A Capital Market Partner Adding to Customer Value

The Comprehensive Management Plan for Algorithmic Trading in the KRX Derivatives Market

04.29.2013

The Korea Exchange

Announcement
This booklet is published for the briefing held in Seoul in April 29th, 2013 for the business staff and IT developers who work for the derivatives members of the Korea Exchange.
* It is scheduled to distribute this document to the participants email addresses from the submitted business cards when the briefing is over. If there are any members excluded from receiving this document, feel free to contact the department of the Derivatives Development & Regulations by sending a request to [email protected].

This proposal is not yet to be finalized, therefore subjected to any potential changes to be made in consideration for members, investors, and the financial authorities. In regard to any revisions to be made in this proposal, the Korea Exchange will be in contact with each of its members by notification or briefing.

The Korea Exchange always cares for voices of its members. If there is a member who likes to leave a comment on the proposal inside, please be sure to submit before the deadline, May 3rd, 2013, to the department of the Derivatives Development & Regulations. Please include the following information along with your comment. Name Comment on the proposal Comment on the enforcement date Etc. * Recipient: the department of the Derivatives Development & Regulation ([email protected])

A Capital Market Partner Adding to Customer Value

I. In progress
The Korea Exchange (the Derivatives Development & Regulations of the Derivatives Market Division) is opening this briefing in order to provide its members with the latest updates regarding 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 a comprehensive management plan designed to prevent such abnormalities. Through this briefing as a cornerstone, the Korea Exchange is expecting to create a meaningful opportunity to listen to members opinions.

After the briefing, the Korea Exchange plans to finalize amending the derivatives market regulation once a review process with the financial authorities has been completed and to improve the system.

A Capital Market Partner Adding to Customer Value

II. Summary of the comprehensive management plan

Assortment Detail - Register the algorithmic trading Risk management of algorithmic trading accounts to KRX - Set the cumulative order quantity - Minimize the negative market limit - Take advantage of the Kill Switch Operate the automated impacts due to abnormal Anticipated Outcome

transactions by the algorithmic

order trading errors

cancellation system Excessive order management Risk management of the ex-post customer margin account - Restrict receiving excessive orders - Impose an extra service charge for - Secure the stability of the excessive orders - Increase the management level of the risk exposure amount - Reduce the risk that institutional exchange derivatives system

- Abolish the duty that requires the investors fail to fulfill their maintenance customer margin in the settlement obligation to maintain ex-post customer margin accounts the ex-post customer margin

This booklet is prepared to assist the understanding of members on matters related to order receipt and submission. It should be kept in mind that the contents herein can change when the Business Regulations of KRX Markets are amended.

A. Risk management of algorithmic trading

1. Duty to register the algorithmic trading accounts to KRX

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

on every automated transaction or to detect traces of abnormal transactions in absence of the information, members account information in algorithmic trading.

Currently, it is mandatory to register only the market making accounts of members and the ex-post customer margin accounts to KRX.

b. Improvement: KRX becomes capable of shielding the market against the negative
market impacts, such as a technical glitch generated by abnormal orders due to the algorithmic trading errors, by making use of the 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 strongly required to register the algorithmic trading accounts of their own and their customers to KRX before placing an order.

* In regard to investors who trade on algorithms and manually at the same time, they are also on duty to register their algorithmic trading accounts in advance.

* Members are asked to fill in extra information such as process ID and contact information for emergency use in the registration process.

Within the extent of the registered algorithmic trading accounts, KRX is going to monitor all transaction records to detect signs of abnormal orders through the monitoring system under development.

In regard to members with the unregistered algorithmic trading accounts with over 20,000 daily orders, they are strongly advised to submit a statement to prove their nonalgorithmic trading action by the market closing time of the following day.

<Guideline of registering the algorithmic trading accounts>

Assortment Applicant - Members - All the derivatives accounts in use for algorithmic trading (Both members and their customers) Object to register * 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. - It is required to report to KRX without delay whenever there is any Details

change on the status of the algorithmic trading accounts as long as those When to report
* Members should report to KRX especially when they permanently close their algorithmic trading accounts. By doing so the exchange derivatives system can reduce burden of unnecessary workload.

accounts are registered and valid for use.

How to register

- It is required to input the information into the exchange derivatives system using the member derivatives system (API method) Item to register Account No. of the algorithmic trade accounts Order process ID in use for -To provide the function called Cancel on Disconnect** - Provided only if it is an exclusive process To make contact without with delay the in Details -To provide members with the Kill Switch*

Registration in details

The algorithmic trading accounts Contact Information of The representative in charge of algorithmic trading

representative emergency

* Kill Switch: allocated to the account No. of the registered account ** Cancel on Disconnect: allocated to the 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 current account code types.

Account code

* Current account code types Customer: 31, Member: 41, Market Making: 42, Arbitrage& Hedge: 51

- When the algorithmic trading account code appears from the unregistered accounts while receiving orders, it is necessary to make How to process the code from unregistered accounts - When the non-algorithmic trading account code appears from the registered accounts while receiving orders, it is necessary to make confirmation with the corresponding members. The registered accounts continuously remain algorithmic to KRX until they are reported permanently closed to KRX. - KRX gives a notification to members who hold the unregistered Statement submission to prove non-algorithmic trading action - Members are required to submit a statement to prove their nonalgorithmic trading action by 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 matches with the requirements of algorithmic trading accounts accounts with over 20,000 daily orders (except for the trade on CME Globex and the negotiated trade) after the closing of trade. confirmation with the corresponding members. It is not to be processed until members confirm the fact.

2. Introduction of the cumulative order quantity limit

a. Current Problem: There exists the order quantity limit, but no safety net to put a
cap on the heavily accumulated orders caused by irregular duplication of individual orders which comply with the quantity limit per contract though. (January 7th, 2013).
* Ex) the order quantity limit for KOSPI 200 futures: 1,000 contracts

b. Improvement: Members should estimate and then input their cumulative order
quantity limit for their own and their customers ex-post margin accounts to curb orders beyond the limit.

* The 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 goes equal for both members and their customers.

* Members are entitled to set their own cumulative order quantity limit within the scope of the fixed figures** to the long/short* as KRX stipulates.
* It is not easy to detect irregular repetition of the long/ short 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 long/short for the ex-post customer margin accounts of the algorithmic trading accounts, whereas it is 15,000 Delta to the long/short for the ex-post customer margin accounts which are not in the category of the algorithmic trading

accounts.

* Investors, including members, are temporarily allowed to place mass orders beyond the cumulative order quantity limit if they acquire an authorization from the department of the risk management of their own to raise the limit for a short time. * All records relevant to the case above should be kept in a secured storage.

<Guideline of the cumulative order quantity limit>

Assortment - Members Applicant
* It is way beyond the capability of the exchange derivatives system to estimate every cumulative order quantity limit for all the derivatives accounts each system of members can share the burden

Details

Applicable product

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

* Expected to be gradually expanded to all products.

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

* The upfront initial customer margin accounts, quantities of which are already ceiled due to adoption of the upfront initial customer margin, are exempted from

Object to verify

adopting the cumulative order quantity limit.

- It intends to verify the order quantities which are set to be placed during the order receiving hours of the regular session
* The trade on CME Globex and the negotiated trade are not counted

- It is newly added to the existing verification by members

- Excessive orders over the cumulative order quantity limit will be automatically dropped

- Members are entitled to set their own cumulative order quantity limit within the scope of the fixed figures to the long/short as KRX stipulates. How to verify - The cumulative order quantity limit is 7,500 Delta to the long/short for the ex-post customer margin accounts of the algorithmic trading accounts

- The cumulative order quantity limit is 15,000 Delta to the long/short for the ex-post customer margin accounts which are not in the category of the algorithmic trading accounts.

- Investors, including members, are temporarily allowed to place mass orders beyond the cumulative order quantity limit if they acquire an authorization from the department of the risk management of their own to raise the limit for a short time.

<Formula to calculate the cumulative order quantities>

Assortment

Remarks (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)+

Long

|(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| (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)+

Short

|(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 use of managing the open interest limit * The multiplier ratio= option trade multiplier/ futures trade multiplier 1 for KOSPI 200 Products

3. Introduction of the 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 per account by one click. As a consequence, the system is potentially exposed to the huge risk of failure to fulfill settlement because there is no fence to stay away from algorithmic and systematic errors.
Assortment Current situation - Inconvenience to cancel* each Order cancellation order in a separate way, not - The existing cancellation method allowing to cancel a batch of orders takes at once too long to cancel entire Problem

unmatched orders if algorithmic traders

* The individual order No. is hold a multiple number of them. required to cancel each order. - The exchange is not capable of Order shut down Unless abnormal orders are

shutting down receiving orders immediately detected and taken care of, from a particular account it is unavoidable to skyrocket the size

* Yet, there is a way to block of the loss due to the algorithmic receiving orders from a particular trading errors. member

b. Improvement: The Kill Switch is set out for use to enable members to cancel a
batch of orders by one-click and to shut down additional orders afterwards.
* Taking advantage of the Kill Switch, members can make a quick response to an unintended, abnormal order by the algorithmic trading errors and prepare not to repeat the unfortunate accident that recently happened in January 7th, 2013.

<Guideline of the Kill Switch>

Assortment Details - Members should pass through the user-authentication process to access to the Applicant application section for the Kill Switch - KRX cannot initiate the Kill Switch without a request from its members
* It is very unlikely to discover irregular orders only with the partial information about orders/ transactions

- The algorithmic trading accounts in which an irregular activity, such as a technical glitch or an error, arises. - It cannot be initiated to the unregistered algorithmic trading accounts Applicable object
* Due to the way the Kill Switch operates in the exchange system, it is strongly required to register to KRX in advance.

- If the Kill Switch is in operation for every account, there arises risk to burden the exchange system, in forms of system overload or system lag. For that reason, only the registered algorithmic trading accounts to KRX are covered for operation of the Kill Switch.
* Total No. of the algorithmic trading accounts: approx. 50 to 100 Total No. of the entire trade accounts: approx. 30,000 to 40,000

Operating hour How to apply

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

- Apply through the Member Derivatives System (API method) or the member derivatives terminal - When members input the account no. of their algorithmic trading accounts on

Application process details

the system, the registration process for the Kill Switch is completed. - It is irrevocable once the application process has been completed.
* Members are responsible for initiating the kill switch, therefore should be careful enough not to freeze the well-functioning accounts by mistake

- One stop process(+) Cancel a batch of unmatched orders from the account by one click Operation process of the Kill Switch Automatically shut down receiving orders from the account
* It saves the 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. - It is possible to stop* the Kill Switch operation in 10 minutes from the initiation.

Release of the Kill Switch Operation

* Stop means to release an action of blocking receiving orders from the corresponding account, getting the account back to the normal state.

- Initiating the Kill Switch should not be abused for the purpose of investment strategies. To avoid such kind of abusive usage, it continues to stay active at least 10 minutes for each time.

- The Kill Switch operation continues to be valid unless there is an official request from members.(It goes on the following day and after if not)

4. The duty to operate the automated order cancellation system

a. Current Problem: According to the regulations of the Korea Exchange, there

exists no clause about mandating to operate the automated order cancellation system* in the 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, the 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 customers 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 becomes the first priority to come up with a contingency plan to cope with abnormal orders for the time being until the next generation system Exture+ debuts.
* It is on schedule to introduce Exture+ in Feb, 2014

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

cancellation system*.
* It is planned to be included in the requirements for the member derivatives system (Enforcement Rules 117-3)

It is anticipated that it becomes possible to take care of any abnormal orders from

members accounts promptly by activating the 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 Feb, 2014

Comparison between the two systems

Assortment From member to KRX Out of the exchange - Input the order No. for cancellation - Process each cancellation separately (the current method to cancel an order) The automated order cancellation system - Automate the existing process The Kill Switch - Initiate the Kill Switch on a particular account - Input the account No. - Process order cancellation a batch by one click in

B. Excessive Order Management

1. Restriction on receiving excessive orders

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

orders, undermining the potential risk that the exchange derivatives system goes through a critical technical glitch due to excessive orders accidentally submitted by the 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 order 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 the higher volume of orders than the current system does.

b. Improvement: It becomes possible to refuse acceptance of excessive orders in

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

< Guideline for refusing to receive excessive orders>

Step

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

Members are obliged to control the interval of order submission immediately after the exchange notifies them.

In case where it exceeds the excessive order quantity limit The exchange refuse to receive orders from the corresponding account In case where it seems to exceed the maximum order receipt limit of the entire exchange

derivatives system The exchange immediately shuts down the whole trade operation for 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.

2. Impose an extra service charge for excessive orders

a. Current Problem: Due to a large number of orders by algorithmic trading, it

simultaneously burdens the exchange derivatives system, consequently generating an increasing number of the unmatched orders. Therefore, It is essential to avoid such ineffectiveness and to impose* an extra service charge on excessive orders.
* It seems more reasonable that the member, who trades on a frequent basis within the exchange derivatives system, pays more for maintenance of the system.

b. Improvement: KRX imposes an extra service charge on the accounts where appear
to put out excessive orders for the KOSPI 200 futures/ option products depending on a degree of contribution to the exchange derivatives system.

<Brief guideline of imposing the service charge for excessive orders>

Assortment Details KOSPI 200 futures (incl. futures spread)/ option product
* except for the trade on CME Globex and the negotiated trade

Object

The market making accounts are exempted if they belong to the market making products
* It is not applicable for the KOSPI 200 futures/ option product since it is not in the category of the market making products.

All accounts meeting the standards in both quantity and quality Quantity Standard: Total No. of orders per day 20,000 Quality Standard: The ratio, No. of orders: Trading Volume of orders, is higher than 20:1 or 10:1 depending on the No. of orders The accounts with No. of orders < 20,000 Not Applied The accounts with No. of orders 20,000

Imposing standard

< 100,000 The ratio of the accounts 20:1 The account with orders 100,000 The ratio of the accounts 10:1 Applied No. of orders Assortment Trading Volume of orders (Quality) <10:1 <20,000 No. of 20,000Orders 100,000 (Quantity) 100,000 N/A Applied Applied Applied N/A N/A Applied Applied N/A 10:1-20:1 N/A 20:1 N/A N/A Applied

F E E

Amount For use

The fixed cost, KRW 1,000,000 per month Only for improvement of the exchange derivatives system

Payment

A member, who receives a bill from the exchange on the transaction date (Tday), should make payment within 2days (T+2) from the day.

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

1. Increase the management level for the risk exposure amount

a. Current problem: It is urgent to raise the management level for the risk exposure
amount of the ex-post customer margin accounts, not to repeat committing the very same accident caused by the algorithmic trading errors in January 7th, 2013
* Originally, management for the risk exposure amount of the ex-post customer margin account was first introduced in March 28th, 2011 to protect members from the risk of failure to fulfill the settlement obligation after the option shock (November 11th, 2010) arose.

Assortment

Status

Problem - The current level of the limit is too

Limit on the risk exposure amount

- Members are required to set the high and broad to prevent the risk of risk exposure limit lower than 10 failure times of the total depository. to fulfill when the the settlement algorithmic

obligation

trading errors arise. - Within an hour members should - It is currently given a certain request their customers to lower the duration of time to resolve a problem risk exposure amount voluntarily. Measurement Over the limit - If it is not settled yet, members should balance the exceeding - However, it turns out ineffective in on their own for convenience of the qualified institutional investors.

amount by either applying the deal with emergency quickly because upfront initial margin or performing there exist the risks of delay and

an opposite transaction.

abusive usage by some institutional investors

b. Improvement: It is meant to increase the management level of the risk exposure

amount in the 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 settle down a problem on their own - But, It is exceptionally allowed to receive orders to lower the risk exposure amount.

2. Abolish the duty that requires the maintenance customer margin in the ex-post customer margin accounts

a. Current Problem: It needs to trim the way to find the customer margin of the expost customer margin account so as not to provoke investors misunderstanding because of its highly complicated method.

<Current method to find the customer margin of the ex-post customer margin accounts> The domestic Object The customer margin Deposit Deadline qualified institutional investors Until 10 AM*** From 10 AM The account with a new trade on the day* Calculate and Open for trade Closed The foreign qualified institutional investors Open for trade Closed unless it is the public of banks

apply the ex-post customer margin

holiday overseas or

submitted

with a copy of the payment

instruction The account without a trade or only with an Calculate apply additional and Until 12 PM the From 12 PM Closed until the additional customer margin is paid or the position is

offsetting trade**

customer margin

closed out by reverse dealing

* 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 - It is not clear enough to realize the benefit of dividing into the ex-

Assortment by characteristics of a trade

post/maintenance customer margin according to the types of orders - It is not considered rational to adapt the ex-post customer margin to a new trade from the investors holding a multiple number of the open interests. - There arises a frequent dispute between members and institutional

Level of understanding about the duty

investors because an order is not to be processed when the maintenance customer margin is not enough. Most institutional investors

misunderstand that only the ex-post customer margin is adapted to the ex-post customer margin accounts. But in fact, the maintenance customer margin is adapted to it as well.

b. Improvement: For the ex-post customer margin accounts, only the ex-post
customer margin is applied, which means keeping the maintenance customer margin is not required anymore.

The qualified institutional investors are only asked to pay the ex-post customer margin by 10AM of the following day, minimizing confusion among members and investors.

It should be hardly burdensome since most of the qualified institutional investors retain enough amounts of substitute securities more than the required margin.

< Modified way to find the customer margin of the ex-post customer margin accounts> The Object Customer margin Deadline The domestic qualified institutional investors Until All the ex- Calculate post customer margin accounts and 10AM* Closed Closed unless it is the public holiday of overseas banks or submitted with a copy of the payment instruction Open for trade Open for trade The foreign qualified institutional investors

apply From the ex-post 10AM* customer margin

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

A Capital Market Partner Adding to Customer Value

III. Future Plans

There will be an opportunity to share opinions in May, 2013 In May, 2013

<The scheduled enforcement dates of the management plan for algorithmic trading> Assortment Detail - Register the algorithmic trading accounts to KRX - Set the cumulative order quantity limit Risk management of algorithmic trading Exture+) - Operate the automated order cancellation system Sep.30th, 2013 Feb. 3rd, 2014 Excessive order management Exture+) - Impose an extra service charge for excessive orders Risk management of the expost customer margin account customer margin in the ex-post customer margin accounts June. 24th, 2013 amount - Abolish the duty that requires the maintenance - Increase the management level of the risk exposure Sep.30th, 2013 June. 24th, 2013 - Restrict receiving excessive orders (The estimated operational date of - Take advantage of the Kill Switch (The estimated operational date of The scheduled date Sep. 30th, 2013 Sep. 30th, 2013 Feb. 3rd, 2014