August 20, 1998
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street N.W.
Washington, D.C. 20549
Re: SEC Release Nos. 34-39884 (File No. S7-12-98)
Dear Mr. Katz:
The proposed rules ("Proposed Rules") relating to alternative trading systems ("ATSs") in Securities Exchange Act Release No. 39884 (April 17, 1998), 63 FR 23504 (April 28, 1998) (the "Release") constitutes a constructive proposal by the Securities and Exchange Commission ("SEC" or "Commission") with respect to the difficult regulatory and competitive issues posed by ATSs. The Pacific Exchange Inc. ("PCX") commends the SEC for the forward-looking thrust of the Proposed Rules, particularly for the strong emphasis in the Release on the need to assure fair competition among all securities markets. Nevertheless, we do not believe that the Proposed Rules go far enough toward assuring competitive fairness. Indeed, if the Proposed Rules are adopted as proposed, the competitive playing field will continue to be seriously and unfairly tilted to the disadvantage of registered exchanges.
In PCXs view, the key goal of the national market system ("NMS") is the "linking of all markets for qualified securities. . . through communication and data processing facilities" in a manner that fosters fair competition among those markets together with appropriate access, transparency, and efficiency. Section 11A(a)(1)(C) and (D) of the Securities Exchange Act of 1934. We are convinced that "all markets" means "all markets" regardless of whether they are characterized as "exchanges," "ATSs," or "internal broker-dealer systems." Unfortunately, the Proposed Rules essentially ignore significant markets -- the internal broker-dealer systems that compete with the exchanges and ATSs for order flow -- and leave substantial and inappropriate disparities in the regulatory burdens imposed on other markets -- exchanges in contrast to ATSs. In this letter we present our recommendations for amending the Proposed Rules to bring them more into line with the key NMS objective.
Our comments on the Proposed Rules are organized around four central points. Each point relates to the desirability of eliminating disparities in both competitive opportunities and regulatory burdens that would result from adoption of the Proposed Rules in the form in which they now stand. The four points can be summarized as follows. First, the Proposed Rules inappropriately exclude what are defined as "internal broker-dealer systems" from the reach of the regulatory requirements in Proposed Regulation ATSs. Second, the volume thresholds in the Proposed Rules for triggering enhanced order display, fair access and systems integrity, capacity, and security requirements are set far too high. Third, wherever the volume threshold is set for the imposition of requirements related to the capacity, integrity and security of automated systems ("Systems Requirements"), that threshold should apply to exchanges and internal broker/dealer systems as well as to ATSs. And fourth, the opportunities for innovation offered to exchanges by proposed Rule 19b-5 are largely illusory, and a new procedure for the implementation by exchanges of pilot programs needs to be adopted.
I. Internal Broker/Dealer Systems Should Be Subject to the Requirements of Regulation ATS
In the Release, the SEC requests comment on whether its proposed definition of an "exchange" is appropriate. Our answer is "yes" and "no." "Yes" because the definitional structure the SEC proposes allows an ATS the appropriate choice of either registering as a broker-dealer or as an exchange. "No" because that definitional structure is overly complex and confusing, but most importantly because it would exclude from the coverage of proposed Regulation ATS all internal broker-dealer systems, including those that compete directly with exchanges for order flow ("Competitive Dealer Systems"). Let us explain our "no" answer in more detail.
The Commission proposes to define the operative language in the statutory definition of exchange in such a way that that language would include 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. Proposed Rule 3b-12(a) (the "New Exchange Definition"). Excluded from the New Exchange Definition are order routing systems, single dealer quotation systems, and single broker-dealer order management and execution systems.
Next, the Commission proposes to define an ATS as a "system" that falls within the New Exchange Definition but that neither sets rules governing matters other than trading on that system nor disciplines subscribers. Despite the fact that an ATS would be an "exchange" under the New Exchange Definition, an ATS would be "exempt" from the statutory definition of an "exchange" if that ATS was in compliance with proposed Regulation ATS. Proposed Rule 3a1-1.
Finally, and most confusingly, an "internal broker-dealer system," a term that is not used in either proposed Rule 3a1-1 or proposed Rule 3b-12, is defined as "any facility . . . 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" -- but that is not an exchange or an ATS. Proposed Rule 17a-3(16)(ii)(A).
This four part definitional scheme -- proposed Rules 3b-12, 3a11, 17a-3(a)(16)(ii), and Section 300 of proposed Regulation ATS -- is overly complex and unclear. 1 But apart from the definitional schemes complexity, our major concern is that it does not accomplish what it should: appropriate regulation of all relevant markets. The SECs proposed definitional scheme leaves internal broker-dealer systems, particularly Competitive Dealer Systems, entirely exempt from the market regulatory initiatives imposed historically on exchanges and by the Proposed Rules on ATSs. For example, under the proposed definitional scheme, Instinet would become either an exchange or an ATS, but Bernard L. Madoff and E.B. Shaw would be neither. Indeed, they would become subject to less market and system regulation than they are now. This makes neither competitive nor regulatory sense. Market execution centers like these third market dealers should be held to the same minimum standards of fairness, transparency, access and efficiency as are other markets with similar market power and importance.
The Commission states that internal broker-dealer systems "do not involve the systematic interaction of customer orders where the customers themselves are informed of and have an opportunity to agree to the terms of their trades (or agree to the priorities under which the terms will be set)." Moreover, internal-broker dealer trading systems in the Commissions view "typically give discretion to that broker-dealer to select the market where the order will ultimately be executed, how the order may be split up or worked, and whether the broker-dealer will execute the order as a principal or as agent." Release at 22.
Whether or not these observations are correct insofar as Competitive Dealer Systems are concerned, they miss the point. For the issue with which the SEC should be concerned is not whether internal broker-dealer systems are like exchanges, but whether internal broker-dealer systems, or, at least, some significant subset of them encompassing Competitive Dealer Systems, are "markets" in the statutory sense of that term (Section 11(a)(1)(C) and (D)) and should be linked and regulated accordingly.
In adopting Rule 17a-23, the SEC made clear that market maker firms with fully or partly automated trading systems, i.e., Competitive Dealer Systems, should be included within the scope of that rule because their capacity for "potential concentration of volume outside of the national market system may have significant market effects." 2 The PCX agreed with that conclusion then, and believes that it provides a solid and appropriate basis now for subjecting these Competitive Dealer Systems to the requirement of proposed Regulation ATS.
The PCX agrees with the Commission that there are clear distinctions between exchanges, ATSs, and dealer trading systems. But the PCX does not agree that those distinctions should necessarily lead to fundamentally different regulatory burdens. The main focus of the Commissions efforts in the regulation of markets should be to assure that all markets that have significant market effects are included appropriately within the NMS. Exchanges, ATSs, and Competitive Dealer Systems are all centers for the interaction and execution of orders, and all three types of systems compete for order flow. To the extent that one of these market types is subject to lesser regulatory requirements than its competitors, it has a distinct and unfair competitive advantage. The markets that should be linked and regulated as markets should be identified by pricing and volume importance and not by their similarity to "traditional" exchanges or their satisfaction of the criteria in the New Exchange Definition.
Accordingly, we urge the Commission to amend the proposed definitional structure in the Proposed Rules to subject Competitive Dealer Systems to the requirements of proposed Regulation ATS. Unfortunately, given the proposed definitional approach -- defining ATSs as "exchanges" that do not regulate or discipline their subscribers -- such a change may appear awkward. Nevertheless, it could be accomplished without affecting any of the Commissions substantive objectives in a variety of ways. 3 Whatever way the definitional change is accomplished, however, the important point is that Competitive Dealer Systems, exchanges, and ATSs that have comparable market importance should be integrated into the NMS in comparable ways.
In summary, it is both necessary and appropriate that Competitive Dealer Systems be included within the NMS initiatives contained in the Proposed Rules. Competitive Dealer Systems engage in activities similar to both ATSs and traditional exchanges, and compete directly with them for order flow. Further, several Competitive Dealer Systems have far greater trading volume and market importance than many exchanges. If the objectives of market transparency, systems adequacy, fair access, and fair competition are to be achieved, internal broker-dealer systems that compete directly for order flow should be required to comply with Regulation ATS. 4
II. The Volume Thresholds for Integration of ATSs into
NMS Mechanisms Are Set Too High
The Commission proposes to trigger the imposition of various enhanced regulatory requirements for ATSs based on a set of threshold volume levels. The Commissions approach in the Proposed Rules demonstrates an appropriate awareness that regulatory burdens should increase as the pricing and volume importance of a market increases. The PCX fully supports this approach. However, the PCX believes that the proposed thresholds are set too high.
The Commission proposes that if an ATS accounts for more than ten percent of the aggregate daily share volume in an equity security, it would be required to integrate its ATS orders into the public quotation stream and to provide access to its best bid and offer. The purpose of the proposed rule is to increase transparency, i.e., to ensure that the public quote reflects the true trading interest in a particular security. Release at 38. The Commission also proposes that if an ATS accounts for more than twenty percent of the average daily share volume in any equity security, it should be required (1) to establish standards for granting access to trading on its system and (2) to comply with enhanced regulatory requirements relating to systems capacity, integrity, and security. The purpose of the latter rules is to prevent ATSs from engaging in unfairly discriminatory actions that hurt investors lacking access to their systems and to avoid or minimize the adverse effects of potential systems problems in significant markets.
The PCX believes that the ten and twenty percent volume thresholds are too high and that they seriously and unfairly skew the competitive field in favor of ATSs to the disadvantage of registered exchanges. 5 Furthermore, thresholds set at such high levels will not accomplish the Commissions goals of market transparency, fair access, and assured systems capacity, integrity, and security. The PCX notes that many exchanges do not now account for ten, much less twenty percent, of the aggregate volume in any ITS security. Indeed, OTC dealers in exchange traded stocks are required to publicly display their quotes, and the limit orders of their customers, if their total trading is more than one percent of aggregate trading volume. Rule 11Ac1-1(a) (25). We believe this quotation display threshold is an appropriate one, and, therefore, recommend that the order display requirements in Regulation ATS be triggered by volume greater than one percent of aggregate trading volume. With respect to the requirements of fair access and assured systems capacity, integrity, and security in Regulation ATS, we believe these should be triggered by volume greater than ten percent of aggregate trading volume.
III. The Volume Threshold for Required Compliance with Commission Standards for Systems Capacity, Integrity, and Security Should Be Applied Uniformly to Exchanges, ATSs and Competitive Dealer Systems
Under the Proposed Rules, an ATS that accounted for more than twenty percent of the share volume in an equity security would be required to meet the proposed capacity, integrity and security requirements. We expressed above our belief that this threshold is too high and should be lowered to not more than ten percent. But whatever the level of this threshold, it should be used not just for ATSs, but for exchanges and Competitive Dealer Systems as well, in determining whether any given market should be subject to the mandatory Systems Requirements.
As already noted, many exchanges do not account for ten percent, much less twenty percent, of the trading in any ITS eligible equity security; yet all exchanges are now required to comply with the full panoply of regulatory requirements for systems capacity, integrity and security. These regulatory obligations impose substantial costs on exchanges and are a major cost element for the smaller exchanges. By contrast, the Commissions Proposed Rules would impose the Systems Requirements of Regulation ATS, with their associated costs and burdens, on only a few ATSs. 6 Further, no Competitive Dealer System would be required to comply with these requirements regardless of its trading volume in any security.
There is simply no rational basis for imposing Systems Requirements on exchanges when such requirements are not imposed on ATSs or Competitive Dealer Systems that have substantially greater trading volume. All trade execution centers should be dealt with in this regard in a comparable manner. The Commission states that the proposed systems capacity, integrity and security requirements are intended "to ensure that (ATSs) that have a significant role in the market maintain sufficient systems and procedures to avoid or minimize the effects of potential systems problems in the secondary market." Release at 53 (emphasis added). We agree. But if ATSs with less than a specified volume threshold are considered not to have a significant role in the market, and, therefore, are exempt from these requirements, then exchanges and Competitive Dealer Systems that also account for less than the threshold trading volume should likewise be exempt.
IV. The Proposed Exemption for Pilot Trading Systems Does Not Go Far Enough To Create Equal Opportunities for Innovation on the Part of Registered Exchanges.
The PCX commends the Commission for its efforts to enhance the competitive opportunities of registered exchanges through its proposed Rule 19b-5. Nevertheless, although proposed Rule 19b-5 is a step in the right direction, it is far too limited in scope to enable meaningful innovation on the part of registered exchanges, and would do little to level the competitive playing field with respect to innovation by exchanges, ATSs, and Competitive Dealer Systems.
Proposed Rule 19b-5 provides two exemptions from an exchanges normal rule filing obligations under Section 19(b) of the Exchange Act. First, an exchange would be exempt from Section 19(b)s rule filing requirements with respect to a proposed "pilot trading system" that did not trade more than one percent of the aggregate average daily trading volume of any security traded on the system and did not have an average daily trading volume of more than twenty percent of the trading volume of all securities traded on trading systems operated by the exchange. Second, an exchange would be exempt from Section 19(b)s rule filing requirements with respect to a proposed "pilot trading system" that was "independent" of any other trading system operated by the exchange, traded no more than five percent of the aggregate average daily trading volume of any security traded on the system, and did not have an average daily trading volume of more than twenty percent of the trading volume of all securities traded on trading systems operated by the exchange. A system would be deemed to be "independent" only if it operated at different times than, or traded different securities from those traded on, other exchange trading systems, or prohibited all exchange specialists or market makers from effecting transactions in securities for which they were specialists or market makers.
The Commissions stated purpose in proposing Rule 19b-5 was to "level the competitive playing field between SROs and alternative trading systems," and it has requested comment on whether the rule accomplishes this objective. We do not believe it does. While volume restrictions make sense in the context of imposing enhanced regulatory requirements on ATSs, they do not make sense with respect to limiting the ability of registered exchanges to introduce new trading systems -- particularly when neither ATSs nor Competitive Dealer Systems are subject to similar volume limitations. ATSs, regardless of volume, would be able to introduce new or changed systems by merely filing a 30-day notice with the Commission that would not be subject to any approval process. Moreover, their filings would be confidential. Competitive Dealer Systems may introduce and alter their systems without any notice or approval process whatsoever, and their operations are completely confidential.
Accordingly, the PCX believes that proposed Rule 19b-5 should be amended so that it effectively treats exchange pilot trading systems as though they were ATSs for two years, subject to the systems not exceeding a fairly high percentage of total trading volume in any security, say ten percent. As proposed Rule 19b-5 now stands, the one and twenty percent volume limitations for "non-independent" trading systems are so low as to severely limit the ability of any exchange to innovate. Similarly, the standards for "independence" are so severe that the five percent volume limitation is virtually meaningless.
We can see no regulatory justification for the proposed limitations in Rule 19b-5, particularly given that neither ATSs nor Competitive Dealer Systems are subject to similar restrictions. The PCX is convinced that if the Commission is serious about leveling the competitive playing field between SROs and ATSs, then it must provide an exemption from the Rule 19b-4 process that is far more extensive than that provided in proposed Rule 19b-5. In our view, the way to do this is to permit exchanges, ATSs, and Competitive Dealer Systems to launch new systems without pre-approval by the Commission, and to impose on all such entities the same notice and disclosure requirements. 7
The articulated goals of the Proposed Rules are to "more effectively integrate ATSs into the national market system" and to "provide an opportunity for registered exchanges to better compete." Release at 1. The PCX believes that the Commissions Proposed Rules are a major step toward accomplishing these goals, but we also believes that further modifications to the proposed regulatory scheme are necessary if those goals are to be actually achieved. Considerable competitive inequalities would continue to exist among registered exchanges, ATSs and Competitive Dealer Systems if the Proposed Rules were adopted as proposed.
Markets that perform comparable functions and compete directly against one another should be comparably regulated insofar as possible. Competitive Dealer Systems and ATSs compete directly against exchanges; they perform functions similar to exchanges; and in many cases they have greater trading volume than exchanges. Accordingly, we urge the Commission to modify the Proposed Rules so that (1) Competitive Dealer Systems are not exempt from the regulatory requirements of Regulation ATS; (2) the thresholds for application of order display, access and System Requirements are substantially lowered; (3) registered exchanges, ATSs and Competitive Dealer Systems are held to the same standards for application of System Requirements, and (4) registered exchanges are allowed to initiate systems innovations on a basis that is comparable to -- not far more difficult than -- ATSs and Competitive Dealer Systems.
We hope the comments in this letter are helpful to the Commission in its efforts to adjust the regulation of exchanges, ATSs, and Competitive Dealer Systems in light of rapid technological change. Please be assured that the PCX is available to discuss these matters with the Commission or to provide any further assistance in this important endeavor.
Very truly yours,
David E. Rosedahl
Executive Vice President and Chief Regulatory Officer
cc: Chairman Arthur Levitt
Commissioner Norman S. Johnson
Commissioner Isaac C. Hunt, Jr.
Commissioner Paul R. Carey
Commissioner Laura S. Unger
Richard R. Lindsey, Director, Division of Market Regulation
Robert L.D. Colby, Deputy Director, Division of Market Regulation
Belinda Blaine, Associate Director, Division of Market Regulation
Elizabeth King, Senior Special Counsel, Division of Market Regulation
Marianne Duffy, Special Counsel, Division of Market Regulation
-- For example, why is an ATS not defined simply as an exchange that does not set conduct rules or discipline subscribers? If an existing exchange amended its rules to eliminate (1) conduct rules other than those related to trading on such organization and (2) disciplinary authority, would it be an ATS? Is a "facility" under Rule 17a-3(a)(16)(ii) an "organization, association, or group of persons" for purposes of Rule 3b-12(b)? Can a "facility" be an "internal broker-dealer system" without falling within the New Exchange Definition (Rule 3b-12(a)) and being excluded from that definition by reason of one or more of the exclusions in proposed Rule 3b-12(b)? Is a sponsor of an "internal broker-dealer system" an "organization, association, or group of persons" that is excluded from the New Exchange Definition by reason of proposed Rule 3b-12 (b)? If so, why is it necessary to define an "internal broker-dealer system" in terms of "facilities" that are not an exchange or ATS? If not, on what basis other than proposed Rule 3b-12(b) could an "internal broker-dealer system," as defined in Section 300 of Regulation ATS, ever not fall within the New Exchange Definition?
-- Rule 17a-23 Release, supra note 11, at 66705.
-- Among the possible approaches are the following: ATSs could be defined separately, not as exchanges, and in a way that included internal broker-dealer systems that competed with exchanges and ATSs for order flow. A regulatory scheme essentially identical to that proposed for ATSs could be imposed directly on Competitive Dealer Systems. Or the exclusions proposed in Rule 3b-12(b) could be revised to make clear that Competitive Dealer Systems were not covered by this section and that such systems, by their very nature, do, in fact, set non-discretionary material conditions to the trading effected through them.
-- In contrast to our recommendations, under the Proposed Rules, all internal broker-dealer systems would be subject to reduced regulatory requirements. The Commission is proposing to amend Rules 17a-3 and 17a-4 under the Exchange Act to require that records of trading conducted through internal broker-dealer systems be maintained. However, internal broker-dealer systems would no longer be required to report any information to the Commission as they are required to do today under Rule 17a - 23. Release at 81.
-- The Commission has requested comment on whether, once a volume threshold for order display is met, it should be applied on a security-by-security basis or to all securities in the relevant category traded by the ATS. We believe that the latter approach would better accomplish the Commissionís goals of market transparency. Once an ATS has reached the specified volume threshold, it has demonstrated its significance for the purposes of integration into the NMS and should be held to the same standards as other participants in the NMS.
-- The Commission estimates that only 2-3 out of 43 ATSs would have sufficient trading volume to cause them to have to comply with the enhanced regulatory requirements at the present time.
-- The Commission also has requested comment on whether the information that must be filed on a proposed new Form PILOT should be kept confidential. We believe that the same form, whatever is adopted, should be used by registered exchanges, ATSs and internal broker-dealer systems. We also believe that strict and complete confidentiality is necessary to prevent competitors from "free riding" on the innovative efforts of others. We also do not believe that the public would in any way be harmed by the confidentiality of Form PILOT filings. Registered exchanges, ATSs and Competitive Dealer Systems that market their systems to the public will provide the public with necessary information about the system, without the need to disclose the technical aspects and operation of the system to competitors. Registered exchanges, ATSs and internal broker-dealer systems should not be required to disclose information to others through SEC filings unless all competitors are held to the same requirements.