limit and stopping receiving orders without delay.

Lower the risk exposure limit below 5 times of the total depository.

In case of the excess over the limit, it immediately blocks receiving orders from

customers without offering a time to resolve a problem on their own

- But, exception may be applicable to receive orders in case of lowering risk exposure

amount.

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2. Abolish the obligation that requires maintenance customer margin in ex-

post customer margin accounts

a. Current Problem: It is necessary to trim the method to yield customer margin of

the ex-post customer margin account so as not to provoke investors’

misunderstanding because of its high level of complication.

<Current method to find customer margin of ex-post customer margin accounts>

Object

Customer

margin

Deposit

Deadline

Domestic

qualified

institutional

investors

Foreign

qualified

institutional

investors

The account

with new trade

on the day*

Calculate and

apply ex-post

customer

margin

Until 10 AM*** Open for trade Open for trade

From 10 AM Closed Closed unless it

is the public

holiday of

overseas banks

or submitted

with a copy of

the payment

instruction

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The account

without trade

or only with

offsetting

trade**

Calculate and

apply additional

customer margin

Until 12 PM

Closed until additional customer

margin is paid or the position is

closed out by reverse dealing

From 12 PM

* Enforcement rules 146(Deposit of Ex-post Customer Margin), 148(-post Cash Deposit

Requirement)

** Enforcement rules 150(in Total Deposit), 151(Shortfall in Cash Deposit)

*** Anytime as members select prior to 10AM of the day or the following day

Status problem

Assortment by

characteristics of

trade

- It is much beneficial to take advantage of the benefit by dividing into

ex-post/maintenance customer margin depending on types of orders

- It doesn’t seem rational to adapt ex-post customer margin to a new

trade from investors holding a multiple number of open interests.

Level of

understanding

about the

obligation

- There arises a frequent dispute between members and institutional

investors because an order is not processed when maintenance customer

margin is low. Most institutional investors often misunderstand that only

ex-post customer margin is applied to ex-post customer margin

accounts. But in fact, maintenance customer margin is applied too.

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b. Improvement: For ex-post customer margin accounts, only ex-post customer

margin is applied, which means keeping maintenance customer margin is not required

anymore.

Qualified institutional investors are only asked to pay ex-post customer margin until

10AM of the following day, minimizing confusion among members and investors.

It should not be burdensome since most qualified institutional investors retain enough

amounts of substitute securities more than required margin.

< Modified way to find the customer margin of the ex-post customer margin accounts>

Object

Customer

margin

Deadline

Domestic qualified

institutional

investors

Foreign qualified

institutional investors

All ex-post

customer

margin

accounts

Calculate

and apply

ex-post

customer

margin

Until

10AM*

Open for trade Open for trade

From

10AM*

Closed Closed unless it is the public

holiday of overseas banks or

submitted with a copy of the

payment instruction

* Anytime as members select prior to 10AM of the day or the following day

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“A Capital Market Partner Adding to Customer Value”

III. Future Plans

<Scheduled enforcement dates of the management plan for algorithmic trading>

Assortment Detail Scheduled date

Risk

management

of

algorithmic

trading

- Register algorithmic trading accounts to KRX Sep. 30th, 2013

- Set the cumulative order quantity limit Sep. 30th, 2013

- Take advantage of ‘Kill Switch’

1st half, 2014

(Estimated

operational date of

‘Exture+’)

- Set up the automated order cancellation system Sep.30th, 2013

Excessive

order

management

- Restrict receiving excessive orders

1st half, 2014

(Estimated

operational date of

‘Exture+’)

- Impose a surcharge for excessive orders Sep.30th, 2013

Risk

management

of the ex-

post

customer

margin

account

- Increase management level of the risk exposure

amount

Sep.30th, 2013

- Abolish the obligation that requires maintenance

customer margin in ex-post customer margin accounts

Sep.30th, 2013