SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 202, 240, 242 and 249
Release No. 34-40760; File No. S7-12-98
RIN 3235-AH41
Regulation of Exchanges and Alternative Trading Systems
AGENCY: Securities and Exchange Commission
ACTION: Final rules
SUMMARY: The Securities and Exchange Commission today is
adopting new rules and rule amendments to allow alternative
trading systems to choose whether to register as national
securities exchanges, or to register as broker-dealers and
comply with additional requirements under Regulation ATS,
depending on their activities and trading volume. The
Commission is also adopting amendments to rules regarding
registration as a national securities exchange, repealing
Rule 17a-23, and amending the books and records rules by
transferring the recordkeeping requirements from Rule 17a-23
to Rules 17a-3 and 17a-4 as they apply to broker-dealer
internal trading systems. Finally, the Commission is
excluding from the rule filing requirements for self-
regulatory organizations certain pilot trading systems
operated by national securities exchanges and national
securities associations. These rules will more effectively
integrate the growing number of alternative trading systems
into the national market system, accommodate the
registration of proprietary alternative trading systems as
exchanges, and provide an opportunity for registered
exchanges to better compete with alternative trading
systems.
DATES: Effective Date: [Insert date 120 days after
publication in the Federal Register], except §§
242.301(b)(5)(i)(D) and (E) and §§ 242.301(b)(6)(i)(D) and
(E), which shall become effective on April 1, 2000.
Compliance Date: Prior to [insert date 120 days
after publication in the Federal Register], the Commission
will publish a schedule of those securities with respect to
which alternative trading systems must comply with §
242.301(b)(3) on [insert date 120 days after publication in
the Federal Register] and those securities with respect to
which alternative trading systems must comply with §
242.301(b)(3) on [insert date 240 after publication in the
Federal Register]. See Section VIII of this release.
FOR FURTHER INFORMATION CONTACT: Elizabeth King, Senior
Special Counsel, at (202) 942-0140, Marianne Duffy, Special
Counsel, at (202) 942-4163, Constance Kiggins, Special
Counsel, at (202) 942-0059, Kevin Ehrlich, Attorney, at
(202) 942-0778, Denise Landers, Attorney, at (202) 942-0137
and John Roeser, Attorney, at (202) 942-0762, Division of
Market Regulation, Securities and Exchange Commission, Stop
10-1, 450 Fifth Street, N.W., Washington, D.C. 20549. For
questions or comments regarding securities registration
issues raised in this release, contact David Sirignano,
Associate Director, at (202) 942-2870, Division of
Corporation Finance, Securities and Exchange Commission,
Stop 3-1, 450 Fifth Street, N.W., Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION:
Table of Contents:
I. Introduction
Today the Securities and Exchange Commission
("Commission" or "SEC") is adopting a regulatory framework
for alternative trading systems,[1] to strengthen the public
markets for securities, while encouraging innovative new
markets. During the past three years, the Commission has
undertaken a reevaluation of its regulatory framework for
markets because of substantial changes in the way securities
are traded. Market participants have incorporated
technology into their businesses to provide investors with
an increasing array of services, and to furnish these
services more efficiently, and often at lower prices. The
current regulatory framework, however, designed more than
six decades ago, did not envision many of these trading and
business functions. In particular, market participants have
developed a variety of alternative trading systems that
furnish services traditionally provided solely by registered
exchanges.
To better understand the questions raised by
technological developments in the U.S. markets, in May 1997,
the Commission published a concept release exploring ways to
respond to the rapid technological developments affecting
securities markets and, in particular, the growing
significance of alternative trading systems ("Concept
Release"). [2] After taking into consideration the comments
submitted in response to the Concept Release, in April 1998,
the Commission proposed a new regulatory framework for
alternative trading systems ("Proposing Release"). [3]
Alternative trading systems now handle more than twenty
percent of the orders in securities listed on The Nasdaq
Stock Market ("Nasdaq"), and almost four percent of orders
in exchange listed securities. These systems operate
markets similar to the registered exchanges and Nasdaq.
Over time, an alternative trading system may become the
primary market for some securities. Yet these markets are
private, available only to chosen subscribers, and are
regulated as broker-dealers, not in the way registered
exchanges and Nasdaq are regulated. This creates
disparities that affect investor protection and the
operation of the markets as a whole.
Our national market system, as it has evolved since
1975, has sought the benefits of both market centralization
-- deep, liquid markets -- and competition. To achieve
these benefits, the national market system has maintained
equally regulated, individual markets, which are linked
together to make their best prices publicly known and
accessible. Alternative trading systems have remained
largely outside the national market system. For example,
the evidence in the Commission’s report on the National
Association of Securities Dealers, Inc. ("NASD") and Nasdaq
suggested that widespread use of Instinet by market makers
as a private market had a significant impact on public
investors and the operation of the Nasdaq market.[4]
Through Instinet, market makers were able to quote prices
better than those made available to public investors. This
private market developed only because the activity on
alternative trading systems is not fully disclosed, or
accessible, to public investors. Moreover, these trading
systems have no obligation to provide investors a fair
opportunity to participate in their systems or to treat
their participants fairly. These systems may also not be
adequately surveilled for market manipulation and fraud. In
fact, market participants can manipulate the prices in the
public securities markets through the use of alternative
trading systems.[5] In addition, alternative trading
systems have no obligation to ensure that their systems are
sufficient to handle rapid increases in trading volume as
occurs in times of market volatility, and at times they have
failed to do so. Because of the increasingly important role
of alternative trading systems, these differences are
inconsistent with the national market system goals set forth
by Congress in the 1975 amendments to the Securities
Exchange Act of 1934 ("1975 Amendments")[6] and call into
question the fairness of current regulatory requirements.
In 1996, Congress provided the Commission with greater
flexibility to regulate new trading systems by giving the
Commission broad authority to exempt any person from any of
the provisions of the Securities Exchange Act of 1934
("Exchange Act") and impose appropriate conditions on their
operation.[7] This new exemptive authority, combined with
the ability to facilitate a national market system, provides
the Commission with the tools it needs to adopt a regulatory
framework that addresses its concerns about alternative
trading systems without jeopardizing the commercial
viability of these markets. In the Proposing Release, the
Commission proposed ways to use these tools to adopt new
rules and rule amendments designed to resolve many of the
concerns raised by alternative trading systems, better
integrate these systems into our national market system
structure, and make the benefits of these systems available
to more investors.
In response to its Proposing Release,[8] the Commission
received seventy comment letters.[9] Commenters generally
supported the Commission’s proposals and welcomed the
regulatory flexibility these proposals offered.[10] Many
commenters agreed with the Commission that the regulatory
structure needs to be modernized to better integrate
alternative trading systems into the national market
system.[11] For example, several commenters expressed the
view that, on balance, the proposed regulatory framework for
alternative trading systems represented a preferable
alternative to the current regulation of these systems as
broker-dealers, which is not only inadequate for many
alternative trading systems, but also results in disparate
regulatory treatment of exchange markets and their
alternative trading system competitors. [12] Other
commenters believed that the Commission’s proposal was a
step in the right direction, both from a competitive
business perspective and from an investor protection and
fair regulation perspective. While some commenters thought
that the Commission should continue the present framework
for alternative trading systems,[13] most believed that the
proposal provided a framework that could maintain a
competitive balance among the markets offering services to
investors.[14] Other commenters were pleased by the
Commission’s determination to allow market participants to
engage in business decisions regarding how to register with
the Commission.[15] Commenters also generally supported the
Commission’s proposal to allow for-profit exchanges,[16] and
generally supported the proposed temporary exemption for
pilot trading systems.[17]
The Commission believes that its regulation of markets
should both accommodate traditional market structures and
provide sufficient flexibility to ensure that new markets
promote fairness, efficiency, and transparency. In adopting
a new regulatory framework for alternative trading systems
today, the Commission has incorporated suggestions and
responded to requests for clarification made by commenters.
The Commission believes that this regulatory approach
effectively addresses commenters’ concerns while carefully
tailoring a regulatory framework that is flexible enough to
accommodate the evolving technology of, and benefits
provided by, alternative trading systems.
While the revised regulatory scheme implemented today
is designed to address changes in the way securities are
traded, the Commission’s assessment of the impact that these
systems may have on the trading of unregistered securities
(i.e. of both domestic and foreign issuers), and of the
appropriate regulatory posture to these developments, is
still ongoing. This matter and the broader issues involving
recent trends and initiatives that give U.S. investors
greater and more instantaneous access to foreign securities
markets create tensions between competing Commission goals.
The Commission, for example, wishes to foster developments
that enable U.S. investors to execute securities trades more
efficiently, but it also desires that foreign securities
traded in U.S. markets have full and fair disclosure. These
tensions and issues will be addressed by the Commission in
the future.
II. Executive Summary of Final Rules
The final rules seek to establish a regulatory
framework that makes sense both for current and future
securities markets. This regulatory framework should
encourage market innovation while ensuring basic investor
protections. The Commission continues to believe that the
approach outlined in the Proposing Release will accomplish
these goals. In general, this approach gives securities
markets a choice to register as exchanges, or to register as
broker-dealers and comply with Regulation ATS.[18] The
Commission believes the framework it is adopting meets the
varying needs and structures of market participants and is
flexible enough to accommodate the business objectives of,
and the benefits provided by, alternative trading systems.
The principal components of this new framework are discussed
below.
A. New Interpretation of "Exchange"
A fundamental component of the new regulatory framework
is new Rule 3b-16. This rule interprets key language in the
statutory definition of "exchange" under Section 3(a)(1) of
the Exchange Act.[19] Rule 3b-16 reflects a more
comprehensive and meaningful interpretation of what an
exchange is in light of today’s markets. Until now, the
Commission’s interpretation of the exchange definition
reflected relatively rigid regulatory requirements and
classifications for "exchange" and "broker-dealers."
Advancing technology has increasingly blurred these
distinctions, and alternative trading systems today are used
by market participants as functional equivalents of
exchanges. Accordingly, the Commission’s new interpretation
of exchange contained in Rule 3b-16[20] encompasses these
equivalent markets and the Commission’s new general
exemptive authority enables it to craft a new regulatory
framework.
The statutory definition of "exchange" includes a
"market place or facilities for bringing together purchasers
and sellers of securities or for otherwise performing with
respect to securities the functions commonly performed by a
stock exchange."[21] In response to commenters’ concerns
and suggestions, the Commission has carefully revised Rule
3b-16 to define these terms to mean any organization,
association, or group of persons that: (1) brings together
the orders of multiple buyers and sellers; and (2) uses
established, non-discretionary methods (whether by providing
a trading facility or by setting rules) under which such
orders interact with each other, and the buyers and sellers
entering such orders agree to the terms of a trade.[22]
Rule 3b-16 explicitly excludes those systems that the
Commission believes perform only traditional broker-dealer
activities. The Commission modified these exclusions to
address issues raised by commenters. Rule 3b-16 now
expressly excludes the following systems from the revised
interpretation of "exchange": (1) systems that merely route
orders to other facilities for execution; (2) systems
operated by a single registered market maker to display its
own bids and offers and the limit orders of its customers,
and to execute trades against such orders; and (3) systems
that allow persons to enter orders for execution against the
bids and offers of a single dealer.[23]
B. Exemption for Regulated Alternative Trading
Systems
The framework the Commission adopts today uses the
Commission’s new exemptive authority to allow most
alternative trading systems to choose to be regulated either
as exchanges or as broker-dealers. Rule 3a1-1 exempts most
alternative trading systems from the definition of
"exchange," and therefore the requirement to register as an
exchange, if they comply with Regulation ATS. However, any
system exercising self- regulatory powers, such as
regulating its members’ or subscribers’ conduct when engaged
in activities outside of that trading system, must register
as an exchange or be operated by a national securities
association. This is because self-regulatory activities in
the securities markets must be subject to Commission
oversight under Section 19 of the Exchange Act.[24] Thus
any system exercising self-regulatory powers will not be
permitted the option of registering as a broker-dealer.
In addition, the Commission can determine that a
dominant alternative trading system should be registered as
an exchange. An alternative trading system would first have
to exceed certain volume levels and the Commission, after
notice and an opportunity for the alternative trading system
to respond, would have to determine that an exemption from
exchange regulation is not necessary or appropriate in the
public interest or consistent with the protection of
investors, taking into account the requirements of exchange
registration and the objectives of the national market
system.[25] At this time, however, the Commission does not
believe that it is necessary or appropriate under this
provision that any alternative trading system register as an
exchange.
C. Regulation ATS
The Commission is adopting new Regulation ATS,
substantially in the form proposed, to impose essential
elements of market-oriented regulation on alternative
trading systems. This new regulation addresses the concerns
raised by the market activities of alternative trading
systems that choose to register as broker-dealers. To allow
new markets to start, without disproportionate burdens, a
system with less than five percent of the trading volume in
all securities it trades is required only to: (1) file with
the Commission a notice of operation and quarterly reports;
(2) maintain records, including an audit trail of
transactions; and (3) refrain from using the words
"exchange," "stock market," or similar terms in its name.
If, however, an alternative trading system with five
percent or more of the trading volume in any national market
system security chooses to register as a broker-dealer --
instead of as an exchange -- the Commission believes it is
in the public interest to integrate its activities into the
national market system. In addition to the requirements for
smaller alternative trading systems, Regulation ATS requires
alternative trading systems that trade five percent or more
of the volume in national market system securities to be
linked with a registered market in order to disseminate the
best priced orders in those national market system
securities displayed in their systems (including
institutional orders) into the public quote stream.[26]
Such alternative trading systems must also comply with the
same market rules governing execution priorities and
obligations that apply to members of the registered exchange
or national securities association to which the alternative
trading system is linked.[27]
In addition, alternative trading systems with twenty
percent or more of the trading volume in any single
security, whether equity or debt, would be required to: (1)
grant or deny access based on objective standards
established by the trading system and applied in a non-
discriminatory manner; and (2) establish procedures to
ensure adequate systems capacity, integrity, and contingency
planning. The Commission believes that these requirements
will better integrate those significant alternative trading
systems into national market system mechanisms. Moreover,
because alternative trading systems that choose to register
as broker-dealers are not required to surveil activities on
their markets, the Commission intends to work with the self-
regulatory organizations ("SROs") to ensure that they can
operate ongoing, real-time surveillance for market
manipulation and fraud and develop surveillance and
examination procedures specifically targeted to alternative
trading systems they oversee.
D. For-Profit Exchanges
In this release, the Commission also expresses its view
that registered exchanges may structure themselves as for-
profit organizations. This will allow alternative trading
systems, which are typically proprietary, to choose to
register as exchanges without changing their organizational
structure. In addition, currently registered exchanges --
which are all membership organizations -- could choose to
demutualize. This release provides guidance on ways for
proprietary markets to meet their fair representation
requirements as non-membership national securities
exchanges.[28]
E. Temporary Exemption from Rule Filing Requirements
for SROs’ Pilot Trading Systems
To help reduce competitive impediments to innovation by
SROs, the Commission is allowing them to start new trading
systems without preapproval by the Commission. The
Commission is adopting Rule 19b-5 to permit SROs, without
filing for approval with the Commission, to operate new
pilot trading systems for up to two years. These pilot
trading systems will be subject to specific conditions,
including limitations on their trading volumes.[29] The
purpose of this new rule is to provide registered exchanges
and national securities associations with a greater
opportunity to compete with alternative trading systems
registered as broker-dealers and with foreign markets.
III. Rule 3b-16 under the Exchange Act
The Commission today is adopting new Rule 3b-16 under
the Exchange Act. This rule defines terms used in the
statutory definition of "exchange," found in Section 3(a)(1)
of the Exchange Act.[30] The statutory definition of
"exchange" includes a "market place or facilities for
bringing together purchasers and sellers of securities or
for otherwise performing with respect to securities the
functions commonly performed by a stock exchange." The new
rule interprets these terms to include any organization,
association, or group of persons that: (1) brings together
the orders of multiple buyers and sellers; and (2) uses
established, non-discretionary methods (whether by providing
a trading facility or by setting rules) under which such
orders interact with each other, and the buyers and sellers
entering such orders agree to the terms of a trade.[31]
This rule revises the current interpretation of the term
"exchange," as set forth in the Delta Release.[32]
New Rule 3b-16 is an important element of the
Commission’s new regulatory framework for alternative
trading systems. As discussed above, the rapid growth and
technological advancements of alternative trading systems
have eroded the distinctions between the roles played by
alternative trading systems and by traditional exchanges.
Alternative trading systems today provide services more akin
to exchange functions than broker-dealer functions, such as
matching counterparties’ orders, executing trades, operating
limit order books, and facilitating active price discovery.
For many of these systems, regulation as a market more
appropriately fits their economic functions. Rule 3b-16
defines terms in the statutory definition of exchange to
include markets that engage in activities functionally
equivalent to markets currently registered as national
securities exchanges. Moreover, because in some cases
exchange regulation may better meet these systems’ business
objectives, the Commission believes that alternative trading
systems should have the option to register as national
securities exchanges.[33] The rule helps modernize the
Commission’s approach to these systems because it adapts the
concept of what is "generally understood" to be an exchange
to reflect changes in the markets brought about by automated
trading. In addition, in light of recent technological
developments, Rule 3b-16 more closely reflects the statutory
concept of "bringing together" buying and selling interests.
The Proposing Release sought comment on whether the
proposed definition captures the fundamental features of an
exchange as that term is generally understood today. The
Commission received several comments supportive of its
proposed revision to the interpretation of "exchange." For
example, the NASD commented that this new definition "is not
inappropriate, particularly with the express exclusion for
internal broker-dealer systems."[34] Other commenters also
supported broadening the Commission’s interpretation of what
constitutes an exchange and agreed that the proposed rule
accurately identified the fundamental features of a
securities "exchange."[35] On the other hand, some
commenters questioned the basis and need for the Commission
to move away from its interpretation in Delta. The
Commission responds to these comments below in Section VII.
Finally, one commenter expressed concern that the
proposed revision to the Commission’s interpretation of
"exchange" would encompass every market participant
providing electronic or other technologically advanced
trading service.[36] The Commission does not intend for the
distinction between exchanges and broker-dealers to turn on
automation, and does not believe that its revised
interpretation of "exchange" has this effect. In
particular, the Commission notes that paragraph (a) of new
Rule 3b-16 does not contain the word automation, but is
instead descriptive of those activities the Commission
considers to be the activities of a "market" where buyers
and sellers meet and includes purely floor-based exchanges,
as well as fully automated ones. Moreover, paragraph (b)
clearly excludes certain systems that -- even though
automated -- are not exchanges, such as automated single
dealer systems.
The language of Rule 3b-16 the Commission is adopting
today modifies the language the Commission proposed in
response to commenters’ suggestions and concerns, and their
requests for clarification. The discussion below is
intended to further explain how the Commission envisions
that its new interpretation of "exchange" will be applied
and responds to specific requests for clarification by
commenters.
A. Brings Together the Orders of Multiple Buyers and
Sellers
In order to be covered by the definition in Rule 3b-16,
a system must satisfy the first part of Rule 3b-16(a) --
brings together the orders of multiple buyers and sellers.
This emphasizes the concept of "bringing together purchasers
and sellers of securities" set forth in the definition of
"exchange" in Section 3(a)(1) of the Exchange Act. While
the intent is the same, the language in Rule 3b-16(a)(1) has
been modified from the proposal to address the concerns of
some of the commenters who requested that the definition be
clarified.
1. To Bring Together
The Commission is adopting the language "brings
together" in Rule 3b-16, rather than "consolidates" as
originally proposed. While the Commission believes that
"consolidates" and "brings together" have the same meaning,
the latter more closely mirrors the language in the statute
and is a plainer use of language.
A system brings together orders if it displays, or
otherwise represents, trading interests entered on the
system to system users. These systems include consolidated
quote screens, such as the system operated by Nasdaq. A
system also brings together orders if it receives
subscribers’ orders centrally for future processing and
execution. For example, a limit order matching book that
allows subscribers to display buy and sell orders in
particular securities and to obtain execution against
matching orders contemporaneously entered or stored in the
system "brings together orders." These activities are
currently performed by systems that bring together orders
internally for crossing[37] or matching,[38] as well as
floor-based markets that impose trading rules. In addition,
interdealer brokers ("IDBs")[39] bring together orders,
regardless of their level of automation.[40] Accordingly, a
system "brings together orders" when orders entered in the
system for a given security have the opportunity to interact
with other orders entered into the system for the same
security.
2. Multiple Buyers and Sellers
In addition, to satisfy paragraph (a)(1) of Rule 3b-16,
a system must bring together orders of multiple buyers and
multiple sellers. The Commission proposed to use the term
"multiple parties" in paragraph (a)(1) of Rule 3b-16, rather
than the term "multiple buyers and sellers." The Commission
believes that this modification to the language proposed in
Rule 3b-16 addresses the concerns of those commenters who
requested that the Commission clarify that systems in which
there is only a single seller, such as systems that permit
issuers to sell their own securities to investors, would not
be included within Rule 3b-16. While such systems have
multiple buyers (i.e., investors), they have only one seller
for each security (i.e., issuers) and, therefore, do not
meet the multiple buyers and sellers test. An example of
this type of system is CP Direct in which an issuer can
offer to sell its commercial paper to the customers of CS
First Boston. [41] Another example of systems that do not
meet the multiple buyers and sellers criteria are systems in
which securities are offered by a single seller at
successively lower prices. In addition, systems designed
for the purpose of executing orders against a single
counterparty, such as the dealer operating a system, would
not be considered to have multiple buyers and sellers. Thus
a single counterparty that buys and sells securities through
a system, where other parties entering orders only execute
against the single designated counterparty, would not meet
the requirements of the first part of Rule 3b-16.[42]
However, the mere interpositioning of a designated
counterparty as riskless principal for settlement purposes
after the purchasing and selling counterparties to a trade
have been matched would not, by itself, mean that the system
does not have multiple buyers and sellers.
3. Definition of "Order"
Finally, the rule makes clear that, to be included
within the definition in Rule 3b-16(a), a system must bring
together participants’ "orders." The term "order" is
defined in paragraph (c) of Rule 3b-16 to include any firm
indication of a willingness to buy or sell a security,
whether made on a principal or agency basis.[43] Firm
indications of buying or selling interest specifically
include bid or offer quotations, market orders, limit
orders, and any other priced order.
Several commenters requested that the Commission
clarify the proposed definition of "order." One commenter
expressed concern that the proposed definition of "order"
was too broad and recommended that the revised
interpretation of "exchange" be clarified to exclude trading
systems that broadcast non-executable indicative quotations,
and noted that IDBs frequently communicate an indicative
price to a customer, which is merely a starting point for a
negotiation of the final transaction price.[44] The
Commission notes that the term "order" is defined as "any
firm indication of a willingness to buy or sell a security,
. . . including any bid or offer quotation, market order,
limit order, or other priced order."[45] Whether or not an
indication of interest is "firm" will depend on what
actually takes place between the buyer and seller.
The label put on an order -- "firm" or "not firm" -- is
not dispositive. For example, a system claiming it displays
only "indications of interest" that are not orders, may be
covered by the new interpretation of "exchange" if those
indications are, in fact, firm in practice. In general, the
Commission intends to read the definition of "order" broadly
and will not consider systems to fall outside the definition
in Rule 3b-16 based solely on a system’s labeling of
indications of interest as "not firm." Instead, what
actually takes place between the buyers and sellers
interacting in a particular system will determine whether
indications of interest are "firm" or not. At a minimum, an
indication of interest will be considered firm if it can be
executed without the further agreement of the person
entering the indication. Even if the person must give its
subsequent assent to an execution, however, the indication
will still be considered firm if this subsequent agreement
is always, or almost always, granted so that the agreement
is largely a formality. For instance, indications of
interest where there is a clear or prevailing presumption
that a trade will take place at the indicated price, based
on understandings or past dealings, will be viewed as
orders.
Generally, however, a system that displays bona fide,
non-firm indications of interest -- including, but not
limited to, indications of interest to buy or sell a
particular security without either prices or quantities
associated with those indications -- will not be displaying
"orders" and, therefore, not fall within Rule 3b-16.
Nevertheless, the price or size of an indication of
interest may be either explicit or may be inferred from the
facts and circumstances accompanying the indication. For
example, an indication of interest will be considered to
include a price if the system in which the indication of
interest is entered defaults automatically to a price pegged
to another market, index, rate, or other variable, or if the
person entering such indication indicates that such person
is interested in trading at a price pegged to another
market, index, rate, or other variable, which includes
"market" orders.
The same commenter expressed concern that the proposed
definition of order could have the effect of including
markets within the definition of "exchange" that quote
prices over the telephone for a potential transaction.[46]
As discussed above, whether or not a particular system is an
exchange does not turn solely on the level of automation
used: "orders" can be given over the telephone, as well as
electronically.
The Commission emphasizes that merely because a system
"brings together orders of multiple buyers and sellers,"
does not mean that the system is an exchange. In order to
fall within Rule 3b-16, a system must also satisfy the
requirements in paragraph (a)(2). Thus, whether or not an
"order" is part of a system that falls within the new
interpretation of "exchange" depends upon the activities of
that system taken as a whole. For example, a system could
display subscribers’ "orders" to other market participants,
but would not be encompassed by Rule 3b-16 if subscribers
contacted each other and agreed to the terms of their trades
outside of the system.[47] Unless a system also establishes
rules or operates a trading facility under which subscribers
can agree to the terms of their trades, the system will not
be included within Rule 3b-16, even if it brings together
"orders."
Finally, the NYSE commented that the Commission’s
definition of "order" appeared to cover trading interest
that, in the Order approving the Pacific Exchange ("PCX")
Application of the OptiMark System ("OptiMark Order"), the
Commission did not consider to be an order. In the OptiMark
Order, the Commission took the position that the profiles
entered into OptiMark are not bids or offers under Rule
11Ac1-1 ("Firm Quote Rule").[48] The Commission’s
definition of "order" in paragraph (c) of Rule 3b-16 is
intended to be broader than the terms bid and offer in the
Firm Quote Rule.[49] Therefore, it is possible for an
indication of interest to be an "order" under Rule 3b-16,
without being a bid or offer under the Firm Quote Rule.
B. Established, Non-Discretionary Methods
In addition to bringing together the orders of multiple
parties, to be included within Rule 3b-16, a system would
have to use established, non-discretionary methods . . .
under which such orders interact with each other and the
buyers and sellers entering orders agree to the terms of the
trade. A system uses established non-discretionary methods
either by providing a trading facility or by setting rules
governing trading among subscribers. The Commission intends
for "established, non-discretionary methods" to include any
methods that dictate the terms of trading among the multiple
buyers and sellers entering orders into the system. Such
methods include those that set procedures or priorities
under which open terms of a trade may be determined. For
example, traditional exchanges’ rules of priority, parity,
and precedence are "established non-discretionary methods,"
as are the trading algorithms of electronic systems.
Similarly, systems that determine the trading price at some
designated future date on the basis of pre-established
criteria (such as the weighted average trading price for the
security on the specified date in a specified market or
markets) are using established, non-discretionary methods.
A requirement that the trade subsequently be ratified does
not avoid this element. For example, a system that trades
limited partnership units might use established, non-
discretionary methods even though approval from the general
partner is required prior to settlement. Rules that merely
supply the means of communication with a system (for
example, software or hardware tools that subscribers may use
in accessing a system), however, do not satisfy this element
of Rule 3b-16.
In general, where customers of a broker-dealer exercise
control over their own orders in a trading system operated
by the broker-dealer, that broker-dealer is unlikely to be
viewed as using discretionary methods in handling the order.
An example of systems that the Commission believes do not
use established, non-discretionary methods are traditional
block trading desks. Block trading desks generally retain
some discretion in determining how to execute a customer’s
order, and frequently commit capital to satisfy their
customers’ needs. For example, a block positioner may
"shop" the order around in an attempt to find a contra-side
interest with another investor. In some cases, the block
positioner may take the other side of the order, keeping the
block as a proprietary position. While block trading desks
do cross customers’ orders, these crosses are not done
according to fixed non-discretionary methods, but instead
are based on the block trading desks’ ability to find a
contra-side to the order. It may cross two customer orders,
or it may assemble a block of several customer orders with
completion dependent on its willingness to take a
proprietary position for part of the block. Execution
prices, size of the proprietary position and agency
compensation may all be part of a single negotiated deal.
Consequently, the Commission would not consider traditional
block trading desks to be using established, non-
discretionary methods and, therefore, they would not fall
within Rule 3b-16.
In addition, systems that merely provide information to
subscribers about other subscribers’ trading interest,
without facilities for execution, do not fall within
paragraph (a) of Rule 3b-16. One commenter asked the
Commission to clarify that such systems would not be viewed
as exchanges.[50] While such vendors may allow buyers and
sellers to find each other, they do not provide a facility
or set rules under which those orders interact with each
other. Accordingly, the Commission agrees with this
commenter that such systems are not exchanges.
In contrast, when a customer gives a broker-dealer
flexibility in how to handle an order, it relinquishes a
degree of control over that order. The Commission
recognizes that broker-dealers exercising discretion or
judgment over customer orders may use internal systems to
trade and manage these orders. The mere use of these
systems does not make a broker an exchange, unless those
systems themselves predetermine the handling and execution
practices for the order, replacing the broker-dealer’s
judgment and flexibility in working the order.
One commenter suggested that the lack of display of
customer orders outside the broker-dealer should be
determinative of whether the system was an exchange.[51]
The Commission notes that it is possible for a system to use
established, non-discretionary methods even if orders are
not displayed. For example, the OptiMark System -- by
design -- does not display participants’ indications of
interest. There is, however, no discretion exercised by the
operator of the OptiMark System; the trade optimization
calculations are established, non-discretionary methods.
Finally, the Commission proposed to explicitly exclude
from the revised interpretation of "exchange" trading
systems that allow a single broker-dealer to internally
manage its customers’ orders.[52] The Commission was
concerned that such systems might technically be covered by
paragraph (a) of Rule 3b-16 if they occasionally crossed or
matched customer orders. Because the Commission believes
that these systems have generally automated traditional
brokerage functions, it proposed to clearly exclude them
from the revised interpretation of "exchange." Several
commenters noted their agreement with the Commission’s
proposed exclusion of these internal broker-dealer systems
from its reinterpretation of "exchange,"[53] but requested
that the Commission clarify it. In particular, the
Securities Industry Association ("SIA") and The Bond Market
Association ("TBMA") requested that the Commission clarify
the intended meaning of the terms "predetermined procedures"
and "communicated to customers" as used in the proposed
exclusion.[54]
The Commission intended to exclude a number of
different types of systems under this proposed exclusion.
First, this exclusion was intended to cover internal systems
operated by market makers to automate the management of
their customer orders, including the display of customer
limit orders, and to match those displayed orders with other
customer orders. The Commission is now adopting a more
specific exclusion to cover these types of systems.
In addition, in large part, the Commission intended to
exclude systems that automate the management of customer
orders that require a broker-dealer to use its discretion.
These types of systems would not be included within
paragraph (a) of Rule 3b-16 because -- like traditional
block trading desks -- they do not use established, non-
discretionary methods. The purpose of the proposed
exclusion for internal broker-dealer systems was to exclude
traditional internal systems created to increase efficiency
rather than to provide a non-discretionary trading system
for customers. In light of the comments on the proposed
exclusion for internal broker-dealer systems and the
difficulty of distinguishing among internal systems on this
basis, the Commission now believes it is better not to
attempt to set specific requirements that internal broker-
dealer systems must meet in order to be excluded from Rule
3b-16. Instead, the Commission is clarifying that trading
systems that do not use established, non-discretionary
methods fail to meet the two-part test in paragraph (a) and
are, therefore, not included within the revised
interpretation of "exchange."
1. Established, Non-Discretionary Methods
Provided by a Trading Facility
As stated previously, a trading system that uses
established, non-discretionary methods would include a
traditional exchange floor where specialists are responsible
for executing orders. It would also include a computer
system (whether comprised of software, hardware, protocols,
or any combination thereof) through which orders interact,
or any other trading mechanism that provides a means or
location for the bringing together and execution of orders.
For example, the Commission considers the use of an
algorithm by an electronic trading system that sets trading
procedures and priorities to be a trading facility that uses
established, non-discretionary methods.
The Commission will attribute the activities of a
trading facility to a system if that facility is offered by
the system directly or indirectly (such as where a system
arranges for a third party or parties to offer the trading
facility). Thus, if a system that brings together the
orders of multiple parties arranges for a third party vendor
to distribute software that establishes non-discretionary
methods under which orders interact, that system will fall
within Rule 3b-16. Similarly, if a bulletin board operator
contracted with another party to provide execution
facilities for the bulletin board users, the bulletin board
will be deemed to have established a trading facility
because it took affirmative steps to arrange for the
necessary exchange functions for its users.[55] In
addition, if an organization arranges for separate entities
to provide different pieces of a trading system, which
together meet the definition contained in paragraph (a) of
Rule 3b-16, the organization responsible for arranging the
collective efforts will be deemed to have established a
trading facility. For example, the arrangement between the
Delta Government Options Corporation ("Delta"), RMJ Options
Trading Corporation, and Security Pacific National Trust
Company, as described in a 1990 Commission release,[56]
would together meet the definition set forth in Rule 3b-16.
Moreover, a trading system that falls within the
Commission’s interpretation of "exchange" in Rule 3b-16 will
still be considered an "exchange," even if it matches two
trades and routes them to another system or exchange for
execution. Whether or not the actual execution of the order
takes place on the system is not a determining factor of
whether the system falls under Rule 3b-16.
2. Established, Non-Discretionary Methods
Provided by Setting Rules
Alternatively, a system may use established, non-
discretionary methods through the imposition of rules under
which parties entering orders on the system agree to the
terms of a trade. For example, if a system imposes
affirmative quote obligations on its subscribers, such as
obligations to post two-sided quotations or to post
quotations no worse than the quotes subscribers post on
other systems, the Commission will consider it to be using
established, non-discretionary methods.
In addition, rules imposing execution priorities, such
as time and price priority rules, would be "established,
non-discretionary methods." Similarly, a system that
standardizes the material terms of instruments traded on the
system, such as the system operated by Delta at the time the
Commission published the Delta Release,[57] will be
considered to use established, non-discretionary methods.
Similarly, Nasdaq’s use of established, non-
discretionary methods bring it within the revised
interpretation of "exchange" in Rule 3b-16. The NASD
imposes basic rules by which securities are traded on
Nasdaq. Specifically, it imposes affirmative obligations on
market makers in Nasdaq National Market ("Nasdaq NM") and
SmallCap securities, including obligations to post firm and
two-sided quotes. It also operates the Small Order
Execution System ("SOES") and SelectNet systems, requiring
market makers to accept executions or orders for execution
in these securities. Through Nasdaq, market participants
act in concert to centralize and disseminate trading
interest and establish the basic rules by which securities
are traded. The Commission believes that Nasdaq performs
what today is generally understood to be the functions
commonly performed by a stock exchange. Nasdaq, however, is
currently registered as a securities information processor
under Section 11A of the Exchange Act[58] and is operated by
the NASD, a registered securities association under Section
15A of the Exchange Act.[59] Because the requirements
currently applicable to a registered securities association
are virtually identical to the requirements applicable to
registered exchanges, the Commission does not believe it is
necessary or appropriate in the public interest to require
Nasdaq to register as an exchange.[60] Under the rules the
Commission is adopting today, however, Nasdaq could choose
to register under Section 6 of the Exchange Act as a
national securities exchange. [61]
C. Systems Excluded From Rule 3b-16
The Proposing Release specifically excluded from the
proposed, revised interpretation of "exchange" several types
of activities that could be considered traditional brokerage
activities: order routing systems, dealer quotation systems,
and internal broker-dealer order management and execution
systems. Commenters widely agreed that automated broker-
dealer functions should not be encompassed in the meaning of
"exchange."[62] The Commission agrees. Commenters did,
however, ask for clarification about the application of the
exclusions in paragraph (b). In particular, some commenters
appeared to misunderstand Rule 3b-16 as requiring that a
system fall within one of the exclusions in paragraph (b) in
order to be outside of the revised interpretation of
"exchange." This was not the Commission’s intent. A system
is not included within the revised interpretation of
"exchange" if: (1) it fails to meet the two-part test in
paragraph (a) of Rule 3b-16; or (2) it falls within one of
the exclusions in paragraph (b).
The Commission has included paragraph (b) of Rule 3b-16
to explicitly exclude some systems that the Commission
believes are not exchanges. Paragraph (b) of Rule 3b-16
expressly excludes: (1) systems that merely route orders to
other execution facilities; and (2) systems that allow
persons to enter orders for execution against the bids and
offers of a single dealer, and systems that automate the
activities of registered market markers.
Two commenters asked the Commission to exclude from the
revised interpretation of "exchange" all correspondent
clearing relationships, as well as agreements among broker-
dealers to handle their respective order flow.[63] The
Commission has excluded routing systems under Rule 3b-
16(b)(1). Whether or not correspondent clearing
relationships are excluded, however, depends on the nature
of the systems used in that relationship. The Commission
does not believe that systems operated by clearing firms
should be excluded simply because their correspondents
participate in them. The Commission believes that such an
exclusion would be overly broad.
One commenter questioned whether IDBs are the
functional equivalent of internal broker-dealer systems and,
therefore, should be excluded from Rule 3b-16.[64] The
Commission believes that most screen-based IDBs function by
displaying, on an anonymous basis, the offers to buy and
sell securities that are placed with them by subscribers.
While typically a subscriber uses a telephone to place the
orders and ordinarily use the telephone to request
execution, multiple buyers and sellers are involved, and
generally customers view some or all orders on screens.
Thus, IDBs bring together the orders of multiple buyers and
sellers. Where an IDB has set procedures under which it
executes subscriber orders against displayed or retained
orders in a predetermined fashion, the methods by which
these orders are brought together likely would be
established and non-discretionary. The Commission believes
that IDBs that function in this fashion are covered by Rule
3b-16. If an IDB does not display orders or communicate
them verbally to customers, and does not execute orders
according to pre-determined, well-understood rules, it may
not be covered by the rules the Commission is adopting
today. As a general matter, however, the Commission
believes that most IDBs would be covered by the definition
in Rule 3b-16(a) and not excluded by any of its exclusions.
In addition, one commenter recommended that any entity
that has the discretion to commit capital to a trade be
excluded from Rule 3b-16, because broker-dealers commit
capital, but exchanges do not.[65] The Commission generally
views the willingness to predictably commit capital as a
traditional broker-dealer activity. For this reason it is
explicitly excluding registered market maker and single
dealer systems, which commit capital in all -- or almost all
-- trades. In addition, broker-dealers frequently commit
capital as part of their block trading desk activities. As
discussed above, the Commission does not believe that
traditional block trading desks are covered under paragraph
(a) of Rule 3b-16. However, the Commission does not believe
that a system engaging in activities as a market should be
excluded from the scope of Rule 3b-16 simply because the
broker-dealer operating the system may participate as a
dealer in that system.
Finally, one commenter asserted that "passive systems,"
such as POSIT,[66] should be excluded from the Commission’s
revised interpretation of "exchange," because they do not
have a traditional price discovery mechanism.[67] The
Commission, however, does not agree that systems like POSIT
are simply an automation of traditional brokerage functions,
but believes they are markets. Like other markets,
"passive" or derivative pricing systems bring together the
orders of multiple buyers and sellers. All subscribers
enter orders,[68] which interact at pre-specified times. In
addition, "passive systems" establish non-discretionary
methods under which subscribers agree to the terms of the
trade. Such systems cross orders at pre-established times
during the day according to specified priorities, such as
time priority. While these orders are traded at a price
that is not known at the time a subscriber enters an order,
the parameters under which such price will be determined are
established and not subject to discretion by the operator of
the "passive system." While these systems do not themselves
have traditional price discovery mechanisms, they have the
potential to -- and frequently do -- affect the markets from
which their prices are derived.[69] The Commission,
however, agrees with this commenter that these systems do
not raise the same concerns as alternative trading systems
with price discovery mechanisms and, therefore, even if such
systems have significant trading volume, if they choose to
register as broker-dealers they are not required to meet the
fair access and systems capacity requirements.[70] The
Commission, however, will monitor the activities of these
passive systems and if concerns arise with regard to their
activities will reconsider whether these requirements should
apply.
1. Order Routing Systems
The Commission proposed to exclude from proposed Rule
3b-16 those trading systems that merely route orders to an
exchange or broker-dealer for execution. The only commenter
to address this provision was the SIA, which expressed its
support for this exclusion.[71] The Commission is adopting
the exclusion as proposed in Rule 3b-16(b)(1). Examples of
such systems include the New York Stock Exchange’s
("NYSE’s") and the American Stock Exchange’s ("Amex’s")
Common Message Switch[72] and BRASS.[73] Nasdaq, however,
is not merely a routing system. In addition to SelectNet’s
routing capabilities, Nasdaq is a quotation facility,
permits executions through its SOES system, and establishes
rules for its members regarding the firmness of their bids
and offers and how members deal with each other.
The Commission does not believe that these routing
systems meet the two-part test in paragraph (a) of Rule 3b-
16 because they do not bring together orders of multiple
buyers and sellers. Instead, all orders entered into a
routing system are sent to another execution facility. In
addition, routing systems do not establish non-discretionary
methods under which parties entering orders interact with
each other.
2. Dealer Systems
In the Proposing Release, the Commission discussed the
application of proposed Rule 3b-16 to single dealer systems.
Such systems automate the order routing and execution
mechanisms of a single market maker and guarantee that the
market maker will execute orders submitted to it at its own
posted quotation for the security or, for example, at the
inside price quoted on Nasdaq. Because single market maker
systems merely provide a more efficient means of executing
the trading interest of separate customers with one dealer,
the Commission stated that they should not be considered
exchanges. Accordingly, the Commission proposed to
explicitly exclude from proposed Rule 3b-16 those trading
systems that display the quotations of a single dealer and
allow persons to enter orders for execution against the
dealer’s proprietary account, usually at the dealer’s quote.
This exclusion was intended to encompass systems operated by
third market makers,[74] as well as those systems operated
by dealers, primarily in debt securities, who display their
own quotations to customers and other broker-dealers on
proprietary or vendor screens.
The Commission is today adopting paragraph (b)(2) of
Rule 3b-16 to exclude systems that display quotes of a
single dealer and allow persons to enter orders for
execution against the bids and offers of a single dealer.
If a market maker executes a customer order at the National
Best Bid or Offer ("NBBO"), rather than at its displayed bid
or offer, the Commission will consider the NBBO as the
market maker’s quote for purposes of that trade. As in the
proposal, paragraph (b)(2) is intended to exclude from Rule
3b-16 all dealers, including third market makers.
The Commission received two comment letters asking the
Commission to reconsider its proposed exclusion of third
market makers.[75] These commenters disagreed with the
Commission’s distinction between third market makers and
exchanges, and stated that these systems compete directly
with the regional exchanges for order flow. Consequently,
these commenters suggested that the Commission include third
market makers within its revised interpretation of
"exchange." As discussed in the Proposing Release, however,
the Commission does not believe that a single dealer that
automates its means of communicating trading interest to
customers is a market. Instead, such systems automate
functions traditionally performed by dealers.
Accordingly, the exclusion the Commission is adopting
today in paragraph (b)(2) of Rule 3b-16 is intended to cover
systems operated by third market makers. Because of the
Commission’s own rules and those of the SROs, a third market
maker’s quote may not always reflect its own bids and
offers, but may -- at times -- represent a customer limit
order. The Limit Order Display Rule[76] requires third
market makers (among others) to display customer limit
orders in a security that are at a price that would improve
the bid or offer of such market maker in that security. The
Commission does not believe that a market maker engaging
principally in the business of trading for its own account
should be included within Rule 3b-16 solely because it is
complying with the Limit Order Display Rule. Consequently,
in the Proposing Release the Commission stated that, for
purposes of this exclusion, if a dealer displayed a customer
order to comply with a Commission or SRO rule, that customer
order would be considered to be the "dealer’s quote."[77]
To ensure that Rule 3b-16 clearly excludes such dealers, the
Commission is adopting paragraph (b)(2)(ii) of Rule 3b-16.
Paragraph (b)(2)(ii) excludes a registered market maker that
displays its own quotes and customer limit orders, and
allows its customers and other broker-dealers to enter
orders for execution against the displayed orders. The
exclusion also allows such a registered market maker, as an
incidental activity resulting from its market maker status,
to match or cross orders for securities in which it makes a
market, even if those orders are not displayed.[78]
Two other commenters expressed their support for the
single dealer exclusion.[79] One of these commenters,
however, suggested that the Commission modify the exclusion
so that trading systems that display the quotes of a dealer
and its affiliates and allow persons to execute against
those quotes be excluded from Rule 3b-16.[80] The
Commission is adopting the exclusion from Rule 3b-16 for
single dealer systems, but does not agree with this
commenter that a dealer’s affiliates should be included in
the exclusion.
In addition, one commenter requested that the
Commission clarify whether the exclusion for dealer
quotation systems would apply to systems that allow other
broker-dealers to execute against a single dealer’s
quotations.[81] The Commission intends for this exclusion
to cover dealer quotation systems that permit other broker-
dealers to execute against the dealer’s quotations and
realizes that its use of the term "customer" in the proposal
would preclude this. Accordingly, the Commission is
adopting the exclusion in paragraph (b)(2) so that it
encompasses single dealer systems that allow any person to
enter orders for execution against that dealer’s quotes.[82]
A single dealer system could also match orders that are not
displayed to any person other than the dealer and its
employees, provided this matching is only incidental to its
primary activity as a dealer.[83]
D. Examples of Systems Illustrating Application of
Rule 3b-16
The following examples are provided to illustrate
various applications of Rule 3b-16.[84] While these
examples are intended to provide guidance, the application
of Rule 3b-16 will be fact-specific.
1. Examples of Systems Included Within Rule 3b-
16
a. System A is a trading floor that maintains a
continuous two-sided auction market under a unitary
specialist system. Through the use of an electronic
communication system, orders are transmitted from member
firms to the floor and execution reports are transmitted
from the floor to the member firms. System A also has
an automated routing and small order execution system.
Price discovery occurs through the interaction of bids
and offers of market participants under the application
of System A’s rules of priority, parity, and precedence.
The specialist’s dealings are subject to compliance
obligations established by System A. System A is
included under Rule 3b-16.
b. System B allows participants to enter, replace, or
cancel limit orders prior to a pre-established auction
cutoff time. Bids and offers (including price and size)
are displayed in the System B’s order book, which
participants can view on their screens. After the
cutoff time, the system reviews all orders with respect
to each security and determines the price at which the
volume of buying interest is closest to the volume of
selling interest. That price is the "auction price."
Participants that have entered bids at or above, and
offers at or below, the auction price receive an
execution at the auction price on the basis of time
priority up to the available size. Matched orders are
executed by a registered broker-dealer. System B is
included under Rule 3b-16.
c. System C allows participants to enter limit
orders and matches those orders with other orders in
System C based on internal parameters. System C
displays unmatched limit orders in the system’s book on
an anonymous basis to all participants. The broker-
dealer operating System C acts as a riskless principal
in executing all matched orders. System C is included
under Rule 3b-16.
d. System D limits participation to institutional
investors that trade illiquid restricted securities. To
offer a security, a seller notifies System D as to the
security, the price and the amount offered. After
System D accepts an order, it enters it into the system
where it is posted anonymously. Prospective purchasers
may accept a posted order or seek to negotiate a
transaction by contacting System D. System D
facilitates the purchase and sale of securities through
the system on an agency basis. Participants enter a bid
or offer by calling a dedicated telephone number at
System D. Once each side of the transaction agrees to
the terms of the trade, System D obtains necessary
documentation from the participants and reviews all the
documentation. Once all the documentation has been
processed, System D notifies the parties setting the
transfer and settlement date, at which time System D
will coordinate the transfer of funds and the issuer is
notified to effect the transfer on its books. System D
is included under Rule 3b-16.
e. System E allows participants to enter orders
for securities by computer, facsimile, or telephone.
Those orders are not displayed to other participants.
System E crosses orders at specified times at a price
derived from another market such as the closing price, a
volume weighted average price, or the midpoint between
the closing bid and ask on the primary market. System E
is included under Rule 3b-16, but would be exempt from
the requirements of Regulation ATS under Rule 301(a)(5)
if it is registered as a broker-dealer.
f. System F displays, on an anonymous basis,
firm offers to buy and sell securities from its
participants. Participants typically telephone an
employee of System F to place a bid or offer, which the
employee enters into the system for display to other
participants. To execute against a bid or offer
displayed on the computer screen, a participant
telephones an employee at System F. The employee is
required to execute the participant’s order against the
displayed order if it matches. System F is included
under Rule 3b-16. If System F allowed subscribers to
execute against a displayed order by sending a message
electronically, it would also be included under Rule 3b-
16.
g. System G permits competing market makers to post
continuous two-sided quotes in certain securities.
Quotes are consolidated and disseminated to subscribers
electronically. System G maintains and enforces rules
setting standards for the posting of quotes and
executions. Trades are executed by subscribers calling
market makers outside the system and executing trades
based on quotes displayed in the system. System G is
included under Rule 3b-16.
h. System H is owned and operated by a bank. System
H permits registered broker-dealers to place orders to
buy or sell securities at specified prices and sizes and
have those orders displayed to all users on an anonymous
basis. Registered broker-dealers may trade both for
their own account or on an agency basis on behalf of
their customers. System H automatically executes an
order if it matches an existing order. If no match is
immediately available, System H displays the order on
the system on an anonymous basis to all users. System H
is included under Rule 3b-16.
i. System I permits participants to enter a
range of ranked contingent buy and sell orders at which
they are willing to trade securities. These orders are
matched based on a mathematical algorithm whose
priorities are designed to achieve the participants’
objectives. System I does not display orders to any
participants. System I is included under Rule 3b-16.
2. Examples of Systems Not Included Within Rule
3b-16
a. System J routes orders from broker-dealers to
registered exchanges or to other broker-dealers for
execution. System J also routes execution reports back
to the broker-dealers that entered the orders. System J
provides no facility for execution, but rather only acts
as a communications system for the transmission of
orders and execution reports. System J falls within the
exclusion in paragraph (b)(1) of Rule 3b-16.
b. System K displays a registered market maker’s
quotes in exchange-listed securities and permits
subscribers to submit orders for those securities to the
market maker. Limit orders are displayed in the market
maker’s quote pursuant to requirements under the
Commission’s order execution rules. Market orders are
executed against the market maker’s quote or at the NBBO
or at a price better than the NBBO. Limit orders are
held until marketable. System K falls within the
exclusion in paragraph (b)(2) of Rule 3b-16.
c. System L allows a dealer to disseminate its
proprietary quotations to its customers and permits
customers to transmit orders to buy from or sell to that
dealer at those quoted prices. System L is not included
under Rule 3b-16 because it falls within the exclusion
in paragraph (b)(2) of Rule 3b-16.
d. System M is operated by a broker-dealer that makes
markets in Nasdaq securities. System M permits the
broker-dealer’s customers, as well as other broker-
dealers (including correspondent broker-dealers with
whom it has a clearing arrangement) to send orders
electronically or by telephone to the broker-dealer. An
order transmitted electronically goes directly to the
system server. An order transmitted by phone is
received by an employee of the broker-dealer, who enters
it into the System M. If it is a market order for a
Nasdaq security in which the broker-dealer makes a
market, System M checks to see if the order can be
crossed against a customer limit order held by the
broker-dealer. If two customer orders cannot be
crossed, System M automatically executes the market
order against the firm’s inventory if the order size is
at or below certain parameters. If the order size
exceeds those parameters, the market order will be
routed to a trader for manual execution against the
firm’s inventory, or other handling as the trader
determines. If the order is for a security in which the
broker-dealer does not make a market, System M sends the
order to a market maker in the security or to another
market for execution. System M falls within the
exclusions in paragraph (b)(1) and (b)(2) of Rule 3b-16.
e. System N allows participants to post the
names of securities they wish to buy or sell. Other
participants view this "bids wanted list" or "offers
wanted list" and place bids or offers for the specified
securities during a defined auction period. The
participant who posted the security on the "bids wanted
list" or "offers wanted list" may either accept or
reject the best bid or offer at the close of the
auction. System N is not included under Rule 3b-16
because there is only one seller.
f. System O permits correspondent firms of a
broker-dealer to send orders electronically to that
broker-dealer. The broker-dealer executes the orders
against its own inventory. System O falls within the
exclusion in paragraph (b)(2)(i) of Rule 3b-16.
g. System P is an Internet web site set up by an
issuer. Through this web site, the issuer provides
information to prospective buyers and sellers of its
common stock. Prospective buyers and sellers post their
identities, contact information, and the number of
shares offered or sought at a given price. The issuer
makes that information, along with the date the
information was submitted, available to prospective
buyers and sellers. The participants contact each other
outside of the web site to execute trades. System P is
not included under Rule 3b-16 because it does not
establish non-discretionary methods under which buyers
and sellers interact.
h. System Q is a screen-based system on which broker-
dealers post indications of interest to institutional
customers in the securities the broker-dealers wish to
trade and advertise trades they have recently conducted.
System R sets no requirements and provides no procedures
regarding whether or how posted quantities and prices of
securities can be executed. System Q is not included
under Rule 3b-16 because it does not establish non-
discretionary methods under which buyers and sellers
interact.
i. System R is an internal system operated by a
broker-dealer to display only to its registered
representatives the prices and sizes of securities
offered for sale by the firm in its capacity as a
dealer. A registered representative can enter a buy
order, specifying price and size, on behalf of its
customer. If the terms of the customer’s order match
the dealer’s posted offer, System R automatically
executes the order. If the terms are different, System
R places the customer’s order on the screen for later
matching. Assuming the matches of customer orders are
merely incidental relative to the dealer’s own trades,
System R falls within the exclusion in paragraph
(b)(2)(i) of Rule 3b-16.
j. System S permits an issuer to post prices to
sell its own securities to a broker-dealer’s customers.
The issuer is under no obligation to post prices on the
system and may choose to do so at any time. If a
customer accepts the posted price and size, System S
routes the order to the issuer who retains discretion to
accept or reject the trade. If the posted price or size
is not accepted as posted, System S automatically alerts
the issuer that further negotiation is necessary.
System S is not included under Rule 3b-16 because it has
only one seller and, therefore, fails to meet the
"multiple buyers and sellers requirement."
k. System T facilitates the clearance and settlement
of securities products. Participating IDBs disseminate
and match trading interest through their own proprietary
trading screens to their own customers. The
participating IDBs then submit matched transactions
between their customers to System T for clearance and
settlement. The IDBs’ screens are not linked together
and the IDBs interact only with those dealers using the
system. The customers’ orders interact only with the
quote of the IDB of which they are a customer and do not
interact with the other customer orders of that IDB.
Dissemination and execution of orders by the IDBs is
governed solely by their rules and not by System T.[85]
System T is not included under Rule 3b-16.
E. Exemption from the Definition of "Exchange"
Section 36 of the Exchange Act[86] gives the Commission
broad authority to exempt any person, security, or
transaction from provisions of the Exchange Act and the
rules thereunder. Such an exemption may be subject to
conditions. Using this authority, the Commission is
adopting Rule 3a1-1.[87] This rule exempts from the
definition of "exchange": (1) any alternative trading system
that complies with Regulation ATS;[88] (2) any alternative
trading system that under Rule 301(a) of Regulation ATS is
not required to comply with Regulation ATS;[89] and (3) any
alternative trading system operated by a national securities
association.[90] Finally, as described more fully
below,[91] paragraph (b)(1) of Rule 3a1-1 also conditions an
alternative trading system’s exemption on the absence of a
Commission determination that the exemption in a particular
case is not "necessary or appropriate in the public interest
or consistent with the protection of investors."[92]
The Commission has determined that this exemption is in
the public interest and will promote efficiency,
competition, and capital formation because it has the effect
of providing alternative trading systems with the option of
positioning themselves in the marketplace as either
registered exchanges or as broker-dealers. The Commission
believes that allowing alternative trading systems to make a
business decision about how to register with the Commission
will continue to encourage the development of new and
innovative trading facilities. The Commission has also
determined that this exemption is consistent with the
protection of investors because investors will benefit from
conditions governing an alternative trading system, in
particular Regulation ATS’s enhanced transparency, market
access, system integrity, and audit trail provisions.
Moreover, because national securities associations are
subject to requirements virtually identical to those
applicable to national securities exchanges,[93] Rule 3a1-1
also exempts from the definition of "exchange" any
alternative trading system operated by a national securities
association.[94] The Commission believes that the
regulation of alternative trading systems operated by a
national securities association is adequate, and therefore,
that such systems should not be required to register either
as exchanges, or as broker-dealers and comply with
Regulation ATS. Consequently, trading systems operated by
national securities associations may continue to operate as
they do now.
Finally, in response to a commenter’s request that the
Commission clarify that the exemption from the definition of
"exchange" provided in Rule 3a1-1(a)(2) includes broker-
dealers that are excluded from the scope of Regulation ATS
by Rule 301(a),[95] the Commission is adding paragraph
(a)(3) to Rule 3a1-1. The Commission intended for broker-
dealers that perform only activities delineated in Rule
301(a) to be exempt from the definition of exchange under
Rule 3a1-1, and is making this clear by adding this new
paragraph.[96]
The Commission intends for the exemption provided by
Rule 3a1-1 to make clear that alternative trading systems
that register as broker-dealers and comply with Regulation
ATS not be regulated as national securities exchanges. The
Commission believes that the requirements in Regulation ATS
as adopted will address the market-like functions of
alternative trading systems without imposing requirements
applicable to exchanges that might not fit comfortably with
certain alternative trading systems’ structures and
businesses.
In the Proposing Release, the Commission requested
comment on whether an exclusion from the definition in Rule
3b-16 for alternative trading systems that register as
broker-dealers and comply with the provisions of Regulation
ATS would be preferable to the exemption under Rule 3a1-1.
Several commenters expressed a preference for an exclusion,
rather than an exemption.[97] Most of these commenters were
concerned that foreign regulators would view these systems,
currently registered as broker-dealers, as exchanges if they
were now exempted from the definition of exchange rather
than excluded from it. The Commission believes that its new
framework being adopted today represents a carefully
balanced approach to the regulation of markets that is
grounded in the particular statutory structure of the
Exchange Act. First, the Commission notes that its
exemption for alternative trading systems applies to the
definition of an exchange. By exempting alternative trading
systems from this definition, the Commission is making clear
its view that these systems should not be treated as
exchanges under the Exchange Act or in any other context.
Moreover, the Commission does not intend its interpretation
of exchange to be used outside of the Exchange Act context.
The Commission strongly cautions against applying this
interpretation in other contexts where its effects will
differ from those under the Exchange Act. The Commission
also believes that application in another context of only
one element of the structure adopted today would be
inappropriate and would seriously call into question the
validity of the interpretation in that context.
Another concern raised by at least one commenter was
that investors could be influenced in how they view a
trading system, if such trading system is included within
the Commission’s interpretation of "exchange."[98] The
Commission believes that investors’ views of systems are
shaped more by the functions those systems perform than by
the way they are classified. The Commission also believes
that the enhanced regulation of alternative trading systems
that choose to remain registered as broker-dealers that is
provided by Regulation ATS provides more protection for the
investors who use these systems.
In the Proposing Release, the Commission also requested
comment on the scope, form, and conditions of the exemption
in Rule 3a1-1. Commenters generally approved of the
Commission’s proposal to allow alternative trading systems
the choice to register as exchanges or be exempt from the
definition of "exchange" by registering as broker-dealers
and complying with Regulation ATS.[99] One commenter
questioned whether national securities exchanges would have
the choice to register as alternative trading systems, in
effect ceasing to act as SROs and electing instead to be
regulated as a broker-dealer under Regulation ATS.[100] The
Commission believes that, as a general matter, national
securities exchanges do have this choice under the rules the
Commission is adopting today.[101] Any national securities
exchange making this choice would, of course, be required to
give up its SRO functions and privileges, and to register as
a broker-dealer and become a member of a national securities
association or other SRO.[102] That organization would then
act as the SRO for this alternative trading system. If a
national securities exchange chose, as part of this
restructuring, to allow its members to form their own
national securities association to operate this new
alternative trading system, that alternative trading system
would be run directly by a national securities association,
and, as stated above, would be regulated in a manner that
was equivalent to being regulated as a national securities
exchange.[103]
F. Commission’s Authority to Require Registration as
an Exchange
Rule 3a1-1(b) contains an exception to the exemption
from the exchange definition. Under this exception, the
Commission effectively may require a trading system that is
a substantial market (as set forth in the rule) to register
as a national securities exchange if it finds in a
particular case that it is necessary or appropriate in the
public interest or consistent with the protection of
investors.[104] In particular, the Commission could deny or
withhold exemptive status from a trading system that
otherwise meets the exemptive conditions under Rule 3a1-
1(a). Although the standard for denying or withholding the
exemption is based on objective factors, the Commission has
discretion whether to initiate any process to consider
whether to revoke a particular entity’s exemption under the
rule.
Specifically, under Rule 3a1-1(b), if an organization,
association, or group of persons meets certain, specified
volume levels, the Commission could consider whether
registration as an exchange is necessary. The Commission
will not consider making an assessment whether a particular
system should register as an exchange unless that system,
during three of preceding four calendar quarters had: (1)
Fifty percent or more of the average daily dollar trading
volume in any security and five percent or more of the
average daily dollar trading volume in any class of
security; or (2) Forty percent or more of the average daily
dollar trading volume in any class of securities. The
Commission would also provide such a system with notice and
an opportunity to respond before determining that exemption
from registration as an exchange is not appropriate in the
public interest. In making that determination, the
Commission would take into account the requirements for
exchange registration under Section 6 of the Exchange Act
and the objectives of the national market system under
Section 11A of the Exchange Act. For example, it may not be
consistent with the protection of investors or in the public
interest for a trading system that is the dominant market,
in some important segment of the securities market, to be
exempt from registration as an exchange if competition
cannot be relied upon to ensure fair and efficient trading
structures in that case. In that case it may be necessary
for the Commission’s greater oversight authority over
registered exchanges to apply.[105] As another example, if
the Commission believed that an exemption under Rule 3a1-1
for a particular trading system that meets the volume
thresholds would create systemic risk or lead to instability
in the securities markets’ infrastructure, it could
determine that an exemption from registration as an exchange
was not appropriate in the public interest or consistent
with the protection of investors.
The Commission believes that there are alternative
trading systems operating today that exceed the volume
levels in paragraph (b)(1) of Rule 3a1-1. However, the
Commission does not believe at this time that there are any
alternative trading systems -- given their current
operations -- for which the exemption from the definition of
exchange in paragraph (a) of Rule 3a1-1 is not appropriate.
In addition, under Section 19(c)(3) of the Exchange
Act,[106] the Commission has the authority to promulgate
rules for the de-registration of an exchange. In order to
ensure a smooth transition for exchanges that wish to de-
register and become registered broker-dealers subject to
Regulation ATS, the Commission will consider promulgating
de-registration rules. Such rules would also give the
Commission the opportunity to formally consider whether
certain exchanges should be prohibited from de-registering,
just as Rule 3a1-1(b) gives the Commission the opportunity
to consider whether certain alternative trading systems
registered as broker-dealers should be compelled to register
as exchanges.
IV. Regulation of Alternative Trading Systems
Securities markets have become increasingly
interdependent. The use of technology permits market
participants to link products, implement complex hedging
strategies across markets and across products, and trade on
multiple markets simultaneously. While these opportunities
benefit many investors, they may also create misallocations
of capital, widespread inefficiency, and trading
fragmentation if markets are not coordinated. In addition,
a lack of coordination among markets has the potential to
increase system-wide risks. Congress adopted the 1975
Amendments, in part, to address these negative effects of
potentially fragmented markets.[107] The Commission
believes that it is consistent with Congress’ goals to
integrate significant alternative trading systems into the
national market system.
In the 1975 Amendments, Congress specifically endorsed
the development of an national market system, and sought to
clarify and strengthen the Commission’s authority to promote
the achievement of such a system.[108] Because of
uncertainty as to how technological and economic changes
would affect the securities markets, Congress explicitly
rejected mandating specific components of an national market
system.[109] Instead, Congress recognized that the
securities markets dynamically change and, accordingly,
granted the Commission broad authority to oversee the
implementation, operation, and regulation of the national
market system in accordance with Congressional goals and
objectives.[110]
Congress identified two paramount objectives in the
development of an national market system: the maintenance
of stable and orderly markets with maximum capacity, and the
centralization of all buying and selling interest so that
each investor has the opportunity for the best possible
execution of his or her order, regardless of where the
investor places the order.[111] In addition, Congress
directed the Commission to remove present and future
competitive restrictions on access to market information and
order systems, and to assure the equal regulation of
markets, exchange members, and broker-dealers effecting
transactions in the national market system.[112] In
particular, Congress found that it was in the public
interest to assure "fair competition . . . between exchange
markets and markets other than exchange markets."[113]
To further national market system goals, Congress
granted the Commission broad authority to make rules,
including those to: (1) prevent the use and publication of
deceptive trade and order information; (2) assure the
prompt, accurate, and reliable distribution of quotation and
transaction information; (3) enable non-discriminatory
access to such information; and (4) assure that all broker-
dealers transmit and direct orders for securities in a
manner consistent with the operation of an national market
system.[114] Moreover, Congress recognized that in order to
implement national market system goals, the Commission would
need to classify markets, firms, and securities and
facilitate the development of "subsystems within the
national market system."[115]
The Commission believes the rules it is adopting today
advance national market system goals. At present,
alternative trading systems are not fully integrated into
the national market system, leaving gaps in market access
and fairness, systems capacity, transparency, and
surveillance. These concerns, together with the increasing
significance of alternative trading systems, call into
question the fairness of current regulatory requirements,
the effectiveness of existing national market system
mechanisms, and the quality of public secondary markets.
Under the rules the Commission is adopting today,
alternative trading systems that have the most significant
effect on our markets will be required to integrate their
trading into national market system mechanisms. Alternative
trading systems may choose to register either as national
securities exchanges or as broker-dealers. Systems that
elect broker-dealer regulation will be integrated into the
national market system under Regulation ATS if they have
significant trading volume.[116] Discussed in Section IV.A.
below are the requirements for alternative trading systems
that choose to register as broker-dealers and comply with
Regulation ATS. Any alternative trading system that
registers as a national securities exchange will be
obligated -- as currently registered exchanges are -- to
participate in the national market system mechanisms.
Section IV.B. contains a discussion of the requirements
applicable to alternative trading systems that choose to
register as exchanges.
A. Regulation ATS
1. Scope of Regulation ATS
a. Definition of Alternative Trading System
The Commission proposed to define the term "alternative
trading system" as any system that: (1) constitutes,
maintains, or provides a marketplace or facilities for
bringing together purchasers and sellers of securities or
for otherwise performing with respect to securities the
functions commonly performed by a stock exchange under
Exchange Act Rule 3b-16;[117] and (2) does not set rules
governing the conduct of subscribers other than the conduct
of such subscribers’ trading on such organization,
association, person, group of persons, or system, or
discipline subscribers other than by exclusion from
trading.[118] This proposed definition would have the
effect of precluding any trading system that performs self-
regulatory functions from opting to register as a broker-
dealer, rather than as an exchange. Such a system would
consequently be required to register as an exchange or be
operated by a national securities association. Nothing,
however, would prevent a registered exchange from giving up
its self-regulatory functions and choosing instead to comply
with Regulation ATS.[119]
The Commission received only one comment on this
proposed definition. This commenter suggested that the
proposed definition for alternative trading systems was too
complex and should instead, simply be defined as an exchange
that does not set conduct rules or discipline
subscribers.[120] Under the framework the Commission is
adopting today, an alternative trading system is exempt from
the definition of an exchange if it registers as a broker-
dealer and complies with Regulation ATS.[121]
Because the Commission continues to believe that any
system that uses its market power to regulate its
participants should be regulated as an SRO, the Commission
is adopting the definition of alternative trading system as
proposed. The Commission would consider a trading system to
be "governing the conduct of subscribers" outside the
trading system if it imposed on subscribers, as conditions
of participation in trading, any requirements for which the
trading system had to examine subscribers for compliance.
In addition, if a trading system imposed as conditions of
participation, directly or indirectly, restrictions on
subscribers’ activities outside of the trading system, the
Commission believes that such a trading system should be a
registered exchange or operated by a national securities
association. For example, the Commission would not consider
a trading system to be an alternative trading system, as
defined in Rule 300(a), if that trading system prohibited
subscribers from placing orders on its system at prices
inferior to those subscribers place on other systems. The
Commission believes such rules should only be imposed and
enforced by regulatory bodies because of the potential that
they may be applied for anti-competitive purposes. The
Commission does not intend for this limitation to preclude
an alternative trading system from imposing credit
conditions on subscribers or requiring subscribers to submit
financial information to the alternative trading system.
b. Exclusion of Trading Systems Registered
as Exchanges or Operated by a National
Securities Association
The Commission proposed to exclude from the scope of
Regulation ATS certain alternative trading systems that are
subject to other appropriate regulations. In particular,
Rule 301(a) would exclude alternative trading systems (1)
registered as exchanges, (2) exempt from exchange
registration based on limited volume,[122] or (3) operated
by a national securities association. These systems are
subject to regulation as markets under other provisions of
the Exchange Act. The Commission is adopting these
exclusions as proposed.
c. Exclusion of Alternative Trading Systems
Trading Solely Government and Related
Securities
(i) Discussion
In addition, the Commission proposed that any
alternative trading system that trades only government
securities,[123] Brady Bonds, and repurchase and reverse
repurchase agreements involving government securities or
Brady Bonds be excluded from the scope of Regulation ATS, as
long as the alternative trading system is registered as a
broker-dealer. The Commission believes that alternative
trading systems trading only government securities raise
several of the structural issues raised by alternative
trading systems trading equity and other debt securities.
Nevertheless, the Commission recognizes that government
securities are subject to other forms of regulation that
help to ensure that those markets are fair and orderly. In
particular, government securities broker-dealers are
currently regulated jointly by the Commission, U.S.
Department of the Treasury ("Treasury"), and federal banking
regulators, under the Exchange Act (particularly the
provisions of the Government Securities Act of 1986) and the
federal banking laws.[124] Unlike surveillance of trading
in equities and other instruments traded primarily on
registered exchanges,[125] surveillance of trading in
government securities is coordinated among the Treasury, the
Commission, and the Board of Governors of the Federal
Reserve System.
The Commission is adopting this proposed exclusion from
Regulation ATS with some modifications.[126] Specifically,
the Commission is eliminating Brady Bonds from the types of
securities an alternative trading system can trade and fall
within this exclusion. The Commission received no comments
specifically addressing the trading of Brady Bonds by
alternative trading systems. Based on information the
Commission has available about trading on alternative
trading systems, however, the Commission is not aware of any
systems trading Brady Bonds that do not also trade other
non-government securities, most typically other emerging
market debt. Accordingly, no alternative trading systems
trading Brady Bonds would have been exempt under the
proposals. Further, the Commission does not treat Brady
Bonds in the same manner as government securities in other
contexts. Moreover, the significance of Brady Bonds in the
market is diminishing.
In addition, the Commission is expanding the exclusion
in two respects. First, the Commission is adding commercial
paper[127] and certain options on government securities[128]
to the types of securities alternative trading systems may
trade without being subject to Regulation ATS. The
Commission believes this expansion is appropriate because
commercial paper does not require registration even as a
broker-dealer, and because the term "government securities"
includes certain options on government securities for
purposes of Sections 15C and 17A of the Exchange Act.[129]
Second, the Commission is expanding this exclusion from
Regulation ATS to include alternative trading systems that
are banks and that trade solely government securities,
repurchase and reverse repurchase agreements on government
securities, certain options of government securities, and
commercial paper because of banks’ traditional role in the
government securities market.[130]
(ii) Response to Commenters
The Commission solicited comment on whether it was
appropriate to exclude from the regulatory framework for
alternative trading systems those alternative trading
systems trading solely government and other related
securities. Of those commenters who addressed this issue,
most were in favor of excluding such systems. Most of these
commenters agreed with the Commission that alternative
trading systems trading government securities are subject to
their own specialized oversight structure and, therefore,
were appropriately excluded from the scope of the
Commission’s proposal.[131] Only one commenter opposed the
proposed exclusion of alternative trading systems that trade
government securities.[132]
One commenter suggested that the Commission exclude
alternative trading systems that trade government securities
from the definition in Rule 3b-16, rather than exclude them
from Regulation ATS. This commenter stated that if these
alternative trading systems were classified as exchanges
that fact would be cited by proponents of a narrow
interpretation of the Treasury Amendment to the Commodity
Exchange Act, potentially resulting in a broad definition of
"board of trade" beyond its intended meaning as a
traditional organized exchange.[133] As stated earlier, the
Commission believes that it would be inappropriate and
without a reasoned basis to transfer part or all of its
determination regarding regulation to other statutory
contexts.[134] The Commission’s reinterpretation of
"exchange" is grounded on its decision to use its exemptive
authority to allow alternative trading systems to choose to
be regulated as broker-dealers. The Commission’s
reinterpretation of exchange should not be relied upon by
other regulators to interpret other, potentially more
restrictive statutory schemes.
In addition, this same commenter encouraged the
Commission to consider the effects of the proposed rules on
banks that operate alternative trading systems. In
particular, this commenter noted that the exclusion for
alternative trading systems that trade government securities
applied only if the alternative trading system registered as
a broker-dealer, not if the alternative trading system were
a bank.[135] The Commission did not intend to require banks
trading government securities to register as broker-dealers
and, therefore, Rule 301(a)(4), as adopted, excludes from
Regulation ATS alternative trading systems that trade
government securities if these systems are registered as
broker-dealers or are banks.
Several commenters raised questions about the
application of Regulation ATS to alternative trading systems
that trade not only government securities, but also other
types of securities.[136] One commenter asked the
Commission to extend the proposed exemption for alternative
trading systems that trade only government securities and
other related securities to all trading in those securities.
This commenter stated that broker-dealers that trade
government securities, as well as other securities and
financial instruments, should not be required to restructure
their operations to avail themselves of an exclusion for
government securities activities.[137]
The Commission does not believe that an alternative
trading systems’ government securities trading will be
subject to more burdensome regulation if it is conducted in
the same system as trading in other securities, than if it
is conducted in a separate and, therefore, excluded system.
Accordingly, the exclusion applies to systems that only
trade government and other related securities.
Government securities are not "covered securities"[138]
and, therefore, are not subject to the transparency
requirements of Regulation ATS. In addition, an alternative
trading system is only required to comply with the fair
access requirements for those securities (or categories of
securities) in which it represents twenty percent or more of
the total volume. The fair access requirement does not
apply to government securities regardless of whether
government securities trading is conducted in the same
alternative trading system as securities subject to the fair
access requirements or in a separate alternative trading
system. Finally, the capacity, integrity, and security
requirements would never be triggered by an alternative
trading system’s government securities trading. If,
however, the trading in other securities on that same system
exceeds the twenty percent threshold, an alternative trading
system in which government securities are traded would have
to meet the capacity, integrity, and security standards.
Nevertheless, it seems unlikely that an alternative trading
system would choose to create a separate alternative trading
system for its government securities trading solely for the
privilege of trading government securities on a system with
lesser capacity, integrity, and security than the system on
which other securities are traded. Therefore, the
Commission does not believe that it will be necessary, as a
practical matter, for an alternative trading system to
restructure its system to avail itself of the government
securities exclusion.
Another commenter asked that the Commission expressly
confirm that the exclusion from the scope of Regulation ATS
for systems trading government and related securities does
not preclude such an alternative trading system from
offering services involving products other than
securities.[139] In response, the Commission has clarified
that to be excluded from the scope of Regulation ATS an
alternative trading system need only limit its securities
activities to government securities, Brady Bonds, repurchase
and reverse repurchase agreements on such instruments, and
commercial paper.
Finally, this commenter suggested that the Commission
adopt rules to permit government securities alternative
trading systems to trade other fixed income securities on a
limited pilot basis. This commenter argued that, without
such a limited exemption, Regulation ATS would have a
chilling effect on the ability of government securities
alternative trading systems to introduce technological
innovation, and that such a provision would raise no
significant investor protection concerns.[140] The
Commission, however, does not believe that allowing one
category of alternative trading systems (i.e., those trading
government securities) to trade other types of fixed income
securities where the regulation and surveillance is
different, without complying with Regulation ATS is
appropriate. The notice and recordkeeping requirements
under Regulation ATS are limited and should not interfere
with market participants’ ability to test new, innovative
systems.
d. Alternative Trading Systems Trading Non-
Government Debt Securities
(i) Discussion
The Commission proposed that alternative trading
systems that trade debt securities (other than those trading
government and other related securities) be subject to
Regulation ATS, if they choose not to register as exchanges.
Under Regulation ATS, these systems would be required to
file a notice with the Commission, maintain an audit trail,
periodically report certain information to the Commission,
and ensure that they have adequate safeguards to protect
subscribers’ confidential trading information. In addition,
alternative trading systems with twenty percent or more of
the trading volume in a particular category of debt would
have to meet the fair access and systems capacity,
integrity, and security standards.[141] The Commission
solicited comment on what categories of debt would be
appropriate for this purpose and what sources of debt
transaction volume information is available. Specifically,
the Commission solicited comment on whether the following
categories would be appropriate: mortgage and asset-backed
securities, municipal securities, corporate debt securities,
foreign corporate debt securities, and sovereign debt
securities.
The Commission is adopting the proposal to include
alternative trading systems that trade fixed income
securities within its new regulatory framework. With
respect to the fair access and systems capacity, integrity
and security requirement, the rules as adopted require
alternative trading systems with twenty percent or more of
the volume in municipal securities, investment grade
corporate debt securities, and non-investment grade
corporate debt securities to comply with the fair access and
systems capacity, integrity, and security requirements.
Accordingly, the Commission is adopting rules to define
these three categories of debt securities. The Commission
is deferring any action on requiring alternative trading
systems that trade foreign corporate debt or foreign
sovereign debt to comply with the fair access and systems
capacity, integrity, and security requirements.
For municipals, the Commission is incorporating into
Regulation ATS the definition of municipal securities in
Section 3(a)(29) of the Exchange Act.[142] A debt security
(other than an exempted security) with a fixed maturity of
at least one year will be considered investment grade
corporate debt if it is rated in one of the four highest
ratings categories by at least one Nationally Recognized
Statistical Ratings Organization,[143] and will be
considered non-investment grade corporate debt if it is not
so rated.[144] The Commission believes that these
categories are widely recognized as relatively distinct
markets within the debt market as a whole and, while not
encompassing all forms of debt securities, will ensure that
alternative trading systems that provide markets for
significant segments of the debt market take adequate
measures for systems capacity, integrity, and security, as
well as provide fair access.
While the Commission is adopting rules to establish the
appropriate categories for debt securities, the volume-based
rules with respect to all categories, except municipal
securities, will not become effective until volume
information is available in a format that will enable
alternative trading systems to determine their relative
volume. Volume data for municipal securities is available
and being published through the Municipal Securities
Rulemaking Board’s ("MSRB") Daily Volume Price Reports. On
August 24, 1998, the MSRB started producing a Combined Daily
Report to summarize both intra-dealer and customer
transactions of municipal securities that are traded four or
more times per day pursuant to Rule G-14. This report is
made available through data vendors, such as Bloomberg, by
approximately 6:00am each business day.[145] Among other
information, the Combined Daily Report provides total volume
data against which alternative trading systems that trade
municipal securities can measure their compliance
obligations under Regulation ATS.
Volume data for the remaining two categories --
investment grade and non-investment grade corporate debt --,
however, is not currently compiled or published so that
alternative trading systems can determine their obligations
under Regulation ATS. In order to allow time for logistical
arrangements to make such data available, the Commission
will not make these fair access and systems capacity,
integrity and security provisions of Regulation ATS
effective until April 1, 2000.[146]
(ii) Response to Commenters
Some commenters thought that the Commission should
exclude debt securities entirely from Regulation ATS.[147]
On the other hand, several commenters supported the
Commission’s proposal to include alternative trading systems
that trade debt securities.[148] The Commission believes
that many of the same concerns about the trading of equity
securities on alternative trading systems apply equally to
the trading of fixed income securities on alternative
trading systems. Specifically, it is important that markets
with significant portions of the volume in particular
instruments have adequate systems capacity, integrity, and
security, regardless of whether those instruments are equity
securities or debt securities. Similarly, as electronic
systems for debt grow, it will become increasingly important
for the fair operation of our markets for market
participants to have fair access to significant market
centers in debt securities. One of the consequences of the
growing role of alternative trading systems in the
securities markets generally is that debt securities are
increasingly being traded on these systems, similar to the
way equity securities are traded. This change in the market
requires appropriate measures for markets for debt.
Two commenters suggested that the Commission exempt or
exclude alternative trading systems trading municipal
securities for the same reasons that it proposed to exclude
alternative trading systems that trade government
securities.[149] For example, one commenter asserted that
the municipal securities market is overseen not only by
securities regulators, but also by the federal banking
regulators. This commenter also pointed out that the
Commission had proposed excluding municipal securities in
the Concept Release and stated that the Commission should
have maintained this approach in the Proposing Release.[150]
Although the Commission did solicit comment in the Concept
Release on whether alternative trading systems trading
municipal securities should be excluded from any proposed
new regulatory framework, the Commission has concluded that
it would not be appropriate to do so.
There are substantial differences between the oversight
of the government securities market and the municipal
securities markets, and between government securities
instruments and municipal securities instruments. For
example, municipal securities are far more varied products
than government securities. While traditional general
obligation bonds issued by municipalities are more akin to
government securities in that they are backed by the full
faith and credit of the issuing taxing authority, revenue
bonds, which bear greater resemblance to privately issued
bonds due to their ties to specific revenue sources, are
riskier products.[151] Most municipal bonds are rarely
traded. The market for government securities, on the other
hand, is deep and liquid.[152] Therefore, alternative
trading systems that may develop for municipal securities
may have widely different qualities than those for
government securities. Moreover, regulation of the
government securities market is shared by the Federal
Reserve Board, the Treasury Department and the Commission
and other bank regulators, while oversight of the municipal
securities market is assigned to the Commission and the
MSRB. For these reasons, the Commission believes it would
not be appropriate to exempt alternative trading systems
that trade municipal securities from Regulation ATS.
Only one commenter directly addressed the Commission’s
request for comment on possible categories of debt.
Although TBMA encouraged the Commission to exclude
alternative trading systems trading debt securities from
Rule 3b-16,[153] it stated that, if the Commission chose to
go forward with the proposal, it "believes that the proposed
categories reflect a reasonable indication of how market
participants view and trade debt securities."[154]
Several commenters recommended that the Commission
consider the clearing agencies as a source of information on
the trading volume in the debt market. [155] One commenter
also noted that for municipal securities, the MSRB’s
transaction reporting requirements could be a good source
for volume information.[156] As discussed above, the
Commission plans to use the MSRB’s transaction reporting
program as a basis for volume in the municipal securities
market.
e. Exemptions from Certain Requirements of
Regulation ATS Pursuant to Application
to the Commission
The Commission today is also adopting a provision to
allow the Commission, upon application by an alternative
trading system, to exempt by order such alternative trading
system from one or more of the requirements of Regulation
ATS.[157] The Commission expects to issue such an order
only under unusual circumstances, and only after determining
that such an order is consistent with the public interest,
the protection of investors and the removal of impediments
to, and the perfection of the mechanisms of, a national
market system.
While the Commission believes that the requirements it
is adopting under Regulation ATS are appropriate for all
alternative trading systems operating today, the Commission
is aware that a system may develop in the future to which
these requirements may not be appropriate, and they could
hinder the development of specialized trading systems. For
example, the Commission could consider exempting an
alternative trading system that limited participation only
to investment companies with similar investment strategies,
such as index funds, from the transparency
requirements.[158]
2. Requirements for Alternative Trading Systems
Subject to Regulation ATS
Discussed below are the requirements for alternative
trading systems subject to Regulation ATS.
a. Membership in an SRO
Because alternative trading systems that choose to
register as broker-dealers will not themselves have self-
regulatory responsibilities, the Commission believes it is
important for such systems to be members of an SRO. For
this reason, the Commission proposed to require alternative
trading systems subject to Regulation ATS to be members of
an SRO.
Most alternative trading systems are currently
registered as broker-dealers and, therefore, are also
members of an SRO.[159] The Commission understands some
alternative trading systems may have concerns about SROs
abusing their regulatory authority for competitive reasons.
While the Commission understands that SROs operate competing
markets and, therefore, have potential conflicts of interest
in overseeing alternative trading systems, the Commission
believes these conflicts can be minimized using the
Commission’s oversight.[160] The Commission considers it
part of its own oversight responsibility over SROs to
prevent and take the necessary steps to address any such
actions by SROs.[161] Further, an alternative trading
system that wishes to avoid potential conflicts of interest
altogether may choose to register as an exchange. The
Commission also notes that Section 15A of the Exchange Act
would permit an association of brokers and dealers to
establish an SRO that does not operate a market.[162] Such
a national securities association could be established
solely for purposes of overseeing the activities of
alternative trading systems. Of course, this association
must be able to effectively conduct its SRO
responsibilities.
The Commission expects SROs to effectively surveil
trading that occurs on alternative trading systems by
integrating alternative trading system trading data into the
SRO’s existing surveillance systems. SROs should also
incorporate relevant information regarding the entities
trading on such systems into their existing surveillance
programs. The enhanced recordkeeping requirements for
alternative trading systems will aid SRO oversight
considerably in this regard.[163]
The Commission believes it is appropriate to continue
to require alternative trading systems that register as
broker-dealers to be SRO members and is, therefore, adopting
this requirement as proposed.[164]
b. Notice of Operation as an Alternative
Trading System and Amendments
The Commission proposed to require an alternative
trading system registered as a broker-dealer to file a
notice with the Commission before commencing operation,
amendments to this notice in the event of material changes,
and a notice when an alternative trading system ceases
operation. The Commission is adopting these requirements as
proposed.
More specifically, under Regulation ATS, alternative
trading systems are required to file an initial operation
report with the Commission on Form ATS at least twenty days
prior to commencing operation.[165] Alternative trading
systems operating currently must file Form ATS within twenty
days of the effective date of these final rules.[166] Form
ATS requests information about the alternative trading
system, including a detailed description of how it will
operate, its prospective subscribers, and the securities it
intends to trade. In addition, the alternative trading
system is required to describe its existing procedures for
reviewing systems capacity, security, and contingency
planning. Alternative trading systems are currently
required to report most of this information on Part I of
Form 17A-23, which the Commission proposed to repeal.[167]
Form ATS is not an application and the Commission would not
"approve" an alternative trading system before it began to
operate. Form ATS is, instead, a notice to the Commission.
An alternative trading system is also required to
notify the Commission of material changes to its operation
by filing an amendment to Form ATS at least twenty calendar
days prior to implementing such changes.[168] One commenter
requested that the Commission provide more specific guidance
as to what would be considered a "material change."[169] As
discussed in the Proposing Release, material changes to an
alternative trading system include any change to: the
operating platform, the types of securities traded, or the
types of subscribers. The Commission notes that currently
all alternative trading systems implicitly make materiality
decisions in determining when to notify their subscribers of
changes.
In addition to reporting material changes at least
twenty days before implementation, alternative trading
systems are required to notify the Commission in quarterly
amendments of any changes to the information in the initial
operation report that have not been reported in a previous
amendment.[170] Finally, if an alternative trading system
ceases operations, it is required to promptly file a notice
with the Commission.[171] Under Regulation ATS, the initial
operation report, any amendments, and the report filed when
an alternative trading system ceases operation will be kept
confidential.
In the Proposing Release,[172] the Commission requested
comment on the notice requirements and Form ATS. The
Commission specifically requested comment on whether such
requirements would be burdensome for alternative trading
systems, and if so, whether the burden is inappropriate.
The Commission also sought comment on the frequency of
filings and whether more or less frequent filings would be
preferable. Finally, the Commission sought comment on
whether it would be appropriate to permit or to require
electronic filing of Form ATS and all subsequent amendments.
Most of the commenters did not comment directly on the
notice requirements or Form ATS. One commenter recommended
that the Commission allow for filing of the initial
operation report on Form ATS within twenty days after
commencing operation, rather than twenty days before
commencing operation as proposed.[173] This commenter
stated that such a change would ease the regulatory burden
on new systems that often have uncertain timelines and would
avoid the possibility that a new trading system would be
prevented from operating solely because of the need to wait
for a twenty-day regulatory time period to run.
The Commission, however, believes that twenty days is a
short enough period of time that alternative trading systems
would not be inconvenienced by the requirement. If a system
were only required to provide notice after it commenced
operations, the Commission would have no notice of potential
problems that might impact investors before the system
begins to operate. The Commission also notes that currently
broker-dealer trading systems have an identical requirement
to file Form 17A-23 with the Commission twenty days prior to
commencing operation. The Commission knows of no broker-
dealer trading system that was unable to start operating
because of the twenty day period. Consequently, the
Commission believes the Rule, as adopted, is a reasonable
means for the Commission to carry out its functions and
imposes no unnecessary burdens on respondents.
The Commission also requested comment on whether the
information in Form ATS should remain confidential. Two
commenters supported the Commission’s proposal to keep
confidential the information contained in Form ATS,[174] and
one commenter encouraged the public availability of filed
information.[175] The Commission continues to believe that
notice reports filed with the Commission and the alternative
trading system’s SRO pursuant to Regulation ATS should be
kept confidential. Information required on Form ATS may be
proprietary and disclosure of such information could place
alternative trading systems in a disadvantageous competitive
position. Further, because the Commission wishes to
encourage candid and complete filings in order to make
informed decisions and track market changes, preserving
confidentiality provides respondents with the necessary
comfort to make full and complete filings. Finally, based
on the Commission’s experience with Rule 17a-23 filings, the
Commission believes that confidentiality is appropriate.
Finally, the Commission solicited comment on the
possibility of permitting Form ATS to be filed
electronically. Several commenters supported the acceptance
of electronic filings by the Commission as a way to reduce
the regulatory burden of filing Form ATS and in light of the
technological nature of alternative trading systems.[176]
The Commission agrees that electronic filing is an important
goal and plans to work toward it. Currently, however, legal
and technological limitations -- primarily relating to
security and authentication -- make an electronic filing
system infeasible. At this time, the Commission is capable
of, and plans to, provide alternative trading systems with
the ability to access Form ATS and Form ATS-R on-line,
through the Commission’s web site, so that the form can be
downloaded. Alternative trading systems would then have to
submit these forms to the Commission by mail or facsimile.
Ultimately, the Commission anticipates that current
technological barriers will be overcome, and a system able
to electronically accept Forms ATS and ATS-R will be
available.
c. Market Transparency
(i) Importance of Market Transparency
In 1997, the Commission implemented rules that require
a market maker or specialist to make publicly available any
superior prices that it privately offers through certain
types of alternative trading systems known as ECNs.[177]
The rules permit an ECN to fulfill these obligations on
behalf of market makers or specialists using its system, by
submitting the ECN’s best priced market maker or specialist
quotations to an SRO for inclusion into public quotation
displays ("ECN Display Alternative").[178]
Since the Order Handling Rules were implemented, the
spread between bids and offers in covered securities has
narrowed dramatically.[179] This has benefited investors,
including retail investors, who have enjoyed significant
cost savings when trading covered securities.[180]
These rules, however, were not intended to fully
coordinate trading on alternative trading systems with
public market trading.[181] While these rules have helped
integrate orders on certain alternative trading systems into
the public quotation system, they only disclose the orders
market makers and specialists enter into ECNs, unless the
system voluntarily undertakes to disclose institutional
prices. [182] In many cases, institutional orders, as well
as other non-market maker orders, remain undisclosed to the
public. [183] Moreover, it is voluntary for an ECN to
reflect the best priced quotations in the public quotation
system on behalf of market makers and specialists that
participate in its system.
Because certain trading interest on alternative trading
systems is not integrated into the national market system,
price transparency is impaired and dissemination of
quotation information is incomplete. These developments are
contrary to the goals the Commission enunciated over twenty-
five years ago when it noted that an essential purpose of a
national market system:
[I]s to make information on prices, volume,
and quotes for securities in all markets
available to all investors, so that buyers
and sellers of securities, wherever located,
can make informed investment decisions and
not pay more than the lowest price at which
someone is willing to sell, and not sell for
less than the highest price a buyer is
prepared to offer.[184]
(ii) Integration of Orders into the
Public Quotation System
Alternative trading systems are becoming increasingly
popular venues for trading securities. Because these
systems are not registered exchanges and do not participate
in the national market system, there is a possibility that
our securities markets could become less transparent over
time.[185] The Commission believes that it is inconsistent
with congressional goals for an national market system if
the best trading opportunities are made accessible only to
those market participants who, due to their size or
sophistication, can avail themselves of prices in
alternative trading systems. The vast majority of investors
may not be aware that better prices are disseminated to
alternative trading system subscribers and many do not
qualify for direct access to these systems and do not have
the ability to route their orders, directly or indirectly,
to such systems. As a result, many customers, both
institutional and retail, do not always obtain the benefit
of the better prices entered into an alternative trading
system. As the American Association of Individual Investors
pointed out, "[s]imply stated, investors benefit, as do
markets, from knowing the full array of best-priced orders
from all sources. . . . It is in the best interests of
individual investors that alternative trading systems
disseminate best-priced orders into quotation systems that
are available to the public."[186]
(A) New Requirements for
Alternative Trading Systems
The Commission is adopting Exchange Act Rule 301(b)(3)
to further enhance transparency of orders displayed on
alternative trading systems, and to ensure that publicly
displayed prices better reflect market-wide supply and
demand. Specifically, this rule requires alternative
trading systems with five percent or more of the trading
volume in any "covered security"[187] to publicly
disseminate their best priced orders in those securities.
These orders will then be included in the quotation data
made available to quotation vendors by national securities
exchanges and national securities associations.[188] Only
those orders that are displayed to more than one alternative
trading system subscriber would be subject to the public
display requirement. As discussed in Section IV.A.2.c.iii.
below, alternative trading systems are also required to
provide all registered broker-dealers with access to these
displayed orders.
Importantly, the public display requirement in Rule
301(b)(3) applies only to orders in "covered securities."
The term "covered securities" includes only exchange-listed,
Nasdaq NM, and Nasdaq SmallCap securities. Accordingly,
alternative trading systems trading equity securities not
included within the definition of "covered security," or
debt securities, would not be subject to the public display
requirement under Regulation ATS.
In the Proposing Release, the Commission proposed a
public display requirement substantially similar to the one
it is adopting today. The proposal, however, would have
only required alternative trading systems to publicly
display their best priced orders in a covered security when
the system represents ten percent of the trading volume in
that security. The Commission decided instead to adopt a
five percent threshold in light of the comment letters, many
of which supported the public display requirement and
recommended that the volume threshold be lower than ten
percent.
In the Proposing Release, the Commission proposed that
the display requirement be applied on a security-by-security
basis and would not have required an alternative trading
system to publicly display orders for any securities in
which its trading volume accounted for less than ten percent
of the total volume for such security. The Commission,
however, requested comment on whether an alternative trading
system should be required to display the best priced orders
in all securities traded in its system, if it reaches the
volume threshold in a specified number or percentage of the
securities it trades.
After considering the comments on the issue, the
Commission is adopting the security-by-security approach as
proposed. Although a system that trades more than the
volume threshold in a substantial number of securities could
be considered a significant market whose best prices in all
securities should be transparent, for now the Commission has
decided to take the security-by-security approach with a
lower volume threshold (five percent) than proposed. The
security-by-security approach, among other things, will more
readily enable the phase-in of securities subject to the
transparency requirements as discussed below.
The Commission emphasizes that, as proposed, Rule
301(b)(3) only requires alternative trading systems to
publicly display subscribers’ orders that are displayed to
more than one other system subscriber. Thus, if an
alternative trading system, like some crossing systems, by
its design does not display orders to other subscribers, the
rules do not require those orders to be integrated into the
public quote stream.[189] Similarly, if a portion of a
subscriber’s order is not displayed to other alternative
trading system subscribers, that hidden portion is not
subject to the public display requirement in Rule 301(b)(3).
Thus, the Commission’s rules allow institutions and non-
market makers to guard the full size of their orders by
using the "reserve size" features offered by some
alternative trading systems, which allow subscribers to
display orders incrementally. For example, a subscriber
that wishes to sell 100,000 shares of a given security could
place its order in an alternative trading system and specify
that only 10,000 shares are to be displayed to other
alternative trading system subscribers at a time. In this
instance, Rule 301(b)(3) requires that only 10,000 shares be
reflected in the public quote. The ability to continue to
control how much of their own orders to reveal was a concern
of several institutions who commented.[190] Finally,
alternative trading systems are not required to provide to
the public quote stream orders displayed to only one other
alternative trading system subscriber, such as through use
of a negotiation feature.
The Commission believes that in light of the
significant trading volume on some alternative trading
systems, integration of institutional and non-market maker
broker-dealer orders into the national market system is
essential to prevent the development of a two-tiered market.
Trading anonymity will be preserved because an alternative
trading system will comply with any public display
requirement by identifying itself, rather than the
subscriber that placed the order. Thus, the Commission’s
proposal, much like the ECN Display Alternative, is designed
to preserve the benefits associated with anonymity.
Moreover, the Commission believes that the continued ability
of institutions to retain their anonymity and to use
features within alternative trading systems to shield the
full size of their orders gives institutions the ability to
keep their full trading interest private. The Commission
recognizes that anonymity is often important to
institutional investors so that when they are unwinding or
building security holdings they do not signal their trading
strategy and negatively impact their own market
position.[191]
Requiring alternative trading systems to furnish to the
public quotation system the full size of the best displayed
buy and sell orders will ensure that the public quote better
reflects true trading interest in a particular security.
Furthermore, the Commission believes that institutional
investors’ orders entered into alternative trading systems
provide valuable liquidity, and that displaying such trading
interest will substantially strengthen the national market
system. Moreover, this public display requirement levels
the playing field between market makers -- who, when they
send customer limit orders to ECNs, the ECN must publicly
display that order -- and those ECNs, who do not have to
display customer limit orders sent directly to the ECN.
In order to monitor the effects of the public display
requirement, however, the rules will permit affected
alternative trading systems to phase-in institutional orders
in covered securities.[192] Before [insert date 120 days
after publication in the Federal Register], the Commission
will publish a schedule for the phase-in of individual
securities. Fifty percent of the securities subject to the
transparency requirement will be phased-in on [insert date
120 days after publication in the Federal Register] and the
remainder of the securities will be phased-in on [insert
date 240 days after publication in the Federal
Register].[193]
(B) Response to Comments
The Commission requested comment on whether a ten
percent volume threshold would effectively ensure that
alternative trading systems comprising a significant
percentage of the market are subject to basic market
transparency requirements. The commenters that responded to
this issue were split on whether a ten percent volume
threshold was too high or too low, although most felt it was
too high and should be lowered.[194] A few commenters,
however, stated that they believed the volume thresholds
were too low.[195]
As discussed above, the transparency requirement the
Commission is adopting in Rule 301(b)(3) obligates an
alternative trading system to disseminate into the public
quote the best priced orders in each covered security in
which the trading on such system represents more than five
percent of total trading volume. The Commission is
persuaded by commenters that stated that a ten percent
threshold would exclude trading on too many alternative
trading systems. The Commission believes that lowering the
threshold to five percent will provide more benefits to
investors, promote additional market integration, and
further discourage two-tier markets. At the same time, the
Commission believes that those alternative trading systems
with less than five percent of the volume would not add
sufficiently to transparency to justify the costs associated
with linking to a market.
The Commission requested comment on whether an
alternative trading system should be required to display the
best priced orders in all securities traded in its system,
if it reaches the volume threshold in a specified number or
percentage of the securities it trades. Of those commenters
addressing this issue, most were in favor of display of the
best priced orders in all securities traded on an
alternative trading system once that alternative trading
system exceeded the volume threshold in some fixed number of
securities. [196] The NYSE stated that if an alternative
trading system developed a "general presence" in the market,
for example by reaching the volume threshold in ten or more
securities, that alternative trading system should display
the best priced orders in all securities it trades. One
commenter, however, specifically opposed the display of all
securities traded on an alternative trading system rather
than mandating display on a security-by-security basis.[197]
This commenter also noted that even display on a security-
by-security basis may capture a system that trades a
significant amount of one security, despite the fact that
that security was a minor part of the overall trading in the
system. As discussed above, however, the Commission is
adopting the rule as proposed.
The Commission also requested comment on whether
alternative trading systems should be required to display
the full size of the best priced order, even if the full
size is hidden from alternative trading system subscribers
through use of a "reserve size" or similar feature. All
commenters directly addressing this issue[198] stated that
the reserve feature should be maintained, especially if the
Commission’s rules as adopted required displayed
institutional orders to be integrated into the public
quotation stream. The Commission agrees that the reserve
features are critical to institutions’ ability to minimize
the market impact of their orders. Further, when orders are
not displayed to anyone, the Commission’s concerns about a
two-tiered market -- where some market participants have
information others do not -- are absent. Accordingly, Rule
301(b)(3) only requires alternative trading systems to
publicly disseminate the best priced orders that are
displayed to other alternative trading system subscribers.
The Commission requested comment on whether it would be
more appropriate to adopt an alternative to Rule 301(b)(3)
that would permit, but not require, the public display of
the best-priced institutional orders displayed in a high
volume alternative trading system. Under this alternative,
an alternative trading system meeting the requirements of
Rule 301(b)(3)(i) would only be required to provide to a
national securities exchange or national securities
association the best-priced orders in covered securities
displayed in the alternative trading system by any broker or
dealer and by any other subscriber that elects to make its
orders available for public display. The Commission
requested comment on whether such an alternative would
sufficiently address the Commission’s concerns with
transparency and fragmentation in the markets. The
Commission is concerned, however, that this alternative
could exacerbate the competitive disparities between broker-
dealers and ECNs. Under the Order Handling Rules, different
order display requirements are imposed on limit orders
received by a market maker and forwarded to an ECN, than are
imposed on orders entered directly into an ECN. One
commenter expressed concern that this differential treatment
could serve as a disincentive for customers to place orders
with a broker-dealer that acts as a market maker in a
security.[199]
Most commenters that expressed support for the display
of institutional and non-market maker broker-dealer orders
did so because the display of these orders would increase
transparency and liquidity in the market. The Investment
Company Institute ("ICI") stated that it would support the
display of institutional orders because it believed display
of those orders would improve the overall transparency and
liquidity of the market. This support, however, was
contingent upon the continued availability of the "reserve"
feature offered by some alternative trading systems.[200]
Another commenter, similarly, supported disclosure of
institutional orders because displayed orders "are good for
markets," and stated that there was no cause for concern
that requiring institutions to display in the public
quotation stream would lead to a decrease in orders
displayed through alternative trading systems. In fact,
this commenter stated its belief that the opposite would
occur, and pointed to the proliferation of ECNs as
evidence.[201] The NYSE also commented that requiring
display of institutional orders in the market would add
transparency and liquidity. The NYSE added that it strongly
believes all orders of high volume alternative trading
systems, including orders of 10,000 shares or more, should
be required to be publicly displayed.[202] Ashton suggested
that orders of up to 10,000 shares on all alternative
trading systems should be fully displayed, and orders
exceeding 10,000 shares should have at least 10,000 shares
publicly displayed. Ashton stated that it believed this
would strike the appropriate balance between displaying such
orders and minimizing their market impact.[203]
The commenters who opposed display of non-market maker
broker-dealer and institutional orders did so because of the
market impact they felt such orders would have if displayed.
Instinet stated that requiring the display of institutional
orders would have several negative effects on the market.
In particular, Instinet claimed that public display of
institutional orders could have a "significant negative
impact" on the price and volatility of a security, would
divert this order flow to entities not subject to Regulation
ATS or to offshore markets, and would curtail the ability of
institutions to manage the securities transactions of the
individual investors for whom they act as proxy.[204]
Instinet also stated that institutional and other non-market
maker investors do not perform specialized market functions,
and therefore should not be subject to mandatory display in
the public quotation system. Finally, Instinet stated it
believed that customers should be able to determine the
transparency of their orders whether they were placed with a
"traditional brokerage firm" or a firm "that offers both
traditional and electronic execution opportunities."[205]
The Commission is not persuaded by commenters that
suggest that institutions currently willing to use
alternative trading systems to display their orders to other
alternative trading system subscribers, including other
institutions, market-markers, and broker-dealers, will be
less willing to use alternative trading systems that must
display those orders to the public market. Our reasons are
as follows. The primary group of market participants that
will benefit from the public display of institutional orders
is retail investors. Retail investors are not currently
alternative trading system subscribers. To avoid market
impact, institutions try to avoid signaling other
institutions and market professionals, not retail investors.
Almost all market professionals and a significant number of
institutions already subscribe to alternative trading
systems. Thus, the Commission believes that the additional
exposure to the market should not affect institutions’
behavior in their use of alternative trading systems.
Moreover, to the extent that institutions want to display
small sized orders in the public market, rather than their
entire order, they will still be able to make use of an
alternative trading system’s "reserve size" feature. This
will enable institutions to avoid exposing the total size of
their order to the public market.
The Commission also received numerous comment letters
from institutions who expressed similar concerns. Some of
these commenters appeared to be concerned that they might be
forced to display all orders sent to alternative trading
systems, even those orders, or those portions of orders,
that are not displayed to any other alternative trading
system subscribers. [206] To the extent that these letters
are concerned with "full disclosure," that concern is
misplaced. Instead, the Commission proposed, and is
adopting, a public display requirement that applies only to
those orders (or those portions of orders) that alternative
trading system subscribers have already decided to display
to the large number of other alternative trading system
subscribers. Institutions will remain free to use a reserve
feature, if an alternative trading system has one, to not
display full size of their orders to other alternative
trading system subscribers. That non-display of total order
size will also apply if that order is displayed in the
public quote.
Other commenters generally expressed concerns similar
to those expressed by Instinet, emphasizing concerns about
best execution for institutional orders, and expressing
concern about increased market volatility. [207] The
Commission believes that display of institutional orders in
the public quote stream will not harm best execution -- if
anything -- best execution will be enhanced as all market
participants will have an opportunity to execute against
these orders. The Commission also believes that the
experience with display of market maker orders under the
Order Handling Rules suggests that display of institutional
orders will not lead to increased market volatility. Many
of the largest market participants already have access to
alternative trading system institutional orders; therefore,
their display in the public quote stream should not
necessarily lead to increased market volatility. It will,
however, allow those market participants who do not have
access to these alternative trading systems to have the
opportunity to execute against these orders.
Some of the letters the Commission has received since
the beginning of November also express a concern that if
institutional orders were publicly displayed, institutions
would lose their anonymity.[208] The Commission did not
propose, nor is it adopting, any requirement that would
jeopardize an institution’s anonymity. Similar to the way
in which ECNs currently display orders in the public quote,
alternative trading systems would display their best priced
orders in the public quote, but would not indicate which of
their subscribers had entered the order.
In addition, a number of institutional commenters
suggested if Nasdaq had implemented its proposed limit order
file, they would not oppose a requirement that alternative
trading systems publicly display institutional orders, if
those orders represent the best priced order in the
alternative trading system they use.[209] Unfortunately,
none of these commenters explained why they would be willing
to publicly display their orders through a Nasdaq sponsored
central limit order file, but not publicly display orders
they have chosen to display to other alternative trading
system subscribers.
Finally, one commenter expressed concern that the order
display rule would mean that retail investors would
increasingly observe trades taking place below the bid and
above the ask, and would be frustrated by their lack of
access to these trades.[210] Because certain institutions’
orders will now be displayed in the public quote, however,
retail investors will have access to them. The lack of
access retail investors currently have to alternative
trading systems is one of the reasons the Commission
believes that the display of institutional orders in the
public quote stream is particularly important. In addition,
this commenter stated that requiring public display of
institutional orders would tilt the playing field in favor
of dealers who do not have to display institutional
orders.[211] Under the Order Handling Rules, however market
makers are required to display all customer limit orders
that improve their quote.
For these reasons, the Commission agrees with those
commenters who believe that institutional orders that are
displayed to subscribers of an alternative trading system
should be integrated into the public quotation system if
they represent the top of the book in the alternative
trading system.[212] The Commission believes that any
market impact that results from such display will be
vitiated by the retention of the reserve feature, as
discussed above. The Commission notes that such
institutional orders are currently displayed to the
subscribers of alternative trading systems, who may number
in the thousands. These subscribers are often the market
makers and other active traders in the security. As a
result, prices displayed only on alternative trading systems
are immediately known to key market players who can adjust
their trading to take advantage of their information
advantage. Moreover, the Commission believes that these
orders will provide enhanced transparency and liquidity when
integrated into the public quotation stream, and will
further curtail the development of a two-tiered market.
Nonetheless, the Commission is concerned about
commenters’ statements that institutions may react to the
transparency requirement by shipping more orders upstairs or
overseas. The Commission intends to closely monitor the
impact of this requirement, and will modify it if harm
appears to result.
(iii)Access to Publicly Displayed Orders
(A) Application of Access
Requirements under
Regulation ATS
The Commission believes that in addition to the display
of better alternative trading system prices in the public
quotation system, the availability of such trading interest
to public investors is an essential element of the national
market system. Therefore, the Commission proposed that
alternative trading systems afford all non-subscriber
broker-dealers equivalent access to the alternative trading
system orders displayed in the public quote, similar to the
manner in which ECNs currently comply with the ECN Display
Alternative under the Quote Rule.[213] The Commission
agrees with those commenters who stressed the importance of
equivalent access for non-participants and who stated that
simply requiring alternative trading systems to display
prices in the public quotation system does not go far enough
to facilitate the best execution of customer orders without
a mechanism to access orders at those prices.[214]
Accordingly, the Commission is adopting the requirement as
proposed.[215] Specifically, with respect to any security
in which an alternative trading system is required to
publicly display its best priced orders because it has five
percent or more of all trading in that security, such
alternative trading system must provide for members of the
SRO with which it is linked the ability to effect a
transaction with those orders. As discussed above, the
Commission is phasing in the public display
requirement.[216] In addition, alternative trading systems
are not required to provide access to a security until the
public display requirement is effective for that
security.[217]
The Commission believes that non-subscribing broker-
dealers should be able to execute against those alternative
trading system orders that are publicly displayed to the
same extent as if that price had been reflected in the
public quote by a national securities exchange or national
securities association. Thus, an alternative trading system
should respond to orders entered by non-participants no
slower than it responds to orders entered directly by
subscribers. The Commission believes that, under current
NASD rules, any alternative trading system that allows non-
subscribing broker-dealers to execute against publicly
displayed alternative trading system orders in the same
manner as ECNs linked to the Nasdaq market currently do
would comply with this requirement. The NASD does not
currently require ECNs to automatically execute orders sent
to the ECN through the NASD’s SelectNet linkage with the
ECN. Any SRO to which alternative trading systems may be
linked, may determine that it is necessary for the fair and
orderly operation of its market to require that publicly
displayed alternative trading system orders be subject to
automatic execution. Any such proposed rule change, of
course, would be have to be filed with the Commission by the
SRO, published for comment, and approved by the Commission.
The Commission would not approve any such SRO rule unless it
finds that such rule is consistent with the Exchange Act.
(B) Response to Comments
The Commission asked for comment on whether alternative
trading systems should be required to provide non-
subscribers with equivalent access to displayed orders.
Several commenters responded to this issue. Most of these
commenters stated that non-subscribers should be given
equivalent access.[218] Only one commenter cautioned
against granting such access. This commenter argued that
alternative trading systems and traditional broker-dealers
engage in the same business and, therefore, it would impede
innovation as well as be unfair to require fair access to
trading opportunities on alternative trading systems when
the Commission is not proposing to require such access to
more traditional broker-dealers.[219] The Commission does
not believe that alternative trading systems and traditional
broker-dealers engage in the same business.[220] As
discussed above, the Commission believes that the public
display of orders on alternative trading systems that are
currently displayed only to the subscribers of those
alternative trading systems will improve the public
securities markets. Without a mechanism to access these
orders, any public display requirement is insufficient.
Accordingly, the Commission is adopting the fair access
requirement.
In the Proposing Release, the Commission also stated
that it believes that for an alternative trading system to
comply with this equivalent execution access requirement,
the publicly displayed alternative trading system orders
would need to be subject to automatic execution through
small order execution systems operated by the SRO to which
the alternative trading system is linked. One commenter
strongly urged the Commission to eliminate the automatic
execution access requirements from its proposal. This
commenter was opposed to such a linkage, because it believed
it would effectively eliminate pure agency brokers from
markets in covered securities, because brokers would be
required to commit capital if automatic execution resulted
in multiple executions against client orders. This
commenter also noted that the Commission’s Order Handling
Rules do not require automatic execution, but require only
that response times for non-subscriber trade requests are no
slower than response times for subscribers, and believed
this to be a more balanced approach to execution access
issues. [221] Similarly, American Century, while supporting
equivalent access to non-subscribers, stated that automatic
execution access requirements were risky as well, because of
the possibility of double execution.[222] The Commission
does not expect -- by operation of its rules alone -- that
alternative trading systems will be subject to automatic
execution through SROs’ small order execution systems.
Nevertheless, the Commission believes that an SRO to which
an alternative trading system is linked should be able to
establish rules regarding how that alternative trading
system is integrated into its market. The Commission notes
that any change to SRO rules regarding automatic execution
would have to be approved by the Commission after notice and
the opportunity for the public to comment, and subject to
Commission review for competitive fairness and consistency
with the Exchange Act.
In addition, the Commission asked if there was a
feasible way to allow market-wide interaction without
linkage to SRO order execution systems, and whether there
was a feasible way to grant equivalent non-subscriber access
to institutions that are not broker-dealers.
(iv) Execution Access Fees
(A) Limitations on
Alternative Trading
System Fees Charged to
Non-Subscribers
In the Proposing Release, the Commission stated that an
alternative trading system’s fee schedules should not be
used to circumvent the ability of non-participants to access
a system’s publicly displayed orders.[223] Because
reasonable fees are a component of equal access, the rules
the Commission is adopting today prohibit an alternative
trading system from setting fees that are inconsistent with
the principle of equivalent access to the alternative
trading system quotes by members of the SRO to which the
alternative trading system is linked. The rules also
require an alternative trading system to comply with the
rules or standards governing fees established by the
national securities exchange or national securities
association through which non-subscribers have access.[224]
The Commission believes that fees charged by an
alternative trading system would be inconsistent with
equivalent access if they have the effect of creating
barriers to access for non-subscribers. As the Commission
stated in adopting the Order Handling Rules, any ECN fees
should be similar to the communications or systems charges
imposed by various markets.[225] In addition, the
Commission believes that the national securities exchange or
national securities association to which the alternative
trading system provides the prices and sizes of its best
priced orders should have further authority to assure that
fees charged by alternative trading systems to non-
subscribers are disclosed or otherwise consistent with fees
typically charged by the members of the exchange or
association for access to displayed orders. There are a
number of ways the exchange or association could address the
issue of fees charged by alternative trading systems. For
example, subject to Commission review and approval, an
exchange or association could establish a standard for what
constitutes a fair and reasonable fee for non-subscriber
access to an alternative trading system, consistent with the
effective operation of the self regulatory organization’s
market and the Commission’s equivalent access requirement.
The exchange or association may also require alternative
trading system fees to be charged in a manner consistent
with the exchange’s or association’s market, such as
requiring the fee to be incorporated in the displayed quote.
At such time as quotations in the national market
system are reflected in decimals rather than in fractions,
the Commission will reconsider the rule’s limitation on
alternative trading systems charging fees only as permitted
by the national securities exchange or national securities
association to which they are linked. At that time, the
Commission will also consider whether alternative trading
systems should be permitted or required to reflect any fee
charged in their quotations.
Any rules the exchange or association develops will of
course need to be consistent with the goals of promoting
competition and protecting investors. The Commission
encourages SROs that accept alternative trading system
quotes to work with alternative trading systems to develop
uniform standards regarding display and execution access by
SRO members to alternative trading systems linked to the
SRO.[226] In addition, to foster equivalent access to
alternative trading systems for exchange-listed securities,
the Commission expects Intermarket Trading System ("ITS")
participants to modify ITS Plan requirements where necessary
to accommodate alternative trading system participation in
the markets of ITS participants, and access to those
alternative trading systems through ITS. If the SROs and
ITS participants cannot come to terms with affected
alternative trading systems within a reasonable time, the
Commission will consider exercising its authority to mandate
the necessary linkages.
(B) Response to Comments
The Commission requested comment on the fees that
alternative trading systems should be permitted to charge
non-subscribers under the proposed rules. In addition, the
Commission requested comment on whether there were
alternatives for assuring fair execution access for non-
subscribers other than limiting fees, or another test for
determining whether non-subscriber fees assure equal access.
Ten comment letters addressed the issue of fees charged
by alternative trading systems for access by non-
subscribers. Of these, seven were generally in favor of
permitting alternative trading systems to charge some fee to
non-subscribers, [227] two were opposed,[228] and one felt
the issue needed to be addressed in a separate release by
the Commission.[229]
Most of the commenters who were in favor of allowing
fees stated that fees should be "reasonable," or should not
exceed the fees typically charged to subscriber broker-
dealers. The NASD, while not opposing such fees, stated
that the Commission should reconsider the benchmark for an
alternative trading system’s fees, because it believed that
for many alternative trading systems, non-subscriber orders
were of primary importance. Because of this, the NASD
stated that any fees should be set at the low end of the
threshold, rather than at the level that a "substantial
proportion" of an alternative trading system’s broker-dealer
customers were paying. The NASD supported permitting SROs
to regulate fees, so that such issues could be discussed at
the SRO level. The NASD also recommended that the
Commission discuss "the practical issues related to billing
disputes and refusals to trade," because billing disputes
have led to locked and crossed markets.[230] Finally, the
NASD asked the Commission to address the best execution
obligations of market participants when a fee is not
included in the publicly displayed price of an order. A
broker-dealer’s duty of best execution requires it to seek
the most favorable terms reasonably available under the
circumstances for a customer’s transaction. While price is
the predominant element of best execution, the traditional
non-price factors of executions should also be
considered.[231]
Instinet commented that market forces should determine
the appropriate fees that broker-dealers can charge for
their services. Consequently, Instinet opposed any proposal
to limit (or eliminate entirely) access fees charged by a
broker-dealer subject to Regulation ATS if the rules of the
national securities exchange or association to which the
broker-dealer is linked limits (or prohibits) such fees.
The Commission will, of course, review any proposed SRO
rules relating to access fees. To be approved by the
Commission, any such rules must be necessary to maintain
consistency within the SRO’s market, as well as being
designed to promote just and equitable principles of trade,
to promote fair competition, to facilitate transactions in
securities, and, in general, to protect investors and the
public interest.[232] Instinet also stated, however, that
it would urge the Commission to ensure that all public
execution access fee requirements were handled in such a way
that all orders integrated into the public quote stream were
treated consistently, and so that all broker-dealers were
able to set appropriate fees for the services they
performed, subject to SRO rules.[233]
American Century stated that all market participants
who posted bids and offers, not just alternative trading
systems, should be permitted to charge fees. American
Century recommended that participants who provide liquidity
be permitted to charge a fee for that liquidity, and that
those who took liquidity should pay fees.[234] OptiMark
stated that the Commission should consider what economic
incentive it would be creating by permitting alternative
trading systems that register as broker-dealers to charge
fees, but not permitting those that register as exchanges to
do so.[235]
The Commission also requested comment on whether fees
should be included in the price of an order quoted to the
public, particularly once orders are quoted in decimals. In
this regard, the NYSE and the Chicago Stock Exchange ("CHX")
stated that fees made it difficult to determine the true
cost of executing an order and indicated that this would
change if fees could be included in the quote.[236] As
discussed above, when quotations in the national market
system are reflected in decimals rather than fractions, the
Commission will reconsider whether alternative trading
systems should reflect any fees charged in their quote, and
if so, whether they should be subject to SRO requirements.
(v) Amendment to Rule 11Ac1-1 under the
Exchange Act
The Commission also proposed an amendment to Rule
11Ac1-1 under the Exchange Act.[237] The amendment would
expand the ECN Display Alternative to allow alternative
trading systems that display orders and provide equal
execution access to those orders under Rule 301(b)(3) of
Regulation ATS to fulfill market makers’ and specialists’
obligations under the Quote Rule. Only two comment letters
addressed the proposed amendment to the Quote Rule, both of
which supported it. [238]
The Commission is adopting the amendment to the Quote
Rule as proposed.[239] The Quote Rule currently requires
all market makers and specialists to make publicly available
any superior prices that it privately offers through ECNs.
The ECN Display Alternative in the Quote Rule permits an ECN
to fulfill these obligations on behalf of market makers and
specialists using its system by submitting the ECN’s best
market maker or specialist priced quotation to an SRO for
inclusion into the public quotation.[240] Today’s amendment
to the Quote Rule is intended to expand the ECN Display
Alternative to allow alternative trading systems that
display orders and provide equal execution access to those
orders under Rule 301(b)(3) of proposed Regulation ATS to
fulfill market makers’ and specialists’ obligations under
the Quote Rule.
d. Fair Access
(i) Importance of Fair Access
The Exchange Act requires registered exchanges and
national securities associations to consider the public
interest in administering their markets and to establish
rules designed to admit members fairly.[241] These
requirements are intended to ensure that markets treat
investors and other market participants fairly.[242]
Alternative trading systems that choose to register as
exchanges will be subject to these requirements. Under the
current regulatory approach, however, there is no mechanism
to prevent unfair denials or limitations of access by
alternative trading systems or regulatory oversight of such
denials or limitations of access. Access to alternative
trading systems may not be critical when market participants
are able to substitute the services of one alternative
trading system with those of another. However, when an
alternative trading system has a significantly large
percentage of the volume of trading, unfairly discriminatory
actions hurt investors lacking access to the system.
Fair treatment by alternative trading systems of
potential and current subscribers is particularly important
when an alternative trading system captures a large
percentage of trading volume in a security, because viable
alternatives to trading on such a system are limited.
Although the Commission is adopting rules to require
alternative trading systems with significant trading volume
to publicly display their best bid and offer and provide
equal access to those orders,[243] direct participation in
alternative trading systems offers benefits in addition to
execution against the best bid and offer. For example,
participants can enter limit orders into the system, rather
than just execute against existing orders on a fill-or-kill
basis. Participants in an alternative trading system can
view all orders, not just the best bid or offer, which
provides important information about the depth of interest
in a particular security. Participants also have access to
unique features of alternative trading systems, such as
"negotiation" features, whereby one participant can send
orders to another participant proposing specific terms to a
trade, without either participant revealing its identity.
Some alternative trading systems also allow participants to
enter "reserve" orders which hide the full size of an order
from view. Because of these advantages to participants in
an alternative trading system, access to the best bid and
offer through an SRO is an incomplete substitute.
Therefore, the rules the Commission is adopting today
require most alternative trading systems that are registered
as broker-dealers and that have a significant percentage of
overall trading volume in a particular security to comply
with fair access standards, as described in more detail
below. [244]
(ii) Fair Access Requirement
The Commission is adopting Exchange Act Rule 301(b)(5)
to ensure that qualified market participants have fair
access to the nation’s securities markets. As the
Commission proposed, an alternative trading system
registered as a broker-dealer and subject to Regulation ATS
will be required to establish standards for access to its
system and apply those standards fairly to all prospective
subscribers, if the alternative trading system, during four
of the preceding six months, accounts for twenty percent or
more of the trading volume.[245] This twenty percent volume
threshold will be applied on a security-by-security basis
for equity securities.[246] Accordingly, if an alternative
trading system accounted for twenty percent or more of the
share volume in any equity security, it must comply with the
fair access requirements in granting access to trading in
that security.
For debt securities, the Commission proposed that if an
alternative trading system accounted for twenty percent or
more of the volume in any category of debt security, the
alternative trading system would be subject to the fair
access requirements in granting access to trading in
securities in that category. The Commission solicited
comment on the appropriate categories of debt securities.
Specifically, the Commission asked whether categories such
as mortgage and asset-backed securities, municipal
securities, corporate debt securities, foreign corporate
debt securities, and foreign sovereign debt securities would
be appropriate. After considering the comments, the
Commission is adopting rules that require alternative
trading systems with twenty percent or more of the volume in
municipal securities, investment grade corporate debt
securities, and non-investment grade corporate debt
securities to meet the fair access requirements with respect
to that category. The Municipal Securities Rulemaking
Board’s transaction reporting plan now provides information
on the aggregate trading in municipal securities.[247] The
fair access requirement will be effective for alternative
trading systems with twenty percent or more of the volume in
municipal securities on [insert date 120 days after
publication in the Federal Register].
Because similar information for investment grade and
non-investment grade corporate debt, however, is not
currently available, the fair access requirements in Rule
301(b)(5)(D) and (E) will not be made effective until April
1, 2000 with the expectation that further information will
be available at that time.[248] The Commission is deferring
action on the system reliability standards for alternative
trading systems trading a substantial portion of the market
in foreign corporate debt and foreign sovereign debt until
such time as reliable data is available by which alternative
trading systems may determine their relative portion of the
market.
The Commission is excluding from the fair access
requirement those alternative trading systems that match
customer orders for securities with other customer orders,
at prices for those same securities established outside such
system.[249] Thus, regardless of their trading volume,
systems that, for example, match customer orders prior to
the market opening and then execute those orders at the
opening price for the securities are not required to comply
with the fair access requirement. In addition, systems that
match unpriced orders at the mid-point of the bid and ask,
or at a value weighted average or prices on another market
are not subject to the fair access requirements. The
Commission, however, would not consider an alternative
trading system to be excluded from the fair access
requirements in paragraph (b)(5) of Rule 301 if that system
priced any security traded on that system using prices
established outside such system for instruments other than
the particular security being executed. Therefore, a system
would not be excluded if it traded options or other
derivatives based on prices established on the primary
market for the underlying security.
Alternative trading systems subject to this fair access
requirement must comply with the requirements in paragraph
(b)(5)(ii) of Rule 302. Specifically, these alternative
trading systems must establish standards for granting access
to trading on their systems,[250] and maintain these
standards in their records.[251] An alternative trading
system must apply these standards fairly and is prohibited
from unreasonably prohibiting or limiting any person with
respect to trading in any equity securities, or in certain
categories of debt securities, when that trading exceeds the
twenty percent volume threshold. For example, the
Commission will consider it a denial of access by an
alternative trading system if the alternative trading system
refuses to open an account for a customer, thereby denying
that customer the use of its trading facilities.[252] In
addition, if an alternative trading system grants, denies or
limits access to trading to any person, the alternative
trading system is required to keep records of each action,
including the reasons for such action.[253] Each
alternative trading system will also be required to provide
a list of all grants, denials or limitations of access to
the Commission on Form ATS-R each quarter. For each grant,
denial or limitation of access, alternative trading systems
must provide the name of the person, nature and effective
date of the decision, and any other information that the
alternative trading system deems relevant. For denials or
limitations of access, alternative trading systems must
provide information describing the reasons for the
decision.[254] For example, if an applicant has a relevant
disciplinary history, has insufficient financial resources,
or refuses to agree to abide by the rules of the alternative
trading system, an alternative trading system should include
such reasons in its filing with the Commission. The
Commission intends to enforce the fair access rules by
reviewing these reports and investigating any possible
violations of the rule.[255]
The fair access requirements the Commission is adopting
today are based on the principle that qualified market
participants should have fair access to the nation’s
securities markets. Alternative trading systems remain free
to have reasonable standards for access. Such standards
should act to prohibit unreasonably discriminatory denials
of access. A denial of access is reasonable if it is based
on objective standards. For example, an alternative trading
system may establish minimum capital or credit requirements
for subscribers.[256] Similarly, an alternative trading
system may reasonably deny access to investors based on a
relevant, unfavorable disciplinary history. In addition, an
alternative trading system could allow institutional
subscribers the option of refusing to trade with broker-
dealer subscribers, as long as the alternative trading
system grants this option to subscribers based on objective
and fairly applied standards. Provided that these or other
standards were applied consistently to all subscribers, an
alternative trading system would be considered to be
granting and denying access fairly. A denial of access
might be unreasonable, however, if it were discriminatorily
applied among similar subscribers or if it were based solely
on the trading strategy of a potential participant.
The proposed rules included a right of appeal to the
Commission of any denial or limitation of access, as well as
a requirement that an alternative trading system notify a
person denied or limited access of their right of appeal.
The Commission has decided not to adopt these provisions.
The Commission is concerned that such a right of appeal
would prove burdensome to the alternative trading system,
the party denied or limited access, and Commission staff.
In addition, commenters generally approved of the goals of
fair access, but were not supportive of providing a right of
appeal to the Commission.
(iii)Response to Comments
Commenters who addressed the proposed fair access
requirement generally agreed with the Commission’s goal of
ensuring that alternative trading systems with significant
volume establish criteria for fairly determining access.
[257] Two commenters, for various reasons, did not believe
that a requirement ensuring fair access by alternative
trading systems was necessary.[258] Another commenter
argued that alternative trading systems that do not display
to subscribers should not be required to grant access to
non-subscribers.[259]
The Commission solicited comment on the level of volume
at which fair access requirements should be applied. Of
those commenters who addressed the Commission’s proposed
threshold of twenty percent, three believed that the level
should be raised,[260] two believed it should be
lowered,[261] and one believed twenty percent was
appropriate.[262] One of the commenters that recommended
the Commission lower the threshold from twenty percent
stated that fair access should be ensured regardless of
volume, because volume levels are subject to variation over
time, and because unfair denials of access by even small
systems could make access to quotes in illiquid securities
particularly difficult.[263]
The Commission agrees with this commenter that fair
access is an important element of fair markets.
Nevertheless, in balancing the need for fair access with the
costs that may be associated with such a requirement, the
Commission believes that a twenty percent threshold strikes
the right balance. As discussed above, the rules the
Commission is adopting today require that an alternative
trading system subject to Regulation ATS comply with fair
access requirements if, during at least four of the
preceding six months, the alternative trading system
accounted for twenty percent or more of the average daily
share volume in any equity security or certain categories of
debt.[264]
The Commission also requested comment on whether
persons denied access to an alternative trading system
should have the right to appeal this action to the
Commission, what form the appeal should take, and what the
appropriate standard for Commission review should be. Five
comment letters directly addressed the issue of appeal to
the Commission of denials of access.
One commenter favored a right to appeal a denial of
access, but stated that the appeal process should begin at
the SRO level.[265] This commenter stated that appeal to
the Commission should occur only if the SRO fails to resolve
the dispute. Another commenter, similarly, stated that it
believes denials or limitations of access should be handled
through current SRO complaint and disciplinary procedures,
rather than through procedures used to appeal SRO
determinations to the Commission. This commenter stated
that it believes formal Commission procedures could blur the
allocation of supervisory authority over broker-dealers and
could lead to duplicative or inconsistent review proceedings
in some cases. Moreover, this commenter was concerned that
a right to appeal to the Commission could lead to the
frequent filing of frivolous or vexatious complaints against
the broker-dealer, thereby impeding its ability to screen
out potentially unqualified customers.[266] As discussed
above, the Commission has decided not to adopt the proposed
right of appeal to the Commission.
One commenter opposed a right to appeal denial of
access, on the basis that there was no need for it. If,
however, the Commission did implement its proposal to
provide those denied access with the right to appeal to the
Commission, this commenter recommended that the Commission
ensure that this process did not become a means to dictate
with whom a proprietary system may contract and that the
allowable relief not be so expansive as to allow the
Commission to alter the alternative trading system’s
published access standards.[267]
e. Capacity, Integrity, and Security
Standards
As discussed in the Proposing Release,[268] in November
1989 and May 1991, the Commission published two policy
statements regarding the use of technology in the securities
markets.[269] These policy statements established the
automation review program and called for the SROs to
establish, on a voluntary basis, comprehensive planning,
testing, and assessment programs to determine systems’
capacity and vulnerability. The Commission recommended that
SROs: (1) establish current and future capacity estimates;
(2) conduct capacity stress tests; and (3) obtain annual
independent assessments of systems to determine whether they
can perform adequately.[270] In addition, the Commission
staff conducts oversight reviews of the SROs’ systems
operations. All SROs currently participate in the
Commission’s automation review program, which has been a
significant force in stimulating the SROs to upgrade their
systems technology.[271]
The automation review program was established because
of "the impact that systems failures have on public
investors, broker-dealer risk exposure, and market
efficiency."[272] While this program did not directly apply
to alternative trading systems, the Commission noted that
all broker-dealers should engage in systems testing and use
the policy statement as a guideline.[273] Because some
alternative trading systems now account for a significant
share of trading in the U.S. securities markets, failures of
their automated systems have as much of a potential to
disrupt the securities markets as failures of SROs’
automated systems. For this reason, the Commission proposed
to require alternative trading systems with significant
volume to meet certain systems capacity, integrity, and
security standards. [274] The proposed requirements were
similar to those standards SROs currently follow under the
automation review program.
(i) Application of Capacity, Integrity,
and Security Standards
The Commission is adopting Exchange Act Rule 301(b)(6)
to reduce the likelihood that alternative trading systems
that play a significant role in our national market system
will disrupt the securities markets due to failures of their
automated systems. This rule requires alternative trading
systems trading twenty percent or more of the volume in any
equity security or in certain categories of debt
securities[275] to comply with standards regarding the
capacity, integrity, and security of their automated
systems. As for the fair access requirements discussed
above, the volume thresholds are on a security-by-security
basis for equity securities. Accordingly, if any one equity
security traded on an alternative trading system accounts
for more than twenty percent of the total share volume in
that security during four of the preceding six months, the
alternative trading system is required to meet the capacity,
integrity, and security requirements for that security,
although in practice this may cause compliance with the
standards for all securities traded in that system. With
respect to debt securities, an alternative trading system is
required to meet the systems capacity, integrity, and
security standards if it trades twenty percent or more of
the volume during four of the preceding six months in any of
the following categories: municipal securities, non-
investment grade corporate debt, and investment grade
corporate debt.[276]
The Municipal Securities Rulemaking Board’s transaction
reporting plan now provides information on the aggregate
trading in municipal securities.[277] Because similar
information for investment grade and non-investment grade
corporate debt, however, is not currently available, the
system capacity, integrity, and security requirements in
Rule 301(b)(6)(D) and (E) will not be made effective until
April 1, 2000.[278] The Commission is deferring action on
the system reliability standards for alternative trading
systems trading a substantial portion of the market in
foreign corporate debt and foreign sovereign debt until such
time as reliable data is available by which alternative
trading systems may determine their relative portion of the
market.
As for the fair access requirement, the Commission is
excluding from the systems capacity, integrity, and security
requirement those alternative trading systems that match
customer orders for securities with other customer orders,
at prices for those same securities established outside such
system.[279] Thus, regardless of their trading volume,
systems that, for example, match customer orders prior to
the market opening and then execute those orders at the
opening price for the securities are not required to comply
with these systems reliability requirements. In addition,
systems that match unpriced orders at the mid-point of the
bid and ask, or at a value weighted average or prices on
another market are not subject to the fair access
requirements. The Commission, however, would not consider
an alternative trading system to be excluded from the
requirements in paragraph (b)(6) of Rule 301 if that system
priced any security traded on that system using prices
established outside such system for instruments other than
the particular security being executed. Therefore, a system
would not be excluded if it traded options or other
derivatives based on prices established on the primary
market for the underlying security.
An alternative trading system that meets these volume
thresholds will be required to: (1) establish reasonable
current and future capacity estimates; (2) conduct periodic
capacity stress tests of critical systems to determine such
system’s ability to process transactions in an accurate,
timely, and efficient manner; (3) develop and implement
reasonable procedures to monitor system development and
testing methodology; (4) review the vulnerability of its
systems and data center computer operations to internal and
external threats, physical hazards, and natural disasters;
and (5) establish adequate contingency and disaster recovery
plans. An alternative trading system is required to meet
these proposed standards with respect to all its systems
that support order entry, order handling, execution, order
routing, transaction reporting, and trade comparison in the
particular security.[280] In addition, alternative trading
systems subject to this provision are required to notify the
Commission staff of material systems outages and material
systems changes.[281] This information will enable
Commission staff to better understand the operation of the
alternative trading system and to identify potential
problems and trends that may require attention.
Finally, under Regulation ATS, alternative trading
systems that meet the volume levels set forth above are
required to perform an annual independent review of the
systems that support order entry, order handling, execution,
order routing, transaction reporting and trade
comparison.[282] As discussed in greater detail in the
Commission’s May 1991 Policy Statement,[283] an independent
review should be performed by competent, independent audit
personnel following established audit procedures and
standards. If internal auditors are used by an alternative
trading system to complete the review, these auditors should
comply with the standards of the Institute of Internal
Auditors and the Electronic Data Processing Auditors
Association ("EDPAA"). If external auditors are used, they
should comply with the standards of the American Institute
of Certified Public Accountants ("AICPA") and the EDPAA.
(ii) Response to Comments
In the Proposing Release,[284] the Commission requested
comment on its proposal to require significant alternative
trading systems to satisfy systems capacity, integrity, and
security standards. While most commenters did not
specifically address this proposed requirement, those that
did comment generally supported it.[285]
The Commission asked whether the twenty percent volume
threshold proposed was appropriate. In this regard, the
NASD supported the twenty percent proposed volume
threshold.[286] Two other commenters, however, suggested
that the Commission’s proposed threshold was too low.[287]
Specifically, one of these commenters argued that the
Commission should raise the volume threshold from twenty
percent to thirty-five percent to avoid including debt
market participants with no significant role in price
discovery. This commenter stated that, given the
decentralized and fungible nature of the debt markets, an
alternative trading system trading debt securities would
need twenty percent or more of the relevant market to
materially affect the markets in the manner in which the
Commission is concerned. [288] Another commenter,
similarly, suggested that these requirements not be imposed
until an alternative trading system had forty percent of the
market in any security. In addition, before the capacity,
integrity, and security requirements are triggered, this
commenter recommended that any security (or category of
debt) in which the alternative trading system reached forty
percent of aggregate daily volume also represent twenty
percent or more of the alternative trading system’s overall
trading activity.[289] One commenter, however, argued that
the Commission’s proposed threshold was too high, and that
it should instead be applicable to alternative trading
systems with one percent of the consolidated volume in a
category of equity securities, such as listed or Nasdaq
securities.[290]
In addition, while the ICI stated its belief that
competitive pressures will generally suffice to ensure that
alternative trading systems have the capacity to execute
trades in a timely manner, the ICI also stated that it would
not oppose such requirements as long as the Commission
applied them in a flexible manner and did not dictate how
alternative trading systems structure their operations.[291]
The Commission believes that alternative trading
systems that have a significant role in the marketplace
should be able to handle reasonably foreseeable volume
surges and be prepared for reasonably anticipated future
volume increases. As a result, the Commission continues to
believe that the volume thresholds above are appropriate.
Investors and other market participants increasingly rely on
alternative trading systems to buy and sell securities. The
ability of these markets to meet the demands of market
participants is directly related to the reliability of their
automated systems. The Commission realizes that alternative
trading systems have significant business incentives to
ensure that their systems have adequate capacity so that
participants’ orders do not experience unnecessary delays.
The systems capacity, integrity, and security rules are
intended as a back-up to ensure that alternative trading
systems that have a significant role in the market maintain
sufficient systems and procedures to minimize the effects of
potential systems problems in the secondary markets.
f. Examination, Inspection, and
Investigations of Subscribers
The Commission proposed that an alternative trading
system be required to cooperate with the Commission’s or an
SRO’s inspection, examination, or investigation of the
alternative trading system or any of the alternative trading
system’s subscribers. Presently, the Commission has the
authority to inspect and examine any member of any national
securities exchange or any national securities association
directly. This is because all such members are broker-
dealers. Alternative trading systems, however, also could
have certain other subscribers, such as institutions or
individuals, to which the Commission’s inspection authority
does not extend. Because alternative trading systems could
be used by subscribers to manipulate the market in a
security,[292] it is imperative that alternative trading
systems cooperate in all inspections, examinations, and
investigations. Although neither the Commission nor the
SROs has the authority to directly inspect non-broker-dealer
subscribers of alternative trading systems, any relevant
trading information involving such subscribers would be
maintained by the alternative trading system under its
recordkeeping requirements, and would be required to be made
available upon request to its SRO or the Commission. Under
the rules the Commission is adopting today, an alternative
trading system’s exemption from exchange registration is
conditioned on it cooperating with the Commission’s or an
SRO’s inspection, examination, or investigation of the
alternative trading system or any of its subscribers. [293]
g. Recordkeeping
The Commission proposed that alternative trading
systems be required to keep certain records. The Commission
is adopting these recordkeeping requirements as proposed.
As adopted, Regulation ATS requires alternative trading
systems to make and keep the records necessary to create a
meaningful audit trail.[294] Specifically, alternative
trading systems are required to maintain daily summaries of
trading and time-sequenced records of order information,
including the date and time the order was received, the
date, time, and price at which the order was executed, and
the identity of the parties to the transaction. In
addition, alternative trading systems are required to
maintain a record of subscribers and any affiliations
between subscribers and the alternative trading system.
[295] While some of the information that is required by the
Regulation ATS will also be required under the NASD’s Order
Audit Trail System ("OATS"),[296] OATS is an NASD rule and
does not cover all securities traded through alternative
trading systems.
These recordkeeping requirements also require
alternative trading systems to keep records of all notices
provided to subscribers, including notices addressing hours
of operation, system malfunctions, changes to system
procedures, and instructions pertaining to access to the
alternative trading system.[297] In addition, alternative
trading systems are required to keep documents made (if any)
in the course of complying with the systems capacity,
integrity, and security standards in Rule 301(b)(6). These
documents include all reports to an alternative trading
system’s senior management, and records concerning current
and future capacity estimates, the results of any stress
tests conducted, procedures used to evaluate the anticipated
impact of new systems when integrated with existing systems,
and records relating to arrangements made with a service
bureau to operate any automated systems. These records will
allow the Commission to examine whether alternative trading
systems are complying with the requirements under Proposed
Rule 301(b)(6). Finally, an alternative trading system
subject to the fair access requirements discussed above is
required to keep a record of its access standards.[298]
Regulation ATS requires that these records be kept for
at least three years, the first two years in an easily
accessible place. Some records, such as partnership
articles and articles of incorporation, must be kept for the
life of the alternative trading system.[299] Alternative
trading systems are permitted to keep records in any form
broker-dealers are permitted to keep records under Rule 17a-
4(f) under the Exchange Act.[300]
The Commission recognizes that alternative trading
systems subject to Regulation ATS are subject to the
recordkeeping requirements for broker-dealers under Rules
17a-3 and 17a-4 of the Exchange Act,[301] which may require
that some of the same records be made and kept. Regulation
ATS does not require an alternative trading system to
duplicate trading records maintained in the course of its
normal recordkeeping operations, provided that the
alternative trading system can sort and retrieve system
records separately upon request. In addition, as broker-
dealers are currently permitted to do,[302] Regulation ATS
permits an alternative trading system to retain a service
bureau, depository, or other recordkeeping service to
maintain required records on behalf of the alternative
trading system as long as the designated party agrees to
make the records available to the Commission upon
request.[303]
The Commission solicited comment on these recordkeeping
requirements. In general, the comments received on this
provision were mixed. Two commenters supported requiring
alternative trading systems to keep the records necessary to
create a meaningful audit trail.[304] On the other hand,
one commenter expressed concern that the Commission’s
proposal would impose the same recordkeeping requirements on
both small and large alternative trading systems. Instead,
this commenter argued that smaller systems should be subject
to none or only minimal regulation generally, and that even
the recordkeeping requirements may serve as a significant
barrier to market entry and innovation.[305]
The Commission believes that, for the most part, the
records it is requiring alternative trading systems to make
and keep are records that alternative trading systems would
otherwise keep as part of their business, and that therefore
these requirements will not place undue burdens upon
alternative trading systems. In addition, the Commission
believes that the highly automated nature of alternative
trading systems will help facilitate the construction and
maintenance of an audit trail. The Commission also believes
that these recordkeeping requirements are necessary to
permit surveillance and examination to help assure fair and
orderly markets.
One commenter recommended that an alternative trading
system’s records and reports only be available to an
alternative trading system’s SRO on a confidential, need-to-
know basis.[306] Regulation ATS provides that alternative
trading systems are required to permit inspections and
examinations of their records by the Commission or the SRO
of which they are a member.[307] The Commission noted in
the Proposing Release that, while potential conflicts of
interest in overseeing alternative trading systems may
arise, the Commission believes these conflicts can be
managed using the Commission’s oversight authority. The
Commission also recognized that some market participants
might be concerned that SROs could abuse their regulatory
authority, but noted that the Commission has oversight
responsibility over SROs to prevent such activity. In this
regard, the Commission expects SROs to carefully assess, and
revise where necessary, their internal policies and
procedures for protecting the confidentiality of sensitive
information obtained in the course of fulfilling their SRO
regulatory responsibilities.[308]
Finally, one commenter asked that the Commission
consider the relationship of any new recordkeeping
requirements with applicable SRO recordkeeping rules, such
as the NASD’s recently-adopted OATS.[309] The Commission
notes that, while some of the information required by
Regulation ATS will also be required by SRO rules, such
rules do not have the same scope and are not designed to
meet the same goals. Moreover, SRO rules may not apply to
all alternative trading system activities. In addition, the
Commission is only requiring that records of certain
information be made and kept, but is not dictating in what
form those records are maintained. This means that
alternative trading systems have flexibility in how they
comply with SRO and Commission rules. Further, if
duplicative rules exist, the same alternative trading system
practices should serve to satisfy both sets of rules.
h. Reporting and Form ATS-R
The Commission proposed that alternative trading
systems be required to periodically report certain
information about their activities. The Commission is
adopting these requirements as proposed. Regulation ATS, as
adopted, requires alternative trading systems to file with
the Commission transaction reports within 30 calendar days
of the end of each calendar quarter on Form ATS-R.[310]
Specifically, Form ATS-R requires alternative trading
systems to report total volume in terms of number of units
traded and dollar value for the following categories of
securities: (1) listed equity securities, (2) Nasdaq NM
securities, (3) Nasdaq SmallCap securities, (4) equity
securities that are eligible for resale pursuant to Rule
144A under the Securities Act of 1933,[311] (5) penny
stocks, (6) equity securities not included in (1)-(5), (7)
rights and warrants, (8) listed options, and (9) unlisted
options. In addition, alternative trading systems are
required to report the total settlement value in U.S.
dollars for: (1) corporate debt securities (separately for
investment grade and non-investment grade), (2) government
securities, (3) municipal securities, (4) mortgage related
securities, and (5) debt securities not included in (1)-(4).
Alternative trading systems are required to file after-hours
trading information in listed equity, Nasdaq NM, and Nasdaq
Small Cap securities, as well as listed options. This
information will permit the Commission to monitor the
trading on alternative trading systems. In addition,
alternative trading systems subject to the fair access
requirements in Rule 301(b)(5), as discussed above,[312]
must report quarterly on Form ATS-R the persons to whom they
grant, deny or limit access to the alternative trading
systems, as well as the date of the action, the effective
date of the action, and the nature of the denials or
limitations of access.
Because Rule 17a-23[313] will be eliminated, data filed
by alternative trading systems on Form ATS-R will replace
the information currently filed on Form 17A-23 by broker-
dealers operating trading systems. Unlike Part II of Form
17A-23, Form ATS provides a template on which alternative
trading systems are required to file the requested
information with the Commission. This template should allow
alternative trading systems to file the required information
in a more uniform format that will be more useful to the
Commission. For example, the Commission anticipates using
this information to develop examination modules for the
inspection of alternative trading systems. The Commission
also expects to use the information to further understand
the effect of alternative trading systems on the securities
markets.
Another difference between Part II of Form 17A-23 and
Form ATS is that Form ATS requires alternative trading
systems to provide information about the volume of
particular types of securities that are not listed on an
exchange or traded on Nasdaq. These new reporting
requirements on Form ATS-R will improve the quality of the
data that the Commission has available to consider the
effectiveness of its regulatory program. Due to the highly
automated nature of alternative trading system operations
and the experiences with Rule 17a-23, the Commission does
not anticipate that gathering and submitting the data
required on Form ATS-R will be overly burdensome.
Alternative trading systems are also required to make
reports on Form ATS-R available to surveillance personnel of
any SRO of which they are a member.[314]
The Commission solicited comment on the transaction
reporting requirements and Form ATS-R. In particular, the
Commission solicited comment on the frequency and scope of
transaction reporting requirements proposed in Regulation
ATS. No commenters responded to the Commission’s request
for comments on the information requested on Form ATS-R.
The Commission received no comments opposing the
proposed reporting requirements. Several commenters
generally supported the Commission’s proposal to require
alternative trading systems to report their trading
volume.[315] One commenter, however, commented that the
Commission should require monthly reporting instead of the
proposed quarterly reporting requirement.[316] The
Commission believes that quarterly reporting under
Regulation ATS, as adopted, will provide sufficiently
frequent reporting to the Commission. In view of the
Commission’s desire to minimize respondent reporting
burdens, the Commission believes that more frequent
reporting would not provide materially improved investor
protections. Based on the Commission’s experience with
reporting requirements under Rule 17a-23, the Commission
believes that a quarterly filing requirement of Form ATS-R
is appropriate.
The Commission also requested comment on the
appropriateness of permitting Form ATS-R to be filed
electronically. Two commenters thought that if the
Commission were to accept filings electronically it would be
faster and less expensive.[317]
Finally, one commenter recommended that an alternative
trading system’s records and reports only be available to an
alternative trading system’s SRO on a confidential, need-to-
know basis.[318] As described above with respect to the
recordkeeping requirements,[319] the Commission believes
that the separation between the market and regulatory
functions of an SRO and the Commission’s oversight of SROs
are sufficient to maintain an appropriate level of
confidentiality of, and access to, alternative trading
system information. The Commission believes that SROs need
to have access to relevant information in order to carry out
their oversight responsibilities. The Commission expects
that SROs will maintain and enforce appropriate internal
policies and procedures to protect against misuse of such
information.
i. Procedures to Ensure Confidential
Treatment of Trading Information
The Commission requested comment on proposed Rule
301(b)(10) requiring alternative trading systems to have in
place safeguards and procedures to protect trading
information and to separate alternative trading system
functions from other broker-dealer functions, including
proprietary and customer trading. The Commission did not
propose specific procedures, but encouraged commenters to
express their views on the requirements, including how to
prevent the misuse by alternative trading systems of
confidential customer information. The Commission received
only three comment letters which directly addressed this
issue. All supported the Commission’s proposal, although
one also requested clarification on what the confidentiality
provisions covered.[320]
The rules the Commission is adopting today require
alternative trading systems to have in place safeguards and
procedures to protect trading information and to separate
alternative trading system functions from other broker-
dealer functions, including proprietary and customer
trading. The Commission believes that the sensitive nature
of the trading information subscribers send to alternative
trading systems requires such systems to take certain steps
to ensure the confidentiality of such information. For
example, unless subscribers consent, registered
representatives of alternative trading systems should not
disclose information regarding trading activities of such
subscribers to other subscribers that could not be
ascertained from viewing the alternative trading system’s
screens directly at the time the information is conveyed.
The Commission’s concern regarding confidentiality grew
out of its inspections of some ECNs, during which the
Commission staff found that some of the broker-dealers
operating ECNs used the same personnel to operate the ECN as
they did for more traditional broker-dealer activities, such
as handling customer orders that were received by telephone.
These types of situations create the potential for misuse of
the confidential trading information in the ECN, such as
customers’ orders receiving preferential treatment, or
customers receiving material confidential information about
orders in the ECN. The rules concerning confidentiality
that the Commission is adopting today are designed to
eliminate the potential for abuse of the confidential
trading information that subscribers send to alternative
trading systems. The Commission recognizes that some
alternative trading systems provide traditional brokerage
services as well as access to their alternative trading
systems. The proposed rules are not intended to preclude
these services; rather, they are designed to prevent the
misuse of private customer information in the system for the
benefit of other customers, the alternative trading system
operator, or its employees.
Therefore, the Commission is adopting rules which
require that: (1) information, such as the identity of
subscribers and their orders, be available only to those
employees of the alternative trading system who operate the
system or are responsible for its compliance with the
proposed rules; (2) the alternative trading system has in
place procedures to ensure that all its employees are unable
to use any confidential information for proprietary or
customer trading, unless the customer agrees; and (3)
procedures exist to ensure that employees of the alternative
trading system cannot use such information for trading in
their own accounts.[321]
The Commission intends the rules to prevent the
disclosure or the use of information about a customer’s
trading orders. Many of the alternative trading systems
operating today are anonymous; one of the reasons ECNs are
popular with investors is that they permit wide
dissemination of orders but provide anonymity. The broker-
dealers operating these systems, under the rules the
Commission is adopting today, cannot disclose any
confidential customer information (including the identity of
the subscriber entering an order) to other customers, or use
that information for proprietary or agency trades.
The Commission expects that existing alternative
trading systems will implement procedures such as these as
quickly as possible, if they do not already have them in
place. These procedures should be clear and unambiguous and
presented to all employees, regardless of whether they have
direct responsibility for the operation of the alternative
trading system. Presently, many broker-dealers employ
various means to ensure that sensitive information does not
flow from one division to another. These methods include
physical separation, written procedures, separate personnel,
and restricted access. The Commission believes that
firewalls such as these could be used by broker-dealers that
operate alternative trading systems to ensure that sensitive
information regarding the alternative trading system is
contained in the proper unit of the broker-dealer.
The Commission is not adopting specific procedures
because it believes that the broker-dealers who operate the
alternative trading systems are in the best position to know
what procedures would best prevent abuses. Experience has
demonstrated, however, potential for abuse and the
Commission regards these procedures as important.
B. Registration as a National Securities Exchange
Trading systems that fall within Rule 3b-16 are only
required to comply with Regulation ATS if they wish to be
exempt from the definition of "exchange." Such systems may
choose instead to register as national securities exchanges.
The Commission expects that some trading systems will find
that registration as a national securities exchange provides
attractive benefits that make this option more suitable to
their business objectives. In particular, registered
exchanges enjoy more autonomy in their daily operations than
do broker-dealers that are members of SROs. Because any
trading system that registers as an exchange would be an
SRO, it would not be subject to oversight by a competing
national securities exchange or national securities
association.[322] Similarly, as a national securities
exchange, a trading system would be able to establish its
own rules of conduct, trading rules, and fee structures for
access. An alternative trading system registered as a
broker-dealer, on the other hand, would have to comply with
the rules of the SRO to which it belongs, including any
rules regarding fees or the automatic execution of orders.
In addition, systems that elect to register as
exchanges may benefit from the added prestige and investor
confidence associated with status as a registered exchange.
Registered exchanges are also able to establish listing
standards, which may promote investor confidence in the
quality of the securities traded on the exchange.
Registered exchanges may also become direct participants in
the national market system mechanisms, such as the ITS,
Consolidated Tape Association ("CTA"), and the Consolidated
Quotation System ("CQS"). Direct participation in these
systems may provide a higher degree of transparency and
execution opportunities for subscribers to a trading system.
As direct participants in the national market system
mechanisms, registered exchanges are also entitled to share
in the revenues generated by the national market system
systems, such as revenue from CTA fees. Moreover, as the
Commission noted in the Proposing Release, only registered
exchanges are eligible to be participants of the Options
Clearing Corporation ("OCC").[323] Consequently, any
trading system that wants to trade standardized options
issued by the OCC would have to register as an exchange and
become a member of the OCC.
Finally, if a trading system chooses to register as an
exchange, it could allow broker-dealers that are members of
exchanges with off-board trading restrictions to trade
certain securities on the trading system pursuant to
unlisted trading privileges. The Commission believes that
if a trading system is registered and regulated as an
exchange, it should be considered to be an exchange, rather
than an over-the-counter market, for purposes of exchange
off-board trading.[324]
As discussed in the Proposing Release, the Commission
views certain obligations of exchanges as fundamental to
fair and efficient operation in the marketplace and critical
for the protection of investors. The Commission did not
propose any relief from the current obligations of
registered exchanges under the Exchange Act. Nevertheless,
the Commission requested comment on whether any exemptions
from exchange regulatory provisions would be necessary or
appropriate to enable alternative trading systems to
register as exchanges. Commenters, however, generally
thought that any trading system that chooses to register as
an exchange should be subject to the same requirements as
currently registered exchanges and cautioned the Commission
against relieving registered exchanges from any requirements
because of their for-profit structure. Consequently, at
this time the Commission has determined that those trading
systems choosing to register as exchanges should satisfy all
requirements that apply to national securities exchanges
under the Exchange Act.[325]
Many, if not all, alternative trading systems currently
operating are proprietary, rather than not-for-profit
entities. The Commission does not believe that there is any
overriding regulatory reason to require exchanges to be not-
for-profit membership organizations, and believes that
alternative trading systems may retain their proprietary
structure even if they choose to register as exchanges. The
Exchange Act does not require national securities exchanges
to be not-for-profit organizations. As the Commission
stated in the Proposing Release, it believes that Congress
clearly intended the 1975 Amendments to encourage innovation
by exchanges and recognized that future exchanges may adopt
diverse structures.[326] The Commission believes that it is
possible for a for-profit exchange to meet the standards set
forth in Section 6(b) of the Exchange Act.
Any system meeting the definition set forth in Rule 3b-
16 may apply for registration as a national securities
exchange by filing an application with the Commission on
Form 1.[327] The Commission, in Rule 6a-1, set forth the
procedure for filing such an application.[328] All Exhibits
must accompany Form 1, including audited financial
statements prepared in accordance with United States
Generally Accepted Accounting Principles.
The Commission has adopted an amendment to its Rules of
Practice regarding the processing of filings. Applications
for registration as a national securities exchange, as well
as applications for exemption from registration due to the
limited volume of transactions, will not be considered filed
until all necessary information, including financial
statements and other required documents, have been furnished
in the proper form.[329] Further, under Section 6(b) of the
Exchange Act, the Commission must make certain
determinations before registering an exchange.[330] In
reviewing applications for registration as a national
securities exchange, the Commission will not register an
exchange unless it is satisfied that the exchange meets the
requirements discussed below.
1. Self-Regulatory Responsibilities
As a prerequisite for the Commission’s approval of an
exchange’s application for registration, the exchange must
be organized and have the capacity to carry out the purposes
of the Exchange Act. Specifically, an exchange must be able
to enforce compliance by its members, and persons associated
with its members, with the federal securities laws and the
rules of the exchange.[331] The Commission believes that
the self-regulatory role of registered exchanges is
fundamental to the enforcement of the federal securities
laws. Congress has delegated to the SROs certain quasi-
governmental functions and responsibilities, and has charged
the Commission with overseeing the SROs to make sure they
have the ability and resources to comply with those
obligations. In this regard, the Commission believes that
persons responsible for operating an SRO should not have a
disciplinary history, and will seriously question the
ability of an exchange to carry out its SRO functions if the
founders or prospective managers of an applicant for
registration as a national securities exchange are subject
to a statutory disqualification, as that term is defined in
Section 3(a)(39) of the Exchange Act.[332] The Commission
believes that persons who, for example, have willfully
violated the federal securities laws or have been convicted
within the past ten years of a felony or misdemeanor
involving misappropriation of funds, or securities fraud,
larceny, theft, robbery, extortion, or other related crimes
would be inappropriate selections to fill the role of
director, officer, or manager of an exchange.
An alternative trading system wishing to register as a
national securities exchange may choose to set listing
standards for its system. If an applicant chooses to set
listing standards, it must have written listing and
maintenance standards, as well as an adequate regulatory
staff to apply those standards.[333] The applicant must
also have rules restricting the listing of securities issued
in a limited partnership rollup transaction.[334] The
ability to carry out these functions must be adequately
represented on an exchange’s application for registration
before the Commission will register the exchange.
An applicant for registration as an exchange must also
have rules designed to prevent fraudulent and manipulative
acts and practices, to promote just and equitable principles
of trade, and to refrain from imposing any unnecessary or
inappropriate burdens on competition, among other
things.[335] For example, an exchange must maintain
procedures to surveil for securities law violations, such as
insider trading and manipulation on the exchange. The
Commission understands that surveillance procedures can vary
and will depend on the nature of, and types of securities
traded, on a particular exchange. Thus, while the
Commission will require all applicants for registration as
an exchange to have adequate measures in place, they will
not have to use the same procedures. The Commission will
also require an applicant for registration as a national
securities exchange to show that it has sufficient
resources, including both staff expertise and capital, to
support its surveillance function.[336] Consistent with
these requirements, an applicant should, at a minimum,
demonstrate that the officers charged with day-to-day
management of the exchange are familiar with the federal
securities laws and the role of a registered exchange as an
SRO. In addition, an applicant for registration as a
national securities exchange must demonstrate that it has
the capability to maintain an audit trail of the
transactions on its system. Furthermore, an applicant must
establish rules providing for the allocation of fees for the
use of its system.[337]
An exchange must also have general conflict of interest
rules regarding, for example, trading on the exchange by its
employees, owners, or exchange officials. Moreover, an
exchange must have rules that ensure that no member’s order
is unfairly disadvantaged. For example, if an exchange has
priority rules, those rules need to treat all exchange
members fairly. Finally, an exchange must have rules
establishing procedures for the clearance and settlement of
trades effected on the exchange. Alternatively, an exchange
must have rules requiring members to make their own
arrangements for clearance and settlement of trades.
While exchanges are required to enforce compliance by
their members, and persons associated with their members,
with applicable laws and rules, the Commission has used its
authority under Sections 17 and 19 of the Exchange Act to
allocate to particular SROs oversight of broker-dealers that
are members of more than one SRO ("common members").[338]
For example, in order to avoid unnecessary regulatory
duplication, the Commission appoints a single SRO as the
designated examining authority ("DEA") to examine common
members for compliance with the financial responsibility
requirements.[339] When an SRO has been named as a common
member’s DEA, all other SROs to which the common member
belongs are relieved of the responsibility to examine the
firm for compliance with applicable financial responsibility
rules.[340] Consistent with past Commission action, the
Commission may continue to designate one SRO, such as the
NASD or the NYSE, as the primary DEA for common members of
exchanges.
In addition, the Commission has previously permitted
existing SROs to contract with each other to allocate non-
financial regulatory responsibilities. [341] Rule 17d-2
under the Exchange Act permits SROs to establish joint plans
for allocating the regulatory responsibilities imposed by
the Exchange Act with respect to common members.[342] An
SRO participating in a regulatory plan is relieved of
regulatory responsibilities with respect to a broker-dealer
member of such SRO, if those regulatory responsibilities
have been designated to another SRO under the regulatory
plan. Alternative trading systems registered as exchanges
would also be able to establish joint plans with respect to
common members.
A registered exchange would also be expected to
maintain an audit trail of trading. A fully automated
exchange, however, can produce comprehensive, instantaneous
automated records that can be monitored remotely.
Therefore, fully automated exchanges might be able to
contract with other SROs to perform certain oversight
activities, while retaining ultimate responsibility for
ensuring that these activities are performed.
Further, the Commission also believes that the ultimate
responsibility for enforcement and disciplinary actions for
violations relating to transactions executed in an SRO’s
market or rules unique to that SRO should continue to be
retained by that SRO. In addition, these exchanges must
establish a disciplinary process including appropriate
sanctions for violations of the rules and a fair procedure
for administering the disciplinary process.[343] Existing
exchanges generally employ personnel and establish extensive
programs to fulfill this responsibility. However, it may
be possible for an exchange to contract with another SRO to
perform its day-to-day enforcement and disciplinary
activities. Nevertheless, a registered exchange would
retain ultimate responsibility for this function.[344] In
considering an exchange’s application for registration the
Commission will consider whether allowing the exchange to
contract with another SRO to perform its day-to-day
enforcement and disciplinary activities would be consistent
with the public interest.
2. Fair Representation
Section 6(b)(3) of the Exchange Act requires that
registered exchanges have rules that: (1) provide that one
or more directors is representative of issuers and
investors, and not associated with a member of the exchange,
or with any broker-dealer; and (2) "assure a fair
representation of its members in the selection of its
directors and administration of its affairs."[345]
(i) Public Directors
Congress adopted the requirement that at least one
director be representative of issuers and investors because
of the public’s interest in ensuring the fairness and
stability of significant markets.[346] Public
representation on an exchange’s board of directors helps to
achieve this goal. The Commission believes that, under this
structure, representation of the public on an oversight body
that has substantive authority and decision making ability
is critical to ensure that an exchange actively works to
protect the public interest and that no single group of
investors has the ability to systematically disadvantage
other market participants through use of the exchange
governance process.[347] Therefore, the Commission would
expect alternative trading systems that apply for
registration as exchanges to have public representation on
their boards of directors.
(ii) Fair Representation of Exchange Members
The second requirement, that of fair representation of
an exchange’s members, also serves to ensure that an
exchange is administered in a way that is equitable to all
market members and participants. Because a registered
exchange is not solely a commercial enterprise, but also has
significant regulatory powers with respect to its members,
competition between exchanges may not be sufficient to
ensure that an exchange carries out its regulatory
responsibilities in an equitable manner. The fair
application of an exchange’s authority to bring and
adjudicate disciplinary procedures may be particularly
important, because these actions can have significant and
far-reaching ramifications for broker-dealers.
Historically, the fair representation requirement was
one of the major obstacles to the regulation of alternative
trading systems as exchanges because of the concern that it
would be incompatible with their proprietary
structures.[348] In the Proposing Release, however, the
Commission proposed to allow non-membership, for-profit
alternative trading systems that choose to register as
exchanges some flexibility in satisfying this "fair
representation" requirement.
The Commission notes that it has not, in the past,
interpreted an exchange’s obligation to provide fair
representation of its members to mean that all members must
have equal rights. Instead, the Commission has allowed
registered SROs a degree of flexibility in complying with
this requirement. For example, PCX "electronic access
members" ("ASAP Members") do not have voting rights, and
therefore are not represented on the board of that
exchange.[349]
More recently, the Commission approved the merger
between the Amex and the NASD. As a result of the merger,
Amex, reorganized as New Amex LLC ("New Amex"), is now a
subsidiary of the NASD. In reviewing the merger, the
Commission considered several fair representation issues.
Specifically, the Commission considered, among other things,
Amex member representation on the Board of Governors of New
Amex, Amex member representation on the Board of the NASD,
the voting rights of the Amex membership, and representation
of the Amex membership in the disciplinary process.
The Commission found that the composition of the New
Amex Board satisfied the fair representation requirement by
providing the Amex membership with the opportunity to
nominate four Amex floor governors to the New Amex
Board.[350] Further, the Commission found that the
inclusion of one New Amex floor governor on the NASD
Board[351] helped to fulfill the fair representation
requirement by providing for New Amex input on the parent
Board.[352] In addition, the Commission believes that the
fair representation requirement was furthered by the
corporate governance provisions of New Amex’s constitution
that require the consent of either Amex (through a
Membership vote), the Amex Committee (a committee designed
specifically to represent the interests of the Amex
membership), or both, in situations impacting certain
membership interests or material market changes to New Amex.
Lastly, the Commission found that the disciplinary
procedures of New Amex met the fair representation
requirement by providing for review of all disciplinary
matters by a committee composed of both Amex members and
public representatives. Specifically, the Amex Adjudicatory
Council, which is empowered to act for the full New Amex
Board in reviewing appeals from disciplinary proceedings, is
composed of three Public Members and three Floor Governors,
all of whom are nominated by the Amex Nominating Committee
(or by petition signed by twenty-five Members) and elected
by a full Amex Membership vote.[353]
In addition, with respect to clearing agencies, the
Commission has stated that registered clearing agencies may
employ several methods to comply with the fair
representation standard.[354] The Commission believes that
other structures may also provide independent, fair
representation for an exchange’s constituencies in its
material decision making processes if the exchange is not
owned by its participants. For example, a proprietary
alternative trading system that registers as an exchange
might be able to fulfill this requirement by establishing an
independent subsidiary that has final, binding
responsibility for bringing and adjudicating disciplinary
proceedings and making rules for the exchange, and ensuring
that the governance of such subsidiary equitably represents
the exchange’s participants.[355] As another possibility,
certain directors appointed to the board to represent the
interests of trading members or participants could be
limited to considering certain topics relating to system use
and rules, while consideration of ownership issues could be
restricted to board members representing the interests of
the owners or stockholders.[356]
Some commenters expressed concern that the flexibility
afforded alternative trading systems in complying with their
"fair representation" requirement not extend so far as to
result in unequal regulation of alternative trading systems
registered as exchanges and traditional exchanges. In
addition, these commenters expressed concern that the
efficiency of the markets not be compromised.[357] American
Century also expressed its support for structures in which
an alternative trading system’s board included both owners
and participants.[358] On the other hand, several
commenters stated that members (or participants) of a
proprietary exchange should not have any right to
participate in the governance of the exchange and that
imposing constraints on the manner in which alternative
trading systems are governed may undermine the factors that
lead to their efficiency and innovativeness.[359]
The Commission believes alternative trading systems
should be required to assure fair representation of their
members if they choose to register as exchanges. As
discussed above, registered exchanges have special
responsibilities under the Exchange Act, regardless of
whether they are not-for-profit or for-profit. Accordingly,
the Commission continues to believe that exchange
participants -- including participants in a for-profit
exchange -- need to have substantive input into disciplinary
and other key processes to prevent these processes from
being conducted in an inequitable, discriminatory, or
otherwise inappropriate fashion.
The NASD asked the Commission to provide more specific
guidance on the details of the flexibility the Commission
proposes to allow alternative trading systems applying for
registration as exchanges.[360] The Commission has provided
several examples of ways in which fair representation
requirements can be met in non-traditional ways and believes
that there may be other acceptable ways. The Commission,
however, does not believe it is necessary to specify in
greater detail what types of structures would be acceptable
to it. What constitutes fair representation for a
particular exchange will be determined in the context of
that system’s application for registration under Sections
6(a) and 19(a) of the Exchange Act. Under Section 19(a) of
the Exchange Act, notice of an application for registration
as an exchange is published for comment before
approval.[361] This will provide interested persons with
notice of, and an opportunity to comment on, the manner in
which a particular exchange proposes to meet its fair
representation obligations.[362]
3. Membership on a National Securities Exchange
An applicant for registration as a national securities
exchange must have rules to admit members and persons
associated with those members.[363] Section 6(c)(1) of the
Exchange Act[364] prohibits exchanges from granting new
membership to any person not registered as a broker-dealer,
or associated with a broker-dealer. In the Concept
Release, the Commission solicited commenters’ views on
whether to allow institutional membership on national
securities exchanges. Because most commenters were opposed
to institutional membership on exchanges, the Commission did
not propose to exempt registered exchanges from the
limitations in Section 6(c)(1). Nevertheless, in the
Proposing Release, the Commission asked for comment on
whether institutions should be permitted to be members of
national securities exchanges.
Most commenters expressing a view on institutional
membership on registered exchanges agreed that such
exchanges should be prohibited from having non-broker-dealer
members.[365] One commenter, however, believed that direct
institutional access to exchanges is a choice that would
benefit market participants by providing lower execution
costs for the shareholders of institutional funds. Although
this commenter noted the Commission’s concerns about the
regulatory burden an institution might face if it chose to
be a direct member of an exchange, it thought that
membership should be a choice available to those
institutions that feel they have the economies of scale to
warrant direct access or believe that anonymity is worth the
regulatory cost of membership.[366]
As discussed in the Proposing Release, the Commission
believes that, in order to ensure the central goals of
exchange regulation, direct institutional members or
participants in exchanges would have to be subject to the
majority of rules and regulations to which broker-dealers
are currently subject.[367] Moreover, because institutions
that were granted exchange membership or direct access to
exchanges would likely need to become members in one or more
of the national clearance and settlement corporations in
order to clear and settle their trades, these institutions
would need to demonstrate and maintain financial
creditworthiness. Insufficient net capital and incomplete
books and records could compromise financial soundness,
audit trails, and other general risk management objectives
that are critical to sound markets and clearance and
settlement systems. Consequently, the Commission would need
to require non-broker-dealer institutions to comply with
financial responsibility obligations, including the
requirements to maintain certain minimum levels of net
capital and appropriate books and records.[368] Without
such requirements, institutional membership on an exchange
may also conflict with an exchange’s obligation to have
rules that foster the efficient clearance and settlement of
securities transactions.
The Commission believes that non-broker-dealer
institutions essentially would be required to comply with
the same requirements imposed on registered broker-dealers
and, therefore, undermine most benefits an institution
receives by virtue of not registering as a broker-
dealer.[369] Thus, the Commission does not believe that
allowing institutional membership on exchanges would be any
less costly to an institution than establishing a broker-
dealer affiliate, which can become a member in a registered
exchange. At the same time, it would impose ad-hoc
regulatory burdens on the Commission and the exchanges as
they tried to impose critical rules and regulations on
institutions. Further, the Commission does not believe that
it is currently practical or serves the best interests of
investors or the markets generally to allow non-broker-
dealers to be members of national securities exchanges,
because of the potential lack of regulatory oversight the
Commission would have over these entities. Therefore, just
as currently registered exchanges are required to limit
membership to broker-dealers, alternative trading systems
that choose to register as exchanges would be prohibited
from extending membership to non-broker-dealers.
Accordingly, the Commission believes that exchange
membership should continue to be limited to registered
broker-dealers and persons associated with registered
broker-dealers in accordance with Section 6(c)(1) of the
Exchange Act.[370] Institutions, however, would be able to
access alternative trading systems registered as exchanges
through a registered broker-dealer member of such a trading
system, including an affiliate of the institution.
Institutions currently have efficient access to the NYSE
through SuperDOT terminals given to them by NYSE
members,[371] and the OptiMark System [372] will enable
institutions to directly enter orders in the OptiMark System
through use of an exchange member give-up. Access of this
nature should not impose significant costs or burdens on
institutions or on broker-dealers providing the access. The
Commission believes if institutions continue to have
indirect access to exchanges, their needs can be met without
compromising important regulatory objectives.
Finally, while the NASD agreed with the Commission’s
views that institutions should not be "members" of
registered exchanges, it asked the Commission to provide
guidance on whether a registered exchange may set up a
broker-dealer subsidiary to provide sponsored access to
retail and institutional customers. Further, the NASD asked
whether the registered exchange could be the SRO for its
broker-dealer subsidiary. The NASD believes that there is
an inherent conflict of interest in such an arrangement and
that the Commission should explain its views and provide
SROs with guidance on the responsibilities for oversight of
the broker-dealer in such circumstances.[373]
In this regard, a registered exchange is not explicitly
prohibited from establishing a broker-dealer subsidiary
through which it can provide sponsored access to its non-
broker-dealer customers. Nonetheless, the Commission
recognizes concerns about the potential conflict of interest
if a registered exchange were the SRO for its subsidiary,
and believes that it may be difficult for an exchange to
fulfill its obligations under Sections 6(b)(6), 6(b)(7), and
19(g) with respect to such a subsidiary.[374]
4. Fair Access
Sections 6(b)(2)[375] and 6(c)[376] of the Exchange Act
prohibit registered exchanges from denying access to, or
discriminating against, members. The obligation to ensure
fair access for members does not, however, restrict the
authority of a national securities exchange to maintain
reasonable standards for access.[377] The securities
industry and the general public need access to exchanges to
ensure the best execution of orders. Exchanges are venues
for trading that should be open to all qualified persons.
The Commission stated in the Proposing Release that
alternative trading systems that register as exchanges would
be required to comply with Section 6(b)(2) and Section 6(c)
of the Exchange Act. IBEX was the only commenter to express
a view on this requirement and its comment was
favorable.[378] Thus, the Commission would require any
alternative trading system registered as an exchange to
ensure the fair access of registered broker-dealers.
In a similar vein, exchanges are prohibited from
adopting any anti-competitive rules.[379] To further
emphasize the goal of vigorous competition, Congress
requires the Commission to consider the competitive effects
of exchange rules,[380] as well as the Commission’s own
rules.[381] The fair access and fair competition
requirements in the Exchange Act are intended to ensure that
national securities exchanges treat investors and their
participants fairly, consistent with the expectations of the
investing public. For example, as discussed above, an
exchange’s rules, including its rules of priority, must
treat all members fairly. Accordingly, before granting an
application for registration as an exchange, the Commission
would review the exchange’s rules for compliance with these
requirements.
5. Compliance with ARP Guidelines
All national securities exchanges are expected to
maintain sufficient systems capacity to handle foreseeable
trading volume. Applicants for registration as a national
securities exchange must have adequate computer system
capacity, integrity and security to support the operation of
an exchange. The Commission believes that adequate capacity
is vital to the efficient operation of exchanges,
particularly during periods of high volume or volatility,
such as have been experienced in the past year. To this
end, all exchanges and the NASD currently participate in the
Commission’s automation review program ("ARP").[382] Given
the highly automated nature of most alternative trading
systems, the Commission stated in the Proposing Release that
it would expect any exchange applying for registration as a
national securities exchange to comply with the policies and
procedures outlined by the Commission in its policy
statements concerning the automation review program,
including cooperation with any reviews conducted by the
Commission. In this regard, the Commission would consider
the resources and ability of an applicant for registration
as an exchange to meet the standards set forth in the
automation review program. In particular, the Commission
would consider whether the applicant had sufficient capital
to maintain its automated systems, and staff with technical
expertise.
The Commission received one comment letter addressing
this issue. The PCX commented that registered exchanges
should only have to comply with the ARP guidelines if they
reach the threshold level that triggers these requirements
for alternative trading systems registered as broker-
dealers. The PCX noted that, although many exchanges do not
account for twenty percent, or even ten percent, of the
trading in ITS eligible equity securities, all exchanges are
required to comply with the ARP guidelines. The PCX
commented that these regulatory requirements impose
substantial costs on exchanges and that there is no basis
for imposing these types of requirements on exchanges when
such requirements are not imposed on alternative trading
systems registered as broker-dealers that have substantially
greater trading volume.[383]
The Commission notes that today it is adopting a
requirement that alternative trading systems with twenty
percent or more of the volume in any equity security, or
certain categories of debt, comply with certain systems
capacity, integrity, and security requirements. While some
registered exchanges may have less than twenty percent of
the volume in similar securities, the Commission
nevertheless believes that these exchanges’ direct
participation in the national market system necessitates
participation in the automation review program. Moreover,
while there are costs associated with capacity planning and
testing, contingency planning, stress testing, and
independent reviews, as well as ensuring that automated
systems have sufficient capacity, these are costs that all
highly automated business must bear and not merely
regulatory costs.[384] The Commission’s ARP guidelines are
intended only to ensure that short-term cost cutting by
registered exchanges does not jeopardize the operation of
the securities markets.
6. Registration of Securities
Under the Exchange Act, securities traded on a national
securities exchange must be registered with the Commission
and approved for listing on the exchange.[385] In addition,
national securities exchanges are permitted to trade
securities listed on other exchanges and Nasdaq pursuant to
unlisted trading privileges ("UTP").[386] These
requirements ensure that investors have adequate information
and that all relevant trading activity in a security is
reported to, and surveilled by, the exchange on which it is
listed. The Commission discussed in the Proposing Release
that an alternative trading system choosing to register as
an exchange would be subject to these requirements and would
be required to have rules for trading the class or type of
securities it seeks to trade pursuant to UTP.[387]
Moreover, to trade Nasdaq NM securities, such a system would
have to become a signatory to an existing plan governing
such trading.[388]
With regard to these securities registration
requirements, OptiMark commented that they would preclude,
as a practical matter, those alternative trading systems
that trade privately placed securities or unregistered
foreign securities from choosing to register as exchanges.
In addition, the various conditions and limited scope of the
Nasdaq/National Market System/Unlisted Trading Privileges
("OTC-UTP") plan[389] would impair the ability of
alternative trading systems that offer competing facilities
for securities listed on existing exchanges to register as
exchanges. For example, UTP may be extended for Nasdaq NM
securities, but this does not include Nasdaq SmallCap
securities or other over-the-counter securities. Moreover,
formally amending the OTC-UTP plan to admit any new member
and to allocate expenses and revenues among competing market
centers is a time-consuming process.
Consequently, OptiMark recommended that the Commission
exercise its exemptive authority to reduce the differences
in regulatory treatment between alternative trading systems
registered as exchanges and those registered as broker-
dealers. In particular, OptiMark suggested that, regardless
of whether they are registered exchanges or broker-dealers,
alternative trading systems that limit their screen
availability to certain qualified persons be permitted to
trade unregistered securities, including private placements
and foreign securities. Similarly, OptiMark believed that
alternative trading systems that seek to compete for order
flow with existing exchanges should be able to do so in all
securities listed on those exchanges, regardless of the
alternative trading system’s registration status.[390]
The issue of trading unregistered securities, and in
particular unregistered foreign securities, on exchanges
raises many difficult issues. Registration of securities
provides public information for investors that is prepared
in accordance with U.S. accounting and auditing standards.
This assures that the issuer’s disclosures are consistently
presented and can be easily compared to the information
provided by other issuers. For this reason, the Exchange
Act requires securities to be registered if they trade on
national securities exchanges.
The Commission has maintained the current structure in
the final rules: continuing to require registered exchanges
to trade only registered securities, but not extending this
requirement to alternative trading systems not registered as
exchanges. The Commission is continuing to review on a
broader basis the issuing and trading of unregistered
foreign securities in the U.S. and, as part of that review,
will specifically consider whether unregistered foreign
securities should continue to be freely traded on
alternative trading systems that are not registered as
exchanges.
7. National Market System Participation
As discussed in the Proposing Release, any alternative
trading system that elects to register as a national
securities exchange would also be expected to become a
participant in the market-wide transaction and quotation
reporting plans currently operated by registered exchanges
and the NASD. These plans -- the CQS,[391] the CTA,[392]
the ITS,[393] the Options Price Reporting Authority
("OPRA"),[394] and OTC-UTP[395] -- link trading, quotation,
and reporting for all registered exchanges and the NASD and
are responsible for the transparent, efficient, and fair
operation of the securities markets. These plans form the
backbone of the national market system and participation in
these plans by all registered exchanges is vital to the
success of the national market system.
Participation in effective quote and transaction
reporting plans and procedures would, therefore, be
mandatory for any newly registered exchange, as it is now
for currently registered exchanges.[396] The CTA and the
CQS, which make quote and transaction information in
exchange-listed securities available to the public,[397]
both have provisions governing the entry of participants to
the plans,[398] and allow any national securities exchange
or registered national securities association to become a
participant.[399] New participants are required to pay
certain entry fees to the existing participants.[400]
Participants in these plans share in the income and expenses
associated with the plans’ operations.[401] Because
national securities exchanges are required to participate in
an effective quote and transaction reporting plan, the
Commission expects the participants of existing plans to
include them in the plans under reasonable conditions
adapted to the situations of the new exchanges.
In addition to requiring participation by newly
registered exchanges in quote and transaction reporting
plans, the Commission would expect newly registered
exchanges to participate in ITS,[402] or an equivalent
system if one were developed. ITS provides trading links
between market centers and enables a broker or dealer who
participates in one market to execute orders, as principal
or agent, in an ITS security at another market center,
through the system.[403] The ITS plan requires that the
members of participant markets avoid initiating a purchase
or sale at a worse price than that available on another ITS
participant market ("trade-throughs").[404] Participation
in ITS would give users of these new exchanges access to
other ITS participant markets. Moreover, participation in
ITS would require new exchanges to adopt rules to comply
with other applicable ITS plan provisions and policies on
matters such as, for example, trade-throughs, locked
markets,[405] and block trades.[406] As with the quote and
transaction reporting plans, alternative trading systems
that register as exchanges would have to be integrated into
ITS, or another system that links markets for trading
purposes would have to be created to accomplish full
integration of the newly registered exchanges into the
national market system.
The Commission solicited comment on what issues were
raised by the possible integration of new exchanges into
ITS. One commenter strongly believed that the current
voting structure of ITS establishes barriers to entry, which
leads to barriers to innovation. This commenter was
concerned that the network supporting ITS may not be strong
enough to handle sharply higher volumes of securities
transactions and that, in an environment with multiple
exchanges, the failure of these linkages would impede market
participants’ quest for best prices.[407] Another
commenter, similarly, expressed concern that the means of
access to, and participation in, the national market system
plans more generally was not clearly defined and, therefore,
provided the current participants in these plans an
opportunity to delay and to set unreasonable terms and
conditions for entry of new participants.[408] The
Commission realizes that integrating new exchanges into the
national market system plans may require amendments to these
plans and notes that national market system plans may be
amended either by vote of the participants, or by Commission
action.[409]
The Commission also requested comment on whether any
changes were necessary to incorporate alternative trading
systems registered as exchanges into the national market
system plans. In this regard, the Chicago Board Options
Exchange ("CBOE") and the NYSE stated that they did not
believe that there would need to be significant changes to
these plans, and that any changes that would be necessary to
accommodate alternative trading systems registered as
exchanges into ITS would be relatively easy to resolve.[410]
The CBOE, however, did state that alternative trading
systems registered as exchanges should be subject to the
same requirements regarding access to the national market
system plans as are applicable to traditional exchanges,
including payment of participation entry fees.[411]
The NASD suggested that, before the Commission approves
an alternative trading system’s application for registration
as an exchange, the Commission address more completely the
manner in which such an alternative trading system
registered as an exchange may participate in national market
system plans. The NASD noted three areas in which the
Proposing Release was silent. First, the Commission did not
address what mechanism would be used for access among any
new exchange and other exchanges or markets. For example,
in the context of Nasdaq securities, the NASD thought it was
unclear whether the existing approach to linkage and
execution should continue to occur through Nasdaq’s
SelectNet system or its successor, or whether there should
be a new ITS-like entity formed with a completely new
approach to access. The NASD expressed a preference for
using the current approach to linkages. Second, the NASD
noted that the Commission did not address whether
alternative trading systems registered as exchanges could
continue to charge an access fee, and believed strongly that
such alternative trading systems should not be allowed to
charge for another market accessing displayed interest.
Third, the Commission did not address the intermarket
linkage issues raised by access to traditional exchanges by
non-broker-dealers that have indirect access to alternative
trading systems registered as exchanges.[412]
OptiMark asked the Commission to consider the effect of
an alternative trading system’s ability to charge an
execution fee on its choice to register as an exchange or as
a broker-dealer. OptiMark noted that the Proposing Release
only contemplated that alternative trading systems operating
as broker-dealers would be able to charge a fee to non-
subscribers; alternative trading systems registered as
exchanges and participating in ITS would not.[413]
Susquehanna Investment Group ("Susquehanna") expressed
concern about potentially integrating many alternative
trading systems registered as exchanges into the national
market system mechanisms. Susquehanna commented that
integrating new exchanges’ quotations into the national
market system should be done only with careful consideration
for the preservation of the ITS trade-through rule.[414]
Instinet also stated that in order for an alternative
trading system to make a determination about the feasibility
of registering as an exchange, the Commission needs to
address those unresolved issues relating to ITS, including
the rules governing time/price priority within a multiple
exchange structure. In addition, Instinet stated that
inter-exchange rules need to be set forth for both the
listed and over-the-counter securities markets.[415]
The Commission agrees that access to national market
system systems is of key importance. It currently has
outstanding proposals for incorporation of one linkage into
ITS of an alternative trading system -- OptiMark -- and a
traditional exchange -- PCX -- and has sought comment on
organizational and other changes to ITS to make it more
responsive to changing conditions.[416] The precise
arrangements for inclusion of new exchanges into these plans
depends on the structure of these exchanges, and will be
addressed when an applicant seeks registration as an
exchange.
8. Uniform Trading Standards
In addition to participation in national market system
mechanisms, an alternative trading system that registers as
an exchange would be required to comply with any Commission-
instituted trading halt relating to securities traded on or
through its facilities.[417] Newly registered exchanges
would be required in some instances to adopt trading halt
rules to comply with certain Commission rules.[418] A newly
registered exchange would also have the authority and be
expected to impose trading halts for individual securities,
for classes of securities, and for its system as a whole
under the appropriate circumstances.[419] The Commission
does not believe that this requirement would present any
undue burden for alternative trading systems that elect to
register as national securities exchanges because most
alternative trading systems are already subject to the
imposition of trading halts as members of the NASD.
In addition, to promote the orderly operation of the
securities markets in accordance with Section 6 of the
Exchange Act,[420] the Commission would expect all newly
registered national securities exchanges to implement
circuit breaker rules to temporarily halt trading during
periods of extraordinary market volatility or unusual market
declines. The Commission believes that for circuit breakers
to be effective, all markets must impose corresponding
circuit breakers.[421]
9. Proposed Rule Changes
Under Section 19(b)(1) of the Exchange Act, SROs are
required to file all proposed rule changes with the
Commission.[422] Thus, once registered as an exchange, an
alternative trading system would have to submit copies of
any proposed rule changes to the Commission for approval.
C. Application for Registration as an Exchange
The Commission proposed to revise Rules 6a-1, 6a-2 and
6a-3 under the Exchange Act[423] to clarify the requirements
for registration as an exchange and to accommodate the
registration as exchanges of automated and proprietary
trading systems. Additionally, the Commission proposed to
revise Form 1, the application used by exchanges to register
or to apply for an exemption based on limited volume, and to
repeal Form 1-A. After considering the comments, the
Commission is adopting the amendments to Rule 6a-1, Rule 6a-
2, Rule 6a-3 and Form 1 as proposed.
1. Revisions to and Repeal of Form 1-A
The Commission is adopting the revisions to Form 1 and
repealing Form 1-A as proposed. Form 1 is revised by
reorganizing and redesignating the Statements and the
exhibits. Because the Commission expects most future
applicants for registration as an exchange to be fully or
partially automated, the Commission revised some of the
information requested in Form 1 to be more applicable to
automated exchanges. Specifically, the Commission is adding
two new exhibits requiring an applicant for registration as
an exchange to describe the way any of its electronic
trading systems operate, and the criteria used by the
exchange in admitting members.[424] In addition, the
Commission is adding a new exhibit to Form 1 to reflect the
possibility that an exchange is owned by shareholders,
rather than members.[425] The Commission is also adopting
other changes to the information requested on Form 1 to
reflect the fact that a for-profit exchange would have
participants or subscribers trading, rather than members.
Both the NYSE and the Amex expressed concern that these
new Exhibits would require new and additional
information.[426] Exhibits E and L, however, need only
accompany the application for registration as an exchange
and, therefore, are inapplicable to currently registered
exchanges. In addition, Exhibit K applies only to non-
member owned exchanges. Therefore, because all currently
registered exchanges are member-owned, new Exhibit K does
not apply to them. The Commission has clarified that
Exhibit K exclusively applies to non-member owned exchanges.
If, however, a currently registered, member-owned exchange
were to convert to a for-profit structure, it would have to
comply with the requirement to update Exhibit K.
Exchanges currently registered with the Commission are
required to use amended Form 1 in complying with Rules 6a-2
and 6a-3. The information registered exchanges are required
to update under Rules 6a-2 and 6a-3 is not substantially
different from what registered exchanges are required to
update today. The Commission has provided the chart below
to assist currently registered exchanges in complying with
the filing obligations under amended Rules 6a-2 and 6a-3.
---------------------------------------------------------------
|Amended Form |Filing Requirements Under Amended |
Corresponding |
| | | |
|1 | Rules 6a-2 and 6a-3 | part of |
| | | |
| | |former Form|
| | | |
| | |1 on which |
| | | |
| | |information|
| | | |
| | | was |
| | | |
| | |requested |
---------------------------------------------------------------
| | | |
| | | |
|Questions 1- |File an amendment within 10 days |Questions 1-
|
| | | |
|7 of the |after any action is taken that |6 of the |
| | | |
|Execution |renders the information previously |Statement |
| | | |
|Page |filed inaccurate (Rule 6a- | |
| | | |
| |2(a)(1)). | |
| | | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit A |File an amendment every three |Exhibit A(1)
|
| | | |
| |years (Rule 6a-2(c)) or make | |
| | | |
| |information available by | |
| | | |
| |publication, upon request, or via | |
| | | |
| |an Internet Web site (Rule 6a- | |
| | | |
| |2(d)). | |
| | | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit B |File an amendment every three |Exhibit A(2)
|
| | | |
| |years (Rule 6a-2(c)) or make | |
| | | |
| |information available by | |
| | | |
| |publication, upon request, or via | |
| | | |
| |an Internet Web site (Rule 6a- | |
| | | |
| |2(d)). | |
| | | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit C |File an amendment every three |Question 7 |
| | | |
| |years (Rule 6a-2(c)) or make |of the |
| | | |
| |information available by |Statement |
| | | |
| |publication, upon request, or via | |
| | | |
| |an Internet Web site (Rule 6a- |Exhibit |
| | | |
| |2(d)). |A(3)Exhibit|
| | | |
| |File an amendment within 10 days |H |
| | | |
| |after any action is taken that | |
| | | |
| |renders the information previously | |
| | | |
| |filed inaccurate (Rule 6a-2(a)(2)).| |
| | | |
---------------------------------------------------------------
---------------------------------------------------------------
| | | |
| | | |
|Exhibit D |File an annual amendment (Rule 6a- |Exhibit F |
| | | |
| |2(b)(1)). | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit E |No requirement to update; only | |
| | | |
| |required on application for | |
| | | |
| |registration. | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit F |File an amendment within 10 days |Exhibit B |
| | | |
| |after any action is taken that | |
| | | |
| |renders the information previously | |
| | | |
| |filed inaccurate (Rule 6a-2(a)(2)).| |
| | | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit G |File an amendment within 10 days |Exhibit C |
| | | |
| |after any action is taken that | |
| | | |
| |renders the information previously | |
| | | |
| |filed inaccurate (Rule 6a-2(a)(2)).| |
| | | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit H |File an amendment within 10 days |Exhibit D |
| | | |
| |after any action is taken that | |
| | | |
| |renders the information previously | |
| | | |
| |filed inaccurate (Rule 6a- | |
| | | |
| |2(a)(2)). | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit I |File an annual amendment (Rule 6a- |Exhibit E |
| | | |
| |2(b)(1)). | |
| | | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit J |File an amendment every three |Exhibit G |
| | | |
| |years (Rule 6a-2(c)) or make | |
| | | |
| |information available by | |
| | | |
| |publication, upon request, or via | |
| | | |
| |an Internet Web site (Rule 6a- | |
| | | |
| |2(d)). | |
| | | |
| |File an amendment within 10 days | |
| | | |
| |after any action is taken that | |
| | | |
| |renders the information previously | |
| | | |
| |filed inaccurate (Rule 6a- | |
| | | |
| |2(a)(2)). | |
---------------------------------------------------------------
---------------------------------------------------------------
|Exhibit K | | |
| | | |
| |Only for-profit exchanges are | |
| | | |
| |required to file an annual | |
| | | |
| |amendment (Rule 6a-2(b)(2)) or | |
| | | |
| |make information available by | |
| | | |
| |publication, upon request, or via | |
| | | |
| |an Internet Web site (Rule 6a- | |
| | | |
| |2(d)), and to file an amendment | |
| | | |
| |within 10 days after any action is | |
| | | |
| |taken that renders the information | |
| | | |
| |previously filed inaccurate (Rule | |
| | | |
| |6a-2(a)(2)). | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit L |No requirement to update; only | |
| | | |
| |required on application for | |
| | | |
| |registration as an exchange. | |
| | | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit M |File an annual amendment (Rule 6a- |Question 8 |
| | | |
| |2(b)(2)) or make information |of the |
| | | |
| |available by publication, upon |Statement |
| | | |
| |request, or via an Internet Web | |
| | | |
| |site (Rule 6a-2(d)). |Question |
| | | |
| |File an amendment within 10 days |9(a) of the|
| | | |
| |after any action is taken that |Statement |
| | | |
| |renders the information previously | |
| | | |
| |filed inaccurate (Rule 6a- |Exhibit I |
| | | |
| |2(a)(2)). |Exhibit J |
| | | |
---------------------------------------------------------------
| | | |
| | | |
|Exhibit N |File an annual amendment (Rule 6a- |Exhibit K |
| | | |
| |2(b)(2)) or make information |Exhibit L |
| | | |
| |available by publication, upon |Exhibit M |
| | | |
| |request, or via an Internet Web | |
| | | |
| |site (Rule 6a-2(d)). | |
| | | |
---------------------------------------------------------------
|deleted | |Question |
| | | |
| | |9(b) of the|
| | | |
| | |Statement |
---------------------------------------------------------------
2. Amendments to Rules 6a-1, 6a-2, and 6a-3
under the Exchange Act
In order to reduce some of the filing burdens for
exchanges and to allow exchanges to comply with the filing
requirements by posting information on an Internet web page,
the Commission is amending Rules 6a-1, 6a-2, and 6a-3 under
the Exchange Act.
a. Rule 6a-1 Application for Registration
as an Exchange or Exemption Based on
Limited Volume of Transactions
The Commission proposed to amend Rule 6a-1 to clarify
that Form 1 should only be used by an exchange to apply for
registration as a national securities exchange or for an
exemption from registration under Section 5 of the Exchange
Act based on such exchange’s limited volume of transactions.
The Commission received no comments on these proposed
changes and is adopting them as proposed.
b. Rule 6a-2 Periodic Amendments
Paragraph (a) of amended Rule 6a-2 requires an exchange
to file an amendment to Form 1 within 10 days of changes to:
(1) information filed on the Execution Page of Form 1, or
amendment thereto; (2) information regarding all affiliates
and subsidiaries (Exhibit C); (3) application for
membership, participation or subscription to the exchange or
for a person associated with a member, participant, or
subscriber of the exchange (Exhibit F); (4) financial
statements, reports or questionnaires required of members,
participants or subscribers (Exhibit G); (5) listing
applications, any agreements required to be executed in
connection with listing and a schedule of listing fees
(Exhibit H);[427] (6) officers, governors, members of all
standing committees, or persons performing similar
functions, who presently hold or have held their offices or
positions during the previous year (Exhibit J); (7) persons
with direct ownership and control for non-member owned
exchanges (Exhibit K); and (8) any members, participants,
subscribers or other users and the information pertaining
thereto (Exhibit M).[428] Additionally, rather than
exchanges filing these changes in the form of a notice, as
is currently required under paragraph (a) of Rule 6a-3, the
changes will be filed in the form of an amendment on Form 1.
These amendments to Rule 6a-2 relieve exchanges from
some of the filing requirements to which exchanges are
currently subject. Specifically, a registered exchange no
longer has to file notice within 10 days of changes to: (1)
its constitution, articles of incorporation or association,
or by-laws (Exhibit A); (2) written rulings or settled
practices of any governing board or committee of the
exchange that have the effect of rules or interpretations
(Exhibit B); and (3) the schedule of securities listed on
the exchange (Exhibit N).
Paragraph (b) of amended Rule 6a-2 requires an exchange
to file annually an amendment to Form 1 with the following
information: (1) unconsolidated financial statements for
each subsidiary or affiliate or the exchange for latest
fiscal year (Exhibit D); (2) audited consolidated financial
statements for last fiscal year of the exchange prepared in
accordance with, or reconciled to, United States generally
accepted accounting principals (Exhibit I);[429] (3) a list
of persons with direct ownership and control for non-member
exchanges (Exhibit K); (4) a list of all members,
participants, subscribers or other users and the information
pertaining thereto (Exhibit M); and (5) a schedule of
securities listed on the exchange, securities admitted to
unlisted trading privileges and securities admitted to
trading on the exchange which are exempt from registration
under Section 12(a) of the Act (Exhibit N).[430] These
amendments remove exchanges’ obligations to include the
following as part of the annual amendment: (1) the
exchange’s affiliates and subsidiaries (Exhibit C) and (2) a
list of officers, governors, and members of standing
committees be included as part of an annual amendment
(Exhibit J).
Paragraph (c) of amended Rule 6a-2 requires an exchange
to file an amendment to Form 1 every three years with the
following information: (1) a copy of the constitution,
articles or incorporation or association and by-laws
(Exhibit A); (2) a copy all written rulings, settled
practices having effect of rules and interpretations of any
governing board or committee of the exchange (Exhibit B);
(3) information regarding all affiliates and subsidiaries
(Exhibit C); and (4) a list of officers, governors, members
of all standing committees, or persons performing similar
functions, who presently hold or have held their offices or
positions during the previous year (Exhibit J).[431]
Paragraph (d) of amended Rule 6a-2 provides exchanges
with alternatives to the annual filing requirement for
Exhibits K, M, and N, and to the three year filing
requirement for Exhibits A, B, C, and J. Pursuant to Rule
6a-2(d) exchanges have the following options, in lieu of
paper filing: (1) to publish or cooperate in the publication
of this information on an annual or more frequent basis, and
to certify to the accuracy of the information; (2) to keep
the information up to date, and certify that the information
is up to date and available to the Commission and the public
upon request; or (3) to make the information available
continuously on an Internet web site controlled by an
exchange, indicate the location of the Internet Web site
where such information may be found, and to certify that the
information available at such location is accurate as of its
date.[432]
Comments from the NYSE and the Amex suggested that the
amendments to Rule 6a-2 and Form 1, as adopted, reimpose
some of the annual filing requirements previously
eliminated.[433] As discussed above, Rule 6a-2 and Form 1,
as adopted, relax the current filing burdens without
reimposing any filing requirements. The technical
modifications to the amendments to Rule 6a-2 clarify the
operation of the rule, as adopted.
c. Rule 6a-3 Supplemental Material
Paragraph (b) of Rule 6a-3 currently requires
registered exchanges, or exchanges exempt from registration
based on their limited volume of transactions, to furnish to
the Commission copies of all materials issued or made
available to members. The Commission proposed to continue
to require exchanges to provide the Commission with the
information currently required under the rule. However, as
an alternative to filing such information on paper, the
Commission proposed to permit exchanges to make the
information available on an Internet web site and provide
the Commission with the location of the web site. The
Commission did not receive comments addressing these
proposed changes, and is adopting the amendments to Rules
6a-3(b) as proposed.[434]
D. National Securities Exchanges Operating
Alternative Trading Systems
National securities exchanges could, under the rules
the Commission is adopting today, form subsidiaries or
affiliates that operate alternative trading systems
registered as broker-dealers.[435] If a national securities
exchange chose to form such a subsidiary or affiliate, the
exchange itself could remain registered as a national
securities exchange, while the subsidiary or affiliate
operated as a broker-dealer. Such subsidiaries or
affiliates would of course be required to become members of
a national securities association or another national
securities exchange.[436] In addition, any subsidiary or
affiliate of a registered exchange could not integrate, or
otherwise link the alternative trading system with the
exchange, including using the premises or property of such
exchange for effecting or reporting a transaction, without
being considered a "facility of the exchange."[437]
V. Broker-Dealer Recordkeeping and Reporting Obligations
A. Elimination of Rule 17a-23
Under the regulatory framework adopted in this release,
alternative trading systems are required to register as
exchanges or broker-dealers, and comply with the
requirements under Regulation ATS. These systems are
currently subject to recordkeeping and reporting
requirements under Rule 17a-23 of the Exchange Act.[438]
Because these alternative trading systems are now subject to
recordkeeping and reporting requirements relating to their
operations, either as registered exchanges or as broker-
dealers under proposed Regulation ATS, the Commission is
eliminating duplicative recordkeeping and reporting
obligations for these systems by repealing Rule 17a-23.
Only the recordkeeping requirements in Rule 17a-23 as they
apply to broker-dealers that are not also alternative
trading systems, are being moved to the broker-dealer
recordkeeping rules, Rules 17a-3 and 17a-4 under the
Exchange Act.
B. Amendments to Rules 17a-3 and 17a-4
Certain trading systems operated by broker-dealers are
not alternative trading systems, and therefore are not
required to register as exchanges or comply with Regulation
ATS under the framework the Commission is adopting today.
This group of internal broker-dealer systems[439] will
continue to be regulated under the traditional broker-dealer
regulatory scheme. The Commission is amending Rules 17a-3
and 17a-4 under the Exchange Act[440] to require broker-
dealers to continually make and keep records regarding the
activities of internal broker-dealer systems for non-
alternative trading systems. These recordkeeping
requirements are similar to the recordkeeping requirements
under Rule 17a-23, which the Commission today is
repealing.[441] The Commission believes that these
recordkeeping requirements continue to be valuable to the
oversight and inspections of internal broker-dealer systems
by the Commission and the SROs.
These amendments ensure that broker-dealers continue to
keep records of any of their customers that have access to
their internal broker-dealer system, as well as any
affiliations between those customers and the broker-dealer.
Broker-dealers are also required to keep daily trading
summaries, including information on the types of securities
for which transactions have been executed through the
internal broker-dealer system, and transaction volume
information.[442] In addition, to clarify the application
of Rule 17a-3, the Commission is defining, for the purposes
of the rule, the terms "internal broker-dealer system,"[443]
"sponsor,"[444] and "system order."[445]
The Commission is also amending Rule 17a-4 under the
Exchange Act to require that the records required under the
amendments to Rule 17a-3 be preserved for three years, the
first two years in an accessible place.[446] This amendment
also requires the preservation of all notices regarding an
internal broker-dealer system provided to its participants,
whether communicated in writing, through the internal
broker-dealer system, or by other automated means. Such
notices include notices concerning the internal broker-
dealer system’s hours of operations, malfunctions,
procedural changes, maintenance of hardware and software,
and instructions for accessing the system.
VI. Temporary Exemption of Pilot Trading System Rule
Filings
A. Introduction
The Commission recognizes that registered exchanges,
unlike alternative trading systems registered as broker-
dealers, must submit rule filings for Commission approval.
In the Concept Release, the Commission generally sought
comment on ways to expedite the rule filing process and
specifically sought comment on whether the Commission should
exempt new SRO trading systems or mechanisms from rule
filing requirements.[447] Commenters pointed out that,
under the current regulatory structure, registered exchanges
and alternative trading systems compete on a "playing field
that is far from level,"[448] and attributed this, in part,
to exchanges’ inability to implement new trading systems
before submitting a rule filing and receiving Commission
approval.[449] In response to commenters’ concerns and to
make existing markets more competitive, the Commission
proposed Rule 19b-5, a temporary exemption for SROs that
would defer the rule filing requirements of Section 19(b)
under the Exchange Act[450] for pilot trading systems
("pilot trading system rule").[451]
In formulating the pilot trading system rule, the
Commission drew on its prior experience with SROs’ attempts
to operate new pilot trading systems for their members.[452]
In the Proposing Release, the Commission sought comment on
whether the proposed pilot trading system rule would provide
appropriate regulation and would level the competitive
playing field between SROs and alternative trading systems.
As an alternative, the Commission sought comment on the
benefits and disadvantages of allowing SROs to file proposed
rule changes relating to pilot trading systems under an
expedited approval process pursuant to Section 19(b)(3)(A)
of the Exchange Act. Overall, comments on the proposed
pilot trading system rule were supportive of it as a way to
ease the regulatory disparity between registered exchanges
and alternative trading systems.
The Commission received no comments opposing proposed
Rule 19b-5. In general, commenters supported the proposal,
stating that it would encourage further innovation and
reduce some of the regulatory burdens that make it difficult
for SROs to compete with broker-dealer operated trading
systems. Some commenters, while generally supporting the
temporary exemption, suggested modifying proposed Rule 19b-
5. These comments focused on the proposed definition of a
pilot trading system, the types of securities the Commission
proposed to allow SROs to trade on pilot trading systems,
and the confidential treatment of information filed by SROs
regarding their pilot trading systems.[453] After
considering the comments, the Commission is adopting Rule
19b-5 substantially as proposed.
Currently, SROs are required to submit a rule filing to
the Commission and undergo a public notice, comment, and
approval process before they operate any new trading
system.[454] As adopted, the pilot trading system rule
permits SROs that develop separate, new systems that qualify
as "pilot trading systems,"[455] to begin their operation
shortly after submitting new Form PILOT to the Commission.
Form PILOT is merely an informational filing and an SRO does
not need to await Commission approval to begin operating its
pilot trading system.[456] During the operation of the
pilot trading system, the sponsoring SRO must submit to the
Commission quarterly reports, as well as amendments to Form
PILOT concerning any material changes to the pilot trading
system. Rule 19b-5 exempts an SRO from the requirement to
file rule changes for the pilot trading system with the
Commission for two years. Before two years expire, the SRO
must submit a rule filing to obtain from the Commission
permanent approval of the pilot trading system or must cease
operation of the trading system.[457] In addition, the
temporary exemption under Rule 19b-5 expires sixty days
after a pilot trading system exceeds certain volume levels.
A pilot trading system that exceeds these volume levels must
file for permanent approval before the two-year period
expires.[458]
The Commission believes the pilot trading system rule
addresses many of the concerns raised by commenters.[459]
Inherent in the rule filing process is public disclosure of
SROs’ business plans for trading systems prior to their
operation. Consequently, SROs’ competitors are informed
about the proposed pilot trading system and have an avenue
to copy, delay, or obstruct implementation of the trading
system before it can be tested in the marketplace.[460] The
rule filing process also hinders innovation because
registered exchanges do not realize the full competitive
benefits of their efforts.[461] In contrast, alternative
trading systems that offer similarly innovative, start-up
services do not have the same rule filing obligations and,
thus, have a significant advantage in their flexibility to
devise, implement, and modify new pilot trading systems.
Comments to the Proposing Release echo these concerns.[462]
By deferring the rule filing process, the pilot trading
system rule allows SROs to better compete with alternative
trading systems, while continuing to ensure that investors
are protected and the pilot trading system is operated in a
manner consistent with the Exchange Act.
Finally, the Commission recognizes that domestic
markets must compete with less regulated foreign markets and
broker-dealers. The Commission agrees with commenters that
excessive regulation of traditional exchanges, alternative
trading systems, or other markets hinders these exchanges’
ability to compete and survive in the global arena. The
pilot trading system rule responds to SROs’ need for a more
balanced competitive playing field.
B. Rule 19b-5
The Commission is adopting Rule 19b-5 to provide a
temporary exemption from Section 19(b) of the Exchange Act
for SRO proposed rule changes concerning the operation of
pilot trading systems.
1. Types of Systems Eligible for Exemption Under
Rule 19b-5
a. Definition of Pilot Trading System
The Commission is adopting the definition of pilot
trading system substantially as proposed. Under paragraph
(c) of Rule 19b-5, a trading system operated by an SRO would
be a "pilot trading system" if it met one of two
definitions. First, a trading system would be a "pilot
trading system," even if it traded the same securities or
operated during the same hours as an SRO’s existing trading
system, if the SRO operated it for less than two years, and
during at least two of the last four consecutive calendar
months, it traded no more than one percent of the U.S.
average daily trading volume of each security traded on the
trading system. In addition, the trading system could not
have an aggregate share trading volume of more than twenty
percent of the average daily trading volume of all trading
systems operated by the SRO.[463] Second, a trading system
would also be considered a "pilot trading system" if it were
independent[464] of any other trading system operated by the
SRO, the SRO operated it for less than two years, and,
during at least two of the last four consecutive calendar
months, it traded no more than five percent of the U.S.
average daily trading volume of each security traded on the
trading system. In addition, under this second definition,
the trading system would have to have aggregate share
trading no more than twenty percent of the average daily
trading volume of all trading systems operated by the
SRO.[465]
If at any time within the two-year period a pilot
trading system exceeds the volume thresholds, it would be
allowed to continue to operate for 60 more days under this
exemption.[466] During this 60 day period, if the SRO
intended to continue operating the trading system, it would
have to file for permanent approval under Section 19(b) of
the Exchange Act of the rules related to the trading system.
The Commission received several comments asking the
Commission to relax or eliminate the proposed requirement
that, to be a pilot trading system with five percent of the
trading volume in a security, the pilot trading system would
have to be "independent." As proposed, a pilot trading
system would be independent if it trades securities
different from the issues of securities traded on any other
trading system that is operated by the same SRO and that has
been approved by the Commission. A pilot trading system
would also be deemed independent if it does not operate
during the same trading hours as any other trading system
that is operated by the same SRO and that has been approved
by the Commission. Finally, a pilot trading system would be
deemed independent if no market maker or specialist on any
other trading system operated by the SRO trades on the pilot
trading system the same securities in which they act as a
market maker or specialist.[467] The Commission emphasized
that a pilot trading system need only satisfy one of the
three criteria to qualify the pilot trading system as
independent. After considering the comments, the Commission
continues to believe such criteria are not unduly
restrictive and are necessary for the protection of
investors, and is adopting it as proposed.
b. Response to Comments on the Proposed
Definition of Pilot Trading System
In its proposed definition of a pilot trading system,
the Commission sought to impose limits that were in the
public interest and for the protection of investors, while
still providing SROs with the flexibility to innovate. The
Commission requested comment on this proposed definition,
and specifically asked whether the proposed two-year time
period, trading volume limits, and independence criteria
were appropriate. Commenters were asked to provide specific
reasons for any concerns about the proposed definition and
to suggest alternatives. Several commenters focused on
particular aspects of the proposed pilot trading system
definition.
The NYSE commented that the specific provisions of
proposed Rule 19b-5 were carefully crafted. In addition,
the NYSE agreed with the Commission’s proposal to
distinguish between systems that are "independent" of other
SRO trading systems and systems that work together with
existing SRO trading systems.[468] The ICI supported the
proposed limited exemption for pilot trading systems. The
ICI, however, discouraged any further expansion of the
criteria that would constitute a pilot trading system and
encouraged the Commission to carefully monitor pilot trading
systems as they operate under the exemption.[469]
On the other hand, several commenters stated that Rule
19b-5 should be liberalized to provide SROs with a
meaningful opportunity to develop pilot trading systems on a
comparable basis to alternative trading systems.[470] For
example, the CME generally asserted that the numerous
proposed restrictions on what would qualify as a pilot
trading system would render the proposal of little practical
value to exchanges.[471] With regard to the volume
thresholds proposed by the Commission, the NASD and the PCX
stated that the volume thresholds were too low. [472] The
PCX stated that the volume restrictions did not make sense
because they limited the ability of registered exchanges to
introduce new trading systems -- particularly when neither
alternative trading systems nor third market makers are
subject to similar volume limitations. Instead, the PCX
stated that Rule 19b-5 should treat exchange pilot trading
systems as though they were alternative trading systems for
two years, provided the trading systems did not exceed a
fairly high percentage (perhaps ten percent) of total
trading volume in any security.[473] Moreover, the Amex
said the volume thresholds for individual securities would
limit the utility of the exemption for primary markets. In
particular, the Amex suggested that the Commission apply
only an aggregate volume threshold whereby volume in an SRO
pilot trading system could not exceed a specified percentage
of total volume in all such SRO’s trading systems. This
approach, the Amex believed, would eliminate the
administrative burden on SROs monitoring the one percent or
five percent thresholds and would avoid the potentially
adverse impact on the operation and success of a pilot
trading system that could occur by removing securities from
the system that exceeded a specified threshold.[474]
Other commenters thought the criteria establishing the
independence of a pilot trading system from other trading
systems operated by the same SRO were too restrictive.[475]
In particular, the CBOE and NASD asserted that the
independence criteria unnecessarily precluded exchange
specialists and market makers from participating in pilot
trading systems.[476] Similarly, the CHX stated that it was
too limiting to require a pilot trading system to trade
different securities or operate during different hours than
the sponsoring SRO’s other trading systems in order to be
"independent."[477]
c. Adopted Definition of Pilot Trading
System
The Commission has considered these comments. As
discussed above, it believes that, because the proposed
definition of a pilot trading system, including the proposed
volume thresholds and independence criteria is novel and
untried, the criteria are appropriate. The Commission notes
that, pursuant to paragraph (b)(5) under Section 6 of the
Exchange Act, rules of a registered exchange should be
designed, among other things, to prevent fraudulent and
manipulative acts and practices, to promote just and
equitable principles of trade and, in general, to protect
investors and the public interest.[478] The Commission
believes that the desire of the registered exchanges to
innovate and compete with alternative trading systems must
be balanced with their statutory obligations under Section 6
of the Exchange Act. Therefore, the volume thresholds and
other standards are designed to ensure that once a pilot
trading system’s activities reach a significant level, the
pilot trading system will be subject to the public notice
and comment process under Section 19(b) of the Exchange Act.
The Commission recognizes that the definition of "pilot
trading system" is more narrow than some SROs would prefer,
but notes that this does not prevent registered exchanges
from developing trading systems that do not meet the
definition of "pilot trading system" and filing proposed
rule changes relating to those systems under Section 19(b)
of the Exchange Act.
Similarly, through the independence criteria, the
Commission identified characteristics that render pilot
trading systems sufficiently distinct from the sponsoring
SRO’s other trading systems so that a five percent, rather
than one percent volume level, is acceptable. "Independent"
pilot trading systems pose less risk of substantially
changing the existing markets in a manner detrimental to
investors and, therefore, the Commission believes should be
able to operate under the exemption at higher volume
thresholds than their "non-independent" counterparts before
having to submit proposed rule filings under Section 19(b)
of the Exchange Act.[479] The Commission will monitor use
of the pilot trading system exemption, and will consider
modifying these criteria in the future based on its
experience with SRO’s use of the exemption.
2. Scope of Pilot Trading Rule Exemption
The Commission is adopting Rule 19b-5 to provide a
temporary exemption from Section 19(b) of the Exchange Act
for SRO proposed rule changes concerning the operation of
pilot trading systems. This temporary exemption includes
all rules related to the operation of pilot trading systems.
The Commission defines trading system in paragraph (b) of
Rule 19b-5 to include the rules of a self-regulatory
organization that: (i) determine how the orders of multiple
buyers and sellers are brought together; and (ii) establish
non-discretionary methods under which such orders interact
with each other and under which the buyers and sellers
entering such orders agree to the terms of trade.[480] The
Commission intends this exemption to provide SROs with
flexibility to establish and modify the pilot trading system
without obtaining prior approval from the Commission.
However, this exemption does not include any SRO rules that
would fundamentally affect the relationship between an SRO’s
members and those members’ customers, or an SRO’s oversight
of its members.
The Commission notes that Rule 19b-5 does not relieve
SROs from any obligation under the federal securities laws,
other than the requirement to file proposed rule changes
relating to the operation of a pilot trading system. Rule
19b-5, therefore, does not provide an exemption for SRO
rules relating to other requirements imposed under other
provisions of the Exchange Act, such as Sections 11(a) and
10(a), and Rule 10a-1 thereunder. In addition, an SRO must
ensure that securities listed and traded on any pilot
trading system comply with, among other things, the
registration requirements of the Exchange Act.[481] An SRO
also continues to be required to enforce compliance with its
own rules and the federal securities laws, including
members’ compliance with the Order Handling Rules.[482]
SROs, similarly, are expected to operate the pilot trading
systems in compliance with rules governing market-wide
trading halts.
3. SROs’ Continuing Obligations Regarding Pilot
Trading Systems
In order to ensure that pilot trading systems are
operated in a manner consistent with the Exchange Act, the
Commission proposed requiring SROs to comply with certain
conditions before a pilot trading system would be eligible
for the temporary exemption. In particular, the Commission
proposed that SROs comply with the following with regard to
pilot trading systems: (1) notify and periodically file
information about the pilot trading system with the
Commission, (2) implement trading rules and procedures, (3)
establish effective surveillance, (4) establish reasonable
clearance and settlement procedures, (5) limit the types of
securities traded, (6) cooperate with inspections and
examinations by the Commission, and (7) have procedures to
ensure the confidential treatment of trading
information.[483]
The Commission sought comment on whether there were any
additional conditions with which SROs should be required to
comply in order to be temporarily exempt from the rule
filing requirements under Rule 19b-5. Commenters did not
recommend any additional conditions. The Commission notes,
however, that, as discussed below, it is adding a
requirement that SROs make publicly available the rules
relating to the operation of the pilot trading system.[484]
In the Proposing Release, the Commission stated that
SROs would have to "ensure" that these conditions were
satisfied in order to rely on the temporary exemption under
proposed Rule 19b-5. One commenter raised concerns
regarding the requirement that SROs "ensure" that the
conditions were met in order to rely on the proposed pilot
trading system rule. Specifically the CBOE requested that
an SRO be allowed to rely on proposed Rule 19b-5 if the SRO
acts in good faith in determining that the requirements of
the pilot trading system rule have been met.[485] Based
upon the Commission’s experience with reviewing new pilot
trading system proposals submitted by SROs, the Commission
continues to believe that SROs operating pilot trading
systems should satisfy the proposed requirements in order to
operate such systems in a manner consistent with the
Exchange Act. Nonetheless, the Commission recognizes that
full compliance with some of the conditions may be beyond
the SROs’ control. The Commission agrees it is not
practical to hold SROs strictly liable for the failure of
unaffiliated entities to satisfy certain requirements of the
proposed pilot trading system rule. Therefore, the
Commission will consider an SRO exempt from rule filing
requirements under Rule 19b-5 if the SRO acts in good faith
in determining that the operation of the pilot trading
system meets the conditions set out in paragraph (e) of that
rule, and in operating the pilot trading system.
a. Notice and Filings to the Commission
The Commission proposed that SROs be required to
provide written notice of, and information about, the
operation of a pilot trading system to the Commission on new
Form PILOT. On Form PILOT, an SRO would have to provide
general information about the pilot trading system,
including: (1) the date the SRO expects to commence
operation of the pilot trading system; (2) a list of
securities to be traded; (3) a list of anticipated members
to the pilot trading system; and (4) the names of entities
assisting in the operation of the pilot trading system.[486]
The SRO could start operation of the pilot trading system
twenty days after this filing is complete. If the SRO
materially changes its proposed pilot trading system prior
to commencing operation, the SRO would be required to file
an amendment to Form PILOT and wait twenty days before
commencing operation. The Commission is adopting the notice
requirement and Form PILOT as proposed.[487]
The twenty day period following an SRO’s filing of Form
PILOT is intended to provide the Commission with time to
review the form for compliance by the SRO with the pilot
trading system rule. In addition, after reviewing Form
PILOT the Commission may determine, after notice to the SRO
and an opportunity for the SRO to respond, that the
operation of a particular pilot trading system would not be
necessary or appropriate in the public interest or
consistent with the protection of investors without the SRO
filing proposed rule changes under Section 19(b) of the
Exchange Act.[488]
The Commission also proposed to require an SRO to file
an amendment to Form PILOT at least twenty days before it
implements any material change to the operation of the pilot
trading system. The Commission would consider a material
change to the pilot trading system to include the addition
of new types of securities, or a new date for commencing
operation of the pilot trading system. The Commission
proposed that an SRO also submit quarterly reports on Form
PILOT that would include information about the trading
volume effected on the pilot trading system during the most
recent calendar quarter. The Commission received no
comments on these requirements and is adopting them as
proposed.[489]
The Commission proposed that all notices and reports
filed on Form PILOT be kept confidential. The Commission,
however, requested comment on whether all information on
Form PILOT should be publicly available or whether, as an
alternative, information on Form PILOT should be publicly
available, unless an SRO specifically requests confidential
treatment. The Commission received several comments on the
confidential treatment of information on Form PILOT. The
CBOE recommended that all information about a pilot trading
system filed quarterly on Form PILOT be deemed
confidential.[490] The NYSE suggested only limited
confidentiality for filings on Form PILOT, that is, pilot
trading system information should be publicly available
shortly prior to, or on the date of, launch of a new
system.[491] Another commenter offered that the Commission
make public only certain information on Form PILOT.[492]
One commenter suggested that the confidential treatment of
Form PILOT information be at the filer’s discretion.[493]
After considering commenters’ suggestions, the
Commission has determined that the confidential treatment of
Form PILOT information is an important element in reducing
the disparate regulatory treatment of SROs and alternative
trading systems and that such confidentiality is critical in
the period prior to a pilot trading system commencing
operations. However, the Commission also considers
important the public’s interest in having access to accurate
information about the pilot trading system. Accordingly,
the Commission is modifying proposed Rule 19b-5, so that
information reported by an SRO on Form PILOT is confidential
until the pilot trading system commences operation.[494]
Thereafter, Form PILOT information will be made available to
the public.
b. Fair Access
Because information and access advantages of certain
SRO members could subvert the fair and orderly trading of
securities on a pilot trading system or the primary market,
the Commission is adding a specific condition to the pilot
trading system rule requiring that the SRO provide fair
access to the pilot trading system to all members of the
SRO. The Commission is adding this fair access requirement
in order to ensure that markets treat their members
fairly.[495] In particular, the SRO shall establish written
standards for granting access to the pilot trading system
and apply those standards fairly to all members. Fair
access does not require an SRO to allow every member to
trade on a pilot trading system or to give each member
trading on the pilot trading system the same privileges.
However, this requirement does prohibit an SRO from unfairly
discriminating in the access it does give its members to the
pilot trading system. In addition, the SRO must ensure that
information regarding orders on the pilot trading system is
equally available to all members of the SRO with access to
the pilot trading system.[496] However, a specialist may
have preferred access to information regarding orders it
represents in its capacity as specialist on the pilot
trading system.[497] This means that such SRO rules need
not require a member acting as a specialist on the pilot
trading system to expose its orders to all members, that is
maintain an "open book." Such rules established by the SRO
will be considered part of the pilot trading system for
purposes of the temporary exemption.[498]
c. Trading Rules and Procedures
The Commission proposed to require SROs operating pilot
trading systems under Rule 19b-5 to adopt and implement
trading rules and procedures necessary to operate the pilot
trading system in a manner consistent with the Exchange Act.
The Commission received no comments specifically addressing
this condition and is adopting it substantially as proposed.
As adopted, an SRO must have appropriate trading rules and
procedures to promote the fair and orderly trading of
securities on the pilot trading system, including: (1)
margin requirements; (2) listing standards; (3) sales
practice guidelines, such as rules regarding communications
with the public; and (4) disclosure requirements. The
trading rules and procedures should be appropriate for, and
ensure the fair and orderly trading of, each type of
security to be traded on the pilot trading system.[499]
d. Surveillance
Under the proposal, an SRO would have to establish
procedures for the effective surveillance of trading
activity on a pilot trading system. In the Proposing
Release, the Commission noted the importance of an SRO being
able to obtain information necessary to detect and deter
market manipulation, illegal trading, and other trading
abuses. To satisfy this requirement, the Commission
proposed that an SRO have to develop and implement internal
surveillance procedures to monitor transactions effected on
the pilot trading system, and obtain surveillance
information from other markets, both domestic and foreign.
Specifically, in the Proposing Release, the Commission
discussed its expectation that there be a comprehensive
information sharing agreement ("ISA") in place between the
SRO operating a pilot trading system and any other market
trading the securities, or trading the underlying securities
of derivative securities products, traded on such pilot
trading system.[500] Such agreements provide a necessary
deterrent to manipulation because they facilitate the
availability of information needed to fully investigate a
potential manipulation. An SRO operating a pilot trading
system trading U.S. securities, or new derivative securities
products overlying U.S. securities, would have to continue
to ensure that all exchanges on which the U.S. securities
trade are members of the Intermarket Surveillance Group
("ISG").[501] The ISG was formed to coordinate, among
other things, effective surveillance and investigative
information sharing arrangements in the stock and options
markets.
The Commission received no comments specifically
addressing the surveillance requirement under the proposed
pilot trading system rule. The Commission continues to
believe that in order for an SRO to operate a pilot trading
system in a manner consistent with the Exchange Act, the SRO
must be able to obtain information necessary to detect and
deter market manipulation, illegal trading, and other
trading abuses. Therefore, the Commission is adopting, as
proposed, the requirement that an SRO develop and implement
internal surveillance procedures to monitor transactions
effected on the pilot trading system, and obtain
surveillance information from other markets, both domestic
and foreign by means of an ISA.[502]
e. Clearance and Settlement
In the Proposing Release, the Commission observed that
the integrity of the trading markets depends on the prompt
and accurate clearance and settlement of securities
transactions. For this reason, the Commission proposed
that, as a condition of the exemption under Rule 19b-5, an
SRO establish reasonable clearance and settlement procedures
for transactions effected on the pilot trading system. For
example, to ensure that adequate linkages have been formed,
part of the user agreement should, at a minimum, request
information about the name of the clearing agency member
through which the user will clear its trades. The
Commission received no comments specifically addressing the
clearance and settlement requirement under the proposed
pilot trading system rule. Therefore, the Commission is
adopting as proposed, the requirement that an SRO operating
a pilot trading system ensure that the necessary linkages to
clearing agencies exist for all pilot trading system
users.[503]
f. Types of Securities
The Commission proposed to limit the types of
securities an SRO could trade on a pilot trading system.
Two separate limitations were proposed. First, under the
proposal a pilot trading system would only be permitted to
trade securities listed on a national securities exchange or
to which unlisted trading privileges was extended pursuant
to a rule, regulation, or order of the Commission under
Section 12(f) of the Exchange Act. In general, Section 12
of the Exchange Act requires an exchange to trade only those
securities that the exchange lists, except that Section
12(f) of the Exchange Act provides UTP under certain
circumstances.[504] For example, under the OTC-UTP plan,
exchanges are permitted to trade certain over-the-counter
securities pursuant to a Commission order.[505] As
proposed, a pilot trading system operated by a registered
exchange or a national securities association would be
limited to trading listed securities or securities to which
UTP has been extended under Section 12(f) of the Exchange
Act. Because national securities associations currently
trade securities that are neither exchange listed or subject
to UTP, this provision was unnecessarily restrictive.
Consequently, the Commission is modifying the limitation on
the types of securities a pilot trading system may trade
from that proposed. In particular, Rule 19b-5(e)(6), as
adopted, only restricts pilot trading systems by requiring
that securities traded be registered under Section 12 of the
Exchange Act.[506] Registered exchanges will still be
required to comply with Sections 12(a) and 12(f) of the
Exchange Act, and therefore, can only trade securities
listed on that exchange, or securities it is permitted to
trade under the OTC-UTP Plan.
g. Activities of Specialists
As proposed, an SRO’s pilot trading system would not
be eligible for the exemption in Rule 19b-5 if it traded
derivative securities, such as options, warrants, or hybrid
products, the value of which were based, in whole or in
part, upon the performance of any security traded on another
trading system operated by that SRO. Similarly, the
proposed exemption excluded SRO pilot trading systems that
traded any security or instrument, such as an equity
security, the derivative of which traded on another trading
system operated by that SRO. The Commission, in proposing
these limitations, intended to preclude an SRO from relying
on the temporary exemption if a pilot trading system
simultaneously traded a security overlying or underlying a
security traded on that SRO’s primary market. The
Commission has always considered this type of trading to
raise special concerns that should be resolved through the
normal rule filing process.[507]
In commenting on proposed Rule 19b-5, the CBOE and the
Amex considered these limitations overly restrictive. The
Amex suggested removing this limitation and instead
requiring SROs to specify on Form PILOT their rules and
procedures for trading such securities on the pilot trading
system.[508] The CBOE suggested an alternative to the
limitation that pilot trading systems may not trade
securities that overlie or underlie securities traded on
another trading system operated by the same SRO. In
particular, the CBOE suggested requiring the SRO to create
firewalls or other safeguards between persons trading the
derivative and the underlying or overlying securities,
rather than flatly prohibiting it.[509]
After considering the commenters’ recommendations, the
Commission has determined that SROs may operate pilot
trading systems under Rule 19b-5 that simultaneously trade a
security that is overlying or underlying a security traded
on another trading system operated by that market, provided
that such trading remains separate. This means that, as
part of the SRO’s general requirement to have written
trading rules and procedures to operate the pilot trading
system,[510] an SRO must have adequate rules and procedures
to trade related securities simultaneously. In addition,
the Commission is adopting a more narrow prohibition than it
proposed, which prohibits a member firm that is a specialist
in a security from acting as a specialist on a pilot trading
system operating during the same hours in a related
security.[511] For example, a member firm may not be a
specialist in a security, such as an equity security, on the
pilot trading system when it is also a specialist in a
derivative of that security, such as an option or equity-
linked note, whose value, in whole or significant part, is
based on the performance of that security.[512] The
Commission would not consider listed options in a single
underlying instrument to be related securities, for purposes
of the pilot trading system exemption.. The limitation
under Rule 19b-5(e)(7)(ii) does not preclude any member firm
from being a specialist on a pilot trading system in a
security related to a security in which the member firm is a
specialist on the SRO’s other trading systems, when such
related securities trade at different times.[513] Also, a
member may be a specialist in related securities that, the
Commission, upon application by the SRO, later determines is
necessary or appropriate in the public interest and
consistent with the protection of investors.[514]
The Commission notes that Rule 19b-5 does not prohibit
an SRO from developing a trading system that permits a
member firm to be a specialist in related securities that
trade simultaneously on trading systems operated by the same
SRO. However, the SRO could not avail itself of the Rule
19b-5 temporary exemption, and instead would have to file
proposed rule changes with the Commission under Section
19(b) of the Exchange Act for public notice and comment and
obtain Commission approval prior to operating such trading
system.
h. Inspections and Examinations
As a condition to the exemption, the Commission
proposed that an SRO cooperate with any examination or
inspection by the Commission of persons effecting
transactions on the pilot trading system. The Commission
received no comments on this requirement and is adopting it
as proposed.[515] As adopted, the SRO shall cooperate with
the examination, inspection, or investigation by the
Commission of transactions effected on the pilot trading
system. The Commission staff will review SRO compliance
with the conditions in Rule 19b-5 through its routine
inspections. In order for the Commission staff to determine
whether an SRO has properly relied on the exemption under
Rule 19b-5, the SRO must maintain at its principal place of
business all relevant records and information pertaining to
the pilot trading system and the basis for which the SRO
relied on the exemption from the rule filing
requirement.[516] The Commission notes that if an SRO
outsources the operation or maintenance of any aspect of a
pilot trading system, such vendor would be considered to be
operating a facility of an SRO and therefore would also be
subject to Commission examination or inspection.
i. Public Availability of Pilot Trading
System Rules
Although pilot trading system rules do not need to be
approved by the Commission, the Commission believes the
current trading rules and procedures of the pilot trading
system should be publicly available. Accordingly, the
Commission is adopting a requirement that the SRO make its
trading rules and procedures of the pilot trading system
publicly available.[517]
C. Rule Filing Under Section 19(b)(2) of the Exchange
Act Required Within Two Years
Within two years of a pilot trading system commencing
operation, an SRO must submit a rule filing under Section
19(b)(2) of the Exchange Act to obtain approval for the
pilot trading system to operate on a permanent basis.[518]
In accordance with Section 19(b) of the Exchange Act, after
a formal notice and comment period, the Commission will
decide whether to approve the proposed rule changes relating
to a pilot trading system on a permanent basis or whether to
institute proceedings to disapprove the proposed rule
changes. Simultaneous with its request for Commission
approval under to Section 19(b)(2) of the Exchange Act, an
SRO may request Commission approval pursuant to Section
19(b)(3)(A) of the Exchange Act, effective immediate upon
filing, to continue to operate the trading system for a
period not to exceed six months. [519]
VII. The Commission’s Interpretation of the "Exchange"
Definition
A. The Commission’s Interpretation in Delta
In the Exchange Act, Congress provided a broad
definition of the term "exchange," permitting the Commission
to apply the definition flexibly as the securities markets
evolve over time.[520] Section 3(a)(1) of the Exchange Act
provides that:
The term ‘exchange’ means any organization,
association, or group of persons, whether
incorporated or unincorporated, which
constitutes, maintains, or provides a market
place or facilities for bringing together
purchasers and sellers of securities or for
otherwise performing with respect to
securities the functions commonly performed
by a stock exchange as that term is generally
understood, and includes the market place or
market facilities maintained by such
exchange.[521]
Although the statutory definition of "exchange" is
quite broad, in the 1990 Delta Release,[522] the Commission
interpreted the definition narrowly to include only those
organizations that are "designed, whether through trading
rules, operational procedures or business incentives, to
centralize trading and provide buy and sell quotations on a
regular or continuous basis so that purchasers and sellers
have a reasonable expectation that they can regularly
execute their orders at those price quotations."[523] Based
on this interpretation, which was upheld by the Seventh
Circuit on review,[524] the Commission staff has given
operators of trading systems that do not enhance liquidity
in traditional ways through market makers, specialists, or a
single price auction structure, assurances that it would not
recommend enforcement action if those systems operated
without registering as exchanges.[525]
Several concerns compelled the Commission in 1990 to
narrowly interpret the definition of the term exchange.
First, the Commission was concerned that a broad
interpretation would place "evolving [alternative] trading
systems within the ‘strait jacket’ of exchange regulation,"
thus stifling innovation.[526] Second, the Commission was
concerned that a broad definition would subject brokers,
dealers, and other statutorily defined entities to the
regulatory scheme prescribed for exchanges.[527] Third, the
Commission was concerned that "an expansive definition of
the term ‘exchange’ would force a non-member, for-profit,
proprietary trading system into a regulatory scheme for
which it is ill-suited, thus ignoring the Congressional and
judicial mandate to apply flexibly the definition of the
term ‘exchange’ to the economic realm."[528] These
concerns, however, are largely eliminated by Congress’ broad
grant of exemptive authority in 1996,[529] which has
permitted the Commission to craft a regulatory framework for
markets which excludes other statutorily defined entities
(e.g., broker-dealers operating internal matching systems)
and flexibly regulate markets to accommodate their diverse
business structures. In addition, while the Delta
interpretation was appropriate at the time, its emphasis on
the "expectation" of regular execution of orders at quoted
prices no longer reflects today’s markets where alternative
trading systems compete directly with registered exchanges
and Nasdaq. The Delta approach has resulted in the anomaly
of regulating as exchanges small volume entities that raise
an expectation of liquidity within their system (such as
AZX), while regulating as broker-dealers higher volume
entities (such as Instinet).
More fundamentally, although traditional exchanges
still provide liquidity through two-sided quotations and,
hence, raise an expectation of execution at the quoted
price, this is no longer the essential characteristic of a
securities market where stock and other securities exchange
hands. Today's technology enables market participants and
investors to tap simultaneous and multiple sources of
liquidity from remote locations. Market makers and
specialists may be important liquidity providers on a
particular exchange, but liquidity now comes from many
sources across multiple markets.[530] For example, the
public exposure of investor limit orders means that it is
now easier to access liquidity in trading venues that do not
have market makers or specialists.[531] Today, through
their computer terminals and other communication links,
brokers acting on behalf of their customers or institutions
trading for themselves can see what the quoted price is on
an exchange or Nasdaq and check it against the price
available for the same security on one or more alternative
trading systems.[532]
Notably, in Delta, the Commission indicated that the
Exchange Act does not preclude an alternative trading system
from coming within the "exchange definition."[533] The
Commission recognized that its interpretation of the term
"exchange" could be subject to change as the securities
markets continued to change:
In order to permit the Commission to apply
flexibly the [Exchange] Act’s definition of
the term ‘exchange’ to innovative trading
systems in securities, Congress imbued the
[Exchange] Act’s definition of the term
‘exchange’ with a certain ‘plasticity’. . . .
; "it invites reinterpretation as the way the
term . . . ‘generally understood’
evolves."[534]
Moreover, on review, although the United States Court
of Appeals for the Seventh Circuit Court accepted the
Commission’s interpretation of the term "exchange" and
affirmed the Commission’s determination that Delta was not
an "exchange," the court nevertheless stated that the
"Commission could have interpreted the section to embrace
the Delta System" but that it was not compelled to do
so.[535]
B. The Growing Significance of Alternative Trading
Systems in the National Market System
Within the past six years, the significance of
alternative trading systems in the securities markets has
increased dramatically. In 1994, the Commission’s Division
of Market Regulation reported that alternative trading
systems accounted for thirteen percent of the volume in
Nasdaq securities and 1.4 percent of the trading volume in
NYSE-listed securities.[536] In the Proposing Release, the
Commission estimated that, as of the end of 1996, the
trading volume on alternative trading systems amounted to
almost twenty percent of the trades in Nasdaq stocks, and
almost four percent of orders in securities listed on the
NYSE.
In addition to the general increase in the volume of
trading occurring on alternative trading systems, the actual
number of alternative trading systems has skyrocketed. In
1991, the Commission was aware of only a few such systems.
Today, over forty such systems are currently operating. The
viability of this number of alternative trading systems
indicates that these systems account for an increasing
proportion of trading and that a growing number of investors
use these systems. Moreover, the arrival of trading
services on the Internet portends an increasing level of
retail interest in alternative means for trading.
As more alternative trading systems have developed to
offer varying services to diverse customer bases, the
availability of trading information and the accessibility of
trading opportunities have become increasingly fragmented.
The national market system relies on centralized sources of
trading opportunities and trading information. Exchange
regulation is designed to facilitate centralization and
enhance the general public’s opportunities to obtain trading
information and to access trading interest.
The narrow interpretation of the term "exchange" in
Delta has eroded the effectiveness of the Commission’s
oversight of markets. For example, as discussed in the
Concept Release, it is clear that regulatory concerns may be
raised by entities that constitute a market where buyers and
sellers interact, but do not necessarily ensure a two-sided
market by design.[537] Moreover, the Commission’s
traditional approach to broker-dealer regulation is not
designed to substitute for market regulation. Consequently,
these alternative trading systems are not fully integrated
into the mechanisms that promote market fairness,
efficiency, and transparency. In addition to raising
regulatory fairness concerns, this lack of integration into
the national market system has had a negative impact on the
quality and pricing efficiency of secondary markets.[538]
C. The Revised Interpretation of "Exchange"
For purposes of effectively regulating the securities
markets, including alternative trading systems, the
Commission believes a revised interpretation of what
constitutes an exchange is in order.[539] Although the
Commission has considered many characteristics of the modern
exchange in revising its interpretation,[540] it believes
two elements most accurately reflect the functions and uses
of today’s exchange markets. Under the interpretation in
Rule 3b-16, the first essential element of an exchange is
the bringing together of orders of multiple buyers and
sellers. This reflects the statutory concept of bringing
together purchasers and sellers and also reflects the
reality of today’s marketplace -- where supply and demand
originate from a variety of sources, not simply from
individual brokers and dealers.[541] The second essential
element is that trading on an exchange takes place according
to established, non-discretionary rules or procedures. As
discussed above, an essential indication of the non-
discretionary status of rules and procedures is that those
rules and procedures are communicated to the system’s users.
Thus, participants have an expectation regarding the manner
of execution -- that is, if an order is entered, it will be
executed in accordance with those procedures and not at the
discretion of a counterparty or intermediary.[542]
Some commenters thought the Commission should retain
its current interpretation of an exchange. For example,
TBMA advocated a less expansive definition of exchange, and
recommended that the Commission continue to regulate
alternative trading systems within the broker-dealer
framework, crafting appropriate regulations to address
particular issues presented by unique operations as they
develop.[543] TBMA also raised a question about whether, by
eliminating the requirement that a system provide a
reasonable expectation of liquidity to be considered an
exchange, the Commission’s proposal conflicted with the
statutory definition of "exchange" because liquidity is
"generally understood" to be a fundamental characteristic of
an exchange. As noted above, however, today's technology
gives market participants the ability to access multiple
markets for liquidity at any given time. As a result,
assuring liquidity within a single market by posting
continuous two-sided quotations is no longer the essential
characteristic of a market where securities exchange
hands.[544]
Accordingly, the Commission believes that new Rule 3b-
16 more accurately describes the range of markets that
perform exchange functions as understood today. At the same
time, the Commission's exemption from the exchange
definition for many alternative trading systems provides a
flexible framework, permitting each participant to choose
the regulatory approach that best serves its own business
needs.
D. Other Practical Reasons for Revising the Current
Interpretation
1. Additional Flexibility Provided by the
National Securities Markets Improvement Act
of 1996
As stated above, one principal reason the Commission,
to date, has interpreted the term "exchange" narrowly has
been to avoid the imposition of unnecessary and burdensome
regulatory obligations on small and emerging trading
systems, which could stifle innovation.[545] The enactment
of NSMIA,[546] however, alleviates the concern that an
expanded interpretation of the term exchange will inhibit
innovation.[547] Specifically, NSMIA added Section 36(a)(1)
to the Exchange Act, which provides that:
the Commission, by rule, regulation, or
order, may conditionally or unconditionally
exempt any person, security, or transaction,
or any class or classes of persons,
securities, or transactions, from any
provision or provisions of [the Exchange Act]
or of any rule or regulation thereunder, to
the extent that such exemption is necessary
or appropriate in the public interest, and is
consistent with the protection of
investors.[548]
Prior to adoption of NSMIA, the Commission’s authority
under the Exchange Act to reduce or eliminate certain
consequences of exchange registration was limited.[549]
Section 36, however, allows the Commission greater
flexibility in regulating new trading systems by giving the
Commission broad authority to exempt any person from any
provision of the Exchange Act. As a result, the Commission
now has greater authority to adopt a more consistent
regulatory approach to securities markets in general, and
particularly for alternative trading systems that do not
neatly fit into the existing regulatory framework.[550]
2. No-action Approach to Alternative Trading
Systems is No Longer Workable
The Commission also believes that the proliferation of
new trading systems necessitates the revision of the
interpretation of the term "exchange." The no-action review
process that the Commission has used to date to address
hybrid systems that incorporate features of both exchanges
and broker-dealers worked well and was consistent with the
protection of investors when relatively few systems applied
for no-action treatment. The no-action process allowed the
Division to review the system’s services and mechanisms and
to monitor the impact of such systems on a case-by-case
basis. This is no longer practicable. Absent a revised
interpretation of "exchange," the Commission would have to
continue to respond to an increasing volume of no-action
requests from developing alternative trading systems that
seek to avoid the burdens associated with registration as a
national securities exchange. The Commission’s revised
interpretation eliminates the need for this no-action
approach. By codifying a regulatory framework that does not
rely on Commission staff review of each novel system
development, the Commission believes that technological
improvements and enhanced services will become available
more rapidly.
3. More Rational Treatment of Regulated Entities
The Commission believes that the revised interpretation
of the term exchange, in combination with the adoption of
Regulation ATS, which allows alternative trading systems to
register as broker-dealers,[551] is consistent with other
goals and provisions of the Exchange Act. The new
regulatory framework, including the revised interpretation
of "exchange" avoids the need for the Commission to draw
what are now arbitrary distinctions between organizations
that perform similar functions, avoids classifying
alternative trading systems in a manner that does not fit
the structure of these systems, and squarely addresses the
regulatory concerns raised by these systems
Moreover, the Commission’s new framework helps assure
consistency with existing broker-dealer regulations. For
those alternative trading systems that wish to participate
in the markets as exchanges, regulation as a national
securities exchange is available. However, the Commission
expects that many alternative trading systems will not elect
to register as national securities exchanges. Under the
Commission’s proposal, these systems would have to maintain
a structure more akin to that of traditional broker-dealers
and comply with regulatory obligations more appropriately
tailored to their chosen business structure. These
obligations include the new requirements for more
significant alternative trading systems to address the
transparency, fair access, and systems capacity, integrity,
and security concerns raised by these particular
systems.[552]
VIII.Effective Dates and Compliance Dates
The rules and rule amendments adopted in this release
are effective on [insert date 120 days after publication in
the Federal Register], except for Exchange Act Rules
301(b)(5)(D) and (E) and Rules 301(b)(6)(D) and (E), which
shall become effective on April 1, 2000. Alternative
trading systems, however, will only have to comply with the
public display requirement in Rule 301(b)(3) for fifty
percent of the securities subject to this requirements on
[insert date 120 days after publication in the Federal
Register]. Alternative trading systems will have to comply
with Rule 301(b)(3) for all such securities by [insert date
240 days after publication in the Federal Register].[553]
Prior to [insert date 120 days after publication in the
Federal Register], the Commission will publish a schedule of
those securities for which alternative trading systems must
comply with Rule 301(b)(3) on [insert date 120 days after
publication in the Federal Register.]
IX. Costs and Benefits of the Rules and Amendments
To assist the Commission in its evaluation of the costs
and benefits that may result from the rules and amendments,
commenters were requested to provide analysis and data, if
possible, relating to the costs and benefits associated with
the proposals. The Commission initially identified certain
costs and benefits associated with its changes in the
Proposing Release. Although the Commission received seventy
comment letters, as of December 1, 1998 concerning the
proposed rules, none of the commenters responded
specifically to the request for comment on the cost/benefit
analysis. Some commenters did raise related issues and the
Commission will address those comments in this analysis.
After considering the comments, the Commission continues to
believe that the benefits of the rules and amendments
justify the associated costs.
A. Costs and Benefits of the Rules and Amendments
Regarding Alternative Trading Systems
The Commission identified several benefits and costs to
investors and market participants in the Proposing Release
with regard to alternative trading systems. The Commission
is not making any changes to the rules or amendments that
increase the cost estimates for alternative trading system
notice, reporting and recordkeeping obligations. The most
significant change the Commission is making in the rules as
adopted is to revise the fair access provisions. The rules
and amendments in the Proposing Release provided investors
with a right of appeal to the Commission and required
alternative trading systems to provide investors denied or
limited access to the system with notice of that action and
their right to appeal the decision to the Commission. The
Commission has decided not to adopt the right of appeal
provisions and the requirement of notice to investors denied
or limited access. Instead, alternative trading systems
with significant volume will be required to provide
quarterly notices to the Commission on Form ATS-R of all
grants, denials, and limitations of access as well as
descriptive information regarding those access decisions.
The net effect of these changes to the fair access
requirements is a decrease, relative to the original
proposal, in the burdens on alternative trading systems with
significant volume. Several commenters objected to the
proposed fair access rules on various grounds.[554]
Several commenters had general comments with regard to
the burdens imposed on respondents under Regulation ATS.
One commenter argued that the Commission should impose only
minimal requirements on start-up or smaller trading
systems.[555] The alternative trading system rules have
been tailored to minimize their burden on alternative
trading systems generally and small systems specifically.
Because many of the provisions in the rules are triggered by
a volume threshold, the Commission expects that small
alternative trading systems will not have sufficient volume
to trigger those thresholds and will, therefore, not have to
comply with those provisions. The recordkeeping and
reporting requirements with which smaller, lower volume
alternative trading systems will have to comply under
Regulation ATS are substantially similar to those with which
alternative trading systems currently comply. Consequently
the costs for smaller alternative trading systems should
remain unchanged.
One commenter argued that material changes on Form ATS
should be reported twenty days after such a change is made
rather than twenty days before.[556] The Commission
believes that is important to have some advance notice of
significant changes in order to permit it to carry out its
market oversight and investor protection functions. By
requiring notice before such changes are made, the
Commission has an opportunity to make inquiries to clarify
any questions that might arise. Currently, alternative
trading systems are required to give twenty days prior
notice of material changes on Part 1-A of Form 17A-23. This
burden remains unchanged under the new rules.
Several commenters pointed out areas for possible
reductions of regulatory overlap. One commenter argued that
the Commission should eliminate those broker-dealer
requirements that would be irrelevant for alternative
trading systems.[557] The Commission, however, does not
believe that the broker-dealer requirements as they apply to
alternative trading systems, are irrelevant or overly
burdensome. Another commented that recordkeeping burdens
should be coordinated with the NASD’s OATS program.[558]
These recordkeeping rules do not specify the manner in which
such records must be maintained, but only that they must be
made available upon request. Such records may be required
for other purposes, but it is important to assure that all
alternative trading systems maintain records sufficient to
construct an audit trail.
One commenter argued that the Commission’s rules and
amendments impose costs and burdens on market innovators
rather than encouraging such systems.[559] As discussed
above, however, the Commission does not intend its new
regulatory framework to impose a penalty on systems because
of their use of technology. The Commission’s new framework
is based on the functions performed by a trading system, not
on its use of technology.
Finally, a large number of institutional subscribers to
alternative trading systems submitted comments within the
last two weeks. These commenters expressed a number of
concerns about the public display requirement. Among the
concerns voiced by these commenters was a concern about
decreasing liquidity, limiting a potentially advantageous
trading strategy, being able to provide best execution for
their clients, and increasing costs to execute trades. The
Commission responds to these concerns below.[560]
The Commission solicited comment on the feasibility of
permitting alternative trading systems to file forms
electronically. Three commenters supported electronic
filing as an option to reduce the burdens on
respondents.[561] While not feasible at this time, the
Commission intends to make electronic filing an option when
it is possible.
Three commenters argued that the Commission’s rules
should not apply to debt securities, in part, due to the
burdens that such requirements would place on a largely
decentralized market.[562] Other commenters supported
including debt securities within Regulation ATS.[563] The
Commission continues to believe that many of the same
concerns about the trading of equity securities on
alternative trading systems apply equally to the trading of
fixed income securities on alternative trading systems.
Debt securities are increasingly being traded on alternative
trading systems, similar to the way that equity securities
are traded. Accordingly, the Commission’s new regulatory
framework would require alternative trading systems trading
debt securities, other than alternative trading systems
trading solely government and related securities, to
register as an exchange or register as a broker-dealer and
comply with Regulation ATS. If an alternative trading
system chooses to register as a broker-dealer, Regulation
ATS applies the same notice, recordkeeping, and reporting
requirements on debt alternative trading systems as apply to
equity alternative trading systems. Because of the way the
debt market currently operates, however, the transparency
provisions do not apply to alternative trading systems that
trade debt securities. Only those alternative trading
systems that trade at least twenty percent of certain
categories of debt are be subject to the fair access
requirements[564] and the provisions governing systems
capacity, security, and integrity.[565]
Under the rules and amendments in this release,
alternative trading systems have a choice between
registering as a national securities exchange or registering
as a broker-dealer and complying with Regulation ATS. The
choice between these two options is complex and each
alternative trading system will make a choice based on its
business plan and the role it wishes to play in the market.
There are several factors that will have an impact on each
alternative trading system’s decision.
First, the regulatory costs associated with registering
and operating as a national securities exchange are higher
than the regulatory costs associated with registering as a
broker-dealer and complying with Regulation ATS. Second,
registered exchanges have national market system obligations
that require those exchanges to bear the expenses associated
with joining the CTA, CQS, and ITS plans. To offset some of
those costs, however, registered exchanges also participate
in the revenue generated from the sale of quotation
information. Third, registered exchanges are SROs and,
therefore, have obligations to surveil trading activity and
member conduct on the exchange. These obligations can be
significant in terms of time, personnel, and financial
resources. However, a significant advantage to a registered
exchange of being an SRO is that it is not subject to
oversight by a competitor. Fourth, registered exchanges are
subject to the statutory requirement to provide fair access,
which requires a commitment of resources to consider
membership applications and to report denials to the
Commission and defend any denial decisions before the
Commission if an appeal is made.
Because of the range of obligations of registered
exchanges, operation as an exchange requires a significant
investment of financial resources. A relatively high volume
of trading may be required to justify this financial
investment. While the advent of for-profit and non-member
owned exchanges may make it easier to raise the financial
resources necessary to operate as a registered exchange, the
Commission does not expect that many alternative trading
systems will choose to register as exchanges.
On the other hand, alternative trading systems that
register as broker-dealers must comply with the filing and
conduct obligations associated with being a registered
broker-dealer including membership in an SRO and compliance
with that SRO’s rules. They must also comply with
Regulation ATS, which includes filing, recordkeeping and
reporting obligations. Unlike registered exchanges,
alternative trading systems are subject to oversight by an
SRO, which may operate a competing market. Regulation ATS
is designed to impose few requirements on lower volume
alternative trading systems. Only alternative trading
systems with significant volume are required to link to an
SRO and publicly display orders, provide investors with fair
access, and comply with systems capacity, integrity, and
security requirements. These obligations for alternative
trading systems with significant volume are similar,
although not identical, to obligations of registered
exchanges. Therefore, it is more likely that a high volume
alternative trading system will consider the costs and
benefits of registering as an exchange to be more comparable
to the costs and benefits of regulation as a broker-dealer
alternative trading system. The costs associated with
regulation as a registered exchange, and with operating as a
broker-dealer and complying with Regulation ATS are
discussed more fully below.
1. Benefits
a. Improved Market Transparency
The Commission’s amendments and rules enhance
transparency of trading on alternative trading systems.
Transparency of orders helps ensure that publicly available
prices fully reflect overall supply and demand and helps
reduce the negative consequences of market fragmentation
(e.g., the chance that an order for a security in one market
will be executed at a price inferior to that available at
the same time in another market). The Commission has been
particularly concerned that the development of so-called
"hidden markets," in which a market participant privately
publishes quotations at prices superior to the quotation
information it disseminates publicly, impedes national
market system objectives. Some systems that permit this
activity have become significant markets in their own right,
but are not currently required to integrate their orders
into the public quote because they are not registered as
national securities exchanges or national securities
associations.
For alternative trading systems choosing to register as
broker-dealers, the Commission’s amendments and rules
improve the transparency of orders in systems that account
for a significant portion of the trading volume in any
security. The amendments and rules help to incorporate
alternative trading system quotes into the national market
system, thus reducing fragmentation, improving liquidity,
facilitating price discovery, and narrowing the quoted
spread.[566]
Because non-market maker broker-dealers and
institutions at times enter the best priced orders in an
alternative trading system, the Commission expects that
display of these orders in the public quote will also
improve the NBBO. For example, of all orders on ECNs by
non-market maker broker-dealers and institutions that could
improve the NBBO if included in the public quote stream,
only about six percent of those orders were actually entered
into the public quote stream. Consequently, about ninety-
four percent of those orders that could have improved the
NBBO were not included in the public quote stream and thus
did not impact the NBBO. These orders were therefore
unavailable to some investors, in particular, retail
investors, who do not have direct access to ECNs. The
unavailability of these quotes continues to effectively
result in a two-tiered market. While the Commission is
unable to precisely quantify the market impact of these
changes, it does believe that the benefit for investors will
be significant based on preliminary estimates.
Based on an analysis of ECN trading activity during a
four day period in June 1997 (June 23, 1997 to June 27,
1997), the staff estimates that spreads could decrease by as
much as four percent for Nasdaq issues when non-market maker
broker-dealer and institutional orders are displayed in the
public quote. In making this estimate, the staff has
assumed an average spread of 35 cents per share, a maximum
increase of eleven percent for the times that ECNs could
narrow the inside, and a maximum of 12.5 cents per share
improvement. In addition to the effects on the bid-ask
spread, retail investors and other non-subscribers will gain
access to the liquidity and better prices now available only
to alternative trading system subscribers. Moreover,
because many broker-dealers offer retail customers automatic
execution of their small orders at the publicly quoted
price, a better price in the public quote potentially
improves the price received by thousands of broker-dealer
customers. Larger orders negotiated between institutions
and broker-dealers also potentially benefit because the
price negotiated will reflect a smaller spread. For these
reasons, the Commission believes that new display and access
requirements will result in significant benefits to
investors.
The above data is consistent with the results of the
transparency improvements achieved through the
implementation of the Order Handling Rules.[567] The NASD
studied the effect of the Order Handling Rules on the Nasdaq
market by comparing various measures between a pre-period of
twenty days in the beginning of 1997 (December 18, 1997 to
January 17, 1998) and a post-period of twenty days in the
beginning of 1998 (January 5, 1998 to February 2, 1998).
The success of the Order Handling Rules further supports the
view that the amendments and rules the Commission is
adopting today will further investors’ opportunities to
trade at the best prices.
In its study, the NASD also found that quoted spreads
in the Nasdaq market decreased by an average of forty-one
percent. The NASD estimates that this reduction in spreads
resulted in annual savings to investors of between $284
million and $673 million. Because of the increased market
transparency provided by the display of institutional and
non-market maker broker-dealer orders, the Commission
believes that the rules and amendments in this release will
also further shrink spreads.
Finally, the Commission believes that improved
transparency of orders in alternative trading systems will
reduce the potential for alternative trading system
subscribers to manipulate the public market. It has been
alleged that institutions and non-market makers
intentionally influence the market by displaying an order in
an alternative trading system that locks the price displayed
in the public market. For example, if the public market is
displaying a bid of 20 and an offer of 21, an institution or
non-market maker might display an offer of 20 in an
alternative trading system. Market participants often then
assume that the order in the alternative trading system
indicates the direction in which the market is moving and
begin selling to market makers bidding 20, pushing the
public market lower. The price in the alternative trading
system is then canceled and the institution or non-market
maker buys securities at a lower price. This type of
activity is possible only because institution and non-market
maker orders in alternative trading systems are not
displayed to the public market. The Commission believes
that the integrity of the public markets is threatened when
institutions and non-market makers can affect the public
markets without participating in them.
The transparency of trading on alternative trading
systems that choose to register as exchanges will also
improve. All registered exchanges are expected to
participate in the national market system plans, such as the
CTA, CQS, and ITS. These plans form an integral part of the
national market system, and contribute greatly to the
operation of linked, transparent, efficient, and fair
markets. In addition to improving transparency, alternative
trading system participation in these market-wide mechanisms
will benefit investors by reducing trading fragmentation.
b. Improved Investor Protections
The Commission’s amendments and rules provide benefits
to investors by improving the surveillance of trading on
alternative trading systems. Adequate surveillance of the
trading on alternative trading systems is critical to the
continued integrity of our markets. This is particularly
the case with regard to alternative trading systems that
have a significant percentage of the trading volume in one
or many issues of securities. The oversight of trading
activities on alternative trading systems that choose to
register as broker-dealers will improve because the
proposals clarify the relationship between SROs and
alternative trading systems.
The notice, reporting, and recordkeeping requirements
under Regulation ATS also contribute to the Commission’s and
the SROs’ ability to effectively oversee alternative trading
systems regulated as broker-dealers. The Commission
believes that these enhancements to the surveillance and
oversight of alternative trading systems regulated as
broker-dealers benefit the public by helping to prevent
fraud and manipulation.
The surveillance of trading on alternative trading
systems that choose to register as exchanges under the
Commission’s proposal will also be improved. All registered
exchanges are SROs, which have direct obligations to surveil
the trading on their own markets. The Commission believes
that, through improved surveillance mechanisms, it will be
better able to detect fraud and manipulation that could
occur on alternative trading systems. For example,
alternative trading systems can be used to artificially
narrow the NBBO spreads for the sole purpose of trading
through a broker-dealer’s automatic execution system at the
artificial prices.[568] The Commission and the SROs will be
able to more readily detect such activity through enhanced
surveillance. The Commission believes that this more direct
oversight of trading activities will therefore benefit
investors and the market generally by helping to prevent
fraud and manipulation.
c. Fair Access
The Commission’s rules require alternative trading
systems with significant volume to provide a fair
opportunity to participate in alternative trading systems.
Fair and non-discriminatory treatment of potential and
current subscribers by alternative trading systems is
important, especially when an alternative trading system
captures a large percentage of trading volume in a security.
Although an alternative trading system with significant
volume is required to provide access to orders that it is
required to display in the public quote stream, there are
other benefits to direct participation on an alternative
trading system. In particular, participation on an
alternative trading system allows an investor to enter its
own orders, view contingent orders not publicly displayed
(such as all or none orders) and use special features of an
alternative trading system, such as a negotiation feature or
reserve size feature. Accordingly, the rules prevent
discriminatory denials of access and ensure that market
participants are not prevented from gaining access to
significant sources of liquidity.
d. Systems Capacity, Integrity, and
Security
The Commission believes that its rules regarding
systems capacity, integrity, and security of alternative
trading systems provide several benefits to the marketplace
and to investors. Marketplaces are increasingly reliant on
technology and most of their functions are becoming highly
automated. Alternative trading systems are subject only to
business incentives to avoid system breakdowns that may
disrupt the market. In the past, alternative trading system
failures have affected the public market, particularly
during periods of high trading volume. Some alternative
trading systems have had prolonged shut-downs during the
busiest trading sessions due to systems problems. For
example, during the past year, Instinet, Island, Bloomberg,
and Archipelago (operated by Terra Nova) have all
experienced systems outages due to problems with their
automated systems. On a number of occasions, ECNs have had
to stop disseminating market maker quotations in order to
keep from closing altogether, including during the market
decline of October 1997 when one significant ECN withdrew
its quotes from Nasdaq because of lack of capacity.
Similarly, a major IDB in non-exempt securities experienced
serious capacity problems in processing the large number of
transactions in October 1997 and had to close down
temporarily.
The Commission’s rules require alternative trading
systems that handle a significant volume of trades to
establish reasonable capacity estimates, conduct stress
tests, implement procedures to monitor system development,
review systems vulnerability, and establish adequate
contingency plans. Investors will benefit from the rules
because significant systems will be less likely to shut down
as a result of systems failures and will be better equipped
to handle market demand and provide liquidity during periods
of market stress. The ability of alternative trading
systems to provide more reliable and consistent service in
the market benefits investors and the public markets
generally. The Commission also believes that investors will
benefit from robust system security provided by ensuring
that significant alternative trading systems maintain
sufficient security measures to prevent unauthorized access.
All currently registered exchanges participate in the
Commission’s automation review program. Alternative trading
systems that choose to register as exchanges will similarly
be expected to participate in this program. Under the
automation review program, exchanges are expected to
maintain sufficient systems capacity to meet current and
anticipated volume levels. The benefits to investors and
the public generally, as with significant alternative
trading systems, will be the assurance that systems are
reasonably equipped to handle market demand and provide
liquidity during periods of market stress.
2. Costs
The alternative trading system rules and amendments
have been tailored to minimize their burden on alternative
trading systems and especially small systems. Many of the
provisions in the rules and amendments are triggered by a
volume threshold. The Commission expects that small
alternative trading systems will not have sufficient volume
to trigger those thresholds and will therefore not have to
comply with those provisions. The recordkeeping and
reporting requirements with which smaller, lower volume
alternative trading systems have to comply under Regulation
ATS are substantially similar to those with which
alternative trading systems currently comply. Consequently
the costs for smaller alternative trading systems should
remain materially unchanged. The paperwork, filing, and
recordkeeping costs are discussed in the Paperwork Reduction
Act section below.
a. Notice, Reporting, and Recordkeeping
All alternative trading systems that will be subject to
notice, reporting, and recordkeeping requirements under the
Commission’s new rules are currently subject to similar
requirements under Rule 17a-23. The requirements under
Regulation ATS, however, require some additional information
that is not currently required under Rule 17a-23.
Under Regulation ATS, alternative trading systems file
an initial operation report, notices of material systems
changes, and quarterly reports. The rules also include new
Forms ATS and ATS-R to standardize reporting of such
information and make it more useful for the Commission. The
rules require information that is not currently required
under Rule 17a-23, such as greater detail about the system
operations, the volume and types of securities traded,
criteria for granting access to subscribers, procedures
governing order execution, reporting, clearance and
settlement, procedures for reviewing systems capacity and
contingency procedures, and the identity of any other
entities involved in operating the system.
Regulation ATS requires staff time to comply with the
initial notice and amendment requirements. While the
Commission has designed the requirements in an effort to
balance the costs of filing with the benefits to be gained
from the information, some effort will be necessary to
gather and file this information. Most of the information,
however, already exists. Alternative trading systems will
only be required to gather this information and supply it in
the required format to the Commission. The periodic
updating requirements will also require staff time over the
life of the alternative trading system to comply with the
rules.
The Commission estimates that there are currently about
forty-five alternative trading systems that will be required
to register as exchanges or register as broker-dealers and
comply with Regulation ATS.[569] The Commission also
estimates that, over time, there will be approximately three
new alternative trading systems each year that choose to
register as broker-dealers and comply with Regulation
ATS.[570] The Commission also estimates that, over time,
there will be approximately three alternative trading
systems that file cessation of operations reports each year.
Thus, the Commission anticipates that, over time, if all
forty-five current alternative trading systems choose to
register as broker-dealers and comply with Regulation ATS,
there will be approximately forty-five alternative trading
systems operating each year.
b. Public Display of Orders and Equal
Execution Access
Regulation ATS requires that alternative trading
systems with significant volume display their best-priced
orders for securities in which they have 5 percent or more
of total trading volume in the public quote. The Commission
identified the anticipated benefits of this requirement
above. Below is a discussion of possible costs associated
with this requirement.
One possible cost is the impact on institutional order
flow to alternative trading systems generally. Institutions
have several options available to them to execute trades.
They can send orders to block trading desks, a number of
different types of alternative trading systems, or directly
to registered exchanges through broker-dealer give-ups.
Although not currently displayed to the public, orders sent
to an alternative trading system by institutions are
displayed to other alternative trading system
subscribers.[571] Thus, placing large orders, or a series
of successive small orders, in an alternative trading system
signals to a large number of sophisticated market
participants the interest in a particular security.
The Commission is not persuaded by commenters that
suggest that institutions currently willing to use
alternative trading systems to display their orders to other
alternative trading system subscribers, including other
institutions, market-markers, and broker-dealers, will be
less willing to use alternative trading systems that must
display those orders to the public market. Our reasons are
as follows. The primary group of market participants that
will benefit from the public display of institutional orders
is retail investors. Retail investors are not currently
alternative trading system subscribers. To avoid market
impact, institutions try to avoid signaling other
institutions and market professionals, not retail investors.
Almost all market professionals and a significant number of
institutions already subscribe to alternative trading
systems. Thus, the Commission believes that the additional
exposure to the market should not affect institutions’ use
of alternative trading systems. Moreover, to the extent
that institutions want to display small sized orders in the
public market, rather than their entire order, they will
still be able to make use of an alternative trading system’s
"reserve size" feature. This will enable institutions to
avoid exposing the total size of their order to the public
market.
Nonetheless, assuming institutions do have a preference
for showing their sized orders to other alternative trading
system subscribers but not the public market, there may be
two reactions by institutions. First, institutions could
choose to move their orders to more opaque venues, such as
block trading desks. The cost of this movement of orders
would be a loss of transparency to the limited group of
alternative trading system subscribers who now benefit from
the display of institutional orders on alternative trading
systems, and the loss of business to alternative trading
systems. While block trading desks would benefit from the
increased business, it likely would increase institutions’
transaction costs. For this reason, as well as those
discussed above, the Commission believes it unlikely for
institutions to react this way. Second, because the public
display requirement only applies to alternative trading
systems with five percent or more of the volume in a
particular security, there is a possibility that
institutions may move their order flow to smaller
alternative trading systems in order to avoid the public
display requirement. Such movements of order flow could
benefit some alternative trading systems in the form of
increased revenue and be a cost to other alternative trading
systems who lose revenue.
Currently, alternative trading systems are able to
attract subscribers because prices in their systems are
often better than the prices available in the public
markets. Because alternative trading systems are now
required to publicly display their best priced orders for
securities in which they represent five percent or more of
the trading volume, the best priced orders for certain
securities will also be available through the public
markets. Alternative trading systems will no longer be
able to provide subscribers with the unlimited ability to
avoid public display in the NBBO and possible interaction
with non-subscribers. Consequently, some subscribers could
leave an alternative trading system if they think there are
fewer advantages than before in having direct access to the
alternative trading system.
However, the growth of ECNs since the Order Handling
Rules were implemented indicates that alternative trading
systems can, and are, attracting subscribers.[572] As
mentioned above, there are still significant benefits to
being a subscriber to an alternative trading system,
including, but not limited to: the ability to enter orders
and the use of such features as a negotiation feature or a
"reserve size" feature; the ability to access the best
priced orders for securities in which an alternative trading
system represents less than 5 percent of the trading volume
and therefore is not subject to the transparency
requirements; and access to the entire "book," not merely
the "top of the book," that contains important real-time
market information regarding depth of trading interest. All
of these benefits will be retained under the new display
requirement.
Despite the impact on high volume alternative trading
systems, integrating their best-priced orders into the
public market is critical to the national market system.
Section 11A of the Exchange Act directs the Commission to
facilitate a national market system and to carry out
Congress’ objectives of, among other things, assuring "the
practicability of brokers executing investors’ orders in the
best market."[573] The public display requirement adopted
today furthers the objectives in Section 11A of the Exchange
Act by ensuring that the public markets reflect the best
priced orders displayed in alternative trading systems that
have a significant trading market in particular securities.
Several commenters also expressed concern about whether
or not alternative trading systems will be permitted to
continue charging fees to non-subscribers that access
alternative trading systems publicly displayed orders.
Currently, alternative trading systems charge a range of
fees to subscribers. In particular, alternative trading
systems may allow institutional subscribers to select higher
fees and then have soft-dollars rebated in an amount equal
to the excess above the actual cost for execution of a
trade. Because of the presence of soft dollars, it is
difficult to estimate the amount of revenue that alternative
trading systems receive from institutional subscribers. The
Commission notes, however, that it is not requiring
alternative trading systems to change their fee structures.
The Commission is merely limiting alternative trading
systems to charging non-subscribers fees that are consistent
with equivalent access.[574] The Commission does not
believe that such limitations will substantially affect an
alternative trading system’s revenues. In fact, some
alternative trading systems may have increased revenues from
the fees charged to non-subscribers.
The rules the Commission is adopting today prohibit an
alternative trading system from charging fees that would
effectively deny non-subscribers equivalent access to an
alternative trading system’s publicly displayed orders. As
long as a fee does not deny equivalent access, it would be
permissible under these rules. The SROs will be able to
establish rules to ensure that alternative trading system
fees are not inconsistent with the standard of equivalent
access. Any SRO rule impacting an alternative trading
system’s access fees would have to be filed with the
Commission for public comment, review, and approval. The
Commission cannot approve any SRO rule unless it finds that
such rule is consistent with the Exchange Act, including
whether the rule will promote "efficiency, competition, and
capital formation."[575]
As discussed above, one of the expected benefits of
displaying the best-priced orders in alternative trading
systems to all investors is that spreads will shrink. The
success of the Order Handling Rules indicates that the
Commission’s current proposal should further enhance
liquidity and price improvement opportunities in the public
markets. Because non-market maker broker-dealers and
institutions at times enter the best priced orders in an
alternative trading system, the Commission expects that
display of these orders in the public quote will improve the
NBBO. As a result, some market markers may experience a
loss of revenue. For example, a market maker may currently
be at the NBBO even when an alternative trading system is
better than that market maker’s bid or offer. Accordingly,
if the better priced institutional or non-market maker
broker-dealer order were displayed in the public quote, that
market maker would not execute an order unless it improved
its quote. While reduced spreads may represent a cost to
market makers, as discussed above, it represents a
corresponding benefit to investors. Moreover, reduced
spreads make the overall market more efficient by reducing
transaction costs. If trading is less expensive, all other
things being equal, investors can be expected to trade more.
The staff also notes that a market maker is not
required to execute a customer order at the NBBO if the best
available price is represented by an alternative trading
system quote. Instead, a market maker may attempt to
execute that customer order against the alternative trading
system quote. If the market maker acts as agent in
effecting the customer’s trade, it may be entitled to a
brokerage fee. Therefore, market makers may be able to
offset, at least partially, the loss of trading profits with
additional brokerage revenues.
c. Fair Access
Under Regulation ATS, alternative trading systems with
significant volume are required to establish and maintain
standards for granting access to their system and keep
records of such standards. In addition, such alternative
trading systems must apply those standards in a fair and
non-discriminatory manner and submit certain information
regarding grants, denials, and limitations of access with
their quarterly reports on Form ATS-R. Based on current
volume estimates, at most two alternative trading systems
will be initially subject to this requirement. The
Paperwork Reduction Act section of this release summarizes
the filing and recordkeeping costs associated with the fair
access requirement.
The fair access requirement, as adopted, differs from
that proposed. The proposal would have provided market
participants who believe they had been unfairly denied or
limited access to an alternative trading system subject to
the fair access requirement with a right to appeal that
alternative trading system’s action to the Commission.
Alternative trading systems subject to the fair access
requirement would also have been required to provide
investors with notice of a denial or limitation of access
and their right to appeal that action to the Commission.
The fair access requirement being adopted today does not
include any right to appeal an alternative trading system’s
access decisions to the Commission. Instead, the Commission
intends to enforce the prohibition on alternative trading
systems with significant volume unfairly denying access
through its inspection and enforcement authority. The
Commission believes the fair access requirement it is
adopting will be less costly to alternative trading systems
than the one proposed because alternative trading systems
will not be required to defend their access decisions in
appeals before the Commission. Moreover, the requirement
adopted does not require alternative trading systems to send
notice of their decisions to market participants.
d. Systems Capacity, Integrity, and
Security
The Commission does not believe that its amendments and
rules requiring alternative trading systems to meet certain
systems related standards imposes significant costs. The
standards the Commission is adopting are general standards
that are consistent with good business practices. In
addition, smaller alternative trading systems will not be
subject to the proposed requirements. For those alternative
trading systems that do not, for business reasons alone,
ensure adequate capacity, integrity, and security of their
systems, there will be costs associated with complying with
the requirements. The costs associated with upgrading
systems to an adequate level may include, for example,
investing in computer hardware and software. In addition,
alternative trading systems will incur costs associated with
the independent review of their systems on an annual basis.
An independent review should be performed by competent,
independent audit personnel following established audit
procedures and standards. If internal auditors are used by
an alternative trading system to complete the review, these
auditors should comply with the standards of the EDPAA. If
external auditors are used, they should comply with the
standards of the AICPA and the EDPAA. The review must be
conducted according to established procedures and standards.
The costs involved may vary widely depending on the business
of the alternative trading system. Alternative trading
systems will also be subject to paperwork burdens and
recordkeeping and reporting requirements. These
requirements are necessary for the Commission and the
appropriate SROs to ensure compliance with systems related
requirements. In addition, keeping such records permits
alternative trading systems to effectively analyze systems
problems that occur. While alternative trading systems are
not required to file such documentation with the Commission
on a regular basis, the Commission recognizes that
generating and maintaining such documentation will impose
some additional costs.
The notification requirement for material systems
outages should impose relatively little additional costs on
alternative trading systems. Moreover, the Commission
believes that this small burden is justified by the need to
keep Commission staff abreast of systems’ developments and
problems. The Paperwork Reduction Act section of this
release summarizes the costs associated with the
recordkeeping and reporting burdens of compliance with the
systems capacity, integrity, and security requirements.
e. Costs of Exchange Registration
The framework the Commission is adopting today for
alternative trading systems is designed to allow such
systems the option of registering as national securities
exchanges. If an alternative trading system chooses to
register as an exchange, corresponding regulatory
obligations could impose costs on such systems, however, the
elective nature of exchange regulation under the framework
the Commission is adopting today ensures that only those
entities for whom it is cost-effective will choose exchange
registration and therefore bear the costs.
For example, exchange-registered alternative trading
systems will have to be organized to, and have the capacity
to, carry out the purposes of the Exchange Act, including
their own compliance and the ability to enforce member
compliance with the securities laws. Consequently, any
newly registered exchange will have to establish appropriate
surveillance and disciplinary mechanisms. In addition,
newly registered exchanges will incur certain start-up costs
associated with this obligation, such as writing rule
manuals.
National securities exchanges currently operating have
significant assets and expenses in order to carry out their
functions. The cost of acquiring the necessary assets and
the operating funds required to carry out the day-to-day
functions of a national securities exchange are significant.
For example, for the fiscal year 1997, the NYSE had total
assets of $1,174,887,000 and total expenses of $488,811,000.
The Cincinnati Stock Exchange ("CSE"), currently the only
completely automated national securities exchange, had total
assets of $13,124,585 and total expenses of $5,343,403. Due
to these costs, it appears that an alternative trading
system will need to have significant volume in order to make
the benefits of exchange registration outweigh the costs.
As registered exchanges, alternative trading systems
will also be subject to more frequent inspection by the
Commission. As broker-dealers, alternative trading systems
will be inspected on a regular basis by any SRO of which
they are a member, and by the Commission only on an
intermittent basis. As registered exchanges, these systems
will be inspected more regularly by Commission staff, but
will, of course, no longer be subject to examinations by
SROs.
The Commission inspects different SRO programs on
independent review cycles. For example, separate
inspections are conducted for an SRO’s surveillance,
arbitration, listings, and financial soundness programs.
Where appropriate, SROs will be examined for other programs
they may operate, such as index programs. Each type of
examination will be performed at regular intervals, which
are typically two to three years. An SRO, however, may
expect several examinations throughout a particular year,
each in a different program. Each examination typically
involves three to four attorneys and/or accountants from the
Commission, who spend one week at the SRO, or up to two
weeks for particularly large programs, to examine records
and interview SRO personnel. In order to comply with
Section 17(b) under the Exchange Act, an SRO must expend
resources to provide copies of relevant documents to, and
answer questions from, the Commission staff. The cost to an
SRO of each examination varies greatly depending on the
scope of the examination and the size or complexity of the
SRO’s particular program.
In addition, there will also be costs associated with
meeting the obligations set forth in Section 11A of the
Exchange Act and the rules thereunder. These costs include
the costs of joining, or creating new, market-wide plans,
such as the CQS, CTA, ITS, and OTC-UTP, although some of
these costs will be offset by the right to share in the
revenues generated by these plans. For example, to join the
CTA plan, applicants will be asked to pay, as a condition to
entry into the plan, an amount that reflects the value of
the tangible and intangible assets created by the CTA plan
that will be available to the applicant.[576] Similarly,
new participants in ITS will have to pay a share of the
development costs, which will reflect a share of the initial
development costs, which were $721,631, and a share of costs
incurred after June 30, 1978.[577] These costs will also
include the costs of complying with Rule 11Ac1-1(b) under
the Exchange Act,[578] which requires national securities
exchanges and national securities associations to make the
best bid, best offer, and aggregate quotation size for each
security traded on its facilities available to quotation
vendors for public dissemination.[579] These costs will
vary depending on the nature and size of the systems
involved.
The Commission notes that the remaining costs will be
partially offset because the alternative trading systems
assuming the costs of exchange registration will no longer
be regulated as broker-dealers. Consequently, they will no
longer be obligated to comply with the broker-dealer
requirements, such as filing and updating Form BD,
maintaining books and records in accordance with Rules 17a-3
and 17a-4 under the Exchange Act, and paying fees for
membership in an SRO. In addition, because exchange-
registered alternative trading systems share the
responsibilities of self-regulation, the regulatory burden
carried by currently registered exchanges should be reduced.
Other benefits include the freedom from oversight by a
competing SRO, no obligation to comply with net capital
requirements, the right to establish trading and conduct
rules, the right to establish fee schedules, the ability to
directly participate in the national market system
mechanisms, and the right to share in the profits and
benefits produced by the national market system mechanisms
such as the CQS, CTA, ITS and OTC-UTP plans.[580]
The costs of exchange registration also include certain
paperwork, filing, and recordkeeping requirements. These
costs are discussed in the Paperwork Reduction Act section
below.
The Commission anticipates that only a few of the
existing alternative trading systems would consider
registering as a national securities exchange. For most of
the alternative trading systems currently in existence, the
Commission believes that the costs and obligations discussed
above potentially make registering as a national securities
exchange less commercially viable than registering as a
broker-dealer and complying with Regulation ATS.
B. Amendments to Application and Related Rules for
Registration as an Exchange
The Commission identified several costs and benefits to
investors and market participants in the Proposing Release
with respect to amendments to the application and rules for
exchange registration. Only two commenters identified areas
of concern regarding exchange registration. These
commenters suggested that the Commission was seeking to
reimpose annual filing requirements previously eliminated in
1994.[581] In response, the Commission has made technical
modifications to Rule 6a-2 to clarify the operation of the
rule. The Commission does not believe that these filing
burdens are reimposed under the rules as adopted. These
commenters also questioned the value of requiring exchanges
to compile and submit amendments to Form 1 that contain
information that has been provided to the Commission
throughout the year in other contexts. The Commission
continues to believe that it is important to have all the
required information gathered in one place in order to make
it useful for Commission staff. In addition, the additional
costs should be minimal because the respondents are required
only to compile existing documents rather than generate new
material.
1. Benefits
The Commission believes that the amendments provide
benefits to organizations that are currently registered, or
in the future will apply for registration, as national
securities exchanges. Generally, the Commission expects that
the regulatory framework discussed in this release
accommodates automated and for-profit exchanges and makes
registering as a national securities exchange more
commercially viable for possible future exchanges.[582]
First, the amendments to Rules 6a-1, 6a-2, and 6a-3 ease
compliance burdens by simplifying the rule. By simplifying
the rule language itself, the Commission anticipates that
parties attempting to comply with Rules 6a-1, 6a-2, and 6a-3
will be better able to understand the rules’ requirements
and comply with them. Much of the information required on
Form 1 will not change, but the revised form recasts the
questions and exhibits in a different format that will ease
compliance and make the responses more relevant to investors
and the Commission. While national securities exchanges
have traditionally been membership-owned, Form 1 also is
revised to accommodate proprietary national securities
exchanges.
Second, the amendments give national securities
exchanges the option of complying with certain ongoing
filing requirements by posting information on an Internet
web site and supplying the location to the Commission,
instead of filing a complete paper copy with the Commission.
The Commission anticipates that exchanges will choose to use
the Internet to comply with Rules 6a-2 and 6a-3 rather than
filing many exhibits on paper. The availability of such
information on the Internet will also provide the public
with easier and less expensive access to the information
than requesting paper copies from the Commission or the
national securities exchanges as currently required. In
addition, permitting exchanges to use the Internet as a
means of compliance will reduce expenses associated with
clerical time, postage, and copying.
The amended rules also reduce the frequency of certain
ongoing filings to update the information in Form 1,
directly reducing the compliance burden on national
securities exchanges while still meeting investors’ and the
Commission’s need for reasonably current information.
Specifically, the amendments eliminate exchanges’
requirement to submit changes to their constitution, their
rules, or the securities listed on the exchange within ten
days. The amendments also permit exchanges to file certain
information regarding subsidiaries and affiliates every
three years rather than annually. These amendments will
conserve registered exchanges’ staff time to comply with the
rules.
2. Costs
The amendments are intended to simplify the filing
requirements and reduce the compliance burdens for national
securities exchanges and will likely impose few additional
costs on national securities exchanges. Initially, there
may be some additional personnel costs required to review
the proposed rules and revised Form 1, but the Commission
believes that the simplified requirements will reduce
overall compliance burdens and costs over time. Reducing
the frequency of filings for some requirements may result in
some information being less current. The Commission,
however, believes that much of this type of information does
not change frequently. Moreover, the option of posting such
information on an Internet web site should encourage more
frequent updating of current information. Compliance with
Rules 6a-1, 6a-2, and 6a-3 also include certain paperwork
costs, which are discussed as "burdens" in the Paperwork
Reduction Act section below.
C. Costs and Benefits of the Repeal of Rule 17a-23
and the Amendments to Rules 17a-3 and 17a-4
The Commission identified several costs and benefits to
investors and market participants in the Proposing Release
with respect to Rules 17a-23, 17a-3, and 17a-4. One
commenter stated that the transfer of recordkeeping burdens
would impose no additional burdens.[583]
Approximately forty-five of the broker-dealer trading
systems currently filing reports under Rule 17a-23 will be
alternative trading systems under the amendments and rules
in this release. These trading systems will not fall within
the definition of "internal broker-dealer system," and will,
therefore, not be required to maintain records under the new
provisions of Rules 17a-3(a)(16) and 17a-4(b)(10). In its
Paperwork Reduction Act analysis, the Commission notes that
annual aggregate burdens for the recordkeeping obligations
under Rule 17a-23 will be eliminated. Although the
reporting requirements under Rule 17a-23 will be eliminated,
alternative trading systems will be subject to similar
recordkeeping requirements under Regulation ATS.[584] These
paperwork "burdens" are discussed below in the Paperwork
Reduction Act section.
D. SRO Pilot Trading System
The Commission identified several costs and benefits to
investors and market participants in the Proposing Release
with respect to Rule 19b-5. While the Commission solicited
comment on the costs and benefits of Rule 19b-5, no comments
were received specifically on that point. Several
commenters did, however, address the Commission’s proposal.
One commenter agreed that Rule 19b-5 would reduce regulatory
costs and encourage innovation, but believed that the rule’s
limitations should be reduced.[585] Two other commenters
expressed support for the goals of Rule 19b-5, but argued
that burdens wouldn’t be reduced as a practical matter due
to the limitations of the rule.[586] In response, the
Commission notes that it has adopted the rule with some
changes that should permit SROs more flexibility in taking
advantage of the temporary exemption from rule filing
requirements.
By permitting SROs to begin operating eligible pilot
trading systems immediately and to continue operating for
two years under a flexible regulatory scheme, the Commission
believes that Rule 19b-5 will benefit SROs and investors.
Rule 19b-5 will enhance competition in the trading markets
without imposing significant SRO compliance burdens.[587]
Rule 19b-5 will permit the timely implementation of pilot
trading systems without the widespread dissemination of
critical business information. Therefore, Rule 19b-5 will
reduce SRO costs associated with the Commission approval
process and improve the competitive balance between SROs and
alternative trading systems that are regulated as broker-
dealers.[588] Moreover, the Commission believes that Rule
19b-5 will foster innovation and create a streamlined
procedure for SROs to operate pilot trading systems and will
reduce filing costs for SROs pilot trading systems.
The costs of complying with Rule 19b-5 includes certain
paperwork, filing, and recordkeeping requirements that are
discussed below in the Paperwork Reduction Act section.
X. Effects on Competition, Efficiency and Capital
Formation
Section 23(a)(2)[589] of the Act requires that the
Commission, when promulgating rules under the Exchange Act,
to consider the impact any rule would have on competition
and to not adopt any rule that would impose a burden on
competition that is not necessary or appropriate in the
public interest. In the Proposing Release, the Commission
solicited comment on the effects on competition, efficiency
and capital formation of the rules and amendments.
Specifically, the Commission requested commenters to address
how the proposed rules and amendments would affect
competition between and among alternative trading systems,
broker-dealers, exchanges, investors, and other market
participants. The Commission received no comments
specifically regarding these issues.
The Commission has considered the rules and rule
amendment in light of the standards cited in Section
23(a)(2) of the Act and believes they would not likely
impose any significant burden on competition not necessary
or appropriate in furtherance of the Exchange Act. As
discussed above in the Cost - Benefit Section, the
Commission recognizes that some alternative trading systems
and their institutional users will be affected competitively
by the rules adopted today. Nonetheless, the Commission
believes that the rules and amendments will encourage
innovation, accommodate the growing role of technology in
the securities markets, improve transparency for market
participants and ensure the stability of trading systems
with a significant role in the markets, thereby furthering
the development of a national market system in accordance
with the goals under Section 11A of the Exchange Act. In
particular, as discussed above in the Cost - Benefit
Section, the Commission believes that the rules and
amendments will significantly reduce spreads, thereby
benefiting all investors.
In adopting these rules and amendments, the Commission
has considered whether the action will protect investors,
and promote efficiency, competition, and capital
formation.[590] The Commission believes that the rules and
amendments will allow the Commission to better oversee the
activities of alternative trading systems and integrate
alternative trading systems into the national market system.
The rules and amendments will also better accommodate
automated and for-profit exchanges and permit SROs to
operate pilot trading systems temporarily without Commission
approval. These steps will help to protect investors by
preventing discriminatory denials or limitations of access,
preventing systems related failures, and permitting access
to best-priced orders. In addition, alternative trading
systems should continue to compete based on innovation,
price, and service rather than access to "hidden markets."
Rules 3a1-1, 3b-16, and Regulation ATS adopted today
are intended to provide a choice between registering as a
broker-dealer and registering as an exchange for markets
operated as alternative trading systems.[591] In addition,
the amendments to Rules 6a-1, 6a-2, and 6a-3 adopted today
are intended to update the requirements for registered or
exempt exchanges in order to accommodate different forms of
organization and methods of operation. The Commission
believes that these changes will create a more efficient
market, encourage competition among alternative trading
systems, and stimulate capital formation by making the
regulatory framework sufficiently flexible to accommodate
new or different approaches to exchange formation and
operation, including automated and for-profit exchanges.
The Commission further believes that the costs identified in
the above analysis are not substantial enough to deter any
market participants from attempting to become an alternative
trading system.[592]
In addition, Rule 19b-5 and Form Pilot are intended to
provide SROs the opportunity to develop and operate pilot
trading systems with less cost and time delay. As
previously stated, currently, SROs are required to submit a
rule filing to the Commission and undergo a public notice,
comment, and approval process, before they operate a new
pilot trading system. Rule 19b-5 would permit SROs that
develop pilot trading systems to begin operation shortly
after submitting Form PILOT to the Commission. One of the
consequences of SROs filing rule changes before
implementation is that the rule filing process informs SROs’
competitors about the proposed pilot trading system and
provides an avenue for those competitors to copy, delay, or
obstruct implementation of a pilot trading system before it
can be tested in the marketplace. As a result, the
Commission believes that proposed Rule 19b-5 and Form Pilot
should help create a more efficient market, encourage
competition between SROs and alternative trading systems,
and stimulate capital formation by creating a streamlined
procedure for SROs to operate pilot trading systems and
reducing filing costs for SROs generally.
XI. Summary of Final Regulatory Flexibility Analysis
A Final Regulatory Flexibility Analysis ("FRFA") has
been prepared in accordance with Section 4 of the Regulatory
Flexibility Act ("RFA").[593] The FRFA relates to the
adoption of new rules 3a1-1,[594] 3b-16,[595] 19b-5,[596]
Regulation ATS,[597] new Forms ATS,[598] ATS-R,[599]
PILOT,[600] amendments to rules 6a-1,[601] 6a-2,[602] 6a-
3,[603] 11Ac1-1,[604] 17a-3,[605] 17a-4,[606] the
Commission’s Rules of Practice,[607] to Form 1, and the
repeal of Rule 17a-23[608] under the Exchange Act.[609] The
FRFA notes the potential costs of operation and procedural
changes that may be necessary to comply with the new rules
and rule amendments ("new regulatory framework"). A summary
of the Initial Regulatory Flexibility Analysis ("IRFA")
appeared in the Proposing Release.[610]
As more fully discussed in the FRFA, market
participants have developed a variety of alternative trading
systems that furnish services traditionally provided solely
by registered exchanges. Our current regulatory framework,
designed more than six decades ago, however, did not foresee
many of these trading and business functions. Alternative
trading systems now handle twenty percent or more of the
orders in securities listed on Nasdaq, and almost four
percent of orders in listed securities. Even though these
systems provide services that are similar to those provided
by the registered exchanges and Nasdaq, the current
regulatory framework largely ignores the market functions of
alternative trading systems. This creates disparities that
affect investor protection, market intermediaries, and other
markets. For example, activity on alternative trading
systems is not fully disclosed to, or accessible by, public
investors and may not be adequately surveilled for market
manipulation and fraud. Moreover, these trading systems
have no obligation to provide investors a fair opportunity
to participate in their systems or to treat their
participants fairly. In addition, they do not have an
obligation to ensure that their capacity is sufficient to
handle trading demand. Because of the increasingly
important role of alternative trading systems, these
differences call into question not only the fairness of
current regulatory requirements, but also the efficacy of
the existing national market system structure.
As described in the FRFA, under the new regulatory
framework, the Commission will offer trading systems a
choice between broker-dealer regulation and exchange
regulation. Specifically, the Commission proposed to allow
alternative trading systems to choose whether to register as
national securities exchanges, or to register as broker-
dealers and comply with additional requirements under
proposed Regulation ATS depending on their activities and
trading volume. In conjunction with this proposal, the
Commission proposed to repeal Rule 17a-23, which currently
requires alternative trading systems -- as well as broker-
dealer trading systems that are not alternative trading
systems -- to maintain certain records and file reports with
the Commission. The Commission also proposed amendments to
Form 1, which securities markets file to register as
national securities exchanges, and related rules. Finally,
to enable registered exchanges and national securities
associations to better compete in the fast changing
marketplace, the Commission proposed to temporarily exempt
certain pilot trading systems operated by such exchanges and
associations from the rule filing requirements of the
Exchange Act.
In the Proposing Release, the Commission solicited
public comment on the proposed new rules and rule amendments
which were designed to resolve many of the concerns raised
by alternative trading systems. As discussed in the FRFA,
commenters generally supported the Commission’s proposals
and welcomed the regulatory flexibility these proposals
offered. While no public comments were received in response
to the IRFA, several of the comments were related to the
IRFA. Several commenters encouraged the Commission to
accept electronic filings as a means of reducing the burden
on market participants. The Commission is, in fact, working
toward the goal of accepting filings in electronic form.
One commenter suggested that the Commission impose only
minimal regulatory requirements, if any, on alternative
trading systems that trade only minimal volume in order to
avoid erecting significant barriers to entry and innovation.
The Commission believes that the requirements of Regulation
ATS are minimal for new alternative trading systems,
especially as compared to the current no-action letter
process. Regulation ATS sets forth concrete requirements
for a system to operate, imposes only notice filings, and
reserves more burdensome requirements for high volume
systems. Another commenter stated that the reporting
requirements under proposed Regulation ATS are similar to
current Rule 17a-23 and, thus, are not inappropriately
burdensome. The Commission agrees and notes that most
current potential respondents under Regulation ATS already
have experience with the requirements and burdens associated
with Rule 17a-23, so Regulation ATS will not impose
significant new burdens on currently operating alternative
trading systems.
The Commission is adopting new Regulation ATS
substantially in the form it was proposed.
The FRFA addresses how the proposal would affect
broker-dealers that operate alternative trading systems and
internal broker-dealer trading systems that are small
entities. As more fully explained in the FRFA, the
Commission believes that the improved regulatory framework
provided by Regulation ATS justifies the costs incurred by
industry participants to comply with Regulation ATS. The
FRFA also describes the Commission’s consideration of
significant alternatives to Regulation ATS. The FRFA
concludes that the alternatives, in the context of the a new
regulatory framework, would not accomplish the stated
objectives of Regulation ATS. A copy of the FRFA may be
obtained by contacting Denise Landers, Attorney, Division of
Market Regulation, Securities and Exchange Commission, 450
Fifth Street, N.W., Mail Stop 10-1, Washington D.C. 20549.
XII. Paperwork Reduction Act
As explained in the Proposing Release, certain
provisions of the rules and rule amendments contain
"collection of information" requirements within the meaning
of the Paperwork Reduction Act of 1995 (44 U.S.C. 3501 et
seq.) ("PRA"). Accordingly, the Commission submitted the
collection of information requirements contained in the
rules and rule amendments to the Office of Management and
Budget ("OMB") for review and were approved by OMB which
assigned the following control numbers: Form 1, Rules 6a-1
and 6a-2, control number 3235-0017; Rule 6a-3, control
number 3235-0021; Rule 17a-3(a)(16), control number 3235-
0508; Rule 17a-4(b)(10), control number 3235-0506; Rule 19b-
5 and Form PILOT, control number 3235-0507; Rule 301, Form
ATS and Form ATS-R, control number 3235-0509; Rule 302,
control number 3235-0510; and Rule 303, control number 3235-
0505. The collections of information are in accordance with
Section 3507 of the PRA.[611] With regard to Rule 301, Form
ATS, and Form ATS-R, Rule 302, and Rule 303, the Commission
staff has changed its estimate of the paperwork burdens
slightly due to an increase in the estimated number of
respondents that will be affected and a change to the fair
access rules. Accordingly, the Commission has submitted a
PRA change worksheet to OMB.[612]
The collection of information obligations imposed by
the rules and rule amendments are mandatory. However, it is
important to note that an alternative trading system
operating as a broker-dealer is optional, operation of a
national securities exchange is optional, and operating a
pilot trading system is optional. The information
collected, retained, and/or filed pursuant to the rules and
rule amendments under Regulation ATS will be kept
confidential to the extent permitted by the Freedom of
Information Act [5 U.S.C. §§ 552 et seq.]. The information
collected, retained, and/or filed pursuant to the rules for
registration as a national securities exchange will not be
confidential and will be available to the public. The
information collected, retained, and/or filed pursuant to
the rules for operation of pilot trading systems will not be
confidential and will be made available to the public when
the pilot trading system starts to operate. An agency may
not conduct or sponsor, and a person is not required to
comply with, a collection of information unless it displays
a currently valid OMB control number.
The collections of information are necessary for
persons to obtain certain benefits or to comply with certain
requirements. As described in the Proposing Release, the
rules and rule amendments to which the collections of
information are related allow the Commission to respond to
the impact of technological developments in the securities
markets and permit the Commission to more effectively
oversee the growing number of alternative trading systems.
The collections of information are also necessary to permit
the Commission to effectively oversee SRO pilot trading
systems. With the exception of two changes to the final
rules, there are no material changes to the rules and
amendments as adopted that affect the burden estimates in
the Proposing Release. The Commission is adopting different
fair access requirements from those it published in the
Proposing Release. The Commission has determined to not
adopt the fair access requirements that would have required
investors denied or limited access to have a right to appeal
to the Commission and alternative trading systems making
access denial or limitation decisions to notify such
investors of the decision and their right of appeal to the
Commission. Instead, the Commission has decided to adopt
rules that require alternative trading systems to report
quarterly to the Commission a record of all grants, denials,
and limitations of access as well as other descriptive
information surrounding the decision. These changes
eliminate the proposed paperwork burden of providing notice
to investors and adds a compliance burden on Form ATS-R to
report such information to the Commission. Aggregate
paperwork burdens have also been revised to reflect updated
information regarding the estimated number of alternative
trading systems that will be subject to the rules. In the
Proposing Release, the Commission staff estimated that there
were approximately forty-three alternative trading systems
operating. The Commission staff now estimates that there
are forty-five alternative trading systems operating, so the
aggregate paperwork burdens have been revised to reflect
this change.
The Commission solicited public comment on the
collection of information requirements contained in the
Proposing Release. While the Commission received no
comments that specifically addressed the PRA portion of the
release, it did receive several comments that touched on PRA
related issues.
Several commenters encouraged the Commission to accept
electronic filings as a means of reducing the burden on
market participants. The Commission is, in fact, working
toward the goal of accepting filings in electronic form.
The Commission anticipates that the option of electronic
filing will be made available to respondents at some point
in the relatively near future. Several commenters also
suggested that the Commission reduce the burden on national
securities exchanges by relieving them of the obligation to
file annual amendments to Form 1 due to the same information
being submitted to the Commission in other forms
periodically throughout the year. The Commission believes
that it is important to have one complete annual filing that
compiles all the changes to the information contained on
Form 1 throughout the year and all other required SRO
information. Additionally, the Commission believes that
such a filing represents only a compilation of existing
information, so the additional burden of requiring an annual
filing is largely clerical and generally minimal.
One commenter suggested that the Commission impose only
minimal regulatory requirements, if any, on alternative
trading systems that trade only minimal volume in order to
avoid erecting significant barriers to entry and innovation.
The Commission believes that the requirements of Regulation
ATS are minimal for new alternative trading systems,
especially as compared to the current no-action letter
process. Regulation ATS sets forth concrete requirements
for a system to operate, imposes only notice filings, and
reserves more burdensome requirements for high volume
systems. Another commenter stated that the reporting
requirements under proposed Regulation ATS are similar to
current Rule 17a-23 and, thus, are not inappropriately
burdensome. The Commission agrees and notes that most
current potential respondents under Regulation ATS already
have experience with the requirements and burdens associated
with Rule 17a-23, so Regulation ATS will not impose
significant new burdens on currently operating alternative
trading systems.
As noted above in the Cost-Benefit section, below is a
summary of the paperwork burdens that were identified in the
Proposing Release. Although not mandated by the PRA, to
give regulated entities and others an understanding of the
paperwork costs, the discussion below provides dollar
estimates assuming certain labor costs.
A. Form 1, Rules 6a-1 and 6a-2
These amendments are intended to simplify the filing
requirements and reduce the compliance burdens for national
securities exchanges and will likely impose few additional
costs on national securities exchanges. Initially, there
may be some additional personnel costs required to review
the proposed rules and revised Form 1, but the Commission
believes that the simplified requirements will reduce
overall compliance burdens and costs over time. Reducing
the frequency of filings for some requirements may result in
some information being less current. The Commission,
however, believes that much of this type of information does
not change frequently. Moreover, the option of posting such
information on an Internet web site should encourage more
frequent updating of current information.
The Commission staff has estimated that each respondent
will incur an average burden of forty-seven hours to comply
with Rule 6a-1 and file an initial application for
registration on Form 1. This represents a two hour increase
from the current average burden due to the estimated
additional burden of the added exhibits. The Commission
staff has estimated that the average additional cost per
response will be approximately $30.[613] Because the
Commission receives applications for registration as an
exchange on Form 1 from time to time, and not on a
predictable basis, it cannot estimate the annual aggregate
costs and burden hours associated with such filings.[614]
The Commission notes that it is making no material
changes to Rule 6a-1, Rule 6a-2, or Form 1 from the
Proposing Release. Thus, the collection of information
burdens are not changing from those proposed.
B. Rule 6a-3
The Commission anticipates that the amendments will not
change the paperwork burden associated with complying with
Rule 6a-3. The Commission staff has estimated that the
average burden for each respondent to comply with Rule 6a-3
is one-half hour per response because compliance only
requires photocopying existing documents. The Commission
also estimates that each respondent will file supplemental
information under Rule 6a-3 approximately twenty-five times
per year. The estimated average cost per response for each
individual respondent is $9.50, resulting in an estimated
annual average cost burden for each respondent of
$237.50.[615]
C. Rule 17a-3(a)(16)
No additional recordkeeping burdens will be imposed on
internal broker-dealer systems under the amendments to Rule
17a-3. The amendments apply only to systems that are
presently subject to the recordkeeping requirements of Rule
17a-23. Because the Commission is repealing Rule 17a-23 and
amending Rules 17a-3 and 17a-4 by transferring the
recordkeeping requirements from Rule 17a-23, the Commission
does not anticipate any new recordkeeping costs or burdens
for respondents.
Based on Commission experience with the burdens
associated with Rule 17a-23, the Commission has estimated
the burdens that will be associated with Rule 17a-3(a)(16).
The Commission staff has estimated that there will be
approximately ninety-four broker-dealers operating one
hundred twenty-three internal broker-dealer systems that
will have to make the records described in Rule 17a-
3(a)(16). The Commission staff has estimated that each
respondent will spend approximately twenty-seven hours per
year keeping the required records under Rule 17a-3(a)(16) at
an annual cost of $1,298.16.[616] The aggregate burden for
approximately ninety-four broker-dealers operating internal
broker-dealer trading systems is estimated to be 2,619 hours
for a total average cost of $122,027.04.[617]
D. Rule 17a-4(b)(10)
No additional recordkeeping burdens will be imposed on
internal broker-dealer systems under the amendments to Rule
17a-4. The amendments apply only to systems that are
presently subject to the recordkeeping requirements of Rule
17a-23. Because the Commission is repealing Rule 17a-23 and
amending Rules 17a-3 and 17a-4 by transferring the
recordkeeping requirements from Rule 17a-23, the Commission
does not anticipate any new recordkeeping costs or burdens
for respondents.
Based on Commission experience with the burdens
associated with Rule 17a-23, the Commission has estimated
the burdens that will be associated with Rule 17a-4(b)(10).
The Commission staff has estimated that there will be
approximately ninety-four broker-dealers operating one
hundred twenty-three internal broker-dealer systems that
will have to keep the records described in Rule 17a-
4(b)(10). The Commission staff has estimated that each
respondent will spend approximately three hours to preserve
the required records under Rule 17a-4(b)(10) at an annual
cost of $144.24.[618] The aggregate burden for
approximately ninety-four broker-dealers operating internal
broker-dealer trading systems is estimated to be two hundred
eighty two hours for a total average cost of
$13,558.56.[619]
E. Rule 19b-5 and Form PILOT
For SROs that choose to operate pilot trading systems
and avail themselves of the provisions of Rule 19b-5,
compliance with Rule 19b-5 and the filings required on Form
PILOT are mandatory. Initial filings on Form PILOT are
confidential until the pilot system is operational and
subsequent filings are not confidential. Thus, after a
pilot trading system starts to operate, all filings on Form
PILOT are available to the public. Rule 19b-5 reiterates
SROs’ existing recordkeeping obligations under Rule 17a-1,
which requires that such records be kept for not less than
five years, the first two years in an easily accessible
place.
The Commission anticipates receiving approximately 6
notices per year regarding pilot trading systems on Form
PILOT.[620] An SRO will be required to submit a Form PILOT
providing detailed operational data and update this
information quarterly. The Commission staff has estimated
that an SRO will expend twenty-four hours to file an initial
operation report and three hours to file a quarterly report
and a systems change notice.[621] The Commission also
estimates that an SRO will file two amendments per year to
report changes to the system.[622] The Commission staff has
estimated that an SRO will expend $1,242 per initial Form
PILOT filing and $155 for each quarterly Form PILOT and
system change notice filed.[623] Thus, the total estimated
annual burden for SROs to comply with Rule 19b-5 by filing
an initial notice on Form PILOT is estimated to be one
hundred forty-four hours for a total average cost of
$7,452.[624] The total estimated annual burden for SROs to
file systems change notices and quarterly reports on Form
PILOT is estimated to be one hundred eight hours for a total
average cost of $5,580.[625]
F. Rule 301, Form ATS and Form ATS-R
For alternative trading systems that choose to register
as a broker-dealer, the requirements of Rule 301, Form ATS
and Form ATS-R are mandatory. All filings required under
Rule 301, Form ATS and Form ATS-R are considered
confidential and are not available to the public. All
records required to be made under the Rule are required to
be preserved for three years, the first two years in an
easily accessible place.
The alternative trading system amendments and rules
have been tailored to minimize their burden on alternative
trading systems and especially small systems. Many of the
provisions in the proposed rules are triggered by a volume
threshold. The Commission expects that small alternative
trading systems will not have sufficient volume to trigger
those thresholds and will therefore not have to comply with
those provisions. The recordkeeping and reporting
requirements with which smaller, lower volume alternative
trading systems have to comply under proposed Regulation ATS
are substantially similar to those with which alternative
trading systems currently comply. Consequently the costs
for smaller alternative trading systems should remain
unchanged.
1. Notice, Reporting, and Recordkeeping
All alternative trading systems that will be subject to
notice, reporting, and recordkeeping requirements under the
Commission’s rules as adopted today are currently subject to
similar requirements under Rule 17a-23. The requirements
under Regulation ATS, however, require some additional
information that is not currently required under Rule 17a-
23.
Under Regulation ATS, alternative trading systems file
an initial operation report, notices of material systems
changes, and quarterly reports. The rules also include new
Forms ATS and ATS-R to standardize reporting of such
information and make it more useful for the Commission. The
rules require information that is not currently required
under Rule 17a-23, such as greater detail about the system
operations, the volume and types of securities traded,
criteria for granting access to subscribers, procedures
governing order execution, reporting, clearance and
settlement, procedures for reviewing systems capacity and
contingency procedures, and the identity of any other
entities involved in operating the system.
Regulation ATS requires staff time to comply with the
initial notice and amendment requirements. While the
Commission has designed the requirements in an effort to
balance the costs of filing with the benefits to be gained
from the information, some effort will be necessary to
gather and file this information. Most of the information,
however, already exists. Alternative trading systems will
only be required to gather this information and supply it in
the required format to the Commission. The periodic
updating requirements will also require staff time over the
life of the alternative trading system to comply with the
rules.
The Commission staff has estimated that there are
currently about forty-five alternative trading systems that
will be required to register as exchanges or register as
broker-dealers and comply with Regulation ATS.[626] The
Commission also estimates that, over time, there will be
approximately three new alternative trading systems each
year that choose to register as broker-dealers and comply
with Regulation ATS.[627] The Commission also estimates
that, over time, there will be approximately three
alternative trading systems that file cessation of
operations reports each year. Thus, the Commission
anticipates that, over time, if all forty-five current
alternative trading systems choose to register as broker-
dealers and comply with Regulation ATS, there will be
approximately forty-five alternative trading systems
operating each year.
The Commission staff has estimated that the average
burden per respondent to file the initial operations report
on Form ATS will be twenty hours. This burden is computed
by estimating that completing the report will require an
average of thirteen hours of professional work and seven
hours of clerical work.[628] The Commission staff has
estimated that the average cost per response will be $1,019
representing the twenty hours and cost of supplies.[629] If
all forty-five alternative trading systems opt to register
as broker-dealers and comply with Regulation ATS, the total,
one time cost to comply with the proposed requirements to
file initial operation reports is estimated to be
$45,855.[630] The Commission also estimates that, over
time, approximately three new alternative trading systems
will register as broker-dealers per year, incurring an
annual aggregate burden of sixty hours for an average total
cost of $3,057 after the first year following adoption of
Regulation ATS.[631]
In addition, the rules require alternative trading
systems to amend their initial operations report to notify
the Commission of material systems changes and other changes
to the information contained in the initial operations
report. The Commission staff has estimated that each
respondent will file six such amendments per year.[632] The
Commission staff has estimated that each respondent will
incur an average burden of two hours per response and incur
an average cost of $111.50 for each amendment to the initial
operation report that it submits.[633] If all forty-five
alternative trading systems opt to comply with Regulation
ATS rather than to register as exchanges, the total
aggregate cost per year to comply with the proposed
requirement to file amendments to the initial operation
reports is estimated to be $30,105.[634]
Alternative trading systems registering as broker-
dealers will also be required to file quarterly reports on
Form ATS-R, reporting participating system subscribers, the
securities traded on the system, and aggregate volume
information. The Commission staff has estimated that the
quarterly reports will cause each respondent to incur an
average burden of 4 hours per response and incur an average
cost of $223 for each Form ATS-R that it submits.[635] The
annual burden per respondent is estimated to be $892.[636]
If all forty-five alternative trading systems opt to
register as broker-dealers and comply with Regulation ATS,
the total cost per year to comply with the requirement to
file quarterly reports is estimated to be $40,140.[637]
Finally, alternative trading systems registered as
broker-dealers will be required to submit a notice and a
report on Form ATS when they cease operations. The
Commission anticipates a total of three such filings per
year. The Commission staff has estimated that individual
respondents will incur a burden of two hours to file the
cessation notice. The Commission staff has estimated that
individual respondents will incur a cost of $111.50 to file
the cessation of operations report on Form ATS.[638] The
annual aggregate burden for three alternative trading
systems to file cessation of operations reports is estimated
to be $334.50.[639]
2. Fair Access
Under Regulation ATS, alternative trading systems with
significant volume are required to establish and maintain
standards for granting access to their system and keep
records of such standards. In addition, alternative trading
systems with significant volume are required to submit
certain information regarding grants, denials, and
limitations of access with their quarterly reports on Form
ATS-R. The Commission staff has estimated that each
respondent obligated to establish and maintain such records
will incur a burden of seventeen hours per year to make and
keep standards for granting access for a total estimated
cost of $958.50.[640]
Although these estimates reflect a program change from
the Proposing Release, the total burdens on respondents are
decreasing slightly as a result of the program changes. The
Commission is eliminating the proposal to require
alternative trading systems that deny investors access to
the system to provide them with notice of the denial and
their right of appeal to the Commission. Under the rules as
adopted, there is no right of appeal to the Commission. In
the Proposing Release, the Commission estimated that the
burden to comply with the notice requirement would be
approximately twenty-seven hours per year for each
respondent. Under the rules as adopted, such alternative
trading systems are required to submit fair access
information on Form ATS-R on a quarterly basis. The burden
for this requirement is only twelve hours per year for each
respondent. Thus, the changes from the Proposing Release
are anticipated to reduce the burden on each respondent by
approximately fifteen hours per year. The Commission staff
has estimated that only two respondents will be affected by
this program change, resulting in an aggregate reduction of
thirty burden hours for all respondents. This reduction,
however, is offset by an increase in the estimated number of
respondents. Specifically, the aggregate paperwork burden
for Rule 301, Form ATS, and Form ATS-R is increasing by one
hundred sixty hours due to updating the estimate of the
number of potential respondents from forty-three in the
Proposing Release to forty-five currently.
3. Systems Capacity, Integrity, and Security
The notification requirement for material systems
outages should impose relatively little additional costs on
alternative trading systems. Moreover, the Commission
believes that this small burden is justified by the need to
keep Commission staff abreast of systems’ developments and
problems.
The Commission staff has estimated that each respondent
will incur an average annual burden of fifteen hours to
comply with the recordkeeping requirements associated with
the systems capacity, integrity, and security provisions of
Regulation ATS. The Commission staff has estimated that
each respondent will make an average of five system outage
notices per year, for an estimated average burden of 1.25
hours per year.[641] The Commission staff has estimated
that the total estimated average cost of compliance for each
respondent will be $85 per year.[642] Such alternative
trading systems will also be required to keep records
relating to the steps taken to comply with systems capacity,
integrity, and security requirements under Regulation ATS.
The Commission staff has estimated that each respondent will
incur a burden of ten hours per year to comply with such
recordkeeping requirements for a total estimated cost of
$675 per year.[643] The Commission staff has estimated that
two alternative trading systems will be required to comply
with the systems capacity, integrity, and security
provisions of Regulation ATS due to their significant
volume. The estimated aggregate cost for these alternative
trading systems chose to comply with the systems capacity,
integrity, and security requirements is $1,520.[644]
G. Rule 302
Rule 302 requires alternative trading systems to make
certain records with respect to trading activity through the
alternative trading systems. This collection of information
will permit the Commission to detect and investigate
potential market irregularities and to ensure investor
protection. Such information is not available in any other
form from any other sources.
For alternative trading systems that choose to register
as a broker-dealer, the requirements of Rule 302 are
mandatory. All records required to be made under Rule 302
are considered confidential and are not available to the
public. All records required to be made under the Rule are
required to be preserved for three years, the first two
years in an easily accessible place.
The Commission staff has estimated that each
alternative trading system that chooses to register as a
broker-dealer will be required to expend an average of
thirty-six hours to comply with Rule 302 at an average cost
of $1,730.88.[645] If all forty-five alternative trading
systems opt to register as broker-dealers, rather than as
exchanges, the total cost for recordkeeping under Rule 302
is estimated to be $77,889.60 per year.[646]
The Commission notes that it is making no material
changes to Rule 302 from the Proposing Release. The
collection of information burdens are increasing slightly
due to an updated estimate of the number of respondents and
not due to any changes to the rule as proposed.
H. Rule 303
Rule 303 requires alternative trading systems
registered as broker-dealers to preserve certain records
produced under Rule 302, as well as standards for granting
access to the system and records generated in complying with
the systems capacity, integrity and security requirements
for alternative trading systems with significant trading
volume. Alternative trading systems registered as broker-
dealers are not required to file such information, but
merely to retain it in an organized manner and make it
available to the Commission upon request.
For alternative trading systems that choose to register
as a broker-dealer, the requirements of Rule 303 are
mandatory. All records required to be made under Rule 303
are considered confidential and are not available to the
public. All records required to be made under the Rule are
required to be preserved for three years, the first two
years in an easily accessible place.
The Commission staff has estimated that each
alternative trading system that chooses to register as a
broker-dealer will be required to expend an average of four
hours per year to comply with Rule 303 at an average cost of
$192.32.[647] If all forty-five alternative trading systems
opt to register as broker-dealers, rather than as exchanges,
the total cost for record preservation is estimated to be
$8,654.40 per year.[648]
The Commission notes that it is making no material
changes to Rule 302 from the Proposing Release. The
collection of information burdens are increasing slightly
due to an updated estimate of the number of respondents and
not due to any changes to the rule as proposed.
XIII.Statutory Authority
The rules and rule amendments in this release are being
adopted pursuant to 15 U.S.C. 78 et seq., particularly
Sections 3(b), 5, 6, 11A, 15, 17(a), 17(b), 19, 23(a), and
36 of the Exchange Act, 15 U.S.C. 78c, 78e, 78f, 78k-1, 78o,
78q(a), 78q(b), 78s(b), 78w(a), and 78mm.
List of Subjects
17 CFR Part 202
Administrative practice and procedure, Securities.
17 CFR Part 240
Brokers-dealers, Fraud, Issuers, Reporting and
recordkeeping requirements, Securities.
17 CFR Part 242
Securities
17 CFR Part 249
Reporting and recordkeeping requirements, Securities.
For the reasons set out in the preamble, Title 17,
Chapter II of the Code of Federal Regulations is amended as
follows.
PART 202 -- INFORMAL AND OTHER PROCEDURES
1. The authority citation for part 202 continues to
read in part as follows:
Authority: 15 U.S.C. 77s, 77t, 78d-1, 78u, 78w,
7811(d), 79r, 79t, 77sss, 77uuu, 80a-37, 80a-41, 80b-9, and
80b-11, unless otherwise noted.
* * * * *
2. Paragraph (b) of § 202.3 is revised to read as
follows:
§ 202.3 Processing of filings.
(a) ***
(b)(1)Applications for registration as brokers,
dealers, investment advisers, municipal securities dealers
and transfer agents are submitted to the Office of Filings
and Information Services where they are examined to
determine whether all necessary information has been
supplied and whether all required financial statements and
other documents have been furnished in proper form.
Defective applications may be returned with a request for
correction or held until corrected before being accepted as
a filing. The files of the Commission and other sources of
information are considered to determine whether any person
connected with the applicant appears to have engaged in
activities which would warrant commencement of proceedings
on the question of denial of registration. The staff
confers with applicants and makes suggestions in appropriate
cases for amendments and supplemental information. Where it
appears appropriate in the public interest and where a basis
therefore exists, denial proceedings may be instituted.
Within forty-five days of the date of the filing of a
broker–dealer, investment adviser or municipal securities
dealer application (or within such longer period as to which
the applicant consents), the Commission shall by order grant
registration or institute proceedings to determine whether
registration should be denied. An application for
registration as a transfer agent shall become effective
within 30 days after receipt of the application (or within
such shorter period as the Commission may determine). The
Office of Filings and Information Services is also
responsible for the processing and substantive examination
of statements of beneficial ownership of securities and
changes in such ownership filed under the Securities
Exchange Act of 1934, the Public Utility Holding Company Act
of 1935, and the Investment Company Act of 1940, and for the
examination of reports filed pursuant to § 230.144 of this
chapter.
(2) Applications for registration as national
securities exchanges, or exemption from registration as
exchanges by reason of such exchanges’ limited volume of
transactions filed with the Commission are routed to the
Division of Market Regulation, which examines these
applications to determine whether all necessary information
has been supplied and whether all required financial
statements and other documents have been furnished in proper
form. Defective applications may be returned with a request
for correction or held until corrected before being accepted
as a filing. The files of the Commission and other sources
of information are considered to determine whether any
person connected with the applicant appears to have engaged
in activities which would warrant commencement of
proceedings on the question of denial of registration. The
staff confers with applicants and makes suggestions in
appropriate cases for amendments and supplemental
information. Where it appears appropriate in the public
interest and where a basis therefore exists, denial
proceedings may be instituted. Within 90 days of the date
of the filing of an application for registration as a
national securities exchange, or exemption from registration
by reason of such exchanges’ limited volume of transactions
(or within such longer period as to which the applicant
consents), the Commission shall by order grant registration,
or institute proceedings to determine whether registration
should be denied as provided in § 240.19(a)(1) of this
chapter.
PART 240 -- GENERAL RULES AND REGULATIONS, SECURITIES
EXCHANGE ACT OF 1934
3. The authority citation for Part 240 continues to
read in part as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j,
78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5,
78w, 78x, 78ll(d), 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29,
80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted.
* * * * *
4. Section 240.3a1-1 is added before the undesignated
center heading "Definition of ‘Equity Security’ as Used in
Sections 12(g) and 16" to read as follows:
§ 240.3a1-1Exemption from the definition of "Exchange" under
Section 3(a)(1) of the Act.
(a) An organization, association, or group of persons
shall be exempt from the definition of the term "exchange"
under Section 3(a)(1) of the Act, (15 U.S.C. 78c(a)(1)), if
such organization, association, or group of persons:
(1) Is operated by a national securities association;
(2) Is in compliance with Regulation ATS, 17 CFR
242.300 through 242.303; or
(3) Pursuant to paragraph (a) of § 242.301 of
Regulation ATS, 17 CFR 242.301(a), is not required to comply
with Regulation ATS, 17 CFR 242.300 through 242.303.
(b) Notwithstanding paragraph (a) of this section, an
organization, association, or group of persons shall not be
exempt under this section from the definition of "exchange,"
if:
(1) During three of the preceding four calendar
quarters such organization, association, or group of persons
had:
(i) Fifty percent or more of the average daily dollar
trading volume in any security and five percent or more of
the average daily dollar trading volume in any class of
securities; or
(ii) Forty percent or more of the average daily dollar
trading volume in any class of securities; and
(2) The Commission determines, after notice to the
organization, association, or group of persons, and an
opportunity for such organization, association, or group of
persons to respond, that such an exemption would not be
necessary or appropriate in the public interest or
consistent with the protection of investors taking into
account the requirements for exchange registration under
Section 6 of the Act, (15 U.S.C. 78f), and the objectives of
the national market system under Section 11A of the Act, (15
U.S.C 78k-1).
(3) For purposes of paragraph (b) of this section,
each of the following shall be considered a "class of
securities":
(i) Equity securities , which shall have the same
meaning as in § 240.3a11-1;
(ii) Listed options, which shall mean any options
traded on a national securities exchange or automated
facility of a national securities exchange;
(iii)Unlisted options, which shall mean any options
other than those traded on a national securities exchange or
automated facility of a national securities association;
(iv) Municipal securities, which shall have the same
meaning as in Section 3(a)(29) of the Act, (15 U.S.C.
78c(a)(29));
(v) Investment grade corporate debt securities, which
shall mean any security that:
(A) Evidences a liability of the issuer of such
security;
(B) Has a fixed maturity date that is at least one
year following the date of issuance;
(C) Is rated in one of the four highest ratings
categories by at least one Nationally Recognized Statistical
Ratings Organization; and
(D) Is not an exempted security, as defined in Section
3(a)(12) of the Act, (15 U.S.C. 78c(a)(12));
(vi) Non-investment grade corporate debt securities,
which shall mean any security that:
(A) Evidences a liability of the issuer of such
security;
(B) Has a fixed maturity date that is at least one
year following the date of issuance;
(C) Is not rated in one of the four highest ratings
categories by at least one Nationally Recognized Statistical
Ratings Organization; and
(D) Is not an exempted security, as defined in Section
3(a)(12) of the Act, (15 U.S.C. 78o);
(vii)Foreign corporate debt securities, which shall
mean any security that:
(A) Evidences a liability of the issuer of such debt
security;
(B) Is issued by a corporation or other organization
incorporated or organized under the laws of any foreign
country; and
(C) Has a fixed maturity date that is at least one
year following the date of issuance; and
(viii)Foreign sovereign debt securities, which shall
mean any security that:
(A) Evidences a liability of the issuer of such debt
security;
(B) Is issued or guaranteed by the government of a
foreign country, any political subdivision of a foreign
country, or any supranational entity; and
(C) Does not have a maturity date of a year or less
following the date of issuance.
5. Section 240.3b-16 is added before the undesignated
center heading "Registration and Exemption of Exchanges" to
read as follows:
§ 240.3b-16Definitions of terms used in Section 3(a)(1) of
the Act.
(a) An organization, association, or group of persons
shall be considered to constitute, maintain, or provide "a
market place or facilities for bringing together purchasers
and sellers of securities or for otherwise performing with
respect to securities the functions commonly performed by a
stock exchange," as those terms are used in Section 3(a)(1)
of the Act, (15 U.S.C. 78c(a)(1)), if such organization,
association, or group of persons:
(1) Brings together the orders for securities of
multiple buyers and sellers; and
(2) Uses established, non-discretionary methods
(whether by providing a trading facility or by setting
rules) under which such orders interact with each other, and
the buyers and sellers entering such orders agree to the
terms of a trade.
(b) An organization, association, or group of persons
shall not be considered to constitute, maintain, or provide
"a market place or facilities for bringing together
purchasers and sellers of securities or for otherwise
performing with respect to securities the functions commonly
performed by a stock exchange," solely because such
organization, association, or group of persons engages in
one or more of the following activities:
(1) Routes orders to a national securities exchange, a
market operated by a national securities association, or a
broker-dealer for execution; or
(2) Allows persons to enter orders for execution
against the bids and offers of a single dealer; and
(i) As an incidental part of these activities, matches
orders that are not displayed to any person other than the
dealer and its employees; or
(ii) In the course of acting as a market maker
registered with a self-regulatory organization, displays the
limit orders of such market maker’s, or other broker-
dealer’s, customers; and
(A) Matches customer orders with such displayed limit
orders; and
(B) As an incidental part of its market making
activities, crosses or matches orders that are not displayed
to any person other than the market maker and its employees.
(c) For purposes of this section the term order means
any firm indication of a willingness to buy or sell a
security, as either principal or agent, including any bid or
offer quotation, market order, limit order, or other priced
order.
(d) For the purposes of this section, the terms bid
and offer shall have the same meaning as under § 240.11Ac1-
1.
(e) The Commission may conditionally or
unconditionally exempt any organization, association, or
group of persons from the definition in paragraph (a) of
this section.
6. Section 240.6a-1 is amended by revising the section
heading and paragraphs (a) and (b) to read as follows:
§ 240.6a-1Application for registration as a national
securities exchange or exemption from registration based on
limited volume.
(a) An application for registration as a national
securities exchange, or for exemption from such registration
based on limited volume, shall be filed on Form 1 (§ 249.1
of this chapter), in accordance with the instructions
contained therein.
(b) Promptly after the discovery that any information
filed on Form 1 was inaccurate when filed, the exchange
shall file with the Commission an amendment correcting such
inaccuracy.
* * * * *
7. Section 240.6a-2 is revised to read as follows:
§240.6a-2 Amendments to application.
(a) A national securities exchange, or an exchange
exempted from such registration based on limited volume,
shall file an amendment to Form 1, (§ 249.1 of this
chapter), which shall set forth the nature and effective
date of the action taken and shall provide any new
information and correct any information rendered inaccurate,
on Form 1, (§ 249.1 of this chapter), within 10 days after
any action is taken that renders inaccurate, or that causes
to be incomplete, any of the following:
(1) Information filed on the Execution Page of Form 1,
or amendment thereto; or
(2) Information filed as part of Exhibits C, F, G, H,
J, K or M, or any amendments thereto.
(b) On or before June 30 of each year, a national
securities exchange, or an exchange exempted from such
registration based on limited volume, shall file, as an
amendment to Form 1, the following:
(1) Exhibits D and I as of the end of the latest
fiscal year of the exchange; and
(2) Exhibits K, M, and N, which shall be up to date as
of the latest date practicable within 3 months of the date
the amendment is filed.
(c) On or before June 30, 2001 and every 3 years
thereafter, a national securities exchange, or an exchange
exempted from such registration based on limited volume,
shall file, as an amendment to Form 1, complete Exhibits A,
B, C and J. The information filed under this paragraph (c)
shall be current as of the latest practicable date, but
shall, at a minimum, be up to date within 3 months as of the
date the amendment is filed.
(d)(1) If an exchange, on an annual or more frequent
basis, publishes, or cooperates in the publication of, any
of the information required to be filed by paragraphs (b)(2)
and (c) of this section, in lieu of filing such information,
an exchange may:
(i) Identify the publication in which such information
is available, the name, address, and telephone number of the
person from whom such publication may be obtained, and the
price of such publication; and
(ii) Certify to the accuracy of such information as of
its publication date.
(2) If an exchange keeps the information required
under paragraphs (b)(2) and (c) of this section up to date
and makes it available to the Commission and the public upon
request, in lieu of filing such information, an exchange may
certify that the information is kept up to date and is
available to the Commission and the public upon request.
(3) If the information required to be filed under
paragraphs (b)(2) and (c) of this section is available
continuously on an Internet web site controlled by an
exchange, in lieu of filing such information with the
Commission, such exchange may:
(i) Indicate the location of the Internet web site
where such information may be found; and
(ii) Certify that the information available at such
location is accurate as of its date.
(e) The Commission may exempt a national securities
exchange, or an exchange exempted from such registration
based on limited volume, from filing the amendment required
by this section for any affiliate or subsidiary listed in
Exhibit C of the exchange’s application for registration, as
amended, that either:
(1) Is listed in Exhibit C of the application for
registration, as amended, of one or more other national
securities exchanges; or
(2) Was an inactive subsidiary throughout the
subsidiary’s latest fiscal year.
Any such exemption may be granted upon terms and conditions
the Commission deems necessary or appropriate in the public
interest or for the protection of investors, provided
however, that at least one national securities exchange
shall be required to file the amendments required by this
section for an affiliate or subsidiary described in
paragraph (e)(1) of this section.
8. Section 240.6a-3 is revised to read as follows:
§240.6a-3 Supplemental material to be filed by exchanges.
(a)(1)A national securities exchange, or an exchange
exempted from such registration based on limited volume,
shall file with the Commission any material (including
notices, circulars, bulletins, lists, and periodicals)
issued or made generally available to members of, or
participants or subscribers to, the exchange. Such material
shall be filed with the Commission within 10 days after
issuing or making such material available to members,
participants or subscribers.
(2) If the information required to be filed under
paragraph (a)(1) of this section is available continuously
on an Internet web site controlled by an exchange, in lieu
of filing such information with the Commission, such
exchange may:
(i) Indicate the location of the Internet web site
where such information may be found; and
(ii) Certify that the information available at such
location is accurate as of its date.
(b) Within 15 days after the end of each calendar
month, a national securities exchange or an exchange
exempted from such registration based on limited volume,
shall file a report concerning the securities sold on such
exchange during the calendar month. Such report shall set
forth:
(1) The number of shares of stock sold and the
aggregate dollar amount of such stock sold;
(2) The principal amount of bonds sold and the
aggregate dollar amount of such bonds sold; and
(3) The number of rights and warrants sold and the
aggregate dollar amount of such rights and warrants sold.
9. Section 240.11Ac1-1 is amended by redesignating
paragraph (c)(5)(ii)(A) as paragraph (c)(5)(ii)(A)(l),
paragraph (c)(5)(ii)(B) as paragraph (c)(5)(ii)(A)(2),
paragraph (c)(5)(ii)(B)(1) as paragraph (c)(5)(ii)(A)(2)(i),
paragraph (c)(5)(ii)(B)(2) as paragraph
(c)(5)(ii)(A)(2)(ii), in newly designated paragraph
(c)(5)(ii)(A)(2)(ii) removing the period and adding in its
place "; or", and adding new paragraph (c)(5)(ii)(B) to read
as follows:
§ 240.11Ac1-1 Dissemination of quotations.
* * * * *
(c) * * *
(5) * * *
(ii) * * *
(A)(1) * * *
(B) Is an alternative trading system that:
(1) Displays orders and provides the ability to effect
transactions with such orders under § 242.301(b)(3) of this
chapter; and
(2) Otherwise is in compliance with Regulation ATS, §
242.300 through § 242.303 of this chapter.
* * * * *
10. Section 240.17a-3 is amended by adding paragraph
(a)(16) to read as follows:
§ 240.17a-3 Records to be made by certain exchange members,
brokers and dealers.
(a) * * *
(16)(i)The following records regarding any internal
broker-dealer system of which such a broker or dealer is the
sponsor:
(A) A record of the broker’s or dealer’s customers
that have access to an internal broker-dealer system
sponsored by such broker or dealer (identifying any
affiliations between such customers and the broker or
dealer);
(B) Daily summaries of trading in the internal broker-
dealer system, including:
(1) Securities for which transactions have been
executed through use of such system; and
(2) Transaction volume (separately stated for trading
occurring during hours when consolidated trade reporting
facilities are and are not in operation):
(i) With respect to equity securities, stated in
number of trades, number of shares, and total U.S. dollar
value;
(ii) With respect to debt securities, stated in total
settlement value in U.S. dollars; and
(iii)With respect to other securities, stated in number
of trades, number of units of securities, and in dollar
value, or other appropriate commonly used measure of value
of such securities; and
(C) Time-sequenced records of each transaction
effected through the internal broker-dealer system,
including date and time executed, price, size, security
traded, counterparty identification information, and method
of execution (if internal broker-dealer system allows
alternative means or locations for execution, such as
routing to another market, matching with limit orders, or
executing against the quotations of the broker or dealer
sponsoring the system).
(ii) For purposes of paragraph (a) of this section, the
term:
(A) Internal broker-dealer system shall mean any
facility, other than a national securities exchange, an
exchange exempt from registration based on limited volume,
or an alternative trading system as defined in Regulation
ATS, §§ 242.300 through 242.303 of this chapter, that
provides a mechanism, automated in full or in part, for
collecting, receiving, disseminating, or displaying system
orders and facilitating agreement to the basic terms of a
purchase or sale of a security between a customer and the
sponsor, or between two customers of the sponsor, through
use of the internal broker-dealer system or through the
broker or dealer sponsor of such system;
(B) Sponsor shall mean any broker or dealer that
organizes, operates, administers, or otherwise directly
controls an internal broker-dealer trading system or, if the
operator of the internal broker-dealer system is not a
registered broker or dealer, any broker or dealer that,
pursuant to contract, affiliation, or other agreement with
the system operator, is involved on a regular basis with
executing transactions in connection with use of the
internal broker-dealer system, other than solely for its own
account or as a customer with access to the internal broker-
dealer system; and
(C) System order means any order or other
communication or indication submitted by any customer with
access to the internal broker-dealer system for entry into a
trading system announcing an interest in purchasing or
selling a security. The term "system order" does not
include inquiries or indications of interest that are not
entered into the internal broker-dealer system.
* * * * *
11. Section 240.17a-4 is amended by revising paragraph
(b)(1) and adding paragraph (b)(10) to read as follows:
§ 240.17a-4.Records to be preserved by certain exchange
members, brokers and dealers.
* * * * *
(b) * * *
(1) All records required to be made pursuant to
paragraphs (a)(4), (a)(6), (a)(7), (a)(8), (a)(9), and
(a)(10) of § 240.17a-3.
* * * * *
(10) All notices relating to an internal broker-dealer
system provided to the customers of the broker or dealer
that sponsors such internal broker-dealer system, as defined
in paragraph (a)(16)(ii)(A) of § 240.17a-3. Notices,
whether written or communicated through the internal broker-
dealer trading system or other automated means, shall be
preserved under this paragraph (b)(10) if they are provided
to all customers with access to an internal broker-dealer
system, or to one or more classes of customers. Examples of
notices to be preserved under this paragraph (b)(10)
include, but are not limited to, notices addressing hours of
system operations, system malfunctions, changes to system
procedures, maintenance of hardware and software, and
instructions pertaining to access to the internal broker-
dealer system.
* * * * *
12. Section 240.17a-23 is removed and reserved.
13. Section 240.19b-5 is added to read as follows:
Preliminary Notes
1. The following section provides for a temporary
exemption from the rule filing requirement for self-
regulatory organizations that file proposed rule changes
concerning the operation of a pilot trading system pursuant
to Section 19(b) of the Act (15 U.S.C. 78s(b), as amended).
All other requirements under the Act that are applicable to
self-regulatory organizations continue to apply.
2. The disclosures made pursuant to the provisions of
this section are in addition to any other applicable
disclosure requirements under the federal securities laws.
§240.19b-5Temporary exemption from the filing requirements
of Section 19(b) of the Act.
(a) For purposes of this section, the term specialist
means any member subject to a requirement of a self-
regulatory organization that such member regularly maintain
a market in a particular security.
(b) For purposes of this section, the term trading
system means the rules of a self-regulatory organization
that:
(i) Determine how the orders of multiple buyers and
sellers are brought together; and
(ii) Establish non-discretionary methods under which
such orders interact with each other and under which the
buyers and sellers entering such orders agree to the terms
of trade.
(c) For purposes of this section, the term pilot
trading system shall mean a trading system operated by a
self-regulatory organization that is not substantially
similar to any trading system or pilot trading system
operated by such self-regulatory organization at any time
during the preceding year, and that:
(1)(i)Has been in operation for less than two years;
(ii) Is independent of any other trading system
operated by such self-regulatory organization that has been
approved by the Commission pursuant to Section 19(b) of the
Act, (15 U.S.C. 78s(b));
(iii)With respect to each security traded on such pilot
trading system, during at least two of the last four
consecutive calendar months, has traded no more than 5
percent of the average daily trading volume of such security
in the United States; and
(iv) With respect to all securities traded on such
pilot trading system, during at least two of the last four
consecutive calendar months, has traded no more than 20
percent of the average daily trading volume of all trading
systems operated by such self-regulatory organization; or
(2)(i)Has been in operation for less than two years;
(ii) With respect to each security traded on such pilot
trading system, during at least two of the last four
consecutive calendar months, has traded no more than 1
percent of the average daily trading volume of such security
in the United States; and
(iii)With respect to all securities traded on such
pilot trading system, during at least two of the last four
consecutive calendar months, has traded no more than 20
percent of the average daily trading volume of all trading
systems operated by such self-regulatory organization; or
(3)(i)Has been in operation for less than two years;
and
(ii)(A)Satisfied the definition of pilot trading system
under paragraph (c)(1) of this section no more than 60 days
ago, and continues to be independent of any other trading
system operated by such self-regulatory organization that
has been approved by the Commission pursuant to Section
19(b) of the Act, (15 U.S.C. 78s(b)); or
(B) Satisfied the definition of pilot trading system
under paragraph (c)(2) of this section no more than 60 days
ago.
(d) A pilot trading system shall be deemed independent
of any other trading system operated by a self-regulatory
organization if:
(1) Such pilot trading system trades securities other
than the issues of securities that trade on any other
trading system operated by such self-regulatory organization
that has been approved by the Commission pursuant to Section
19(b) of the Act, (15 U.S.C. 78s(b));
(2) Such pilot trading system does not operate during
the same trading hours as any other trading system operated
by such self-regulatory organization that has been approved
by the Commission pursuant to Section 19(b) of the Act, (15
U.S.C. 78s(b)); or
(3) No specialist or market maker on any other trading
system operated by such self-regulatory organization that
has been approved by the Commission pursuant to Section
19(b) of the Act, (15 U.S.C. 78s(b)), is permitted to effect
transactions on the pilot trading system in securities in
which they are a specialist or market maker.
(e) A self-regulatory organization shall be exempt
temporarily from the requirement under Section 19(b) of the
Act, (15 U.S.C. 78s(b)), to submit on Form 19b-4, 17 CFR
249.819, proposed rule changes for establishing a pilot
trading system, if the self-regulatory organization complies
with the following requirements:
(1) Form PILOT. The self-regulatory organization:
(i) Files Part I of Form PILOT, 17 CFR 249.821, in
accordance with the instructions therein, at least 20 days
prior to commencing operation of the pilot trading system;
(ii) Files an amendment on Part I of Form PILOT at
least 20 days prior to implementing a material change to the
operation of the pilot trading system; and
(iii)Files a quarterly report on Part II of Form PILOT
within 30 calendar days after the end of each calendar
quarter in which the market has operated after the effective
date of this section.
(2) Fair access.
(i) The self-regulatory organization has in place
written rules to ensure that all members of the self-
regulatory organization have fair access to the pilot
trading system, and that information regarding orders on the
pilot trading system is equally available to all members of
the self-regulatory organization with access to such pilot
trading system.
(ii) Notwithstanding the requirement in paragraph
(e)(2)(i) of this section, a specialist on the pilot trading
system may have preferred access to information regarding
orders that it represents in its capacity as specialist.
(iii)The rules established by a self-regulatory
organization pursuant to paragraph (e)(2)(i) of this section
will be considered rules governing the pilot trading system
for purposes of the temporary exemption under this section.
(3) Trading rules and procedures and listing
standards.
(i) The self-regulatory organization has in place
written trading rules and procedures and listing standards
necessary to operate the pilot trading system.
(ii) The rules established by a self-regulatory
organization pursuant to paragraph (e)(3)(i) of this section
will be considered rules governing the pilot trading system
for purposes of the temporary exemption under this section.
(4) Surveillance. The self-regulatory organization
establishes internal procedures for the effective
surveillance of trading activity on the self-regulatory
organization’s pilot trading system.
(5) Clearance and settlement. The self-regulatory
organization establishes reasonable clearance and settlement
procedures for transactions effected on the self-regulatory
organization‘s pilot trading system.
(6) Types of securities. The self-regulatory
organization permits to trade on the pilot trading system
only securities registered under Section 12 of the Act, (15
U.S.C. 78l).
(7) Activities of specialists.
(i) The self-regulatory organization does not permit
any member to be a specialist in a security on the pilot
trading system and a specialist in a security on a trading
system operated by such self-regulatory organization that
has been approved by the Commission pursuant to Section
19(b) of the Act, (15 U.S.C. 78s(b)), or on another pilot
trading system operated by such self-regulatory
organization, if such securities are related securities,
except that a member may be a specialist in related
securities that the Commission, upon application by the
self-regulatory organization, later determines is necessary
or appropriate in the public interest and consistent with
the protection of investors;
(ii) Notwithstanding paragraph (e)(7)(i) of this
section, a self-regulatory organization may permit a member
to be a specialist in any security on a pilot trading
system, if the pilot trading system is operated during
trading hours different from the trading hours of the
trading system in which such member is a specialist.
(iii)For purposes of paragraph (e)(7) of this section,
the term related securities means any two securities in
which:
(A) The value of one security is determined, in whole
or significant part, by the performance of the other
security; or
(B) The value of both securities is determined, in
whole or significant part, by the performance of a third
security, combination of securities, index, indicator,
interest rate or other common factor.
(8) Examinations, inspections, and investigations.
The self-regulatory organization cooperates with the
examination, inspection, or investigation by the Commission
of transactions effected on the pilot trading system.
(9) Recordkeeping. The self-regulatory organization
shall retain at its principal place of business and make
available to Commission staff for inspection, all the rules
and procedures relating to each pilot trading system
operating pursuant to this section for a period of not less
than five years, the first two years in an easily accessible
place, as prescribed in § 240.17a-1.
(10) Public availability of pilot trading system rules.
The self-regulatory organization makes publicly available
all trading rules and procedures, including those
established under paragraphs (e)(2) and (e)(3) of this
section.
(11) Every notice or amendment filed pursuant to this
paragraph (e) shall constitute a "report" within the meaning
of Sections 11A, 17(a), 18(a), and 32(a), (15 U.S.C. 78k-1,
78q(a), 78r(a), and 78ff(a)), and any other applicable
provisions of the Act. All notices or reports filed
pursuant to this paragraph (e) shall be deemed to be
confidential until the pilot trading system commences
operation.
(f)(1)A self-regulatory organization shall request
Commission approval, pursuant to Section 19(b)(2) of the
Act, (15 U.S.C. 78s(b)(2)), for any rule change relating to
the operation of a pilot trading system by submitting Form
19b-4, 17 CFR 249.819, no later than two years after the
commencement of operation of such pilot trading system, or
shall cease operation of the pilot trading system.
(2) Simultaneous with a request for Commission
approval pursuant to Section 19(b)(2) of the Act, (15 U.S.C.
78s(b)(2)), a self-regulatory organization may request
Commission approval pursuant to Section 19(b)(3)(A) of the
Act, (15 U.S.C. 78s(b)(3)(A)), for any rule change relating
to the operation of a pilot trading system by submitting
Form 19b-4, 17 CFR 249.819, effective immediate upon filing,
to continue operations of such trading system for a period
not to exceed six months.
(g) Notwithstanding paragraph (e) of this section,
rule changes with respect to pilot trading systems operated
by a self-regulatory organization shall not be exempt from
the rule filing requirements of Section 19(b)(2) of the Act,
(15 U.S.C. 78s(b)(2)), if the Commission determines, after
notice to the SRO and opportunity for the SRO to respond,
that exemption of such rule changes is not necessary or
appropriate in the public interest or consistent with the
protection of investors.
PART 242 -- REGULATIONS M and ATS
14. The authority citation for part 242 is revised to
read as follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c,
78i(a), 78j, 78k-1(c), 78l, 78m, 78mm, 78n, 78o(b), 78o(c),
78o(g), 78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 80a-23, 80a-
29, and 80a-37.
15. The part heading for part 242 is revised as set
forth above.
16. Part 242 is amended by adding Regulation ATS, §§
242.300 through 242.303 to read as follows:
Regulation ATS -- Alternative Trading Systems
§ 242.300 Definitions.
§ 242.301 Requirements for alternative trading systems.
§ 242.302 Recordkeeping requirements for alternative
trading systems.
§ 242.303 Record preservation requirements for
alternative trading systems.
Regulation ATS - Alternative Trading Systems
Preliminary Notes
1. An alternative trading system is required to
comply with the requirements in this Regulation ATS, unless
such alternative trading system:
(a) Is registered as a national securities exchange;
(b) Is exempt from registration as a national
securities exchange based on the limited volume of
transactions effected on the alternative trading system; or
(c) Trades only government securities and certain
other related instruments.
All alternative trading systems must comply with the
antifraud, antimanipulation, and other applicable provisions
of the federal securities laws.
2. The requirements imposed upon an alternative
trading system by Regulation ATS are in addition to any
requirements applicable to broker-dealers registered under
Section 15 of the Act, (15 U.S.C. 78o).
3. An alternative trading system must comply with any
applicable state law relating to the offer or sale of
securities or the registration or regulation of persons or
entities effecting transactions in securities.
4. The disclosures made pursuant to the provisions of
this section are in addition to any other disclosure
requirements under the federal securities laws.
§ 242.300 Definitions.
For purposes of this section, the following definitions
shall apply:
(a) Alternative trading system means any organization,
association, person, group of persons, or system:
(1) That constitutes, maintains, or provides a market
place or facilities for bringing together purchasers and
sellers of securities or for otherwise performing with
respect to securities the functions commonly performed by a
stock exchange within the meaning of § 240.3b-16 of this
chapter; and
(2) That does not:
(i) Set rules governing the conduct of subscribers
other than the conduct of such subscribers’ trading on such
organization, association, person, group of persons, or
system; or
(ii) Discipline subscribers other than by exclusion
from trading.
(b) Subscriber means any person that has entered into
a contractual agreement with an alternative trading system
to access such alternative trading system for the purpose of
effecting transactions in securities or submitting,
disseminating, or displaying orders on such alternative
trading system, including a customer, member, user, or
participant in an alternative trading system. A subscriber,
however, shall not include a national securities exchange or
national securities association.
(c) Affiliate of a subscriber means any person that,
directly or indirectly, controls, is under common control
with, or is controlled by, the subscriber, including any
employee.
(d) Debt security shall mean any security other than
an equity security, as defined in § 240.3a11-1 of this
chapter, as well as non-participatory preferred stock.
(e) Order means any firm indication of a willingness
to buy or sell a security, as either principal or agent,
including any bid or offer quotation, market order, limit
order, or other priced order.
(f) Control means the power, directly or indirectly,
to direct the management or policies of an alternative
trading system, whether through ownership of securities, by
contract, or otherwise. A person is presumed to control an
alternative trading system, if that person:
(1) Is a director, general partner, or officer
exercising executive responsibility (or having similar
status or performing similar functions);
(2) Directly or indirectly has the right to vote 25
percent or more of a class of voting security or has the
power to sell or direct the sale of 25 percent or more of a
class of voting securities of the alternative trading
system; or
(3) In the case of a partnership, has contributed, or
has the right to receive upon dissolution, 25 percent or
more of the capital of the alternative trading system.
(g) Covered security shall have the meaning provided
in § 240.11Ac1-1(a)(6) of this chapter, provided, however,
that a debt or convertible debt security shall not be deemed
a covered security for purposes of Regulation ATS.
(h) Effective transaction reporting plan shall have
the meaning provided in § 240.11Aa3-1(a)(3) of this chapter.
(i) Exchange market maker shall have the meaning
provided in § 240.11Ac1-1(a)(9) of this chapter.
(j) OTC market maker shall have the meaning provided
in § 240.11Ac1-1(a)(13) of this chapter.
(k) Investment grade corporate debt security shall
mean any security that:
(1) Evidences a liability of the issuer of such
security;
(2) Has a fixed maturity date that is at least one
year following the date of issuance;
(3) Is rated in one of the four highest ratings
categories by at least one Nationally Recognized Statistical
Ratings Organization; and
(4) Is not an exempted security, as defined in Section
3(a)(12) of the Act (15 U.S.C. 78c(a)(12)).
(l) Non-investment grade corporate debt security shall
mean any security that:
(1) Evidences a liability of the issuer of such
security;
(2) Has a fixed maturity date that is at least one
year following the date of issuance;
(3) Is not rated in one of the four highest ratings
categories by at least one Nationally Recognized Statistical
Ratings Organization; and
(4) Is not an exempted security, as defined in Section
3(a)(12) of the Act (15 U.S.C. 78c(a)(12)).
(m) Commercial paper shall mean any note, draft, or
bill of exchange which arises out of a current transaction
or the proceeds of which have been or are to be used for
current transactions, and which has a maturity at the time
of issuance of not exceeding nine months, exclusive of days
of grace, or any renewal thereof the maturity of which is
likewise limited.
§ 242.301 Requirements for alternative trading systems.
(a) Scope of section. An alternative trading system
shall comply with the requirements in paragraph (b) of this
section, unless such alternative trading system:
(1) Is registered as an exchange under Section 6 of
the Act, (15 U.S.C. 78f);
(2) Is exempted by the Commission from registration as
an exchange based on the limited volume of transactions
effected;
(3) Is operated by a national securities association;
(4)(i)Is registered as a broker-dealer under Sections
15(b) or 15C of the Act (15 U.S.C. 78o(b), and 78o-5), or is
a bank, and
(ii) Limits its securities activities to the following
instruments:
(A) Government securities, as defined in Section
3(a)(42) of the Act, (15 U.S.C. 78c(a)(42));
(B) Repurchase and reverse repurchase agreements
solely involving securities included within paragraph
(a)(4)(ii)(A) of this section;
(C) Any put, call, straddle, option, or privilege on a
government security, other than a put, call, straddle,
option, or privilege that:
(1) Is traded on one or more national securities
exchanges; or
(2) For which quotations are disseminated through an
automated quotation system operated by a registered
securities association; and
(D) Commercial paper.
(5) Is exempted, conditionally or unconditionally, by
Commission order, after application by such alternative
trading system, from one or more of the requirements of
paragraph (b) of this section. The Commission will grant
such exemption only after determining that such an order is
consistent with the public interest, the protection of
investors, and the removal of impediments to, and perfection
of the mechanisms of, a national market system.
(b) Requirements. Every alternative trading system
subject to this Regulation ATS, pursuant to paragraph (a) of
this section, shall comply with the requirements in this
paragraph (b).
(1) Broker-dealer registration. The alternative
trading system shall register as a broker-dealer under
Section 15 of the Act, (15 U.S.C. 78o).
(2) Notice. (i) The alternative trading system shall
file an initial operation report on Form ATS, § 249.637 of
this chapter, in accordance with the instructions therein,
at least 20 days prior to commencing operation as an
alternative trading system, or if the alternative trading
system is operating as of [insert date 120 days following
publication in the Federal Register], no later than [insert
date 140 days following publication in the Federal
Register].
(ii) The alternative trading system shall file an
amendment on Form ATS at least 20 calendar days prior to
implementing a material change to the operation of the
alternative trading system.
(iii)If any information contained in the initial
operation report filed under paragraph (b)(2)(i) of this
section becomes inaccurate for any reason and has not been
previously reported to the Commission as an amendment on
Form ATS, the alternative trading system shall file an
amendment on Form ATS correcting such information within 30
calendar days after the end of each calendar quarter in
which the alternative trading system has operated.
(iv) The alternative trading system shall promptly file
an amendment on Form ATS correcting information previously
reported on Form ATS after discovery that any information
filed under paragraphs (b)(2)(i), (ii) or (iii) of this
section was inaccurate when filed.
(v) The alternative trading system shall promptly file
a cessation of operations report on Form ATS in accordance
with the instructions therein upon ceasing to operate as an
alternative trading system.
(vi) Every notice or amendment filed pursuant to this
paragraph (b)(2) shall constitute a "report" within the
meaning of Sections 11A, 17(a), 18(a), and 32(a), (15 U.S.C.
78k-1, 78q(a), 78r(a), and 78ff(a)), and any other
applicable provisions of the Act.
(vii)The reports provided for in paragraph (b)(2) of
this section shall be considered filed upon receipt by the
Division of Market Regulation, Stop 10-2, at the
Commission’s principal office in Washington, D.C. Duplicate
originals of the reports provided for in paragraphs
(b)(2)(i) through (v) of this section must be filed with
surveillance personnel designated as such by any self-
regulatory organization that is the designated examining
authority for the alternative trading system pursuant to §
240.17d-1 of this chapter simultaneously with filing with
the Commission. Duplicates of the reports required by
paragraph (b)(9) of this section shall be provided to
surveillance personnel of such self-regulatory authority
upon request. All reports filed pursuant to this paragraph
(b)(2) and paragraph (b)(9) of this section shall be deemed
confidential when filed.
(3) Order display and execution access. (i) An
alternative trading system shall comply with the
requirements set forth in paragraph (b)(3)(ii) of this
section , with respect to any covered security in which the
alternative trading system:
(A) Displays subscriber orders to any person (other
than alternative trading system employees); and
(B) During at least 4 of the preceding 6 calendar
months, had an average daily trading volume of 5 percent or
more of the aggregate average daily share volume for such
covered security as reported by an effective transaction
reporting plan or disseminated through an automated
quotation system as described in Section 3(a)(51)(A)(ii) of
the Act, (15 U.S.C. 78c(a)(51)(A)(ii)).
(ii) Such alternative trading system shall provide to a
national securities exchange or national securities
association the prices and sizes of the orders at the
highest buy price and the lowest sell price for such covered
security, displayed to more than one person in the
alternative trading system, for inclusion in the quotation
data made available by the exchange or association to
quotation vendors pursuant to § 240.11Ac1-1 of this chapter.
(iii)With respect to any order displayed pursuant to
paragraph (b)(3)(ii) of this section, an alternative trading
system shall provide to any broker-dealer that has access to
the national securities exchange or national securities
association to which the alternative trading system provides
the prices and sizes of displayed orders pursuant to
paragraph (b)(3)(ii)(A) of this section, the ability to
effect a transaction with such orders that is:
(A) Equivalent to the ability of such broker-dealer to
effect a transaction with other orders displayed on the
exchange or by the association; and
(B) At the price of the highest priced buy order or
lowest priced sell order displayed for the lesser of the
cumulative size of such priced orders entered therein at
such price, or the size of the execution sought by such
broker-dealer.
(4) Fees. The alternative trading system shall not
charge any fee to broker-dealers that access the alternative
trading system through a national securities exchange or
national securities association, that is inconsistent with
equivalent access to the alternative trading system required
by paragraph (b)(3)(iv) of this section. In addition, if
the national securities exchange or national securities
association to which an alternative trading system provides
the prices and sizes of orders under paragraphs (b)(3)(ii)
and (b)(3)(iii) of this section establishes rules designed
to assure consistency with standards for access to
quotations displayed on such national securities exchange,
or the market operated by such national securities
association, the alternative trading system shall not charge
any fee to members that is contrary to, that is not
disclosed in the manner required by, or that is inconsistent
with any standard of equivalent access established by such
rules.
(5) Fair access. (i) An alternative trading system
shall comply with the requirements in paragraph (b)(5)(ii)
of this section, if during at least 4 of the preceding 6
calendar months, such alternative trading system had:
(A) With respect to any covered security, 20 percent
or more of the average daily volume in that security
reported by an effective transaction reporting plan or
disseminated through an automated quotation system as
described in Section 3(a)(51)(A)(ii) of the Act (15 U.S.C.
78c(a)(51)(A)(ii));
(B) With respect to an equity security that is not a
covered security and for which transactions are reported to
a self-regulatory organization, 20 percent or more of the
average daily volume in that security as calculated by the
self-regulatory organization to which such transactions are
reported;
(C) With respect to municipal securities, 20 percent
or more of the average daily volume traded in the United
States;
(D) With respect to investment grade corporate debt,
20 percent or more of the average daily volume traded in the
United States;
(E) With respect to non-investment grade corporate
debt, 20 percent or more of the average daily volume traded
in the United States.
(ii) An alternative trading system shall:
(A) Establish written standards for granting access to
trading on its system;
(B) Not unreasonably prohibit or limit any person in
respect to access to services offered by such alternative
trading system by applying the standards established under
paragraph (b)(5)(ii)(A) of this section in an unfair or
discriminatory manner; and
(C) Make and keep records of:
(1) All grants of access including, for all
subscribers, the reasons for granting such access;
(2) All denials or limitations of access and reasons,
for each applicant, for denying or limiting access.
(D) Report the information required on Form ATS-R, §
249.638 of this chapter, regarding grants, denials, and
limitations of access.
(iii)Notwithstanding paragraph (b)(5)(i) of this
section, an alternative trading system shall not be required
to comply with the requirements in paragraph (b)(5)(ii) of
this section, if such alternative trading system:
(A) Matches customer orders for a security with other
customer orders;
(B) Such customers’ orders are not displayed to any
person, other than employees of the alternative trading
system; and
(C) Such orders are executed at a price for such
security disseminated by an effective transaction reporting
plan or through an automated quotation system as described
in Section 3(a)(51)(A)(ii) of the Act, (15 U.S.C.
78c(a)(51)(A)(ii)), or derived from such prices.
(6) Capacity, integrity, and security of automated
systems. (i) The alternative trading system shall comply
with the requirements in paragraph (b)(6)(ii) of this
section, if during at least 4 of the preceding 6 calendar
months, such alternative trading system had:
(A) With respect to any covered security, 20 percent
or more of the average daily volume reported by the
effective transaction reporting plan or disseminated through
an automated quotation system as described in Section
3(a)(51)(A)(ii) of the Act, (15 U.S.C. 78c(a)(51)(A)(ii));
(B) With respect to equity securities that are not
covered securities and for which transactions are reported
to a self-regulatory organization, 20 percent or more of the
average daily volume as calculated by the self-regulatory
organization to which such transactions are reported;
(C) With respect to municipal securities, 20 percent
or more of the average daily volume traded in the United
States;
(D) With respect to investment grade corporate debt,
20 percent or more of the average daily volume traded in the
United States;
(E) With respect to non-investment grade corporate
debt, 20 percent or more of the average daily volume traded
in the United States.
(ii) With respect to those systems that support order
entry, order routing, order execution, transaction
reporting, and trade comparison, the alternative trading
system shall:
(A) Establish reasonable current and future capacity
estimates;
(B) Conduct periodic capacity stress tests of critical
systems to determine such system’s ability to process
transactions in an accurate, timely, and efficient manner;
(C) Develop and implement reasonable procedures to
review and keep current its system development and testing
methodology;
(D) Review the vulnerability of its systems and data
center computer operations to internal and external threats,
physical hazards, and natural disasters;
(E) Establish adequate contingency and disaster
recovery plans;
(F) On an annual basis, perform an independent review,
in accordance with established audit procedures and
standards, of such alternative trading system’s controls for
ensuring that paragraphs (b)(6)(ii)(A) through (E) of this
section are met, and conduct a review by senior management
of a report containing the recommendations and conclusions
of the independent review; and
(G) Promptly notify the Commission staff of material
systems outages and significant systems changes.
(iii)Notwithstanding paragraph (b)(6)(i) of this
section, an alternative trading system shall not be required
to comply with the requirements in paragraph (b)(6)(ii) of
this section, if such alternative trading system:
(A) Matches customer orders for a security with other
customer orders;
(B) Such customers’ orders are not displayed to any
person, other than employees of the alternative trading
system; and
(C) Such orders are executed at a price for such
security disseminated by an effective transaction reporting
plan or through an automated quotation system as described
in Section 3(a)(51)(A)(ii) of the Act, (15 U.S.C.
78c(a)(51)(A)(ii)), or derived from such prices.
(7) Examinations, inspections, and investigations.
The alternative trading system shall permit the examination
and inspection of its premises, systems, and records, and
cooperate with the examination, inspection, or investigation
of subscribers, whether such examination is being conducted
by the Commission or by a self-regulatory organization of
which such subscriber is a member.
(8) Recordkeeping. The alternative trading system
shall:
(i) Make and keep current the records specified in
§242.302; and
(ii) Preserve the records specified in § 242.303.
(9) Reporting. The alternative trading system shall:
(i) File the information required by Form ATS-R (§
249.638 of this chapter) within 30 calendar days after the
end of each calendar quarter in which the market has
operated after the effective date of this section; and
(ii) File the information required by Form ATS-R within
10 calendar days after an alternative trading system ceases
to operate.
(10) Procedures to ensure the confidential treatment of
trading information.
(i)
The alternative trading system shall establish adequate
safeguards and procedures to protect subscribers’
confidential trading information. Such safeguards and
procedures shall include:
(A) Limiting access to the confidential trading
information of subscribers to those employees of the
alternative trading system who are operating the system or
responsible for its compliance with these or any other
applicable rules;
(B) Implementing standards controlling employees of
the alternative trading system trading for their own
accounts; and
(ii) The alternative trading system shall adopt and
implement adequate oversight procedures to ensure that the
safeguards and procedures established pursuant to paragraph
(b)(10)(i) of this section are followed.
(11) Name. The alternative trading system shall not
use in its name the word "exchange," or derivations of the
word "exchange," such as the term "stock market."
§ 242.302 Recordkeeping requirements for alternative trading
systems.
To comply with the condition set forth in paragraph
(b)(8) of § 242.301, an alternative trading system shall
make and keep current the following records:
(a) A record of subscribers to such alternative
trading system (identifying any affiliations between the
alternative trading system and subscribers to the
alternative trading system, including common directors,
officers, or owners);
(b) Daily summaries of trading in the alternative
trading system including:
(1) Securities for which transactions have been
executed;
(2) Transaction volume, expressed with respect to
equity securities in:
(i) Number of trades;
(ii) Number of shares traded; and
(iii)Total settlement value in terms of U.S. dollars;
and
(3) Transaction volume, expressed with respect to debt
securities in:
(i) Number of trades; and
(ii) Total U.S. dollar value; and
(c) Time-sequenced records of order information in the
alternative trading system, including:
(1) Date and time (expressed in terms of hours,
minutes, and seconds) that the order was received;
(2) Identity of the security;
(3) The number of shares, or principal amount of
bonds, to which the order applies;
(4) An identification of the order as related to a
program trade or an index arbitrage trade as defined in New
York Stock Exchange Rule 80A;
(5) The designation of the order as a buy or sell
order;
(6) The designation of the order as a short sale
order;
(7) The designation of the order as a market order,
limit order, stop order, stop limit order, or other type or
order;
(8) Any limit or stop price prescribed by the order;
(9) The date on which the order expires and, if the
time in force is less than one day, the time when the order
expires;
(10) The time limit during which the order is in force;
(11) Any instructions to modify or cancel the order;
(12) The type of account, i.e., retail, wholesale,
employee, proprietary, or any other type of account
designated by the alternative trading system, for which the
order is submitted;
(13) Date and time (expressed in terms of hours,
minutes, and seconds) that the order was executed;
(14) Price at which the order was executed;
(15) Size of the order executed (expressed in number of
shares or units or principal amount); and
(16) Identity of the parties to the transaction.
§ 242.303 Record preservation requirements for alternative
trading systems.
(a) To comply with the condition set forth in
paragraph (b)(9) of § 242.301, an alternative trading system
shall preserve the following records:
(1) For a period of not less than three years, the
first two years in an easily accessible place, an
alternative trading system shall preserve:
(i) All records required to be made pursuant to §
242.302;
(ii) All notices provided by such alternative trading
system to subscribers generally, whether written or
communicated through automated means, including, but not
limited to, notices addressing hours of system operations,
system malfunctions, changes to system procedures,
maintenance of hardware and software, instructions
pertaining to access to the market and denials of, or
limitations on, access to the alternative trading system;
(iii)If subject to paragraph (b)(5)(ii) of § 242.301,
at least one copy of such alternative trading system’s
standards for access to trading, all documents relevant to
the alternative trading systems decision to grant, deny, or
limit access to any person, and all other documents made or
received by the alternative trading system in the course of
complying with paragraph (b)(5) of § 242.301; and
(iv) At least one copy of all documents made or
received by the alternative trading system in the course of
complying with paragraph (b)(6) of §242.301, including all
correspondence, memoranda, papers, books, notices, accounts,
reports, test scripts, test results, and other similar
records.
(2) During the life of the enterprise and of any
successor enterprise, an alternative trading system shall
preserve:
(i) All partnership articles or, in the case of a
corporation, all articles of incorporation or charter,
minute books and stock certificate books; and
(ii) Copies of reports filed pursuant to paragraph
(b)(2) of § 242.301 of this chapter and records made
pursuant to paragraph (b)(5) of § 242.301 of this chapter.
(b) The records required to be maintained and
preserved pursuant to paragraph (a) of this section must be
produced, reproduced, and maintained in paper form or in any
of the forms permitted under § 240.17a-4(f) of this chapter.
(c) Alternative trading systems must comply with any
other applicable recordkeeping or reporting requirement in
the Act, and the rules and regulations thereunder. If the
information in a record required to be made pursuant to this
section is preserved in a record made pursuant to § 240.17a-
3 or §240.17a-4 of this chapter, or otherwise preserved by
the alternative trading system (whether in summary or some
other form), this section shall not require the sponsor to
maintain such information in a separate file, provided that
the sponsor can promptly sort and retrieve the information
as if it had been kept in a separate file as a record made
pursuant to this section, and preserves the information in
accordance with the time periods specified in paragraph (a)
of this section.
(d) The records required to be maintained and
preserved pursuant to this section may be prepared or
maintained by a service bureau, depository, or other
recordkeeping service on behalf of the alternative trading
system. An agreement with a service bureau, depository, or
other recordkeeping service shall not relieve the
alternative trading system from the responsibility to
prepare and maintain records as specified in this section.
The service bureau, depository, or other recordkeeping
service shall file with the Commission a written undertaking
in a form acceptable to the Commission, signed by a duly
authorized person, to the effect that such records are the
property of the alternative trading system required to be
maintained and preserved and will be surrendered promptly on
request of the alternative trading system, and shall include
the following provision:
With respect to any books and records maintained or
preserved on behalf of [name of alternative trading system],
the undersigned hereby undertakes to permit examination of
such books and records at any time, or from time to time,
during business hours by representatives or designees of the
Securities and Exchange Commission, and to promptly furnish
to the Commission or its designee a true, correct, complete
and current hard copy of any, all, or any part of, such
books and records.
(e) Every alternative trading system shall furnish to
any representative of the Commission promptly upon request,
legible, true, and complete copies of those records that are
required to be preserved under this section.
PART 249 -- FORMS, SECURITIES EXCHANGE ACT OF 1934
17. The authority citation for part 249 continues to
read in part as follows:
Authority: 15 U.S.C. 78a, et seq., unless otherwise
noted;
******
18. Section 249.1 and Form 1 are revised to read as
follows:
§249.1 Form 1, for application for, and amendments
to applications for, registration as a national securities
exchange or exemption from registration pursuant to Section
5 of the Exchange Act.
The form shall be used for application for, and
amendments to applications for, registration as a national
securities exchange or exemption from registration pursuant
to Section 5 of the Act, (15 U.S.C. 78e).
[Note: Form 1 does not and the amendments will not
appear in the Code of Federal Regulations.]
[INSERT FORM 1]
19. Section 249.1a and Form 1-A are removed.
20. Section 249.636 and Form 17A-23 are removed and
reserved.
21. Section 249.637 and Form ATS are added to read as
follows:
§249.637 Form ATS, information required of alternative
trading systems pursuant to §242.301(b)(2) of this chapter.
This form shall be used by every alternative trading
system to file required notices, reports and amendments
under §242.301(b)(2) of this chapter.
[Note: Form ATS does not and the amendments will not
appear in the Code of Federal Regulations.]
[INSERT FORM ATS]
22. Section 249.638 and Form ATS-R are added to read
as follows:
§249.638 Form ATS-R, information required of alternative
trading systems pursuant to §242.301(b)(8) of this chapter.
This form shall be used by every alternative trading
system to file required reports under §242.301(b)(8) of this
chapter.
[Note: Form ATS-R does not and the amendments will not
appear in the Code of Federal Regulations.]
[INSERT FORM ATS-R]
23. Section 249.821 and Form PILOT are added to read
as follows:
§249.821 Form PILOT, information required of self-
regulatory organizations operating pilot trading systems
pursuant to § 240.19b-5 of this chapter.
This form shall be used by all self-regulatory
organizations, as defined in Section 3(a)(26) of the Act,
(15 U.S.C 78c(a)(26)), to file required information and
reports with regard to pilot trading systems pursuant to §
240.19b-5 of this chapter.
[Note: Form PILOT does not and the amendments will not
appear in the Code of Federal Regulations.]
[INSERT FORM PILOT]
By the Commission.
Jonathan G. Katz
Secretary
December 8, 1998
---------------------------------------------------------------
**FOOTNOTES**
[1]: The term "alternative trading system" is defined in Rule 300(a),
17 CFR 242.300(a). This term encompasses some systems that
previous Commission releases called proprietary trading systems,
broker-dealer trading systems, and electronic communication
networks.
[2]: Securities Exchange Act Release No. 38672 (May 23, 1997), 62 FR
30485 (June 4, 1997). The comment letters to the Concept Release
and a summary of these comments have been placed in Public File
S7-16-97, which is available for inspection in the Commission’s
Public Reference Room.
[3]: Securities Exchange Act Release No. 39884 (Apr. 17, 1998), 63 FR
23504 (Apr. 29, 1998). The comment letters to the Proposing
Release and a summary of those comments received as of August 25,
1998 have been placed in Public File S7-12-98, which is available
for inspection in the Commission’s Public Reference Room.
[4]: See SEC, Report Pursuant to Section 21(a) of the Securities
Exchange Act of 1934 Regarding the NASD and the Nasdaq Market
(1996) ("NASD 21(a) Report").
[5]: See In the Matter of Ian and Lawrence Fishman, Securities Exchange
Act Release No. 40115 (June 24, 1998) (finding that the Fishman
brothers manipulated the national best bid and offer in violation
of Section 10(b) and Rule 10b-5 under the Exchange Act by
coordinating the entry of orders routed to alternative trading
systems).
[6]: Pub. L. No. 29, 89 Stat. 97 (1975). Congress granted to the
Commission authority in 1975 to adopt rules that promote (1)
economically efficient execution of securities transactions, (2)
fair competition, (3) transparency, (4) investor access to the
best markets, and (5) the opportunity for investors' orders to be
executed without the participation of a dealer. See S. Rep. No.
75, 94th Cong., 1st Sess. 8 (1975); H.R. Rep. No. 229, 94th Cong.,
1st Sess 92 (1975). See also Section 11A(a)(1) of the Exchange
Act, 15 U.S.C. §78k-1(a)(1).
[7]: Section 36 of the Exchange Act, 15 U.S.C. 78mm, was enacted as
part of the National Securities Markets Improvement Act of 1996,
Pub. L. No. 104-290 ("NSMIA"). See infra Section VII.D.1.
[8]: See supra note .
[9]: This is the number of comment letters received by the Commission
as of the close of business on December 1, 1998.
[10]: Some commenters, however, suggested that the better approach would
be for the Commission to retain its present regulatory framework
for alternative trading systems. See, e.g., Letter from Robin
Roger, Principal and Counsel, Morgan Stanley Dean Witter to
Jonathan G. Katz, Secretary, SEC, dated Sept. 11, 1998 ("MSDW
Letter") at 3-4; Letter from Christopher J. Carroll and W. Hal
Hinkle, Co-Chairs, ATS Task Force, The Bond Market Association to
Jonathan G. Katz, Secretary, SEC, dated July 28, 1998 ("TBMA
Letter") at 2, 8-12; Letter from Lee B. Spencer, Jr., Chairman,
SIA Federal Regulation Committee and Perry L. Taylor, Jr.,
Chairman, SIA Alternative Trading System Subcommittee, Securities
Industry Association to Jonathan G. Katz, Secretary, SEC, dated
July 31, 1998 ("SIA Letter") at 2, 5. Another commenter suggested
that the Commission solicit comment again on the broader issues
discussed in the Concept Release. See Letter from Louis C.
Magill, President, Corporate Capital Securities, Inc. to Jonathan
G. Katz, Secretary, SEC, dated July 27, 1998 ("Corporate Capital
Letter") at 4.
[11]: See, e.g., Letter from Joanne Moffic-Silver, Secretary and General
Counsel, Chicago Board Options Exchange to Jonathan G. Katz,
Secretary, SEC, dated July 28, 1998 ("CBOE Letter") at 3; Letter
from John C. Katovich, Senior Vice President and General Counsel,
OptiMark Technologies Inc. to Jonathan G. Katz, Secretary, SEC,
dated Aug. 13, 1998 ("OptiMark Letter") at 1.
[12]: See, e.g., CBOE Letter at 3.
[13]: See, e.g., SIA Letter at 1, 5-6.
[14]: See, e.g., Letter from Joan C. Conley, Corporate Secretary,
National Association of Securities Dealers, Inc. to Jonathan G.
Katz, Secretary, SEC, dated Aug. 10, 1998 ("NASD Letter") at 1-2.
[15]: See, e.g., Letter from Douglas M. Atkin, Chief Executive Officer,
Instinet International to Jonathan G. Katz, Secretary, SEC, dated
Aug. 3, 1998 ("Instinet Letter") at 1, 7; Letter from Frederic W.
Rittereiser, President and Chief Executive Officer and William W.
Uchimoto, Executive Vice President and General Counsel, Ashton
Technology Group, Inc. to Jonathan G. Katz, Secretary, SEC, dated
July 28, 1998 ("Ashton Letter") at 1; Letter from Mary Sue Fisher,
Managing Director, Legal and Compliance, Chicago Board Brokerage,
LLC to Jonathan G. Katz, Secretary, SEC, dated July 29, 1998 ("CBB
Letter") at 1-2.
[16]: See, e.g., TBMA Letter at 4; Letter from Larry E. Fondren,
President, Integrated Bond Exchange, Inc. to Jonathan G. Katz,
Secretary, SEC, dated July 27, 1998 ("IBEX Letter") at 13.
[17]: See, e.g., Letter from Craig S. Tyle, General Counsel, Investment
Company Institute to Jonathan G. Katz, Secretary, SEC, dated July
28, 1998 ("7/28/98 ICI Letter") at 5; Letter from James E. Buck,
Senior Vice President and Secretary, New York Stock Exchange, Inc.
to Jonathan G. Katz, Secretary, SEC, dated July 28 ,1998 ("NYSE
Letter") at 9; Letter from Robert H. Forney, President and Chief
Executive Officer, Chicago Stock Exchange to Jonathan G. Katz,
Secretary, SEC, dated July 30, 1998 ("CHX Letter") at 11; Letter
from T. Eric Kilcollin, President and Chief Executive Officer,
Chicago Mercantile Exchange to Jonathan G. Katz, Secretary, SEC,
dated Aug. 5, 1998 ("CME Letter") at 4; Letter from James F.
Duffy, Executive Vice President and General Counsel, Legal and
Regulatory Policy, American Stock Exchange, Inc. to Jonathan G.
Katz, Secretary, SEC, dated Aug. 18, 1998 ("Amex Letter") at 1;
Ashton Letter at 2; CBOE Letter at 3, 8-9. See infra Section VI
for a discussion of the temporary exemption for pilot trading
systems.
[18]: 17 CFR 242.300-303.
[19]: 15 U.S.C. 78c(a)(1).
[20]: 17 CFR 240.3b-16.
[21]: 15 U.S.C. 78c(a)(1).
[22]: Rule 3b-16(a), 17 CFR 240.3b-16(a).
[23]: Rule 3b-16(b), 17 CFR 240.3b-16(b).
[24]: 15 U.S.C. 78s.
[25]: Rule 3a1-1(b)(1), 17 CFR 240.3a1-1(b)(1).
[26]: Rule 301(b)(3), 17 CFR 240.301(b)(3). Alternative trading systems
will only have to comply with this rule for fifty percent of
securities on [insert date 120 days after publication in the
Federal Register]. By [insert date 240 days after publication in
the Federal Register], alternative trading systems will have to
comply with this rule for all securities. Prior to [insert date
120 days after publication in the Federal Register], the
Commission will publish a schedule of those individual securities
for which alternative trading systems must comply with Rule
301(b)(3) on [insert date 120 days after publication in the
Federal Register]. See infra notes - and - and accompanying text.
[27]: This linkage requirement would not apply to alternative
trading systems that do not display participant orders to
anyone, including other system participants. In addition,
this requirement would not apply to alternative trading
systems to the extent that they trade securities other than
national market system securities. See infra Section
IV.A.2.c.(ii).
[28]: See infra Section IV.B.2.
[29]: See infra Section VI.
[30]: 15 U.S.C. 78c(a)(1).
[31]: Rule 3b-16(a), 17 CFR 240.3b-16(a). In the Proposing Release, the
Commission proposed to define the terms in the definition of
"exchange" to be "any organization, association, or group of
persons that: (1) consolidates orders of multiple parties; and (2)
sets non-discretionary material conditions (whether by providing a
trading facility or by setting rules) under which parties entering
such orders agree to the terms of a trade." See Proposing
Release, supra note .
[32]: See Securities Exchange Act Release No. 27611 (Jan. 12, 1990), 55
FR 1980, 1900 (Jan. 19, 1990) ("Delta Release"). See infra
Section VII for a further discussion of the Delta Release and the
basis and purpose of the revised interpretation.
[33]: See infra Section IV.B. (discussing registration as a national
securities exchange). Under Section 5 of the Exchange Act, an
exemption may be granted to an exchange from registration as a
national securities exchange on the basis of low volume, or
expected low volume. Currently, there is only one exchange, the
Arizona Stock Exchange ("AZX"), that is operating under a limited
volume exemption. See Securities Exchange Act Release No. 28899
(Feb. 20, 1991), 56 FR 8377 (Feb. 28, 1991). In addition, the
Commission solicited comment on whether Tradepoint Financial
Networks, plc should be granted a limited volume exemption. See
Securities Exchange Act Release No. 40161 (July 2, 1998), 45 FR
41920 (July 9, 1998).
The Commission believes that the low volume exemption continues to
be appropriate for some exchanges, such as an exchange that, for
example, disciplines its members (other than by excluding them or
limiting them from trading based on objective criteria, such as
creditworthiness), or has other self-regulatory attributes that
exclude it from the definition of alternative trading system, Rule
300(a), and therefore preclude it from making the choice to
register as a broker-dealer. Any exchange seeking a low volume
exemption would, of course, have to have low volume. The
Commission believes that the low volume exemption would be
inappropriate for any alternative trading system that can register
as a broker-dealer and comply with Regulation ATS, and that the
conditions under Regulation ATS should generally be met by any
alternative trading system falling within Rule 3b-16, including an
alternative trading system that, for other reasons, seeks a low
volume exemption.
[34]: NASD Letter at 3, n.4.
[35]: See CME Letter at 2; IBEX Letter at 4.
[36]: Instinet Letter at 7.
[37]: A crossing system is, typically, one that allows participants to
enter unpriced orders to buy and sell securities. Orders are
crossed at specified times at a price derived from another market.
[38]: Matching systems allow participants to enter priced limit orders
and match those orders with other orders in the system.
Participants are able to view unmatched limit orders in the
system’s book. The sponsor of a matching system typically acts as
riskless principal or a dealer firm on behalf of the system acts
as riskless principal, with respect to matched orders, or
contracts with another broker-dealer to perform this function.
[39]: Currently, debt markets are not centrally organized by a single
entity, but are nonetheless informally organized around
interdealer brokers. Interdealer brokers (also called blind
brokers and brokers’ brokers) display, on an anonymous basis, the
offers to buy and sell securities that are placed with them by
subscribers. In order to place a bid or offer, a subscriber
typically telephones the interdealer broker, which enters the
order into its system and displays it to other subscribers. Some
interdealer brokers display all bids and offers; others display
only the best bid and offer. To execute against an offer
displayed on the computer screen, a subscriber telephones the
interdealer broker, although sometimes execution may be
electronic. The identities of the counterparties are, generally,
kept confidential through clearance and settlement of the trade.
Some interdealer brokers, however, reveal the names of each
counterparty after execution. Traditionally interdealer brokers
facilitated trading only between dealers. Increasingly, however,
interdealer brokers are permitting non-dealers to participate in
their systems.
[40]: But see infra notes - and accompanying text (discussing the
exclusion from Regulation ATS for alternative trading systems that
trade exclusively government, and other related, securities).
[41]: See Bruce Rule, PSA Panels Embrace Internet for Institutional
Trading; and Regulators Love the Audit Trail, Investment Dealers’
Digest, Nov. 18, 1996 (discussing CP Direct). The converse
situation -- i.e., where there is one buyer and multiple sellers
for a given instrument -- would also not meet the "multiple buyers
and sellers" requirement. The Commission, however, is not aware
of any system that currently operates this way.
[42]: This type of system would also be expressly excluded from Rule 3b-
16 under paragraph (b)(2). See infra Section III.C.2.
[43]: Rule 3b-16(c), 17 CFR 240.3b-16(c).
[44]: TBMA Letter at 15-16 (stating that the bids and offers associated
with telephone-based IDBs are generally "subject," i.e., the
broker must check back with the dealer client before finalizing
the transaction).
[45]: Rule 3b-16(c), 17 CFR 240.3b-16(c).
[46]: TBMA Letter at 15.
[47]: These bulletin board types of systems were described in no-action
letters from the staff. See Letter dated June 24, 1996 from
Catherine McGuire, Chief Counsel, Division of Market Regulation,
SEC, Jack W. Murphy, Chief Counsel, Division of Investment
Management, SEC, and Martin P. Dunn, Chief Counsel, Division of
Corporate Finance, SEC to Barry Reder, Coblentz, Cahen, McCabe and
Breyer, LLP (counsel to Real Goods Trading Corporation); Letter
dated Aug. 5, 1996 from Catherine McGuire, Chief Counsel, Division
of Market Regulation, SEC to: Bruce D. Stuart, Esq. (counsel to
PerfectData Corporation); and Letter dated April 17, 1996 from
Abigail Arms, Associate Director, Division of Corporate Finance,
SEC, and Catherine McGuire, Associate Director, Division of Market
Regulation, SEC to Andrew Klein (President and Chief Executive
Officer of Spring Street Brewing Company).
[48]: See Securities Exchange Act Release No. 39086 (Sept. 17, 1997), 62
FR 50036 (Sept. 24, 1997). In approving OptiMark, the Commission
stated that OptiMark’s unique design warrants a non-traditional
approach in determining whether to require the dissemination of
trading interest expressed through operation of OptiMark.
[49]: See Rule 11Ac1-1(c), 17 CFR 240.11Ac1-1(c).
[50]: MSDW Letter at 11.
[51]: MSDW Letter, pp. 7-8.
[52]: Proposed Rule 3b-12(b)(2).
[53]: See NASD Letter at 3, n.4; TBMA Letter at 3, 14; SIA Letter at 3,
10; MSDW Letter at 5-6.
[54]: See TBMA Letter at 3, 14-15; SIA Letter at 3, 10-11.
[55]: Whether or not a bulletin board will be considered an exchange
under the rule will also depend on whether it meets the other
elements of the definition.
[56]: See Delta Release, supra note . The Commission notes that the
arrangement between these entities no longer exists, and that
Delta, in its current form, would not fit the new interpretation
of the definition of exchange.
[57]: See id., at 1897.
[58]: 15 U.S.C. 78k-1.
[59]: 15 U.S.C. 78o-3. The NASD, parent of Nasdaq, is the self-
regulatory organization. The NASD delegates to NASD Regulation,
Inc. ("NASDR"), the wholly owned regulatory subsidiary of the
NASD, its SRO responsibilities to surveil trading conducted on
Nasdaq and the OTC Bulletin Boards, and to enforce compliance by
its members (and persons associated with its members) with
applicable laws and rules. Nasdaq also surveils trading conducted
on its market and refers potential violations to NASDR. See also
infra note .
[60]: See infra notes - and accompanying text (discussing Rule 3a1-
1(a)(1), which explicitly exempts any system operated by a
national securities association from the definition of the term
"exchange").
[61]: 15 U.S.C. 78f. If Nasdaq registered as an exchange, it would have
its own SRO responsibilities, but the Commission does not expect
this to increase Nasdaq’s current burden. In view of the NASD’s
SRO status the Commission could use its authority under Sections
17 and 19 of the Exchange Act, 15 U.S.C. 78q and 78s, to delegate
any obligations Nasdaq would have as a registered exchange to
enforce compliance by its members (and persons associated with its
members) with the federal securities laws to NASDR.
[62]: See SIA Letter at 3, 10-11; DBSI Letter at 3; NASD Letter at 4;
TBMA Letter at 3, 14.
[63]: See TBMA Letter at 14, n.26; SIA Letter at 10-11, n.18.
[64]: TBMA Letter at 14, n.25 (suggesting that the Commission expressly
recognize the possibility that some IDBs may be able to rely on
the exclusion for internal broker-dealer systems).
[65]: SIA Letter at 3-4, 6-7, 9.
[66]: POSIT is an alternative trading system operated by ITG Inc.
Broker-dealers and institutions enter unpriced orders to buy and
sell exchange listed and Nasdaq securities into POSIT at any time
prior to a pre-selected crossing time. At the crossing time, buy
orders in the system for each security are crossed, where
possible, with sell orders and crossed orders are executed at a
price derived from the primary market where the security trades.
[67]: Letter from Timothy H. Hosking, General Counsel, ITG Inc., to
Jonathan G. Katz, Secretary, SEC dated Nov. 20, 1998 ("ITG
Letter") at 2-3.
[68]: The indications of interest entered into "passive" or derivative
pricing systems are "orders," under Rule 3b-16(c). While the
orders are entered without a specified price, subscribers agree to
trade at a price based on the primary market, such as the mid-
point of the bid and ask at the time orders are matched or at the
primary market’s opening price.
[69]: In addition, there exists the incentive for subscribers to these
"passive systems" to manipulate the price in the market from which
the "passive system" derives its price in order to obtain a
favorable execution on the passive system.
[70]: See Rules 301(b)(5)(iii) and 301(b)(6)(iii), 17 CFR
242.301(b)(5)(iii) and 242.301(b)(6)(iii). See infra notes , , -
and accompanying text. Further, the Commission did not propose,
nor is it adopting, a requirement that alternative trading systems
that register as broker-dealers publicly display any orders that
are not displayed to that system’s subscribers. Thus, alternative
trading systems -- like most "passive" systems -- that do not
display subscriber orders at all, are not subject to the public
display requirement if they register as broker-dealers under
Regulation ATS.
[71]: SIA Letter at 10.
[72]: A similar system, also operated by the Amex, is Automated Post
Execution Reporting System, or AutoPERS.
[73]: BRASS is an order routing system operated by Automated Securities
Clearance, Ltd. ("ASC"). ASC provides system users with software
and hardware that enables users to enter orders into the system
which are then routed to an exchange or Nasdaq for execution.
BRASS software enables a market maker to execute orders against
its inventory at the market maker’s quoted price, monitor
compliance with the Commission’s Limit Order Display Rule, infra
note , route an order to another market maker or market, report
executed transactions, and monitor, among other things, trading
positions, and profit/loss margins. Separately, an entity
affiliated with ASC, the BRASS Utility, LLC ("BRUT"), operates an
electronic communications network ("ECN") to which orders can be
routed through the use of BRASS software. See infra note .
[74]: Third market firms are NASD member firms that execute orders for
exchange-listed securities.
[75]: See Letter from David E. Rosedahl, Executive Vice President and
Chief Regulatory Officer, Pacific Exchange, Inc. to Jonathan G.
Katz, Secretary, SEC, dated Aug. 20, 1998 ("PCX Letter") at 2-6;
CHX Letter at 3-4.
[76]: Rule 11Ac1-4(b)(1)(i), 17 CFR 240.11Ac1-4(b)(1)(i).
[77]: Proposing Release, supra note , at n.9.
[78]: Rule 3b-16(b)(2)(ii), 17 CFR 240.3b-16(b)(2)(ii).
[79]: See SIA Letter at 10; DBSI Letter at 3.
[80]: DBSI Letter at 3.
[81]: SIA Letter at 11.
[82]: Rule 3b-16(b)(4), 17 CFR 240.3b-16(b)(4).
[83]: Rule 3b-16(b)(2)(i), 17 CFR 240.3b-16(b)(2)(i).
[84]: These systems may also implicate other provisions of the federal
securities laws.
[85]: In some cases, however, the systems operated by the interdealer
brokers may fall within Rule 3b-16. See supra System F.
[86]: 15 U.S.C. 78mm.
[87]: 17 CFR 240.3a1-1.
[88]: 17 CFR 240.3a1-1(a)(2). See infra note and accompanying text for
the definition of an alternative trading system.
[89]: 17 CFR 240.3a1-1(a)(3). See notes - and accompanying text.
[90]: 17 CFR 240.3a1-1(a)(1).
[91]: See infra Section III.F.
[92]: Rule 3a1-1(b), 17 CFR 240.3a1-1(b).
[93]: Registration as a national securities association under Section
15A of the Exchange Act is voluntary. 15 U.S.C. 78o-3. Currently
the only national securities association is the NASD, which
operates Nasdaq.
[94]: Rule 3a1-1(a)(1). See also Rule 301(a)(3) (excluding alternative
trading systems operated by a national securities association from
the scope of proposed Regulation ATS).
[95]: Instinet Letter at 8, n.11.
[96]: 17 CFR 240.3a1-1(a)(3).
[97]: See TBMA Letter at 12-13 (expressing concern that foreign
regulators might be influenced by the Commission’s categorization
of a system as an "exchange," even if that system chose to be
regulated in the U.S. as a broker-dealer); Instinet Letter at 3,
6-7, 13-14 and 6-7, n.9 (stating that classifying a securities
firm as an exchange in the U.S. could significantly impair a
firm’s ability to participate in foreign markets . . . because a
number of foreign regulators may regard all broker-dealers covered
by the expanded ‘exchange’ definition as ‘exchanges’). See also
CBB Letter at 3.
[98]: TBMA Letter at 12.
[99]: See Letter from Mike Cormack, Manager, Equity Trading, American
Century to Jonathan G. Katz, Secretary, SEC, dated Aug. 12, 1998
("American Century Letter") at 1-2 (supporting the Commission’s
proposal to permit alternative trading systems to register as
exchanges because it would provide an option for innovators, and
noting alternative trading systems’ objection to the NASD’s
proposed central limit order book based on the belief that an SRO
regulating alternative trading systems should not operate a
competing system); NASD Letter at 3 (commenting that both
registration as an exchange and Regulation ATS "generally appear
to ensure that alternative trading systems operate with the
appropriate levels of investor protection, while affording
alternative trading systems the necessary flexibility to choose
between different models of regulation"); CME Letter at 3
(generally supporting the additional requirements for alternative
trading systems because they will improve investor protection and
lessen the regulatory disparity that currently exists between
alternative trading systems and traditional exchanges); Instinet
Letter at 7, n.10 (stating that the Commission should modify the
exemption in Rule 3a1-1 from exchange registration so that
alternative trading systems that, while acting in good faith, fail
to comply fully with each of the technical requirements of
Regulation ATS do not violate Sections 5 and 6 of the Exchange
Act); ICI Letter at 2; IBEX Letter at 4.
[100]:CHX Letter at 6 (questioning why traditional exchanges should not
have the opportunity to make the same choice as alternative
trading systems, and commenting that SROs should be permitted to
form subsidiaries that were alternative trading systems registered
as broker-dealers).
[101]:In making this significant decision, a national securities
exchange would have to follow its constitution and by-laws
(including provisions concerning membership votes), and any
applicable state law requirements.
[102]:Section 15(b)(8) of the Exchange Act requires any broker-dealer
engaging in transactions other than solely on a national
securities exchange of which it is a member, to become a member of
a national securities association. 15 U.S.C. 78o(b)(8).
[103]:The Commission does not mean to imply that national securities
exchanges cannot make this choice. The Commission is merely
pointing out that if a national securities exchange does so, it
cannot continue to act as its own SRO.
[104]:Rule 3a1-1(b), 17 CFR 240.3a1-1(b)(1).
[105]:The Commission does not mean to imply that the NASD will be
required to register Nasdaq as a national securities exchange. As
stated above, because Nasdaq is operated by a national securities
association, it is currently subject to requirements virtually
identical to those applicable to national securities exchanges.
Any alternative trading system, however, currently operated by a
national securities association could choose to register as an
exchange.
[106]:15 U.S.C. 78s(c)(3).
[107]:See S. Rep. No. 75, 94th Cong., 1st Sess. 8 (1975) at 2, 8; H.R.
Rep. No. 229, 94th Cong., 1st Sess 92 (1975).
[108]:See supra note .
[109]:See S. Rep. No. 75. supra note . "[T]he increasing tempo and
magnitude of the changes that are occurring in our domestic and
international economy make it clear that the securities markets
are due to be tested as never before," and that it was, therefore,
important to assure "that the securities markets and the
regulations of the securities industry remain strong and capable
of fostering [the] fundamental goals [of the Exchange Act] under
changing economic and technological conditions." Id. at 3.
[110]:S. Rep. No. 75 supra note , at 8-9.
[111]:S. Rep. No. 75 supra note , at 7; see Section 11A(a)(1)(C) of the
Exchange Act, 15 U.S.C. 78k-1(a)(1)(C).
[112]:See S. Rep. No. 75 supra note , at 104-05.
[113]:Section 11A(a)(1)(C)(ii) of the Exchange Act, 15 U.S.C. 78k-
1(a)(1)(C)(ii). A fundamental goal of an national market system
was to "achieve a market characterized by economically efficient
executions, fair competition, [and the] broad dissemination of
basic market information." S. Rep. No. 75 supra note , at 101.
[114]:See Section 11A(c)(1) of the Exchange Act, 15 U.S.C. 78k-1(c)(1).
[115]:S. Rep. No. 75 supra note , at 7.
[116]:In addition to its authority under Section 11A of the Exchange
Act, 15 U.S.C. 78k-1, the Commission is adopting Regulation ATS
pursuant to its rulemaking power under other parts of the Exchange
Act, including Sections 3(b) (power to define terms), 15(b)(1)
(registration and regulation of broker-dealers), 15(c)(2)
(prescribing means reasonably designed to prevent fraud), 17(a)
(books and records requirements), 17(b) (inspection of records),
23(a)(1) (general power to make rules and classify persons,
securities, and other matters), and 36 (general exemptive
authority). 15 U.S.C. 78c(b), 78o(b)(1), 78o(c)(2), 78q(a),
78q(b), 78w(a)(1), and 78mm, respectively. For a discussion on
the general exemptive authority in Section 36 of the Exchange Act,
15 U.S.C. 78mm, see infra Section VII.D.1.
[117]:See supra Section III (discussing Rule 3b-16).
[118]:Rule 300(a), 17 CFR 242.300(a).
[119]:See supra note and accompanying text. The Commission has the
authority to require significant markets to remain registered as
exchanges. See supra Section III.F.
[120]:PCX Letter at 3.
[121]:Rule 3a1-1(a)(2), 17 CFR 240.3a1-1(a)(2).
[122]:See supra note .
[123]:The term "government security" is defined in Section 3(a)(42) of
the Exchange Act, 15 U.S.C. 78c(a)(42).
[124]:See generally Department of the Treasury, Securities and Exchange
Commission, and Board of Governors of the Federal Reserve System,
Joint Study of the Regulatory System for Government Securities
(March 1998); Department of the Treasury, Report of the Secretary
of the Treasury on Specialized Government Securities Brokers and
Dealers (July 1995) ("1995 Treasury Report").
The Government Securities Act of 1986 ("GSA") amended the Exchange
Act to incorporate new Section 15C, which, among other things,
established registration and notice requirements for government
securities brokers and dealers. Section 15C generally requires
government securities brokers and dealers (i.e., 15C firms or
specialized government securities brokers and dealers) to register
with the Commission and to become members of an SRO (twenty-two
firms as of March 1998). Firms that are registered with the
Commission as general securities brokers or dealers (i.e.,
traditional broker-dealers registered under Section 15(b) of the
Exchange Act) are required to file notice with the Commission of
their government securities business (3,023 firms as of April
1998). In addition, financial institutions that engage in
government securities broker or dealer activities are required to
file notice of such activities with their appropriate regulatory
agency (120 institutions as of March 1998).
Under the regulatory structure established by the GSA, the
Treasury was granted authority to adopt regulations for all
government securities brokers and dealers concerning financial
responsibility, protection of investors’ funds and securities,
recordkeeping, reporting, and audit requirements, and to adopt
regulations governing the custody of government securities held by
depository institutions. The Government Securities Act Amendments
of 1993 ("GSAA") expanded the authority of the federal regulators
and the SROs over government securities transactions. The GSAA,
among other things, reauthorized the Treasury’s rulemaking
responsibilities, granted the Treasury authority to prescribe
large position recordkeeping and reporting rules, extended the
Commission’s antifraud and antimanipulation authority to all
government securities brokers and dealers, required government
securities brokers and dealers to provide to the Commission on
request records of government securities transactions to
reconstruct trading in the course of a particular inquiry or
investigation, removed the statutory restrictions on the authority
of the NASD to extend sales practice rules to its members’
transactions in government securities, and provided the bank
regulatory agencies with the authority to issue sales practice
rules for financial institutions engaged in government securities
broker or dealer activities.
The GSA also strengthened the ability of federal regulators to
examine, and to bring enforcement actions against, government
securities brokers and dealers. The Commission and the SROs have
examination and enforcement authority over government securities
brokers and dealers registered under Section 15C and over the
government securities activities of general securities brokers and
dealers. The Commission’s enforcement authority includes the
power to censure, place limitations on the activities, functions,
or operations of, suspend for a period not exceeding 12 months, or
revoke the registration of the entity. For financial institutions
that are government securities brokers or dealers, the
institution’s appropriate regulatory agency has examination and
enforcement authority over the institution. The appropriate
regulatory agency must notify the Commission of any sanctions
imposed on such institutions, and the Commission must maintain a
record of the sanctions.
[125]:Although all marketable Treasury notes, bonds, and zero-coupon
securities are listed on the NYSE, exchange trading volume is a
small fraction of the total over-the-counter volume in these
instruments. See U.S. Department of the Treasury, U.S. Securities
and Exchange Commission, and Board of Governors of the Federal
Reserve System, Joint Report on the Government Securities Market
26 (1992).
[126]:In other words, these systems are not required to register as
either an exchange or to comply with the requirements of
Regulation ATS. Rule 301(a)(4), 17 CFR 242.301(a)(4).
[127]:Rule 301(a)(4)(ii)(E), 17 CFR 242.301(a)(4)(ii)(E). The term
"commercial paper" is defined in Rule 300(m), 17 CFR 242.300(m).
This definition is based on the definition of commercial paper as
set forth in 12 CFR 541.5, an Office of Thrift Supervision
regulation that defines commercial paper, and Section 3(a)(3) of
the Securities Act of 1933, which uses identical language to
identify these securities as one category of exempted securities.
[128]:Rule 301(a)(4)(D), 17 CFR 242.301(a)(4)(D).
[129]:Section 3(a)(42) of the Exchange Act, 15 U.S.C. 78c(a)(42).
[130]:Rule 301(a)(4), 17 CFR 242.301(a)(4).
[131]:See, e.g., TBMA Letter at 17-18 (also urging the Commission to
clarify the application of proposed Regulation ATS where a trading
system trades government securities, as well as non-government
securities); CBB Letter at 3 (but requesting guidance from the
Commission on whether an ATS trading government securities and
relying on such an exemption would be precluded from trading
products other than securities); SIA Letter at 3, 11.
[132]:IBEX Letter at 4-5.
[133]:TBMA Letter at 13, n.21.
[134]:See supra note and accompanying text.
[135]:TBMA Letter at 17.
[136]:See TBMA Letter at 17; Instinet Letter at 8, n.11; CBB Letter at
3-4.
[137]:Instinet Letter at 8, n.11.
[138]:See infra note and accompanying text for the definition of
"covered security."
[139]:CBB Letter at 3.
[140]:CBB Letter at 3-4.
[141]:The proposal would not require an alternative trading system to
publicly display its best orders in fixed income securities.
[142]:15 U.S.C. 78c(a)(29).
[143]:Rule 300(l), 17 CFR 242.300(l).
[144]:Rule 300(m), 17 CFR 242.300(m).
[145]:An initiative by TBMA would also make the MSRB data available on
TBMA’s web site <http://www.investinginbonds.com>. See Robert
Whalen, Investor Aids: TBMA’s Internet-Based Price Reporting Aims
to Increase Market Transparency, The Bond Buyer, Nov. 25, 1998, at
28.
[146]:Due to the Commission’s concerns regarding the Year 2000 computer
technology conversion process, no new Commission rules requiring
major computer reprogramming will be made effective between June
1, 1999 and March 31, 2000. See Securities Exchange Act Release
No. 40377 (Aug. 27, 1998), 63 FR 47501 (Sept. 3, 1998).
Accordingly, because the logistical framework for investment grade
and non-investment grade corporate debt data has not been fully
developed, the Commission is not making Rules 301(b)(5)(D) and (E)
and Rules 301(b)(6)(D) and (E) effective until after the
moratorium is lifted.
[147]:See TBMA Letter at 3, MSDW Letter at 13; SIA Letter at 11; DBSI
Letter at 1 (adopting TBMA Letter).
[148]:See NYSE Letter at 6 (supporting regulation of alternative trading
systems that trade debt securities as important for investor
protection); IBEX Letter at 2-3 (also generally urging the
Commission to take steps to increase transparency, access to best
priced orders, and other investor protections in the debt markets,
e.g., insider trading and front running rules).
[149]:See TBMA Letter at 18-20; SIA Letter at 3, 11.
[150]:TBMA Letter at 19-20.
[151]:See Robert Zipf, How the Bond Market Works 86-87 (1997) (noting
characteristics of general obligation and revenue bonds and the
heightened risk of revenue bonds relative to general obligation
bonds).
[152]:As of June 30, 1998, there was approximately $3.4 trillion of U.S.
Treasury debt securities outstanding with average daily trading
volume of over $200 billion. By comparison, there was
approximately $1.4 trillion of municipal debt securities
outstanding with average daily trading volume of approximately $1
billion. The Bond Market Association, Research Quarterly (August
1998) <http://www.bondmarkets.com/research/9808rschq.pdf>.
[153]:TBMA Letter at 6-7, 21.
[154]:TBMA Letter at 24.
[155]:See TBMA Letter at 23-25; IBEX Letter at 12. IBEX also suggested
reactivating the SIA practice of publishing the average daily
trading volume of corporate and other bonds on a monthly basis
which was discontinued in 1994. IBEX Letter at 12.
[156]:TBMA Letter at 23-25.
[157]:Rule 301(a)(5), 17 CFR 242.301(a)(5).
[158]:The transparency requirements are discussed infra Section
IV.A.2.c.
[159]:Section 15(b)(8) of the Exchange Act, 15 U.S.C. 78o(b)(8).
[160]:For example, the structural reforms undertaken by the NASD since
August 1996 should aid in ensuring the independence of NASDR and
insulating its staff from the commercial interests of Nasdaq .
[161]:See supra note 4.
[162]:Section 15A of the Exchange Act, 15 U.S.C. 78o-3.
[163]:See Rule 301(b)(8), 17 CFR 242.301(b)(8).
[164]:Rule 301(b)(1), 17 CFR 242.301(b)(1).
[165]:Rule 301(b)(2)(i) and Form ATS, 17 CFR 242.301(b)(2)(i) and 17 CFR
249.637.
[166]:Most currently operating alternative trading systems have filed
Part 1 of Form 17A-23. To avail themselves of the exemption in
Rule 3a1-1(a)(2), these systems must file Form ATS within 20 days
of the effective date of these rules. Internal broker-dealer
systems, 17 CFR 240.17a-3(a)(16)(ii)(A), which may also have
previously filed Part I of Form 17A-23, do not have to file Form
ATS.
[167]:17 CFR 240.17a-23. See infra Section V.
[168]:Rule 301(b)(2)(ii), 17 CFR 242.301(b)(2)(ii).
[169]:SIA Letter at 17-18.
[170]:Rule 301(b)(2)(iii), 17 CFR 242.301(b)(2)(iii). Alternative
trading systems would also be required to file an amendment to
Form ATS to correct any previously filed information that has been
discovered to have been inaccurate when filed. Rule
301(b)(2)(iv), 17 CFR 242.301(b)(2)(iv).
[171]:Rule 301(b)(2)(v), 17 CFR 301(b)(2)(v). An alternative trading
system is required to provide a duplicate of each of these filings
to surveillance personnel designated by the SRO of which it is a
member. Rule 301(b)(2)(vii), 17 CFR 301(b)(2)(vii).
[172]:See supra note .
[173]:SIA Letter at 17-18.
[174]:See SIA Letter at 17-18; American Century Letter at 6.
[175]:IBEX Letter at 5.
[176]:See IBEX Letter at 5; SIA Letter at 18; American Century Letter at
6.
[177]:ECNs include any automated trading mechanism that widely
disseminates market maker orders to third parties and permits such
orders to be executed through the system, other than crossing
systems. Rule 11Ac-1-1, 17 CFR 240.11Ac1-1. See also Securities
Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 48290
(Sept. 12, 1996) ("Order Handling Rules Adopting Release").
[178]:Presently, nine alternative trading systems have elected to
display quotes under the ECN Display Alternative. See Letters
dated Jan. 17, 1997 from Richard R. Lindsey, Director, Division of
Market Regulation, SEC to: Charles R. Hood, Senior V.P. and
General Counsel, Instinet Corporation (recognizing Instinet as an
ECN); Joshua Levine and Jeffrey Citron, Smith Wall Associates
(recognizing the Island System as an ECN); Gerald D. Putnam,
President, Terra Nova Trading, LLC (recognizing the TONTO System,
now known as Archipelago, as an ECN); and Roger D. Blanc, Wilkie
Farr & Gallagher (counsel to Bloomberg) (recognizing Bloomberg
Tradebook as an ECN). See also Letter dated October 6, 1997 from
Richard R. Lindsey, Director, Division of Market Regulation, SEC
to Matthew G. Maloney, Dickstein Shapiro Morin & Oshinsky LLP
(counsel to Spear, Leeds & Kellogg) (recognizing the REDI System
as an ECN); Letter dated February 4, 1998 from Robert L.D. Colby,
Deputy Director, Division of Market Regulation, SEC, to Linda
Lerner, General Counsel, All-Tech Investment Group, Inc.
(recognizing the Attain System as an ECN); Letter dated April 21,
1998 from Richard R. Lindsey, Director, Division of Market
Regulation, SEC to Mark Dorsey, Fried, Frank, Harris, Shriver &
Jacobsen (counsel to The Brass Utility, LLC) (recognizing BRUT as
an ECN); and Letters dated Nov. 13, 1998 from Robert L.D. Colby,
Deputy Director, Division of Market Regulation, SEC to: Lloyd H.
Feller, Morgan, Lewis & Bockius LLP (counsel to Strike
Technologies LLC) (recognizing the Strike System as an ECN); John
M. Schaible, PIM Global Equities, Inc. (recognizing the Trading
System as an ECN).
[179]:Quoted spreads, which measure the difference between the inside
ask and the inside bid, have declined by forty-one percent. The
effective spread, which takes into account that trades may occur
inside or outside the quoted spread, declined by twenty-four
percent. The lower decline in the effective spread is due to a
decline in trading inside the spread. See NASD Economic Research,
Market Quality Monitoring: Overview of 1997 Market Changes (Mar.
17, 1998).
[180]:A covered security is defined in the same way as it is under Rule
11Ac1-1(a)(6), 17 CFR 240.11Ac1-1. Specifically, a "covered
security" is any security reported by an effective transaction
reporting plan and any other security for which a transaction
report, last sale data, or quotation information is disseminated
through an automated quotation system as described in Section
3(a)(51)(A)(ii) of the Exchange Act, 15 U.S.C. 78c(a)(51)(A)(ii).
See Rule 300(g). Accordingly, a covered security includes all
exchange-listed securities, Nasdaq NM securities, and Nasdaq
SmallCap securities.
[181]:See Order Handling Rules Adopting Release, supra note , at 87-96.
[182]:There is divergence among ECNs in the extent to which they have
chosen to integrate non-market maker orders into the prices they
display to the public. Several of the nine ECNs that are
currently linked to Nasdaq display to the public the best prices
of any orders entered into their systems (including both market
makers and institutions).
[183]:Because such trading interest frequently remains undisclosed,
within certain alternative trading systems non-market maker
participants are able to display prices that lock and cross the
public quotations. If the quotes of such participants were
disclosed to the public, the Commission believes it would result
in improved price opportunities for public investors.
[184]:See SEC, Statement of the Securities and Exchange Commission on
the Future Structure of the Securities Markets (Feb. 2, 1972), 37
FR 5286 (Feb. 4, 1972) (emphasis added).
[185]:In the Concept Release, supra note , the Commission considered
whether to require certain alternative trading systems to register
as exchanges. This approach would have addressed the Commission’s
concerns about lack of transparency by requiring certain
significant alternative trading systems to participate directly in
the national market system plans. Commenters to the Concept
Release, however, expressed concerns about requiring alternative
trading systems to register as exchanges, and that a much more
workable and realistic approach would be to enhance the system of
broker-dealer regulation under which alternative trading systems
are currently regulated. For example, in recommending that the
Commission consider allowing alternative trading systems to
continue to be regulated as broker-dealers, the SIA commented that
"additional steps to integrate aggregate trading interest on
alternative trading systems to public view would be a sensible way
of addressing concerns that may exist in the aftermath of the
Order Handling Rules." See letter from A. B. Krongard, Chairman,
Securities Industry Association Task Force on Alternative Trading
System Concept Release to Jonathan G. Katz, Secretary, SEC,
received Oct. 6, 1997.
[186]:Letter from John Markese, President, American Association of
Individual Investors, to Jonathan G. Katz, Secretary, SEC, dated
Nov. 24, 1998 ("AAII Letter") at 1.
[187]:See supra note .
[188]:17 CFR 240.11Ac1-1.
[189]:One commenter (who does not internally display orders) expressed
its support for this aspect of the proposed transparency
requirement, stating that, while exchanges and broker-dealers
should be subject to the same public display requirement, if an
alternative trading system did not display any orders to
subscribers, it should not be required to publicly display those
orders to non-subscribers through the public quotation stream.
See OptiMark Letter at 4.
[190]:See infra notes - and accompanying text.
[191]:The Commission plans to monitor the effects of the reserve
function on market liquidity and transparency.
[192]:In addition to phasing in the transparency requirements for
institutional orders, affected alternative trading systems may
also choose to phase-in the access requirements for the covered
securities. See infra notes - and accompanying text.
[193]:The Commission notes that the later date will fall within the
moratorium to facilitate Year 2000 conversion. Securities
Exchange Act Release No. 40377 (Aug. 27, 1998), 63 FR 47051 (Sept.
3, 1998). The Commission believes that the phase-in will not
require major reprogramming, however, and consequently is not
subject to the moratorium. In addition, alternative trading
systems may voluntarily publicly display all non-market maker
broker-dealer and institutional orders covered by the requirement
on or before [insert date 120 days after publication in the
Federal Register].
[194]:See AAII Letter at 1 (suggesting that the volume threshold be much
lower than ten percent), NYSE Letter at 5 (stating that it
believed a more appropriate level would be five percent of the
aggregate daily volume in a security in any two of the three most
recent months, because very few registered markets (exchanges and
associations) accounted for more than ten percent of the volume in
any security); CHX Letter at 8 (suggesting that the Commission
require all alternative trading systems to display their best
orders regardless of trading volume); NASD Letter at 1 (suggesting
a volume threshold of one percent); American Century Letter at 5
(stating opposition to any volume threshold, as volume in any
alternative trading system may be sporadic over time). See also
ICI Letter at 3; IBEX Letter at 7-8; Ashton Letter at 4; TBMA
Letter pp. 21-22 (stating that it concurred that display of equity
securities trading on alternative trading systems was beneficial
to the market as a whole).
[195]:See SIA Letter at 12 (stating that a volume level of ten percent
had the potential to capture insignificant market players and
therefore recommending that the Commission consider a level of
twenty percent).
[196]:See ICI Letter at 2, n.5 (stating that the display requirement
should apply to all securities and to all alternative trading
systems, regardless of volume. The ICI stated that this would
avoid the practice of routing to a particular system simply to
avoid display); NYSE Letter at 5 (stating that if an alternative
trading system developed a "general presence" in the market, for
example by reaching the volume threshold in ten or more
securities, that alternative trading system should display the
best priced orders in all securities it traded); Ashton Letter at
4 (stating that once an alternative trading system achieved one
percent in a given "category" of securities over a six month
period, the system should be required to display its best orders
in all the securities in that category); CHX Letter at 8 (stating
that any volume threshold should be applied on an alternative
trading system as a whole, not on a security-by-security basis,
because of the burden of tracking security-by-security); American
Century Letter at 5 (commenting that a rule requiring public
display of all orders displayed in an alternative trading system
was preferable). See also IBEX Letter at 8; NASD Letter at 11.
But see SIA Letter at 12.
[197]:See SIA Letter at 13-14 (supporting display of orders on a
security-by-security basis and recommending that the volume
threshold be raised to twenty percent of the trading volume in
that security nationwide; also stating that no orders should be
required to be displayed in the public quotation stream unless the
trading volume in that security on the alternative trading system
exceeded twenty percent of the alternative trading system’s
overall trading activity). Of course, the Commission assumes that
those commenters who opposed display of non-market maker orders
generally would also oppose the display of all securities as well,
rather than only those above a certain volume threshold. See
infra notes -.
[198]:See ICI Letter at 3 (stating that the ICI supports display of
institutional orders provided that the reserve size feature is
retained, and provided that orders are displayed in the public
quotation system under the name of the alternative trading system,
and not the name of the subscriber placing the order, thereby
preserving anonymity); IBEX Letter at 8-9 (stating that the
"reserve size" feature permitted alternative trading system
subscribers to avoid adverse market impact and negotiate a larger
transaction with a single counter-party, two features IBEX
believes to be of considerable value. IBEX stated, however, that
reserve size availability to subscribers to an alternative trading
system should be contingent on an initial increment being publicly
displayed; non-subscribers being able to execute against the
reserve size; and the full size and price of each increment being
immediately reported, as executed, to the public quotation
system); Ashton Letter at 6 (stating that all orders up to 10,000
shares should be displayed, and that orders in excess of 10,000
shares, should have a minimum of 10,000 shares publicly displayed;
also stating that negotiation and reserve size features should be
available to non-subscribers, as well as subscribers); American
Century Letter at 5 (stating that it was "imperative" that the
reserve feature be maintained, because it provided depth of supply
and demand at a price, while protecting the order from being used
as a "free option" by other participants in the market). See also
Instinet Letter at 11-13 (arguing against total pre-trade
transparency); Bloomberg Letter at 19 n.32 (noting reserve feature
in the Tradebook System); Letter from Daniel G. Weaver, Associate
Professor of Finance, Zicklin School of Business, Barauch College
to Jonathan G. Katz, Secretary, SEC dated Nov. 23, 1998 ("Weaver
Letter") (stating that institutions will move their trading
upstairs even if the full size of their orders is hidden from
alternative trading system subscribers through their use of a
"reserve size" feature).
[199]:See Letter from Wessels, Arnold & Henderson, LLC to Jonathan G.
Katz, Secretary, SEC, dated Nov. 12, 1997 (commenting on the
Concept Release).
[200]:7/28/98 ICI Letter at 2-3. In a later letter, the ICI requested
clarification of whether certain orders the ICI described as "non-
firm" would be subject to display under the Commission’s rules.
See Letter from Craig S. Tyle, General Counsel, ICI, to Jonathan
G. Katz, dated November 13, 1998 ("11/13/98 ICI Letter"). See
also the discussion supra at Section III.A.3.
[201]:American Century Letter at 4-5.
[202]:NYSE Letter at 6.
[203]:Ashton Letter at 6
[204]:Instinet Letter at 3, 12, and 14.
[205]:Id. at n.18 and n.23. See also Letter from David K. Whitcomb,
Professor of Finance and Economics, Rutgers University to Jonathan
G. Katz, Secretary, SEC, dated July 27, 1998 ("Whitcomb Letter")
at 2-3 (stating that institutions may, in some instances, feel
strongly that displaying their orders more widely than to other
participants in the alternative trading system is undesirable, and
that, as a result, institutions may be induced to spread their
business among firms on the basis of whether the alternative
trading system has reached the volume threshold for public display
of orders, rather than on the basis of quality of service.);
Letter from Ruben Lee, Oxford Finance Group to Jonathan G. Katz,
Secretary, SEC, dated July 28, 1998 ("Lee Letter") at 2-3 (stating
that while mandatory transparency might help retail investors
monitor the quality of their executions and reduce the inequality
in access to information that retail investors face, it could
compromise efficiency and liquidity).
[206]:See 7/28/98 ICI Letter; 11/13/98 ICI Letter; Letter from Rick
Dahl, Chief Investment Officer, Missouri State Employees’
Retirement System to Jonathan G. Katz, Secretary, SEC, dated Nov.
12, 1998 ("Mosers Letter"); Letter from Russell Rhoads, Director
of Equity Trading, and Michael B. Orkin, Chairman and CEO,
Caldwell & Orkin, Inc. to Jonathan G. Katz, Secretary, SEC, dated
Nov. 20, 1998 ("Caldwell Letter"); Letter from Todd M. Sheridan,
Senior Portfolio Manager, Caterpillar Investment Management Ltd.
to Jonathan G. Katz, Secretary, SEC, dated Nov. 19, 1998; Letter
from Praveen K. Gottipalli, Director of Investments, Symphony
Asset Management to Jonathan G. Katz, Secretary, SEC, dated Nov.
20, 1998 ("Symphony Letter"); Letter from Cinda A. Carmer, Senior
Securities Trader, Heartland Capital Management, Inc. to Jonathan
G. Katz, Secretary, SEC, dated Nov. 17, 1998; Letter from Patrick
J. McCloskey, Senior Vice President, Wellington Management
Company, LLP to Jonathan G. Katz, Secretary, SEC, dated Nov. 23,
1998 ("Wellington Letter"); Letter from Carrie Canter, Principal,
Equity Trading, Barrow, Hanley, Mewhinney & Strauss, Inc. to
Jonathan G. Katz, Secretary, SEC, dated Nov. 12, 1998 ("Barrow
Letter"). See also Weaver Letter (stating that if the Commission
required institutions to display the full size of their orders,
even if the full size is hidden from alternative trading system
subscribers through their use of a "reserve size" feature,
institutions will move their trading upstairs).
[207]:See Letter from Gary E. Shugrue, General Partner, Argos Partners
Ltd., to Jonathan G. Katz, Secretary, SEC, dated Nov. 11, 1998
("Argos Letter"); Letter from Stacey Matthews, Chelsey Capital, to
Jonathan G. Katz, Secretary, SEC, dated Nov. 16, 1998, ("Chelsey
Letter"); Letter from John D. Race, Partner, DePrince, Race &
Zollo, Inc., to Jonathan G. Katz, Secretary, SEC, dated Nov. 16,
1998, ("DePrince Letter"); Letter from Michael W. Masters,
Portfolio Manager, Masters Capital Investments, LLC, to Jonathan
G. Katz, Secretary, SEC, dated Nov. 16, 1998, ("Masters Letter");
Letter from Denise O’Brien, Head of Equity Trading, Wanger Asset
Management, LP, to Jonathan G. Katz, Secretary, SEC, received Nov.
19, 1998, ("Wanger Letter"); Letter from Gerald N. Brown, Becker
Capital Management, to Jonathan G. Katz, Secretary, SEC, received
Nov. 19, 1998 ("Becker Letter"); Letter from Della L. Hood-Laster,
V.P. Equity Trading, Loomis Sayles & Company, LP, to Jonathan G.
Katz, Secretary SEC, dated Nov. 12, 1998, ("Loomis Letter"). See
also Barrow Letter and Mosers Letter.
[208]:See Letter from Susan Ellis, Vice President, Trading, Granahan
Investment Management, Inc. to Jonathan G. Katz, Secretary, SEC
dated Nov. 16, 1998; Letter from Genrald N. Brown, Becker Capital
Management to Jonathan G. Katz, Secretary, SEC received Nov. 19,
1998; Letter from Teresa M. Brandt, Head Equity Trader, Advantus
Capital Management, Inc. to Jonathan G. Katz, Secretary, SEC dated
Nov. 19, 1998; Letter from Kristen Straubel, Head Trader and
Robert T. Lutts, President, Cabot Money Management, Inc. to
Jonathan G. Katz dated Nov. 20, 1998; Letter from Tracy
Altebrando, Senior Equity Trader, Metropolitan Capital Advisors,
Inc. to Jonathan G. Katz, Secretary, SEC, dated Nov. 25, 1998.
See also Wanger Letter, Caldwell Letter, Symphony Letter,
Wellington Letter.
[209]:See, e.g., Loomis Letter, Chelsey Letter.
[210]:Letter from Ed Restrepo, Head Trader, VanWagoner Capital
Management to Jonathan G. Katz, Secretary, SEC, dated Nov. 16,
1998 ("VanWagoner Letter").
[211]:See VanWagoner Letter. See also Letter from Stacey Carter Fleece,
Chief Financial Officer, Brookhaven Capital Management to Jonathan
G. Katz, Secretary, SEC dated Nov. 18, 1998 (stating that
institutional orders submitted to dealers do not have to be
published); Letter from John D. Robinson, Head Trader, Longwood
Asset Management to Jonathan G. Katz, Secretary, SEC, dated Nov.
25, 1998.
[212]:Under Rule 301(b)(3), non-market maker broker-dealer orders
entered into alternative trading systems must also be displayed.
17 CFR 242.302(b)(3).
[213]:Rule 11Ac1-1(c)(5)(ii), 17 CFR 240.11Ac1-1(c)(5)(ii) ("Quote
Rule"). See also Order Handling Rules Adopting Release, supra
note .
[214]:See infra note and accompanying text.
[215]:Rule 301(b)(5), 17 CFR 242.301(b)(5).
[216]:See supra notes - and accompanying text.
[217]:The Commission emphasizes that, as with the transparency phase-in,
alternative trading systems may voluntarily provide access to non-
subscribers on or before [insert date 120 days after publication
in the Federal Register] in all securities covered by the rule.
[218]:See ICI Letter at 3; IBEX Letter at 9-10; Ashton Letter at 6;
American Century Letter at 2; OptiMark Letter at 4.
[219]:Instinet Letter at 10.
[220]:See supra notes - and accompanying text.
[221]:Instinet Letter at 16-17.
[222]:American Century Letter at 2.
[223]:See Proposing Release, supra note , at n. 108.
[224]:Rule 301(b)(4), 17 CFR 242.301(b)(4).
[225]:See Order Handling Rules Adopting Release, supra note , at n.272.
[226]:See, e.g., NASD Rule 4623. Securities Exchange Act Release Nos.
38156 (Jan. 10, 1997), 62 FR 2415 (Jan. 16, 1997); 38008 (Dec. 2,
1996), 61 FR 64550 (Dec. 5, 1996).
[227]:See ICI Letter at 3; Instinet Letter at 17-18; NASD Letter at 12;
American Century Letter at 2; OptiMark Letter at 5. See also IBEX
Letter at 11 (opposing allowing SROs to dictate a fee schedule for
alternative trading systems, in which fees charged non-subscribers
are lower than those charged subscribers), Ashton Letter at 6, n.7
(opposed to the idea that non-subscribers be linked through an SRO
execution system only).
[228]:See NYSE Letter at 7; CHX Letter at 8-10.
[229]:SIA Letter at 17 (stating that fees imposed by alternative trading
systems raised a number of procedural, structural and policy
issues, and recommending that the Commission make these the
subject of a separate release).
[230]:NASD Letter at 12. See also ICI Letter at 3 (recommending that
alternative trading systems be required to comply with any SRO
rules limiting fees).
[231]:See Order Handling Rules Adopting Release, supra note , at nn.347-
65 and accompanying text; Division of Market Regulation, Division
of Market Regulation, Market 2000: An Examination of Current
Equity Market Developments App V (1994) ("Market 2000 Study").
[232]:While SRO proposed rule changes relating to fees imposed by the
SRO are eligible to become effective upon filing under Section
19(b)(3)(A)(ii) of the Exchange Act, and Rule 19b-4(e)(2) of the
Exchange Act, the Commission continues to require SROs to file
proposed rule changes regarding fees applicable to non-members or
non-participants under Section 19(b)(2) for full notice and
comment. See Securities Exchange Act Release No. 35123 (Dec. 20,
1994), 59 FR 66692 (Dec. 28, 1994). Thus, a proposed SRO rule
relating to fees that alternative trading systems charge would not
be eligible to become effective upon filing.
[233]:Instinet Letter at 17-18 (also stating that the SRO to which an
alternative trading system belonged should not be authorized to
set fees).
[234]:American Century Letter at 2 (also agreeing that decimalization
will provide a more valid framework for this pricing structure).
See also ICI Letter at 3, n.8 (stating that market makers should
be able to assess liquidity fees when their quotes are "hit").
[235]:OptiMark Letter at 4-5.
[236]:NYSE Letter at 7 (stating that such fees could make it impossible
for market participants to determine the true cost of executing
orders, but indicating that if fees were included in the
disseminated quotation that would be acceptable); CHX Letter at 8-
10 (alternatively, CHX suggested the Commission allow firms to
ignore alternative trading system quotes at the NBBO if the next
price available after payment of the access fee is worse than the
next best available execution). But see IBEX Letter at 11
(opposing including fees in the public quote).
[237]:See supra note .
[238]:See Ashton Letter at 6 (suggesting that the Commission consider
amending the Quote Rule to require all exchanges, over-the-counter
dealers, and alternative trading systems to disseminate to the
public quote the actual size behind the best bid and offer
quotations). See also IBEX Letter at 11.
[239]:Rule 11Ac1-1(c)(5)(ii)(A) and (B), 17 CFR 11Ac1-1(c)(5)(ii)(A) and
(B).
[240]:See supra notes - and accompanying text.
[241]:Sections 6(b)(2) and 6(c) of the Exchange Act, 15 U.S.C. 78f(b)(2)
and (c); Section 15A(b)(8) of the Exchange Act, 15 U.S.C. 78o-
3(b)(8).
[242]:"Restraints on membership cannot be justified as achieving a valid
regulatory purpose and, therefore, constitute an unnecessary
burden on competition and an impediment to the development of a
national market system." H.R. Rep. No. 123, 94th Cong., 1st Sess.
53 (1975).
[243]:See supra Section IV.A.2.c.(ii).
[244]:Rule 301(b)(5), 17 CFR 242.301(b)(5). Alternative trading systems
that derive their prices for securities from prices for those same
securities on another market are not subject to this requirement.
[245]:The Commission notes that this twenty percent volume threshold is
based on current market conditions. If there is a change in these
market conditions, or if the Commission believes that alternative
trading systems with less than twenty percent of the trading
volume are engaging in inappropriate exclusionary practices or in
anticompetitive conduct, the Commission may revisit these fair
access thresholds. The Commission intends to monitor the impact
and effect of these fair access rules, as well as the practices of
alternative trading systems, and will consider changing these
rules if necessary to prevent anticompetitive behavior and ensure
that qualified investors have access to significant sources of
liquidity in the securities markets.
[246]:The term "equity security" is defined in Section 3(a)(11) of the
Exchange Act, 15 U.S.C. 78c(a)(11) and Rule 3a1-1, 17 CFR 240.3a1-
1. Options and limited partnerships are included within the
definition of an equity security.
[247]:See supra Section IV.A.1.d.
[248]:See supra note (discussing the April 1, 2000 effective date).
[249]:Rule 301(b)(5)(iii), 17 CFR 242.301(b)(5)(iii).
[250]:Several commenters agreed with the Commission that an alternative
trading system should be required to establish standards for
granting access to trading in its system. See IBEX Letter at 12;
Ashton Letter at 6; SIA Letter at 4, 14.
[251]:Rule 303(a)(1)(iii), 17 CFR 242.303(a)(1)(iii). The Commission
expects an alternative trading system to maintain a record of its
standards at each point in time. If the alternative trading
system amends or modifies its access standards, the records kept
should reflect historic standards, as well as current standards.
[252]:Moreover, if an alternative trading system requires subscribers to
open an account with another broker-dealer with which the
alternative trading system has a clearing arrangement, the
alternative trading system is responsible for ensuring that the
clearing broker-dealer does not unfairly deny access to any
person. Thus, the alternative trading system -- as part of its
agreement with the clearing firm -- must ensure that the clearing
firm establishes standards for customers opening an account and
that notices are sent to any prospective customer denied an
account.
[253]:Rule 301(b)(5)(ii), 17 CFR 242.301(b)(5)(ii).
[254]:Rule 301(b)(5)(ii)(D), 17 CFR 242.301(b)(5)(ii)(D).
[255]:Rule 301(b)(9), 17 CFR 242.301(b)(9); Form ATS-R, 17 CFR 249.638.
[256]:For example, the Commission has recognized that the
creditworthiness of a counterparty is a legitimate concern of
market participants. See Letter from Richard R. Lindsey,
Director, Division of Market Regulation, SEC, to Richard Grasso,
Chairman and Chief Executive Officer, NYSE, dated Nov. 22, 1996 at
17. The Commission also requested comment on what might be
appropriate reasons for an alternative trading system to deny
market participants access. Most commenters also stated that
objective standards, such as creditworthiness, would be
appropriate, provided that these standards were applied in a non-
discriminatory manner. See IBEX Letter at 12 (stating that
credit-worthiness would be the most significant standard); ICI
Letter at 4 (requesting that the Commission clarify that the
standards for access can take into account factors that are
relevant to credit or other forms of counterparty risk); SIA
Letter at 14 (recommending that the Commission allow alternative
trading systems to limit access to any category of its choosing,
provided that the standards are not applied in a discriminatory
manner, and stating that an alternative trading system should be
permitted to select its standards, publish them, and apply them as
stated in a non-discriminatory manner); TBMA Letter at 26
(requesting that the Commission clarify that an alternative
trading system would still be allowed to set standards describing
the customers with whom it wishes to do business, provided its
standards are applied in a non-discriminatory manner). See also
OptiMark Letter at 4, n.8 (stating that non-subscribers who wished
to become subscribers should not be "unreasonably denied").
[257]:See, e.g., IBEX Letter at 12 (stating that reasonable credit or
capital requirements or past bad faith dealings should be the only
basis for denying access); Ashton Letter at 6 (arguing that
alternative trading systems should be required to provide
equivalent access through nondiscriminatory system fees).
[258]:See TBMA Letter at 26 (stating that it would support a fair access
requirement for exchanges, but not for alternative trading
systems); ICI Letter at 4 (stating that it was not aware of any
material barriers to entry to the existing ECNs, and so did not
believe that the fair access requirement was necessary).
[259]:OptiMark Letter at 4.
[260]:See TBMA Letter at 22-23 (recommending that the threshold level be
raised to thirty-five percent to avoid capturing insignificant
market participants, particularly in regard to the bond market);
SIA Letter at 3-4 (recommending that the threshold level be raised
to forty percent); ICI Letter at 4 (recommending raising the
threshold level to fifty percent).
[261]:See IBEX Letter at 12 (recommending that the threshold level be
lowered to ten percent); American Century Letter at 3.
[262]:NASD Letter at 12 (stating that twenty percent is an appropriate
level).
[263]:American Century Letter at 3.
[264]:Rule 301(b)(5)(i), 17 CFR 242.301(b)(5)(i).
[265]:IBEX Letter at 13. See also ICI Letter at 4 (stating that the
Commission should not provide a right to appeal denial of access,
but that complaints should be handled as any other complaint
against broker-dealers were handled: through the appropriate SRO
or the Commission).
[266]:Instinet Letter at 19.
[267]:SIA Letter at 14-15. See also TBMA Letter at 26.
[268]:See Proposing Release, supra note , at Section III.A.2.e.
[269]:Securities Exchange Act Release No. 27445 (Nov. 16, 1989), 54 FR
48704 ("ARP I"); Securities Exchange Act Release No. 29185 (May 9,
1991), 56 FR 22489 ("ARP II"). ARP I and ARP II were published
in response to operational difficulties experienced by SRO
automated systems during the October 1987 market break. These
releases predicted future capacity requirements, emphasized the
need to maintain accurate trade and quote information, and
discussed the degree to which computer automation has become, and
is likely to increase as, an integral part of securities trading.
[270]:ARP II, supra note , set forth guidance concerning the nature of
these independent reviews.
[271]:The Commission notes that the United States General Accounting
Office ("GAO") has conducted several studies on the subject of
computer systems and their role in the financial markets.
Generally, the GAO has recommended that the Commission take steps
to improve systems capacity, integrity, and security. See GAO,
Stronger System Controls and Oversight Needed to Prevent NASD
Computer Outages (Dec. 1994) (regarding Nasdaq system outages);
GAO, Stock Markets: Information Vendors Need SEC Oversight to
Control Automation Risks (Jan. 1992) (regarding risk assessments
of automated operations of stock market information dissemination
vendors); GAO, Computer Security Controls at Five Stock Exchanges
Need Strengthening (Aug. 1991) (regarding systems related risks at
stock markets); GAO, Active Oversight of Market Automation by SEC
and CFTC Needed (Apr. 1991) (regarding automation risks of the
securities and futures markets); GAO, Tighter Computer Security
Needed (Jan. 1990) (regarding the Common Message Switch System and
the Intermarket Trading System operated by the Securities Industry
Automation Corporation and the Nasdaq system operated by the
NASD).
[272]:ARP I, supra note , 54 FR at 48705; ARP II, supra note , 56 FR at
22490.
[273]:See ARP I, supra note , 54 FR at 48706, at n.17; ARP II, supra
note , 56 FR at 22493, at n.15.
[274]:With regards to system capacity, integrity, and security
standards, the Commission notes that during the past year,
Instinet, Island, Bloomberg, and Archipelago (operated by Terra
Nova) have all experienced system outages due to problems with
their automated systems. On a number of occasions, ECNs have had
to stop disseminating market maker quotations in order to keep
from closing altogether, including during the market decline of
October 1997 when one significant ECN withdrew its quotes from
Nasdaq because of lack of capacity. Similarly, a major
interdealer broker in non-exempt securities experienced serious
capacity problems in processing the large number of transactions
in October 1997 and had to close down temporarily. As a result,
the Commission believes that the volume thresholds discussed above
are necessary to ensure that trading systems have developed
systems capacity, integrity, and security standards that are
adequate to prevent such system outages.
[275]:Rule 301(b)(6) applies to the same categories of debt securities
as Rule 301(b)(5), discussed supra note and accompanying text.
Specifically, the categories are investment grade corporate debt
securities, non-investment grade corporate debt securities, and
municipal securities. 17 CFR 242.301(b)(6).
[276]:See supra Section IV.A.2.d.
[277]:See supra Section IV.A.1.e.
[278]:See supra note (discussing the April 1, 2000 effective date).
[279]:Rule 301(b)(6)(iii), 17 CFR 242.301(b)(6)(iii).
[280]:Rule 301(b)(6)(ii)(A) - (F), 17 CFR 242.301(b)(6)(ii)(A) - (F).
[281]:Rule 301(b)(6)(ii)(G), 17 CFR 242.301(b)(6)(ii)(G).
[282]:Rule 301(b)(6), 17 CFR 242.301(b)(6). Regulation ATS also
requires alternative trading systems to preserve documentation
relating to their efforts to meet the requirements of this rule.
See Rule 303(a)(1)(iv), 17 CFR 242.303(a)(iv).
[283]:See ARP II, supra note .
[284]:See Proposing Release, supra note , at Section III.A.2.e.
[285]:See Ashton Letter at 5; NASD Letter at 11; TBMA Letter at 27 (but
only if a system plays some role in price discovery such as a
traditional exchange does).
[286]:NASD Letter at 11.
[287]:See TBMA Letter at 22-23; SIA Letter at 13.
[288]:See TBMA Letter at 22-23.
[289]:SIA Letter at 13.
[290]:Ashton Letter at 5.
[291]:ICI Letter at 4.
[292]:The Commission is aware of several incidents involving the
manipulation of quotations through alternative trading systems.
The participants who engaged in the manipulation were able to
profit as a result. See supra note .
[293]:Rule 301(b)(7), 17 CFR 242.301(b)(7).
[294]:Rule 301(b)(8), 17 CFR 242.301(b)(8).
[295]:Rule 302(a), 17 CFR 242.302(a).
[296]:Securities Exchange Act Release No. 39729 (Mar. 6, 1998), 63 FR
12559 (Mar. 13, 1998).
[297]:Rule 303(a)(1)(ii), 17 CFR 242.303(a)(1)(ii).
[298]:See supra Section IV.A.2.d.
[299]:Rule 303(a)(2), 17 CFR 242.303(a)(2).
[300]:Rule 303(b), 17 CFR 242.303(b). Rule 17a-4(f) provides for the
maintenance of records on microfilm, microfiche, or electronic
storage media. The Commission recognizes that alternative trading
systems may generate much of the information in electronic form
and generally may wish to keep records in electronic format. 17
CFR 240.17a-4(f).
[301]:17 CFR 240.17a-3 and 17 CFR 240.17a-4.
[302]:17 CFR 240.17a-4(i).
[303]:Rule 303(d), 17 CFR 242.303(d).
[304]:See ICI Letter at 4; Ashton Letter p. 5.
[305]:TBMA Letter at 16. TBMA suggested exempting alternative trading
systems that do not exceed fifteen percent of the relevant market
from Regulation ATS and, thus, from the recordkeeping
requirements. TBMA stated that the additional recordkeeping
requirements would not provide the Commission significant new
information beyond what is currently included within broker-dealer
recordkeeping requirements. Id.
[306]:Ashton Letter at 5. Ashton pointed out that, because SRO-
sponsored systems compete directly with alternative trading
systems, SROs should not be able to gain confidential information
through the regulatory reporting process. Id.
[307]:Rule 301(b)(7), 17 CFR 242.301(b)(7).
[308]:See also Securities Exchange Act Release No. 35124 (Dec. 20,
1994), 59 FR 66702 (Dec. 28, 1994 (addressing similar concerns in
the context of Rule 17a-23).
[309]:Instinet Letter at 20-21. Instinet stated that the Commission
should work with SROs to establish recordkeeping requirements that
minimize duplication and inconsistency as well as providing
alternative trading systems substantial flexibility in structuring
their recordkeeping operations. Id.
[310]:Rule 301(b)(9), 17 CFR 242.301(b)(9).
[311]:17 CFR 230.144A. Brokers and others who use alternative trading
systems to trade Rule 144A eligible securities and other types of
restricted securities should ensure those systems are structured
to permit the traders’ compliance with their obligations under
Rule 144A and under the Securities Act of 1933.
[312]:See supra notes - and accompanying text.
[313]:See infra Section V. Rule 17a-23 under the Exchange Act generally
requires U.S. broker-dealers that sponsor broker-dealer trading
systems to provide a description of their systems to the
Commission and report transaction volume and other information on
a quarterly basis. This rule also requires that such broker-
dealers keep records regarding system activity and to make such
records available to the Commission. 17 CFR 240.17a-23. See also
Securities Exchange Act Release No. 35124 (Dec. 20, 1994), 59 FR
66702 (Dec. 28, 1994).
[314]:Rule 301(b)(2)(vii), 17 CFR 242.301(b)(2).
[315]:See ICI Letter at 4 (supporting the proposal to require reports
quarterly); Ashton Letter at 5; IBEX Letter at 5.
[316]:Ashton Letter at 5.
[317]:See IBEX Letter at 5; American Century Letter at 6.
[318]:Ashton Letter at 5. Ashton pointed out that, because SRO-
sponsored systems compete directly with alternative trading
systems, SROs should not be able to gain confidential information
through the regulatory reporting process. Id.
[319]:See supra Section IV.A.2.g.
[320]:See ICI Letter at 4-5 (stating that it agreed that the failure to
keep trading information confidential created the potential for
abuse); Instinet Letter at 21 (requesting that the Commission
clarify whether or not the proposed confidentiality provisions
would prohibit registered representatives from providing customers
with information (other than confidential customer information)
regarding the trading activity of the alternative trading system);
American Century Letter at 1-2 (stating that agency broker-dealer
functions should be separate from intermediated broker-dealer
functions that allow an alternative trading system employee to
"work" an order on behalf of customers, and that these employees
should not have access to the orders of customers who choose to
work their orders without the assistance of employees of the
alternative trading system).
[321]:Rule 301(b)(10), 17 CFR 242.301(b)(10).
[322]:Alternative trading systems that continue to be regulated as
broker-dealers would remain subject to oversight by national
securities exchanges and the NASD, in their self-regulatory
capacities. See supra Section IV.A.2.a.
[323]:Options Clearing Corporation By-laws, Art. VII, Sections 1 and 4.
Registered exchanges that are members of the OCC determine such
matters as listing, registration, clearance, issuance and exercise
of options contracts. Exchange members of the OCC are also able
to use registration and disclosure materials tailored for
standardized options.
[324]:The Commission has the authority to review final disciplinary
sanctions imposed by SROs on members or associated persons of
members, including sanctions imposed for violations of SRO rules.
The Commission may only affirm a sanction imposed by an SRO on one
of its members, participants or associated persons of its members
for a violation an SRO’s rules, if the Commission finds that: (1)
the member, participant, or associated person of the member
engaged in the acts or practices that the SRO found were engaged
in; (2) such acts or practices are in violation of the SRO’s
rules; and (3) the SRO’s rules, and the application by the SRO of
its rules, are consistent with the purposes of the Exchange Act.
Sections 19(d)(2) and 19(e) of the Exchange Act, 15 U.S.C.
78s(d)(2) and 78s(e).
[325]:15 U.S.C. 78f.
[326]:See S. Rep. No. 75, supra note .
[327]:Section 6(a) of the Exchange Act, 15 U.S.C. 78f(a)
[328]:17 CFR 240.6a-1
[329]:17 CFR 202.3(b)(2). The Commission is not required to propose
changes to its Rules of Practice prior to adoption. See 5 U.S.C.
553(b)(3)(A).
[330]:Section 6(b) of the Exchange Act, 15 U.S.C. 78f(b).
[331]:Section 6(b)(1) of the Exchange Act, 15 U.S.C. 78f(b)(1).
[332]:15 U.S.C. 78c(a)(39). See also 15 U.S.C. 78o(b).
[333]:See Section 12(d) of the Exchange Act, 15 U.S.C. 78l(d); Rule
12d2-2, 17 CFR 240.12d2-2 (requiring national securities exchanges
to file an application with the Commission to strike a security
from listing and registration).
[334]:See 15 U.S.C. 78f(b)(9).
[335]:Section 6(b)(5) of the Exchange Act, 15 U.S.C. 78f(b)(5). See
also Section 6(b)(8) of the Exchange Act, 15 U.S.C. 78f(b)(6).
[336]:The Commission notes that, according to the audited financial
statements for 1997, the NYSE had total assets of $1,174,887,000
and total expenses of $488,811,000; the Amex had total assets of
$195,547,000 and total expenses of $173,742,000; the PCX had total
assets of $67,622,000 and total expenses of $60,636,000; the CSE
had total assets of $13,124,585 and total expenses of $5,343,403;
and the Boston Stock Exchange ("BSE") had total assets of
$33,339,961 and total expenses of $16,106,837.
[337]:Section 6(b)(4) of the Exchange Act, 15 U.S.C. 78f(b)(4).
[338]:15 U.S.C. 78q and 78s. See also 17 CFR 240.17d-2; 17 CFR
240.19g2-1.
[339]:With respect to a common member, Section 17(d)(1) of the Exchange
Act authorizes the Commission, by rule or order, to relieve an SRO
of the responsibility to receive regulatory reports, to examine
for and enforce compliance with applicable statutes, rules, and
regulations, or to perform other specified regulatory functions.
15 U.S.C. 78q(d)(1).
[340]:See Securities Exchange Act Release No. 23192 (May 1, 1986) 51 FR
17426 (May 12, 1986). Moreover, Section 108 of NSMIA, supra note
, adds a provision to Section 17 of the Exchange Act that calls
for improving coordination of supervision of members and
elimination of any unnecessary and burdensome duplication in the
examination process.
[341]:For example, the Commission has approved a regulatory plan filed
by the Amex, CBOE, NASD, NYSE, PCX, and the Philadelphia Stock
Exchange ("Phlx") that divides the oversight responsibilities
among these SROs for common members, by designating each
participating SRO as the options examination authority for a
portion of the common members. This designated SRO has sole
regulatory responsibility for certain options-related trading
matters. See Securities Exchange Act Release No. 20158 (Sept. 8,
1983), 48 FR 41265 (Sept. 14, 1983). The SRO designated under the
plan as a broker-dealer's options examination authority is
responsible for conducting options-related sales practice
examinations and investigating options-related customer complaints
and terminations for cause of associated persons. The designated
SRO is also responsible for examining a firm's compliance with the
provisions of applicable federal securities laws and the rules and
regulations thereunder, its own rules, and the rules of any SRO of
which the firm is a member. Id.
[342]:17 CFR 240.17d-2. Securities Exchange Act Release No. 12935 (Oct.
28, 1976), 41 FR 49093 (Nov. 8, 1976). In addition to the
regulatory responsibilities it otherwise has under the Exchange
Act, the SRO to which a firm is designated under these plans
assumes regulatory responsibilities allocated to it. Under Rule
17d-2(c), the Commission may declare any joint plan effective if,
after providing notice and opportunity for comment, it determines
that the plan is necessary or appropriate in the public interest
and for the protection of investors, to foster cooperation and
coordination among the SROs, to remove impediments to, and foster
the development of, a national market system and a national
clearance and settlement system, and in conformity with the
factors set forth in Exchange Act § 17(d). 15 U.S.C. 78q(d). The
Commission has approved plans filed by the equity exchanges and
the NASD for the allocation of regulatory responsibilities
pursuant to Rule 17d-2. See, e.g., Securities Exchange Act
Release Nos. 13326 (Mar. 3, 1977), 42 FR 13878 (Mar. 14, 1977)
(NYSE/Amex); 13536 (May 12, 1977), 42 FR 26264 (May 23, 1977)
(NYSE/BSE); 14152 (Nov. 9, 1977), 42 FR 59339 (Nov. 16, 1977)
(NYSE/CSE); 13535 (May 12, 1977), 42 FR 26269 (May 23, 1977)
(NYSE/CHX); 13531 (May 12, 1977), 42 FR 26273 (May 23, 1977)
(NYSE/PSE); 14093 (Oct. 25, 1977), 42 FR 57199 (Nov. 1, 1977)
(NYSE/Phlx); 15191 (Sept. 26, 1978), 43 FR 46093 (Oct. 5, 1978)
(NASD/BSE, CSE, CHX and PSE); and 16858 (May 30, 1980), 45 FR
37927 (June 5, 1980) (NASD/BSE, CSE, CHX and PSE).
[343]:See Section 6(b)(6) of the Exchange Act, 15 U.S.C. 78f(b)(6). See
also Section 6(b)(7) of the Exchange Act, 15 U.S.C. 78f(b)(7).
[344]:See, e.g. Section 19 of the Exchange Act, 15 U.S.C. 78s
[345]:Section 6(b)(3) of the Exchange Act, 15 U.S.C. 78f(b)(3).
[346]:Id.
[347]:See NASD 21(a) Report, supra note .
[348]:See Delta Release, supra note , at 1900. In Board of Trade of the
City of Chicago v. Securities and Exchange Commission, 923 F.2d
1270 (7th Cir. 1991) ("Delta II"), the court stated that:
The Delta system cannot register as an exchange because the
statute requires that an exchange be controlled by its
participants, who in turn must be registered brokers or
individuals associated with such brokers. So all the financial
institutions that trade through the Delta system would have to
register as brokers, and [the system sponsors] would have to turn
over the ownership and control of the system to the institutions.
The system would be kaput.
Id. at 1272-73.
[349]:See Securities Exchange Act Release No. 28335 (Aug. 13, 1990), 55
FR 34106 (Aug. 21, 1990) (order approving rule change establishing
electronic access memberships on the PCX).
[350]:The New Amex Board consists of eighteen total governors. Floor
governor nominees will be proposed by either the Amex Nominating
Committee (consisting of three floor members and two public
members) or a petition signed by twenty five members and will be
selected by a plurality of the Amex Regular and Options Principal
members voting together as a single class. The Amex membership
elects the members of the Amex Nominating Committee.
[351]:The Chief Executive Officer of New Amex will also be a governor on
the NASD Board.
[352]:The New Amex Floor Governor is nominated by the Amex Membership
and will be able to directly express the Amex members’ viewpoint
and concerns within the NASD Board forum. In addition, the Chief
Executive Officer of New Amex will be able to provide information
about, and communicate the needs of, New Amex to the NASD Board.
[353]:See Securities Exchange Act Release No. 40622 (Oct. 30, 1998), 63
FR 59819 (Nov. 5, 1998).
[354]:15 U.S.C. 78q-1(b)(3)(c). These methods include: (1) solicitation
of board of directors nominations from all participants; (2)
selection of candidates for election to the board of directors by
a nominating committee which would be composed of, and selected
by, the participants or representatives chosen by participants;
(3) direct participation by participants in the election of
directors through the allocation of voting stock to all
participants based on their usage of the clearing agency; or (4)
selection by participants of a slate of nominees for which
stockholders of the clearing agency would be required to vote
their share. See Securities Exchange Act Release No. 14531 at 24
(Mar. 6, 1978), 43 FR 10288 (Mar. 10, 1978). See also Securities
Exchange Act Release No. 16900 (June 17, 1980), 45 FR 41920 (June
23, 1980).
[355]:The proprietary foreign exchange Easdaq, a recognized secondary
market in Belgium, has established a "regulatory authority" that
has a degree of independence from Easdaq's board of directors.
[356]:The Commission in the past has approved exchange rules limiting
the voting rights of "special access" or non-equity members as
consistent with Section 6(b)(3) of the Exchange Act, 15 U.S.C.
78f(b)(3). See, e.g., Securities Exchange Act Release No. 22959
(Feb. 28, 1986), 51 FR 8060 (Mar. 7, 1986) (approving rule change
by NYSE establishing "electronic access membership" with
restricted voting rights).
[357]:See CBOE Letter at 5-6; NASD Letter at 4-5.
[358]:American Century Letter at 6.
[359]:See Ashton Letter at 4 (for-profit exchanges should be afforded
considerable flexibility in their formative business stages in
meeting fair representation obligations); OptiMark Letter at 3-4
(users of alternative trading systems should be treated fairly,
but are not entitled to exercise any formal rights in regard to
the management of the system, and are adequately protected through
a combination of regulatory safeguards and market forces); Lee
Letter at 1-2 (owners of exchanges already have incentives to
create suitable governance structures).
[360]:NASD Letter at 4-5.
[361]:15 U.S.C. 78s(a).
[362]:15 U.S.C. 78f(a) and 78s(a). See NASD Letter at 4-5 (commenting
that the public should have an opportunity to comment on the
proposed governance structure of an exchange before the Commission
approves its application for registration).
[363]:15 U.S.C. 78f(b)(3)-(4) and 78f(c).
[364]:15 U.S.C. 78f(c)(1). Section 6(c)(1), adopted in 1975, prohibits
exchanges from granting new memberships to non-broker-dealers. At
the time this Section was adopted, one non-broker-dealer
maintained membership on an exchange. This non-broker-dealer was
not affected by the prohibition and continues to maintain its
membership.
[365]:CBOE Letter at 6 ("it would be difficult, if not impossible, for
the Commission to adequately regulate or oversee the array of non-
broker-dealer institutions that currently are, or may become,
participants on [alternative trading systems]"); NASD Letter at 8
(institutions should not be members of alternative trading systems
that register as exchanges); IBEX Letter at 13 (institutional and
individual investors should be granted exchange access through the
sponsorship of discount or full-service broker-dealers).
[366]:American Century Letter at 4.
[367]:Sections 6(f) and 15(e) of the Exchange Act, 15 U.S.C. 78f(f) and
78o(e), would permit the Commission to subject institutional
members to all exchange rules and relevant Exchange Act
provisions.
[368]:The Commission could adopt such requirements pursuant to its
authority under Section 15(c) of the Exchange Act, 15 U.S.C.
78o(e).
[369]:The Commission notes that institutions currently have the option
to establish a broker-dealer affiliate, which can become a member
in an exchange. The institution can then direct its order flow
through its affiliated entity. Many investment companies already
have affiliated broker-dealers.
[370]:15 U.S.C. 78f(c)(1).
[371]:Exchange members are subject to regulatory action by the NYSE for
violations of NYSE rules by their customers entering orders
through the members’ SuperDOT terminals.
[372]:See infra note .
[373]:NASD Letter at 8.
[374]:15 U.S.C. 78f(b)(6)-(7) and 15 U.S.C. 78s(g). These provisions
require that a registered exchange be able to enforce compliance
by its members with the federal securities laws, appropriately
discipline its members for violations of such laws, and provide a
fair disciplinary procedure. The Commission notes, however, that
unless a broker-dealer effects transactions in securities solely
on a national securities exchange of which it is a member, it must
become a member of a national securities association or another
national securities exchange. Section 15(b)(8) of the Exchange
Act, 15 U.S.C. 78o(b)(8).
[375]:15 U.S.C. 78f(b)(2).
[376]:15 U.S.C. 78f(c).
[377]:A denial of access would be reasonable, for example, if it were
based on objective standards, such as capital and credit
requirements, and if these standards were applied fairly.
[378]:IBEX Letter at 13-14.
[379]:Section 6(b)(8) of the Exchange Act, 15 U.S.C. 78f(b)(8); Section
15A(b)(9) of the Exchange Act, 15 U.S.C. 78o-3(b)(9).
[380]:Section 6(b)(6) of the Exchange Act, 15 U.S.C. 78f(b)(6).
[381]:Section 23(a) of the Exchange Act, 15 U.S.C. 78w(a).
[382]:See supra notes - and accompanying text.
[383]:PCX Letter at 7-8.
[384]:In this regard, those exchanges applying for registration in 1999
should also be prepared to demonstrate that their systems are year
2000 compliant.
[385]:Section 12(a) of the Exchange Act makes it unlawful for any
member, broker, or dealer to effect any transaction in any
security (other than an exempted security) on a national
securities exchange unless a registration statement has been filed
with the Commission and is in effect as to such security for such
exchange in accordance with the provisions of the Exchange Act and
the rules and regulations thereunder. 15 U.S.C. 78l(a). Section
12(b) of the Exchange Act, 15 U.S.C. 78l(b), contains procedures
for the registration of securities on a national securities
exchange. Section 12(a) does not apply to an exchange that the
Commission has exempted from registration as a national securities
exchange. See, e.g., Securities Exchange Act Release No. 28899
(Feb. 20, 1991), 56 FR 8377 (Feb. 29, 1991). See also Securities
Exchange Act Release No. 37271 (June 3, 1996), 61 FR 29145 (June
7, 1996).
[386]:Section 12(f) of the Exchange Act, 15 U.S.C. 78l(f). Under
Section 12(f) of the Exchange Act, 15 U.S.C 78l(f), exchanges
cannot trade securities not listed on an exchange or classified as
Nasdaq NM securities (such as Nasdaq SmallCap or OTC securities)
without Commission action. Section 12(f) of the Exchange Act
authorizes the Commission to permit the extension of UTP to any
security listed otherwise than on an exchange. The OTC-UTP plan
which provides UTP for Nasdaq NM securities, is the only extension
to date approved by the Commission. See OTC-UTP plan, infra note
. Thus, registered exchanges cannot currently trade Nasdaq
SmallCap securities or exempted securities that are not separately
listed on the exchange.
[387]:Rule 12f-5, 17 CFR 240.12f-5.
[388]:See OTC-UTP plan, infra note and accompanying text.
[389]:The OTC-UTP plan provides for the collection, consolidation, and
dissemination of quotation and transaction information for Nasdaq
NM securities by its participants. Any registered Exchange where
Nasdaq NM securities are traded may become a full participant in
the OTC-UTP plan. See infra note . See also Securities Exchange
Act Release Nos. 24407 (Apr. 27, 1987), 52 FR 17349 (May 7, 1987);
36985 (Mar. 18, 1996), 61 FR 12122 (Mar. 25, 1996).
[390]:OptiMark Letter at 3.
[391]:The CTA provides vendors and other subscribers (including
alternative trading systems) with consolidated last sale
information for stocks admitted to dealings on any exchange
pursuant to a plan approved by the Commission ("CTA plan"). See,
e.g., Securities Exchange Act Release Nos. 10787 (May 10, 1974),
39 FR 17799 (final rules approving CTA plan); 16983 (July 16,
1980), 45 FR 49414 (July 24, 1980); 37191 (May 9, 1996), 61 FR
24842 (May 16, 1996).
[392]:The CQS gathers quotations from all market makers in exchange-
listed securities and disseminates them to vendors and other
subscribers pursuant to a plan approved by the Commission ("CQ
plan"). Securities Exchange Act Release No. 16518 (Jan. 22,
1980), 45 FR 6521 (final rules approving CQ plan); 37191 (May 9,
1996), 61 FR 24842 (May 16, 1996).
[393]:The ITS is a communications system designed to facilitate trading
among competing markets by providing each market participating in
the ITS pursuant to a plan approved by the Commission ("ITS plan")
with order routing capabilities based on current quotation
information. See, e.g., Securities Exchange Act Release Nos.
37191 (May 9, 1996), 61 FR 24842 (May 16, 1996); 17532 (Feb. 10,
1981), 46 FR 12919 (Feb. 18, 1981); 23365 (June 23, 1986), 51 FR
23865 (July 1, 1986) (CSE/ITS linkage); 18713 (May 6, 1982) 47 FR
20413 (May 12, 1982) (NASD's CAES/ITS linkage); 28874 (Feb. 12,
1991), 56 FR 6889 (Feb. 20, 1991) (CBOE/ITS linkage).
[394]:See infra note and accompanying text for a description of the
OPRA plan.
[395]:See infra note and accompanying text for a description of the
OTC-UTP plan.
[396]:See Rules 11Ac1-1(b)(1) and 11Aa3-2(c), 17 CFR 240.11Ac1-1(b)(1)
and 240.11Aa3-2(c).
[397]:Both the CTA and the CQS are presently operated by the eight
national securities exchanges and the NASD.
[398]:The CTA plan also contains a provision for entities other than
participants to report directly to the CTA as "other reporting
parties." Pursuant to this provision, parties other than a
national securities exchange or association may be permitted to
provide transaction data directly to the CTA. Alternative trading
systems that do not elect to register as exchanges would be
eligible for participation in the CTA plan pursuant to this
provision; however, as non-member participants, these systems
would neither be obligated to pay the required fees and expenses
to the plan, nor able to share in the plan’s profits.
[399]:See Securities Exchange Act Release No. 37191 (May 9, 1996), 61 FR
24842 (May 16, 1996).
[400]:These fees represent the "tangible and intangible assets" provided
by the plans to the new participant. See Proposing Release, supra
note at nn.342-43 (discussing entry fees for the CTA, CQS, and
ITS plans).
[401]:Similar to the CTA and CQ plans, the OTC-UTP plan governing
trading of Nasdaq NM securities provides for the collection,
consolidation, and dissemination of quotation and transaction
information for Nasdaq NM securities by its participants. Any
national securities exchange where Nasdaq NM securities are traded
may become a full participant of the OTC-UTP plan. The plan also
provides that new participants pay a share of development costs,
share ongoing operating costs, and are entitled to share in the
plan’s profits. See Joint Self-Regulatory Organization Plan
Governing the Collection, Consolidation and Dissemination of
Quotation and Transaction Information for Exchange-listed
Nasdaq/National Market System Securities and for Nasdaq/National
Market System Securities Traded on Exchanges on an Unlisted
Trading Privilege Basis ("OTC-UTP plan"). Securities Exchange Act
Release No. 24407 (Apr. 29, 1987), 52 FR 17349 (May 7, 1987). See
also Securities Exchange Act Release No. 36985 (Mar. 18, 1996), 61
FR 12122 (Mar. 25, 1996).
The OPRA plan also provides for the collection and dissemination
of last sale and quotation information with respect to options
that are traded on the participant exchanges. Under the terms of
this plan, any national securities exchange whose rules governing
the trading of standardized options have been approved by the
Commission may become a party to the OPRA plan. The plan provides
that any new party, as a condition of becoming a party, must pay a
share of OPRA's start-up costs. It also provides for revenue
sharing among all parties. The OPRA plan was approved pursuant to
Section 11A of the Exchange Act and Rule 11a3-2 thereunder. See
Securities Exchange Act Release No. 17638 (Mar. 18, 1981) ("OPRA
plan").
[402]:To become a participant in ITS, an exchange or association must
subscribe to, and agree to comply and to enforce compliance with,
the provisions of the plan. See ITS plan, supra note , at section
3(c).
[403]:ITS also establishes a procedure that allows specialists to
solicit pre-opening interest in a security from specialists and
market makers in other markets, thereby allowing these specialists
and market makers to participate in the opening transaction.
Participation in an opening transaction can be especially
important when the price of a security has changed since the
previous close.
[404]:A trade-through occurs when an ITS participant purchases
securities at a lower price or sells at a higher price than that
available in another ITS participant market. For example, if the
NYSE is displaying a bid of 20 and an offer of 20 1/8 for an ITS
security, the prohibition on trade-throughs would prohibit another
ITS participant market from buying that security from a customer
at 19 7/8 or selling that security to a customer at 20 1/2. In
addition, each participant market has in place rules to implement
the ITS Trade-Through Rule. See, e.g., NASD Rule 5262. The plan
also provides a mechanism for satisfying a market aggrieved by
another market's trade-through.
[405]:A locked market occurs when an ITS participant disseminates a bid
for an ITS security at a price that equals or exceeds the price of
the offer for the security from another ITS participant or
disseminates an offer for an ITS security at a price that equals
or is less than the price of the bid for the security from another
ITS participant. The plan provides a mechanism for resolving
locked markets.
[406]:The ITS block trade policy provides that the member who represents
a block size order shall, at the time of execution of the block
trade, send or cause to be sent, through ITS to each participating
ITS market center displaying a bid (or offer) superior to the
execution price a commitment to trade at the execution price and
for the number of shares displayed with that market center's
better priced bid (or offer).
[407]:American Century Letter at 3 (citing instances of downtime on
alternative trading systems that are attributable to SelectNet,
rather than the alternative trading system).
[408]:Ashton Letter at 4 (also stating that the Commission should be
sensitive to the "veiled anti-competitive motives" of the existing
plan participants and be prepared to direct any new qualified
exchanges to be accepted into all national market system plans).
[409]:Securities Exchange Act Release No. 40204 (July 15, 1998), 63 FR
390306 (July 22, 1998) (proposal providing for the linkage of the
PCX application of the OptiMark system to the ITS system);
Securities Exchange Act Release No. 40260 (July 24, 1998), 63 FR
40748 (July 30, 1998) (proposal expanding the ITS/CAES linkage to
all listed securities, including non-Rule 19c-3 securities).
[410]:See CBOE Letter at 4-5; NYSE Letter at 8-9. The NYSE also stated
that consideration of this issue can be better evaluated at the
time an alternative trading system registers as an exchange and
seeks to become a member of ITS. Id. But see CHX Letter at 7
(expressing concern about a for-profit exchange becoming a full
participant in the national market system plans because such
exchanges would be subject to pressures not to expend significant
resources on maintaining surveillance and enforcement capability
and would not have the same commitment to the public interest and
the investing public as traditional not-for-profit exchanges).
[411]:CBOE Letter at 4-5.
[412]:NASD Letter at 7.
[413]:OptiMark Letter at 4-5 (also asking that the Commission consider
how members of exchanges, other than the exchange through which an
alternative trading system registered as a broker-dealer
disseminates its quotations, could access such alternative trading
system’s quotes).
[414]:Letter from Gerald D. O’Connell, Susquenhanna Investment Group to
Jonathan G. Katz, Secretary, SEC, dated July 23, 1998
("Susquehanna Letter") at 1-2. See also OptiMark Letter at 4
(asking the Commission to clarify that participation in national
market system plans is not conditioned on any universal public
display requirement).
[415]:Instinet Letter at 1-2, 3, 6.
[416]:See supra note .
[417]:The Commission may suspend trading in any security for up to 10
days, and all trading on any national securities exchange or
otherwise, for up to 90 days pursuant to Sections 12(k)(1)(A) and
(B) of the Exchange Act, 15 U.S.C. 78l(k)(1)(A) and (B).
[418]:For example, a newly registered exchange would be required under
Rule 11Ac1-1, 17 CFR 240.11Ac1-1, to halt trading when neither
quotation nor transaction information can be disseminated.
[419]:The Commission has found that trading halt rules instituted by a
national securities exchange or a national securities association
are consistent with the objectives of Section 6(b)(5) of the
Exchange Act, 15 U.S.C. 78f(b)(5). See, e.g., Securities Exchange
Act Release Nos. 39582 (Jan. 26, 1998), 63 FR 5408 (Feb. 2, 1998);
26198 (Oct. 19, 1988), 53 FR 41637 (Oct. 24, 1988). See, e.g.,
Amex Rule 117, NASD Rule 4120(a)(3), and NYSE Rules 80B and 717.
There is no requirement that exchanges or associations of
securities dealers employ identical trading halt rules, and these
rules may vary according to the needs of the individual market.
[420]:15 U.S.C. 78f.
[421]:If circuit breakers are imposed in one market, but not in another,
overall market disruptions caused by trading imbalances can
migrate from one market to the next, and efforts to stabilize such
imbalances during periods of heavy trading and extreme volatility
would be subverted. See also Securities Exchange Act Release No.
39846 (Apr. 9, 1998), 63 FR 18477 (Apr. 15, 1998) (approving
proposed changes to SRO rules regarding circuit breakers).
[422]:Section 19(b) of the Exchange Act, 15 U.S.C. 78s(b).
[423]:17 CFR 240.6a-1, 240.6a-2 and 240.6a-3.
[424]:Exhibit E requires an exchange to describe, among other things,
the means of access to the electronic trading system, the
procedures governing display of quotes and/or orders, execution,
reporting, clearance, and settlement. Exhibit L requires an
exchange to describe its criteria for membership, conditions under
which members may be subject to suspension or termination, and
procedures that would be involved in such suspension or
termination.
[425]:Exhibit K requires non-member owned exchanges to provide a list of
direct owners and control persons.
[426]:See NYSE Letter at 11; Amex Letter at 6.
[427]:A technical modification was made to the amendments as
proposed to include Exhibit H in Rule 6a-2(a)(2).
[428]:Rule 6a-2(a), 17 CFR 240.6a-2(a).
[429]:A technical modification was made to the amendments as
proposed to remove Exhibit I from Rule 6a-2(a)(2) and to
include Exhibit I in Rule 6a-2(b)(1).
[430]:A technical modification was made to the amendments to
include Exhibit N in Rule 6a-2(b)(2).
[431]:A technical modification was made to the amendments to
include Exhibit J in Rule 6a-2(c).
[432]:Rule 6a-2(d), 17 CFR 240.6a-2(d).
[433]:Securities Exchange Act Release No. 35123 (Dec. 20,
1994), 59 FR 66692 (Dec. 28 1994).
[434]:17 CFR 240.6a-3. This rule is now found at paragraph
(c) of Rule 6a-3.
[435]:In addition, the owner of the alternative trading
system would continue to be liable for securities law
violations.
[436]:But see supra note .
[437]:Section 3(a)(2) of the Exchange Act, 15 U.S.C.
78c(a)(2). See also supra note (discussing the OptiMark
System as a facility of the PCX); 35030 (Nov. 30, 1994), 59
FR 63141 (Dec. 7, 1994) (discussing the Chicago Match system
as a facility of the CHX); 29237 (May 24, 1991), 56 FR 24853
(May 31, 1991) (discussing the Off-Hours Trading system as a
facility of the NYSE).
[438]:17 CFR 240.17a-23.
[439]:The term "internal broker-dealer system" is defined as
"any facility, other than a national securities exchange, an
exchange exempt from registration based on limited volume,
or an alternative trading system as defined in Regulation
ATS . . . that provides a mechanism, automated in full or in
part, for collecting, receiving, disseminating, or
displaying system orders and facilitating agreement to the
basic terms of a purchase or sale of a security between a
customer and the sponsor, or between two customers of the
sponsor, through use of the internal broker-dealer system or
through the broker or dealer sponsor of such system." Rule
17a-3(a)(16)(ii)(A), 17 CFR 240.17a-3(a)(16)(ii)(A).
[440]:17 CFR 240.17a-3 and 240.17a-4.
[441]:Only one commenter addressed the Commission’s proposal
to repeal Rule 17a-23 and amend Rules 17a-3 and 17a-4. This
commenter agreed that amended Rules 17a-3 and 17a-4 would
impose similar obligations as current Rule 17a-23. TBMA
Letter at 25-26.
[442]:Rules 17a-3(a)(16)(i)(B) and (C), 17 CFR 240.17a-
3(a)(16)(i)(B) and (C).
[443]:See supra note .
[444]:The term "sponsor" is defined as "any broker or dealer
that organizes, operates, administers, or otherwise directly
controls an internal broker-dealer system or, if the
operator of the internal broker-dealer system is not a
registered broker or dealer, any broker or dealer that,
pursuant to contract, affiliation, or other agreement with
the system operator, is involved materially on a regular
basis with executing transactions in connection with use of
the internal broker-dealer system, other than solely for its
own account or as a customer with access to the internal
broker-dealer system." Rule 17a-3(a)(16)(ii)(B), 17 CFR
240.17a-3(a)(16)(ii)(B).
[445]:The term "system order" is defined as "any order or
other communication or indication submitted by any customer
with access to the internal broker-dealer system for entry
into a trading system announcing an interest in purchasing
or selling a security," but specifically excludes "inquiries
or indications of interest that are not entered into the
internal broker-dealer system." Rule 17a-3(a)(16)(ii)(C),
17 CFR 240.17a-3(a)(16)(ii)(C).
[446]:Rules 17a-4(b)(1) and (10), 17 CFR 240.17a-4(b)(1) and
(10).
[447]:See Concept Release, supra note , 62 FR at 30518-19.
[448]:See Proposing Release, supra note (discussing
comments responding to the Concept Release).
[449]:Id. at n.252.
[450]:15 U.S.C. 78s(b).
[451]:The Commission is also adopting measures to relieve
SROs of the requirement to file rule changes with the
Commission when an SRO wishes to list or trade new
derivative securities products. Securities Exchange Act
Release No. 40761 (Dec. 8, 1998).
[452]:For example, in November 1990, the NYSE submitted a
rule filing proposing an after-hours crossing system to
automate the execution of single stock orders and baskets of
securities and received Commission approval in May 1991.
See Securities Exchange Act Release Nos. 29237 (May 24,
1991), 56 FR 24853 (May 31, 1991); 32368 (May 25, 1993), 58
FR 31565 (June 3, 1993). In August 1993, the CHX submitted
a rule filing to operate the Chicago Match system, an
electronic matching system that crossed orders entered by
the CHX’s members and non-members including institutional
customers, and obtained Commission approval in November
1994. See Securities Exchange Act Release No. 35030 (Nov.
30, 1994), 59 FR 63141 (Dec. 7, 1994). More recently, in
May 1997, the PCX submitted a rule filing for approval of
the OptiMark System and received Commission approval in
September 1997. See Securities Exchange Act Release No.
39086 (Sept. 17, 1997), 62 FR 50036 (Sept. 24, 1997).
[453]:See ICI Letter at 5; Corporate Capital Letter at 2;
CBOE Letter at 8; CHX Letter at 11; NASD Letter at 13; Amex
Letter at 1-2; NYSE Letter at 9; American Century Letter at
6. See also Ashton Letter at 2; CME Letter at 4; SIA Letter
at 15; PCX Letter at 8.
[454]:Section 19(b)(1) of the Exchange Act, 15 U.S.C.
78s(b)(1), requires an SRO to file with the Commission any
proposed rule or any proposed rule change ("proposed rule
change") accompanied by a concise general statement of the
basis and purpose of the proposal. Once a proposed rule
change has been filed, the Commission is required to publish
notice of it and provide an opportunity for public comment.
The proposed rule change may not take effect unless it is
approved by the Commission or is otherwise permitted to
become effective under Section 19(b) of the Exchange Act.
Section 19(b)(2) of the Exchange Act, 15 U.S.C. 78s(b)(2),
sets forth the standards and time periods for Commission
action either to approve a proposed rule change or to
institute and conclude a proceeding to determine whether a
proposed rule change should be disapproved. The Commission
may also approve a proposed rule change on an accelerated
basis if the Commission finds good cause for so doing and
publishes its reasons for so finding. Section 19(b)(2) of
the Exchange Act, 15 U.S.C. 78s(b)(2)(B).
[455]:See paragraph (c) of Rule 19b-5, 17 CFR 240.19b-5(c),
for the definition of "pilot trading system."
[456]:17 CFR 249.821
[457]:Rule 19b-5(f)(1) and (f)(2), 17 CFR 240.19b-5(f)(1)
and (f)(2). See also infra Section VI.C.
[458]:Rule 19b-5(c)(3), 17 CFR 240.19b-5(c)(3).
[459]:See infra Section VI.B.
[460]:See Proposing Release, supra note , at ns.256-61 and
accompanying text.
[461]:See Proposing Release, supra note , at n.261.
[462]:See Ashton Letter at 2; SIA Letter at 15; CME Letter
at 3; Amex Letter at 1; Bloomberg Letter at 6.
[463]:Rule 19b-5(c)(2), 17 CFR 240.19b-5(c)(2).
[464]:A pilot trading system is "independent" of other
trading systems if it meets one of the standards set forth
in paragraph (d) of Rule 19b-5.
[465]:Rule 19b-5(c)(1), 17 CFR 240.19b-5(c)(1).
[466]:Rule 19b-5(c)(3), 17 CFR 240.19b-5(c)(3). See also
infra Section VI.C.
[467]:Rule 19b-5(d), 17 CFR 240.19b-5(d). For purposes of
the pilot trading system rule, a specialist means any member
subject to a requirement of an SRO that such member
regularly maintain a market in a particular security. Rule
19b-5(a), 17 CFR 240.19b-5(a).
[468]:NYSE Letter at 9.
[469]:ICI Letter at 5.
[470]:See CBOE Letter at 2, 9; CHX Letter at 11; CME Letter
at 4; PCX Letter at 8-10.
[471]:See CME Letter at 4; PCX Letter at 9-10.
[472]:See NASD Letter at 13; PCX Letter at 9-10.
[473]:PCX Letter at 9-10.
[474]:Amex Letter at 1, 3.
[475]:See CBOE Letter at 9; CHX Letter at 11.
[476]:See CBOE Letter at 9; NASD Letter at 2, 14.
[477]:CHX Letter at 11.
[478]:15 U.S.C. 78f(b)(5).
[479]:See supra note and accompanying text.
[480]:Rule 19b-5(b), 17 CFR 240.19b-5(b).
[481]:See supra notes - and accompanying text.
[482]:See Section 6(b)(2) of the Exchange Act, 15 U.S.C.
78f(2). See also Order Handling Rules Adopting Release,
supra note .
[483]:The Commission is not adopting the requirement
concerning the procedures to ensure the confidential
treatment of trading information because SROs are not
currently required to do this with regard to their other
trading systems.
[484]:See discussion infra VI.B.3.i.
[485]:CBOE Letter at 10.
[486]:Examples include computer companies that design and
maintain systems and clearing agencies.
[487]:Rule 19b-5(e)(1), 17 CFR 240.19b-5(e)(1).
[488]:Rule 19b-5(g), 17 CFR 240.19b-5(g).
[489]:Rule 19b-5(e)(1), 17 CFR 240.19b-5(e)(1). The
Commission requires that SROs identify filings made pursuant
to Rule 19b-5 by including a file number on Form PILOT that
appears as follows: PILOT - name of SRO - year - file
number.
[490]:CBOE Letter at 9.
[491]:NYSE Letter at 9.
[492]:Amex Letter, p. 2.
[493]:American Century Letter, p. 6.
[494]:Rule 19b-5(e)(11), 17 CFR 240.19b-5(e)(11).
[495]:The Commission notes that registered exchanges and
national securities associations already have obligations to
ensure that their markets treat investors and other market
participants fairly. The Exchange Act requires registered
exchanges and national securities associations to consider
the public interest in administering their markets and to
establish rules designed to admit members fairly. Sections
6(b)(2) and 6(c) of the Exchange Act, 15 U.S.C. 78f(b)(2)
and (c); Section 15A(b)(8) of the Exchange Act, 15 U.S.C.
78o-3(b)(8). See also supra notes - and accompanying text.
[496]:Rule 19b-5(e)(2)(i), 17 CFR 240.19b-5(e)(2)(i).
[497]:Rule 19b-5(e)(2)(ii), 17 CFR 240.19b-5(e)(2)(ii).
[498]:Rule 19b-5(e)(2)(iii), 17 CFR 240.19b-5(e)(2)(iii).
[499]:Rule 19b-5(e)(3), 17 CFR 240.19b-5(e)(3).
[500]:The Commission believes that a comprehensive ISA
requires that the parties provide to each other, upon
request, information about market trading, clearing
activity, and the identity of the ultimate purchasers and
sellers of securities. See Securities Exchange Act Release
No. 31529 (Nov. 27, 1992), 57 FR 57248 (Dec. 3, 1992).
Similarly, an SRO that operates a pilot trading system that
trades securities, or derivatives of securities that are
listed or traded on a foreign market, should have a
comprehensive ISA with such foreign markets. In addition,
the SRO should ensure there are no blocking or secrecy laws
in the foreign country that would prevent or interfere with
the transfer of information under the comprehensive ISA. If
securing a comprehensive ISA is not possible, the SRO should
contact the Commission. In such instances, the Commission
may determine that it is appropriate instead to rely on a
Memorandum of Understanding ("MOU") between the Commission
and the foreign regulator. Generally, the Commission has
permitted an SRO to rely on an MOU in the absence of a
comprehensive ISA only if the SRO receives an assurance from
the Commission that such an MOU can be relied on for
surveillance purposes and includes, at a minimum, the
transaction, clearing, and customer information necessary to
conduct an investigation. See Securities Exchange Act
Release No. 35184 (Dec. 30, 1994), 60 FR 2616 (Jan. 10,
1995). In addition, an SRO should endeavor to develop
comprehensive ISAs with foreign exchanges even if the SRO
receives prior Commission approval to rely on an MOU in
place of a comprehensive ISA.
[501]:See ISG Agreement, dated July 14, 1983, amended Jan.
29, 1990. The ISG members are: Amex, BSE, CBOE, CHX, NASD,
NYSE, PCX, and Phlx. The major stock index futures
exchanges joined the ISG as affiliate members in 1990.
[502]:Rule 19b-5(e)(4), 17 CFR 240.19b-5(e)(4).
[503]:Rule 19b-5(e)(5), 17 CFR 240.19b-5(e)(5).
[504]:15 U.S.C. 78l(f).
[505]:See Securities Exchange Act Release No. 39505 (Dec.
31, 1997), 63 FR 1515 (Jan. 9, 1998 ).
[506]:Rule 19b-5(e)(6), 17 CFR 240.19b-5(e)(6).
[507]:See, e.g., Securities Exchange Act Release Nos. 21759
(Feb. 14, 1985), 50 FR 7250 (Feb. 21, 1985) (order approving
NYSE proposal to trade options on NYSE-listed stocks in a
separate physical location from the equity trading floor);
26147 (Oct. 3, 1988), 53 FR 39556 (Oct. 7, 1988) (order
approving the trading on the Amex of options on Amex-listed
stocks, concluding that side-by-side trading or integrated
market-making issues did not arise because the Amex proposed
to trade stocks and related options in physically separate
locations); and 28556 (Oct. 19, 1990), 55 FR 43233 (Oct. 26,
1990) (order approving rule changes to establish rules
governing the trading of stocks, warrants, and other
securities instruments and contracts on the CBOE conditioned
on the fact that trading in securities other than options
will take place on a trading floor separate from the
location where options are traded).
[508]:Amex Letter at 4.
[509]:CBOE Letter at 10.
[510]:Rule 19b-5(e)(3), 17 CFR 240.19b-5(e)(3).
[511]:Rule 19b-5(e)(7)(iii), 17 CFR 240.19b-5(e)(7)(iii),
defines related securities to mean any two securities in
which the value of one security is determined, in whole or
significant part, by the performance of the other security;
or the value of both securities is determined, in whole or
significant part, by the performance of a third security,
combination of securities, index, indicator, interest rate
or other common factor.
[512]:A specialist, for purposes of the pilot trading system
rule, means any member that is subject to an SRO requirement
to regularly maintain a market in a particular security.
Rule 19b-5(a), 17 CFR 240.19b-5(a). The definition of
specialist is meant to preclude member firms with exclusive
information about buy and sell orders from using unfairly
such non-public material market information to their
competitive advantage. For instance, a member acting as a
specialist on the NYSE also could not simultaneously act as
a specialist in related securities on a pilot trading system
sponsored by the NYSE. Similarly, a member acting as a
designated primary market maker on the CBOE also could not
simultaneously act as a designated primary market maker in
related securities on a pilot trading system sponsored by
the CBOE.
[513]:An SRO also may request an exemption from the
limitation under Rule 19b-5(e)(7)(i) by filing an
application for an order for exemptive relief under Section
36. See 17 CFR 240.0-12.
[514]:Rule 19b-5(e)(7), 17 CFR 240.19b-5(e)(7).
[515]:Rule 19b-5(e)(8), 17 CFR 240.19b-5(e)(8).
[516]:Rule 19b-5(e)(9), 17 CFR 240.19b-5(e)(9).
[517]:Rule 19b-5(e)(10), 17 CFR 240.19b-5(e)(10). This
specific requirement is necessary because Rule 6a-2, as
amended, requires exchanges to file its trading rules and
procedures only once every three years, while national
securities associations have no such publication requirement
except through the rule filing process under Section 19(b)
of the Exchange Act.
[518]:Rule 19b-5(f)(1), 17 CFR 240.19b-5(f)(1).
[519]:Rule 19b-5(f)(1) and (f)(2), 17 CFR 240.19b-5(f)(1)
and (f)(2).
[520]:It was recognized at the time the Exchange Act was
enacted that a regulatory structure for securities exchanges
would "be of little value tomorrow if it is not flexible
enough to meet new conditions immediately as they arise and
demand attention in the public interest." See SEC, Report
of the Special Study of the Securities Markets of the
Securities and Exchange Commission, H.R. Doc. No. 95, 88th
Cong., 1st Sess. Pt. 1 (1963) ("Special Study"), at 6. See
also S. Rep. No. 792, 73rd Cong., 2d Sess. (1934) at 5
(noting that "exchanges cannot be regulated efficiently
under a rigid statutory program," and that "considerable
latitude is allowed for the exercise of administrative
discretion in the regulation of both exchanges and the over-
the-counter market.")
[521]:15 U.S.C. 78c(a)(1).
[522]:Delta Release, supra note . In 1988, the Commission
granted Delta temporary registration as a clearing agency to
allow it to issue, clear, and settle options executed
through a trading system operated by RMJ Securities ("RMJ").
Concurrently, the Commission's Division of Market Regulation
issued a letter stating that the Division would not
recommend enforcement action against RMJ if its system did
not register as a national securities exchange.
Subsequently, the Board of Trade of the City of Chicago and
the Chicago Mercantile Exchange petitioned the U.S. Court of
Appeals for the Seventh Circuit for review of the
Commission's actions. Both challenges were premised on the
view that RMJ's system unlawfully failed to register as an
exchange or obtain an exemption from registration. The
Seventh Circuit vacated Delta's temporary registration as a
clearing agency, pending publication of a reasoned
Commission analysis of whether or not RMJ's system was an
exchange within the meaning of the Exchange Act. Board of
Trade of the City of Chicago v. Securities and Exchange
Commission, 883 F.2d 525 (7th Cir. 1989) ("Delta I"). In
1989, the Commission solicited comment on the issue, and in
1990 published its interpretation of the term "exchange" and
its determination that RMJ's system did not meet that
interpretation.
[523]:See Delta Release, supra note . The Commission also
identified the following factors as supporting the
conclusion that the system in Delta should not be classified
as an exchange. Unlike a traditional exchange, the system
(1) was not open to the participation of retail investors on
an agency basis; (2) did not offer limit order protection;
and (3) provided a forum for trading instruments that lacked
certain indicia of standardization. These factors were
admittedly outside the Commission’s "central focus" in
Delta. Id. Moreover, most alternative trading systems that
will fall now under the Commission’s new interpretation in
Rule 3b-16 allow broker-dealer subscribers to act on behalf
of retail customers in placing and executing orders on the
system; function as limit order books where orders are
executed according to time, price, and size priority; and
trade standard securities.
[524]:Board of Trade of the City of Chicago v. SEC, 923 F.2d
1270 (7th Cir. 1991).
[525]:For a list of no-action letters issued to system
sponsors until the end of 1993 and a short history of the
Commission’s oversight of such systems, see Securities
Exchange Act Release No. 33605, 59 FR 8368, 8369-71 (Feb.
18, 1994). See also Letters from the Division of Market
Regulation to: Tradebook (Dec. 3, 1996); The Institutional
Real Estate Clearinghouse System (May 28, 1996); Chicago
Board Brokerage, Inc. and Clearing Corporation for Options
and Securities (Dec. 13, 1995).
[526]:Delta Release, supra note , at 1899.
[527]:Id.
[528]:Id.
[529]:See supra note .
[530]:The rules adopted today reflect and facilitate
multiple sources of liquidity. Increasing the linkages
among markets where significant trading activity occurs --
both exchanges and alternative trading systems -- will make
the overall market for securities more transparent and
liquid.
[531]:See Order Handling Rules Adopting Release, supra note
at Section III.
[532]:In fact, an alternative trading system that posts firm
orders to buy or sell a security does raise a certain
expectation of execution at those quoted prices. The
expectation is based on the life of the outstanding orders
in the system, rather than on continuous two-sided
quotations published by specialists or market makers.
[533]:See Delta Release, supra note , at 1900.
[534]:Delta Release, supra note , at 1895 (quoting Delta I,
supra note , at 535).
[535]:Delta II, supra note , at 1273. The court held that,
because the statutory provision is ambiguous, the Commission
had the discretion to interpret the definition the way it
did.
[536]:See Division of Market Regulation, Market 2000: An
Examination of Current Equity Market Developments app IV
(1994) ("Market 2000 Study").
[537]:See Proposing Release, supra note , at n.290.
[538]:For example, the evidence in the Commission's report
on the NASD and the Nasdaq market pursuant to Section 21(a)
of the Exchange Act suggests that widespread use of Instinet
by market makers as a private market has had a significant
impact on public investors and the operation of the Nasdaq
market. See NASD 21(a) Report, supra note .
[539]:Courts have consistently upheld an agency's discretion
to revise earlier interpretations when a revision is
reasonably warranted by changed circumstances. See, e.g.,
Rust v. Sullivan, 500 U.S. 173, 186 (1991). In Rust, the
Court stated that "an initial agency interpretation is not
instantly carved in stone, and the agency, to engage in
informed rulemaking, must consider varying interpretations
and the wisdom of its policy on a continuing basis." Id. at
186 (quoting Chevron v. Natural Resources Defense Council,
467 U.S. 837, 844-45 (1984)). The Court also stated that
"an agency is not required to ‘establish rules of conduct to
last forever,’ but rather ‘must be given ample latitude to
adapt its rules and policies to the demands of changing
circumstances.’" Id. at 186-87 (quoting Motor Vehicles
Mfrs. Ass'n of United States v. State Farm Mut. Automobile
Ins. Co., 463 U.S. 29, 42 (1983)). See also Arkansas AFL-
CIO v. FCC, 11 F.3rd 1430, 1441 (8th Cir. 1993) (deferring
to Federal Communications Commission decision to alter its
interpretation of the statutory term "operated in the public
interest" to meet the changing realities of the broadcast
industry).
[540]:See Concept Release, supra note , at nn.125-133 and
accompanying text.
[541]:This broad conception of "bringing together" buyers
and sellers is consistent with the Delta Release, which
emphasized that the means employed for bringing together
buyers and sellers "may be varied, ranging from a physical
floor or trading system ... to other means of intermediation
(such as a formal market making system or systemic
procedures such as a consolidated limit order book or
regular single price auction)." Delta Release, supra note ,
at 1899.
[542]:The elements of the interpretation are discussed in
greater detail in Section III, supra.
[543]:See TBMA Letter at 3-4.
[544]:The Commission also notes that the statutory
definition of "exchange" is written in the disjunctive:
facilities for bringing together purchasers and sellers or
facilities performing functions commonly performed by stock
exchanges. Section 3(a)(1) of the Exchange Act, 15 U.S.C.
78c(a)(1). See TBMA Letter, at 8-9 (recommending that the
Commission continue to rely on its interpretation in the
Delta Release); SIA Letter at 2, 6-7 (a significant
characteristic of exchanges is structural features that
create a reasonable expectation of the regular execution of
orders at posted prices). See also Letter from Christopher
J. Carroll, Managing Director, Deutsche Bank Securities,
Inc. to Jonathan G. Katz, Secretary, SEC, dated July 31,
1998 ("DBSI Letter") at 2 ; NYSE Letter at 2-3, 4-5, 8
(commenting that only alternative trading systems meeting
the Delta interpretation of exchange should have the ability
to register with the Commission as an exchange); Instinet
Letter at 8 (recommending that the Commission retain its
current interpretation of "exchange"); CBB Letter at 3
(recommending that if the Commission believed its current
interpretation of "exchange" in the Delta Release was
inadequate, that the Commission should simply withdraw that
interpretation and rely solely on the statutory definition
of "exchange").
[545]:For example, at the time of the Delta Release, the
Commission sought to avoid interpreting the term "exchange"
in a way that could unintentionally and inappropriately
subject many broker-dealers to exchange regulation. One key
factor in the Commission's decision not to regulate the
Delta system as an exchange was the concern that doing so
would subject traditional broker-dealer activities to
exchange regulation. Delta Release, supra note .
[546]:Pub. L. 104-290, 110 Stat. 3416 (1996). 15 U.S.C.
78mm.
[547]:Throughout the past 60 years, the Commission has
attempted to accommodate market innovations within the
existing statutory framework to the extent possible in light
of investor protection concerns, without imposing regulation
that would stifle or threaten the commercial viability of
such innovations. For example, at various times, the
Commission considered the implications of evolving market
conditions on exchange regulation. See Securities Exchange
Act Release Nos. 8661 (Aug. 4, 1969), 34 FR 12952 (initially
proposing Rule 15c2-10); 11673 (Sept. 23, 1975), 40 FR 45422
(withdrawing then-proposed Rule 15c2-10 and providing for
registration of securities information processors); 26708
(Apr. 13, 1989), 54 FR 15429 (reproposing Rule 15c2-10);
33621 (Feb. 14, 1994), 59 FR 8379 (withdrawing proposed Rule
15c2-10).
[548]:15 U.S.C. 78mm(a)(1).
[549]:Prior to the addition of Section 36 to the Exchange
Act, the Commission could only exempt an exchange from the
registration provisions of Sections 5 and 6 on the basis of
an exchange’s limited volume of transactions. See Section 5
of the Exchange Act, 15 U.S.C. 78e.
[550]:See S. Rep. No. 104-293, 104th Cong. 2d Sess. 15
(1996).
[551]:See supra Section IV.A.
[552]:See supra IV.A.2.
[553]:Because the rules and rule amendments regarding
Regulation ATS, exchange registration, and Rule 19b-5
constitute "major rules" within the meaning of the Small
Business Regulatory Enforcement Act of 1996, 5 U.S.C. 801 et
seq., the rules and rule amendments cannot take effect until
60 days after the date of publication in the Federal
Register. Although the amendments to Rules 17a-3 and 17a-4
and repeal of Rule 17a-23 and Form 17A-23 do not constitute
"major rules," they will become effective at the same time
as Regulation ATS because they operate in an integrated
fashion with Regulation ATS.
[554]:See ICI Letter at 4 (stating that requirements would
be overly burdensome for alternative trading systems); IBEX
Letter at 13 (arguing that appeal process should begin at
the SRO level); Instinet Letter at 19 (stating that a right
of appeal to the Commission could lead to frequent frivolous
appeals).
[555]:TBMA Letter at 16.
[556]:SIA Letter at 17-18. But see IBEX Letter at 5
(stating that the reporting requirements under proposed
Regulation ATS were not inappropriately burdensome).
[557]:CBB Letter at 4.
[558]:Instinet Letter at 20.
[559]:Instinet Letter at 10.
[560]:See supra Section IV.A.2.c.
[561]:See IBEX Letter at 5; SIA Letter at 18; American
Century Letter at 6.
[562]:See TBMA Letter at 6-7, 21; SIA Letter at 3, 11; DBSI
Letter at 1; MSDW Letter at 13.
[563]:See NYSE Letter at 6; IBEX Letter at 2-3.
[564]:Rule 301(b)(5), 17 CFR 242.301(b)(5).
[565]:Rule 301(b)(6), 17 CFR 242.301(b)(6).
[566]:The Office of Management and Budget has recognized
that although it may be difficult to quantify the benefits
of price transparency, "[t]here is a strong consensus among
economists that regulations requiring the disclosure of
information about the price and quality of products and
services can produce significant benefits for consumers and
improve the functioning of markets when this information
would not otherwise be available." Office of Management and
Budget, Draft Report to Congress on the Costs and Benefits
of Federal Regulations, 63 FR 44034 (Aug. 17, 1998).
[567]:See supra note . Under the Order Handling Rules,
market makers who enter orders on ECNs are required to
reflect those prices in their public quotations. In the
alternative, the ECN can make the best market maker prices
publicly available through an SRO.
[568]:See supra note .
[569]:This estimate is based on filings made with the
Commission under Rule 17a-23. At the time of the Proposing
Release, the Commission estimated that forty-three
alternative trading systems would be required to register as
exchanges or broker-dealers and comply with Regulation ATS.
The Commission now estimates that there are forty-five
alternative trading systems operating.
[570]:Based on the Commission’s experience over the last
three years with Rule 17a-23, it appears that there are more
than three new alternative trading systems per year.
However, we expect that in the future, there will be
approximately three new alternative trading systems per
year. The rapid growth experienced over the last several
years is unlikely to continue in perpetuity.
[571]:A number of ECNs, however, currently display the best
order in their system in the public quote, regardless of
whether that order is entered by an institution, market
maker or another broker-dealer although the Commission’s
Order Handling Rules only require the display of market
maker orders. Thus, institutional orders sent to these
systems are already displayed to the public.
[572]:When the Order Handling Rules were implemented on
January 17, 1997, four ECNs linked to Nasdaq. Today there
are a total of nine ECNs linked to the public quote stream.
See supra note .
[573]:Section 11A(a)(1)(C) of the Exchange Act, 15 U.S.C.
78k-1(a)(1)(C).
[574]:Under the Order Handling Rules, ECNs are limited to
charging non-subscribers fees consistent with equivalent
access.
[575]:Section 3(f) of the Exchange Act, 15 U.S.C. 78c(f).
[576]:The amount to be paid to the CTA plan will vary on a
case-by-case basis and may reflect a current independent
valuation of the CTA facilities, prior valuations, an
assessment of costs contributed to the plan by existing
members, the estimated usage of the plan facilities by the
applicant, costs for anticipated system modifications to
accommodate the applicant, and other relevant factors as
determined by the current participants. CTA Plan: Second
Restatement of Plan Submitted to the Securities and Exchange
Commission Pursuant to Rule 11Aa3-1 under the Securities
Exchange Act of 1934, May 1974 as restated March 1980 and
December 1995, at 8-9. See supra note . The terms of the
CQ plan are substantially similar with respect to the
assessment of a payment upon entry into the system. CQ
Plan: Restatement of Plan Submitted to the Securities and
Exchange Commission Pursuant to Rule 11Ac1-1 under the
Securities Exchange Act of 1934, July 1978, as restated
December 1995, at 8-9. See supra note .
[577]:Plan for the Purpose of Creating and Operating an
Intermarket Communication Linkage Pursuant to Section
11A(a)(3)(B) of the Securities Exchange Act of 1934,
Composite: Amendments through May 30, 1997, at 78-79.
[578]:17 CFR 240.11Ac1-1.
[579]:The Commission estimates that each national securities
exchange or national securities association will submit
information to vendors approximately 24,266,000 times per
year, which reporting is generally done through automated
facilities that conduct the reporting on a continuous basis.
Due to the continuous nature of the information feeds, the
Commission does not believe that it is feasible to estimate
the average cost per response or annual burdens hours
involved in complying with Rule 11Ac1-1(b) for a new
registered exchange. 17 CFR 240.11Ac1-1(b).
[580]:See supra Section III.B.1.
[581]:See NYSE Letter at 10; Amex Letter at 5-6.
[582]:For example, the International Securities Exchange,
which announced its intentions to register as a national
securities exchange on November 10, 1998, would not be able
to register as a national securities exchange without the
changes to the rules as adopted today. See International
Securities Exchange Will be First Fully Electronic Options
Exchange in U.S., International Securities Exchange Press
Release, Nov. 10, 1998.
[583]:TBMA Letter at 25-26.
[584]:The costs and benefits associated with these
recordkeeping requirements are discussed in Section
IX.A.2.a. supra.
[585]:CBOE Letter at 8-9.
[586]:See CME Letter at 3-4; PCX Letter at 8.
[587]:The Commission estimates that the current preparation
and filing of proposed rule changes pursuant to Section
19(b)(2) of the Exchange Act to operate a pilot trading
system constitute major market impact filings requiring
approximately 100 hours and $10,000 to $15,000 of SRO time
and money, respectively, for each proposal. This does not
include the cost to the SRO of any delay in obtaining
Commission approval or in disclosing business information;
nor does this include the benefit to an SRO of bringing its
new pilot trading system to market in a shorter amount of
time. The cost per hour and per filing is derived from
information supplied by the SROs. For the purposes of our
estimates, we have valued related overhead at thirty-five
percent of the value of legal work. See GSA Guide to
Estimating Reporting Costs (1973).
[588]:The Commission estimates that under current
procedures, a rule filing for a new pilot trading system
takes 90 days, on average, from the date of the original
submission to be approved. In contrast, the expedited
treatment of SRO rule changes for pilot trading systems in
this release permits SROs to operate a pilot trading system
twenty days after submitting an initial operation report on
Form PILOT, so long as such system complies with Rule 19b-5
under the Exchange Act.
[589]:15 U.S.C. 78w(a)(2).
[590]:15 U.S.C. 78c(f).
[591]:The Commission further believes that repealing Rule
17a-23 and amending Rules 17a-3 and 17a-4 under the Act will
help to create a more efficient market, encourage
competition, and stimulate capital formation innovation.
[592]:As previously stated, alternative trading systems are
able to attract subscribers because prices in their systems
are often better than the prices available in the public
markets. Because alternative trading systems are now
required to publicly display their best priced orders for
securities in which they represent more than 5 percent of
the trading volume, the best priced orders for certain
securities will also be available through the public
markets. Consequently, some subscribers could leave an
alternative trading system if they think there are fewer
advantages than before in having direct access to the
alternative trading system. However, the growth of ECNs
since the Order Handling Rules were implemented indicates
that alternative trading systems can, and are, attracting
subscribers. As mentioned above, there are still
significant benefits to being a subscriber to an alternative
trading system, including, but not limited to: the ability
to enter orders and the use of such features as a
negotiation feature or a "reserve size" feature; the ability
to access the best priced orders for securities in which an
alternative trading system represents less than 5 percent of
the trading volume and therefore is not subject to the
transparency requirements; and access to the entire "book,"
not merely the "top of the book," that contains important
real-time market information regarding depth of trading
interest.
[593]:5 U.S.C. 604.
[594]:17 CFR 240.3a1-1.
[595]:17 CFR 240.3b-16.
[596]:17 CFR 240.19b-5.
[597]:17 CFR 242.300 et seq.
[598]:17 CFR 242.637.
[599]:17 CFR 242.638.
[600]:17 CFR 249.821.
[601]:17 CFR 240.6a-1.
[602]:17 CFR 240.6a-2.
[603]:17 CFR 240.6a-3.
[604]:17 CFR 240.11Ac1-1.
[605]:17 CFR 240.17a-3.
[606]:17 CFR 240.17a-4.
[607]:17 CFR 202.3.
[608]:17 CFR 240.17a-23.
[609]:15 U.S.C. 78a et seq.
[610]:See supra note .
[611]:44 U.S.C. § 3507.
[612]:For a further discussion of the changes, see the
discussions of Rule 301, Form ATS, Form ATS-R, Rule 302, and
Rule 303, infra.
[613]:The estimated average additional cost per response of
$30 is derived from two additional hours of clerical work at
$15 per hour.
[614]:Since 1991, the Commission has received three total
applications for registration as a national securities
exchange.
[615]:The estimated average cost per response of $9.50 is
composed of $7.50 for clerical work (0.5 hours at $15 per
hour) and $2 for printing, supplies, copying, and postage
(approximately thirty-five percent of the total labor
costs). The Commission staff has estimated overhead for
this collection of information burden, and all other
collection of information burdens discussed below, based on
thirty-five percent of total labor costs based on the GSA
Guide to Estimating Reporting Costs (1973). The estimated
average annual cost of $237.50 is derived from twenty-five
annual filings at a cost of $9.50 per filing.
[616]:The Commission staff has estimated that an employee of
a broker-dealer charged to ensure compliance with Commission
regulations receives annual compensation of $100,000. This
compensation is the equivalent of $48.08 per hour ($100,000
divided by 2,080 payroll hours per year). The estimated
annual cost of $1,298.16 is derived from twenty-seven burden
hours per respondent at $48.08 per hour.
[617]:The estimated aggregate burden of 2,619 hours is
derived from ninety-four broker-dealer respondents incurring
an average burden of twenty-seven hours each. The estimated
aggregate cost of $122,027.04 is derived from ninety-four
broker-dealer respondents incurring an average burden of
$1,298.16 each.
[618]:The Commission staff has estimated that an employee of
a broker-dealer charged to ensure compliance with Commission
regulations receives annual compensation of $100,000. This
compensation is the equivalent of $48.08 per hour ($100,000
divided by 2,080 payroll hours per year). The estimated
annual cost of $144.24 is derived from three burden hours
per respondent at $48.08 per hour.
[619]:The estimated aggregate burden of two hundred eighty-
two hours is derived from ninety-four broker-dealer
respondents incurring an average burden of three hours each.
The estimated aggregate cost of $13,558.56 is derived from
ninety-four broker-dealer respondents incurring an average
burden of $144.24 each.
[620]:This estimate is based on a review of past SRO filings
under Section 19(b) of the Exchange Act. The Commission
staff has estimated that approximately 6 rule filings per
year in the past could have been filed under Rule 19b-5.
[621]:The estimates for burden hours involved with filing
Form PILOT are based on the Commission’s experience with
similar reporting requirements under Rule 17a-23.
[622]:This estimate is based on the Commission’s experience
with collection of similar information under Rule 17a-23.
[623]:The estimated average cost of $1,242 to file an
initial Form PILOT is composed of $800 for in-house
professional work (sixteen hours at $50 per hour), $120 for
clerical work (eight hours at $15 per hour) and $322 for
printing, supplies, copying, and postage (approximately
thirty-five percent of the total labor costs).
The estimated average cost of $155 to file quarterly
reports and system change notices on Form PILOT is composed
of $100 for in-house professional work (two hours at $50 per
hour), $15 for clerical work (one hour at $15 per hour) and
$40 for printing, supplies, copying and postage
(approximately thirty-five percent of the total labor
costs).
[624]:The estimated average burden of one hundred forty-four
hours is derived from six SRO respondents incurring an
average burden of twenty-four hours per filing. The
estimated average cost of $7,452 is derived from six SRO
respondents making six initial Form PILOT filings at $1,242
per filing.
[625]:The estimated average burden of one hundred eight
hours is derived from six SRO respondents filing four
quarterly reports and two systems change notices at three
burden hours per filing. The estimated average cost of
$5,580 is derived from six SRO respondents filing four
quarterly reports and two systems change notices at $155 per
filing.
[626]:This estimate is based on filings made with the
Commission under Rule 17a-23. At the time of the Proposing
Release, the Commission estimated that forty-three
alternative trading systems would be required to register as
exchanges or broker-dealers and comply with Regulation ATS.
Since that time, two such alternative trading systems have
started to operate.
[627]:Based on the Commission’s experience over the last
three years with Rule 17a-23, it appears that there are more
than three new alternative trading systems per year.
However, we expect that in the steady state over time, there
will be approximately three new alternative trading systems
per year. The rapid growth experienced over the last
several years is unlikely to continue at such a high rate in
perpetuity.
[628]:This estimate for burden hours of filing Form ATS is
based on the burdens associated with filing Form 1, adjusted
for differences between Form 1 and Form ATS. The division
between professional and clerical time is based on estimates
of the proportions used in the estimates of burdens for
filing Form 1.
[629]:The estimated average cost per response of $1,019 is
composed of $650 for in-house professional work (thirteen
hours at $50 per hour), $105 for clerical work (seven hours
at $15 per hour) and $264 for printing, supplies, copying,
and postage (approximately thirty-five percent of the total
labor costs).
[630]:This estimated cost of $45,855 is derived from forty-
five alternative trading systems filing at an average cost
of $1,019 each.
[631]:This estimated cost of $3,057 is derived from three
new alternative trading systems filing at an average cost of
$1,019 each.
[632]:This estimate is based on the Commission’s experience
with collection of similar information under Rule 17a-23.
[633]:The estimated average cost per response of $111.50 is
composed of $75 for in-house professional work (1.5 hours at
$50 per hour), $7.50 for clerical work (0.5 hours at $15 per
hour), and $29 for printing, supplies, copying, and postage
(approximately thirty-five percent of the total labor
costs).
[634]:This estimated cost of $30,105 is composed of $111.50
cost per amendment for forty-five alternative trading
systems filing six times per year.
[635]:The estimated cost of $223 per response is composed of
$150 for in-house professional work (three hours at $50 per
hour), $15 for clerical work (one hour at $15 per hour) and
$58 for printing, supplies, copying, and postage
(approximately thirty-five percent of the total labor
costs).
[636]:The estimated annual cost of $892 to file Form ATS-R
is derived from four quarterly reports at an estimated
annual cost of $223 per filing.
[637]:This estimated cost of $40,140 is derived from forty-
five alternative trading systems with an estimated annual
filing cost for each of $892.
[638]:The estimated cost of $111.50 per response is
composed of $75 for in-house professional work (1.5 hours
at $50 per hour), $7.50 for clerical work (0.5 hours at $15
per hour), and $29 for printing, supplies, copying and
postage (approximately thirty-five percent of the total
labor costs).
[639]:The estimated cost of $334.50 is derived from an
average of three alternative trading systems filing one
cessation of operations report per year on Form ATS at an
estimated cost of $111.50 each.
[640]:The estimated burden of seventeen hours is derived
from five hours for establishing and maintaining standards
for fair access and twelve hours to report fair access
information on Form ATS-R on a quarterly basis (four
responses at three hours per response). The estimated cost
of $958.50 is derived from $650 for professional work
(thirteen hours at $50 per hour), $60 for clerical work
(four hours at $15 per hour), and $248.50 for printing,
supplies, copying, and postage (approximately thirty-five
percent of the total labor costs). The Commission staff has
estimated overhead based on thirty-five percent of total
labor costs based on the GSA Guide to Estimating Reporting
Costs (1973). The estimated burden of thirteen hours of
professional work is derived from five hours for
establishing and maintaining standards for fair access and
eight hours (two hours for four quarterly reports on Form
ATS-R) to compile and report fair access information. The
estimated burden of four hours of clerical work is derived
from one hour per quarter to compile and send information on
Form ATS-R.
[641]:The Commission notes that compliance with the notice
provision can be achieved by a telephone call, so the burden
for each notice is minimal. The Commission staff has
estimated only 0.25 hours per notice will be required. The
estimate of five system outage notices per year is based on
the Commission’s experience with the Automated Review
Program.
[642]:The estimated average cost per response of $17 is
composed of $12.50 for in-house professional work (0.25
hours at $50 per hour) and $4.50 for printing, supplies,
copying, and postage (approximately thirty-five percent of
the total labor costs). The estimated annual cost of $85 is
derived from five notices at $17 per notice.
[643]:The total estimated cost of $675 is composed of $500
for in-house professional work (ten hours at $50 per hour)
and $175 for printing, supplies, copying, and postage
(approximately thirty-five percent of the total labor
costs).
[644]:The estimated aggregate cost of $1,520 is derived from
two alternative trading systems incurring an estimated
annual cost of $760 each ($85 for providing systems outage
notices and $675 for recordkeeping requirements).
[645]:The estimated cost of $1,730.88 is derived from an
average of thirty-six hours of compliance time at $48.08 per
hour. The value of compliance time is estimated as follows:
an employee of a broker-dealer charged to ensure compliance
with Commission regulations receives estimated annual
compensation of $100,000. This compensation is the
equivalent of $48.08 per hour ($100,000 divided by 2,080
payroll hours per year).
[646]:This estimated cost of $77,889.60 is derived from
forty-five alternative trading systems incurring an annual
cost of $1,730.88 each.
[647]:The estimated cost of $192.32 is derived from an
average of four hours of compliance time at $48.08 per hour.
The value of compliance time is estimated as follows: an
employee of a broker-dealer charged to ensure compliance
with Commission regulations receives estimated annual
compensation of $100,000. This compensation is the
equivalent of $48.08 per hour ($100,000 divided by 2,080
payroll hours per year).
[648]:This estimated cost of $8,654.40 is derived from
forty-five alternative trading systems incurring an annual
cost of $192.32 each.