October 20, 1997

Mr. Jonathan G. Katz

Securities and Exchange Commission

450 5th Street N.W.

Washington, D.C. 20549

Re: File No. S7-16-97

Dear Mr. Katz:

The Concept Release ¹ issued by the Securities and Exchange Commission ("SEC") in May of this year provides a thoughtful analysis of the current structure and operation of the equity markets and a series of far reaching proposals for regulatory change. The Pacific Exchange Inc. ("PCX") commends the SEC for the depth, creativity, and provocativeness of the entire document. Because the Concept Release raises so many complex and interdependent issues, the comment period has been too brief for us to give the extensive attention to all of the issues that they deserve. Nevertheless, in an effort to respond in, at least, a preliminary way to the fundamental thrust of the Concept Release, PCX has organized its responses around five principal areas of concern and interest.

First, we specifically address Questions 31 and 89, which pose in broad scope the issue underlying the entire Release: whether the broker-dealer approach to regulation of alternative trading systems ("ATSs"), or the "tiered" exchange approach to such regulation, is preferable. Because this issue is at the very heart of the Concept Release, we attempt to explain in detail why we believe the broker-dealer approach can and should be used to integrate ATSs into the national market system ("NMS") and why we believe the "tiered" exchange approach is inappropriate and unnecessary. In this regard, we think it is important to emphasize that the concept of an "exchange" is not, and should not become, the paradigm for the regulatory standards to which all trading facilities should be held. As we explain in more detail below, casting the "exchange" net over entities that are not now caught within it would not be beneficial and in all likelihood would be counterproductive.

Second, building on the SEC’s analysis, we articulate our own views as to the regulatory objectives and minimum standards (Question 4) that should be common to all trade execution centers -- whether they are traditional market makers (including third-market market makers), broker-dealer trading systems ("BDTS") reporting under Rule 17a-23, broker-dealers that fall with the definition of electronic communication networks ("ECNs") for purposes of Rule 11Ac1-1, broker-dealers that would fall within the SEC’s proposed expanded definition of "exchange," the NASDAQ Stock Market, or the currently registered exchanges. There can be no argument with the Commission’s conclusion that "the distinctions among market service providers have become blurred . . . ." ² Yet those distinctions may not be all that important if proper steps are taken to assure that all trading centers are required to adhere to the same standards of market responsibility. Accordingly, we seek to identify these core regulatory requirements and then offer suggestions as to how they can best be imposed on relevant markets.

Third, because of our belief that broker-dealer regulation provides an appropriate scheme for fully integrating ATSs into the NMS, we discuss in detail our answers to the SEC’s specific questions directed to the appropriateness and effectiveness of the broker-dealer regulatory scheme. (Questions 10 through 30.) In doing so, we also discuss why we believe that although the ATSs that would fall within the expanded definition of "exchange" may present difficult classification issues, these trading systems are by no means unique among trade execution centers in their need to adhere to core regulatory principles of transparency, access, competitive fairness and efficiency.

Fourth, in response to the SEC’s statement that it is "considering ways to reduce unnecessary regulatory requirements that make it difficult for currently registered exchanges to remain competitive in a changing regulatory environment," ³ we discuss our views as to certain areas in which the regulatory requirements imposed on some or all of the traditional exchanges can be reduced. (Questions 90 through 96).

And fifth, in response to the questions the Commission asks regarding the regulation of foreign market activities in the U.S., the PCX provides detailed comments regarding its view of an appropriate regulatory response to these activities.

One further preliminary point before we turn to our substantive comments. The issues raised in the Concept Release are so important and far reaching that we urge the Commission to proceed with their resolution through a highly interactive and cooperative process with the industry. Specifically, we recommend that the Commission establish a broad based advisory committee under Section 11A(a)(3)(A) of the Act to work directly with the Commission to review all responses to the Concept Release and to develop a set of proposed recommendations. We suggest this approach in large part because the PCX has found, from its own experience in dealing with its members in the context of rule formulation, that working in a collaborative manner can often lead to solutions to controversial issues that are more carefully crafted and that have much stronger support that those that are devised unilaterally. We are concerned that if the SEC proceeds through normal notice and comment rule making in the sensitive and controversial areas addressed in the Concept Release, there is a high risk of factionalizing the industry and generating substantial opposition to the final result, whatever it might be.

I. THE APPROPRIATE REGULATORY

SCHEME FOR ALTERNATIVE TRADING SYSTEMS

A. Background

Since at least the introduction of the first ATS, the SEC has been expressing its uncertainty as to how these trading systems should be regulated. For example, in 1969, shortly after Instinet filed its original application for registration as a broker-dealer, the Commission proposed Rule 15c2-10 out of concern that "the applicability or adaptability of the existing statutory classifications to (such automated trading information systems) is not entirely clear . . . . Although it appears that automated trading information systems should be regulated under the (Securities Exchange) Act in some form, the form of regulation remains to be decided." ⁴

Despite this early recognition by the SEC of the apparent discontinuity between the regulatory scheme in the Securities Exchange Act of 1934 (the "Act") and emerging market technologies, at no time during consideration of the legislation that became the Securities Acts Amendments of 1975 ("1975 Amendments") did the SEC propose a new statutory classification for ATSs or an amendment to the existing classifications that would better address unique characteristics. Nevertheless promptly after the 1975 Amendments were enacted, the SEC stated that "(i)n view of the regulatory scheme provided by the 1975 Amendments . . . further consideration, or adoption, of (Rule 15c2-10) is deemed no longer necessary." ⁵

The SEC’s concern about the appropriate form of regulation for ATSs returned in the middle 1980’s when it began, without formal announcement, to subject ATSs to an extra-statutory no-action scheme. Under this scheme, ATSs that were concerned that they might fall within a simplistic, literal reading of the definition of "exchange," were effectively required to apply to and receive from the staff of the Division of Market Regulation of the SEC ("Division") assurances that it would not recommend enforcement action if the ATSs operated without registering as exchanges. The price for this regulatory comfort was a requirement that each ATS sponsor comply with record keeping and reporting requirements, very similar to those eventually imposed in 1995 on all BDTS by Rule 17a-23.

Fourteen years after the SEC withdrew proposed Rule 15c2-10, it reproposed the rule, this time in a significantly expanded form that would have imposed a series of obligations on broker-dealer sponsors of proprietary trading systems that "somewhat resembled SRO regulations." ⁶ For example, such sponsors would have been required to "supervise the system to ensure compliance by participants and subscribers with . . . the federal securities laws," to ensure that system capacity was adequate, not to deny access to the system unfairly, to file amendments to their "plans" for review by the SEC in a manner very similar to that provided for in Rule 19b-4, and to satisfy the standards imposed by Rule 11Aa3-2(c)(1) and (2) on national market systems plans before these trading systems could commence operations. In other words, the SEC proposed to impose on ATSs much of the operational and supervisory responsibilities of an exchange, but not to require, among other things, that these trading systems comply with the "fair representation" standard in Section 6(b)(3), have "members" that must be broker-dealers, or allocate fees "equitably." The SEC stated that it was not imposing these latter requirements because it believed that to do so "would substantially deter development of innovative trading systems." ⁷

Five years after reproposing Rule 15c2-10, the SEC again withdrew the proposal. Its stated reason for doing so was that it had ceased to believe "that it would be appropriate to adopt the structure contemplated by (the Rule) at this time." ⁸ This conclusion was based on the Division’s finding in the Market 2000 report that the "extensive regulatory framework" contemplated by Rule 15c2-10 was not "appropriate . . . at this time." ⁹ Instead of imposing such a scheme, the Market 2000 report recommended that the SEC adopt a "record keeping and reporting rule (that) would provide the Commission . . . with better regulatory oversight of the market aspects of automated trading systems without burdening the systems with unnecessary regulations." ¹⁰

Following this recommendation, the Commission proposed and adopted Rule 17a-23. Three aspects of this rule are significant. First, unlike either of the Rule 15c2-10 proposals, Rule 17a-23 is applicable to all BDTS; that is, it is applicable not only to trading systems that facilitate transactions between participants but also to trading systems that facilitate transactions between a participant and the system sponsor. Thus, the Rule applies not only to Instinet and POSIT-type systems but also to automated dealer systems. Second, the rule is premised on the SEC’s view that its appropriate calibration of regulatory "initiatives" is being "hindered by a lack of critical information regarding the activity of BDTSs." ¹¹ And third, despite the abandonment of the Rule 15c2-10 approach, the SEC made clear that adoption of Rule 17a-23 would not affect its no-action scheme, noting that "(s)ponsors of BDTSs seeking relief from exchange . . . registration requirements may continue to request no-action positions from the Division." ¹²

Now, three years after the adoption of Rule 17a-23, the SEC has issued the Concept Release. Using almost the same words it used in 1969, the SEC again has noted that "it is often unclear whether (automated trading) systems should register as exchanges, broker-dealers, or both." ¹³ In the Concept Release, however, the SEC has developed, for the first time, detailed proposals as to what a regulatory scheme might look like under each of these alternatives. One, a scheme of broker-dealer regulation, would build on the current approach through additional rule making. The other, a scheme of "tiered" exchange regulation, would essentially turn the second Rule 15c2-10 approach upside down; that is, rather than imposing some but not all of the Section 6 requirements on ATSs through a "plan," the SEC would require ATSs that fall within an expanded definition of "exchange" to register under Section 6 but would relieve them of some of that section’s "inappropriate" requirements through the use of its new exemptive powers under Section 36.

The PCX is sympathetic to the SEC’s difficulties in dealing with ATSs in the context of the statutory classifications in the Act. Yet, more than 25 years have passed since the SEC first recognized the need to develop a program for integrating technological change into the Act’s scheme of market regulation. It is now time for a clear regulatory scheme to be put in place that will provide certainty, and a fair allocation of market responsibilities, for the ATSs and their competitors. The PCX hopes that its comments in this letter will help facilitate that process.

B. Exchange Regulation of

Alternative Trading Systems Is Inappropriate

In the Concept Release, the SEC states that the Exchange Act relies "primarily on trading markets to implement and operate market mechanisms for enforcing the federal securities laws . . ." and that "all significant trading activity and market participants (should be) supervised by an SRO." ¹⁴ The PCX questions both assertions and suggests that adherence to these would inhibit a resolution of the regulatory dilemma posed by ATSs.

With regard to the first of these assertions, significant OTC market makers, third-market market makers, and block positioning firms are all "trading markets." Indeed, in many cases they are the sole market, the only place where anything is happening. Yet these market makers are not expected to enforce the federal securities laws -- nor do we believe that they should be. Market makers are proprietary, competitive businesses that must comply with the federal securities laws but should not be expected to enforce them on their customers. As for the second statement, institutional investors are surely the major "market participants" in all of our markets, and yet they have never been, nor is there any indication in the Act or its legislative history that they should be, subject to supervision by an SRO.

The operation of markets and the regulation of markets and their participants are not the same thing and need not be done by the same persons. Traditional exchanges combine these functions because of history and a statutory scheme that was designed to control a historical phenomenon. But through the judicious use of the SEC’s exemptive authority, the regulatory functions of an exchange and the trading functions of that exchange could be separated without loss of investor protections or harm to the public interest. When originally established, the NASD was solely a regulator; it was not a market operator. And as the recent separation of NASD Regulation, Inc. ("NASDR") from The NASDAQ Stock Market, Inc. ("NASDAQ") makes clear, the structure of the over-the-counter dealer market is not such as to require the combination of market operation and market regulation.

The PCX shares the SEC’s belief that "alternative trading systems are not fully integrated into the national market system." ¹⁵ But we do not share the SEC’s apparent belief that requiring such trading systems to register as "exchanges" and forcing these proprietary businesses to assume the quasi-governmental authorities and responsibilities of SROs is necessary to accomplish such integration. Furthermore, beyond being unnecessary to integrate ATSs fully into the NMS, the PCX is convinced that the scheme of "tiered" exchange regulation set forth in the Concept Release is at odds with the fundamental regulatory assumptions of the Act and is likely to have adverse and unintended consequences. We elaborate on those two points in the following sections.

1. The Act Is Premised On

Exchanges Being Membership Organizations

The SEC recognizes that ATSs "do not fit neatly" into the "traditional" view "that all persons trading on an exchange would be members of that exchange, and would be registered as, or associated with, broker-dealers." ¹⁶ Nevertheless, the SEC proceeds to suggest how ATSs, with their non-broker-dealer participants, might be made to fit in the Act’s regulatory scheme for "exchanges," addressing specifically limitations on "floor" access, the prohibition of non-broker-dealer members, and the requirement of "fair representation." ¹⁷ These suggestions appear to us to miss the larger point that "(t)he concept of ‘membership’ -- i.e., voluntary association with an industry organization -- is fundamental to the self-regulatory system established by the Exchange Act." ¹⁸ This is true for, at least, two reasons.

First, the unique concept of self-regulation has taken hold in the securities industry in large part because the business is highly complex, involving "intricate merchandise" and delicate and rapidly changing market mechanisms. In such a circumstance, self-regulation is highly desirable because:

members of the affected business can bring to bear on the problems of regulation a degre(e) of expertness, and in many circumstances expedition, not to be expected of a necessarily more remote governmental agency . . . . (P)erson on the scene and familiar with the intricacies of securities and markets from daily and full-time pursuit of the business can more readily perceive and comprehend some types of problems and more promptly devise solutions than a governmental agency which, however great its collective knowledge and skill, may be able to concern itself only intermittently with specific problems, may become aware of them only after the event, and often must defer decision and action until thorough investigation or study has been completed. ¹⁹

At present, the participants in the ATSs are not involved in the management or operations of these trading systems and there is no suggestion in the Concept Release that such involvement is needed or would be beneficial in perceiving problems or devising solutions. Furthermore, the Concept Release is silent on the need or practicality of forcing ATS participants to become members and thus looked to "bring to bear on the problems of regulation (of the ATS and its participants) a degree of expertness ... not to be expected of a necessarily more remote government agency." When discussing the messiness of the membership notion if ATSs were treated as "exchanges," the Concept Release focuses solely on the manner in which participants, particularly those that are not broker-dealers, would be regulated by these newly registered "exchanges." But equal attention needs to be given to how these participants would do the regulation. In other words, the "self" in self-regulation needs to be taken seriously, and when that is done, the artificiality of the "tiered" exchange approach becomes apparent.

Second, in discussing the broker-dealer approach for regulating ATSs, the SEC identifies as a "regulatory gap" left by this approach, the absence of "meaningful redress for unfairly discriminatory acts taken by the operators of these systems." ²⁰ The SEC then suggests that this gap would be filled if ATSs were regulated as exchanges. ²¹ But the various antidiscriminatory provisions in the Act applicable to exchanges -- requirements of equitable allocation of fees, non-discriminatory access, fair representation, and no unjustified competitive burdens -- exist in large part because exchanges are membership organizations. In the absence of members, most if not all of the rationale for these provisions would disappear.

Traditional exchanges are operated by members who are the only direct participants in those markets. It is hardly an original insight that these members may have an all-too-human inclination to operate those markets for their own benefit, to the exclusion or detriment of others. As the Special Study puts the point:

(S)elf-regulation by a member organization involves some degree of impairment of competition. . . . Inherent in self-regulation is the "private" formulation of restrictive standards of business conduct and their enforcement by, at the very least, exclusionary practices. It is essential that the standards and their application not be left to the unfettered discretion, or perhaps even lack of bona fide regulatory purpose, of the private regulators. The accommodation of various public policies inherent in the formulation of appropriate standards and their proper application cannot be abdicated by public authority. ²²

By and large, the PCX believes that the existing exchanges do a very good job as SROs, but the Exchange fully recognizes that the antidiscriminatory requirements to which we and the other exchanges are subject exist because we are membership organizations with both "private" interests and "public" obligations. In such a situation "regulatory structures and procedures (are needed to) be sure that the legitimate rights and interests of no affected group are overridden . . . ." ²³

At present, ATSs have neither members nor quasi-governmental responsibilities or obligations. If there were good reasons to force them to take on both members and SRO responsibilities through adoption of the "tiered" exchange approach, then, of course, they ought to be made subject to the same antidiscriminatory standards as the traditional exchanges. To argue, however, that because ATSs are not subject to these antidiscriminatory procedures, they should, therefore, be required to register as exchanges and view their participants as "members," is to turn the regulatory structure of the Act on its head. ATS are not subject to the antidiscriminatory provisions of Section 6 because they do not have members. To force them to have members in order to subject them to these antidiscriminatory provisions would be unwarranted.

This same point can be made another way. If a traditional exchange, such as the PCX, were to change its structure and abandon the membership concept, it would be entirely reasonable and appropriate for the SEC use its Section 36 power to exempt that exchange from a wide variety of requirements in Section 6, including "fair representation" and "equitable allocation" of fees.

2. Forcing ATS To Register As Exchanges

Would Have Unintended And Undesirable Consequences

In 1989, the SEC stated that "subjecting proprietary trading systems to exchange registration pursuant to Section 6 would substantially deter development of innovative trading systems." ²⁴ Yet in the Concept Release, the SEC does not address or question the impact on innovation of requiring ATSs to register as exchanges. Indeed, the only concern that the SEC does express about constraints on innovation resulting from the regulation of ATSs as exchanges is that the participation of ATSs in the various NMS plans would "open the door for competing exchanges to use (these plans) as a vehicle to inhibit innovation by alternative trading systems." ²⁵

We do not know whether the SEC has altered its opinion about the likely inhibitions on innovation resulting from exchange regulation of ATSs or whether it believes that by exempting ATSs from "those exchange requirements that are unnecessary or inappropriate for propriety, automated systems," ²⁶ it could adequately assuage its historical concerns in this regard. Whichever the case, we think the SEC has missed the mark, for there are fundamental obstacles to innovation inherent in the current structure of exchange regulation and those obstacles would remain in the "tiered" structure the SEC proposes. Rather than focusing on the possibility that the existing exchanges would use the NMS plans to inhibit the innovativeness of the ATSs -- an unlikely but, in any event, easily controlled problem -- the SEC needs to give careful attention to the extent to which the creative dynamism and rapid response time that have characterized the ATSs would be curtailed if they were regulated as exchanges. It is hard for us to believe that there are any benefits of exchange regulation of ATS that would not be outweighed by the ATSs’ resulting loss of technological flexibility and competitive responsiveness.

The PCX wants to be certain that its position regarding inappropriate regulatory constraints on innovation by ATSs not be misunderstood. The PCX competes with ATSs and the competitive playing field is far from level. ATSs can implement, modify, operate and administer their trading systems with none of the restrictions, procedural requirements or pricing restraints to which the Exchange is subject. The relative burdens and benefits, obligations and opportunities, administrative requirements and entrepreneurial incentives imposed on or available to the traditional exchanges versus the ATSs are seriously skewed. As a result, PCX now competes with ATSs in a fundamentally unfair regulatory environment.

Looked at solely from this perspective, the PCX should be arguing that subjecting ATSs to the same regulatory restraints imposed on the traditional exchanges is a needed and appropriate step toward regulatory and competitive parity. The problem with that argument is that the public would be the loser if ATSs and not just the traditional exchanges and the NASD were to have their innovative opportunities and competitive flexibility constrained by exchange-like regulation. At present, the public receives, at least, the benefits of ATSs being able to respond rapidly and with wide diversity to changing market requirements and demands. For the public to lose that market responsiveness from the ATSs for the sake of regulatory comparability with the traditional exchanges would be a bad trade despite the fact it would enhance the exchanges' immediate competitive position.

If the SEC were to subject ATSs to exchange regulation, however "tiered", there would be fairer competition within the NMS, but that competition would be far less likely to produce significant market innovations and overall public benefits than the present arrangement. In the PCX’s view, a way must be found to make competition among all trade execution centers fairer without the loss of either appropriate investor protections or the innovative potential of the ATSs. We believe this can be done only if (1) all trade execution centers, including the ATSs, are held to the same fundamental, minimum standards of market responsibility, and (2) the regulatory requirements applicable to the existing exchanges are substantially reduced to allow them, consistent with the public interest and the protection of investors, "to remain competitive in changing business environments." ²⁷

II. ALL TRADE EXECUTION CENTERS

SHOULD BE HELD TO THE SAME MINIMUM

STANDARDS OF MARKET RESPONSIBILITY

The SEC asks, "what should be the goals of market regulation?" ²⁸ For the PCX, these goals are clearly set forth in the Act and are in no need of revision or elaboration. In summary, they are (1) market access, (2) market transparency, (3) fair market competition, and (4) market efficiency. ²⁹

At the same time it established the goals for the NMS, the Congress granted "the Commission broad authority to oversee the implementation, operation, and regulation of the national market system and . . . charg(ed) it with the clear responsibility to assure that the system develops and operates in accordance with (these) congressionally determined goals and objectives." ³⁰ At this stage of its evolution, the assurance that the NMS continues to develop and operate in accordance with these "goals and objectives," depends on ATSs being "fully integrated into the national market system." ³¹ In our view, this can only be done if ATSs are treated as "markets" that must be "linked" with all others "markets for qualified securities through communication and data processing facilities" ³² in a manner that fosters those "goals and objectives." This does not mean, however, that ATSs should be treated as exchanges. Quite the contrary, their unique characteristics should be preserved to the full extent they are compatible with adherence to the minimum standards of market operation to which all linked markets in the NMS should be held, standards we will refer to as the minimum standards of market responsibility.

A. ATSs, The Exchanges, And The NASD Need

Not Be Placed In The Same Statutory

Category To Achieve Appropriate Market Regulation

As we have already noted, the SEC is correct in stating that "the distinctions between market service providers have become blurred . . . ." ³³ ATSs have exchange-like characteristics, automated dealer trading systems often have more pricing impact than regulated markets, and traditional exchanges use automated execution systems to compete as dealers. But it does not follow from this blurring of traditional distinctions that the achievement of a competitively fair and investor sensitive scheme of market regulation requires the extension of the "exchange" category to non-membership, proprietary business entities.

The goal for the NMS should be the appropriate regulation of all relevant markets -- that is, all trade execution centers. We pointed out above why the proposed redefinition of "exchange," is inappropriate as a policy matter. But beyond that, such a radical regulatory initiative would not achieve the basic NMS goals. For example, under the proposed expanded definition of "exchange," Instinet would become an exchange but Bernard L. Madoff and E.B. Shaw would fall safely within the traditional broker-dealer category. This makes little competitive or regulatory sense. Market execution centers should be held to minimum standards of fairness, transparency, access and efficiency based on their market power and importance, not on whether they fit within one or another definition of "exchange."

Another way of making the same point is to look at the Act and its legislative history. Nowhere in that statute or its history is there any suggestion that the wide variety of trade execution centers now operating, or even any significant subset of them, should be required to function as exchanges. To the contrary, the Congress sought to make clear that the SEC has a responsibility to administer the Act so as "to enhance competition and to allow economic forces, interacting within a fair regulatory field, to arrive at appropriate variations in practices and services. It would obviously be contrary to this purpose to compel elimination of differences between types of markets or types of firms that might be competition-enhancing." ³⁴ The specific legislative embodiment of this objective is in Section 11A(a)(1)(C)(ii) which provides that it is necessary and appropriate "to assure . . . fair competition . . . between exchange markets and markets other than exchange markets."

Section 11A(a)(1)(D) of the Act directs the SEC to "facilitate" the "linking of all markets for qualified securities . . . ." In that directive there is no implicit or explicit assumption that the "markets" that are to be "linked" must or should be exchanges, much less SROs. The designation of the markets that should be linked, if the objectives of market regulation are to be realized, and the location of self-regulatory authority and responsibility are separate and distinct issues. Whether the current set of SROs is retained, the universe of SROs is significantly expanded in accordance with the SEC’s "tiered" exchange proposal, or a "sole self-regulator" established, as the NASD first proposed over 20 years ago, ³⁵ the content and focus of market regulation would be unaffected. "Markets" and SROs are distinct. SROs are not necessarily markets and markets are not necessarily SROs. To conflate the two forces a series of policy contortions ³⁶ that could seriously undermine the sound and effective regulatory patterns of the Act. Without question, there must be an SRO for every market execution center, but every market execution center does not have to be an SRO.

Because of our belief that SROs and markets must be viewed separately, we approach the issue of which markets should be linked and thus held to the minimum standards of market responsibility without any notion that all of these markets should necessarily fit into the same regulatory classifications in the Act. We see nothing anomalous about brokers, dealers, NASDAQ, and exchanges all being considered to be markets for purposes of Section 11A1(a)(1)(D). Given that perspective, in the following two sections, the PCX presents its views as to, first, the appropriate approach for identifying the market execution centers that should be subject to minimum standards of market responsibility, and second, the content of those standards and the steps that need to be taken to assure appropriate extension and application of those standards to the appropriate market execution centers.

B. The Markets To Be Linked In the NMS Include All ATSs

The Concept Release uses the term "alternative trading systems" to refer "generally to automated systems that centralize, display, match, cross, or otherwise execute trading interest . . . ." ³⁷ We assume that this term encompasses all BDTSs reporting to the SEC pursuant to Rule 17a-23. ³⁸ We also assume all broker-dealers that are ECNs covered by Rule 11Ac1-1 are ATSs. (Although the SEC states that "(a)ll ECNs are broker-dealer trading systems . . . ," this is not quite correct, for SelectNet is on ECN and is not a broker-dealer. ³⁹ ). Nevertheless, we believe it is important to make explicit that in the following discussion of the steps that we believe need be taken to assure that ATSs are "fully integrated into the national market system," ⁴⁰ ATSs are to be understood to include both "matching," "crossing," and "single-price auction" systems ⁴¹ and automated dealer systems that allow participants to interact with a single dealer. ⁴²

In adopting Rule 17a-23, the SEC made clear that market maker firms with fully or partly automated trading systems should be included within the scope of the rule because their capacity for "potential concentration of volume outside of national market systems may have significant market effects." ⁴³ The PCX agrees with this conclusion, and it believes that it also holds so far as the identification of the trading systems that need to be linked to achieve the promise of the NMS.

The markets that should be linked -- and thus regulated as markets -- should be identified by pricing and volume importance and not by their similarity to "traditional" exchanges. In creating the BDTS category, the SEC established a presumptive identification of those trading systems that should, along with the traditional markets, be held to the minimum standards of market responsibility. In Section III of this letter we suggest benchmarks for exempting certain of these trading systems from these standards, but as a starting point, we believe it should be explicitly recognized that the trade execution centers that are the object of market regulation are both the traditional markets and all ATSs.

C. Minimum Standards of Market Responsibility

In its Release proposing the adoption of Rule 17a-23, the SEC observed:

There are many different competitors for order flow, e.g., derivative products, upstairs dealers, third market makers, and BDTSs. These should not all be regulated identically simply because they compete for market share. The level of regulation should be tailored to the functions being performed by an entity and the corollary need for regulation. The functions performed by BDTSs are most closely aligned with the functions performed by broker-dealers: consequently, broker-dealer regulation of BDTS sponsors is appropriate. ⁴⁴

The PCX shares this view, and does, indeed, believe that broker-dealer regulation of ATSs is appropriate. Nevertheless, to the extent that ATSs function as trade execution centers, that is, systems that offer participants the ability to effect securities transactions through their use of those system, either with other participants or with the system sponsors, they are functioning in a manner similar to the established markets. In such situations, as the SEC has stated, the level of the regulation of these ATSs "should be tailored to the functions being performed."

We find nothing anomalous about registering ATSs as broker-dealers and also holding them to the same minimum basic standards of market responsibility as the traditional markets. Broker-dealers now fall into different categories -- for example, specialists, market makers, block positioners, BDSTs, ECNs, and those that take custody and possession of customer securities and funds -- and, are held to different regulatory standards depending on which categories are applicable. Accordingly, we believe it is entirely appropriate for the SEC to impose market responsibility requirements on broker-dealers that are subject to reporting obligations under Rule 17a-23 as BDTS. As for the broker-dealer regulatory requirements that may be inappropriately imposed on these trading systems, ⁴⁵ we believe the SEC can easily use its exemptive authority under Section 36 or its power to classify under Section 23(a)(1) to be certain the regulatory scheme for broker-dealer ATSs is appropriate to their activities.

In the two releases proposing Rule 15c2-10, the Market 2000 report and the Concept Release the SEC has discussed various market responsibility obligations that might be imposed upon ATSs if they were to continue to be regulated as broker-dealers. In the following sections, we comment on the SEC’s various suggestions and explain our own views as to the minimum obligations to which all markets should be subject in the areas of access, transparency, fair competition, and efficiency.

1. Market Transparency

Since the Institutional Investor Study Report in 1971, the SEC has recognized the importance of creating "a strong central market system . . . in which all buying and selling interest in (securities of national importance) could participate and be represented under a competitive regime." ⁴⁶ This recognition represented a "shift in the historic position of the Commission, which over many years . . . tended to favor competing but separate markets." ⁴⁷ This shift in the SEC’s position on the appropriate relation of markets to one another resulted from technological developments that made it possible "to tie markets together . . .," ⁴⁸ through the "prompt and complete disclosure of material facts pertaining to the trading in a given security . . . ." ⁴⁹

There has been a progressive evolution in the understanding of the nature of the "material facts pertaining to the trading in a given security" that should be given "prompt and complete disclosure." Over the past 25 years the general expectation as to the appropriate degree of transparency for the equity markets has increased considerably. From the establishment of the composite tape and composite quotation systems in the early 1970’s, through the SEC’s action last year to amend Rule 11Ac1-1 ("Quote Rule") and adopt new Rule 11Ac1-4 ("Display Rule") (collectively the "Order Handling Rules), the SEC has progressively moved to create greater and greater transparency in the equity trading environment.

With the adoption of the Order Handling Rules and the industry’s move away from the one-eighth pricing system, the Division’s recommendations in the Market 2000 report for further increases in transparency have been largely realized. A market maker’s priced orders entered into an ECN now must be publicly displayed and a customer’s limit orders held by a market maker (with certain exceptions) that are priced better than the market maker’s quote or that adds to the size associated with such quote if it is equal to the national best bid or offer must also be publicly displayed ("Display Criteria").

Despite these substantial improvements in transparency, the equity markets still do not meet the Division’s ideal of a "completely transparent" market. For complete transparency to be realized, the markets would need to publicly disseminate on a real time basis for each reported security "(1) information that accurately indicates the size and price of (all) prospective trading interest(s,) such as firm quotations in representative size and resting limit orders, both at the best bid and ask quotations, and away from such quotations (so-called ‘pre-trade’ transparency); and (2) the trade price and volume of completed transactions from all markets trading that security (so-called ‘post-trade’ transparency)." ⁵⁰

The equity markets are not "completely transparent" in a variety of respects. For example, focusing only on so-called pre-trade transparency, limit orders away from the best bid or ask are not publicly displayed; limit orders that are at the best bid or ask are not displayed unless they are held by a market maker; limit orders held by a market maker are not displayed if the investor specifically requests the market maker not to display them; and, if those orders are of block size, the investor does not specifically request the market maker to display them.

Obviously, many issues would be raised by any further broad move toward more transparency. Issues of cost, liquidity, and risk must be carefully accessed and weighed against pricing efficiency and trading opportunity. As a general matter, the PCX believes that the current level of transparency is appropriate and that no major new initiative is called for at this time. There is, however, one specific, limited step toward increased transparency that the PCX believes should be taken at the earliest possible time.

At present, all limit orders held in the traditional markets -- that is, on exchanges by specialists or in the NASDAQ market by over-the-counter market makers -- must be publicly displayed if they satisfy the display criteria. Yet there is no requirement that limit orders satisfying the display criteria that are entered into an ATS directly by a non-market maker -- that is limit orders held by an ATS for an institutional investor -- must be publicly displayed. We assume that much of the rationale for the absence of such a disclosure requirement is based on the view that ATSs (other than automated dealer systems) are "brokers" and that brokers are not required to publicly display the limit orders they hold.

But viewing ATSs as traditional brokers for limit order display purposes is no longer supportable. Unlike traditional brokers, ATSs, as the SEC points out, "centralize orders and give participants control over the interaction of these orders." ⁵¹ To this extent, ATSs are "markets" and not just brokers. As such, they need to be linked with other markets if the full promise of the NMS is to be achieved.

Markets are linked through transparency and access. But if transparency among markets is not comparable, a market that permits "opaque trading . . . prevents other market centers from considering those trades in assessing the overall supply and demand for the securities. Consequently, determinations of the optimal price for the securities may be inaccurate. With (comparable) transparency, this inefficiency is eliminated, and price discovery is enhanced. Transparency, thus, has the advantage of counterbalancing the effects of market fragmentation while preserving competition among multiple markets." ⁵²

The PCX is proposing that ATSs that are not automated dealers be required to furnish to the public quotation facility, subject to the same exceptions that are in Rule 11Ac1-4(c) for customer limit orders entered by market makers ("Display Limitations"), the best priced orders entered into their systems directly by non-broker-dealers. This could be accomplished in a variety of ways and will certainly require amendments to the Display Rule, NASD rules, including Rule 4623, and the ITS Plan. But whatever technical approach is taken, the important point is to hold ATSs to the same standards of transparency as the traditional markets. This would mean that subject to the same Display Limitations the best priced orders held in every market -- whether by an exchange specialist, an upstairs market maker, or an ATS -- would be displayed in the public quotation system.

As we noted above, there are legitimate questions about how much transparency is necessary or appropriate -- that is, how broadly "material" should be defined for purposes of determining the facts about the trading of a given security that should be promptly disclosed. But there should be no question that existing standards of transparency should be uniform across all markets that need to be linked to assure the realization of the NMS. If a limit order held on the PCX must be displayed, then that same limit order held in an ATS should be similarly displayed. Without such comparability, trading on the ATSs will remain opaque with a resulting loss of market efficiency and competitive fairness.

2. Market Access

The Act directs the SEC "to assure . . . (t)he practicality of brokers executing investors’ orders in the best market . . . ." ⁵³ Broker-dealer access to all markets is a fundamental goal of the NMS, for, together with transparency, appropriate access is essential to the "linking of all markets" called for by the 1975 Amendments. Access has multiple facets: efficiency, cost, speed, neutrality, etc. We wish to focus here only on the issue of competitive fairness, that is, assuring that any broker-dealer can access trading interest in any market on a basis essentially equivalent to that of any other comparably situated broker-dealer.

A serious concern about ATSs is that they may operate as private markets, facilities where only participants know of and may interact with priced orders. Because of this concern, the Order Handling Rules prohibit a market maker from entering a priced order in an ECN that is not also reflected in the market maker’s quotation unless (1) the ECN has arranged with an exchange or the NASD for the inclusion in the public quotation system of the best priced of the market maker orders within its system, and the size associated with such orders, and (2) all broker-dealers, regardless of whether they are participants in the ECN, have access to the orders for which prices are displayed in the public quotation system on a basis "equivalent to the access that would have been available . . . if these prices had been published in the market makers’ . . . quotation." ⁵⁴ (This latter requirement will be referred to as the "Access Requirement.") The extent and form of "equivalent access" depends on "the form(s) of access available in the market to which the ECN supplies (the priced orders) for public dissemination." ⁵⁵

We recommended above that the SEC require that the best priced orders entered directly by institutional investors in an ATS be publicly displayed on the same basis as market maker orders. The necessary corollary of that recommendation is that those displayed orders be accessible to broker-dealers that are not participants in that ATS. In our view, that accessibility should be on essentially the same terms as those provided for in the Access Requirement. This would mean that all ATSs (other than automated dealer systems, which are already subject to the Order Handling Rules) would be required to arrange with an exchange or the NASD for the inclusion of their best priced buy and sell orders, and the sizes associated with them, in the public quotation system. They would also be required to provide non-subscriber broker-dealers with access to those priced orders on a basis equivalent to the access available to orders in that security that are otherwise displayed by the market with which the ATS has made such an arrangement.

We recognize that the display of and access to priced orders entered into an ATS by institutional investors may raise unique issues for the SRO to which these priced orders are submitted, and for the ITS Plan participants collectively in the case of listed securities. As the SEC has noted, however, the SRO "may establish conditions regarding display of these prices as part of (its) agreement" with the ATS. ⁵⁶ What is essential is that institutional orders entered in an ATS be publicly displayed and accessible by broker-dealers on a basis equivalent to the access such broker-dealers now have to market maker orders being displayed by ECNs.

There are three other access issues that we wish to comment on briefly. The first concerns access to Rule 19c-3 securities displayed by an ECN pursuant to the Display Rule. In the Order Handling Release, the SEC noted that if priced orders in exchange-listed stocks are submitted by an ECN to the NASD for inclusion in the public quotation system, "the orders must be as accessible to broker-dealers as the quotes published by third-market makers . . . . For non-Rule 19c-3 securities (this means telephone access to the ECN). For Rule 19c-3 securities, the ECN must also be accessible through the ITS/CAES linkage . . . ." ⁵⁷ At present, priced orders in Rule 19c-3 securities displayed by an ECN are not accessible through ITS/CAES. We recognize that such access requires an amendment to the ITS plan and that difficult issues, including trade-through protection, are raised by such an amendment. Nevertheless, we believe that these issues can be resolved through the cooperation of all ITS participants.

The second access issue concerns the differential access broker-dealers have to third-market makers maker quotations for Rule 19c-3 securities and non-Rule 19c-3 securities. As noted above, third-market quotes for Rule 19c-3 securities are accessible (or should be) through the ITS/CAES linkage, but quotations for non-Rule 19c-3 securities are not. In the past, the PCX has argued that the ITS/CAES linkage should not be extended to non-Rule 19c-3 securities until (1) the regional exchanges are permitted to trade newly listed stocks on a UTP basis at the same time third-market makers are permitted to commence their trading in those stocks; (2) appropriate "rule" filing obligations be imposed on ATSs; (3) certain exchange rule filings are allowed to become effective on filing; and (4) the NASD institute appropriate surveillance over ATSs. ⁵⁸ Apart from the UTP issue, if the PCX’s recommendations in this comment letter are adopted, these conditions will have been satisfied. We urge the Commission to act on the UTP issue and the recommendations in this letter promptly, for it is important that the ITS participants eliminate the differential in the quality of access to "types" of listed stocks at the earliest possible time.

The third issue concerns the accessibility of quotations for, and priced orders in, NASDAQ stocks. At present, exchange specialists trading NASDAQ stocks pursuant to the OTC-UTP plan ⁵⁹ have available to them neither SOES nor SelectNet. As a consequence, these market makers may not electronically access orders displayed by NASDAQ market makers or an ECN. This competitive disparity in the accessibility of NASDAQ orders is inappropriate, and PCX urges the participants in the OTC-UTP plan promptly to devise ways to eliminate it.

3. Fair Market Competition

Fair competition among markets is one of the principal goals of the NMS. Because "the ability of . . . the various exchanges and over-the-counter markets to compete with one another will be a critical element in the successful functioning of the national market system," ⁶⁰ the 1975 Amendments declare it to be in the public interest "to assure . . . (f)air competition among . . . . exchange markets and markets other than exchange markets." ⁶¹ Puzzlingly, the Concept Release focuses little direct attention on the issue of competitive fairness between the ATSs and the traditional exchanges or on how the competitive playing field between them can be made more level. In the PCX’s view, the SEC should give the highest priority to finding ways to assure fair competition within the NMS.

The PCX has argued above that ATSs should continue to be regulated as broker-dealers and that any attempt to regulate them as exchanges would be fundamentally misguided. Nevertheless, the PCX also believes that ATSs need to be subject to regulations appropriate to their circumstances. To the extent that these markets compete with and function in a manner similar to traditional exchanges, they ought to be subject to regulations that are comparable to those to which the exchanges are subject. Assuring fair and comparable regulation of both exchanges and ATSs requires attention to three areas: (1) scrutiny of new initiatives, (2) market surveillance, and (3) SEC inspection.

a. Scrutiny of New Initiatives

As we discussed above, we do not believe that the innovative potential of the ATSs should be unduly constrained. Indeed, the PCX respects the advances that these trading systems have made in market responsiveness and trading opportunities. Nevertheless, the ATSs are not subject to enough SEC scrutiny in the introduction and modification of their trading systems, and the PCX and other exchanges are subject to too much. A happy medium of regulatory and public scrutiny of new trading mechanisms must be found, and wherever that medium lies, those requirements and procedures should apply equally to the trading systems, structures and mechanisms of both exchanges and ATSs.

In Section IV, we discuss specific suggestions for the modification of the rule review process under Rule 19b-4. This process, to be quite frank, is broken, and it needs to be fixed. Focusing only on the area of changes in trading systems and processes, the markets that are subject to Rule 19b-4 are inappropriately constrained in their introduction of new services. At present, the review process is too long, too detailed, and too little standards-based. A new approach needs to be developed, one that more sensibly balances the need to foster competitive incentives with the assurance of appropriate levels of investor protection. Of course, certain new trading systems may raise sufficiently important policy issues that they should receive a thorough public vetting before they become effective. Optimark is a perfect example of such a system, and the Commission’s handling of that proposal was a model of appropriate regulatory scrutiny. But other trading system initiatives -- for example, such matters as competing specialists, hand-held terminals, and automated execution system enhancements -- ought to be allowed to proceed with little or no Commission involvement.

We urge the Commission to promptly modify the Rule 19b-4 processes in accordance with our specific suggestions in Section III. The objective in doing so should be to assure that exchanges truly do have the "ability to implement prompt, flexible, and innovative systems changes." ⁶² With such a streamlined Rule 19b-4 process in place, the ATSs should be made subject to analogous requirements, perhaps by utilizing a model similar to that in proposed Rule 15c2-10 for "plan amendments." Under such an arrangement, exchanges would still be subject to rule filing requirements in many areas in which ATSs would not, but in the area of competitive innovation, markets of all types would be subject to comparable SEC scrutiny before they were permitted to make significant changes in their trading systems and procedures. If there is a need "to ensure that the interest of investors (are) considered in (permitting a proposed systems change to be implemented), and that persons with a significant stake are provided with notice and opportunity to comment on (such a change)," ⁶³ then that need exists equally with respect to ATS system changes as it does with respect to exchange system changes.

b. Comparable Surveillance

Many ATSs are not subject to real-time surveillance for market manipulation and fraud." ⁶⁴ Therefore, in Section III, we urge that the SRO for the ATS, which we believe in all cases is the NASD, should have full access, on a real time basis, to all relevant information concerning all trading on these systems. We agree with the Commission that the NASD should then "integrate (this) additional data provided by the alternative tracking systems into (its) audit trail and real-time surveillance function . . . (and) use this data to enhance (its) ongoing, real-time surveillance of these (ATS) by developing specifically tailored surveillance and examination procedures to detect fraud and manipulation on particular systems and among systems." (CR at 41.)

We see nothing inappropriate or objectionable in subjecting the ATSs to the active and vigorous surveillance of the NASD. Of course, we recognize the potential problems of subjecting the ATSs to regulation by a "competitor." ⁶⁵ But the NASD has already taken steps to insulate its regulatory function from its market operation function, and to the extent that the ATSs request further appropriate assurances that NASDR’s regulatory decisions and informational reviews will be kept strictly separate from NASDAQ’s market operations, they are entitled to those assurances. The important point, however, is that the ATSs need to be subject to far more vigorous surveillance than they have been. In the absence of such surveillance, competition between the exchanges and the ATSs is unfair and investor protection is at risk. With NASDR’s thorough surveillance of the trading on and the trading processes of the ATSs, it is our hope that the regulation of the ATSs will become as scrupulous and effective as the regulation of the exchange markets.

We do not believe that ATSs themselves should be subject to an obligation, such as that included in proposed Rule 15c2-10, "to supervise (their) system(s) to ensure compliance by (their) participants" with the federal securities laws. That responsibility appropriately belongs to NASDR and would, in any event, be an inappropriate obligation to impose on for-profit businesses. On the other hand, we do think that each ATS should be subject to an explicit obligation, such as that also included in proposed Rule 15c2-10, "to report to the Commission (and its SRO) any information (it) receives that provides it reasonable grounds to suspect that a participant . . . may have violated the federal securities laws."

c. SEC Inspections

The operation of the SEC’s Office of Compliance, Inspection & Examinations ("OCIE") is another area in which the burdens on the exchanges are often disproportionate to the public benefits and can have the effect of the impeding fair competition between the exchanges and the ATSs. As OCIE’s processes have evolved with respect to the PCX (and we assume other exchanges), the SEC staff has asserted itself far too deeply into the detailed operations and processes of the Exchange. The PCX recognizes that the Commission is responsible for assuring "that delegated power is exercised (by the SROs) effectively to meet regulatory needs in the public interest, and . . . that delegated power is not exercised (by the SROs) in a manner inimical to the public interest or unfair to private interests." ⁶⁶ Indeed, one objective of the 1975 Amendments was to assure that "the Commission’s oversight powers are ample and its responsibility to correct self-regulatory lapses is unmistakable." ⁶⁷ Nevertheless, a balance needs to be maintained between self-regulatory autonomy and SEC oversight processes. At present, the Exchange believes careful attention needs to be given to that balance.

It is important to remember that the Commission’s powers with respect to the SROs are oversight powers: powers that are to be held in reserve and used only as needed to assure that regulatory needs are met fully and effectively. As the Special Study so accurately pointed out, "the workability of self-regulation is dependent on restraint in the Commission’s exercise of its reserve power . . . . (S)elf-regulatory agencies must enjoy such degree of autonomy as will enable them to act as responsible, dynamic partners (with the Commission) in a cooperative enterprise." ⁶⁸

Our concern with the activities of OCIE arises because there appears to be little "restraint" in its involvement in exchange operations and insufficient appreciation on its part that an exchange must have a sufficient degree of "autonomy" to function as a responsible, dynamic partner with the Commission. We recognize that OCIE has as its charge on-site inspection of the operations of the SROs. In performing this role disagreements are inevitable between OCIE and an exchange as to the manner in which various self-regulatory functions should be performed. When those disagreements arise, however, it does not mean that OCIE is necessarily right and the exchange necessarily wrong. Moreover, the appropriate resolution of those disagreements, in the absence of a clear violation of law, should be through cooperative negotiation and substantial deference on the part of OCIE to the expertise and "front-line" position of the exchange.

From time to time, an SRO may fail in the performance of its responsibilities under the Act. If and when it does, OCIE should identify the failure and recommend appropriate corrective measures to the Commission. Likewise, there are always improvements that can be made in an SRO’s surveillance and enforcement mechanisms and to the extent that OCIE has practical, constructive suggestions for improvement, it should make them and the SRO should give them all due consideration. But there is a clear line between offering suggestions for improvement and dictating operational methods and procedures, and we believe OCIE has a tendency to cross to the wrong side of that line. As a result, as OCIE is now operating with respect to the PCX, it often inhibits both innovation and competitive responsiveness without generally improving the exchange’s performance of its self-regulatory responsibilities. We urge the Commission carefully to review the role and processes of OCIE. As it conducts that review, we hope the Commission will bear in mind the wise counsel of the Special Study:

A nongovernmental agency (i.e., the exchange) having responsibility to carry out public regulatory objectives cannot be expected to exercise the full measure of responsibility if the Commission is looking over its shoulder and directing or second-guessing each individual action that it takes. Furthermore, the existence of the power of oversight, and the risk that in the exercise of that power its own standing and prestige may be tarnished by having its performance called into question, provides strong compulsion for the assumption and proper discharge of the self-regulatory function. Thus, the very nature of the self-regulatory role points, at the same time, to the need for autonomy and the sufficiency of thorough oversight and broad powers in reserve. ⁶⁹

4. Market Efficiency

In recent years, the Commission has undertaken a major initiative to assure that the SROs are doing all that they should to assure the adequacy of their systems’ capacity, security, and contingency planning. ⁷⁰ While we believe that the Commission’s automation review policy ("ARP") has inappropriately moved from encouraging SRO self-assessment on a voluntary basis to prescribing capacity levels, security procedures, and contingency protocols ⁷¹ , we share the Commission’s belief that all SROs should have "comprehensive planning and assessment programs to test systems capacity and vulnerability." ⁷²

Unfortunately, there is no ARP process for ATSs and, as the Commission notes, various "alternative trading systems may have serious capacity problems." ⁷³ All markets, whether the exchanges, NASDAQ, or ATSs, should have an ongoing commitment to maintaining sufficient system capacity, integrity and security. That commitment is essential to the maintenance not only of economically efficient markets but also markets that are fair, stable, and orderly. Accordingly, the PCX recommends that all ATSs be subject to the same ARP processes as are the exchanges. In Section IV, we seek to persuade the Commission to modify those processes to being back more of their supposedly "voluntary" character. But whatever the ARP processes, all markets should be subject to them.

III. ANSWERS TO SPECIFIC QUESTIONS

CONCERNING BROKER-DEALER REGULATION OF ATSs

In Section IVA of the Concept Release, the SEC discusses how ATSs might be more fully integrated into the NMS by means of broker-dealer regulation. It also poses 22 specific questions about the operation of such a regulatory approach. The PCX has already expressed its view that broker-dealer regulation is both appropriate and adequate to achieve the integration of ATSs into the NMS. There is no doubt, however, that many important questions are raised by such an approach. Therefore, in an effort to be as helpful to the Commission as possible, the PCX has attempted to provide its views on the specific questions posed in this section of the Concept Release.

A. Question 10

As the Exchange stated in Section II.B of this letter, all ATSs should be regulated as broker-dealers and subject to the minimum standards of market responsibility we discuss in Section II.C. A question might arise as to whether certain ATSs should be exempt from some of these standards, e.g., transparency and access, because of their low trading volume. For example, upstairs market makers are not required to publish quotations in an exchange-traded security (or a NASDAQ security under the amendment to the Quote Rule proposed in Release No. 34-37620) unless the market maker accounts for more than one percent of the aggregate trading volume for that security. ⁷⁴ Thus it might be argued that ATSs should be treated similarly to market makers and exempted from any quotation requirements unless they accounted for a specified volume amount.

Nevertheless, all market makers, even those that are not required to publish their own quotations, are required to publicly display all limit orders they hold that satisfy the Display Criteria and are not covered by the Display Limitations. In our view, all ATSs should be held to the same requirements, that is, ATSs should be required to display all priced orders (subject to both the Display Criteria and Display Limitations) in all cases. There are two fundamental reasons underlying this position.

First, the markets with which the ATSs compete -- the exchanges and traditional upstairs market makers -- must display the customer limit orders they hold regardless of their trading volume in the relevant security. We can see no justification for permitting an ATS not to display a priced order it is holding if an exchange specialist or upstairs market maker would be required display that order if it held it.

Second, the Display Rule "was designed to facilitate greater transparency of customer trading interest, with the expectation that orders would have an increased opportunity for best execution without the interaction of a dealer . . . . (T)hese objectives are more difficult to achieve if customer trading interest is not routinely represented in publicly displayed quotes." ⁷⁵ We agree with the Commission on this point and believe that a regulatory scheme that permitted ATSs to withhold priced customer trading interest from the public quotation system would work directly against the clear objectives of an NMS.

B. Questions 11-13

The Exchange believes it may be misleading for the Commission to ask whether ATSs should be required to submit "all orders" to the public quotation system. Neither specialists nor market makers now do this, and, indeed, the Display Rule only requires these dealers to display limit orders they hold that meet the Display Criteria. The current system is based on established standards of transparency, and the PCX sees no need to fundamentally change those standards because of the ATSs. All that needs to be done to integrate the ATSs into the NMS is for the current scheme to be expanded to require that customer orders affecting the best bid or offer held in ATSs be displayed in the public quotation system. If the current order display scheme were expanded in this way, existing mechanisms would deal with the potential for duplicate prints.

There are, of course, numerous other methods available for integrating non-broker dealer orders submitted to ATSs into the public quotation system. These methods range from prohibiting an ATS from having non-broker-dealer participants, to allowing ATSs to become direct participants in the CQS Plan, to mandating a composite limit order book. The PCX does not, however, support any of these other methods, for they are all likely to be extremely disruptive and their consequences are far too uncertain. The proposal we have advanced is incremental, evolutionary, and appropriately limited. We would oppose any more radical approach.

C. Questions 14 through 17

We proposed in Section II.C.2 above, that non-participant broker-dealers should have access to institutional orders displayed by an ATS on the same basis that non-participant broker-dealers now have access to market makers’ orders displayed by an ECN. We recognize that even if this proposal is implemented, a non-participant in an ATS may still not be able to access orders that that system is publicly displaying in as faster or convenient a manner as a direct participant in that system. In our view, however, this should not now be the focus of attention. Indeed, this situation is analogous to the possibly more advantageous access to an exchange that a member has compared to a non-member. What is important, we believe, is that institutional orders held by all ATSs are, in fact, integrated through public display into the NMS and that all broker-dealers have reasonable access to those displayed orders. The PCX is convinced that its proposal will accomplish these objectives.

With respect to assuring the reasonableness of the fees that an ATS charges non-participants for executing against orders of system participants, the situation is slightly more complex than that involved in assuring reasonably priced access by non-participants to orders displayed by an ECN under the Order Display Rules. In the latter situation, the SEC stated that an "ECN . . . may impose charges for access to its systems, similar to the communications and system charges imposed by various markets, if not structured to discourage access by non-subscriber broker-dealers." ⁷⁶ To monitor compliance with this requirement, the SEC has used the no-action process it established to identify the ECNs that are in compliance with the ECN display alternative. ⁷⁷ In the case of ATSs, however, there is no comparable no-action process.

PCX does not believe that the SEC should be in the fee regulation business. Nevertheless, just as exchange fees generally must be "reasonable," the PCX believes that ATS fees, at least those it charges non-participants to execute against orders of system participants, should be reasonable, that is "not structured to discourage access." It appears to us that the most direct and least intrusive method of assuring that such fees are reasonable, would be for the Commission to require all ATSs periodically to file with it their non-participant fees together with an explanation of the bases for such fees and why they are reasonable. Those filings should be made publicly available and subject to comment for an appropriate period, say 30 days. In the event there are objections to these fees, the SEC should be able to institute a public proceeding to determine the reasonableness of the fees.

D. Questions 18 through 20

The Exchange believes that ATSs should be required to provide their SRO with all relevant information on trades, counterparties, and orders within their systems on an automated basis. In addition, we believe that the NASDR should review its recently proposed Order Audit Trail System ("OATS") program (File No. SR-NASD-97-56) to be certain that under that program it will be receiving from those of its members that are ATSs all of the trade and market information it will require to carry out the enhanced surveillance the Commission is proposing. Such information gathering, in our view, is imperative to insuring the fairness and proper functioning of NASDR’s audit trail and surveillance responsibilities.

With respect to the question of whether an SRO should be required to surveil trading by its members in securities that are not quoted in the market operated by that SRO, we believe the answer turns on what the Commission means by "surveil." If the SEC is asking whether an SRO with designated examining authority should inspect its members for possible securities law violations in connection with the trading of securities not quoted in that SRO’s market, the answer is "yes." If, however, the SEC is asking whether an SRO should be required to surveil on a continuous or other basis the ongoing trading activity in securities not quoted in that SRO’s market, our answer is "no" unless the SEC provides the SRO with specific directions, parameters and guidelines as to the types of securities to be surveilled, the nature of the surveillance to be undertaken, and a mechanism to obtain compensation for undertaking this additional market surveillance function.

E. Questions 21 through 23

Our response to these questions are contained in our response to question 94, in Section IV below.

F. Questions 24 through 26

With respect to access to ATSs, we believe it is important to distinguish between (1) access to orders in an ATS that are displayed as part of the public quotation system, and (2) access to the ATS itself, that is, the ability to become a participant in or subscriber to that ATS. With respect to the first situation, we have already expressed our view that broker-dealers should have access to displayed ATS orders on essentially the same basis that broker-dealers now have access to market maker orders displayed by ECNs. With respect to the second situation, the PCX does not believe sufficient information is available to reach a definite conclusion as to whether ATSs should be subject to a fair access requirement.

Under Rule 17a-23, all BDTSs are required to file with the Commission their criteria for granting access to their systems. In adopting this rule, however, the SEC chose to delete a provision in the rule as originally proposed that would have required BDTSs to retain information regarding all applicants denied participation in their systems. In light of the legitimate concern that ATSs may deny participation to applicants in an arbitrary or discriminatory manner, we recommend that the SEC amend Rule 17a-23 to require all ATSs to report quarterly any denial of access to their systems and the basis for such denial and to include with such report a written statement of any applicant that has been denied participation if such applicant wishes to make such a statement. With that reporting mechanism established, we believe that the Commission and the industry will be in a better position to assess the true need for imposing a fair access requirement on ATSs.

We note in this regard that proposed Rule 15c2-10 would have established a procedure for Commission review of an ATS’s denial of participation. As we have indicated, we do not believe that a sufficient showing has been made to justify adopting such a procedure at this time, but if the SEC receives information through the enhanced Rule 17a-23 reporting process we are recommending, which indicates a serious need for such a procedure, we believe proposed Rule 15c2-10 would provide an appropriate model.

G. Questions 27 through 30

The Exchange believes that enhanced surveillance of ATSs by SROs does, indeed, raise legitimate competitive concerns. We also believe that an SRO’s separation of its market operations from its regulatory operations should adequately address those concerns. Thus, the NASD’s separation of NASDR from NASDAQ should eliminate such concerns on the part of the ATSs that the NASD regulates. Nevertheless, if those ATSs request further assurances from the NASD that NASDR’s regulatory functions will be administered in a fair, impartial and balanced fashion, and that any information NASDR gains during its investigations and oversight will not be provided to the business or marketing arm of NASDAQ, we believe that the NASD should provide those assurances in an appropriately detailed and specific manner.

In the Exchange’s view, vigorous regulation of the ATSs by NASDR is the most effective and efficient way to assure that ATSs are subject to appropriate surveillance. While an association of ATSs, just as any "association of brokers and dealers," would be free to establish another national securities association under Section 15A of the Act, such a step appears to us to be both unnecessary and unwise. Such a new SRO would be expensive, duplicative and run the risk of becoming "captive" to one particular type of broker-dealer. We would be very concerned that such an SRO, with such a limited and highly specialized membership, would not be capable of providing the degree of surveillance that ATSs require. Furthermore, the introduction of a new SRO into the NMS would raise numerous divisive and unnecessary issues under the NMS plans and regulatory allocation agreements now in place. Therefore, the PCX would not support the establishment of a new SRO for ATSs. We believe the far better course is to make certain that ATSs are providing NASDR with all appropriate information and that NASDR is fulfilling its mandated market surveillance responsibilities with respect to ATSs.

IV. REDUCED REGULATION FOR TRADITIONAL EXCHANGES

As we have argued, the PCX believes that ATSs can be fully integrated into the NMS through a process of increased, specifically focused broker-dealer regulation. In the preceding sections, we have attempted to spell out the nature and content of such regulation and to indicate why such regulation is appropriate in light of the market functions of these alternative trading systems. Yet increased regulation of ATSs is only part of what needs to be done at this time to enhance the operation of the NMS. Hand-in-hand with the increased regulation of ATSs must come the decreased regulation of the traditional exchanges. There is no question in our mind that the traditional exchanges are subject to substantial "unnecessary regulatory requirements that make it difficult for these (exchanges) to remain competitive in changing business environments." ⁷⁸ Accordingly, in this section of our response to the Concept Release, we address certain of these unnecessary regulatory requirements and suggest ways in which these requirements can be reduced or eliminated so that the exchanges can operate their markets, consistent with the objectives of the NMS, in a more flexible, responsive and innovative manner.

A. Questions 90 through 92

SRO rule filings are processed by the Commission pursuant to Section 19(b) of the Exchange Act. Under Section 19(b)(1), "regular way" rule filings involve notice and comment; under Section 19(b)(2), accelerated review of rule filings occur when the SEC finds "good cause" for such treatment; and under Section 19(b)(3)(A), expedited rule filings are available for specific types of rule changes and are effective on filing, subject to a 60 day abrogation period.

In recent years, the Commission has required more and more matters of exchange operation and administration to be submitted as "regular way" rule filings. This has meant that matters that would not have previously involved a rule filing at all are now expected to be the subject of such a filing and the notice and comment procedure. Whether this shift is due to a deliberate change in Commission policy, an unintended expansion of bureaucratic process, or the evolution of industry circumstances is unclear. Whatever the cause, however, the increased involvement by the Commission in the day-to-day activities of the exchanges has imposed a very significant regulatory, and resulting competitive, burden on them. Furthermore, this process builds on itself. As the number and scope of filings increases, the expectation increases that more and more matters of exchange policy and administration will be subject to "regular way" filings.

The Section 19(b) process as currently administered by the Commission is often inflexible, overly technical, and unnecessarily inhibitory to innovation and competitive responsiveness. Moreover, the problems with filing process are exacerbated by frequent changes in the staff reviewing proposed rule changes. While staff changes are a normal part of any organization’s operations, staff changes in conjunction with the excessively detailed nature of the rule review process and, the lead time required to bring new staff members up to speed with respect to the characteristics and activities of a particular exchange, serves to further delay and confuse the entire procedure.

Because of the serious difficulties with the Section 19(b) process, the PCX urges the Commission to give serious consideration to the following six recommendations for improving this process. In making these recommendation, we fully recognize the Commission’s responsibility to assure that all exchange rule changes are "consistent with the registration requirements for the (exchange) and the purposes of the Exchange Act." ⁷⁹ Our recommendations, however, are designed to permit the Commission to fulfill that clear statutory responsibility without "looking over (the exchange’s) shoulder and directing or second-guessing each individual action that it takes." ⁸⁰

First, in the Concept Release the Commission asks whether a "standard-oriented approach" would be appropriate for the regulation of markets. ⁸¹ In our view, the answer is "yes," at least, in a broad range of self-regulatory functions subject to Section 19(b) review. Many of these functions -- governance, fair access, due disciplinary process, market surveillance procedures, etc. -- are ideal candidates for standard-oriented regulation. Unquestionably, the specification of such standards will require a substantial amount of effort on the part of the SROs and the Commission. But once the standards have been developed, we believe the Commission staff could and should devote far less time to the detailed review of standard-based filings by the SROs. Indeed, we believe such standard-based rule filings should be added to the list of changes in Rule 19b-4(e), that may take effect upon filing.

Second, formally at the present time, if one SRO receives approval for a rule change in a particular area, for example, competing specialists, and a second SRO then files a rule change in the same area that takes a different regulatory or systems approach, the Commission staff will more likely than not attempt to force the second SRO to drop its different approach and conform its rule change to that of the first SRO. Such a process of forced conformity is contrary to the clear goals of the NMS. There are real public benefits to be gained from material diversity in the processes, procedure, and systems of the SROs. This is so not just because the SROs and their markets are different and should be treated as such, but also because real competition depends on competitors being able to differentiate among themselves based on approach, service, and products. In this regard, we commend to the Commission Commissioner’s Wallman’s recent comment, "Individual markets should be permitted to create rules that regulate their own members behavior on that market. Market centers can then compete with different rules and different structures." ⁸² Accordingly, we recommend that the Commission issue a formal policy statement acknowledging the importance of diversity among the markets and providing appropriate assurances that different regulatory approaches to the same end will all be dealt with on their own merits.

Third, the Commission chides the SROs for not taking "better advantage of the expedited (rule approval) process available under Section 19(b)(3)(A)." ⁸³ We do not believe this is a fair criticism. The PCX, at least, does not generally use this expedited process because of the staff’s resistance to such filings, and its tendency to force most filings into the "regular way" process of Section 19(b)(1).

We agree with the Commission that far more use can and should to be made of the Section 19(b)(3)(A) process, but for this to happen two things must occur. (1) The Commission must provide more explicit guidance as to the scope of permissible expedited rule filings. This would mean establishing concrete, useful parameters for interpreting the general phrases in Rule 19b-4 such as "significantly affect," "significant burdens," and "limiting access." (2) The staff must be prepared to accept at face value an SRO’s designation of a given rule filing as within Section 19(b)(3)(A). In other words, if the Commission truly wants to make the Section 19(b)(3)(A) procedure a meaningful and useful procedure, it must counsel its staff to be receptive to the SROs’ designation of rule filings as appropriate for expedited treatment. Of course, if it were to be found that a particular SRO were not making such designations in good faith, the Commission could revoke or limit that SRO’s ability to use the expedited process in the future.

Fourth, a new procedure for dealing with "pilot programs" involving trading systems should be established. In the Concept Release, the Commission appears to be both intrigued by the possibility of permitting pilot programs with little or no prior review and concerned that, unless carefully limited, pilot programs could adversely affect investors. ⁸⁴ While we understand the Commission’s concerns, we believe that in the area of systems innovation it is neither wise nor required by the standards or goals of the Act to strive for zero risk.

Heretofore, the ATSs have been generally free to introduce certain new trading systems and mechanisms without the constraints of the Section 19(b) rule review requirements. While we believe that this should change and that ATSs should become subject to review requirements comparable to those applicable to exchanges, ⁸⁵ we do not think that the new systems implemented by the ATSs have adversely affected investors. Quite to the contrary, they have spurred healthy competition in systems innovation throughout the industry. Therefore, as the Commission considers the establishment of procedures for pilot programs, we recommend that it use the ATS experience as a guide, not its own past practice in administering Section 19(b).

Specifically, we believe pilot programs should be permitted for trading systems and mechanisms regardless of whether they affect the market’s main trading system or are otherwise linked to a market’s primary operations. Furthermore, we believe that the standards for determining whether a particular proposal qualifies as a pilot program should be defined broadly so that excessive time is not spent negotiating with the staff over whether a particular systems change is in or out of the process. In addition, pilot programs should be largely market driven. That is, a market should be given considerable flexibility in determining whether a system change will or will not be treated as a pilot. If the market chooses to proceed with the system change as a pilot, it should be required to submit a standards-based filing, responding to the general criteria established by the Commission, including capacity implications and investor impact. The market should then be allowed to proceed with the pilot after, say, a 15-day non-extendible review period, unless the Commission during that period finds the proposal to be in violation of the established criteria. In this process, there should be minimal staff review, but by the same token there should be no antitrust or other protections attached to the pilots themselves. Finally, the defining characteristic of a pilot program should be its limited duration. After some relatively short period, say, one year, the pilot status of the program should end, and the system change either be eliminated or subjected to the normal review and approval process.

Fifth, the Commission should adopt generic criteria for the listing of options on broad-based indexes (similar to the procedure for narrow-based indexes referred to in footnote 199 of the Concept Release). The adoption of such criteria should substantially shorten the time between filing and trading of such indexes.

Sixth, the Act specifies that the Commission is to approve a proposed rule change or institute proceedings to disapprove it within 35 days of publication. In fact, of course, very few rule changes are acted on within this specified period. In the recent years the Commission has taken steps to reduce the time taken for processing review rule filings. The Exchange urges the Commission to continue this trend by streamlining the rule review process and making the other changes we have suggested above. But beyond that, we believe a greater effort should be made to adhere to the statutory obligation to approve rule filings as submitted within a specified time period unless they are in conflict with specific provisions of the Act.

C. Question 94

We believe the SEC should carefully review the administration of its Automated Review Policy ("ARP") program, for as it currently operates, it imposes significant and unnecessary burdens on markets such as PCX. As originally conceived, the ARP program was "designed to encourage SROs to "establish comprehensive planning and assessment programs to test systems capacity and vulnerability." ⁸⁶ The objective of this planning and assessment was to ensure that the SRO’s "automated systems have the capacity to accommodate current and reasonably anticipated future trading volume levels adequately and to respond to localized emergency conditions." ⁸⁷ The PCX strongly supports this objective.

As the ARP program has evolved, however, there have been two unfortunate developments. First, the direct involvement of SEC staff in the Exchange’s systems planning and assessment process has grown to the point of wasteful inefficiency. Second, the Commission’s objective appears to have shifted from ensuring that an exchange’s automated systems can accommodate "reasonably anticipated" volume and "localized emergencies" to ensuring "that all trade execution centers will remain operational during periods of market stress." ⁸⁸ The PCX believes this new objective is unrealistic and inappropriate.

During the approximately six years that the ARP program has been in effect, the PCX has taken all necessary and appropriate steps to maintain and increase the capacity and security of its automated systems. By and large, PCX has taken these steps as a matter of self-interest to protect itself against the loss of order flow that would result from the failure of its systems to provide adequate and reliable services. The very burdensome requirements for ARP annual reports and periodic inspection reviews adds little of value to this process but diverts substantial and valuable resources away from the PCX Technology Services, Trading Operations, and Internal Audit areas. Further, rather than being asked simply to maintain capacity to protect against its own normal market volatility, it appears the Commission is now asking exchanges to expend their resources to provide capacity to accommodate the additional volume that would result from orders being diverted to them from other markets that might discontinue trading.

In our view, each market should provide the Commission with appropriate periodic assurances that it can reliably handle its own actual and anticipated daily trading volume, but the PCX and markets like it should not be required to add capacity to absorb order flow diverted to them from other market centers or to ensure that they will "remain operational" during all periods of "market stress." The market's assurances could be accompanied by capacity/stress tests, system availability reports, and "major" outage reports. By using the "assurances" process, it should be possible to reduce or eliminate the annual reports and periodic inspection reviews that are currently in place. Furthermore, the ARP requirements for security, computer operations, telecommunications, systems development methodology, and disaster planning could be discontinued entirely because all markets have sufficient incentives to provide these on their own.

We hope the Commission will seriously consider our recommendations for a reduction in the level of direct ARP involvement in the PCX and similar markets. Nevertheless, whatever the ARP program that is applicable to PCX, the same program should be applicable to ATSs. Indeed, all ATSs should promptly submit an initial annual report and be inspected for capacity, protocols and methodologies. Once the Commission has been assured that the ATSs can appropriately fulfill these market obligations in the NMS, ATSs should be put on the same plateau of ARP requirements as markets such as PCX.

V. REGULATION OF FOREIGN MARKET ACTIVITIES IN THE U.S.

A. The Need for a Clear Regulatory Structure to

Address U.S. Investors’ Electronic Cross-Border Trading.

Again, the Commission provides a thoughtful starting point for "initiat(ing) a dialogue" ⁸⁹ regarding the activities of foreign markets in the U.S. The Exchange agrees that investors, foreign markets and other intermediaries will benefit from clarification of the regulatory scheme governing direct access to foreign markets.

The Exchange also agrees that any action in this area should be shaped by the Commission’s fundamental purpose of "ensur(ing) that investors () receive sufficient information to make informed decisions," and that this purpose "should not impose unnecessary obligations on foreign markets that could effectively preclude U.S. investors from taking advantage of an otherwise efficient, cost-effective investment alternative." ⁹⁰ Accordingly, the Commission should balance the protection of investors, the investors right, and choice, to invest outside the United States, and the autonomy of foreign markets.

The need to balance competing interests lead to three themes in this section of the response. First, a distinction should be made between sophisticated and other investors. ⁹¹ Certainly, sophisticated investors have access to information necessary to recognize and evaluate competing regulatory and enforcement schemes. Second, a distinction should also be made between the various foreign markets available to the U.S. investor. Some markets may have a commitment to disclosure, recordkeeping and enforcement as strong as the U.S. Third, some of the Commission’s concerns regarding enforcement and regulation may be addressed by agreements with the foreign markets. Already, the Commission and several U.S. exchanges have entered into memoranda of understanding with foreign markets regarding surveillance and enforcement.

In addition to these reoccurring themes, the Exchange believes that all parties should recognize at the outset that investors necessarily relinquish at least some of the protection they have in U.S. markets when they chose to invest in foreign markets and foreign securities, beyond the jurisdiction of U.S. securities laws.

The Exchange believes that at times these issues will lead to a diminished Commission concern in further regulating investor activity beyond the boundaries of U.S. securities laws.

B. Regulating Foreign Market Activities in the United States

1. Sole Reliance on Foreign Markets’ Home Country Regulation

Question 106

The tone of this section of the Concept Release suggests that the Commission has already concluded that sole reliance on regulation by the foreign market’s home country inadequately safeguards the interests of U.S. investors. The Commission characterizes this approach as "extreme" ⁹² and lists several investor protection and enforcement concerns not addressed by this approach.

Three observations suggest that this alternative should be dismissed prematurely. First, contrary to the Commission’s assertion, we believe it unlikely that investors who are members of foreign exchanges, or who otherwise enjoy direct links with foreign markets (the subjects of this Concept Release), "expect" that their activities on the foreign exchange are "subject to the same protection provided by U.S. securities laws," even if technology makes trading on foreign markets "indistinguishable" from trading on the U.S. market. ⁹³ We do not believe that sophisticated investors are unaware of the special protections provided under the U.S. securities laws. Even if true, this concern can be addressed by requiring access providers to make an appropriate disclosure. Consequently, this concern should have a minimal impact, if any, in the Commission’s analysis.

Second, some of the "essential protections ⁹⁴ cited by the Commission as "expected" ⁹⁵ by investors may not be applicable to certain foreign markets. For example, the U.S. securities laws requirements that market makers and specialists have firm quotes, display certain limit orders, and report trades within 90 seconds, may not be applicable in foreign markets operated as call markets. ⁹⁶

Third, as noted above, some of the Commission’s concerns regarding investor protection and enforcement may alternatively be addressed through agreements with the foreign market. Indeed, the Commission, and certain of the U.S. exchanges, have memoranda of understanding with foreign exchanges that provide for cooperation in surveillance, regulation and enforcement. ⁹⁷ At a minimum, such agreements may address the Commission’s concerns about disclosure of trading processes, enforcement of rules among members, market manipulation, recordkeeping, and distribution and/or disclosure of financial and material information. ⁹⁸

Reliance on home market regulation, will be supplemented by disclosure requirements and MOUs, could make the dismissal of home market regulation premature. At a minimum, these observations should influence the Commission’s selection of particular regulation for access providers and the registration of foreign securities.

2. Requiring Foreign Markets to Register

as National Securities Exchanges

Question 107

We believe that this requirement is not feasible and would result in foreign markets’ denial of access to U.S. investors. As an initial matter, the Commission states its concern that "because trading on a foreign market may be indistinguishable from trading on a domestic market, investors may be lead to expect that such trading would be subject to the same protections provided by the U.S. securities laws" ⁹⁹ . However, the Commission offers no evidence to support this concern, or why this concern would not adequately be addressed by requiring disclosure to U.S. investors of the risks involved in trading in foreign markets. The Exchange believes that the sophistication of the investors currently enjoying links to foreign markets are being underestimated.

The Commission’s also states that a benefit of this approach would be to provide U.S. investors in foreign markets the same protections as provided under registered or exempted exchanges. ¹⁰⁰ As discussed above, some of the "essential" protections identified by the Commission may not be applicable to the particular foreign market. Other concerns may be addressed by intermarket cooperation agreements.

The Exchange believes that foreign markets would find the costs of registration under section 5 of the Exchange Act prohibitive and in any event, for the reasons just stated, not supported by the Commission’s claimed purposes. As the Commission itself acknowledges, this approach would (i) increase the likelihood of conflict with the foreign markets’ home country regulations, ¹⁰¹ (ii) raise jurisdictional and comity concerns, ¹⁰² and (iii) subject the foreign markets to a regulatory scheme not commensurate with the market’s limited activity in the U.S. ¹⁰³ resulting in "unnecessarily duplicative and expensive" costs. ¹⁰⁴

As importantly, this approach would considerably exceed the Commission’s essential purpose, namely, "to ensure that investors will receive sufficient information to make informed decisions," ¹⁰⁵ while leading to the result the Commission expressly seeks to avoid, "impos(ing) unnecessary obligations on foreign markets that could effectively preclude U.S. investors from taking advantage of an otherwise efficient, cost-effective investment alternative. ¹⁰⁶

For these reasons, the Commission should not require foreign market registration under section 5 of the Exchange Act.

3. Regulating Access Products to U.S. Members of Foreign Markets

Question 108

Notwithstanding our comments above regarding the propriety of relying on the regulation of the home market, ¹⁰⁷ we believe that the Commission’s suggestions for imposing reasonable recordkeeping, disclosure and enforcement requirements on access providers is an important investor safeguard, within the appropriate province of the Commission.

First, regarding the appropriateness of Commission regulation of access providers, even if investors knowingly relinquish some U.S. securities law protection by choosing to trade in foreign markets, those investors, individually, may be unable to require their access providers assure basic protections in the form of recordkeeping, disclosure and enforcement. For this reason, the Exchange believes that the Commission should adopt fair and non-prohibitive rules regarding recordkeeping, disclosure and enforcement. This approach is consistent with U.S. securities law and practice and will not impose an overly difficult burden on access providers.

Second, the Commission’s jurisdictional concerns may be alleviated when a foreign market itself provides direct access to a U.S. investor. Unlike foreign broker-dealers exempted under Rule 15a-6, the foreign market access provider is facilitating the U.S. investors’ trading on the foreign market. The Exchange believes such conduct should result in reasonable Commission oversight.

a. Access Providers to U.S. Members of Foreign Markets

Question 109

Entities that provide U.S.-based members of foreign markets direct access to those foreign markets should be required to register as non-exclusive securities information providers ("SIPs"), provided that the recordkeeping and disclosure requirements imposed on such entities are reasonable.

The activities of foreign markets that provide direct access to their U.S.-based members provide the least compelling case for Commission oversight. It is our understanding that foreign markets impose certain membership requirements (e.g., capital) that should have the effect of restricting access to these foreign markets to sophisticated investors. ¹⁰⁸ As noted above, sophisticated investors do not implicate many of the concerns raised by the Commission. Also, other concerns may be addressed under an agreement between the investor, the Commission, or a U.S. exchange in which the investor maintains membership.

Nevertheless, the Exchange believes that the SIP approach put forth by the Commission is a sound one. Importantly, the recordkeeping and disclosure requirements suggested by the Commission do not appear unreasonable or prohibitive. Arguably, foreign markets desiring access to U.S. investors must expect some level of registration and recordkeeping. Also, as importantly, investors are provided a level of protection they may not receive, or seek, individually. Finally, the Commission is able to maintain basic information that will be essential for its own investigation in the event of a dispute between the member and the SIP, a violation of U.S. security law or policy, or a violation of a foreign security law or policy. ¹⁰⁹

Question 110

All entities that provide the electronic facilities or means through which a U.S. member of a foreign market could directly transmit orders to that market should be required to register with the Commission. In order to avoid capturing general providers of electronic access (e.g., telephone companies, internet service providers), the Commission must clearly define the targeted service. For example, the Commission could state that such registration is limited to those entities who actually control the access point to the foreign markets.

Question 111

Because the proposed recordkeeping and disclosure requirements proposed in the Concept Release do not appear unreasonable or unwieldy, the Exchange believes that all entities providing the contemplated links should be required to register as SIPs, regardless of any duplication of links between the entities. Again, the Exchange believes that the required recordkeeping would provide the Commission important information in the event of any future dispute or breach of the national and foreign securities laws.

Question 112

The Commission should provide a "safe harbor" from registration as national securities exchanges to foreign markets that restrict access by U.S. members to links through a registered SIP. For the reasons discussed above, ¹¹⁰ requiring foreign markets to register as national securities exchanges would be self-defeating. Providing a safe harbor from exchange registration would support SIP registration by encouraging foreign markets to control and monitor intermediary access to their markets. ¹¹¹ Foreign markets will know that they are exempt from registration as an exchange so long as the access providers to their markets are registered as SIPs.

Question 113

SIPs should be limited to providing links and market information to the U.S. member of the foreign market. SIPs should be able to advertise their services and such advertising should be subject to the regulation of the Commission. SIPs should be restricted from giving advice about individual securities or markets and providing any other traditional broker-dealer function.

b. Broker-Dealer Access Providers

Questions 114 through 15

For the same reasons for requiring SIP registration, ¹¹² the Exchange believes that broker-dealers providing access to foreign markets should be subject to the same recordkeeping and disclosure requirements contemplated for SIPs.

The Exchange agrees that broker-dealers are already subject to many of the recordkeeping, reporting and antifraud requirements proposed by the Commission in section VII.B.3c(iii) of the concept Release, and that the principal additional requirement for broker-dealers would be the disclosure of any risks in trading on foreign markets. ¹¹³ If this, indeed. is the only difference in the requirements imposed on broker-dealers acting as access providers and those providing traditional brokerage services, including cross-border services, the Exchange suggests that all broker-dealers provide such disclosure to their customers who place orders (whether directly or indirectly) on foreign markets. This approach would answer the Commission’s concern that all investors need to be aware of the risks involved in trading on foreign markets while eliminating the creation of a special category of broker-dealer.

Question 116

The Exchange believes that foreign broker-dealers who provide U.S. investors with direct links to foreign markets should not have to register as U.S. broker-dealers, provided that the foreign broker-dealers limit their U.S. activities to those permitted by Rule 15a-6. Such broker-dealers should, however, be required to register as SIPs.

c. Requirements Applicable to Access Providers

i. Conditions Relating to the Type of Foreign Market

Questions 118 through 120

The definition of bona fide foreign markets should include those markets that (i) are organized under established securities laws of a foreign nation, (ii) have their principal place of business outside the U.S., and (iii) are regulated by a foreign governmental agency comparable (in role) to the Commission. Given this definition a bona fide foreign market and the applicability of these proposed rules to direct links to foreign markets, no limitations on the location of the foreign market’s members or exchange terminals are necessary. The Commission should reserve for future discussion the regulation of a market located outside the U.S. that is controlled by U.S. persons.

Questions 122 through 123

The Commission should designate as bona fide foreign markets only those markets that provide meaningful assistance to the Commission in connection with investigations of possible violations of U.S securities laws. The Commission should also permit access providers to enter into agreements with foreign markets to provide appropriate information and assistance, or to rely on similar agreements between a U.S. exchange and such foreign market. Such information and assistance should include the sharing of disclosed and/or material company information, rules relating to membership, trading, and the enforcement thereof, and assistance in investigating claims of fraud or manipulation involving U.S. investors. The Commission should prohibit direct links with foreign markets that do not meet these conditions.

(ii) Conditions Relating to the Type of Securities and Persons.

Questions 124 through 125

Qualified investors should be permitted direct access to foreign markets through either a registered SIP or broker-dealer access provider. For example, in our view "qualified institutional buyers," for purpose of Rule 144A under the Securities Act of 1933, should be permitted direct access to a foreign market through any such facility.

Additionally, other qualified investors, such as "accredited investors" under Rule 501(a) should also be permitted access if certain requirements are met. For example, such investors might be required (i) first to have received from the access provider a disclosure document, similar to that for trading options under Rule 9b-1(d), setting for the risks of trading in foreign markets,(ii) to complete an application acknowledging such risks and the receipt of the disclosure document, and (iii) be approved by the access provider as a suitable participant in the foreign market.

The Exchange believes that the additional disclosure, recordkeeping and enforcement requirements proposed by the Commission should offer adequate protection to these classes of investor.

(iii) Conditions Relating to Recordkeeping, etc.

Question 129

Access providers should be required to retain (i) customer records, including application and correspondence, (ii) time-stamped records of transactions, (iii) daily summaries of trading, (iv) information disseminated to investors, and (v) copies of membership standards, trading policies and the regulations and rules of the foreign market.

Question 130

Access providers should be required to periodically file (i) a list of the categories of securities traded through the provider, (ii) the number and type of customers, (iii) a list of the foreign markets secured, and (iv) certain transaction information, including total number, volume and value, for each foreign market to which orders are transmitted.

Question 131

Access providers should be required to keep records of denials of access to their services but should not have to notify the Commission of such denials. This would impose an unnecessary burden on access providers. In the event of a complaint because of a denial, the Commission may at that time request the related records.

Question 132

Access providers should provide their customers (i) all material information known by the provider about a foreign market or that is required by the Commission; and (ii) the listing and membership requirements of the foreign market.

Additionally, access providers should state that (i) direct investment in foreign markets carry certain risks and may not be suitable to everyone; (ii) foreign securities laws and rules regarding recordkeeping, disclosure of company material information and trading policies, fraudulent and manipulative practices, and membership in the foreign market, and the enforcement of such laws, may differ substantially from the laws and practices of the U.S.; (iii) investors are encouraged to review the laws and practice of a markets prior to investing; and (iv) investors may have limited recourse to American courts or the Commission in the event of a fraud, manipulation or any other dispute regarding a transaction in the foreign market.

Question 133

Access providers should be required to provide the disclosure described above to all customers.

Questions 135 through 137; 139 through 140

The Commission should continue the exemption for foreign issuers provided under Rule 12g3-2(b). The same jurisdictional and comity concerns underlying the current exemption ¹¹⁴ still exist when direct access is provided to U.S. investors. We agree that a foreign issuer has not "affirmatively taken steps to enter (U.S.) markets, regardless of the level of interest by U.S. investors in the company’s securities". ¹¹⁵ Requiring registration of foreign securities directly traded in foreign markets would have the effect of preventing the direct access to these foreign markets contemplated by the Concept Release. The costs to foreign companies of complying with U.S. accounting standards are prohibitive. As a result, U.S. investors would be denied access to an important alternative investment.

Registration is unnecessary given the availability of reasonable alternatives and the sophistication of certain investors. Although not rising to the level of the protection provided the investor under the Act, the agreements between access providers, U.S. exchanges or the Commission and the foreign markets mentioned above ¹¹⁶ would provide a minimum level of disclosure, access and regulation. Regulation of access providers will provide further investor protection.

The Exchange recognizes that the Commission must strike a balance between the investor’s choice to access international markets with the Commission’s mandate to protect the investor from fraud and manipulation. However, the Exchange believes that a registration requirement swings too far in the direction of investor protection and too far away from choice, access and opportunity.

Question 138

The issue of whether a foreign security having a significant portion of its float traded in the United States should be required to register under the Exchange Act is a complex one. While the Commission clearly has a heightened concern, investor protection, the issues of jurisdiction, comity and the activity of the issuer discussed above are still present.

The Exchange believes that the resolution of this issue should be deferred. There are too many unknown variables to address this issue effectively. Furthermore, this issue may be rendered moot by the expected convergence of accounting standards in 1999. With these difficult issues in mind, the Exchange encourages the Commission to urge haste and diligence in the development of those standards.

Additionally, foreign markets that wish to provide access through registered SIPs may face unintended results. Section 11A requires that a SIP must carry out its functions in a manner consistent with the purposes of the Act. ¹¹⁷ This requirement arguably extends the U.S. securities laws and rules governing trading and disclosure to SIPs. At a minimum, some ambiguity is created. The Commission should address this concern or provide for the formations of a subsidiary by the foreign market which would not result in any liability of the foreign market.

We have one final comment a out the regulations of foreign market activities. Just as we recommended that ATSs be regulated by existing SROs, the PCX believes that many of its recommendations in this Section could be satisfied by utilizing the already existing regulatory structure within the U.S.. Specifically, we believe that the Commission should consider assigning to an existing SRO oversight of the record keeping, disclosure, enforcement, and other activities of the newly registered SIPs.

CONCLUSION

We hope the above comments are helpful to the Commission in its effort to reevaluate its approach to the regulation of ATSs and exchanges in light of technological advances and the growth of cross-border trading opportunities. Although many of the issues raised in the Concept Release are complex and could be more fully addressed if more time were available, the Exchange has attempted to provide its comments with respect to those issues that most directly relate to the Exchange’s ability to function competitively and in a businesslike manner. In this regard, the Exchange is available to provide any further assistance to the Commission in this important endeavor.

Sincerely,

R. Warren Langley

President and Chief Operating Officer

cc: The Hon. Arthur Levitt, Chairman

The Hon. Norman S. Johnson, Commissioner

The Hon. Isaac C. Hunt, Jr., Commissioner

Richard H. Walker, Esq., General Counsel

Dr. Richard R. Landsey, Director,

Division of Market Regulation

Robert L.D. Colby, Esq., Deputy Director,

Division of Market Regulation

Howard Kramer, Esq., Associate Director,

Division of Market Regulation

Brian J. Lane, Director

Division of Corporation Finance

Meredith B. Cross, Esq., Deputy Director,

Division of Corporation Finance

Paul M. Dudek, Esq., Chief,

Office of International Corporate Finance,

Division of Corporation Finance

FOOTNOTES

-[1]- Regulation of Exchanges, Exchange Act Release No. 38672, reprinted in 64 S.E.C. Docket 1631 (May 23, 1997) (hereinafter "Concept Release") (citations will be to original release).

-[2]- See Concept Release, supra note 1, at 19.

-[3]- See Concept Release, supra note 1, at 10.

-[4]- Rule 15c2-10 Proposal, Exchange Act Release No. 8661, 34 Fed. Reg. 12952, at 12953 (Aug. 4, 1969).

-[5]- 11Ab2-1 Adoption, Exchange Act Release No. 11673, 7 S.E.C. Docket 918, at 922-923 (Sep. 23, 1975).

-[6]- S.E.C., Division of Market Regulation, Market 2000: An Examination of Current Equity Market Developments 27 (Jan. 1994) (hereinafter "Market 2000 report").

-[7]- Proprietary Trading Systems, Exchange Act Release No. 26708, 43 S.E.C. Docket 979, at 984 (Apr. 11, 1989) (hereinafter "Rule 15c2-10 Proposal").

-[8]- Proprietary Trading Systems, Exchange Act Release No. 33621, 56 S.E.C. Docket 188, at 189 (Feb. 14, 1994).

-[9]- Market 2000 report, supra note 6, at 27.

-[10]- Id.

-[11]- Recordkeeping and Reporting Requirements, Exchange Act Release No. 35124, 59 Fed. Reg. 66702, at 66703 (Dec. 20, 1994) (hereinafter "Rule 17a-23 Release")

-[12]- Id.

-[13]- Concept Release, supra note 1, at 19.

-[14]- Concept Release, supra note 1, at 96 (emphasis added).

-[15]- Concept Release, supra note 1, at 7.

-[16]- Id., at 59-60.

-[17]- Id., 55-67.

-[18]- S. Rep. No. 94-75, at 23 (1975) (hereinafter "Senate Report").

-[19]- H.R. Rep. No. 88-95, pt. 4, at 693-694 (1963) (hereinafter "Special Study").

-[20]- Concept Release, supra note 1, at 44.

-[21]- ld. at 101.

-[22]- Special Study, supra note 19, at 502.

-[23]- ld. at 696.

-[24]- Rule 15c2-10 Proposals, supra note 7, at 984.

-[25]- Concept Release, supra note 1, at 49.

-[26]- ld. at 49.

-[27]- ld. at 102.

-[28]- ld. at 34, Q.4.

-[29]- See Exchange Act § 11A(a)(1), 15 U.S.C. § 78k-1(a)(1) (1997).

-[30]- Senate Report, supra note 18, at 8-9.

-[31]- Concept Release, supra note 1, at 7.

-[32]- See § 11A(a)(1)(D), 15 U.S.C. § 78k-1(a)(1)(D) (1997).

-[33]- See Concept Release, supra note 1, at 19.

-[34]- See Senate Report, supra note 18, at 8.

-[35]- NASD Discussion Paper, Three Issues in the Development of a Central Securities Market System (Apr. 12, 1976).

-[36]- Concept Release, supra note 1, at 56-67.

-[37]- ld. 7, n.1.

-[38]- ld. at 15, n.15 ("Registered broker-dealers that operate or otherwise sponsor alternative trading systems are required to comply with . . . Rule 17a-23 . . . .").

-[39]- Concept Release, supra note 1, at 28, n.57.

-[40]- Concept Release, supra note 1, at 7.

-[41]- Concept Release, supra note 1, at 7.

-[42]- Rule 17a-23 Release, supra note 11, at 66705.

-[43]- Id.

-[44]- Recordkeeping and Reporting Requirements, Exchange Act Release No. 33605, 56 S.E.C. Docket 41, at 42 (Feb. 9, 1994).

-[45]- Concept Release, supra note 1, at 20-21.

-[46]- H.R. Rep. No. 92-64, pt.8 at XXIV (1971).

-[47]- SEC, Statement on Future Structure of Securities Markets 7 (Feb. 1972), 37 Fed. Reg. 5286 (Feb. 4, 1972).

-[48]- Id.

-[49]- SEC, Statement on Structure of a Central Market System 10 (Mar. 1993).

-[50]- Market 2000 report, supra note 6, at IV-2

-[51]- Concept Release, supra note 1, at 19.

-[52]- Market 2000 report, supra note 6, at IV-31.

-[53]- § 11A(a)(1)(C), 15 U.S.C. § 78k-1(a)(1)(C) (1997).

-[54]- Order Execution Obligations, Exchange Act Release No. 37619, 62 S.E.C. Docket 1795, at 1833 (Aug. 29, 1996) (hereinafter "Order Handling Release").

-[55]- Id. ; see also Rule 11c1-1(c)(5)(ii)(B)(1), 17 C.F.R. § 240.11c1-1(c)(5)(ii)(B)(1) (1997).

-[56]- Letter from Richard R. Lindsey, Director, Division of Market Regulation, SEC, to Robert M. Greber, Chairman & Chief Executive Officer, Pacific Stock Exchange, Inc. of 11/22/96, at 11 n.24 (hereinafter "Lindsey Letter")

-[57]- Concept Release, supra note 1, at 124.

-[58]- e.g. , Letter from Boston Stock Exchange, Inc., Chicago Stock Exchange, Inc., Pacific Exchange, Inc., and Philadelphia Stock Exchange, Inc. to Jonathan G. Katz, Secretary of S.E.C. of 6/23/97.

-[59]- Order Approving Reporting Plan, Exchange Act Release No. 24407, 38 S.E.C. Docket 241 (Apr. 29, 1987).

-[60]- Senate Report, supra note 18, at 13.

-[61]- § 11A(a)(1)(C), 15 U.S.C. § 78k-1(a)(1)(C).

-[62]- Concept Release, supra note 1, at 106.

-[63]- Concept Release, supra note 1, at 109.

-[64]- Concept Release, supra note 1, at 39.

-[65]- Concept Release, supra note 1, at 45-46.

-[66]- Special Study, supra note 19, at 647.

-[67]- Senate Report, supra note 18, at 23.

-[68]- Special Study, supra note 19, at 701-702.

-[69]- Special Study, supra note 19, at 703.

-[70]- See Concept Release, supra note 1, at 42, n.74.

-[71]- See discussion infra at § IV.

-[72]- Automated Systems of Self-Regulatory Organizations, Exchange Act Release No. 29185, 48 S.E.C. Docket 1345, at 1346 (May 15, 1991).

-[73]- Concept Release, supra note 1, at 32.

-[74]- Rule 11Ac1-1(a)(25)(ii), 17 C.F.R. § 240.11Ac1-1(a)(25)(ii) (1997).

-[75]- Order Handling Release, supra note 57, at 1809.

-[76]- Order Handling Release, supra note 54, at 121 n.272.

-[77]- See Lindsey Letter, supra note 56, at 11-12.

-[78]- Concept Release, supra note 1, at 102.

-[79]- Senate Report, supra note 18, at 30.

-[80]- Special Study, supra note 19, at 703.

-[81]- Concept Release, supra note 1, at 35.

-[82]- Wallman, Competition, Innovation and Regulation in the Securities Markets 11, n.10 (Pace Univ. Center for the Study of the Equity Markets) (Sept. 25, 1997).

-[83]- Concept Release, supra note 1, at 106 n.200.

-[84]- See Concept Release, supra note 1, at 108-109.

-[85]- See discussion supra at § II C3.

-[86]- Automated Systems of Self-regulatory Organizations, Exchange Act Release No. 27445, 44 S.E.C. Docket 1582, at 1586 (Nov. 16, 1989).

-[87]- Id.

-[88]- Concept Release, supra note 1, at 32.

-[89]- Concept Release, supra note 1, at 121.

-[90]- Id .

-[91]- Of course, the distinction between sophisticated and other investors is well-established under U.S. securities laws. See , e.g. , Securities Act of 1933, Rule 501(a)(5) & (6), 17 C.F.R. § 230.501(a)(5) & (6).

-[92]- Concept Release, supra note 1, at 11.

-[93]- Id . at 120, 125.

-[94]- Id . at 124.

-[95]- Id .

-[96]- An example is the Deutsche borse AE in Frankfort, Germany.

-[97]- The Commission itself recognizes the agreements with foreign markets. ( See Concept Release, supra note 1, at 134 n.245).

-[98]- See Id . at 122-24.

-[99]- ld., at 125 (emphasis added).

-[100]- Id .

-[101]- Id . at 125, 127.

-[102]- Id . at 126.

-[103]- Id . at 125.

-[104]- Id . at 126.

-[105]- Id . at 121.

-[106]- Id .

-[107]- See discussion supra § V B 1.

-[108]- The Deutsche Boese AG, for one, imposes such requirements.

-[109]- The Exchange expects, and encourages, that the cooperation between market regulatory agencies will continue to increase. To this end, the basic recordkeeping proposed in the Concept Release will enable the Commission to assist other national and market regulators in their own surveillance and regulation.

-[110]- Question 107.

-[111]- The Exchange notes that the Commission may still have to wrestle with jurisdictional issues in various enforcement situations.

-[112]- See Answer to Question 109.

-[113]- Concept Release, supra note 1, at 131 n.241.

-[114]- See Concept Release, supra note 1, at 141.

-[115]- Id .

-[116]- See Questions 122-23.

-[117]- See Exchange Act § 11A(b)(3)(B), 15 U.S.C. § 78k-1(b)(3)(B); see also Concept Release, supra note 1, at 128.