October 3, 1997
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Attention: Mr. Jonathan G. Katz, Secretary
Re: SEC File No. S7-16-97
Ladies and Gentlemen:
Bloomberg L.P. appreciates the opportunity to comment on the Commission's Concept Release on Exchange Regulation, Securities Exchange Act Release No. 38672 (May 23, 1997). Implementation of the policies suggested by the Release would affect Bloomberg's business and therefore we take a special interest in the matters discussed and suggested.
Bloomberg is engaged in the business of providing its customers with financial market information, news and analytics via its worldwide electronic network (the "BLOOMBERG service"). Bloomberg also services its broker-dealer and institutional customers' communications needs and facilitates their transaction of business by offering various additional services, including electronic messaging, non-anonymous offerings, bids wanted and Financial Information Exchange-protocol ("FIX") equity order-routing and indications of interest. More than one and a half million text messages and several billions of dollars of securities transaction messages are sent and received by Bloomberg customers across the BLOOMBERG service every business day.
As the Commission knows, under the current regulatory framework, alternative trading systems ("ATSs") for equity securities generally have had to organize as broker-dealers. For that reason, when Bloomberg established a proprietary electronic anonymous trading system (the "Tradebook System") in 1996, we organized a broker-dealer subsidiary, Bloomberg Tradebook LLC ("Tradebook"). Tradebook registered with the Commission and joined the National Association of Securities Dealers, Inc. (the "NASD"). Bloomberg and Tradebook also contracted with two unrelated parties to provide execution and clearing services to the Tradebook System: B-Trade Services LLC ("B-Trade Services"), an affiliate of ESI Securities Company ("ESI"), executes trades of the Tradebook System and ESI clears and settles the trades.
Through the Tradebook System, Bloomberg offers its institutional and broker-dealer customers, and other broker-dealers that access the Tradebook System via SelectNet, the opportunity to buy and sell equity securities via the BLOOMBERG service. Within the United States, Bloomberg also provides its customers with access to the Arizona Stock Exchange. Outside the United States, Bloomberg provides to institutional customers and others the ability over the BLOOMBERG service to trade on Tradepoint Investment Exchange. 1 In addition, we expect in the future to provide access to additional points of liquidity as customer demand dictates.
Since it has always been Bloomberg's intention that Tradebook not engage in traditional brokerage business, but rather act as a broker-dealer for limited ATS purposes, Bloomberg is open to suggestions about changes to the regulatory structure of ATSs. If the Commission revises the current regulatory framework to better suit the types of services ATSs provide, and to do so without restricting the ability of ATSs to compete aggressively with other economically similar service providers, it would not particularly matter to Bloomberg whether Tradebook is called an exchange or a broker-dealer.
General overview. The Commission's focus on the issues presented in the Release is timely, well needed and appropriate. Technology and the growth of electronic markets have changed the trading landscape irreversibly. The Commission is absolutely right to raise to public debate questions about whether its regulation should be revised, even substantially, in response. To a large degree, the reputation of the U.S. securities markets for reliability and fairness is a direct result of the Congress's legislation, and the Commission's regulation and surveillance of the markets and market participants during the six decades since the enactment of the Securities Act of 1933 (the "Securities Act") and the Securities Exchange Act of 1934 (the "Exchange Act"). Regulatory initiatives to combat abuse have helped to provide an environment in which market forces have cultivated efficiency and innovation in the financial markets and in related services.
The Commission's recent adoption and implementation of the Order Execution Rules 2 have had a dramatic effect on the markets. By requiring greater transparency and integration of and greater access to the public and private markets, the Order Execution Rules appear to have rapidly achieved their direct intended result: better order execution for customers.
An unanticipated, ancillary benefit to the Order Execution Rules has been the unleashing of new competitive forces in the market relating to ATSs. The new rules allow a complying electronic communications network ("ECN"), which is a type of ATS, 3 to publish its best prices for Nasdaq securities in the Nasdaq quotation so that these prices may be available to all investors. We understand that this opportunity for new ATSs to widely disseminate their quotations and receive order flow from NASD members has lowered the principal barrier to entry and encouraged several new competitors to enter the ATS field. While there is some evidence that market makers may be reducing the numbers of stocks in which they will make markets, in the main the new requirements have been beneficial to investors since they have promoted market efficiency and given the public better trade executions.
As a result of the Order Execution Rules, for example, the Tradebook System's "top of the file" is a matter of public record on Nasdaq (except where non-market makers themselves, in entering orders directly into the Tradebook System, have opted that their orders not be displayed, as permitted under the Order Execution Rules) and can be accessed via SelectNet by all NASD members on the same basis as is available to Tradebook participants.
One question the Commission faces is whether, and to what extent, to regulate market structure by affirmative Commission regulation and when, and to what extent, to allow natural market forces to act as the regulator. In some cases, we believe, the balance shifts decidedly in favor of Commission regulation, as was the case with the Order Execution Rules. In others the balance should shift the other way. For example, while we believe the Commission is right to be concerned about issues such as market-wide ATS system capacity, we also believe that the Commission need not, under current circumstances, regulate specific system capacity and reliability issues with respect to ATSs because competition will likely provide sufficient impetus in that arena.
It is precisely as a result of the competition unleashed by the Order Execution Rules that there are now alternatives in the market to any single ATS or market center. We believe any concerns that exist in the marketplace about ATS capacity and reliability represent a commercial opportunity for new competitors such as Tradebook. We are confident that the free market will order the capacity and reliability it needs.
We have concerns, however, regarding the marketplace and the regulatory status of ATSs that were not addressed specifically in the Release. As the Commission is aware, in order to offer the ECN Alternative 4 under the Order Execution Rules to market makers and specialists, an ECN must accept non-participant broker-dealers' orders for execution against orders in the ECN that are publicly displayed, in a manner equivalent to broker-dealers' accessing market-maker orders not displayed in an ECN. In practice this means a complying ECN must provide telephonic and electronic access for non-participant broker-dealers.
Since January 1997, "compliant" ECNs under the Order Execution Rules have provided electronic access to non-participant broker-dealers through the SelectNet order-delivery system operated by The Nasdaq Stock Market, Inc. ("Nasdaq"), a method that places ECNs at a technological disadvantage. Currently, an ECN that executes a SelectNet order cannot bind the order-entry firm to the execution unless and until the ECN has received from SelectNet an acknowledgment of the execution message. Bloomberg's private connections to its customers contain certain safety features such as automatic re-transmission of messages, but the SelectNet technology does not permit an ECN to re-transmit automatically an execution message when SelectNet has not immediately acknowledged the ECN's notice of execution. As a result, when a notice of execution from the ECN back to SelectNet is delayed or lost and the order-entry firm permissibly cancels the order, an order mismatch occurs and the ECN becomes responsible as a principal to its participant for the trade.
To avoid the current disadvantages inherent in Nasdaq's communications systems and the resulting exposures to multiple trade executions, we believe that each market center should be wholly autonomous of all other market centers in receiving and executing orders. Competing market centers, including ATSs, should each be able to contend for participants and order flow on the basis of cost, service and innovation. Under this market structure, institutional investors and broker-dealers would not be dependent on any single market center. We believe technology has made the model of competing market centers an achievable reality and that technology and competition among marketplaces together have the potential to provide an array of additional benefits to market participants and the market as a whole. 5
In addition, Bloomberg believes that, among competing market centers, each market center should be able to deliver an order to another for execution against the other's displayed order. The receiving center should in turn be able immediately to execute that order, or decline it if its displayed quotation has already been filled. The receiving center should not thereupon be dependent on the delivering center to confirm acceptance of the completed trade.
An even greater problem arises from the fact that SelectNet apparently takes, on average, three seconds to deliver a response from an ECN back to the order-entry firm. As a result, although ECNs must, and Tradebook does, respond immediately to non-participant SelectNet orders, the three-second delay has led to complaints by order-entry firms. We understand that a response is currently under consideration that, if implemented, would be truly anti-competitive.
This response would be to allow Nasdaq to send execution messages, rather than orders, to ECNs in the same manner as the Small Order Execution System currently operates. While this would decrease response time for non-participants, it would centralize distribution of order executions and force ECNs both to abandon strict time priority and to prefer non-participant orders over participant orders, in order to avoid the risk of double executions. While non-participant orders would be matched against the ECN's published quotation in Nasdaq and executed immediately, all participant-to-participant matches in the ECN itself would have to be frozen and not executed until the related published quotation in Nasdaq could be withdrawn and confirmation of the withdrawal received. That disparity would effectively destroy ECNs because Nasdaq would offer better access to non-participants than ECNs could offer to their own customers. 6
We believe there is a better solution. We recommend that the Commission establish a standard for directly connected non-participant access to ECNs. ECNs meeting the direct-connection standard would be deemed to provide "fair access" under the ECN Alternative. The standard could require providing direct access via a dedicated communications link at the request of the non-participant, together with software that the non-participants could use to send orders to the ECN. 7 ECNs that chose not to offer direct connection would have to accept execution messages from Nasdaq, making Nasdaq the single market center with respect to those ECNs while eliminating the three-second delay.
ECNs that chose to offer direct connection would provide order access, without the three-second delay, to any non-participant who elected to receive a direct connection. Those ECNs would continue to receive order messages from non-participants who selected Nasdaq as the access provider rather than using a direct connection. These non-participant order messages, would, of course, continue to be treated equally with participant orders. Providing that choice to ECNs would solve the three-second-delay problem without creating an inherent advantage for Nasdaq and also would solve the problem of lost messages. 8
ATS regulation. ATSs are at once similar in a few respects, and dissimilar in many respects, to both traditional broker-dealers and traditional exchanges. An ATS resembles a broker-dealer principally in that it effects transactions for institutional customers. Unlike a traditional full-service broker-dealer, however, an ATS need not carry customer accounts, commit its own capital to make markets or execute trades, engage in underwritings, or provide research or recommendations to "customers".
An ATS is like a traditional exchange in that it provides an economic forum for its users, including broker-dealers and institutional investors, to interact directly with one another. Like an exchange, an ATS adds value to the marketplace as an aggregator of orders. Unlike an exchange, however, an ATS also is in the business of providing service directly to institutional investors. In contrast to an exchange, which typically is a membership, non-profit organization, an ATS is a private, non-membership, for-profit entity.
While ATSs are not accountable as a matter of corporate governance to their participants, nevertheless they are accountable in a commercial sense. If a user of an ATS believes it is not fairly represented or if a prospective user believes it has been denied fair access, they each have the ability to select a competing ATS. Tradebook views issues of fair representation and fair access as commercial opportunities, and we aim to build a business on the demand in the marketplace for alternatives among alternative trading systems.
The Release proposes two alternatives for regulating an ATS: either as an exchange, with certain exemptions from the traditional definition of "exchange", or as a broker-dealer, with increased responsibilities and perhaps a new SRO. Bloomberg is more concerned about preserving Tradebook's ability to respond rapidly and with creativity to the demands of our customers than it is about a change in nomenclature or category of regulation. Given that premise, we would like to comment on the advantages and disadvantages of the proposed approaches and certain specific questions raised in the Release.
Certain benefits would accrue to the market and to ATSs if ATSs were to be reclassified as exchanges. Trading by New York Stock Exchange ("NYSE") and American Stock Exchange ("Amex") members on an "ATS exchange" presumably would be exempt from the off-board trading rules, NYSE Rule 390 and Amex Rule 5, providing greater trading flexibility to NYSE and Amex members, increased liquidity to ATS participants and enhanced competition between and among markets. In addition, as an exchange, an ATS could become a member of the Intermarket Trading System ("ITS"), a system that is currently limited to participation of traditional exchanges. ATS inclusion in the ITS would allow ATS participants to insert their quotations directly in the Composite Quotation System, providing greater transparency for all market participants.
On the other hand, as the Commission recognizes in the Release, certain negative consequences would ensue were ATSs to be considered exchanges without any further adjustments. As we discuss later, in such a case the Commission should use its exemptive power in several ways to create regulation appropriate in extent and substance for ATSs.
1. Continued Regulation of ATSs
The Release suggests that ATSs could continue to be regulated as broker-dealers, with modifications to existing practices. As mentioned above, Bloomberg believes the overall result of changes in regulation could be positive, regardless of whether ATSs are regulated as broker-dealers or exchanges. The real question is what regulatory changes, specifically, does the Commission propose in either event? We consider below several specific issues.
Institutional orders. In the absence of a requirement to do so, a majority of non-market maker Tradebook participants voluntarily permit display of at least a portion of their orders in Nasdaq. This choice is generally made on a "default" basis for all orders using software provided by Tradebook, but the choice can be made or overridden on an order-by-order basis. Tradebook provides SelectNet access for all NASD members to all orders displayed in the Tradebook System, including some not displayed in the Nasdaq quotation.
Were it not the case that institutions display voluntarily, the Commission's legitimate concerns about market transparency could lead to requiring institutions to display. We believe, however, that requiring an ATS to include all participant orders in the public quotation may not be necessary since most of our participants already believe it is in their best interest to do so voluntarily. It appears to us that the trend towards voluntary display will continue, especially as more institutional traders become comfortable with the "Reserve" feature of the Tradebook System and its ability to mitigate the potential adverse impacts they may associate with displaying limit orders.
As the Commission knows, Bloomberg introduced the Reserve feature to the U.S. equity markets to create an incentive for traders to display more of their orders, and to do so more frequently. Others may have borrowed the term "reserve", but only Tradebook's Reserve incorporates the ease of use and flexibility that make voluntary display the rule rather than the exception in the Tradebook System.
We note one current regulatory disparity, however, which we believe is unfair to our market-maker participants and to the institutional investors they serve. While an institutional trader working an order in the Tradebook System may opt not to display the order in Nasdaq when he or she believes it is optimal not to display, a market-maker working that same order as an agent for an institution is denied the same option not to display the order in an ECN, even if the institution (as principal) requests that the order not be displayed. The result is inexplicably to favor institutions entering orders directly into an ECN, rather than through intermediaries. One could argue that the Tradebook System, and ATSs generally, would benefit from this disparity because it should encourage institutional investors to trade directly on the Tradebook System. Bloomberg, however, does not intend to discriminate against its customers or to disintermediate its market-maker customers. If institutions are to continue to have the option to avoid display (which we believe they should), we believe market-makers acting as their agents should have the same option. Bloomberg would like to provide a variety of trading options to its customers and then let them choose which strategy works best for them.
We further note that the option to display market-maker orders and, indeed, the obligation to seek Commission staff approval by no-action letter in order to be used by market-makers as a compliant ECN under the Order Execution Rules, does not extend to all ATSs, but rather only to those that engage in price discovery on a continuous basis. One could envision an ATS holding a series of discrete auctions occurring as frequently as, say, every one, two or five minutes in order to avoid the obligation to display that attaches to continuous-auction systems. Such an ATS could impose a cancellation penalty to reduce the risk that orders would be withdrawn, partially bridging the gaps between auctions and mimicking the features of a continuous auction. We urge the Commission to pay careful attention to this regulatory distinction in the future. We believe a substantial risk of unintended consequences exists in the seams, such as this one, between the regulatory zones. 9
Trade reporting. Whether or not the Commission requires ATSs to display all orders in their systems in the public quotation, we suggest that the Commission assign in full the requirement of reporting trades undertaken in an ATS to the ATS directly, as opposed to requiring the broker-dealer participants of an ATS to report. A complete assignment of this responsibility would eliminate the risk of duplicate reporting by an ATS and its participant broker-dealers and also would address concerns of institutional investor participants regarding anonymity 10 as well as relieving the concerns of broker-dealers about their own possible liability for non-compliance with the reporting requirements if the ATS fails to make the required report.
Non-participant access. The Commission asks in questions 15 through 17 of the Release whether an ATS should be required to allow non-participants to execute against orders in its system. The Commission has already imposed this requirement on ATSs that wish to remain in compliance with the Order Execution Rules, and it remains to be seen whether such a requirement will be problematic in a market break. Bloomberg believes that no regulation in addition to the Order Execution Rules is necessary because the forces of competition will cause ATSs to grant sufficient access to promote the Commission's objectives. We discuss below, however, the need to permit ATSs to screen all order entrants for financial ability to settle trades.
We believe that ATSs have an economic incentive to encourage order flow and provide liquidity. Over the long term, any ATS that does not provide appropriate access will be at a competitive disadvantage to ATSs that allow expanded access. Tradebook allows participants to display bids and offers and for each displayed bid or offer, to add an undisclosed quantity of shares as a reserve, and to execute orders against the bids and offers displayed in the system. Tradebook also allows non-participants access to the Tradebook System, but in a more limited sense: non-participants may execute only against orders on the Tradebook System; they cannot enter orders to be displayed to others. Non-participants may access Reserve quantities, which is not required under the Order Execution Rules since, unlike Display quantities, Reserve quantities are not "widely disseminated", but only up to a total of 10,000 shares per execution (displayed quantity plus accessed Reserve quantity). Participants may access Reserves up to the full amount on a single execution.
Fees. In question 16, the Commission asks how it should determine whether the fees charged by ATSs to non-participants are reasonable and do not have the effect of denying access to orders.
We believe Tradebook's non-participant access fees are appropriate in view of the current regulatory framework and commercial environment in which other ATSs charge access fees. We believe we should be allowed to charge non-participants for the services we provide them, including the communications infrastructure and the capital standing behind each trade. Since an ATS's capital risk increases as trade size increases, we think it is proper for ECN fees to take trade size into account.
We believe, however, the Commission should examine access fees closely. ATSs can choose whether or not to be "complying" ECNs, and therefore to accept non-participant orders. Broker-dealers operating under the requirement that they make reasonable efforts to obtain best execution of their customers' orders sometimes have to execute an order with an ECN when that ECN alone is displaying the best price.
In examining the current framework and weighing the competing interests, we understand the Commission's concern about fees and believe the Commission has the right, perhaps even the obligation, to examine the access-fee issue closely. We would be prepared to lower our access fees, in conjunction with other ECNs, in the interest of promoting greater market access.
Competitive SRO behavior. The Commission raises questions in the Release about increased surveillance of ATSs by their SRO if ATSs continue under the broker-dealer regulatory regime. In its evaluation of that issue, however, the Commission did not focus on its power under section 19(g)(2) of the Exchange Act to exempt an SRO, such as the NASD, from supervision of ATSs. Shifting regulatory oversight of ATSs from the NASD to the Commission, for example, would alleviate concerns about regulation of an ATS "broker-dealer" by a competitor.
In addition, the Commission could use section 19(g)(2) not only to exempt ATS "exchanges" from regulatory oversight responsibilities but also, if ATSs do not become registered as exchanges, to exempt NASD Regulation, Inc. ("NASD-R") from certain oversight responsibilities over ATSs. Unlike traditional broker-dealers, ATSs operate highly technical, computerized trading systems, an area in which NASD-R traditionally has little expertise. Tradebook, as a compliant ECN, has developed algorithms and procedures to comply with, among other regulations, the display requirements for widely disseminated orders under the Order Execution Rules and to avoid violations of NASD regulations prohibiting locked and crossed markets. In this respect, ATSs are more similar to exchanges, which are regulated by the Commission. That would of course shift the responsibility to the Commission and the Commission's Division of Market Regulation is already active in this area.
Since the advent of the Order Execution Rules, as discussed above, ATSs have faced increased competition from other ATSs and market centers, including Nasdaq. In addition, the required development of the order audit trail system ("OATS") by the Commission and Nasdaq will allow Nasdaq to monitor the ATSs markets closely and compile an extensive database of ATS market information.
Given the competitive implications of an SRO supervising and disciplining an ATS, the scope of surveillance activities of an SRO should not extend to the ability to view proprietary, nonpublic ATS system components and other competitively sensitive information, to examine trading algorithms or to receive notice of changes to an ATS's price development mechanism unless the inspection and the information derived therefrom is strictly limited to the regulatory arm of the SRO and not made available to the marketing division. Such inspection rights raise acutely the inherent competitive dilemma of requiring or permitting an SRO to supervise an entity that could potentially compete with it.
As a result, with respect to that specific aspect of ATS operation, the Commission might well consider exercising its authority under section 19(g)(2) of the Exchange Act to relieve the NASD and other SROs from the obligation to regulate ATSs and should impose its own direct regulation and surveillance over ATSs to the extent necessary to protect investors and the markets.
Alternatively, Bloomberg would also support the separation of NASD-R from NASD into an independent entity, an idea recently advanced by Commissioner Wallman. By definition, an independent NASD-R would separate surveillance activities from market functions and would benefit the market in general for several reasons. For example, it would alleviate the inherent conflict of interest presented by the NASD's regulating potential competitors.
Whichever approach is chosen, the Commission's regulation should apply consistently to all ECNs. The Commission's staff has advised Tradebook that if we were to introduce a "negotiation" feature identical to the one offered by a prominent competitor, it would qualify under the definition of "widely disseminated" in the ECN Alternative. The implication, of course, is that market makers' negotiated orders using such a tool would have to be displayed in the Nasdaq quotation, thus undermining the reason many participants have for using the tool. Yet, to the best of our knowledge, the Commission has not stopped our competitor from continuing to offer this feature without displaying the orders in the Nasdaq quotation. We understand that the Commission intends to act on such matters before issuing final no-action letters in connection with the ECN Alternative in January 1998. In the meantime, the negotiation feature is important for institutional customers working large orders. Lack of clear direction on this issue has impeded our ability to introduce a negotiation feature to satisfy our customers' demand.
Capacity and security of ATSs. The Release proposes implementation of guidelines for capacity and integrity of an ATS, including independent system reviews, contingency protocols and processes for preventing, detecting and controlling threats to an ATS system and reporting of system outages on a real-time basis. Capacity and integrity of ECNs are currently regulated via no-action letters which the ATSs have obtained from the Commission to assure their market maker customers that they are compliant ECNs within the meaning of the Order Execution Rules.
Bloomberg believes that this consultation is sufficient to address any short-term problems. Over the long term, as for-profit concerns, ATSs will respond to market forces; customer demand and an ATS's desire to supply its product in the face of competition will dictate expansion of capacity and strengthening of system integrity.
Financial integrity. We believe that the market applies sufficient controls on the financial condition of ATSs. The participants are sophisticated market professionals that are skilled and experienced at determining counterparty risk. Many of Tradebook's broker-dealer and institutional participants are willing to trade in the anonymous Tradebook market only if they have received certain guarantees of financial integrity of the system, most importantly the credit criteria that are imposed for access to other participants of the Tradebook System. B-Trade Services, the executing broker for the Tradebook System, applies objective financial criteria to base its acceptance of participants; to accept participants in any other manner would expose the Tradebook System to undue risk. To deny ATSs the power to screen market players for financial ability to pay would threaten the financial integrity of ATSs and undermine the participants' confidence in the ATS. Effectively, accepting all applicants, regardless of credit worthiness, would amount to a tax on ATSs that would be passed on to and borne by the credit-worthy participants who are the competitors of their unscreened counterparties.
Financial controls on access to an ATS as a participant are important and should not be eliminated through regulation. Competition among ATSs likely will provide protection against unfair denial of access. We believe it is in an ATS's self interest to grant access to as many participants as meet the ATS's credit-worthiness criteria. 11 Governmental regulation and imposition of a fair-access requirement on ATSs should be undertaken only upon a specific determination that such regulation is a better alternative to allowing commercial forces to govern.
One aspect of counterparty risk is the delay between the execution of a trade and the guarantee by the National Securities Clearing Corporation ("NSCC") of a trade, which currently becomes effective only at midnight of the day after the trade occurs. If the Commission is concerned about access and credit criteria in relation to ATSs, requiring the NSCC to become responsible for the trade in a shorter amount of time, ideally from the moment of execution of a trade, would reduce if not eliminate concerns about conditioning participation on financial criteria. If NSCC were required to guarantee trades, it would establish credit criteria of its own and the ATS would have not be involved in credit, and therefore access, determinations with respect to broker-dealer participants.
Proliferating SROs. We do not believe that it would be feasible or beneficial to the market for ATSs to establish a new, separate SRO. The Commission should not expect that ATSs would be able to regulate themselves effectively. ATSs are private, for-profit enterprises in a highly competitive marketplace. At a minimum, it is highly unlikely that the governing bodies of ATSs would be able to reach a collective agreement as to the purpose, rules and regulations of any such SRO. Even were they to reach initial agreement, since ATSs are for-profit, private enterprises, requiring the ATSs to work together in such a fashion might well diminish the competitive environment that today exists. As a result, Bloomberg does not believe a new ATS SRO would benefit it, the market or its participants and customers. 12
Anti-competitive practices. The Release asks whether the Commission should address anti-competitive practices of ATSs, if ATSs continue to be regulated as broker-dealers. We recommend that the Commission not take action at the moment, pending further experience. If an ATS in fact acts in an abusive manner, such as by turning away potential participants arbitrarily, other ATSs are available as alternative suppliers of the ATS service.
2. Proposed Regulation of ATSs
Definitional issues. The Release proposes that ATSs could be regulated as exchanges and deemed to fall under a proposed interpretation of "exchange" (question 32 of the Release) as an organization that both (a) consolidates orders of multiple parties and (b) provides a facility through which, or sets material conditions under which, participants entering such orders may agree to the terms of a trade. The Commission should distinguish, however, between a market center involving interaction among market participants and a dealer itself, which interacts with its own customers but does not facilitate interaction among customer orders. A number of broker-dealers have automated trade execution systems that involve only interactions between a broker-dealer and its individual customers, but not direct interaction between or among customers engaging in certain types of dealer activity. Unlike ATSs, these automated systems do not involve interaction among customers and should not be regulated as exchanges. 13
If ATSs, as private, for-profit entities, are to be considered exchanges, several adjustments and exemptions from current exchange regulation should be implemented:
(i) a for-profit ATS should not have enforcement powers or duties with respect to the business conduct of its participants, which are essentially its customers; 14
(ii) institutional participants should be exempted from the requirement, applicable generally to exchange members, that they register as broker-dealers or organize brokerage affiliates to act as the participants on the ATS "exchange";
(iii) limitations on members' (i.e., participants') trading under section 11(a) of the Exchange Act should be relieved; and
(iv) with respect to treatment of foreign securities, issuers should not be required to register under section 12 of the Exchange Act so long as the audience for an ATS is limited to institutional investors and broker-dealers, because these entities are allowed to purchase foreign securities in an initial sale under Rule 144A of the Exchange Act.
If an ATS were to be regulated as a non-exempted exchange, the Commission would be advised to use its exemptive authority under the Exchange Act to exempt it from numerous regulatory provisions that are not appropriate to impose upon for-profit, non-membership organizations. 15
Participants. The Exchange Act provides that all members of a national securities exchange must be registered broker-dealers. If the Commission's intention is to preserve the ability of ATSs to continue to deliver most of the services they currently provide, then ATSs regulated as exchanges should be allowed to have institutional investors as direct participants. The Commission would need, therefore, to exempt ATSs from this requirement if they were to register as exchanges and keep their institutional participants (unless the institutions organized as broker-dealers for the purpose of participating on one or more ATSs). At the same time, the Commission might wish to consider avoiding direct regulation of institutional investors, such as pension funds, banks, insurance companies and other entities that are regulated by governmental agencies other than the Commission.
Fair representation. Exchanges traditionally have been required to comply with fair representation requirements. Fair representation is a concern if exchanges are to operate self-regulatory machinery, such as inspections, discipline, arbitrations, and enforcement of the law. If, as we strongly recommend, the Commission refrains from imposing these responsibility on ATSs, it should not be necessary to dictate issues of an ATS's corporate governance or to require that participants have a voice in management of the ATS. In a competitive, market-driven environment, ATS participants can vote with their feet, and refuse to join, or depart from participation in, an ATS that behaves inappropriately. If the Commission were to implement restrictive regulation in this manner, ATSs would lose the ability to respond effectively to the demands and opportunities of the marketplace, thereby diminishing the incentives for participants to trade on an ATS.
Low-impact ATSs. If the "exchange" concept is adopted for ATSs, Bloomberg believes that low-impact ATSs and other similar markets should be regulated as exempted exchanges. Bloomberg believes that smaller market participants will have less of an impact on transparency of the market and therefore would not justify the increased cost of regulating such low-impact ATSs as non-exempt exchanges. Volume or market share measures should sufficiently define this type of exemption.
Access to market systems. Since ATSs are substantially distinct from traditional broker-dealers in their market activity and services, regardless of whether ATSs are deemed exchanges or are continued to be regulated as broker-dealers, we believe that ATSs should have access to and be allowed to become participants in market-wide plans currently subscribed to and operated by registered exchanges and the NASD, such as the Consolidated Quotation System, the Consolidated Tape Association and the Intermarket Trading System. Membership is currently available, for example, to the Cincinnati Stock Exchange, a totally electronic, quasi-ATS that is registered as an exchange and is operated out of Chicago, as well as to Nasdaq, which is neither registered as an exchange nor registered as a broker-dealer. These plans benefit the market as a whole by increasing transparency; by allowing ATSs membership in these plans, the market benefit in terms of liquidity and transparency would be increased significantly. We believe that membership in these plans should be available to other ATSs regardless of whether the Commission elects to register them as "exchanges" or to continue to register them as broker-dealers.
The benefits that the plans provide to the market as a whole apply equally to ATSs because ATSs operate interactive markets, different from the activities of traditional broker-dealers, that allow participants, including dealers, to interact directly with one another. Including ATS participant orders in the ITS composite quotation system would increase liquidity and transparency of individual ATS participant orders, individual ATSs and of the market as a whole.
Surveillance. Question 93 raises the issue of whether differences between automated and non-automated trading require materially different types or degrees of surveillance or enforcement procedures. We believe that automated trading by its nature provides less opportunity for fraud or manipulation to occur and a perfect audit trail if manipulation nevertheless is suspected. This feature of automated trading makes surveillance easier and minimizes the need for additional regulation.
Unregistered securities. If ATSs are required to be registered as exchanges, the Commission should not prevent trading in Rule 144A securities or other unlisted securities on an ATS, particularly if the only participants in the ATS are qualified institutional buyers within the meaning of Rule 144A under the Securities Act, since those buyers are allowed to be initial purchasers of the subject securities. We are not aware of any regulatory purpose served in denying them the opportunity to trade these securities in the secondary, transparent, publicized market in an ATS. We believe, therefore, that ATSs should be allowed to trade in these securities in order to promote transparency and liquidity and increase the efficiency of the secondary markets.
3. Regulation of Foreign Market Activities
in the United States.
The Commission has requested comments on whether investors would benefit from a clearer regulatory framework for entities that provide U.S. investors with the technological capability to trade directly on foreign markets from the United States. Certain institutional customers of Bloomberg believe that direct, inter-connected electronic access to foreign markets would provide them with equal access to these foreign markets and provide a more efficient manner to execute trades. The very distance of our U.S.-based institutional customers from these local markets creates a competitive cost disadvantage that electronic trading could erase.
Bloomberg believes that institutions should be allowed to have direct electronic access to foreign markets without necessitating U.S. registration of the foreign markets under the Exchange Act, which we expect would be a practical and political impossibility under current circumstances. 16 The access should not be conditioned on U.S. registration and regulation of the foreign market, so long as the investors are given clear disclosure of the characteristics of the foreign markets and the risks, including risks that arise from reduced governmental regulation and surveillance, or indeed none at all.
The Release also requests suggestions on regulatory approaches that would best address development of automated access to foreign markets. As the Commission is aware, the most common way to place foreign securities in the United States is through Rule 144A offerings. From Bloomberg's perspective, the Commission should not only permit but require transparent trading in secondary market Rule 144A securities by qualified institutional buyers ("QIBs").
These customers currently trade in foreign markets through U.S. broker-dealers and are aware that foreign markets are subject to different (and usually lesser) regulation than are domestic markets. U.S. investors, even "unsophisticated" retail investors, know the difference between the U.S. markets and foreign markets and need not be protected by the U.S. Government from the resulting risks. The Commission currently allows unsophisticated, retail investors to purchase country funds which are registered in the United States under the Investment Company Act of 1940. The prospectuses for such funds make elaborate disclosure of the risks, including the risks of trading in markets the Commission does not regulate. For example, in prospectuses of country funds investing in some emerging markets, it often is disclosed that war, political unrest and civil insurrection, governmental interference and governmental confiscation of the investment company's assets without compensation are all possible. Would it be inappropriate to allow a more wealthy and sophisticated class of investor, such as QIBs and even retail investors who, for example, meet the $5 million invested capital test for "qualified purchasers" in new section 3(c)(7) of the Investment Company Act of 1940, to trade directly, by electronic communications media, in foreign markets?
In regulating the granting of access to such markets, of course, the Commission should remain mindful of the differences between brokerage linkages and the provision of market information. Bloomberg and other news media, as the Commission knows, have constitutionally protected rights in the provision of financial news, whether by electronic or other means, that cannot be lawfully abridged by governmental prohibition or regulation, such as by requiring Bloomberg itself to register as a SIP in connection with its publication of market information. 17
If members of the Commission or of the staff believe we may be of further assistance in these matters, please let us know.
Very truly yours,
By: /s/ Lou Eccleston
By: /s/ Kevin M. Foley
Kevin M. Foley
cc: The Hon. Arthur Levitt, Chairman
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Norman S. Johnson, Commissioner
Dr. Richard R. Lindsey, Director,
Division of Market Regulation
Robert L. D. Colby, Esq., Deputy Director,
Division of Market Regulation
Howard Kramer, Esq., Associate Director,
Division of Market Regulation
Brian J. Lane, Esq., Director,
Division of Corporation Finance
Meredith B. Cross, Esq., Deputy Director,
Division of Corporation Finance
Paul M. Dudek, Esq., Chief,
Office of International Corporate Finance,
Division of Corporation Finance
-- The Tradepoint Investment Exchange ("Tradepoint") is an electronic order-driven stock exchange in the United Kingdom. It is a Recognized Investment Exchange under the U.K. Financial Services Act of 1986 and a Regulated Market under the European Investment Services Directive. The London Clearing House acts as central counterparty on the exchange. Tradepoint provides instant and complete pre- and post-trade transparency and the ability for participants to trade equities free of any trading tariffs.
-- Rules 11Ac1-1 and 11Ac1-4 under the Exchange Act.
-- As the Commission knows, all ECNs are ATSs, but some ATSs, for example, the Arizona Stock Exchange, are not "complying" ECNs under the Order Execution Rules.
-- Section (c)(5) of Rule 11Ac1-1 under the Exchange Act.
-- The rapidly falling cost of dedicated communications bandwidth is a significant factor in making possible multiple inter-connections. Traditionally, the Commission has had to rely on a single market center, and then regulate it as a monopoly, because of the extravagant cost of maintaining duplicate communications facilities. That economic limitation no longer exists as a result of the reduction in bandwidth cost, and the monopoly-based regulatory assumptions will have to change as well.
-- A possible survival measure would be for ECNs to skate beyond the boundary by eliminating a "continuous" auction, thereby escaping the reach of the Order Execution Rules. By instead offering short-term, periodic auctions, they could keep their participant orders out of the public quotation system. That escape route, which might well offer to ECNs their only realistic hope of remaining in business, would in fact subvert market transparency.
-- Presumably, non-participants would be required to enter into certain standard industry agreements to provide for trade comparison and trade reporting, which would provide protections similar to those Nasdaq achieves under the ACT agreement.
-- This solution is feasible because direct connections have become so inexpensive to provide. Alternatively, the Commission could solve the problem of the three-second delay by mandating that Nasdaq upgrade its technology dramatically. In a competitive market environment, however, the Commission could rely on market forces to solve the problem. In that way, Nasdaq would voluntarily improve its own technology and the Commission would achieve the same result with less regulation.
-- See note 7, supra.
-- Under the current regulatory regime, in a broker-to-broker trade, the seller reports. Where an institutional investor is the selling counterparty in a trade with a broker, the broker, as buyer, is required to report the trade; that requirement signals to the broker that the seller was an institutional investor rather than another broker. Some large institutional participants have expressed to us their concern, based on adverse experience, that even this information may help to reveal their identity in some cases. These institutions claim quite convincingly that, because of their size, their trading anonymity must be carefully guarded if they are to defend the interests of the millions of small investors they represent.
-- Credit criteria, as discussed above, are integral to establishing and maintaining the confidence of ATS participants in an ATS and therefore to the success of an ATS and should not be considered prima facie unfair denials of access.
-- History suggests that establishing and sustaining an SRO are not easily accomplished without a clear and compelling economic raison d'être . At various times through the years, as the Commission knows, there have been in existence approximately 100 regional stock exchanges (that is, exchanges not located in New York City), of which only some 35 remained in 1928. Securities & Exch. Comm'n, Report of Special Study of Securities Markets , H. Doc. No. 95, pt. 2, 88th Cong., 1st Sess. 928 (1963). On October 1, 1934, the effective date for the registration of exchanges under the Exchange Act, there were a total of 24 registered exchanges and 12 exempt exchanges and, by the time of the Commission's 1963 Special Study, the number had shrunk to 16 active exchanges, of which four were exempt exchanges. Id . at 911, 917. The number is smaller still today. To promote the organization of the NASD in 1938, the Congress permitted the NASD, in section 15A(e)(1) of the Exchange Act, to have rules preventing members from granting selling concessions to non-members in syndicated offerings, a powerful economic inducement for broker-dealers to join. To our knowledge, the last SRO to be formed under the Exchange Act (other than the Municipal Securities Rulemaking Board, which was created by congressional legislation and is limited to rulemaking) was in 1973, the Chicago Board Options Exchange; the other current exchanges, or their historical antecedents, were in existence at the time the Exchange Act was enacted.
-- We believe the proposed interpretation of "exchange" would provide sufficient distinguishing features to exclude information vendors, bulletin boards and other entities whose activities are limited to provision of trading information were the interpretation of "exchange" to turn on order interaction between and among customers on a system that involves locked-in trades. Accordingly, we believe that new definitions do not appear to be needed.
-- In a traditional exchange structure, members are subject to discipline by an exchange, but in return the members also participate in the development and implementation of the rules to which they are subject. Allowing participants in a for-profit ATS "exchange" to make rules concerning admission of participants, credit-worthiness, trading algorithms and similar matters would fundamentally change the structure of the ATS. Bloomberg believes such a result would be undesirable from a business point of view and should not be required. Assuming that the participants in an ATS would have no input in the rulemaking process or governance of the ATS, Bloomberg does not believe it would be fair to subject these participants to disciplinary action by the ATS "exchange".
-- Sections of the Exchange Act which should be regarded as inapplicable to a for-profit, non-membership ATS include sections 6(b)(1) and 19(g)(enforcement of compliance by members with rules and laws); 6(b)(2) (any broker-dealer or natural person associated therewith may become a member); 6(b)(3) (fair representation); 6(b)(4) (equitable allocation of reasonable dues and other fees); 6(b)(5) (duty to have rules to prevent fraud and manipulative practices); 6(b)(6) and (7) (discipline of members and fair procedures); 6(c) (denial of membership to persons who are not broker-dealers or affiliated with broker-dealers and denial of membership); 6(d) (procedures for bringing disciplinary actions); 6(e) (ability to fix commissions charged by its members); 11(a) (prohibitions on members' trading for proprietary managed accounts); 19(b) (rule-making changes); 19(c) (ability of Commission to amend exchange's rules); 19(d) (imposition of disciplinary sanctions by exchange); 19(e) (review of disciplinary sanctions by exchange); 19(f) (review of denial of membership); and 19(g) (exchange enforcing compliance with rules by members).
-- Eventually, it may be that a system of coordinate registration and regulation of exchanges throughout the developed world can be organized under the auspices of multi-national organizations such as the Fédération Internationale des Bourses de Valeurs and the International Organization of Securities Commissions.
-- Indeed, the definition of SIP in section 3(a)(22)(A) of the Exchange Act specifically excludes "any bona fide newspaper, news magazine, or business or financial publication of regular or general circulation." Cf. Lowe v. Securities & Exch. Comm'n , 472 U.S. 181, 204 (1985), 1985 U.S. LEXIS 125: "Congress, plainly sensitive to First Amendment concerns, wanted to make clear that it did not seek to regulate the press through the licensing of nonpersonalized publishing activities." (Commission requirement that publisher of non-personalized investment advice in bona fide newsletter register as an investment adviser exceeded the Commission's statutory authority; unnecessary to decide constitutional question because Commission action exceeded statutory authority).