Jonathan G. Katz, Secretary

United States Securities and Exchange Commission

450 Fifth Street, N.W.

Washington, D.C. 20549

(also via e-mail to: rule-comments@sec.gov).

Re: File No. S7-16-97

Release No. 34-38672

Dear Mr. Katz:

The Securities Industry Association ("SIA") 1 appreciates the opportunity to provide comments to the Securities and Exchange Commission ("SEC" or "Commission") regarding the Commission’s Concept Release on the oversight of alternative trading systems ("ATSs"), national securities exchanges, foreign market activities in the United States, and related matters. Public trust and confidence in the securities markets is central to SIA's mission. The issues about transparency and access that the Commission poses in this Concept Release are key elements of maintaining that confidence. How the Commission decides to address those issues will play a large role in determining whether investors will continue to have confidence in the fairness, competitiveness and adaptability of U.S. capital markets.

Summary

We wish to commend the Commission for its thoughtful, innovative, and far-reaching effort to provide possible directions for market regulation at the gateway of the 21st century. The Commission’s Concept Release raises significant questions of great concern to the securities industry as well as securities regulators. Following the passage of new legislation that provided the Commission with important new regulatory tools to more easily modernize many aspects of the regulatory framework, a careful assessment by the Commission of the overall direction of its regulation of U.S. secondary markets, and an attempt to anticipate future regulatory issues, is timely.

The Commission’s Release solicits views regarding the need to update the Commission’s regulatory framework to address future changes in the U.S. securities markets, particularly those resulting from technological developments. While the scope of this request is potentially enormous, the Release identifies three specific areas of concern: (i) the growth of trading on ATSs; (ii) the possible need to redefine the role of self-regulatory organizations in the event that the regulatory approach to ATSs changes; and (iii) the regulatory status of certain non-broker-dealers that provide U.S. investors with electronic access to foreign markets.

The following are SIA's key conclusions about the issues raised by the Concept Release:

¨ The Commission has created a regulatory framework in which many innovative trading systems have flourished. "Alternative trading systems", however one might define that term, provide important market services to investors and provide important competition to more traditional market centers. The Commission should proceed with great caution in revamping or reversing a regulatory policy that has provided these benefits.

¨ In order to avoid impeding the expansion and development of existing or future alternative ATSs, any change in the regulatory structure governing these systems should be narrowly crafted to address demonstrated regulatory concerns. The regulatory structure should not be changed in a way that disadvantages investors, or that creates unjustified new regulatory burdens on broker-dealer proprietary systems generally.

¨ To the extent that changes in the regulatory approach to ATSs are necessary, such changes would best be adopted under a system of enhanced broker-dealer regulation. Attempting to restructure exchange regulation to encompass some broker-dealer trading systems raises a number of troubling legal and policy issues. SIA believes that reclassifying ATSs as exchanges is not likely to be in the best interests of investors, or of the competitiveness of U.S. capital markets.

• Regardless of the approach adopted, the Commission should seek to narrow the competitive gap between broker-dealer and exchange regulation by reducing certain of the competitive burdens on exchanges. In particular, exchanges are currently hindered in their efforts to launch new products by the Commission’s review process. SEC review of SRO marketplace and product (as opposed to regulatory) filings should be accelerated significantly, at least where those filings do not impose new burdens on competition.

¨ SIA does not believe that the system of self-regulation should be made more complex by the creation of new categories or tiers of self-regulatory organizations ("SROs") to oversee the activities of ATSs. If the SEC determines to alter the self-regulatory oversight of ATSs, it might want to consider, as an alternative to creating even more SROs, the possibility of consolidating all or many existing SROs, or certain of their regulatory functions, into one organization. While this approach may have its own drawbacks, and is not one that SIA seeks to pursue at this time, it may deserve consideration as an alternative to further multiplication of the existing SROs.

Introduction

An axiom of our time is that information technology continuously reshapes every aspect of modern life. Broker-dealers, like other financial service firms, must continually adapt their business to use new technology to meet customer needs. So far, this adaptation process has served U.S. investors well, as markets have become more efficient and more transparent, and broker-dealers have remained highly competitive with other domestic and foreign financial service providers. However, the process of adaptation never ends. If regulators or broker-dealers fail to adapt to the accelerating pace of change brought about by this information technology revolution, (for example, by adopting rules that effectively restrict the ability of the current market structure to evolve), investors will seek out service providers in other industries, whether domestic, foreign, or in "cyberspace," to fill their needs. This could place U.S. investors in regulatory environments that may depart sharply from the full disclosure and investor protection model of U.S. securities regulation.

Technology and other factors have brought about a related phenomenon that is also becoming a major consideration in charting the future of U.S. securities regulation: the globalization of financial markets. Access to foreign markets benefits the U.S. economy by providing new savings pools, reducing capital costs, and furnishing new investment opportunities. At the same time, because U.S. capital markets compete with foreign markets, U.S. market regulation must be constantly reexamined to ensure that U.S. regulatory requirements neither drive investors or market participants to conduct business offshore nor compromise the well-deserved reputation of U.S. markets for safety, fairness, and transparency.

SIA believes that federal securities regulation has generally worked well, due to efforts of both the regulators and the regulated to earn and maintain the public’s trust and confidence in the securities industry and the U.S. capital markets. The securities industry is committed to maintaining the public's trust and confidence in the U.S. capital markets. SIA's members strive to preserve that trust through responsible management; superior products and services; thorough and ongoing professional education for employees; and clear, consistent and complete information for clients about products, services and the risks and rewards associated with investing and the capital markets.

In SIA’s view, federal securities regulation enhances the public's trust and confidence and the competitiveness of U.S. capital markets when it focuses on the following core principles:

· creating clear-cut rules designed to protect investors and market participants against fraud, manipulation, and similar abuses while providing guidance for market participants seeking to comport legitimate business conduct with legal standards;

· avoiding the temptation to elevate form over substance in writing, interpreting and enforcing rules;

• recognizing that improvements in the availability of international market information have resulted in more fluid movements of capital across national boundaries;

· requiring timely and meaningful financial and economic information from issuers and market participants;

· ensuring the solvency and stability of securities markets and their participants without unnecessarily impairing firms’ abilities to provide liquidity or to compete with other financial institutions operating under different capital requirements;

· bringing about greater transparency within and between markets;

· recognizing that all investors are best served by tailoring regulatory requirements to meet the varying needs of different categories of investors;

· encouraging industry commitment and responsibility by inviting industry participation in setting standards; and

· modernizing the regulatory structure as the nature and conditions of the capital markets changes.

The Commission’s willingness to adapt and experiment is likely to be a key to the continued vitality of U.S. securities regulation. Congress gave the Commission an important new tool for adaptation when it granted the SEC general exemptive authority in 1996. For the first time, the Commission has the statutory authority to craft highly specific regulatory solutions to new market events. SIA strongly supported the adoption of these new provisions because of our belief that that the SEC would exercise its exemptive authority "to promote efficiency, competition and capital formation in the marketplace, consistent with the public interest and investor protection." 2 We are hopeful that the Commission will make these concerns a priority as it assesses whether and how to change the regulatory environment for ATSs. 3

The need for exemptive authority to promote efficiency and competition is illustrated by the contradictory regulatory responsibilities and until recently, inflexible authority, to regulate the development of trading. In 1975, Congress enacted the Securities Acts Amendments of 1975. Section 11A(a)(2) of the Exchange Act directs the Commission to "facilitate the establishment of a national market system for securities (emphasis added)." The Commission was required to facilitate - not dictate - the structure of the marketplace. 4 But Congress never fully articulated its goals for allowing innovation in the marketplace, and the SEC was left largely to its own devices. The Commission faced a bifurcated regulatory structure from the 1930s, which in essence contemplated securities marketplaces (the exchanges and the over-the-counter market) on the one hand, and broker-dealers on the other.

The SEC’s exemptive authority now offers it greater latitude to remove legal or regulatory barriers that might stand in the way of market innovation. However, the development of a more complete national market system can never be achieved by regulatory fiat – assuming that the Commission even has the authority to mandate a particular market structure. The Commission has worked hard over the years to strike the right balance, encouraging the growth of a national market system without inhibiting innovations in trading systems. By careful use of interpretive guidance such as no-action relief, the Commission has resisted the temptation to over-regulate and stifle new trading systems, as well as trading systems that simply employ new technologies. The resulting depth, liquidity and spirit of innovation that permeate the U.S. capital markets demonstrate the wisdom of the Commission’s past overall approach.

I. Regulation of Alternative Trading Systems

A. SEC Analysis The Release reflects Commission concern about the current regulatory structure for ATSs. 5 These systems have evolved in recent decades as technology has permitted new entities to arise offering efficiency and anonymity to investors. Recognizing that the burden of exchange registration would stifle new innovations in trading systems, the Commission chose to allow limited innovation in the context of broker-dealer regulation, largely through no-action and interpretive relief provided through a case-by-case review of such systems.

ATSs have grown from a tiny fraction of market share to a significant conduit of order-flow in exchange- and Nasdaq -listed securities. As the Release notes,

these developments have benefited investors by increasing efficiency and competition, reducing costs, and spurring further technological advancement of the entire market. In particular, for those market participants that have access to ATSs, these systems have provided opportunities for the direct execution of orders without the active participation of an intermediary. 6

Notwithstanding these benefits, it is understandable that this growth causes the Commission to reexamine its regulatory approach. The Release highlights the following concerns with current regulation of ATSs:

¨ an "inherent conflict between SROs’ competitiveness concerns . . . (as a result of operating their own markets) and their regulatory obligations to oversee ATSs"; 7

¨ "regulatory gaps" between entities regulated as broker-dealers and entities performing similar functions that are regulated as exchanges, creating possible competitive advantages to the former while arguably impairing market transparency and stability; 8

¨ a concern that some ATSs might take "anticompetitive," "unfair" or "discriminatory" actions against their customers or other market participants. 9

The Release suggests two possible approaches to enhancing regulatory requirements for ATSs. First, the Release suggests that ATSs might continue to be regulated as broker-dealers, subject to some increased regulatory requirements. The Commission suggests, however, that there may be limitations to this approach, stating that it "may not address certain of the regulatory gaps discussed above." 10

Second, the Release proposes a possible new approach to exchange regulation. Under this approach, an exchange would be defined to encompass "any organization that both: (i) consolidates orders of multiple parties; and (ii) provides a facility through which, or sets material conditions under which, participants entering such orders may agree to the terms of a trade." 11 At the same time, the Release suggests that the Commission could use its exemptive authority to create new categories of exchanges that would be exempt from various aspects of exchange regulation. Exchanges would probably be placed in tiers with different levels of regulatory obligations. The tiers would be based on some combination of trading volume and opportunities for price discovery.

B. SIA Response

1. Success of Current ATS Regulation SIA agrees with the Release that the primary goal in regulating ATSs should be to encourage and facilitate innovation. However, the Commission may be too self-critical about the wisdom and success of its existing regulatory approach toward ATSs. In point of fact, the Commission’s existing regulatory approach toward ATSs has thus far been successful in fostering such innovation. The competitiveness of U.S. capital markets has flourished under the current regulatory approach. The transactional efficiency and anonymity that ATSs provide make them an attractive venue for institutional investors. This in turn has led to a substantial growth in institutional order flow to a number of ATSs, making them even more efficient, and more substantial competitors with other markets and exchanges.

It is reasonable to ask whether the growth in trading volume through ATSs might, either now or in the future, require a change in regulatory approach. The Commission has asked similar questions in the past, most notably four years ago, in its Market 2000 study, and determined that no substantial change in regulatory approach was warranted. In revisiting this issue, it is important to remember that ATS regulation to date has been successful in promoting competition and innovation. The injunction of Hippocrates to "first do no harm" applies with full force here.

The Commission’s central concern about the existing approach to ATS regulation is its belief that "gaps have developed in the structures designed to ensure marketwide fairness, transparency, integrity and stability." Whether and to what extent such gaps exist is difficult to assess right now, as the markets are undergoing substantial changes as a result of implementation of the order-handling rules. These rules are clearly intended to provide considerably greater transparency for many ATSs. 12 Moreover, the Order Audit Trail System ("OATS") that is now being developed should provide much better surveillance tools for secondary market activity in Nasdaq -listed securities, the most significant component of ATS order flow. 13

Price transparency is clearly essential to the proper performance of the markets. SIA strongly believes that transparency plays a fundamental role in the fairness and efficiency of the secondary markets. Real-time dissemination of information about prices enables investors to assess overall supply and demand in the market for a particular security. The Commission is right to continuously reassess whether sufficient transparency exists throughout the national market system.

However, even important public policy goals have to be balanced against the costs of achieving those goals. To take an extreme example, if the Commission were to demand absolute transparency of ATSs and their users (e.g., split-second real-time information on price, volume and counter-party identity coupled with universal access to all ATS quotes) it is difficult to see what advantage ATSs would continue to offer institutional investors. While SIA does not anticipate that the Commission would consider such an extreme requirement, it is possible that at a much lower threshold additional regulatory burdens on ATS customers might severely impair the business advantages that ATSs offer to institutional investors It would be regrettable if an entirely new and untested regulatory model resulted in the disappearance of ATSs, with investor order flow moving back to traditional markets, or possibly to offshore sites.

Just as importantly, neither the Commission nor market participants have had an opportunity to completely assess the impact of major new regulatory changes concerning secondary market trading in Nasdaq-listed securities (the order handling rules and OATS) that may go far to address the concerns expressed in the Release. For these reasons, SIA believes that the Commission should move cautiously. Neither the Commission nor investors, broker-dealers, exchanges, or other market participants have a complete understanding of what "alternative trading systems" are, the reasons why investors elect to use them, the extent of transparency or other regulatory concerns that they may pose, or what the impact would be on investors, intermediaries or markets if ATSs and their users were subject to new regulatory requirements.

Between the two models posited by the Commission for regulating ATS, enhanced broker-dealer regulation and a new species of exchange regulation, SIA much prefers the more flexible and evolutionary course of modified broker-dealer regulation. Within this established regulatory framework the Commission should most easily be able to make appropriate modifications to ensure greater transparency, wider access, and better surveillance without creating unforeseen consequences. Moreover, as discussed in greater detail on pages 14-17 below, this would avoid the extensive and complex regulatory changes, and difficult legal and policy issues, that a tiered exchange approach would entail.

2. Competitive Concerns A principal focus of the Commission’s ATS proposal is the competitive disparity between entities deemed to be exchanges and those deemed merely to be broker-dealers. The Commission’s view is that they really constitute a spectrum that ranges from traditional broker-dealers that engage solely in manual agency or principal executions to the NASD or NYSE that engage in a full array of exchange functions.

The two approaches proffered by the Commission attempt to bridge this gap in contrasting ways. The second approach, which we disfavor, would replace what is now a binary system with a system of multiple levels of regulation. While this approach may have some surface appeal, on closer inspection it would be likely to create new obstacles to competition. That is because there would be new disparities in regulatory treatment at each breakpoint between the different regulatory "tiers’, based on what may be purely arbitrary lines. This would be particularly significant if the thresholds between regulatory categories are based on some measurement of size or volume, rather than on clear functional distinctions.

By contrast, the first approach suggested in the Release, which we strongly prefer, represents a further evolution of the fairly successful case-by case approach followed today, in which specific broker-dealer ATS operations are reviewed individually and appropriate regulatory structures devised. This approach results in a more seamless regulatory structure based on functional distinctions. We believe this is a more effective way to bridge the gulf between exchange and broker-dealer regulation without impairing competition.

We believe that, regardless of the approach adopted, the Commission can also help narrow the competitive gap by reducing certain of the competitive burdens on exchanges. In particular, exchanges are currently burdened in their efforts to launch new products by the Commission’s review process. For example, if an exchange wished to modify a size parameter in an automated execution system, it generally must wait until the SEC staff has received and reviewed a rule filing and published it for comment. This exposes the proposed change to competing exchanges that can (and often do) quickly file similar proposals. Meanwhile, broker-dealers operating ATSs can launch new products without any prior SEC review. This allows them to introduce a product idea before the very exchange that they are emulating. SEC review of SRO marketplace and product (as opposed to regulatory) filings should be accelerated significantly, at least where those filings do not impose new burdens on competition. 14

3. Specific Concerns With Enhanced Broker-Dealer Regulation The Commission proposes, as one possible direction for regulation of ATSs, to impose enhanced broker-dealer regulatory requirements on those systems. As noted above, the need for any extensive new set of regulatory enhancements is not clear in light of the fact that many of the Commission’s concerns are in the process of being met through implementation of the order-handling rules and OATS. However, enhancing the system of broker-dealer regulation under which ATSs are now governed appears much more workable and realistic than building an entirely new regulatory structure to govern ATSs as exchanges. For example, additional steps to integrate aggregate trading interest on ATSs to public view would be a sensible way of addressing any concerns about transparency that may exist in the aftermath of the order-handling rules. Likewise, requiring the additional audit trail information that ATSs, like other broker-dealers will be required to provide to their SROs, will address specific surveillance concerns. The Commission’s concerns about whether ATSs have sufficient systems capacity during periods of market volatility could also be solved through the existing broker-dealer structure.

SIA disagrees with the Concept Release’s suggestion that enhanced broker-dealer regulation is inadequate because ATSs would potentially be able to engage in anticompetitive acts, such as by unfairly excluding participants or applicants, such as other broker-dealers, from the system. 15 In response to questions 24, 25 and 30, unreasonable denials already may give rise to a number of private liabilities in many situations (e.g., breach of contract, securities fraud claims or antitrust claims). If there is evidence that private liability exposure is proving insufficient to prevent unfair denials of access, the Commission could consider using its current regulatory authority over broker-dealers to require reporting of denials of access. Sunlight is still the best disinfectant, and to the extent that unfair denials of access is a problem, mandated public disclosure of access denials would very likely lead to a market solution.

The Concept Release’s concern about the competitive conflicts of having broker-dealer-operated ATSs subject to oversight by SROs operating their own trading systems is a more compelling point. SIA agrees that having SROs examine trading systems that compete with their own proprietary marketplaces is not an ideal regulatory framework. It is the case, however, that competitive issues raised by the exercise by SROs of their regulatory responsibilities arise in a variety of contexts, and not just in their oversight of member firms that operate ATSs. Exchanges may be viewed as having incentives, for instance, to adopt or enforce rules to encourage trades to be executed on their floors rather than on a competing exchange; or to maximize their member firms’ or their own revenues at the expense of the public and other markets. In all of these matters, the provisions of the Securities Exchange Act require that exchange rules not impose burdens on competition that are not necessary or appropriate. The Commission, in turn, must be diligent in assessing proposed rule changes and in overseeing the SROs to assure that their regulatory duties are not discharged in an unfair, discriminatory or anti-competitive manner. Commission monitoring of SRO regulation of member firms’ ATSs is just a part of this general oversight responsibility.

It would be desirable to address the issues that arise when SROs examine trading systems that are competitors of their own marketplaces. However, for the reasons just discussed, SIA does not believe that this competitiveness conflict is sufficiently grave to warrant the enormous new regulatory burdens and legal and business uncertainties that would be entailed in a wholesale reconstruction of the regulatory framework for exchange regulation. Although conceptually SIA believes that it is much more sensible to address any regulatory concerns with ATSs through enhanced broker-dealer regulation than through a rebuilt exchange regulatory system, there are several significant concerns that an enhanced broker-dealer regulatory approach must address in order to be viable.

a. Defining "Alternative Trading Systems" If the Commission determines that a substantial revision of the broker-dealer regulatory regime for ATSs is required, the most significant regulatory issue that the Commission will have to address is how to distinguish between "alternative trading systems" and broker-dealer systems that simply use current technology to perform normal broker-dealer functions. Any effort to re-categorize a wide variety of automated systems would greatly discourage innovation and impede speedy and efficient execution of transactions, the very opposite of results that the Commission has always sought. As the Release states, "(i)ntegrating newly registered national securities exchanges should not cause the homogenizing of all markets – to the contrary, it is as important today as it was in 1975 to cultivate an atmosphere in which innovation is welcome and possible." 16

For example, the Commission should not seek to impose new regulations on a broker-dealer system that permits customers or other broker-dealers to effect transactions with the sponsor of the system. Far from impeding transparency, these broker-dealers provide a normal and essential intermediary function. As with market-makers or specialists, broker-dealers typically use their automated systems to interact with customer orders and to place their own capital at risk. This function is essential to the markets' smooth functioning, especially during volatile periods when broker-dealers provide essential short-term liquidity.

The mere fact that advances in technology make it feasible for a broker-dealer to use a computer screen rather than a telephone to route customer orders internally, or to electronically link customers to existing (or future) exchange electronic order execution systems (e.g., Super Dot), does not require a change in regulatory treatment. Rather, new regulatory requirements must focus only on systems that raise the regulatory concerns identified in the Release. 17 One way of stating the distinction is that the Commission's focus should not go beyond those systems that permit trading directly between customers, or between broker-dealers other than the sponsor and customers.

Questions 56-63 of the Release appear to reflect the Commission’s recognition that broker-dealer functions such as automated block trading and internal execution systems, information vendors and bulletin boards, and most if not all inter-dealer broker services, should not be subject to exchange regulation. The language of the revised interpretation set out in the release appears to sweep more broadly than the Commission may have intended, since it applies to "any organization that both (1) consolidates orders of multiple parties; and (2) provides a facility through which . . . participants entering such orders may agree to the terms of a trade." 18 SIA believes that this language needs to be modified to clarify that, at a minimum, the term "exchange" does not cover entities that regularly put their own capital at risk in processing trades, such as by taking one side of transactions conducted in their system, or that otherwise exercise discretion in determining how to handle customer orders.

Although the Release primarily discusses equity trading systems, it makes occasional reference to trading systems for government or private debt securities. SIA is troubled by the Release's suggestion that trading mechanisms for government and debt securities might be swept up in any enhanced regulation of ATSs. Government securities and most private debt securities have vastly different trading characteristics than equity securities. Government securities are also subject to non-SEC regulatory requirements that reflect their particular importance in implementing domestic financial policy.

b. Permitting Growth Without Undue Regulatory Burden A second issue that the SEC would have to address in revamping broker-dealer regulation of ATSs is how to strike an appropriate balance between imposing new regulatory requirements on ATSs without discouraging these systems from acquiring enough liquidity to ensure their long-term viability. If an ATS knows that it will face substantial new regulatory costs if the ATS "graduates" to a higher level of regulation, the ATS could face a perverse regulatory disincentive from becoming too efficient or too competitive. This counsels for setting the threshold to heightened regulation at a high level. Moreover, new surveillance or transparency requirements should be written so as to provide ATSs with some flexibility to continue to develop new services, or to alter existing services to meet user preferences.

A related issue is how to define the type of "size" by which an ATS’s growth to enhanced regulation is measured. The Release does not discuss the way in which the Commission thinks ATS size should be measured. For example, size might be measured by the daily number of shares traded, by the dollar amount of shares traded, or by the number of transactions. SIA does not have a view at this time on which measurement is most appropriate, but we note that this is a significant question. For example, a measurement based on number of transactions might pick up a very different group of systems than a measurement based on daily dollar value of shares traded.

c. Concerns of Institutional Investors Any enhanced regulatory requirements on ATSs or their customers should be drafted to address the needs and concerns of institutional customers. If ATSs are subject to significantly expanded transaction disclosure requirements these customers could lose the anonymity that ATSs provide to institutions and to broker-dealers that are not market-makers. Moreover, if institutional investors find that by using broker-dealer automated systems they are subject to a new panoply of compliance and other regulatory requirements they may have a significant new incentive to move their business offshore. This result would be in neither the Commission’s nor the securities industry’s best interest.

In this regard, the Commission should limit any new quotation or order disclosure requirements to price disclosure only. Increased market disclosure of quotation and execution prices is extremely important to improved market transparency. However, information as to size of transactions plays a less useful role in providing meaningful transparency, and carries much greater disadvantages for institutional investors (particularly for orders of block size), who may find it much more difficult to accumulate or dispose of positions because their activity will have a much greater impact on market price. 19

While SIA could support enhanced transparency for ATS prices, we believe that new regulations aimed at mandating order transparency for ATSs could well drive institutional order flow to less transparent and less efficient brokerage mechanisms. Therefore, ATSs should be given maximum flexibility in meeting any new transparency obligations. It may be appropriate to permit the ultimate customer to retain the ability to exclude an order from being displayed. Similarly, it would be reasonable to permit ATSs or their customers not to display orders that would result in a locked or crossed market.

d. Public Access to ATS Participant Orders The Release states that if ATSs are required in some manner to publicly display the orders of all participants, they could also be required to provide the public with the ability to execute against those orders. SIA believes that it would be reasonable to support providing non-participants with the ability to execute against all orders in an ATS subject to two conditions. First, access should only be offered through an entity that meets the general standards for participants in the system (e.g., credit quality or net worth). Second, except in situations where the ATS provides a clearance and settlement mechanism, access should only be provided through an entity that can provide appropriate clearance and settlement, such as a broker-dealer, or a non-broker-dealer that has a delivery-versus payment account with a clearing bank.

4. Regulation of Alternative Trading Systems as Exchanges

All of the concerns noted above concerning enhanced broker-dealer regulation are applicable as well regarding regulation of ATSs as exchanges. However, there a number of additional substantial regulatory, policy and legal concerns that in SIA’s view make a new approach to exchange regulation highly inadvisable.

a. Impact on Investors The Release recognizes that reclassification of ATSs as exchanges would change the commercial relationship between ATSs and their customers. In particular, the Commission suggests, and invites comment on, whether institutions should be allowed to participate on registered exchanges to the same extent as registered broker-dealers. 20 Any regulatory attempt to mandate that ATS customers be required to become members of an exchange would have troubling implications. Many institutional investors could find themselves directly regulated by an exchange for the first time. For many institutional investors, the prospect of potentially losing the anonymity that ATSs provide may not be inviting, particularly if they are also subjected to inappropriate compliance requirements and costs.

Another concern is the possible regulatory fragmentation and competitive disparity that could result if customers that are not broker-dealers are able, as a result of membership in an exchange, to perform many functions similar to those performed by broker-dealers without having to register as broker-dealers or take on important broker-dealer regulatory obligations in areas such as best execution or net capital requirements. The Release tries to address some of these concerns by suggesting that some regulatory requirements, such as SRO net capital requirements, could be rewritten "applying different financial requirements to non-broker-dealers than they currently apply to broker-dealers. 21 This suggestion may prove too much. Efforts to "customize" aspects of broker-dealer regulation as complex as capital requirements to non-broker-dealers would be likely to either lead to the regulatory fragmentation just mentioned, or to impose regulatory compliance costs that would drive institutional investors back to traditional exchange relationships.

Additionally, questions of fairness will undoubtedly arise, since placing greater regulatory burdens on ATS customers creates a regulatory preference favoring one class of investors over another. In other contexts, such as Rule 144A and Rule 15a-6, the Commission has recognized that there are differences between institutional investors and retail investors that militate for reduced regulatory requirements in the institutional context. The tiered exchange approach moves in the opposite direction. The anomaly is especially striking in light of the fact that a vast and growing number of small investors participate in the capital markets through institutions such as pension plans and mutual funds. By requiring that retail investors be permitted to interact with institutional order flow, or by imposing other regulatory burdens on institutions that seek to trade among themselves, the Commission would in effect be writing rules that prefer one group of small investors (those who invest directly through a broker-dealer) over another group (those who invest through a mutual fund or pension fund). The policy justification for choosing this path is difficult to see.

b. Impact on Competition Contrary to the Release’s view, SIA believes that reformulating exchange regulation would be likely to reduce competition between market centers. Applying exchange-type regulatory requirements to ATSs will simply weaken their ability to compete with existing exchanges, and will discourage other innovators in the future. Exchange regulation was designed to address the needs of an era when exchanges were natural monopolies, providing the sole location for liquidity in many securities. Regulation to ensure market integrity and fair dealing were an appropriate answer to the possible abuse of that monopoly power. Advances in technology made possible competing markets (or at least market-execution services) in the form of ATSs and other systems. Therefore, far from advancing the goals of exchange regulation, this approach frustrates those goals.

The Release’s view that it can address all of these competitive issues through exemptive orders does not adequately address this concern. For the Commission to accomplish this, it would have to be prepared not merely to issue a raft of exemptive orders to ATSs and their participants upon adoption of such a regulatory program, but it would also have to be prepared, in perpetuity, to continuously refine exemptive orders in a timely manner to address new technological innovations or business developments regarding ATSs or their participants. No matter how capable, well-informed or well-intentioned the Commission staff may be, both now and in the future, this would be a tremendous burden on Commission resources. Moreover, as a practical matter, ATSs and their participants will find themselves in the position of frequently having to cross new legal hurdles to get Commission approval for incremental systems changes and innovations. The legal costs, as well as the costs of delayed implementation, could be very severe.

"Tiered" exchange regulation would reduce competition in other ways as well. As noted above, by imposing new regulatory requirements on ATSs once they reach a certain "critical mass’ of volume and liquidity, ATSs may face a powerful disincentive from growing too large, which would reduce their effectiveness as a competitor for other market centers. Basing different levels of exchange regulation on different size "tiers" would exacerbate this concern. ATSs falling below the minimum threshold for the lowest tier would have reason not to want to cross that threshold, while ATSs in the lowest tier would likewise have reason not to want to grow into the next tier, and so on.

c. Legal Uncertainty The Commission’s discussion of exchange regulation of ATSs is premised entirely on a reversal of the Commission’s prior interpretation of the statutory term "exchange" to encompass ATSs. While the definition of "exchange" contained in Section 3(a)(1) of the Securities Exchange Act ("Exchange Act") is broad on its face, the SEC has previously analyzed that definition and identified certain limitations on the scope of the definition. In a 1990 order finding that the term "exchange" did not apply to an over-the-counter options trading system ("Delta Release"), the Commission stated that "employing an expansive interpretation of section 3(a)(1) results in potential conflicts with other central regulatory definitions under the Act as well as adverse effects on innovation and competition." 22 The Commission’s Delta Release concluded that the statutory definition denoting an exchange to mean "any organization, association or group of persons … performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood" limited the meaning of the term to entities that enhanced liquidity in traditional ways through market makers, specialists, or a single price auction market. 23 As the Release acknowledges, the view taken by the Commission in the Delta Release "effectively excluded most ATSs from exchange regulation."

Notwithstanding the Commission’s interpretation in the Delta Release and in a string of subsequent no-action letters dating up to December 1996, 24 the current Release argues that the Commission should now reverse its interpretation of the term "exchange." The Release bases this conclusion on its belief that there are "several alternative ways in which the definition of "exchange" could be applied more broadly," and lists eight criteria, not explicitly encompassed in the Delta Release, that have been cited to varying degrees in several academic studies as indicators of an exchange. 25 The current Release goes on to suggest that these criteria may themselves prove to be too narrow or too broad to accurately reflect what is "generally understood" to be an exchange. It then posits the definition italicized on page 7 above, which it maintains would update the Commission’s interpretation of the term "exchange" to "reflect changes in the U.S. and world markets brought about by automated trading." 26

SIA agrees with the Commission that there is some ambiguity as to the precise scope of the statutory definition of the term "exchange." Therefore, the Commission could elect to reverse its prior interpretation of the term "exchange" to include ATSs if inclusion of ATSs is a "permissible construction of the statute," in other words, if the Commission can reasonably demonstrate that a "generally understood" interpretation of the term "exchange" includes ATSs. 27

SIA respectfully suggests that the Release falls short of making this demonstration. The term "alternative trading system" as defined in the Release, and the proposed redefinition of "exchange" offered by the Release are both written broadly enough to capture trading systems that SIA does not believe are commonly regarded as "exchanges." As currently drafted, both of these definitions could be read to cover a wide variety of broker-dealer systems that are not commonly regarded as "exchanges" either by the broker-dealers who operate them or the parties that have orders entered in them.

As noted earlier, the Commission uses two separate formulations of the type of systems that it proposes to regulate as exchanges. First, it defines ATS to mean "automated systems that centralize, display, match, cross or otherwise execute trading interest…." Second, it proposes to redefine the term "exchange" to cover any organization that "consolidates orders of multiple parties" and "provides a facility through which … participants may agree to the terms of a trade." (emphasis added). Either of these formulations could be read to cover almost any automated broker-dealer system, even if the broker-dealer system is designed to internalize order flow or provide brokerage or dealer services that go beyond permitting trading directly between customers.

While the Release contains a lengthy footnote discussion of the views of various scholars on the features that characterize an "exchange," there is no discussion to support an interpretation that the term "exchange" is "generally understood" to include systems that provide intermediated trading in which a broker-dealer puts its own capital at risk or exercises discretion in handling customer orders. SIA also questions whether the Commission has demonstrated a "permissible construction" of how the term "exchange" is "generally understood" exclusively through a single footnote citing only to academic views (three of them unpublished). 28 Since the statutory definition hinges on the "generally understood" meaning of the term "exchange", it is puzzling that the wide array of questions posed by the Commission does not include a request for public comment on the scope of the term.

II. Role of Self-Regulatory Organizations

SEC Analysis In conjunction with the possible recategorization of some or all ATSs as exchanges, the Release also proposes fundamental shifts in the role of SROs. First, the Release proposes to impose SRO responsibilities upon certain ATSs under the tiered exchange concept discussed above. Under this approach, the Commission would use its exemptive authority to reduce or eliminate exchange requirements that are incompatible with the operation of for-profit non-membership exchanges. The Commission might also exercise its exemptive authority to permit exchanges in some or all of the tiers to contract out their SRO obligations to a third party. In order to ensure that existing exchanges and possible new exchanges can compete on an even footing , the Release suggests certain respects in which existing exchanges might be relieved of some current regulatory requirements.

SIA Response SIA agrees with much of the Release’s analysis insofar as it posits that if a tiered exchange approach were adopted, major changes in the structure of self-regulation would have to accompany that approach. As the Release suggests, the level of self-regulatory responsibility should be graduated according to the size of the exchange, and regulatory requirements on existing exchanges should be reduced to ensure that they are able to compete with ATSs. However, notwithstanding the Release’s attempt to level the playing field, exchanges would still be subject to more regulatory requirements than their ATS competitors, which would receive exemptions from many requirements in order to facilitate for-profit operation.

As it contemplates creating at least one and possibly many new SROs, it is striking that the Release fails to discuss a simple alternative approach: the consolidation of some or all SRO functions into one entity, which would have no business or organizational affiliation with any exchange other than compliance oversight responsibilities. For example, this might entail spinning off existing exchanges and similar markets, such as the New York Stock Exchange and Nasdaq into separate entities (possibly for-profit), and creating a new entity to oversee both ATSs and existing exchanges. This entity, with no financial or other ties to any exchange, might then be charged with administering many or all of the surveillance, examination, 29 compliance and enforcement functions that are now parceled out among many SROs. 30

While this approach may appear to be a radical departure, it is important to remember that the current structure of multiple SROs is largely a matter of historical accident, rather than an ab initio Congressional or Commission determination that multiple SROs were the best approach to self-regulation of markets. Moving in the direction of a single SRO may create efficiencies and economies of scale in administering self-regulation. 31 It also should alleviate perennial conflicts that arise with multiple SROs on matters ranging from examination coordination of joint members to inconsistencies in sales practice or financial responsibility requirements and have also even extended to advertising "wars." In particular, the concerns raised in the Release about the inherent conflicts of having competitors inspecting or regulating competitors would be substantially reduced.

The governance and funding of such an entity would have to be analyzed and constructed. 32 For example, provisions would have to be made to ensure fair representation of exchanges and different types of broker-dealers in the governance of the SRO. A particularly difficult question is how to structure such an entity in such a way that it retains the principal advantages of existing SROs -- sensitivity to the business realities of operating a market and accountability to its members and to the public. SIA does not necessarily seek to pursue a unitary SRO as its preferred outcome at this time, but believes that this approach deserves serious consideration as an alternative to moving in the direction of an even more fragmented system of self-regulation.

III. Regulation of Cross-Border Trading

A. SEC Analysis. The Release expresses the Commission’s concern that U.S. investors’ ability to trade directly on foreign markets may raise significant investor protection concerns. The Commission solicited specific comment on whether a new two-tiered approach is appropriate -- registering foreign markets and information vendors that provide direct market access as Securities Information Processors and imposing comparable regulatory requirements on both U.S. and foreign broker-dealers.

B. SIA Response. We believe that investors will become more committed to diversification and will continue to recognize the potential for return that exists in many foreign markets. As a result, we expect investment in foreign markets by U.S. investors to grow at an accelerated pace. Further, we believe that U.S. investors will seek out foreign investments, whether or not they are able to do so efficiently through electronic linkages. Clearly, it is in the best interests of investors to encourage the automation of that process, reducing many of the risks they otherwise face and decreasing costs through increased efficiency.

The type of electronic cross-border trading the Commission is looking to regulate is still in its infancy. No one can now predict how it will develop in the future and thus it is difficult to come to definitive conclusions about the appropriate regulatory structure at this early juncture. It may very well be prudent to allow the current structures to evolve in the most economically efficient manner, before deciding whether and how the Commission should regulate electronic cross-border trading.

In such a dynamic environment, any regulatory structure must be flexible enough to accommodate innovation. Paradoxically, the Commission has requested comment on an approach that may penalize the development of more efficient means of trading. By focusing on imposing greater regulatory responsibilities on those market participants that provide more efficient means of executing trades, the Commission may create significant disincentives to innovation. As the Release makes very clear, that is not the Commission’s goal, but it may be the unintended effect.

We agree with the Commission, however, that U.S. customers seeking access to foreign markets in the United States should be provided appropriate protections under U.S. securities laws. In assessing what those protections should be, we urge the Commission to consider the following objectives:

-- Such a regulatory structure must remain flexible to allow international trading to continue to develop and change to accommodate investors’ needs. Such a structure should not discourage innovation.

-- Any regulatory structure the Commission ultimately adopts must not impose unnecessary impediments to the efficient execution of trades or limit the ability of U.S. customers to access foreign markets.

-- Such a regulatory structure must remain flexible to allow international trading to continue to develop and change to accommodate investors’ needs. Such a structure should not discourage innovation.

-- Finally, the Commission must address the Securities Act and Exchange Act registration issues facing foreign issuers whose securities are traded in foreign markets that provide access to U.S. investors.

1. Balancing Effective Regulation and Enhanced Access to Foreign Markets

SIA believes it would not be prudent to try to replicate the entire U.S. regulatory structure in the context of foreign market access. Customers will always face risks other than those they assume in the U.S. markets, with or without Commission oversight. Even if the Commission were to register foreign markets, activities will occur in those markets that are outside the Commission’s jurisdiction. As effective as Commission oversight has been in the United States, it cannot provide customers accessing foreign markets the same level of protection. Thus, there is a potential danger that investors could be lulled into a false sense of security about investing in foreign markets that are registered with the Commission.

We believe that the better approach would be to ensure that investors who seek to access foreign markets are afforded ample protections that are comparable to those currently provided by U.S. registered broker-dealersU.S. broker-dealers currently benefit from the substantial protections afforded customers of U.S. broker-dealers. Those protections include application of suitability and sales practice rules, custody and control and net capital rules, as well as requirements to be members of a self-regulatory organization and the Securities Investor Protection Corporation.

Policy issues arising from increased electronic access to foreign exchanges are similar to the issues the Commission has wrestled with in the area of access by foreign market intermediaries. The Commission’s response to these issues, the safe harbor from the broker-dealer registration requirement in Rule 15a-6, is currently the subject of proposals for reform by SIA and the Public Securities Association (recently renamed the Bond Market Association). SIA believes that the SEC should address these issues promptly in the 15a-6 context as a predicate to addressing issues in the context of foreign exchanges.

SIA believes it is relevant for the Commission to consider, among the factors that may determine the degree of appropriate conditions to foreign market access, the type of securities traded by the market. For example, considerations involving the fixed income markets may well be different from those applied to the equity markets. Derivative markets present yet another product that may appropriately be the subject of unique criteria. This is because equity index options, for example, have characteristics that closely resemble options on stock index futures contracts, and on some foreign exchanges these futures and securities products are traded together. It is anomalous that the Commission, in granting no-action relief to foreign derivatives exchanges such as London, Hong Kong and Paris, has expressly limited access to major institutional investors while futures on the same indices can be freely traded by any U.S. investor under current CFTC rules.

In considering the issues involving foreign access, the Commission must not overlook the impact of the Securities Act of 1933 to the offer and sale to U.S. investors of securities traded on these foreign markets. Indeed, the Commission’s no-action letters granted to foreign derivatives exchanges did not address at all the implications of these products under the registration requirements of the Securities Act. We believe that it is essential to the Commission’s goal of accommodating U.S. investors cross-border trading that these registration issues be resolved for the benefit of U.S. customers, foreign issuers, and intermediaries alike.

Conclusion

SIA again wishes to thank the Commission for the opportunity to comment on its far-reaching Concept Release. We believe that the Concept Release raises issues that will be critically important to the successful regulation of the securities markets in coming years. We look forward to working with the Commission as it charts the course for federal market regulation into the next century.

If SIA can provide further information please contact the undersigned or any of the following SIA staff at (202)296-9410: Stuart J. Kaswell, Senior Vice President and General Counsel; George Kramer, Vice President and Associate General Counsel; or

Judith Poppalardo, Vice President and Associate General Counsel.

Very truly yours,

A.B. Krongard

Chairman, SIA Task Force on Alternative Trading System Concept Release

Vice Chairman, Bankers Trust New York Corporation

Members of the SIA Task Force on the Alternative Trading System Concept Release:

A.B. Krongard -- Bankers Trust New York Corporation;

Scott Abbey -- PaineWebber Group Inc.;

Dan Case -- Hambrecht & Quist, LLP;

Bernard L. Madoff -- Bernard L. Madoff Investment Securities;

Carlos Morales -- Merill Lynch & Co., Inc.

Perry Taylor, Jr., -- ABN Amro Chicago Corporation

Attachment: SIA Response to Selected Questions in ATS Concept Release.

cc (w. attachment):

The Honorable Arthur Levitt, Chairman;

The Honorable Norman S. Johnson, Commissioner;

The Honorable Isaac C. Hunt, Jr., Commissioner;

Richard H. Walker, General Counsel;

Dr. Richard R. Lindsey, Director, Division of

Market Regulation;

Robert L.D. Colby, Deputy Director, Division

of Market Regulation;

Catherine McGuire, Associate Director and Chief

Counsel, Division of Market Regulation;

Belinda Blaine, Senior Special Counsel, Division

of Market Regulation;

Paula Jensen, Deputy Chief Counsel, Division of

Market Regulation.

Appendix -- SIA Response to Selected Questions in ATS Concept Release

(Note: In addition to the answers to specific questions provided below, many other questions posed by the Commission are implicitly addressed throughout SIA’s comment letter.)

Question 1: The Commission seeks comment on the concerns identified above and invites commenters to identify other issues raised by the current approach to regulating alternative trading systems.

Question 2: Are the concerns raised in this release with regard to the operation of alternative trading systems under the current regulatory approach unique to such systems? To what extent could these concerns be raised by broker-dealers that do not operate alternative trading systems, such as a broker-dealer that matches customer orders internally and routes them to an exchange for execution or a broker-dealer that arranges for other broker-dealers to route their customer orders to it for automated execution?

Response to Questions 1 and 2: The Commission states in its Release that its central concern about the existing approach to ATS regulation is its belief that "gaps have developed in the structures designed to ensure marketwide fairness, transparency, integrity and stability." Whether and to what extent such gaps exist is difficult to assess right now, as the markets are undergoing substantial changes as a result of implementation of the order-handling rules. These rules are clearly intended to provide considerably greater transparency for many ATSs. Moreover, the Order Audit Trail System that is now being developed should provide much better surveillance tools for secondary market activity in Nasdaq -listed securities, the most significant component of ATS order flow.

For these and other reasons described in our letter, SIA believes that the Commission should move cautiously. Neither the Commission nor investors, broker-dealers, exchanges, or other market participants have a complete understanding of what "alternative trading systems" are, the reasons why investors elect to use them, the extent of transparency or other regulatory concerns that they may pose, or what the impact would be on investors, intermediaries or markets if ATSs and their users were subject to new regulatory requirements.

Between the two models posited by the Commission for regulating ATSs, enhanced broker-dealer regulation and a new species of exchange regulation, SIA much prefers the more flexible and evolutionary course of modified broker-dealer regulation. Within this established regulatory framework the Commission should most easily be able to make appropriate modifications to ensure greater transparency, wider access, and better surveillance without creating unforeseen consequences. Moreover, this would avoid the extensive and complex regulatory changes, and difficult legal and policy issues, that a tiered exchange approach would entail.

***

Question 3: What regulatory approaches would best address the concerns raised by the growth of alternative trading systems and the needs of the market? Is the current approach the most appropriate one?

Question 8:Is the current regulatory framework an effective form of oversight,

in light of technological changes? Are there other regulatory techniques that would be comparably effective? If so, would the implementation of such techniques be consistent with congressional goals reflected in the Exchange Act?

Response to questions 3 and 8: The primary goal in regulating ATSs should be to encourage and facilitate innovation, and the Commission’s existing regulatory approach toward ATSs has thus far been successful in fostering such innovation. The competitiveness of U.S. capital markets has flourished under the current regulatory approach. The transactional efficiency and anonymity that ATSs provide make them an attractive venue for institutional investors. This in turn has led to a substantial growth in institutional order flow to a number of ATSs, making them even more efficient, and more substantial competitors with other markets and exchanges.

If the Commission determines that a substantial revision of the broker-dealer regulatory regime for ATSs is required, the most significant regulatory issue that the Commission will have to address is how to distinguish between "alternative trading systems" and broker-dealer systems that simply use current technology to perform normal broker-dealer functions. Any effort to re-categorize a wide variety of automated systems would greatly discourage innovation and impede speedy and efficient execution of transactions, the very opposite of results that the Commission has always sought. As the Release states, "(i)ntegrating newly registered national securities exchanges should not cause the homogenizing of all markets – to the contrary, it is as important today as it was in 1975 to cultivate an atmosphere in which innovation is welcome and possible."

For example, the Commission should not seek to impose new regulations on a broker-dealer system that permits customers or other broker-dealers to effect transactions with the sponsor of the system. Far from impeding transparency, these broker-dealers provide a normal and essential intermediary function. As with market-makers or specialists, broker-dealers typically use their automated systems to interact with customer orders and to place their own capital at risk. This function is essential to the markets' smooth functioning, especially during volatile periods when broker-dealers provide essential short-term liquidity.

The mere fact that advances in technology make it feasible for a broker-dealer to use a computer screen rather than a telephone to route customer orders internally, or to electronically link customers to existing (or future) exchange electronic order execution systems (e.g., Super Dot), does not require a change in regulatory treatment. Rather, new regulatory requirements must focus only on systems that raise the regulatory concerns identified in the Release. One way of stating the distinction is that the Commission's focus should not go beyond those systems that permit trading directly between customers, or between broker-dealers other than the sponsor and customers.

* * *

Question 4: What should be the objectives of market regulation? Are the goals and regulatory structure incorporated by Congress in the Exchange Act appropriate in light of technological changes? Are business incentives adequate to accomplish these goals?

Response to question 4: The goals of market regulation should in SIA’s view be those enumerated on page 4 of our letter, particularly ensuring the stability, liquidity competitiveness, creativity and transparency of American capital markets. Exchange regulation was designed to address the needs of an era when exchanges were natural monopolies, providing the sole location for liquidity in many securities. Advances in technology made possible competing markets (or at least market-execution services) in the form of alternative trading systems and other broker-dealer systems. Securities regulation should continue to strive to foster such innovation. In SIA’s view, attempting to re-classify innovative trading systems as exchanges would sacrifice innovation without meaningfully advancing any of the other goals of market regulation.

* * *

Question 17: Are there any reasons that non-participants should not be able to execute against orders of participants in alternative trading systems?

Response to question 17: By requiring that retail investors be permitted to interact with institutional order flow, or by imposing other regulatory burdens on institutions that seek to trade among themselves, the Commission would in effect be writing rules that prefer one group of investors (those who invest directly through a broker-dealer) over another group (institutional investors and those who invest through an institution such as a mutual fund or pension fund). The policy justification for choosing this path is difficult to see.

* * *

Question 24: Is access to alternative trading systems an important goal that the Commission should consider in regulating such systems? If so, are there circumstances in which alternative trading systems should be able to limit access to their systems (for example, should the Commission be concerned about access to an alternative trading system that has arranged for its quotes to be displayed as part of the public quotation system)?

Question 25: If alternative trading systems were to continue to be regulated as broker-dealers and were subject to a fair access requirement, should the Commission consider denial of access claims brought by participants and non-participants in alternative trading systems? If not, are there other methods that could adequately address such claims?

Question 30: If alternative trading systems continue to be regulated as broker-dealers, how can the Commission address anticompetitive practices by such systems?

Response to Questions 24, 25 and 30: Unreasonable denials already may give rise to a number of private liabilities in many situations (e.g., breach of contract, securities fraud claims or antitrust claims). If there is evidence that private liability exposure is proving insufficient to prevent unfair denials of access, the Commission could consider using its current regulatory authority over broker-dealers to require reporting of denials of access. Sunlight is still the best disinfectant, and to the extent that unfair denials of access is a problem, mandated public disclosure of access denials would very likely lead to a market solution.

* * *

Question 33: Is broadening the Commission's interpretation of "exchange" to cover diverse markets, and then exempting all but the most significant of these new exchanges from registration, the most appropriate way to address the regulatory gaps discussed above and provide the Commission with sufficient flexibility to oversee changing market structures?

Response to question 33: SIA believes that reformulating exchange regulation would be likely to reduce competition between market centers. Applying exchange-type regulatory requirements to ATSs will simply weaken their ability to compete with existing exchanges, and will discourage other innovators in the future.

The Release’s view that it can address all of these competitive issues through exemptive orders does not adequately address this concern. For the Commission to accomplish this, it would have to be prepared not merely to issue a raft of exemptive orders to ATSs and their participants upon adoption of such a regulatory program, but it would also have to be prepared, in perpetuity, to continuously refine exemptive orders in a timely manner to address new technological innovations or business developments regarding ATSs or their participants. No matter how capable, well-informed or well-intentioned the Commission staff may be, both now and in the future, this would be a tremendous burden on Commission resources. Moreover, as a practical matter, ATSs and their participants will find themselves in the position of frequently having to cross new legal hurdles to get Commission approval for incremental systems changes and innovations. The legal costs, as well as the costs of delayed implementation, could be very severe.

"Tiered" exchange regulation would reduce competition in other ways as well. As noted above, by imposing new regulatory requirements on ATSs once they reach a certain "critical mass’ of volume and liquidity, ATSs may face a powerful disincentive from growing too large, which would reduce their effectiveness as a competitor for other market centers. Basing different levels of exchange regulation on different size "tiers" would exacerbate this concern. ATSs falling below the minimum threshold for the lowest tier would have reason not to want to cross that threshold, while ATSs in the lowest tier would likewise have reason not to want to grow into the next tier, and so on.

A related issue is how to define the type of "size" by which an ATS’s growth to enhanced regulation is measured. The Release does not discuss the way in which the Commission thinks ATS size should be measured. For example, size might be measured by the daily number of shares traded, by the dollar amount of shares traded, or by the number of transactions. For example, a measurement based on number of transactions might pick up a very different group of systems than a measurement based on daily dollar value of shares traded. SIA does not have a view at this time on which measurement is most appropriate, except that we think that it would be far better to base different regulatory categories on functional distinctions rather than arbitrary measurements of size.

* * *

Question 44: Should the Commission allow institutions to be participants on registered exchanges to the same extent as registered broker-dealers? If so, should the Commission adopt rules allowing registered exchanges to have institutional participants, or should the Commission issue exemptive orders on a case-by-case basis, upon application for relief by registered exchanges?

Response to question 44: Regulatory fragmentation and competitive disparity could result if customers that are not broker-dealers are able, as a result of membership in an exchange, to perform many functions similar to those performed by broker-dealers without having to register as broker-dealers or take on important broker-dealer regulatory obligations in areas such as best execution or net capital requirements. Efforts to "customize" aspects of broker-dealer regulation as complex as capital requirements to non-broker-dealers would be likely to either lead to such regulatory fragmentation, or to impose regulatory compliance costs that would drive institutional investors back to traditional exchange relationships.

In addition, dependence on exemptive authority as a justification for adopting otherwise potentially unwieldy regulatory requirements is troubling. SIA does not believe that Congress intended the SEC’s exemptive authority as a license to write rules that are more far-reaching than it would otherwise propose.

* * *

Question 53: Would the revised interpretation of "exchange" being considered by the Commission adequately and clearly include alternative trading systems that operate open limit order execution systems (even those that also provide brokerage functions)?

Response to question 53: As discussed on pages 15-17, SIA believes that, a legal matter, the Release does not present an adequate basis for reversing the Commission’s current interpretation of the term "exchange." Moreover, both the Commission’s formulations of "alternative trading system" and its formulation of "exchange" could be read to cover almost any automated broker-dealer system, even if it is designed to internalize order flow or provide brokerage or dealer services that go beyond permitting trading directly between customers.

* * *

Question 56: Is it appropriate for the Commission to consider the activities described above as broker-dealer activities?

Question 57: How should a revised interpretation of exchange adequately and clearly distinguish broker-dealer activities, such as block trading and internal execution systems, from market activities?

Question 58: Are the distinctions discussed above accurate reflections of exchange and broker- dealer activities? Are there other factors that may better distinguish a broker-dealer from an exchange?

Question 59: How should a revised interpretation of the term "exchange" adequately and clearly distinguish broker-dealer activities, such as block trading and internal execution systems, from market activities?

Question 60: What factors should the Commission consider in determining whether an organization of dealers is sufficiently "organized" to require exchange registration?

Question 61: Does the revised interpretation of "exchange" described above clearly exclude information vendors, bulletin boards, and other entities whose activities are limited to the provision of trading information? How should the Commission distinguish between information vendors, bulletin boards, and exchanges?

Question 62: If the Commission expands its interpretation of "exchange," should the Commission exempt interdealer brokers that deal only in exempted securities from the application of exchange registration and other requirements?

Question 63: How could the Commission define interdealer brokers in a way that would implement congressional intent not to regulate traditional interdealer brokers as exchanges, without unintentionally exempting other alternative trading systems operated by brokers?

Response to Questions 56-63: These questions appear to reflect the Commission’s recognition that broker-dealer functions such as automated block trading and internal execution systems, information vendors and bulletin boards, and most if not all inter-dealer broker services, should not be subject to exchange regulation. The language of the revised interpretation set out in the release appears to sweep more broadly than the Commission may have intended, since it applies to "any organization that both (1) consolidates orders of multiple parties; and (2) provides a facility through which . . . participants entering such orders may agree to the terms of a trade." SIA believes that this language needs to be modified to clarify that, at a minimum, the term "exchange" does not cover entities that regularly put their own capital at risk in processing trades, such as by taking one side of transactions conducted in their system, or that otherwise exercise discretion in determining how to handle customer orders.

* * *

Question 105: What regulatory approaches would best address the concerns raise by the development of automated access to foreign markets? Would these approaches differ if U.S. investors accessed foreign markets in ways other than those described above, such as through the Internet? Are there any other alternative approaches that could be more appropriate?

Response to question 105: The type of electronic cross-border trading the Commission is looking to regulate is still in its infancy. No one can now predict how it will develop in the future and thus it is difficult to come to definitive conclusions about the appropriate regulatory structure at this early juncture. It may very well be prudent to allow the current structures to evolve in the most economically efficient manner, before deciding whether and how the Commission should regulate electronic cross-border trading. The Release’s example of access over the Internet aptly illustrates the shortcomings of attempting to impose restrictions on investor access to foreign markets.

We agree with the Commission, however, that U.S. customers seeking access to foreign markets in the United States should be provided appropriate protections under U.S. securities laws. In assessing what those protections should be, we urge the Commission to consider the following objectives:

-- Such a regulatory structure must remain flexible to allow international trading to continue to develop and change to accommodate investors’ needs. Such a structure should not discourage innovation.

-- Any regulatory structure the Commission ultimately adopts must not impose unnecessary impediments to the efficient execution of trades or limit the ability of U.S. customers to access foreign markets.

-- Such a regulatory structure must remain flexible to allow international trading to continue to develop and change to accommodate investors’ needs. Such a structure should not discourage innovation.

-- The Commission must address the Securities Act and Exchange Act registration issues facing foreign issuers whose securities are traded in foreign markets that provide access to U.S. investors.


FOOTNOTES

-[1]- The Securities Industry Association brings together the shared interests of more than 770 securities firms throughout North America to accomplish common goals. SIA members -- including investment banks, broker-dealers, and mutual fund companies -- are active in all markets and in all phases of corporate and public finance. In the U.S. SIA members collectively account for approximately 90 percent, or $100 billion, of securities firms' revenues and employ about 350,000 individuals. They manage the accounts of more than 50-million investors directly and tens of millions of investors indirectly through corporate, thrift and pension plans. More information about SIA is available at our Internet web site, http: // www.sia.com.

-[2]- Report of the Committee on Commerce on H.R. 3005, June 17, 1996 at 38. Section 3(f) of the Securities Exchange Act requires that when assessing the public interest, as it must in order to exercise its exemptive authority under Section 36 of the Exchange Act, the Commission must consider "whether the action will promote efficiency, competition, and capital formation."

-[3]- There is some troubling language in the Release suggesting that the Commission might view its new exemptive authority as a license to write rules that are more imprecise or more far-reaching than it would otherwise propose, relying on the use of exemptive orders to fix any problems that the rules might inadvertently create. SIA does not believe that Congress intended exemptive authority to provide such a license. We anticipate that the Commission will continue to follow the tradition of self-discipline and careful draftsmanship in rule-making that underlies so much of its excellent reputation as a regulator.

-[4]- The Commission forced regulatory changes at certain intervals, such as the adoption of Rule 19c-3 and the adoption of the Order Handling Rules.

-[5]- The Release defines alternative trading systems as "automated systems that centralize, display match, cross, or otherwise execute trading interest, but that are not currently registered with the Commission as national securities exchanges or operated by a registered securities association." 62 FR at 30486, n. 1.

-[6]- 62 F.R. at 30489. SIA assumes that the Commission’s choice of words here is not intended to suggest that the "active participation of intermediaries" is undesirable. As we discuss on page 11 below, the active participation of intermediaries (such as market-makers, specialists or other types of dealers) is essential to providing liquidity.

-[7]- 62 FR at 30490.

-[8]- 62 FR at 30491.

-[9]- 62 FR at 30492.

-[10]- 62 FR at 30498.

-[11]- 62 FR at 30499 (emphasis added).

-[12]- The Commission’s Order Handling Rules require market-makers to publicly display any superior prices that they offer through "electronic communications networks" ("ECNs") – a term that appears to encompass many ATSs. Alternatively, the ECN can fulfill this obligation on behalf of market-makers using its system by publicly displaying the best market-maker bid/ask quotations that it receives. 62 FR at 30493; see also Release No. 34-37619A (August 28, 1996), 61 FR 48290, at 48314 (Sept. 6, 1996). According to the Release, to date four ECNs display quotations under this alternative. 62 FR at 30493, n. 59.

-[13]- See Securities Exchange Act Rel. No. 34-38990 (August 28, 1997), 62 FR 47096.

-[14]- However, SIA believes that exchanges should be required to continue publishing proposals to introduce or modify their products. Exchange members should continue to have an opportunity to raise product-related concerns, especially anti-competitive concerns. Similarly, the Commission should continue to ensure that SROs’ authority is not exercised in such a way as to disadvantage broker-dealers and their competing products.

-[15]- The SEC’s concern that broker-dealer-operated ATSs are subject to potentially inapplicable regulatory requirements would appear to be very easily addressed through no-action letters or exemptive orders.

-[16]- 62 FR at 30512.

-[17]- In addition, as noted below, the Commission’s authority to apply the statutory term "exchange" to automated broker-dealer systems that permit transactions with the system’s sponsor is open to question. In SIA’s view, most if not all of these systems are not exchanges "as that term is generally understood," and therefore fall outside Exchange Act Section 3(a)(1).

-[18]- 62 FR at 30507. (emphasis added).

-[19]- The Commission appeared to appreciate this distinction in its Order Handling Rules, which required greater disclosure of ECN prices but not transaction sizes.

-[20]- 62 FR 30504.

-[21]- 62 FR 30515.

-[22]- Securities Exchange Act Release 34-27611 (Jan. 12, 1990); 55 FR 1890, 1900 (Jan. 19, 1990) ("Delta Release").

-[23]- Delta Release at 1900.

-[24]- See, e.g ., letters cited n. 124, 62 FR 30506.

-[25]- 62 FR at 30506.

-[26]- 62 FR at 30507.

-[27]- The Supreme Court has stated that "a revised (agency) interpretation deserves deference because ‘(a)n initial agency interpretation is not instantly carved in stone’ and ‘the agency, to engage in informed rule-making, must consider varying interpretations and the wisdom of its policy on a continuing basis.’ " Rust v. Sullivan , 500 U.S. 173, 186 (1991); quoting Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc. , 467 U.S. 837, 862 (1984). The Court noted that, where "the plain language and legislative history are ambiguous as to Congress’ intent …, we must defer the (agency’s) … permissible construction of the statute." Id. at 187 (emphasis added).

-[28]- See 62 FR 30506, n. 126.

-[29]- SIA appreciates that over the past two years the Commission and SROs have given close attention to reducing the instances in which broker-dealers find themselves subject to overlapping or duplicative routine examinations by different examination authorities.

-[30]- Individual exchanges might still be responsible for setting their own listing standards, membership criteria, trading rules subject to SRO approval, and maintaining their own audit trails, subject to SRO examination.

-[31]- It would be reasonable to expect that the efficiencies created by a consolidation of SROs would result in a reduction in the overall level of fees imposed on broker-dealers.

-[32]- The SRO might be funded through transaction or volume fees, as the NASD and New York Stock Exchange are currently. The level of fees might also be dependent on the tier within which an exchange is placed.