[Federal Register Volume 63, Number 245 (Tuesday, December 22, 1998)]
[Rules and Regulations]
[Pages 70844-70951]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-33299]
[[Page 70843]]
_______________________________________________________________________
Part II
Securities and Exchange Commission
_______________________________________________________________________
17 CFR Part 202 et al.
Exchanges and Alternative Trading Systems and Filing Requirements for
Self-Regulatory Organizations Regarding New Derivative Securities
Products; Final Rules
Federal Register / Vol. 63, No. 245 / Tuesday, December 22, 1998 /
Rules and Regulations
[[Page 70844]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 202, 240, 242 and 249
[Release No. 34-40760; File No. S7-12-98]
RIN 3235-AH41
Regulation of Exchanges and Alternative Trading Systems
AGENCY: Securities and Exchange Commission.
ACTION: Final rules.
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SUMMARY: The Securities and Exchange Commission today is adopting new
rules and rule amendments to allow alternative trading systems to
choose whether to register as national securities exchanges, or to
register as broker-dealers and comply with additional requirements
under Regulation ATS, depending on their activities and trading volume.
The Commission is also adopting amendments to rules regarding
registration as a national securities exchange, repealing Rule 17a-23,
and amending the books and records rules by transferring the
recordkeeping requirements from Rule 17a-23 to Rules 17a-3 and 17a-4 as
they apply to broker-dealer internal trading systems. Finally, the
Commission is excluding from the rule filing requirements for self-
regulatory organizations certain pilot trading systems operated by
national securities exchanges and national securities associations.
These rules will more effectively integrate the growing number of
alternative trading systems into the national market system,
accommodate the registration of proprietary alternative trading systems
as exchanges, and provide an opportunity for registered exchanges to
better compete with alternative trading systems.
DATES: Effective Date: April 21, 1999, except Secs. 242.301(b)(5)(i)(D)
and (E) and Secs. 242.301(b)(6)(i) (D) and (E), which shall become
effective on April 1, 2000.
Compliance Date: Prior to April 21, 1999, the Commission will
publish a schedule of those securities with respect to which
alternative trading systems must comply with Sec. 242.301(b)(3) on
April 21, 1999 and those securities with respect to which alternative
trading systems must comply with Sec. 242.301(b)(3) on August 30, 1999.
See Section VIII of this release.
FOR FURTHER INFORMATION CONTACT: Elizabeth King, Senior Special
Counsel, at (202) 942-0140, Marianne Duffy, Special Counsel, at (202)
942-4163, Constance Kiggins, Special Counsel, at (202) 942-0059, Kevin
Ehrlich, Attorney, at (202) 942-0778, Denise Landers, Attorney, at
(202) 942-0137 and John Roeser, Attorney, at (202) 942-0762, Division
of Market Regulation, Securities and Exchange Commission, Stop 10-1,
450 Fifth Street, NW, Washington, DC 20549. For questions or comments
regarding securities registration issues raised in this release,
contact David Sirignano, Associate Director, at (202) 942-2870,
Division of Corporation Finance, Securities and Exchange Commission,
Stop 3-1, 450 Fifth Street, NW, Washington, DC 20549.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
II. Executive Summary of Final Rules
A. New Interpretation of ``Exchange''
B. Exemption for Regulated Alternative Trading Systems
C. Regulation ATS
D. For-Profit Exchanges
E. Temporary Exemption from Rule Filing Requirements for SROs'
Pilot Trading Systems
III. Rule 3b-16 under the Exchange Act
A. Brings Together the Orders of Multiple Buyers and Sellers
1. To Bring Together
2. Multiple Buyers and Sellers
3. Definition of ``Order''
B. Established, Non-Discretionary Methods
1. Established, Non-Discretionary Methods Provided by a Trading
Facility
2. Established, Non-Discretionary Methods Provided by Setting
Rules
C. Systems Excluded From Rule 3b-16
1. Order Routing Systems
2. Dealer Systems
D. Examples of Systems Illustrating Application of Rule 3b-16
1. Examples of Systems Included Within Rule 3b-16
2. Examples of Systems Not included Within Rule 3b-16
E. Exemption from the Definition of ``Exchange''
F. Commission's Authority to Require Registration as an Exchange
IV. Regulation of Alternative Trading Systems
A. Regulation ATS
1. Scope of Regulation ATS
a. Definition of Alternative Trading System
b. Exclusion of Trading Systems Registered as Exchanges or
Operated by a National Securities Association
c. Exclusion of Alternative Trading Systems Trading Solely
Government and Related Securities
(i) Discussion
(ii) Response to Commenters
d. Alternative Trading Systems Trading Non-Government Debt
Securities
(i) Discussion
(ii) Response to Commenters
e. Exemptions from Certain Requirements of Regulation ATS
Pursuant to Application to the Commission
2. Requirements for Alternative Trading Systems Subject to
Regulation ATS
a. Membership in an SRO
b. Notice of Operation as an Alternative Trading System and
Amendments
c. Market Transparency
(i) Importance of Market Transparency
(ii) Integration of Orders into the Public Quotation System
(A) New Requirements for Alternative Trading Systems
(B) Response to Comments
(iii) Access to Publicly Displayed Orders
(A) Application of Access Requirements under Regulation ATS
(B) Response to Comments
(iv) Execution Access Fees
(A) Limitations on Alternative Trading System Fees Charged to
Non-Subscribers
(B) Response to Comments
(v) Amendment to Rule 11Ac1-1 under the Exchange Act
d. Fair Access
(i) Importance of Fair Access
(ii) Fair Access Requirement
(iii) Response to Comments
e. Capacity, Integrity, and Security Standards
(i) Application of Capacity, Integrity, and Security Standards
(ii) Response to Comments
f. Examination, Inspection, and Investigations of Subscribers
g. Recordkeeping
h. Reporting and Form ATS-R
i. Procedures to Ensure Confidential Treatment of Trading
Information
B. Registration as a National Securities Exchange
1. Self-Regulatory Responsibilities
2. Fair Representation
(i) Public Directors
(ii) Fair Representation of Exchange Members
3. Membership on a National Securities Exchange
4. Fair Access
5. Compliance with ARP Guidelines
6. Registration of Securities
7. National Market System Participation
8. Uniform Trading Standards
9. Proposed Rule Changes
C. Application for Registration as an Exchange
1. Revisions to and Repeal of Form 1-A
2. Amendments to Rules 6a-1, 6a-2, and 6a-3 under the Exchange
Act
a. Rule 6a-1 Application for Registration as an Exchange or
Exemption Based on Limited Volume of Transactions
b. Rule 6a-2 Periodic Amendments
c. Rule 6a-3 Supplemental Material
D. National Securities Exchanges Operating Alternative Trading
Systems
V. Broker-Dealer Recordkeeping and Reporting Obligations
A. Elimination of Rule 17a-23
B. Amendments to Rules 17a-3 and 17a-4
VI. Temporary Exemption of Pilot Trading System Rule Filings
A. Introduction
B. Rule 19b-5
1. Types of Systems Eligible for Exemption Under Rule 19b-5
a. Definition of Pilot Trading System
b. Response to Comments on the Proposed Definition of Pilot
Trading System
c. Adopted Definition of Pilot Trading System
[[Page 70845]]
2. Scope of Pilot Trading Rule Exemption
3. SRO's Continuing Obligations Regarding Pilot Trading Systems
a. Notice and Filings to the Commission
b. Fair Access
c. Trading Rules and Procedures
d. Surveillance
e. Clearance and Settlement
f. Types of Securities
g. Activities of Specialists
h. Inspections and Examinations
i. Public Availability of Pilot Trading System Rules
C. Rule Filing Under Section 19(b)(2) of the Exchange Act
Required Within Two Years
VII. The Commission's Interpretation of the ``Exchange'' Definition
A. The Commission's Interpretation in Delta
B. The Growing Significance of Alternative Trading Systems in
the National Market System
C. The Revised Interpretation of ``Exchange''
D. Other Practical Reasons for Revising the Current
Interpretation
1. Additional Flexibility Provided by the National Securities
Markets Improvement Act of 1996
2. No-action Approach to Alternative Trading Systems is No
Longer Workable
3. More Rational Treatment of Regulated Entities
VIII. Effective Dates and Compliance Dates
IX. Costs and Benefits of the Rules and Amendments
A. Costs and Benefits of the Rules and Amendments Regarding
Alternative Trading Systems
1. Benefits
a. Improved Market Transparency
b. Improved Investor Protections
c. Fair Access
d. Systems Capacity, Integrity, and Security
2. Costs
a. Notice, Reporting, and Recordkeeping
b. Public Display of Orders and Equal Execution Access
c. Fair Access
d. Systems Capacity, Integrity, and Security
e. Costs of Exchange Registration
B. Amendments to Application and Related Rules for Registration
as an Exchange
1. Benefits
2. Costs
C. Costs and Benefits of the Repeal of Rule 17a-23 and the
Amendments to Rules 17a-3 and 17a-4
D. SRO Pilot Trading System
X. Effects on Competition, Efficiency and Capital Formation
XI. Summary of Final Regulatory Flexibility Analysis
XII. Paperwork Reduction Act
A. Form 1, Rules 6a-1 and 6a-2
B. Rule 6a-3
C. Rule 17a-3(a)(16)
D. Rule 17a-4(b)(10)
E. Rule 19b-5 and Form PILOT
F. Rule 301, Form ATS and Form ATS-R
1. Notice, Reporting, and Recordkeeping
2. Fair Access
3. Systems Capacity, Integrity, and Security
G. Rule 302
H. Rule 303
XIII. Statutory Authority
I. Introduction
Today the Securities and Exchange Commission (''Commission'' or
``SEC'') is adopting a regulatory framework for alternative trading
systems,\1\ to strengthen the public markets for securities, while
encouraging innovative new markets. During the past three years, the
Commission has undertaken a reevaluation of its regulatory framework
for markets because of substantial changes in the way securities are
traded. Market participants have incorporated technology into their
businesses to provide investors with an increasing array of services,
and to furnish these services more efficiently, and often at lower
prices. The current regulatory framework, however, designed more than
six decades ago, did not envision many of these trading and business
functions. In particular, market participants have developed a variety
of alternative trading systems that furnish services traditionally
provided solely by registered exchanges.
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\1\ The term ``alternative trading system'' is defined in Rule
300(a), 17 CFR 242.300(a). This term encompasses some systems that
previous Commission releases called proprietary trading systems,
broker-dealer trading systems, and electronic communication
networks.
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To better understand the questions raised by technological
developments in the U.S. markets, in May 1997, the Commission published
a concept release exploring ways to respond to the rapid technological
developments affecting securities markets and, in particular, the
growing significance of alternative trading systems (``Concept
Release'').\2\ After taking into consideration the comments submitted
in response to the Concept Release, in April 1998, the Commission
proposed a new regulatory framework for alternative trading systems
(``Proposing Release'').\3\
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\2\ Securities Exchange Act Release No. 38672 (May 23, 1997), 62
FR 30485 (June 4, 1997). The comment letters to the Concept Release
and a summary of these comments have been placed in Public File S7-
16-97, which is available for inspection in the Commission's Public
Reference Room.
\3\ Securities Exchange Act Release No. 39884 (Apr. 17, 1998),
63 FR 23504 (Apr. 29, 1998). The comment letters to the Proposing
Release and a summary of those comments received as of August 25,
1998 have been placed in Public File S7-12-98, which is available
for inspection in the Commission's Public Reference Room.
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Alternative trading systems now handle more than twenty percent of
the orders in securities listed on The Nasdaq Stock Market
(``Nasdaq''), and almost four percent of orders in exchange listed
securities. These systems operate markets similar to the registered
exchanges and Nasdaq. Over time, an alternative trading system may
become the primary market for some securities. Yet these markets are
private, available only to chosen subscribers, and are regulated as
broker-dealers, not in the way registered exchanges and Nasdaq are
regulated. This creates disparities that affect investor protection and
the operation of the markets as a whole.
Our national market system, as it has evolved since 1975, has
sought the benefits of both market centralization--deep, liquid
markets--and competition. To achieve these benefits, the national
market system has maintained equally regulated, individual markets,
which are linked together to make their best prices publicly known and
accessible. Alternative trading systems have remained largely outside
the national market system. For example, the evidence in the
Commission's report on the National Association of Securities Dealers,
Inc. (``NASD'') and Nasdaq suggested that widespread use of Instinet by
market makers as a private market had a significant impact on public
investors and the operation of the Nasdaq market.\4\ Through Instinet,
market makers were able to quote prices better than those made
available to public investors. This private market developed only
because the activity on alternative trading systems is not fully
disclosed, or accessible, to public investors. Moreover, these trading
systems have no obligation to provide investors a fair opportunity to
participate in their systems or to treat their participants fairly.
These systems may also not be adequately surveilled for market
manipulation and fraud. In fact, market participants can manipulate the
prices in the public securities markets through the use of alternative
trading systems.\5\ In addition, alternative trading systems have no
obligation to ensure that their systems are sufficient to handle rapid
increases in trading volume as occurs in times of market volatility,
and at times they have failed to do so. Because of the increasingly
important role of alternative trading systems, these differences are
inconsistent with the national market system goals set forth
[[Page 70846]]
by Congress in the 1975 amendments to the Securities Exchange Act of
1934 (``1975 Amendments'') \6\ and call into question the fairness of
current regulatory requirements.
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\4\ See SEC, Report Pursuant to Section 21(a) of the Securities
Exchange Act of 1934 Regarding the NASD and the Nasdaq Market (1996)
(``NASD 21(a) Report'').
\5\ See In the Matter of Ian and Lawrence Fishman, Securities
Exchange Act Release No. 40115 (June 24, 1998) (finding that the
Fishman brothers manipulated the national best bid and offer in
violation of Section 10(b) and Rule 10b-5 under the Exchange Act by
coordinating the entry of orders routed to alternative trading
systems).
\6\ Pub. L. 29, 89 Stat. 97 (1975). Congress granted to the
Commission authority in 1975 to adopt rules that promote (1)
economically efficient execution of securities transactions, (2)
fair competition, (3) transparency, (4) investor access to the best
markets, and (5) the opportunity for investors' orders to be
executed without the participation of a dealer. See S. Rep. No. 75,
94th Cong., 1st Sess. 8 (1975); H.R. Rep. No. 229, 94th Cong., 1st
Sess 92 (1975). See also section 11A(a)(1) of the Exchange Act, 15
U.S.C. 78k-1(a)(1).
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In 1996, Congress provided the Commission with greater flexibility
to regulate new trading systems by giving the Commission broad
authority to exempt any person from any of the provisions of the
Securities Exchange Act of 1934 (``Exchange Act'') and impose
appropriate conditions on their operation.\7\ This new exemptive
authority, combined with the ability to facilitate a national market
system, provides the Commission with the tools it needs to adopt a
regulatory framework that addresses its concerns about alternative
trading systems without jeopardizing the commercial viability of these
markets. In the Proposing Release, the Commission proposed ways to use
these tools to adopt new rules and rule amendments designed to resolve
many of the concerns raised by alternative trading systems, better
integrate these systems into our national market system structure, and
make the benefits of these systems available to more investors.
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\7\ Section 36 of the Exchange Act, 15 U.S.C. 78mm, was enacted
as part of the National Securities Markets Improvement Act of 1996,
Pub. L. 104-290 (``NSMIA''). See infra Section VII.D.1.
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In response to its Proposing Release,\8\ the Commission received
seventy comment letters.\9\ Commenters generally supported the
Commission's proposals and welcomed the regulatory flexibility these
proposals offered.\10\ Many commenters agreed with the Commission that
the regulatory structure needs to be modernized to better integrate
alternative trading systems into the national market system.\11\ For
example, several commenters expressed the view that, on balance, the
proposed regulatory framework for alternative trading systems
represented a preferable alternative to the current regulation of these
systems as broker-dealers, which is not only inadequate for many
alternative trading systems, but also results in disparate regulatory
treatment of exchange markets and their alternative trading system
competitors.\12\ Other commenters believed that the Commission's
proposal was a step in the right direction, both from a competitive
business perspective and from an investor protection and fair
regulation perspective. While some commenters thought that the
Commission should continue the present framework for alternative
trading systems,\13\ most believed that the proposal provided a
framework that could maintain a competitive balance among the markets
offering services to investors.\14\ Other commenters were pleased by
the Commission's determination to allow market participants to engage
in business decisions regarding how to register with the
Commission.\15\ Commenters also generally supported the Commission's
proposal to allow for-profit exchanges,\16\ and generally supported the
proposed temporary exemption for pilot trading systems.\17\
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\8\ See supra note 3.
\9\ This is the number of comment letters received by the
Commission as of the close of business on December 1, 1998.
\10\ Some commenters, however, suggested that the better
approach would be for the Commission to retain its present
regulatory framework for alternative trading systems. See, e.g.,
Letter from Robin Roger, Principal and Counsel, Morgan Stanley Dean
Witter to Jonathan G. Katz, Secretary, SEC, dated Sept. 11, 1998
(``MSDW Letter'') at 3-4; Letter from Christopher J. Carroll and W.
Hal Hinkle, Co-Chairs, ATS Task Force, The Bond Market Association
to Jonathan G. Katz, Secretary, SEC, dated July 28, 1998 (``TBMA
Letter'') at 2, 8-12; Letter from Lee B. Spencer, Jr., Chairman, SIA
Federal Regulation Committee and Perry L. Taylor, Jr., Chairman, SIA
Alternative Trading System Subcommittee, Securities Industry
Association to Jonathan G. Katz, Secretary, SEC, dated July 31, 1998
(``SIA Letter'') at 2, 5. Another commenter suggested that the
Commission solicit comment again on the broader issues discussed in
the Concept Release. See Letter from Louis C. Magill, President,
Corporate Capital Securities, Inc. to Jonathan G. Katz, Secretary,
SEC, dated July 27, 1998 (``Corporate Capital Letter'') at 4.
\11\ See, e.g., Letter from Joanne Moffic-Silver, Secretary and
General Counsel, Chicago Board Options Exchange to Jonathan G. Katz,
Secretary, SEC, dated July 28, 1998 (``CBOE Letter'') at 3; Letter
from John C. Katovich, Senior Vice President and General Counsel,
OptiMark Technologies Inc. to Jonathan G. Katz, Secretary, SEC,
dated Aug. 13, 1998 (``OptiMark Letter'') at 1.
\12\ See, e.g., CBOE Letter at 3.
\13\ See, e.g., SIA Letter at 1, 5-6.
\14\ See, e.g., Letter from Joan C. Conley, Corporate Secretary,
National Association of Securities Dealers, Inc. to Jonathan G.
Katz, Secretary, SEC, dated Aug. 10, 1998 (``NASD Letter'') at 1-2.
\15\ See, e.g., Letter from Douglas M. Atkin, Chief Executive
Officer, Instinet International to Jonathan G. Katz, Secretary, SEC,
dated Aug. 3, 1998 (``Instinet Letter'') at 1, 7; Letter from
Frederic W. Rittereiser, President and Chief Executive Officer and
William W. Uchimoto, Executive Vice President and General Counsel,
Ashton Technology Group, Inc. to Jonathan G. Katz, Secretary, SEC,
dated July 28, 1998 (``Ashton Letter'') at 1; Letter from Mary Sue
Fisher, Managing Director, Legal and Compliance, Chicago Board
Brokerage, LLC to Jonathan G. Katz, Secretary, SEC, dated July 29,
1998 (``CBB Letter'') at 1-2.
\16\ See, e.g., TBMA Letter at 4; Letter from Larry E. Fondren,
President, Integrated Bond Exchange, Inc. to Jonathan G. Katz,
Secretary, SEC, dated July 27, 1998 (``IBEX Letter'') at 13.
\17\ See, e.g., Letter from Craig S. Tyle, General Counsel,
Investment Company Institute to Jonathan G. Katz, Secretary, SEC,
dated July 28, 1998 (``7/28/98 ICI Letter'') at 5; Letter from James
E. Buck, Senior Vice President and Secretary, New York Stock
Exchange, Inc. to Jonathan G. Katz, Secretary, SEC, dated July 28,
1998 (``NYSE Letter'') at 9; Letter from Robert H. Forney, President
and Chief Executive Officer, Chicago Stock Exchange to Jonathan G.
Katz, Secretary, SEC, dated July 30, 1998 (``CHX Letter'') at 11;
Letter from T. Eric Kilcollin, President and Chief Executive
Officer, Chicago Mercantile Exchange to Jonathan G. Katz, Secretary,
SEC, dated Aug. 5, 1998 (``CME Letter'') at 4; Letter from James F.
Duffy, Executive Vice President and General Counsel, Legal and
Regulatory Policy, American Stock Exchange, Inc. to Jonathan G.
Katz, Secretary, SEC, dated Aug. 18, 1998 (``Amex Letter'') at 1;
Ashton Letter at 2; CBOE Letter at 3, 8-9. See infra Section VI for
a discussion of the temporary exemption for pilot trading systems.
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The Commission believes that its regulation of markets should both
accommodate traditional market structures and provide sufficient
flexibility to ensure that new markets promote fairness, efficiency,
and transparency. In adopting a new regulatory framework for
alternative trading systems today, the Commission has incorporated
suggestions and responded to requests for clarification made by
commenters. The Commission believes that this regulatory approach
effectively addresses commenters' concerns while carefully tailoring a
regulatory framework that is flexible enough to accommodate the
evolving technology of, and benefits provided by, alternative trading
systems.
While the revised regulatory scheme implemented today is designed
to address changes in the way securities are traded, the Commission's
assessment of the impact that these systems may have on the trading of
unregistered securities (i.e. of both domestic and foreign issuers),
and of the appropriate regulatory posture to these developments, is
still ongoing. This matter and the broader issues involving recent
trends and initiatives that give U.S. investors greater and more
instantaneous access to foreign securities markets create tensions
between competing Commission goals. The Commission, for example, wishes
to foster developments that enable U.S. investors to execute securities
trades more efficiently, but it also desires that foreign securities
traded in U.S. markets have full and fair disclosure. These tensions
and issues will be addressed by the Commission in the future.
II. Executive Summary of Final Rules
The final rules seek to establish a regulatory framework that makes
sense both for current and future securities
[[Page 70847]]
markets. This regulatory framework should encourage market innovation
while ensuring basic investor protections. The Commission continues to
believe that the approach outlined in the Proposing Release will
accomplish these goals. In general, this approach gives securities
markets a choice to register as exchanges, or to register as broker-
dealers and comply with Regulation ATS.\18\ The Commission believes the
framework it is adopting meets the varying needs and structures of
market participants and is flexible enough to accommodate the business
objectives of, and the benefits provided by, alternative trading
systems. The principal components of this new framework are discussed
below.
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\18\ 17 CFR 242.300-303.
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A. New Interpretation of ``Exchange''
A fundamental component of the new regulatory framework is new Rule
3b-16. This rule interprets key language in the statutory definition of
``exchange'' under section 3(a)(1) of the Exchange Act.\19\ Rule 3b-16
reflects a more comprehensive and meaningful interpretation of what an
exchange is in light of today's markets. Until now, the Commission's
interpretation of the exchange definition reflected relatively rigid
regulatory requirements and classifications for ``exchange'' and
``broker-dealers.'' Advancing technology has increasingly blurred these
distinctions, and alternative trading systems today are used by market
participants as functional equivalents of exchanges. Accordingly, the
Commission's new interpretation of exchange contained in Rule 3b-16\20\
encompasses these equivalent markets and the Commission's new general
exemptive authority enables it to craft a new regulatory framework.
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\19\ 15 U.S.C. 78c(a)(1).
\20\ 17 CFR 240.3b-16.
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The statutory definition of ``exchange'' includes a ``market place
or facilities for bringing together purchasers and sellers of
securities or for otherwise performing with respect to securities the
functions commonly performed by a stock exchange.''\21\ In response to
commenters' concerns and suggestions, the Commission has carefully
revised Rule 3b-16 to define these terms to mean any organization,
association, or group of persons that: (1) Brings together the orders
of multiple buyers and sellers; and (2) uses established, non-
discretionary methods (whether by providing a trading facility or by
setting rules) under which such orders interact with each other, and
the buyers and sellers entering such orders agree to the terms of a
trade.\22\
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\21\ 15 U.S.C. 78c(a)(1).
\22\ Rule 3b-16(a), 17 CFR 240.3b-16(a).
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Rule 3b-16 explicitly excludes those systems that the Commission
believes perform only traditional broker-dealer activities. The
Commission modified these exclusions to address issues raised by
commenters. Rule 3b-16 now expressly excludes the following systems
from the revised interpretation of ``exchange'': (1) Systems that
merely route orders to other facilities for execution; (2) systems
operated by a single registered market maker to display its own bids
and offers and the limit orders of its customers, and to execute trades
against such orders; and (3) systems that allow persons to enter orders
for execution against the bids and offers of a single dealer.\23\
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\23\ Rule 3b-16(b), 17 CFR 240.3b-16(b).
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B. Exemption for Regulated Alternative Trading Systems
The framework the Commission adopts today uses the Commission's new
exemptive authority to allow most alternative trading systems to choose
to be regulated either as exchanges or as broker-dealers. Rule 3a1-1
exempts most alternative trading systems from the definition of
``exchange,'' and therefore the requirement to register as an exchange,
if they comply with Regulation ATS. However, any system exercising
self-regulatory powers, such as regulating its members' or subscribers'
conduct when engaged in activities outside of that trading system, must
register as an exchange or be operated by a national securities
association. This is because self-regulatory activities in the
securities markets must be subject to Commission oversight under
Section 19 of the Exchange Act.\24\ Thus any system exercising self-
regulatory powers will not be permitted the option of registering as a
broker-dealer.
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\24\ 15 U.S.C. 78s.
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In addition, the Commission can determine that a dominant
alternative trading system should be registered as an exchange. An
alternative trading system would first have to exceed certain volume
levels and the Commission, after notice and an opportunity for the
alternative trading system to respond, would have to determine that an
exemption from exchange regulation is not necessary or appropriate in
the public interest or consistent with the protection of investors,
taking into account the requirements of exchange registration and the
objectives of the national market system.\25\ At this time, however,
the Commission does not believe that it is necessary or appropriate
under this provision that any alternative trading system register as an
exchange.
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\25\ Rule 3a1-1(b)(1), 17 CFR 240.3a1-1(b)(1).
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C. Regulation ATS
The Commission is adopting new Regulation ATS, substantially in the
form proposed, to impose essential elements of market-oriented
regulation on alternative trading systems. This new regulation
addresses the concerns raised by the market activities of alternative
trading systems that choose to register as broker-dealers. To allow new
markets to start, without disproportionate burdens, a system with less
than five percent of the trading volume in all securities it trades is
required only to: (1) File with the Commission a notice of operation
and quarterly reports; (2) maintain records, including an audit trail
of transactions; and (3) refrain from using the words ``exchange,''
``stock market,'' or similar terms in its name.
If, however, an alternative trading system with five percent or
more of the trading volume in any national market system security
chooses to register as a broker-dealer--instead of as an exchange--the
Commission believes it is in the public interest to integrate its
activities into the national market system. In addition to the
requirements for smaller alternative trading systems, Regulation ATS
requires alternative trading systems that trade five percent or more of
the volume in national market system securities to be linked with a
registered market in order to disseminate the best priced orders in
those national market system securities displayed in their systems
(including institutional orders) into the public quote stream.\26\ Such
alternative trading systems must also comply with the same market rules
governing execution priorities and obligations that apply to members of
the registered exchange or national securities association to which the
alternative trading system is linked.\27\
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\26\ Rule 301(b)(3), 17 CFR 240.301(b)(3). Alternative trading
systems will only have to comply with this rule for fifty percent of
securities on April 21, 1999. By August 30, 1999, alternative
trading systems will have to comply with this rule for all
securities. Prior to April 21, 1999, the Commission will publish a
schedule of those individual securities for which alternative
trading systems must comply with Rule 301(b)(3) on April 21, 1999.
See infra notes 192-193-and 216-217-and accompanying text.
\27\ This linkage requirement would not apply to alternative
trading systems that do not display participant orders to anyone,
including other system participants. In addition, this requirement
would not apply to alternative trading systems to the extent that
they trade securities other than national market system securities.
See infra Section IV.A.2.c.(ii).
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[[Page 70848]]
In addition, alternative trading systems with twenty percent or
more of the trading volume in any single security, whether equity or
debt, would be required to: (1) Grant or deny access based on objective
standards established by the trading system and applied in a non-
discriminatory manner; and (2) establish procedures to ensure adequate
systems capacity, integrity, and contingency planning. The Commission
believes that these requirements will better integrate those
significant alternative trading systems into national market system
mechanisms. Moreover, because alternative trading systems that choose
to register as broker-dealers are not required to surveil activities on
their markets, the Commission intends to work with the self-regulatory
organizations (``SROs'') to ensure that they can operate ongoing, real-
time surveillance for market manipulation and fraud and develop
surveillance and examination procedures specifically targeted to
alternative trading systems they oversee.
D. For-Profit Exchanges
In this release, the Commission also expresses its view that
registered exchanges may structure themselves as for-profit
organizations. This will allow alternative trading systems, which are
typically proprietary, to choose to register as exchanges without
changing their organizational structure. In addition, currently
registered exchanges--which are all membership organizations--could
choose to demutualize. This release provides guidance on ways for
proprietary markets to meet their fair representation requirements as
non-membership national securities exchanges.\28\
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\28\ See infra Section IV.B.2.
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E. Temporary Exemption From Rule Filing Requirements for SROs' Pilot
Trading Systems
To help reduce competitive impediments to innovation by SROs, the
Commission is allowing them to start new trading systems without
preapproval by the Commission. The Commission is adopting Rule 19b-5 to
permit SROs, without filing for approval with the Commission, to
operate new pilot trading systems for up to two years. These pilot
trading systems will be subject to specific conditions, including
limitations on their trading volumes.\29\
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\29\ See infra Section VI. The purpose of this new rule is to
provide registered exchanges and national securities associations
with a greater opportunity to compete with alternative trading
systems registered as broker-dealers and with foreign markets.
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III. Rule 3b-16 Under the Exchange Act
The Commission today is adopting new Rule 3b-16 under the Exchange
Act. This rule defines terms used in the statutory definition of
``exchange,'' found in section 3(a)(1) of the Exchange Act.\30\ The
statutory definition of ``exchange'' includes a ``market place or
facilities for bringing together purchasers and sellers of securities
or for otherwise performing with respect to securities the functions
commonly performed by a stock exchange.'' The new rule interprets these
terms to include any organization, association, or group of persons
that: (1) Brings together the orders of multiple buyers and sellers;
and (2) uses established, non-discretionary methods (whether by
providing a trading facility or by setting rules) under which such
orders interact with each other, and the buyers and sellers entering
such orders agree to the terms of a trade.\31\ This rule revises the
current interpretation of the term ``exchange,'' as set forth in the
Delta Release.\32\
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\30\ 15 U.S.C. 78c(a)(1).
\31\ Rule 3b-16(a), 17 CFR 240.3b-16(a). In the Proposing
Release, the Commission proposed to define the terms in the
definition of ``exchange'' to be ``any organization, association, or
group of persons that: (1) Consolidates orders of multiple parties;
and (2) sets non-discretionary material conditions (whether by
providing a trading facility or by setting rules) under which
parties entering such orders agree to the terms of a trade.'' See
Proposing Release, supra note 3.
\32\ See Securities Exchange Act Release No. 27611 (Jan. 12,
1990), 55 FR 1980, 1900 (Jan. 19, 1990) (``Delta Release''). See
infra Section VII for a further discussion of the Delta Release and
the basis and purpose of the revised interpretation.
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New Rule 3b-16 is an important element of the Commission's new
regulatory framework for alternative trading systems. As discussed
above, the rapid growth and technological advancements of alternative
trading systems have eroded the distinctions between the roles played
by alternative trading systems and by traditional exchanges.
Alternative trading systems today provide services more akin to
exchange functions than broker-dealer functions, such as matching
counterparties' orders, executing trades, operating limit order books,
and facilitating active price discovery. For many of these systems,
regulation as a market more appropriately fits their economic
functions. Rule 3b-16 defines terms in the statutory definition of
exchange to include markets that engage in activities functionally
equivalent to markets currently registered as national securities
exchanges. Moreover, because in some cases exchange regulation may
better meet these systems' business objectives, the Commission believes
that alternative trading systems should have the option to register as
national securities exchanges.\33\ The rule helps modernize the
Commission's approach to these systems because it adapts the concept of
what is ``generally understood'' to be an exchange to reflect changes
in the markets brought about by automated trading. In addition, in
light of recent technological developments, Rule 3b-16 more closely
reflects the statutory concept of ``bringing together'' buying and
selling interests.
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\33\ See infra Section IV.B. (discussing registration as a
national securities exchange). Under Section 5 of the Exchange Act,
an exemption may be granted to an exchange from registration as a
national securities exchange on the basis of low volume, or expected
low volume. Currently, there is only one exchange, the Arizona Stock
Exchange (``AZX''), that is operating under a limited volume
exemption. See Securities Exchange Act Release No. 28899 (Feb. 20,
1991), 56 FR 8377 (Feb. 28, 1991). In addition, the Commission
solicited comment on whether Tradepoint Financial Networks, plc
should be granted a limited volume exemption. See Securities
Exchange Act Release No. 40161 (July 2, 1998), 45 FR 41920 (July 9,
1998).
The Commission believes that the low volume exemption continues
to be appropriate for some exchanges, such as an exchange that, for
example, disciplines its members (other than by excluding them or
limiting them from trading based on objective criteria, such as
creditworthiness), or has other self-regulatory attributes that
exclude it from the definition of alternative trading system, Rule
300(a), and therefore preclude it from making the choice to register
as a broker-dealer. Any exchange seeking a low volume exemption
would, of course, have to have low volume. The Commission believes
that the low volume exemption would be inappropriate for any
alternative trading system that can register as a broker-dealer and
comply with Regulation ATS, and that the conditions under Regulation
ATS should generally be met by any alternative trading system
falling within Rule 3b-16, including an alternative trading system
that, for other reasons, seeks a low volume exemption.
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The Proposing Release sought comment on whether the proposed
definition captures the fundamental features of an exchange as that
term is generally understood today. The Commission received several
comments supportive of its proposed revision to the interpretation of
``exchange.'' For example, the NASD commented that this new definition
``is not inappropriate, particularly with the express exclusion for
internal broker-dealer systems.'' \34\ Other commenters also supported
broadening the Commission's interpretation of what constitutes an
exchange and agreed that the proposed rule accurately identified the
fundamental features of a securities ``exchange.'' \35\ On the other
hand, some commenters questioned the basis and need for the Commission
to move away from its interpretation in Delta. The
[[Page 70849]]
Commission responds to these comments below in Section VII.
---------------------------------------------------------------------------
\34\ NASD Letter at 3, n.4.
\35\ See CME Letter at 2; IBEX Letter at 4.
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Finally, one commenter expressed concern that the proposed revision
to the Commission's interpretation of ``exchange'' would encompass
every market participant providing electronic or other technologically
advanced trading service.\36\ The Commission does not intend for the
distinction between exchanges and broker-dealers to turn on automation,
and does not believe that its revised interpretation of ``exchange''
has this effect. In particular, the Commission notes that paragraph (a)
of new Rule 3b-16 does not contain the word automation, but is instead
descriptive of those activities the Commission considers to be the
activities of a ``market'' where buyers and sellers meet and includes
purely floor-based exchanges, as well as fully automated ones.
Moreover, paragraph (b) clearly excludes certain systems that--even
though automated--are not exchanges, such as automated single dealer
systems.
---------------------------------------------------------------------------
\36\ Instinet Letter at 7.
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The language of Rule 3b-16 the Commission is adopting today
modifies the language the Commission proposed in response to
commenters' suggestions and concerns, and their requests for
clarification. The discussion below is intended to further explain how
the Commission envisions that its new interpretation of ``exchange''
will be applied and responds to specific requests for clarification by
commenters.
A. Brings Together the Orders of Multiple Buyers and Sellers
In order to be covered by the definition in Rule 3b-16, a system
must satisfy the first part of Rule 3b-16(a)--brings together the
orders of multiple buyers and sellers. This emphasizes the concept of
``bringing together purchasers and sellers of securities'' set forth in
the definition of ``exchange'' in section 3(a)(1) of the Exchange Act.
While the intent is the same, the language in Rule 3b-16(a)(1) has been
modified from the proposal to address the concerns of some of the
commenters who requested that the definition be clarified.
1. To Bring Together
The Commission is adopting the language ``brings together'' in Rule
3b-16, rather than ``consolidates'' as originally proposed. While the
Commission believes that ``consolidates'' and ``brings together'' have
the same meaning, the latter more closely mirrors the language in the
statute and is a plainer use of language.
A system brings together orders if it displays, or otherwise
represents, trading interests entered on the system to system users.
These systems include consolidated quote screens, such as the system
operated by Nasdaq. A system also brings together orders if it receives
subscribers' orders centrally for future processing and execution. For
example, a limit order matching book that allows subscribers to display
buy and sell orders in particular securities and to obtain execution
against matching orders contemporaneously entered or stored in the
system ``brings together orders.'' These activities are currently
performed by systems that bring together orders internally for crossing
\37\ or matching,\38\ as well as floor-based markets that impose
trading rules. In addition, interdealer brokers (``IDBs'') \39\ bring
together orders, regardless of their level of automation.\40\
Accordingly, a system ``brings together orders'' when orders entered in
the system for a given security have the opportunity to interact with
other orders entered into the system for the same security.
---------------------------------------------------------------------------
\37\ A crossing system is, typically, one that allows
participants to enter unpriced orders to buy and sell securities.
Orders are crossed at specified times at a price derived from
another market.
\38\ Matching systems allow participants to enter priced limit
orders and match those orders with other orders in the system.
Participants are able to view unmatched limit orders in the system's
book. The sponsor of a matching system typically acts as riskless
principal or a dealer firm on behalf of the system acts as riskless
principal, with respect to matched orders, or contracts with another
broker-dealer to perform this function.
\39\ Currently, debt markets are not centrally organized by a
single entity, but are nonetheless informally organized around
interdealer brokers. Interdealer brokers (also called blind brokers
and brokers' brokers) display, on an anonymous basis, the offers to
buy and sell securities that are placed with them by subscribers. In
order to place a bid or offer, a subscriber typically telephones the
interdealer broker, which enters the order into its system and
displays it to other subscribers. Some interdealer brokers display
all bids and offers; others display only the best bid and offer. To
execute against an offer displayed on the computer screen, a
subscriber telephones the interdealer broker, although sometimes
execution may be electronic. The identities of the counterparties
are, generally, kept confidential through clearance and settlement
of the trade. Some interdealer brokers, however, reveal the names of
each counterparty after execution. Traditionally interdealer brokers
facilitated trading only between dealers. Increasingly, however,
interdealer brokers are permitting non-dealers to participate in
their systems.
\40\ But see infra notes 123-130 and accompanying text
(discussing the exclusion from Regulation ATS for alternative
trading systems that trade exclusively government, and other
related, securities).
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2. Multiple Buyers and Sellers
In addition, to satisfy paragraph (a)(1) of Rule 3b-16, a system
must bring together orders of multiple buyers and multiple sellers. The
Commission proposed to use the term ``multiple parties'' in paragraph
(a)(1) of Rule 3b-16, rather than the term ``multiple buyers and
sellers.'' The Commission believes that this modification to the
language proposed in Rule 3b-16 addresses the concerns of those
commenters who requested that the Commission clarify that systems in
which there is only a single seller, such as systems that permit
issuers to sell their own securities to investors, would not be
included within Rule 3b-16. While such systems have multiple buyers
(i.e., investors), they have only one seller for each security (i.e.,
issuers) and, therefore, do not meet the multiple buyers and sellers
test. An example of this type of system is CP Direct in which an issuer
can offer to sell its commercial paper to the customers of CS First
Boston.\41\ Another example of systems that do not meet the multiple
buyers and sellers criteria are systems in which securities are offered
by a single seller at successively lower prices. In addition, systems
designed for the purpose of executing orders against a single
counterparty, such as the dealer operating a system, would not be
considered to have multiple buyers and sellers. Thus a single
counterparty that buys and sells securities through a system, where
other parties entering orders only execute against the single
designated counterparty, would not meet the requirements of the first
part of Rule 3b-16.\42\ However, the mere interpositioning of a
designated counterparty as riskless principal for settlement purposes
after the purchasing and selling counterparties to a trade have been
matched would not, by itself, mean that the system does not have
multiple buyers and sellers.
---------------------------------------------------------------------------
\41\ See Bruce Rule, PSA Panels Embrace Internet for
Institutional Trading; and Regulators Love the Audit Trail,
Investment Dealers' Digest, Nov. 18, 1996 (discussing CP Direct).
The converse situation--i.e., where there is one buyer and multiple
sellers for a given instrument--would also not meet the ``multiple
buyers and sellers'' requirement. The Commission, however, is not
aware of any system that currently operates this way.
\42\ This type of system would also be expressly excluded from
Rule 3b-16 under paragraph (b)(2). See infra Section III.C.2.
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3. Definition of ``Order''
Finally, the rule makes clear that, to be included within the
definition in Rule 3b-16(a), a system must bring together participants'
``orders.'' The term ``order'' is defined in paragraph (c) of Rule 3b-
16 to include any firm indication of a willingness to buy or sell a
security, whether made on a principal
[[Page 70850]]
or agency basis.\43\ Firm indications of buying or selling interest
specifically include bid or offer quotations, market orders, limit
orders, and any other priced order.
---------------------------------------------------------------------------
\43\ Rule 3b-16(c), 17 CFR 240.3b-16(c).
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Several commenters requested that the Commission clarify the
proposed definition of ``order.'' One commenter expressed concern that
the proposed definition of ``order'' was too broad and recommended that
the revised interpretation of ``exchange'' be clarified to exclude
trading systems that broadcast non-executable indicative quotations,
and noted that IDBs frequently communicate an indicative price to a
customer, which is merely a starting point for a negotiation of the
final transaction price.\44\ The Commission notes that the term
``order'' is defined as ``any firm indication of a willingness to buy
or sell a security, * * * including any bid or offer quotation, market
order, limit order, or other priced order.''\45\ Whether or not an
indication of interest is ``firm'' will depend on what actually takes
place between the buyer and seller.
---------------------------------------------------------------------------
\44\ TBMA Letter at 15-16 (stating that the bids and offers
associated with telephone-based IDBs are generally ``subject,''
i.e., the broker must check back with the dealer client before
finalizing the transaction).
\45\: Rule 3b-16(c), 17 CFR 240.3b-16(c).
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The label put on an order--``firm'' or ``not firm''--is not
dispositive. For example, a system claiming it displays only
``indications of interest'' that are not orders, may be covered by the
new interpretation of ``exchange'' if those indications are, in fact,
firm in practice. In general, the Commission intends to read the
definition of ``order'' broadly and will not consider systems to fall
outside the definition in Rule 3b-16 based solely on a system's
labeling of indications of interest as ``not firm.'' Instead, what
actually takes place between the buyers and sellers interacting in a
particular system will determine whether indications of interest are
``firm'' or not. At a minimum, an indication of interest will be
considered firm if it can be executed without the further agreement of
the person entering the indication. Even if the person must give its
subsequent assent to an execution, however, the indication will still
be considered firm if this subsequent agreement is always, or almost
always, granted so that the agreement is largely a formality. For
instance, indications of interest where there is a clear or prevailing
presumption that a trade will take place at the indicated price, based
on understandings or past dealings, will be viewed as orders.
Generally, however, a system that displays bona fide, non-firm
indications of interest--including, but not limited to, indications of
interest to buy or sell a particular security without either prices or
quantities associated with those indications--will not be displaying
``orders'' and, therefore, not fall within Rule 3b-16.
Nevertheless, the price or size of an indication of interest may be
either explicit or may be inferred from the facts and circumstances
accompanying the indication. For example, an indication of interest
will be considered to include a price if the system in which the
indication of interest is entered defaults automatically to a price
pegged to another market, index, rate, or other variable, or if the
person entering such indication indicates that such person is
interested in trading at a price pegged to another market, index, rate,
or other variable, which includes ``market'' orders.
The same commenter expressed concern that the proposed definition
of order could have the effect of including markets within the
definition of ``exchange'' that quote prices over the telephone for a
potential transaction.\46\ As discussed above, whether or not a
particular system is an exchange does not turn solely on the level of
automation used: ``orders'' can be given over the telephone, as well as
electronically.
---------------------------------------------------------------------------
\46\ TBMA Letter at 15.
---------------------------------------------------------------------------
The Commission emphasizes that merely because a system ``brings
together orders of multiple buyers and sellers,'' does not mean that
the system is an exchange. In order to fall within Rule 3b-16, a system
must also satisfy the requirements in paragraph (a)(2). Thus, whether
or not an ``order'' is part of a system that falls within the new
interpretation of ``exchange'' depends upon the activities of that
system taken as a whole. For example, a system could display
subscribers' ``orders'' to other market participants, but would not be
encompassed by Rule 3b-16 if subscribers contacted each other and
agreed to the terms of their trades outside of the system.\47\ Unless a
system also establishes rules or operates a trading facility under
which subscribers can agree to the terms of their trades, the system
will not be included within Rule 3b-16, even if it brings together
``orders.''
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\47\ These bulletin board types of systems were described in no-
action letters from the staff. See Letter dated June 24, 1996 from
Catherine McGuire, Chief Counsel, Division of Market Regulation,
SEC, Jack W. Murphy, Chief Counsel, Division of Investment
Management, SEC, and Martin P. Dunn, Chief Counsel, Division of
Corporate Finance, SEC to Barry Reder, Coblentz, Cahen, McCabe and
Breyer, LLP (counsel to Real Goods Trading Corporation); Letter
dated Aug. 5, 1996 from Catherine McGuire, Chief Counsel, Division
of Market Regulation, SEC to: Bruce D. Stuart, Esq. (counsel to
PerfectData Corporation); and Letter dated April 17, 1996 from
Abigail Arms, Associate Director, Division of Corporate Finance,
SEC, and Catherine McGuire, Associate Director, Division of Market
Regulation, SEC to Andrew Klein (President and Chief Executive
Officer of Spring Street Brewing Company).
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Finally, the NYSE commented that the Commission's definition of
``order'' appeared to cover trading interest that, in the Order
approving the Pacific Exchange (``PCX'') Application of the OptiMark
System (``OptiMark Order''), the Commission did not consider to be an
order. In the OptiMark Order, the Commission took the position that the
profiles entered into OptiMark are not bids or offers under Rule 11Ac1-
1 (``Firm Quote Rule'').\48\ The Commission's definition of ``order''
in paragraph (c) of Rule 3b-16 is intended to be broader than the terms
bid and offer in the Firm Quote Rule.\49\ Therefore, it is possible for
an indication of interest to be an ``order'' under Rule 3b-16, without
being a bid or offer under the Firm Quote Rule.
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\48\ See Securities Exchange Act Release No. 39086 (Sept. 17,
1997), 62 FR 50036 (Sept. 24, 1997). In approving OptiMark, the
Commission stated that OptiMark's unique design warrants a non-
traditional approach in determining whether to require the
dissemination of trading interest expressed through operation of
OptiMark.
\49\ See Rule 11Ac1-1(c), 17 CFR 240.11Ac1-1(c).
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B. Established, Non-Discretionary Methods
In addition to bringing together the orders of multiple parties, to
be included within Rule 3b-16, a system would have to use established,
non-discretionary methods * * * under which such orders interact with
each other and the buyers and sellers entering orders agree to the
terms of the trade. A system uses established non-discretionary methods
either by providing a trading facility or by setting rules governing
trading among subscribers. The Commission intends for ``established,
non-discretionary methods'' to include any methods that dictate the
terms of trading among the multiple buyers and sellers entering orders
into the system. Such methods include those that set procedures or
priorities under which open terms of a trade may be determined. For
example, traditional exchanges' rules of priority, parity, and
precedence are ``established, non-discretionary methods,'' as are the
trading algorithms of electronic systems. Similarly, systems that
determine the trading price at some designated future date on the basis
of pre-established
[[Page 70851]]
criteria (such as the weighted average trading price for the security
on the specified date in a specified market or markets) are using
established, non-discretionary methods. A requirement that the trade
subsequently be ratified does not avoid this element. For example, a
system that trades limited partnership units might use established,
non-discretionary methods even though approval from the general partner
is required prior to settlement. Rules that merely supply the means of
communication with a system (for example, software or hardware tools
that subscribers may use in accessing a system), however, do not
satisfy this element of Rule 3b-16.
In general, where customers of a broker-dealer exercise control
over their own orders in a trading system operated by the broker-
dealer, that broker-dealer is unlikely to be viewed as using
discretionary methods in handling the order. An example of systems that
the Commission believes do not use established, non-discretionary
methods are traditional block trading desks. Block trading desks
generally retain some discretion in determining how to execute a
customer's order, and frequently commit capital to satisfy their
customers' needs. For example, a block positioner may ``shop'' the
order around in an attempt to find a contra-side interest with another
investor. In some cases, the block positioner may take the other side
of the order, keeping the block as a proprietary position. While block
trading desks do cross customers' orders, these crosses are not done
according to fixed non-discretionary methods, but instead are based on
the block trading desks' ability to find a contra-side to the order. It
may cross two customer orders, or it may assemble a block of several
customer orders with completion dependent on its willingness to take a
proprietary position for part of the block. Execution prices, size of
the proprietary position and agency compensation may all be part of a
single negotiated deal. Consequently, the Commission would not consider
traditional block trading desks to be using established, non-
discretionary methods and, therefore, they would not fall within Rule
3b-16.
In addition, systems that merely provide information to subscribers
about other subscribers' trading interest, without facilities for
execution, do not fall within paragraph (a) of Rule 3b-16. One
commenter asked the Commission to clarify that such systems would not
be viewed as exchanges.\50\ While such vendors may allow buyers and
sellers to find each other, they do not provide a facility or set rules
under which those orders interact with each other. Accordingly, the
Commission agrees with this commenter that such systems are not
exchanges.
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\50\ MSDW Letter at 11.
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In contrast, when a customer gives a broker-dealer flexibility in
how to handle an order, it relinquishes a degree of control over that
order. The Commission recognizes that broker-dealers exercising
discretion or judgment over customer orders may use internal systems to
trade and manage these orders. The mere use of these systems does not
make a broker an exchange, unless those systems themselves predetermine
the handling and execution practices for the order, replacing the
broker-dealer's judgment and flexibility in working the order.
One commenter suggested that the lack of display of customer orders
outside the broker-dealer should be determinative of whether the system
was an exchange.\51\ The Commission notes that it is possible for a
system to use established, non-discretionary methods even if orders are
not displayed. For example, the OptiMark System--by design--does not
display participants' indications of interest. There is, however, no
discretion exercised by the operator of the OptiMark System; the trade
optimization calculations are established, non-discretionary methods.
---------------------------------------------------------------------------
\51\ MSDW Letter, pp. 7-8.
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Finally, the Commission proposed to explicitly exclude from the
revised interpretation of ``exchange'' trading systems that allow a
single broker-dealer to internally manage its customers' orders.\52\
The Commission was concerned that such systems might technically be
covered by paragraph (a) of Rule 3b-16 if they occasionally crossed or
matched customer orders. Because the Commission believes that these
systems have generally automated traditional brokerage functions, it
proposed to clearly exclude them from the revised interpretation of
``exchange.'' Several commenters noted their agreement with the
Commission's proposed exclusion of these internal broker-dealer systems
from its reinterpretation of ``exchange,'' \53\ but requested that the
Commission clarify it. In particular, the Securities Industry
Association (``SIA'') and The Bond Market Association (``TBMA'')
requested that the Commission clarify the intended meaning of the terms
``predetermined procedures'' and ``communicated to customers'' as used
in the proposed exclusion.\54\
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\52\ Proposed Rule 3b-12(b)(2).
\53\ See NASD Letter at 3, n.4; TBMA Letter at 3, 14; SIA Letter
at 3, 10; MSDW Letter at 5-6.
\54\ See TBMA Letter at 3, 14-15; SIA Letter at 3, 10-11.
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The Commission intended to exclude a number of different types of
systems under this proposed exclusion. First, this exclusion was
intended to cover internal systems operated by market makers to
automate the management of their customer orders, including the display
of customer limit orders, and to match those displayed orders with
other customer orders. The Commission is now adopting a more specific
exclusion to cover these types of systems.
In addition, in large part, the Commission intended to exclude
systems that automate the management of customer orders that require a
broker-dealer to use its discretion. These types of systems would not
be included within paragraph (a) of Rule 3b-16 because--like
traditional block trading desks--they do not use established, non-
discretionary methods. The purpose of the proposed exclusion for
internal broker-dealer systems was to exclude traditional internal
systems created to increase efficiency rather than to provide a non-
discretionary trading system for customers. In light of the comments on
the proposed exclusion for internal broker-dealer systems and the
difficulty of distinguishing among internal systems on this basis, the
Commission now believes it is better not to attempt to set specific
requirements that internal broker-dealer systems must meet in order to
be excluded from Rule 3b-16. Instead, the Commission is clarifying that
trading systems that do not use established, non-discretionary methods
fail to meet the two-part test in paragraph (a) and are, therefore, not
included within the revised interpretation of ``exchange.''
1. Established, Non-Discretionary Methods Provided by a Trading
Facility
As stated previously, a trading system that uses established, non-
discretionary methods would include a traditional exchange floor where
specialists are responsible for executing orders. It would also include
a computer system (whether comprised of software, hardware, protocols,
or any combination thereof) through which orders interact, or any other
trading mechanism that provides a means or location for the bringing
together and execution of orders. For example, the Commission considers
the use of an algorithm by an electronic trading system that sets
trading procedures and priorities to be a trading facility that uses
established, non-discretionary methods.
[[Page 70852]]
The Commission will attribute the activities of a trading facility
to a system if that facility is offered by the system directly or
indirectly (such as where a system arranges for a third party or
parties to offer the trading facility). Thus, if a system that brings
together the orders of multiple parties arranges for a third party
vendor to distribute software that establishes non-discretionary
methods under which orders interact, that system will fall within Rule
3b-16. Similarly, if a bulletin board operator contracted with another
party to provide execution facilities for the bulletin board users, the
bulletin board will be deemed to have established a trading facility
because it took affirmative steps to arrange for the necessary exchange
functions for its users.\55\ In addition, if an organization arranges
for separate entities to provide different pieces of a trading system,
which together meet the definition contained in paragraph (a) of Rule
3b-16, the organization responsible for arranging the collective
efforts will be deemed to have established a trading facility. For
example, the arrangement between the Delta Government Options
Corporation (``Delta''), RMJ Options Trading Corporation, and Security
Pacific National Trust Company, as described in a 1990 Commission
release,\56\ would together meet the definition set forth in Rule 3b-
16. Moreover, a trading system that falls within the Commission's
interpretation of ``exchange'' in Rule 3b-16 will still be considered
an ``exchange,'' even if it matches two trades and routes them to
another system or exchange for execution. Whether or not the actual
execution of the order takes place on the system is not a determining
factor of whether the system falls under Rule 3b-16.
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\55\ Whether or not a bulletin board will be considered an
exchange under the rule will also depend on whether it meets the
other elements of the definition.
\56\ See Delta Release, supra note 32. The Commission notes that
the arrangement between these entities no longer exists, and that
Delta, in its current form, would not fit the new interpretation of
the definition of exchange.
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2. Established, Non-Discretionary Methods Provided by Setting Rules
Alternatively, a system may use established, non-discretionary
methods through the imposition of rules under which parties entering
orders on the system agree to the terms of a trade. For example, if a
system imposes affirmative quote obligations on its subscribers, such
as obligations to post two-sided quotations or to post quotations no
worse than the quotes subscribers post on other systems, the Commission
will consider it to be using established, non-discretionary methods.
In addition, rules imposing execution priorities, such as time and
price priority rules, would be ``established, non-discretionary
methods.'' Similarly, a system that standardizes the material terms of
instruments traded on the system, such as the system operated by Delta
at the time the Commission published the Delta Release,\57\ will be
considered to use established, non-discretionary methods.
---------------------------------------------------------------------------
\57\ See id., at 1897.
---------------------------------------------------------------------------
Similarly, Nasdaq's use of established, non-discretionary methods
bring it within the revised interpretation of ``exchange'' in Rule 3b-
16. The NASD imposes basic rules by which securities are traded on
Nasdaq. Specifically, it imposes affirmative obligations on market
makers in Nasdaq National Market (``Nasdaq NM'') and SmallCap
securities, including obligations to post firm and two-sided quotes. It
also operates the Small Order Execution System (``SOES'') and SelectNet
systems, requiring market makers to accept executions or orders for
execution in these securities. Through Nasdaq, market participants act
in concert to centralize and disseminate trading interest and establish
the basic rules by which securities are traded. The Commission believes
that Nasdaq performs what today is generally understood to be the
functions commonly performed by a stock exchange. Nasdaq, however, is
currently registered as a securities information processor under
section 11A of the Exchange Act \58\ and is operated by the NASD, a
registered securities association under Section 15A of the Exchange
Act.\59\ Because the requirements currently applicable to a registered
securities association are virtually identical to the requirements
applicable to registered exchanges, the Commission does not believe it
is necessary or appropriate in the public interest to require Nasdaq to
register as an exchange.\60\ Under the rules the Commission is adopting
today, however, Nasdaq could choose to register under section 6 of the
Exchange Act as a national securities exchange.\61\
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\58\ 15 U.S.C. 78k-1.
\59\ 15 U.S.C. 78o-3. The NASD, parent of Nasdaq, is the self-
regulatory organization. The NASD delegates to NASD Regulation, Inc.
(``NASDR''), the wholly owned regulatory subsidiary of the NASD, its
SRO responsibilities to surveil trading conducted on Nasdaq and the
OTC Bulletin Boards, and to enforce compliance by its members (and
persons associated with its members) with applicable laws and rules.
Nasdaq also surveils trading conducted on its market and refers
potential violations to NASDR. See also infra note 342.
\60\ See infra notes 93-94 and accompanying text (discussing
Rule 3a1-1(a)(1), which explicitly exempts any system operated by a
national securities association from the definition of the term
``exchange'').
\61\ 15 U.S.C. 78f. If Nasdaq registered as an exchange, it
would have its own SRO responsibilities, but the Commission does not
expect this to increase Nasdaq's current burden. In view of the
NASD's SRO status the Commission could use its authority under
Sections 17 and 19 of the Exchange Act, 15 U.S.C. 78q and 78s, to
delegate any obligations Nasdaq would have as a registered exchange
to enforce compliance by its members (and persons associated with
its members) with the federal securities laws to NASDR.
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C. Systems Excluded From Rule 3b-16
The Proposing Release specifically excluded from the proposed,
revised interpretation of ``exchange'' several types of activities that
could be considered traditional brokerage activities: order routing
systems, dealer quotation systems, and internal broker-dealer order
management and execution systems. Commenters widely agreed that
automated broker-dealer functions should not be encompassed in the
meaning of ``exchange.'' \62\ The Commission agrees. Commenters did,
however, ask for clarification about the application of the exclusions
in paragraph (b). In particular, some commenters appeared to
misunderstand Rule 3b-16 as requiring that a system fall within one of
the exclusions in paragraph (b) in order to be outside of the revised
interpretation of ``exchange.'' This was not the Commission's intent. A
system is not included within the revised interpretation of
``exchange'' if: (1) It fails to meet the two-part test in paragraph
(a) of Rule 3b-16; or (2) it falls within one of the exclusions in
paragraph (b).
---------------------------------------------------------------------------
\62\ See SIA Letter at 3, 10-11; DBSI Letter at 3; NASD Letter
at 4; TBMA Letter at 3, 14.
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The Commission has included paragraph (b) of Rule 3b-16 to
explicitly exclude some systems that the Commission believes are not
exchanges. Paragraph (b) of Rule 3b-16 expressly excludes: (1) Systems
that merely route orders to other execution facilities; and (2) systems
that allow persons to enter orders for execution against the bids and
offers of a single dealer, and systems that automate the activities of
registered market markers.
Two commenters asked the Commission to exclude from the revised
interpretation of ``exchange'' all correspondent clearing
relationships, as well as agreements among broker-dealers to handle
their respective order flow.\63\ The Commission has excluded routing
systems under Rule 3b-16(b)(1). Whether or not correspondent clearing
[[Page 70853]]
relationships are excluded, however, depends on the nature of the
systems used in that relationship. The Commission does not believe that
systems operated by clearing firms should be excluded simply because
their correspondents participate in them. The Commission believes that
such an exclusion would be overly broad.
---------------------------------------------------------------------------
\63\ See TBMA Letter at 14, n.26; SIA Letter at 10-11, n.18.
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One commenter questioned whether IDBs are the functional equivalent
of internal broker-dealer systems and, therefore, should be excluded
from Rule 3b-16.\64\ The Commission believes that most screen-based
IDBs function by displaying, on an anonymous basis, the offers to buy
and sell securities that are placed with them by subscribers. While
typically a subscriber uses a telephone to place the orders and
ordinarily use the telephone to request execution, multiple buyers and
sellers are involved, and generally customers view some or all orders
on screens. Thus, IDBs bring together the orders of multiple buyers and
sellers. Where an IDB has set procedures under which it executes
subscriber orders against displayed or retained orders in a
predetermined fashion, the methods by which these orders are brought
together likely would be established and non-discretionary. The
Commission believes that IDBs that function in this fashion are covered
by Rule 3b-16. If an IDB does not display orders or communicate them
verbally to customers, and does not execute orders according to pre-
determined, well-understood rules, it may not be covered by the rules
the Commission is adopting today. As a general matter, however, the
Commission believes that most IDBs would be covered by the definition
in Rule 3b-16(a) and not excluded by any of its exclusions.
---------------------------------------------------------------------------
\64\ TBMA Letter at 14, n.25 (suggesting that the Commission
expressly recognize the possibility that some IDBs may be able to
rely on the exclusion for internal broker-dealer systems).
---------------------------------------------------------------------------
In addition, one commenter recommended that any entity that has the
discretion to commit capital to a trade be excluded from Rule 3b-16,
because broker-dealers commit capital, but exchanges do not.\65\ The
Commission generally views the willingness to predictably commit
capital as a traditional broker-dealer activity. For this reason it is
explicitly excluding registered market maker and single dealer systems,
which commit capital in all--or almost all--trades. In addition,
broker-dealers frequently commit capital as part of their block trading
desk activities. As discussed above, the Commission does not believe
that traditional block trading desks are covered under paragraph (a) of
Rule 3b-16. However, the Commission does not believe that a system
engaging in activities as a market should be excluded from the scope of
Rule 3b-16 simply because the broker-dealer operating the system may
participate as a dealer in that system.
---------------------------------------------------------------------------
\65\ SIA Letter at 3-4, 6-7, 9.
---------------------------------------------------------------------------
Finally, one commenter asserted that ``passive systems,'' such as
POSIT,\66\ should be excluded from the Commission's revised
interpretation of ``exchange,'' because they do not have a traditional
price discovery mechanism.\67\ The Commission, however, does not agree
that systems like POSIT are simply an automation of traditional
brokerage functions, but believes they are markets. Like other markets,
``passive'' or derivative pricing systems bring together the orders of
multiple buyers and sellers. All subscribers enter orders,\68\ which
interact at pre-specified times. In addition, ``passive systems''
establish non-discretionary methods under which subscribers agree to
the terms of the trade. Such systems cross orders at pre-established
times during the day according to specified priorities, such as time
priority. While these orders are traded at a price that is not known at
the time a subscriber enters an order, the parameters under which such
price will be determined are established and not subject to discretion
by the operator of the ``passive system.'' While these systems do not
themselves have traditional price discovery mechanisms, they have the
potential to--and frequently do--affect the markets from which their
prices are derived.\69\ The Commission, however, agrees with this
commenter that these systems do not raise the same concerns as
alternative trading systems with price discovery mechanisms and,
therefore, even if such systems have significant trading volume, if
they choose to register as broker-dealers they are not required to meet
the fair access and systems capacity requirements.\70\ The Commission,
however, will monitor the activities of these passive systems and if
concerns arise with regard to their activities will reconsider whether
these requirements should apply.
---------------------------------------------------------------------------
\66\ POSIT is an alternative trading system operated by ITG Inc.
Broker-dealers and institutions enter unpriced orders to buy and
sell exchange listed and Nasdaq securities into POSIT at any time
prior to a pre-selected crossing time. At the crossing time, buy
orders in the system for each security are crossed, where possible,
with sell orders and crossed orders are executed at a price derived
from the primary market where the security trades.
\67\ Letter from Timothy H. Hosking, General Counsel, ITG Inc.,
to Jonathan G. Katz, Secretary, SEC dated Nov. 20, 1998 (``ITG
Letter'') at 2-3.
\68\ The indications of interest entered into ``passive'' or
derivative pricing systems are ``orders,'' under Rule 3b-16(c).
While the orders are entered without a specified price, subscribers
agree to trade at a price based on the primary market, such as the
mid-point of the bid and ask at the time orders are matched or at
the primary market's opening price.
\69\ In addition, there exists the incentive for subscribers to
these ``passive systems'' to manipulate the price in the market from
which the ``passive system'' derives its price in order to obtain a
favorable execution on the passive system.
\70\ See Rules 301(b)(5)(iii) and 301(b)(6)(iii), 17 CFR
242.301(b)(5)(iii) and 242.301(b)(6)(iii). See infra notes 248, 278,
241-291 and accompanying text. Further, the Commission did not
propose, nor is it adopting, a requirement that alternative trading
systems that register as broker-dealers publicly display any orders
that are not displayed to that system's subscribers. Thus,
alternative trading systems--like most ``passive'' systems--that do
not display subscriber orders at all, are not subject to the public
display requirement if they register as broker-dealers under
Regulation ATS.
---------------------------------------------------------------------------
1. Order Routing Systems
The Commission proposed to exclude from proposed Rule 3b-16 those
trading systems that merely route orders to an exchange or broker-
dealer for execution. The only commenter to address this provision was
the SIA, which expressed its support for this exclusion.\71\ The
Commission is adopting the exclusion as proposed in Rule 3b-16(b)(1).
Examples of such systems include the New York Stock Exchange's
(``NYSE's'') and the American Stock Exchange's (``Amex's'') Common
Message Switch \72\ and BRASS.\73\ Nasdaq, however, is not merely a
routing system. In addition to SelectNet's routing capabilities, Nasdaq
is a quotation facility, permits executions through its SOES system,
and establishes rules for its members regarding the firmness of their
bids and offers and how members deal with each other.
---------------------------------------------------------------------------
\71\ SIA Letter at 10.
\72\ A similar system, also operated by the Amex, is Automated
Post Execution Reporting System, or AutoPERS.
\73\ BRASS is an order routing system operated by Automated
Securities Clearance, Ltd. (``ASC''). ASC provides system users with
software and hardware that enables users to enter orders into the
system which are then routed to an exchange or Nasdaq for execution.
BRASS software enables a market maker to execute orders against its
inventory at the market maker's quoted price, monitor compliance
with the Commission's Limit Order Display Rule, infra note 76, route
an order to another market maker or market, report executed
transactions, and monitor, among other things, trading positions,
and profit/loss margins. Separately, an entity affiliated with ASC,
the BRASS Utility, LLC (``BRUT''), operates an electronic
communications network (``ECN'') to which orders can be routed
through the use of BRASS software. See infra note 178.
---------------------------------------------------------------------------
The Commission does not believe that these routing systems meet the
two-part test in paragraph (a) of Rule 3b-16 because they do not bring
together orders of multiple buyers and sellers.
[[Page 70854]]
Instead, all orders entered into a routing system are sent to another
execution facility. In addition, routing systems do not establish non-
discretionary methods under which parties entering orders interact with
each other.
2. Dealer Systems
In the Proposing Release, the Commission discussed the application
of proposed Rule 3b-16 to single dealer systems. Such systems automate
the order routing and execution mechanisms of a single market maker and
guarantee that the market maker will execute orders submitted to it at
its own posted quotation for the security or, for example, at the
inside price quoted on Nasdaq. Because single market maker systems
merely provide a more efficient means of executing the trading interest
of separate customers with one dealer, the Commission stated that they
should not be considered exchanges. Accordingly, the Commission
proposed to explicitly exclude from proposed Rule 3b-16 those trading
systems that display the quotations of a single dealer and allow
persons to enter orders for execution against the dealer's proprietary
account, usually at the dealer's quote. This exclusion was intended to
encompass systems operated by third market makers,\74\ as well as those
systems operated by dealers, primarily in debt securities, who display
their own quotations to customers and other broker-dealers on
proprietary or vendor screens.
---------------------------------------------------------------------------
\74\ Third market firms are NASD member firms that execute
orders for exchange-listed securities.
---------------------------------------------------------------------------
The Commission is today adopting paragraph (b)(2) of Rule 3b-16 to
exclude systems that display quotes of a single dealer and allow
persons to enter orders for execution against the bids and offers of a
single dealer. If a market maker executes a customer order at the
National Best Bid or Offer (``NBBO''), rather than at its displayed bid
or offer, the Commission will consider the NBBO as the market maker's
quote for purposes of that trade. As in the proposal, paragraph (b)(2)
is intended to exclude from Rule 3b-16 all dealers, including third
market makers.
The Commission received two comment letters asking the Commission
to reconsider its proposed exclusion of third market makers.\75\ These
commenters disagreed with the Commission's distinction between third
market makers and exchanges, and stated that these systems compete
directly with the regional exchanges for order flow. Consequently,
these commenters suggested that the Commission include third market
makers within its revised interpretation of ``exchange.'' As discussed
in the Proposing Release, however, the Commission does not believe that
a single dealer that automates its means of communicating trading
interest to customers is a market. Instead, such systems automate
functions traditionally performed by dealers.
---------------------------------------------------------------------------
\75\ See Letter from David E. Rosedahl, Executive Vice President
and Chief Regulatory Officer, Pacific Exchange, Inc. to Jonathan G.
Katz, Secretary, SEC, dated Aug. 20, 1998 (``PCX Letter'') at 2-6;
CHX Letter at 3-4.
---------------------------------------------------------------------------
Accordingly, the exclusion the Commission is adopting today in
paragraph (b)(2) of Rule 3b-16 is intended to cover systems operated by
third market makers. Because of the Commission's own rules and those of
the SROs, a third market maker's quote may not always reflect its own
bids and offers, but may--at times--represent a customer limit order.
The Limit Order Display Rule \76\ requires third market makers (among
others) to display customer limit orders in a security that are at a
price that would improve the bid or offer of such market maker in that
security. The Commission does not believe that a market maker engaging
principally in the business of trading for its own account should be
included within Rule 3b-16 solely because it is complying with the
Limit Order Display Rule. Consequently, in the Proposing Release the
Commission stated that, for purposes of this exclusion, if a dealer
displayed a customer order to comply with a Commission or SRO rule,
that customer order would be considered to be the ``dealer's quote.''
\77\ To ensure that Rule 3b-16 clearly excludes such dealers, the
Commission is adopting paragraph (b)(2)(ii) of Rule 3b-16. Paragraph
(b)(2)(ii) excludes a registered market maker that displays its own
quotes and customer limit orders, and allows its customers and other
broker-dealers to enter orders for execution against the displayed
orders. The exclusion also allows such a registered market maker, as an
incidental activity resulting from its market maker status, to match or
cross orders for securities in which it makes a market, even if those
orders are not displayed.\78\
---------------------------------------------------------------------------
\76\ Rule 11Ac1-4(b)(1)(i), 17 CFR 240.11Ac1-4(b)(1)(i).
\77\ Proposing Release, supra note 3, at n.9.
\78\ Rule 3b-16(b)(2)(ii), 17 CFR 240.3b-16(b)(2)(ii).
---------------------------------------------------------------------------
Two other commenters expressed their support for the single dealer
exclusion.\79\ One of these commenters, however, suggested that the
Commission modify the exclusion so that trading systems that display
the quotes of a dealer and its affiliates and allow persons to execute
against those quotes be excluded from Rule 3b-16.\80\ The Commission is
adopting the exclusion from Rule 3b-16 for single dealer systems, but
does not agree with this commenter that a dealer's affiliates should be
included in the exclusion.
---------------------------------------------------------------------------
\79\ See SIA Letter at 10; DBSI Letter at 3.
\80\ DBSI Letter at 3.
---------------------------------------------------------------------------
In addition, one commenter requested that the Commission clarify
whether the exclusion for dealer quotation systems would apply to
systems that allow other broker-dealers to execute against a single
dealer's quotations.\81\ The Commission intends for this exclusion to
cover dealer quotation systems that permit other broker-dealers to
execute against the dealer's quotations and realizes that its use of
the term ``customer'' in the proposal would preclude this. Accordingly,
the Commission is adopting the exclusion in paragraph (b)(2) so that it
encompasses single dealer systems that allow any person to enter orders
for execution against that dealer's quotes.\82\ A single dealer system
could also match orders that are not displayed to any person other than
the dealer and its employees, provided this matching is only incidental
to its primary activity as a dealer.\83\
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\81\ SIA Letter at 11.
\82\ Rule 3b-16(b)(4), 17 CFR 240.3b-16(b)(4).
\83\ Rule 3b-16(b)(2)(i), 17 CFR 240.3b-16(b)(2)(i).
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D. Examples of Systems Illustrating Application of Rule 3b-16
The following examples are provided to illustrate various
applications of Rule 3b-16.\84\ While these examples are intended to
provide guidance, the application of Rule 3b-16 will be fact-specific.
---------------------------------------------------------------------------
\84\ These systems may also implicate other provisions of the
federal securities laws.
---------------------------------------------------------------------------
1. Examples of Systems Included Within Rule 3b-16
a. System A is a trading floor that maintains a continuous two-
sided auction market under a unitary specialist system. Through the use
of an electronic communication system, orders are transmitted from
member firms to the floor and execution reports are transmitted from
the floor to the member firms. System A also has an automated routing
and small order execution system. Price discovery occurs through the
interaction of bids and offers of market participants under the
application of System A's rules of priority, parity, and precedence.
The specialist's dealings are subject to compliance obligations
established by System A. System A is included under Rule 3b-16.
[[Page 70855]]
b. System B allows participants to enter, replace, or cancel limit
orders prior to a pre-established auction cutoff time. Bids and offers
(including price and size) are displayed in the System B's order book,
which participants can view on their screens. After the cutoff time,
the system reviews all orders with respect to each security and
determines the price at which the volume of buying interest is closest
to the volume of selling interest. That price is the ``auction price.''
Participants that have entered bids at or above, and offers at or
below, the auction price receive an execution at the auction price on
the basis of time priority up to the available size. Matched orders are
executed by a registered broker-dealer. System B is included under Rule
3b-16.
c. System C allows participants to enter limit orders and matches
those orders with other orders in System C based on internal
parameters. System C displays unmatched limit orders in the system's
book on an anonymous basis to all participants. The broker-dealer
operating System C acts as a riskless principal in executing all
matched orders. System C is included under Rule 3b-16.
d. System D limits participation to institutional investors that
trade illiquid restricted securities. To offer a security, a seller
notifies System D as to the security, the price and the amount offered.
After System D accepts an order, it enters it into the system where it
is posted anonymously. Prospective purchasers may accept a posted order
or seek to negotiate a transaction by contacting System D. System D
facilitates the purchase and sale of securities through the system on
an agency basis. Participants enter a bid or offer by calling a
dedicated telephone number at System D. Once each side of the
transaction agrees to the terms of the trade, System D obtains
necessary documentation from the participants and reviews all the
documentation. Once all the documentation has been processed, System D
notifies the parties setting the transfer and settlement date, at which
time System D will coordinate the transfer of funds and the issuer is
notified to effect the transfer on its books. System D is included
under Rule 3b-16.
e. System E allows participants to enter orders for securities by
computer, facsimile, or telephone. Those orders are not displayed to
other participants. System E crosses orders at specified times at a
price derived from another market such as the closing price, a volume
weighted average price, or the midpoint between the closing bid and ask
on the primary market. System E is included under Rule 3b-16, but would
be exempt from the requirements of Regulation ATS under Rule 301(a)(5)
if it is registered as a broker-dealer.
f. System F displays, on an anonymous basis, firm offers to buy and
sell securities from its participants. Participants typically telephone
an employee of System F to place a bid or offer, which the employee
enters into the system for display to other participants. To execute
against a bid or offer displayed on the computer screen, a participant
telephones an employee at System F. The employee is required to execute
the participant's order against the displayed order if it matches.
System F is included under Rule 3b-16. If System F allowed subscribers
to execute against a displayed order by sending a message
electronically, it would also be included under Rule 3b-16.
g. System G permits competing market makers to post continuous two-
sided quotes in certain securities. Quotes are consolidated and
disseminated to subscribers electronically. System G maintains and
enforces rules setting standards for the posting of quotes and
executions. Trades are executed by subscribers calling market makers
outside the system and executing trades based on quotes displayed in
the system. System G is included under Rule 3b-16.
h. System H is owned and operated by a bank. System H permits
registered broker-dealers to place orders to buy or sell securities at
specified prices and sizes and have those orders displayed to all users
on an anonymous basis. Registered broker-dealers may trade both for
their own account or on an agency basis on behalf of their customers.
System H automatically executes an order if it matches an existing
order. If no match is immediately available, System H displays the
order on the system on an anonymous basis to all users. System H is
included under Rule 3b-16.
i. System I permits participants to enter a range of ranked
contingent buy and sell orders at which they are willing to trade
securities. These orders are matched based on a mathematical algorithm
whose priorities are designed to achieve the participants' objectives.
System I does not display orders to any participants. System I is
included under Rule 3b-16.
2. Examples of Systems Not Included Within Rule 3b-16
a. System J routes orders from broker-dealers to registered
exchanges or to other broker-dealers for execution. System J also
routes execution reports back to the broker-dealers that entered the
orders. System J provides no facility for execution, but rather only
acts as a communications system for the transmission of orders and
execution reports. System J falls within the exclusion in paragraph
(b)(1) of Rule 3b-16.
b. System K displays a registered market maker's quotes in
exchange-listed securities and permits subscribers to submit orders for
those securities to the market maker. Limit orders are displayed in the
market maker's quote pursuant to requirements under the Commission's
order execution rules. Market orders are executed against the market
maker's quote or at the NBBO or at a price better than the NBBO. Limit
orders are held until marketable. System K falls within the exclusion
in paragraph (b)(2) of Rule 3b-16.
c. System L allows a dealer to disseminate its proprietary
quotations to its customers and permits customers to transmit orders to
buy from or sell to that dealer at those quoted prices. System L is not
included under Rule 3b-16 because it falls within the exclusion in
paragraph (b)(2) of Rule 3b-16.
d. System M is operated by a broker-dealer that makes markets in
Nasdaq securities. System M permits the broker-dealer's customers, as
well as other broker-dealers (including correspondent broker-dealers
with whom it has a clearing arrangement) to send orders electronically
or by telephone to the broker-dealer. An order transmitted
electronically goes directly to the system server. An order transmitted
by phone is received by an employee of the broker-dealer, who enters it
into the System M. If it is a market order for a Nasdaq security in
which the broker-dealer makes a market, System M checks to see if the
order can be crossed against a customer limit order held by the broker-
dealer. If two customer orders cannot be crossed, System M
automatically executes the market order against the firm's inventory if
the order size is at or below certain parameters. If the order size
exceeds those parameters, the market order will be routed to a trader
for manual execution against the firm's inventory, or other handling as
the trader determines. If the order is for a security in which the
broker-dealer does not make a market, System M sends the order to a
market maker in the security or to another market for execution. System
M falls within the exclusions in paragraph (b)(1) and (b)(2) of Rule
3b-16.
e. System N allows participants to post the names of securities
they wish to buy or sell. Other participants view
[[Page 70856]]
this ``bids wanted list'' or ``offers wanted list'' and place bids or
offers for the specified securities during a defined auction period.
The participant who posted the security on the ``bids wanted list'' or
``offers wanted list'' may either accept or reject the best bid or
offer at the close of the auction. System N is not included under Rule
3b-16 because there is only one seller.
f. System O permits correspondent firms of a broker-dealer to send
orders electronically to that broker-dealer. The broker-dealer executes
the orders against its own inventory. System O falls within the
exclusion in paragraph (b)(2)(i) of Rule 3b-16.
g. System P is an Internet web site set up by an issuer. Through
this web site, the issuer provides information to prospective buyers
and sellers of its common stock. Prospective buyers and sellers post
their identities, contact information, and the number of shares offered
or sought at a given price. The issuer makes that information, along
with the date the information was submitted, available to prospective
buyers and sellers. The participants contact each other outside of the
web site to execute trades. System P is not included under Rule 3b-16
because it does not establish non-discretionary methods under which
buyers and sellers interact.
h. System Q is a screen-based system on which broker-dealers post
indications of interest to institutional customers in the securities
the broker-dealers wish to trade and advertise trades they have
recently conducted. System R sets no requirements and provides no
procedures regarding whether or how posted quantities and prices of
securities can be executed. System Q is not included under Rule 3b-16
because it does not establish non-discretionary methods under which
buyers and sellers interact.
i. System R is an internal system operated by a broker-dealer to
display only to its registered representatives the prices and sizes of
securities offered for sale by the firm in its capacity as a dealer. A
registered representative can enter a buy order, specifying price and
size, on behalf of its customer. If the terms of the customer's order
match the dealer's posted offer, System R automatically executes the
order. If the terms are different, System R places the customer's order
on the screen for later matching. Assuming the matches of customer
orders are merely incidental relative to the dealer's own trades,
System R falls within the exclusion in paragraph (b)(2)(i) of Rule 3b-
16.
j. System S permits an issuer to post prices to sell its own
securities to a broker-dealer's customers. The issuer is under no
obligation to post prices on the system and may choose to do so at any
time. If a customer accepts the posted price and size, System S routes
the order to the issuer who retains discretion to accept or reject the
trade. If the posted price or size is not accepted as posted, System S
automatically alerts the issuer that further negotiation is necessary.
System S is not included under Rule 3b-16 because it has only one
seller and, therefore, fails to meet the ``multiple buyers and sellers
requirement.''
k. System T facilitates the clearance and settlement of securities
products. Participating IDBs disseminate and match trading interest
through their own proprietary trading screens to their own customers.
The participating IDBs then submit matched transactions between their
customers to System T for clearance and settlement. The IDBs' screens
are not linked together and the IDBs interact only with those dealers
using the system. The customers' orders interact only with the quote of
the IDB of which they are a customer and do not interact with the other
customer orders of that IDB. Dissemination and execution of orders by
the IDBs is governed solely by their rules and not by System T.\85\
System T is not included under Rule 3b-16.
---------------------------------------------------------------------------
\85\ In some cases, however, the systems operated by the
interdealer brokers may fall within Rule 3b-16. See supra System F.
---------------------------------------------------------------------------
E. Exemption From the Definition of ``Exchange''
Section 36 of the Exchange Act \86\ gives the Commission broad
authority to exempt any person, security, or transaction from
provisions of the Exchange Act and the rules thereunder. Such an
exemption may be subject to conditions. Using this authority, the
Commission is adopting Rule 3a1-1.\87\ This rule exempts from the
definition of ``exchange'': (1) Any alternative trading system that
compies with Regulations ATS \88\ (2) any alternative trading system
that under Rule 301(a) of Regulation ATS is not required to comply with
regulation ATS and alternative trading system operated by a national
securities association,\89\ and (3) any alternative trading system
operated by a national securities association.\90\ Finally, as
described more fully below,\91\ paragraph (b)(1) of Rule 3a1-1 also
conditions an alternative trading system's exemption on the absence of
a Commission determination that the exemption in a particular case is
not ``necessary or appropriate in the public interest or consistent
with the protection of investors.'' \92\
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\86\ 15 U.S.C. 78mm.
\87\ 17 CFR 240.3a1-1.
\88\ 17 CFR 240.3a1-1(a)(2). See infra note and accompanying
text for the definition of an alternative trading system.
\89\ 17 CFR 240.3a1-1(a)(3). See notes--and accompanying text.
\90\ 17 CFR 240.3a1-1(a)(1).
\91\ See infra Section III.F.
\92\ Rule 3a1-1(b), 17 CFR 240.3a1-1(b).
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The Commission has determined that this exemption is in the public
interest and will promote efficiency, competition, and capital
formation because it has the effect of providing alternative trading
systems with the option of positioning themselves in the marketplace as
either registered exchanges or as broker-dealers. The Commission
believes that allowing alternative trading systems to make a business
decision about how to register with the Commission will continue to
encourage the development of new and innovative trading facilities. The
Commission has also determined that this exemption is consistent with
the protection of investors because investors will benefit from
conditions governing an alternative trading system, in particular
Regulation ATS's enhanced transparency, market access, system
integrity, and audit trail provisions.
Moreover, because national securities associations are subject to
requirements virtually identical to those applicable to national
securities exchanges,\93\ Rule 3a1-1 also exempts from the definition
of ``exchange'' any alternative trading system operated by a national
securities association.\94\ The Commission believes that the regulation
of alternative trading systems operated by a national securities
association is adequate, and therefore, that such systems should not be
required to register either as exchanges, or as broker-dealers and
comply with Regulation ATS. Consequently, trading systems operated by
national securities associations may continue to operate as they do
now.
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\93\ Registration as a national securities association under
section 15A of the Exchange Act is voluntary. 15 U.S.C. 78o-3.
Currently the only national securities association is the NASD,
which operates Nasdaq.
\94\ Rule 3a1-1(a)(1). See also Rule 301(a)(3) (excluding
alternative trading systems operated by a national securities
association from the scope of proposed Regulation ATS).
---------------------------------------------------------------------------
Finally, in response to a commenter's request that the Commission
clarify that the exemption from the definition of ``exchange'' provided
in Rule 3a1-1(a)(2) includes broker-dealers that are excluded from the
scope of Regulation ATS by Rule 301(a),\95\ the Commission is adding
paragraph (a)(3) to Rule 3a1-
[[Page 70857]]
1. The Commission intended for broker-dealers that perform only
activities delineated in Rule 301(a) to be exempt from the definition
of exchange under Rule 3a1-1, and is making this clear by adding this
new paragraph.\96\
---------------------------------------------------------------------------
\95\ Instinet Letter at 8, n.11.
\96\ 17 CFR 240.3a1-1(a)(3).
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The Commission intends for the exemption provided by Rule 3a1-1 to
make clear that alternative trading systems that register as broker-
dealers and comply with Regulation ATS not be regulated as national
securities exchanges. The Commission believes that the requirements in
Regulation ATS as adopted will address the market-like functions of
alternative trading systems without imposing requirements applicable to
exchanges that might not fit comfortably with certain alternative
trading systems' structures and businesses.
In the Proposing Release, the Commission requested comment on
whether an exclusion from the definition in Rule 3b-16 for alternative
trading systems that register as broker-dealers and comply with the
provisions of Regulation ATS would be preferable to the exemption under
Rule 3a1-1. Several commenters expressed a preference for an exclusion,
rather than an exemption.\97\ Most of these commenters were concerned
that foreign regulators would view these systems, currently registered
as broker-dealers, as exchanges if they were now exempted from the
definition of exchange rather than excluded from it. The Commission
believes that its new framework being adopted today represents a
carefully balanced approach to the regulation of markets that is
grounded in the particular statutory structure of the Exchange Act.
First, the Commission notes that its exemption for alternative trading
systems applies to the definition of an exchange. By exempting
alternative trading systems from this definition, the Commission is
making clear its view that these systems should not be treated as
exchanges under the Exchange Act or in any other context. Moreover, the
Commission does not intend its interpretation of exchange to be used
outside of the Exchange Act context. The Commission strongly cautions
against applying this interpretation in other contexts where its
effects will differ from those under the Exchange Act. The Commission
also believes that application in another context of only one element
of the structure adopted today would be inappropriate and would
seriously call into question the validity of the interpretation in that
context.
---------------------------------------------------------------------------
\97\ See TBMA Letter at 12-13 (expressing concern that foreign
regulators might be influenced by the Commission's categorization of
a system as an ``exchange,'' even if that system chose to be
regulated in the U.S. as a broker-dealer); Instinet Letter at 3, 6-
7, 13-14 and 6-7, n.9 (stating that classifying a securities firm as
an exchange in the U.S. could significantly impair a firm's ability
to participate in foreign markets * * * because a number of foreign
regulators may regard all broker-dealers covered by the expanded
`exchange' definition as `exchanges'). See also CBB Letter at 3.
---------------------------------------------------------------------------
Another concern raised by at least one commenter was that investors
could be influenced in how they view a trading system, if such trading
system is included within the Commission's interpretation of
``exchange.'' \98\ The Commission believes that investors' views of
systems are shaped more by the functions those systems perform than by
the way they are classified. The Commission also believes that the
enhanced regulation of alternative trading systems that choose to
remain registered as broker-dealers that is provided by Regulation ATS
provides more protection for the investors who use these systems.
---------------------------------------------------------------------------
\98\ TBMA Letter at 12.
---------------------------------------------------------------------------
In the Proposing Release, the Commission also requested comment on
the scope, form, and conditions of the exemption in Rule 3a1-1.
Commenters generally approved of the Commission's proposal to allow
alternative trading systems the choice to register as exchanges or be
exempt from the definition of ``exchange'' by registering as broker-
dealers and complying with Regulation ATS.\99\ One commenter questioned
whether national securities exchanges would have the choice to register
as alternative trading systems, in effect ceasing to act as SROs and
electing instead to be regulated as a broker-dealer under Regulation
ATS.\100\ The Commission believes that, as a general matter, national
securities exchanges do have this choice under the rules the Commission
is adopting today.\101\ Any national securities exchange making this
choice would, of course, be required to give up its SRO functions and
privileges, and to register as a broker-dealer and become a member of a
national securities association or other SRO.\102\ That organization
would then act as the SRO for this alternative trading system. If a
national securities exchange chose, as part of this restructuring, to
allow its members to form their own national securities association to
operate this new alternative trading system, that alternative trading
system would be run directly by a national securities association, and,
as stated above, would be regulated in a manner that was equivalent to
being regulated as a national securities exchange.\103\
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\99\ See Letter from Mike Cormack, Manager, Equity Trading,
American Century to Jonathan G. Katz, Secretary, SEC, dated Aug. 12,
1998 (``American Century Letter'') at 1-2 (supporting the
Commission's proposal to permit alternative trading systems to
register as exchanges because it would provide an option for
innovators, and noting alternative trading systems' objection to the
NASD's proposed central limit order book based on the belief that an
SRO regulating alternative trading systems should not operate a
competing system); NASD Letter at 3 (commenting that both
registration as an exchange and Regulation ATS ``generally appear to
ensure that alternative trading systems operate with the appropriate
levels of investor protection, while affording alternative trading
systems the necessary flexibility to choose between different models
of regulation''); CME Letter at 3 (generally supporting the
additional requirements for alternative trading systems because they
will improve investor protection and lessen the regulatory disparity
that currently exists between alternative trading systems and
traditional exchanges); Instinet Letter at 7, n.10 (stating that the
Commission should modify the exemption in Rule 3a1-1 from exchange
registration so that alternative trading systems that, while acting
in good faith, fail to comply fully with each of the technical
requirements of Regulation ATS do not violate Sections 5 and 6 of
the Exchange Act); ICI Letter at 2; IBEX Letter at 4.
\100\ CHX Letter at 6 (questioning why traditional exchanges
should not have the opportunity to make the same choice as
alternative trading systems, and commenting that SROs should be
permitted to form subsidiaries that were alternative trading systems
registered as broker-dealers).
\101\ In making this significant decision, a national securities
exchange would have to follow its constitution and by-laws
(including provisions concerning membership votes), and any
applicable state law requirements.
\102\ Section 15(b)(8) of the Exchange Act requires any broker-
dealer engaging in transactions other than solely on a national
securities exchange of which it is a member, to become a member of a
national securities association. 15 U.S.C. 78o(b)(8).
\103\ The Commission does not mean to imply that national
securities exchanges cannot make this choice. The Commission is
merely pointing out that if a national securities exchange does so,
it cannot continue to act as its own SRO.
---------------------------------------------------------------------------
F. Commission's Authority To Require Registration as an Exchange
Rule 3a1-1(b) contains an exception to the exemption from the
exchange definition. Under this exception, the Commission effectively
may require a trading system that is a substantial market (as set forth
in the rule) to register as a national securities exchange if it finds
in a particular case that it is necessary or appropriate in the public
interest or consistent with the protection of investors.\104\ In
particular, the Commission could deny or withhold exemptive status from
a trading system that otherwise meets the exemptive conditions under
Rule 3a1-1(a). Although the standard for denying or withholding the
exemption is based on objective factors, the Commission has discretion
whether to initiate any process to consider whether to revoke a
[[Page 70858]]
particular entity's exemption under the rule.
---------------------------------------------------------------------------
\104\ Rule 3a1-1(b), 17 CFR 240.3a1-1(b)(1).
---------------------------------------------------------------------------
Specifically, under Rule 3a1-1(b), if an organization, association,
or group of persons meets certain, specified volume levels, the
Commission could consider whether registration as an exchange is
necessary. The Commission will not consider making an assessment
whether a particular system should register as an exchange unless that
system, during three of preceding four calendar quarters had: (1) Fifty
percent or more of the average daily dollar trading volume in any
security and five percent or more of the average daily dollar trading
volume in any class of security; or (2) Forty percent or more of the
average daily dollar trading volume in any class of securities. The
Commission would also provide such a system with notice and an
opportunity to respond before determining that exemption from
registration as an exchange is not appropriate in the public interest.
In making that determination, the Commission would take into account
the requirements for exchange registration under section 6 of the
Exchange Act and the objectives of the national market system under
section 11A of the Exchange Act. For example, it may not be consistent
with the protection of investors or in the public interest for a
trading system that is the dominant market, in some important segment
of the securities market, to be exempt from registration as an exchange
if competition cannot be relied upon to ensure fair and efficient
trading structures in that case. In that case it may be necessary for
the Commission's greater oversight authority over registered exchanges
to apply.\105\ As another example, if the Commission believed that an
exemption under Rule 3a1-1 for a particular trading system that meets
the volume thresholds would create systemic risk or lead to instability
in the securities markets' infrastructure, it could determine that an
exemption from registration as an exchange was not appropriate in the
public interest or consistent with the protection of investors.
---------------------------------------------------------------------------
\105\ The Commission does not mean to imply that the NASD will
be required to register Nasdaq as a national securities exchange. As
stated above, because Nasdaq is operated by a national securities
association, it is currently subject to requirements virtually
identical to those applicable to national securities exchanges. Any
alternative trading system, however, currently operated by a
national securities association could choose to register as an
exchange.
---------------------------------------------------------------------------
The Commission believes that there are alternative trading systems
operating today that exceed the volume levels in paragraph (b)(1) of
Rule 3a1-1. However, the Commission does not believe at this time that
there are any alternative trading systems--given their current
operations--for which the exemption from the definition of exchange in
paragraph (a) of Rule 3a1-1 is not appropriate.
In addition, under section 19(c)(3) of the Exchange Act,\106\ the
Commission has the authority to promulgate rules for the de-
registration of an exchange. In order to ensure a smooth transition for
exchanges that wish to de-register and become registered broker-dealers
subject to Regulation ATS, the Commission will consider promulgating
de-registration rules. Such rules would also give the Commission the
opportunity to formally consider whether certain exchanges should be
prohibited from de-registering, just as Rule 3a1-1(b) gives the
Commission the opportunity to consider whether certain alternative
trading systems registered as broker-dealers should be compelled to
register as exchanges.
---------------------------------------------------------------------------
\106\ 15 U.S.C. 78s(c)(3).
---------------------------------------------------------------------------
IV. Regulation of Alternative Trading Systems
Securities markets have become increasingly interdependent. The use
of technology permits market participants to link products, implement
complex hedging strategies across markets and across products, and
trade on multiple markets simultaneously. While these opportunities
benefit many investors, they may also create misallocations of capital,
widespread inefficiency, and trading fragmentation if markets are not
coordinated. In addition, a lack of coordination among markets has the
potential to increase system-wide risks. Congress adopted the 1975
Amendments, in part, to address these negative effects of potentially
fragmented markets.\107\ The Commission believes that it is consistent
with Congress' goals to integrate significant alternative trading
systems into the national market system.
---------------------------------------------------------------------------
\107\ See S. Rep. No. 75, 94th Cong., 1st Sess. 8 (1975) at 2,
8; H.R. Rep. No. 229, 94th Cong., 1st Sess 92 (1975).
---------------------------------------------------------------------------
In the 1975 Amendments, Congress specifically endorsed the
development of an national market system, and sought to clarify and
strengthen the Commission's authority to promote the achievement of
such a system.\108\ Because of uncertainty as to how technological and
economic changes would affect the securities markets, Congress
explicitly rejected mandating specific components of an national market
system.\109\ Instead, Congress recognized that the securities markets
dynamically change and, accordingly, granted the Commission broad
authority to oversee the implementation, operation, and regulation of
the national market system in accordance with Congressional goals and
objectives.\110\
---------------------------------------------------------------------------
\108\ See supra note 6.
\109\ See S. Rep. No. 75. supra note 107. ``(T)he increasing
tempo and magnitude of the changes that are occurring in our
domestic and international economy make it clear that the securities
markets are due to be tested as never before,'' and that it was,
therefore, important to assure ``that the securities markets and the
regulations of the securities industry remain strong and capable of
fostering (the) fundamental goals (of the Exchange Act) under
changing economic and technological conditions.'' Id. at 3.
\110\ S. Rep. No. 75 supra note 107, at 8-9.
---------------------------------------------------------------------------
Congress identified two paramount objectives in the development of
an national market system: the maintenance of stable and orderly
markets with maximum capacity, and the centralization of all buying and
selling interest so that each investor has the opportunity for the best
possible execution of his or her order, regardless of where the
investor places the order.\111\ In addition, Congress directed the
Commission to remove present and future competitive restrictions on
access to market information and order systems, and to assure the equal
regulation of markets, exchange members, and broker-dealers effecting
transactions in the national market system.\112\ In particular,
Congress found that it was in the public interest to assure ``fair
competition * * * between exchange markets and markets other than
exchange markets.'' \113\
---------------------------------------------------------------------------
\111\ S. Rep. No. 75 supra note 107, at 7; see Section
11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k-1(a)(1)(C).
\112\ See S. Rep. No. 75 supra note 107, at 104-05.
\113\ Section 11A(a)(1)(C)(ii) of the Exchange Act, 15 U.S.C.
78k-1(a)(1)(C)(ii). A fundamental goal of a national market system
was to ``achieve a market characterized by economically efficient
executions, fair competition, (and the) broad dissemination of basic
market information.'' S. Rep. No. 75 supra note 107, at 101.
---------------------------------------------------------------------------
To further national market system goals, Congress granted the
Commission broad authority to make rules, including those to: (1)
Prevent the use and publication of deceptive trade and order
information; (2) assure the prompt, accurate, and reliable distribution
of quotation and transaction information; (3) enable non-discriminatory
access to such information; and (4) assure that all broker-dealers
transmit and direct orders for securities in a manner consistent with
the operation of a national market system.\114\ Moreover, Congress
recognized that in order to implement national market system goals, the
Commission would need to classify markets, firms, and securities and
facilitate the development of
[[Page 70859]]
``subsystems within the national market system.'' \115\
---------------------------------------------------------------------------
\114\ See Section 11A(c)(1) of the Exchange Act, 15 U.S.C. 78k-
1(c)(1).
\115\ S. Rep. No. 75 supra note 107, at 7.
---------------------------------------------------------------------------
The Commission believes the rules it is adopting today advance
national market system goals. At present, alternative trading systems
are not fully integrated into the national market system, leaving gaps
in market access and fairness, systems capacity, transparency, and
surveillance. These concerns, together with the increasing significance
of alternative trading systems, call into question the fairness of
current regulatory requirements, the effectiveness of existing national
market system mechanisms, and the quality of public secondary markets.
Under the rules the Commission is adopting today, alternative trading
systems that have the most significant effect on our markets will be
required to integrate their trading into national market system
mechanisms. Alternative trading systems may choose to register either
as national securities exchanges or as broker-dealers. Systems that
elect broker-dealer regulation will be integrated into the national
market system under Regulation ATS if they have significant trading
volume.\116\ Discussed in Section IV.A. below are the requirements for
alternative trading systems that choose to register as broker-dealers
and comply with Regulation ATS. Any alternative trading system that
registers as a national securities exchange will be obligated--as
currently registered exchanges are--to participate in the national
market system mechanisms. Section IV.B. contains a discussion of the
requirements applicable to alternative trading systems that choose to
register as exchanges.
---------------------------------------------------------------------------
\116\ In addition to its authority under section 11A of the
Exchange Act, 15 U.S.C. 78k-1, the Commission is adopting Regulation
ATS pursuant to its rulemaking power under other parts of the
Exchange Act, including sections 3(b) (power to define terms),
15(b)(1) (registration and regulation of broker-dealers), 15(c)(2)
(prescribing means reasonably designed to prevent fraud), 17(a)
(books and records requirements), 17(b) (inspection of records),
23(a)(1) (general power to make rules and classify persons,
securities, and other matters), and 36 (general exemptive
authority). 15 U.S.C. 78c(b), 78o(b)(1), 78o(c)(2), 78q(a), 78q(b),
78w(a)(1), and 78mm, respectively. For a discussion on the general
exemptive authority in section 36 of the Exchange Act, 15 U.S.C.
78mm, see infra Section VII.D.1.
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A. Regulation ATS
1. Scope of Regulation ATS
a. Definition of Alternative Trading System
The Commission proposed to define the term ``alternative trading
system'' as any system that: (1) Constitutes, maintains, or provides a
marketplace or facilities for bringing together purchasers and sellers
of securities or for otherwise performing with respect to securities
the functions commonly performed by a stock exchange under Exchange Act
Rule 3b-16; \117\ and (2) does not set rules governing the conduct of
subscribers other than the conduct of such subscribers' trading on such
organization, association, person, group of persons, or system, or
discipline subscribers other than by exclusion from trading.\118\ This
proposed definition would have the effect of precluding any trading
system that performs self-regulatory functions from opting to register
as a broker-dealer, rather than as an exchange. Such a system would
consequently be required to register as an exchange or be operated by a
national securities association. Nothing, however, would prevent a
registered exchange from giving up its self-regulatory functions and
choosing instead to comply with Regulation ATS.\119\
---------------------------------------------------------------------------
\117\ See supra Section III (discussing Rule 3b-16).
\118\ Rule 300(a), 17 CFR 242.300(a).
\119\ See supra note and accompanying text. The Commission has
the authority to require significant markets to remain registered as
exchanges. See supra Section III.F.
---------------------------------------------------------------------------
The Commission received only one comment on this proposed
definition. This commenter suggested that the proposed definition for
alternative trading systems was too complex and should instead, simply
be defined as an exchange that does not set conduct rules or discipline
subscribers.\120\ Under the framework the Commission is adopting today,
an alternative trading system is exempt from the definition of an
exchange if it registers as a broker-dealer and complies with
Regulation ATS.\121\
---------------------------------------------------------------------------
\120\ PCX Letter at 3.
\121\ Rule 3a1-1(a)(2), 17 CFR 240.3a1-1(a)(2).
---------------------------------------------------------------------------
Because the Commission continues to believe that any system that
uses its market power to regulate its participants should be regulated
as an SRO, the Commission is adopting the definition of alternative
trading system as proposed. The Commission would consider a trading
system to be ``governing the conduct of subscribers'' outside the
trading system if it imposed on subscribers, as conditions of
participation in trading, any requirements for which the trading system
had to examine subscribers for compliance. In addition, if a trading
system imposed as conditions of participation, directly or indirectly,
restrictions on subscribers' activities outside of the trading system,
the Commission believes that such a trading system should be a
registered exchange or operated by a national securities association.
For example, the Commission would not consider a trading system to be
an alternative trading system, as defined in Rule 300(a), if that
trading system prohibited subscribers from placing orders on its system
at prices inferior to those subscribers place on other systems. The
Commission believes such rules should only be imposed and enforced by
regulatory bodies because of the potential that they may be applied for
anti-competitive purposes. The Commission does not intend for this
limitation to preclude an alternative trading system from imposing
credit conditions on subscribers or requiring subscribers to submit
financial information to the alternative trading system.
b. Exclusion of Trading Systems Registered as Exchanges or Operated by
a National Securities Association
The Commission proposed to exclude from the scope of Regulation ATS
certain alternative trading systems that are subject to other
appropriate regulations. In particular, Rule 301(a) would exclude
alternative trading systems (1) registered as exchanges, (2) exempt
from exchange registration based on limited volume,\122\ or (3)
operated by a national securities association. These systems are
subject to regulation as markets under other provisions of the Exchange
Act. The Commission is adopting these exclusions as proposed.
---------------------------------------------------------------------------
\122\ See supra note 33.
---------------------------------------------------------------------------
c. Exclusion of Alternative Trading Systems Trading Solely Government
and Related Securities
(i) Discussion
In addition, the Commission proposed that any alternative trading
system that trades only government securities,\123\ Brady Bonds, and
repurchase and reverse repurchase agreements involving government
securities or Brady Bonds be excluded from the scope of Regulation ATS,
as long as the alternative trading system is registered as a broker-
dealer. The Commission believes that alternative trading systems
trading only government securities raise several of the structural
issues raised by alternative trading systems trading equity and other
debt securities. Nevertheless, the Commission recognizes that
government securities are subject to other forms of regulation that
help to ensure that those markets are fair and orderly. In particular,
[[Page 70860]]
government securities broker-dealers are currently regulated jointly by
the Commission, U.S. Department of the Treasury (``Treasury''), and
federal banking regulators, under the Exchange Act (particularly the
provisions of the Government Securities Act of 1986) and the federal
banking laws.\124\ Unlike surveillance of trading in equities and other
instruments traded primarily on registered exchanges,\125\ surveillance
of trading in government securities is coordinated among the Treasury,
the Commission, and the Board of Governors of the Federal Reserve
System.
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\123\ The term ``government security'' is defined in section
3(a)(42) of the Exchange Act, 15 U.S.C. 78c(a)(42).
\124\ See generally Department of the Treasury, Securities and
Exchange Commission, and Board of Governors of the Federal Reserve
System, Joint Study of the Regulatory System for Government
Securities (March 1998); Department of the Treasury, Report of the
Secretary of the Treasury on Specialized Government Securities
Brokers and Dealers (July 1995) (``1995 Treasury Report'').
The Government Securities Act of 1986 (``GSA'') amended the
Exchange Act to incorporate new section 15C, which, among other
things, established registration and notice requirements for
government securities brokers and dealers. Section 15C generally
requires government securities brokers and dealers (i.e., 15C firms
or specialized government securities brokers and dealers) to
register with the Commission and to become members of an SRO
(twenty-two firms as of March 1998). Firms that are registered with
the Commission as general securities brokers or dealers (i.e.,
traditional broker-dealers registered under section 15(b) of the
Exchange Act) are required to file notice with the Commission of
their government securities business (3,023 firms as of April 1998).
In addition, financial institutions that engage in government
securities broker or dealer activities are required to file notice
of such activities with their appropriate regulatory agency (120
institutions as of March 1998).
Under the regulatory structure established by the GSA, the
Treasury was granted authority to adopt regulations for all
government securities brokers and dealers concerning financial
responsibility, protection of investors' funds and securities,
recordkeeping, reporting, and audit requirements, and to adopt
regulations governing the custody of government securities held by
depository institutions. The Government Securities Act Amendments of
1993 (``GSAA'') expanded the authority of the federal regulators and
the SROs over government securities transactions. The GSAA, among
other things, reauthorized the Treasury's rulemaking
responsibilities, granted the Treasury authority to prescribe large
position recordkeeping and reporting rules, extended the
Commission's antifraud and antimanipulation authority to all
government securities brokers and dealers, required government
securities brokers and dealers to provide to the Commission on
request records of government securities transactions to reconstruct
trading in the course of a particular inquiry or investigation,
removed the statutory restrictions on the authority of the NASD to
extend sales practice rules to its members' transactions in
government securities, and provided the bank regulatory agencies
with the authority to issue sales practice rules for financial
institutions engaged in government securities broker or dealer
activities.
The GSA also strengthened the ability of federal regulators to
examine, and to bring enforcement actions against, government
securities brokers and dealers. The Commission and the SROs have
examination and enforcement authority over government securities
brokers and dealers registered under section 15C and over the
government securities activities of general securities brokers and
dealers. The Commission's enforcement authority includes the power
to censure, place limitations on the activities, functions, or
operations of, suspend for a period not exceeding 12 months, or
revoke the registration of the entity. For financial institutions
that are government securities brokers or dealers, the institution's
appropriate regulatory agency has examination and enforcement
authority over the institution. The appropriate regulatory agency
must notify the Commission of any sanctions imposed on such
institutions, and the Commission must maintain a record of the
sanctions.
\125\ Although all marketable Treasury notes, bonds, and zero-
coupon securities are listed on the NYSE, exchange trading volume is
a small fraction of the total over-the-counter volume in these
instruments. See U.S. Department of the Treasury, U.S. Securities
and Exchange Commission, and Board of Governors of the Federal
Reserve System, Joint Report on the Government Securities Market 26
(1992).
---------------------------------------------------------------------------
The Commission is adopting this proposed exclusion from Regulation
ATS with some modifications.\126\ Specifically, the Commission is
eliminating Brady Bonds from the types of securities an alternative
trading system can trade and fall within this exclusion. The Commission
received no comments specifically addressing the trading of Brady Bonds
by alternative trading systems. Based on information the Commission has
available about trading on alternative trading systems, however, the
Commission is not aware of any systems trading Brady Bonds that do not
also trade other non-government securities, most typically other
emerging market debt. Accordingly, no alternative trading systems
trading Brady Bonds would have been exempt under the proposals.
Further, the Commission does not treat Brady Bonds in the same manner
as government securities in other contexts. Moreover, the significance
of Brady Bonds in the market is diminishing.
---------------------------------------------------------------------------
\126\ In other words, these systems are not required to register
as either an exchange or to comply with the requirements of
Regulation ATS. Rule 301(a)(4), 17 CFR 242.301(a)(4).
---------------------------------------------------------------------------
In addition, the Commission is expanding the exclusion in two
respects. First, the Commission is adding commercial paper \127\ and
certain options on government securities \128\ to the types of
securities alternative trading systems may trade without being subject
to Regulation ATS. The Commission believes this expansion is
appropriate because commercial paper does not require registration even
as a broker-dealer, and because the term ``government securities''
includes certain options on government securities for purposes of
sections 15C and 17A of the Exchange Act.\129\ Second, the Commission
is expanding this exclusion from Regulation ATS to include alternative
trading systems that are banks and that trade solely government
securities, repurchase and reverse repurchase agreements on government
securities, certain options of government securities, and commercial
paper because of banks' traditional role in the government securities
market.\130\
---------------------------------------------------------------------------
\127\ Rule 301(a)(4)(ii)(E), 17 CFR 242.301(a)(4)(ii)(E). The
term ``commercial paper'' is defined in Rule 300(m), 17 CFR
242.300(m). This definition is based on the definition of commercial
paper as set forth in 12 CFR 541.5, an Office of Thrift Supervision
regulation that defines commercial paper, and section 3(a)(3) of the
Securities Act of 1933, which uses identical language to identify
these securities as one category of exempted securities.
\128\ Rule 301(a)(4)(D), 17 CFR 242.301(a)(4)(D).
\129\ Section 3(a)(42) of the Exchange Act, 15 U.S.C.
78c(a)(42).
\130\ Rule 301(a)(4), 17 CFR 242.301(a)(4).
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(ii) Response to Commenters
The Commission solicited comment on whether it was appropriate to
exclude from the regulatory framework for alternative trading systems
those alternative trading systems trading solely government and other
related securities. Of those commenters who addressed this issue, most
were in favor of excluding such systems. Most of these commenters
agreed with the Commission that alternative trading systems trading
government securities are subject to their own specialized oversight
structure and, therefore, were appropriately excluded from the scope of
the Commission's proposal.\131\ Only one commenter opposed the proposed
exclusion of alternative trading systems that trade government
securities.\132\
---------------------------------------------------------------------------
\131\ See, e.g., TBMA Letter at 17-18 (also urging the
Commission to clarify the application of proposed Regulation ATS
where a trading system trades government securities, as well as non-
government securities); CBB Letter at 3 (but requesting guidance
from the Commission on whether an ATS trading government securities
and relying on such an exemption would be precluded from trading
products other than securities); SIA Letter at 3, 11.
\132\ IBEX Letter at 4-5.
---------------------------------------------------------------------------
One commenter suggested that the Commission exclude alternative
trading systems that trade government securities from the definition in
Rule 3b-16, rather than exclude them from Regulation ATS. This
commenter stated that if these alternative trading systems were
classified as exchanges that fact would be cited by proponents of a
narrow interpretation of the Treasury Amendment to the Commodity
Exchange Act, potentially resulting in a broad definition of ``board of
trade'' beyond its intended meaning as a traditional organized
exchange.\133\ As stated earlier, the Commission believes that it would
be inappropriate and
[[Page 70861]]
without a reasoned basis to transfer part or all of its determination
regarding regulation to other statutory contexts.\134\ The Commission's
reinterpretation of ``exchange'' is grounded on its decision to use its
exemptive authority to allow alternative trading systems to choose to
be regulated as broker-dealers. The Commission's reinterpretation of
exchange should not be relied upon by other regulators to interpret
other, potentially more restrictive statutory schemes.
---------------------------------------------------------------------------
\133\ TBMA Letter at 13, n.21.
\134\ See supra note 97 and accompanying text.
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In addition, this same commenter encouraged the Commission to
consider the effects of the proposed rules on banks that operate
alternative trading systems. In particular, this commenter noted that
the exclusion for alternative trading systems that trade government
securities applied only if the alternative trading system registered as
a broker-dealer, not if the alternative trading system were a
bank.\135\ The Commission did not intend to require banks trading
government securities to register as broker-dealers and, therefore,
Rule 301(a)(4), as adopted, excludes from Regulation ATS alternative
trading systems that trade government securities if these systems are
registered as broker-dealers or are banks.
---------------------------------------------------------------------------
\135\ TBMA Letter at 17.
---------------------------------------------------------------------------
Several commenters raised questions about the application of
Regulation ATS to alternative trading systems that trade not only
government securities, but also other types of securities.\136\ One
commenter asked the Commission to extend the proposed exemption for
alternative trading systems that trade only government securities and
other related securities to all trading in those securities. This
commenter stated that broker-dealers that trade government securities,
as well as other securities and financial instruments, should not be
required to restructure their operations to avail themselves of an
exclusion for government securities activities.\137\
---------------------------------------------------------------------------
\136\ See TBMA Letter at 17; Instinet Letter at 8, n.11; CBB
Letter at 3-4.
\137\ Instinet Letter at 8, n.11.
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The Commission does not believe that an alternative trading
systems' government securities trading will be subject to more
burdensome regulation if it is conducted in the same system as trading
in other securities, than if it is conducted in a separate and,
therefore, excluded system. Accordingly, the exclusion applies to
systems that only trade government and other related securities.
Government securities are not ``covered securities'' \138\ and,
therefore, are not subject to the transparency requirements of
Regulation ATS. In addition, an alternative trading system is only
required to comply with the fair access requirements for those
securities (or categories of securities) in which it represents twenty
percent or more of the total volume. The fair access requirement does
not apply to government securities regardless of whether government
securities trading is conducted in the same alternative trading system
as securities subject to the fair access requirements or in a separate
alternative trading system. Finally, the capacity, integrity, and
security requirements would never be triggered by an alternative
trading system's government securities trading. If, however, the
trading in other securities on that same system exceeds the twenty
percent threshold, an alternative trading system in which government
securities are traded would have to meet the capacity, integrity, and
security standards. Nevertheless, it seems unlikely that an alternative
trading system would choose to create a separate alternative trading
system for its government securities trading solely for the privilege
of trading government securities on a system with lesser capacity,
integrity, and security than the system on which other securities are
traded. Therefore, the Commission does not believe that it will be
necessary, as a practical matter, for an alternative trading system to
restructure its system to avail itself of the government securities
exclusion.
---------------------------------------------------------------------------
\138\ See infra note 180 and accompanying text for the
definition of ``covered security.''
---------------------------------------------------------------------------
Another commenter asked that the Commission expressly confirm that
the exclusion from the scope of Regulation ATS for systems trading
government and related securities does not preclude such an alternative
trading system from offering services involving products other than
securities.\139\ In response, the Commission has clarified that to be
excluded from the scope of Regulation ATS an alternative trading system
need only limit its securities activities to government securities,
Brady Bonds, repurchase and reverse repurchase agreements on such
instruments, and commercial paper.
---------------------------------------------------------------------------
\139\ CBB Letter at 3.
---------------------------------------------------------------------------
Finally, this commenter suggested that the Commission adopt rules
to permit government securities alternative trading systems to trade
other fixed income securities on a limited pilot basis. This commenter
argued that, without such a limited exemption, Regulation ATS would
have a chilling effect on the ability of government securities
alternative trading systems to introduce technological innovation, and
that such a provision would raise no significant investor protection
concerns.\140\ The Commission, however, does not believe that allowing
one category of alternative trading systems (i.e., those trading
government securities) to trade other types of fixed income securities
where the regulation and surveillance is different, without complying
with Regulation ATS is appropriate. The notice and recordkeeping
requirements under Regulation ATS are limited and should not interfere
with market participants' ability to test new, innovative systems.
---------------------------------------------------------------------------
\140\ CBB Letter at 3-4.
---------------------------------------------------------------------------
d. Alternative Trading Systems Trading Non-Government Debt Securities
(i) Discussion
The Commission proposed that alternative trading systems that trade
debt securities (other than those trading government and other related
securities) be subject to Regulation ATS, if they choose not to
register as exchanges. Under Regulation ATS, these systems would be
required to file a notice with the Commission, maintain an audit trail,
periodically report certain information to the Commission, and ensure
that they have adequate safeguards to protect subscribers' confidential
trading information. In addition, alternative trading systems with
twenty percent or more of the trading volume in a particular category
of debt would have to meet the fair access and systems capacity,
integrity, and security standards.\141\ The Commission solicited
comment on what categories of debt would be appropriate for this
purpose and what sources of debt transaction volume information is
available. Specifically, the Commission solicited comment on whether
the following categories would be appropriate: mortgage and asset-
backed securities, municipal securities, corporate debt securities,
foreign corporate debt securities, and sovereign debt securities.
---------------------------------------------------------------------------
\141\ The proposal would not require an alternative trading
system to publicly display its best orders in fixed income
securities.
---------------------------------------------------------------------------
The Commission is adopting the proposal to include alternative
trading systems that trade fixed income securities within its new
regulatory framework. With respect to the fair access and systems
capacity, integrity and security requirement, the rules as adopted
require alternative trading systems with twenty percent or more of the
volume in municipal securities, investment grade corporate debt
securities, and non-investment grade corporate debt securities to
comply with the fair access and systems capacity,
[[Page 70862]]
integrity, and security requirements. Accordingly, the Commission is
adopting rules to define these three categories of debt securities. The
Commission is deferring any action on requiring alternative trading
systems that trade foreign corporate debt or foreign sovereign debt to
comply with the fair access and systems capacity, integrity, and
security requirements.
For municipals, the Commission is incorporating into Regulation ATS
the definition of municipal securities in section 3(a)(29) of the
Exchange Act.\142\ A debt security (other than an exempted security)
with a fixed maturity of at least one year will be considered
investment grade corporate debt if it is rated in one of the four
highest ratings categories by at least one Nationally Recognized
Statistical Ratings Organization,\143\ and will be considered non-
investment grade corporate debt if it is not so rated.\144\ The
Commission believes that these categories are widely recognized as
relatively distinct markets within the debt market as a whole and,
while not encompassing all forms of debt securities, will ensure that
alternative trading systems that provide markets for significant
segments of the debt market take adequate measures for systems
capacity, integrity, and security, as well as provide fair access.
---------------------------------------------------------------------------
\142\ 15 U.S.C. 78c(a)(29).
\143\ Rule 300(l), 17 CFR 242.300(l).
\144\ Rule 300(m), 17 CFR 242.300(m).
---------------------------------------------------------------------------
While the Commission is adopting rules to establish the appropriate
categories for debt securities, the volume-based rules with respect to
all categories, except municipal securities, will not become effective
until volume information is available in a format that will enable
alternative trading systems to determine their relative volume. Volume
data for municipal securities is available and being published through
the Municipal Securities Rulemaking Board's (``MSRB'') Daily Volume
Price Reports. On August 24, 1998, the MSRB started producing a
Combined Daily Report to summarize both intra-dealer and customer
transactions of municipal securities that are traded four or more times
per day pursuant to Rule G-14. This report is made available through
data vendors, such as Bloomberg, by approximately 6:00 am each business
day.\145\ Among other information, the Combined Daily Report provides
total volume data against which alternative trading systems that trade
municipal securities can measure their compliance obligations under
Regulation ATS.
---------------------------------------------------------------------------
\145\ An initiative by TBMA would also make the MSRB data
available on TBMA's web site <http://www.investinginbonds.com>. See
Robert Whalen, Investor Aids: TBMA's Internet-Based Price Reporting
Aims to Increase Market Transparency, The Bond Buyer, Nov. 25, 1998,
at 28.
---------------------------------------------------------------------------
Volume data for the remaining two categories--investment grade and
non-investment grade corporate debt--, however, is not currently
compiled or published so that alternative trading systems can determine
their obligations under Regulation ATS. In order to allow time for
logistical arrangements to make such data available, the Commission
will not make these fair access and systems capacity, integrity and
security provisions of Regulation ATS effective until April 1,
2000.\146\
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\146\ Due to the Commission's concerns regarding the Year 2000
computer technology conversion process, no new Commission rules
requiring major computer reprogramming will be made effective
between June 1, 1999 and March 31, 2000. See Securities Exchange Act
Release No. 40377 (Aug. 27, 1998), 63 FR 47501 (Sept. 3, 1998).
Accordingly, because the logistical framework for investment grade
and non-investment grade corporate debt data has not been fully
developed, the Commission is not making Rules 301(b)(5)(D) and (E)
and Rules 301(b)(6)(D) and (E) effective until after the moratorium
is lifted.
---------------------------------------------------------------------------
(ii) Response to Commenters
Some commenters thought that the Commission should exclude debt
securities entirely from Regulation ATS.\147\ On the other hand,
several commenters supported the Commission's proposal to include
alternative trading systems that trade debt securities.\148\ The
Commission believes that many of the same concerns about the trading of
equity securities on alternative trading systems apply equally to the
trading of fixed income securities on alternative trading systems.
Specifically, it is important that markets with significant portions of
the volume in particular instruments have adequate systems capacity,
integrity, and security, regardless of whether those instruments are
equity securities or debt securities. Similarly, as electronic systems
for debt grow, it will become increasingly important for the fair
operation of our markets for market participants to have fair access to
significant market centers in debt securities. One of the consequences
of the growing role of alternative trading systems in the securities
markets generally is that debt securities are increasingly being traded
on these systems, similar to the way equity securities are traded. This
change in the market requires appropriate measures for markets for
debt.
---------------------------------------------------------------------------
\147\ See TBMA Letter at 3, MSDW Letter at 13; SIA Letter at 11;
DBSI Letter at 1 (adopting TBMA Letter).
\148\ See NYSE Letter at 6 (supporting regulation of alternative
trading systems that trade debt securities as important for investor
protection); IBEX Letter at 2-3 (also generally urging the
Commission to take steps to increase transparency, access to best
priced orders, and other investor protections in the debt markets,
e.g., insider trading and front running rules).
---------------------------------------------------------------------------
Two commenters suggested that the Commission exempt or exclude
alternative trading systems trading municipal securities for the same
reasons that it proposed to exclude alternative trading systems that
trade government securities.\149\ For example, one commenter asserted
that the municipal securities market is overseen not only by securities
regulators, but also by the federal banking regulators. This commenter
also pointed out that the Commission had proposed excluding municipal
securities in the Concept Release and stated that the Commission should
have maintained this approach in the Proposing Release.\150\ Although
the Commission did solicit comment in the Concept Release on whether
alternative trading systems trading municipal securities should be
excluded from any proposed new regulatory framework, the Commission has
concluded that it would not be appropriate to do so.
---------------------------------------------------------------------------
\149\ See TBMA Letter at 18-20; SIA Letter at 3, 11.
\150\ TBMA Letter at 19-20.
---------------------------------------------------------------------------
There are substantial differences between the oversight of the
government securities market and the municipal securities markets, and
between government securities instruments and municipal securities
instruments. For example, municipal securities are far more varied
products than government securities. While traditional general
obligation bonds issued by municipalities are more akin to government
securities in that they are backed by the full faith and credit of the
issuing taxing authority, revenue bonds, which bear greater resemblance
to privately issued bonds due to their ties to specific revenue
sources, are riskier products.\151\ Most municipal bonds are rarely
traded. The market for government securities, on the other hand, is
deep and liquid.\152\ Therefore, alternative trading systems that may
develop for municipal securities may have widely different qualities
than those for government securities. Moreover, regulation of the
government
[[Page 70863]]
securities market is shared by the Federal Reserve Board, the Treasury
Department and the Commission and other bank regulators, while
oversight of the municipal securities market is assigned to the
Commission and the MSRB. For these reasons, the Commission believes it
would not be appropriate to exempt alternative trading systems that
trade municipal securities from Regulation ATS.
---------------------------------------------------------------------------
\151\ See Robert Zipf, How the Bond Market Works 86-87 (1997)
(noting characteristics of general obligation and revenue bonds and
the heightened risk of revenue bonds relative to general obligation
bonds).
\152\ As of June 30, 1998, there was approximately $3.4 trillion
of U.S. Treasury debt securities outstanding with average daily
trading volume of over $200 billion. By comparison, there was
approximately $1.4 trillion of municipal debt securities outstanding
with average daily trading volume of approximately $1 billion. The
Bond Market Association, Research Quarterly (August 1998) <http://
www.bondmarkets.com/research/9808rschq.pdf>.
---------------------------------------------------------------------------
Only one commenter directly addressed the Commission's request for
comment on possible categories of debt. Although TBMA encouraged the
Commission to exclude alternative trading systems trading debt
securities from Rule 3b-16,\153\ it stated that, if the Commission
chose to go forward with the proposal, it ``believes that the proposed
categories reflect a reasonable indication of how market participants
view and trade debt securities.'' \154\
---------------------------------------------------------------------------
\153\ TBMA Letter at 6-7, 21.
\154\ TBMA Letter at 24.
---------------------------------------------------------------------------
Several commenters recommended that the Commission consider the
clearing agencies as a source of information on the trading volume in
the debt market.\155\ One commenter also noted that for municipal
securities, the MSRB's transaction reporting requirements could be a
good source for volume information.\156\ As discussed above, the
Commission plans to use the MSRB's transaction reporting program as a
basis for volume in the municipal securities market.
---------------------------------------------------------------------------
\155\ See TBMA Letter at 23-25; IBEX Letter at 12. IBEX also
suggested reactivating the SIA practice of publishing the average
daily trading volume of corporate and other bonds on a monthly basis
which was discontinued in 1994. IBEX Letter at 12.
\156\ TBMA Letter at 23-25.
---------------------------------------------------------------------------
e. Exemptions From Certain Requirements of Regulation ATS Pursuant to
Application to the Commission
The Commission today is also adopting a provision to allow the
Commission, upon application by an alternative trading system, to
exempt by order such alternative trading system from one or more of the
requirements of Regulation ATS.\157\ The Commission expects to issue
such an order only under unusual circumstances, and only after
determining that such an order is consistent with the public interest,
the protection of investors and the removal of impediments to, and the
perfection of the mechanisms of, a national market system.
---------------------------------------------------------------------------
\157\ Rule 301(a)(5), 17 CFR 242.301(a)(5).
---------------------------------------------------------------------------
While the Commission believes that the requirements it is adopting
under Regulation ATS are appropriate for all alternative trading
systems operating today, the Commission is aware that a system may
develop in the future to which these requirements may not be
appropriate, and they could hinder the development of specialized
trading systems. For example, the Commission could consider exempting
an alternative trading system that limited participation only to
investment companies with similar investment strategies, such as index
funds, from the transparency requirements.\158\
---------------------------------------------------------------------------
\158\ The transparency requirements are discussed infra Section
IV.A.2.c.
---------------------------------------------------------------------------
2. Requirements for Alternative Trading Systems Subject to Regulation
ATS
Discussed below are the requirements for alternative trading
systems subject to Regulation ATS.
a. Membership in an SRO
Because alternative trading systems that choose to register as
broker-dealers will not themselves have self-regulatory
responsibilities, the Commission believes it is important for such
systems to be members of an SRO. For this reason, the Commission
proposed to require alternative trading systems subject to Regulation
ATS to be members of an SRO.
Most alternative trading systems are currently registered as
broker-dealers and, therefore, are also members of an SRO.\159\ The
Commission understands some alternative trading systems may have
concerns about SROs abusing their regulatory authority for competitive
reasons. While the Commission understands that SROs operate competing
markets and, therefore, have potential conflicts of interest in
overseeing alternative trading systems, the Commission believes these
conflicts can be minimized using the Commission's oversight.\160\ The
Commission considers it part of its own oversight responsibility over
SROs to prevent and take the necessary steps to address any such
actions by SROs.\161\ Further, an alternative trading system that
wishes to avoid potential conflicts of interest altogether may choose
to register as an exchange. The Commission also notes that section 15A
of the Exchange Act would permit an association of brokers and dealers
to establish an SRO that does not operate a market.\162\ Such a
national securities association could be established solely for
purposes of overseeing the activities of alternative trading systems.
Of course, this association must be able to effectively conduct its SRO
responsibilities.
---------------------------------------------------------------------------
\159\ Section 15(b)(8) of the Exchange Act, 15 U.S.C. 78o(b)(8).
\160\ For example, the structural reforms undertaken by the NASD
since August 1996 should aid in ensuring the independence of NASDR
and insulating its staff from the commercial interests of Nasdaq.
\161\ See supra note 4.
\162\ Section 15A of the Exchange Act, 15 U.S.C. 78o-3.
---------------------------------------------------------------------------
The Commission expects SROs to effectively surveil trading that
occurs on alternative trading systems by integrating alternative
trading system trading data into the SRO's existing surveillance
systems. SROs should also incorporate relevant information regarding
the entities trading on such systems into their existing surveillance
programs. The enhanced recordkeeping requirements for alternative
trading systems will aid SRO oversight considerably in this
regard.\163\
---------------------------------------------------------------------------
\163\ See Rule 301(b)(8), 17 CFR 242.301(b)(8).
---------------------------------------------------------------------------
The Commission believes it is appropriate to continue to require
alternative trading systems that register as broker-dealers to be SRO
members and is, therefore, adopting this requirement as proposed.\164\
---------------------------------------------------------------------------
\164\ Rule 301(b)(1), 17 CFR 242.301(b)(1).
---------------------------------------------------------------------------
b. Notice of Operation as an Alternative Trading System and Amendments
The Commission proposed to require an alternative trading system
registered as a broker-dealer to file a notice with the Commission
before commencing operation, amendments to this notice in the event of
material changes, and a notice when an alternative trading system
ceases operation. The Commission is adopting these requirements as
proposed.
More specifically, under Regulation ATS, alternative trading
systems are required to file an initial operation report with the
Commission on Form ATS at least twenty days prior to commencing
operation.\165\ Alternative trading systems operating currently must
file Form ATS within twenty days of the effective date of these final
rules.\166\ Form ATS requests information about the alternative trading
system, including a detailed description of how it will operate, its
prospective subscribers, and the securities it intends to trade. In
addition, the alternative trading system is required to describe its
existing procedures for reviewing systems capacity, security, and
contingency planning. Alternative trading systems are currently
required to
[[Page 70864]]
report most of this information on Part I of Form 17A-23, which the
Commission proposed to repeal.\167\ Form ATS is not an application and
the Commission would not ``approve'' an alternative trading system
before it began to operate. Form ATS is, instead, a notice to the
Commission.
---------------------------------------------------------------------------
\165\ Rule 301(b)(2)(i) and Form ATS, 17 CFR 242.301(b)(2)(i)
and 17 CFR 249.637.
\166\ Most currently operating alternative trading systems have
filed Part 1 of Form 17A-23. To avail themselves of the exemption in
Rule 3a1-1(a)(2), these systems must file Form ATS within 20 days of
the effective date of these rules. Internal broker-dealer systems,
17 CFR 240.17a-3(a)(16)(ii)(A), which may also have previously filed
Part I of Form 17A-23, do not have to file Form ATS.
\167\ 17 CFR 240.17a-23. See infra Section V.
---------------------------------------------------------------------------
An alternative trading system is also required to notify the
Commission of material changes to its operation by filing an amendment
to Form ATS at least twenty calendar days prior to implementing such
changes.\168\ One commenter requested that the Commission provide more
specific guidance as to what would be considered a ``material change.''
\169\ As discussed in the Proposing Release, material changes to an
alternative trading system include any change to: the operating
platform, the types of securities traded, or the types of subscribers.
The Commission notes that currently all alternative trading systems
implicitly make materiality decisions in determining when to notify
their subscribers of changes.
---------------------------------------------------------------------------
\168\ Rule 301(b)(2)(ii), 17 CFR 242.301(b)(2)(ii).
\169\ SIA Letter at 17-18.
---------------------------------------------------------------------------
In addition to reporting material changes at least twenty days
before implementation, alternative trading systems are required to
notify the Commission in quarterly amendments of any changes to the
information in the initial operation report that have not been reported
in a previous amendment.\170\ Finally, if an alternative trading system
ceases operations, it is required to promptly file a notice with the
Commission.\171\ Under Regulation ATS, the initial operation report,
any amendments, and the report filed when an alternative trading system
ceases operation will be kept confidential.
---------------------------------------------------------------------------
\170\ Rule 301(b)(2)(iii), 17 CFR 242.301(b)(2)(iii).
Alternative trading systems would also be required to file an
amendment to Form ATS to correct any previously filed information
that has been discovered to have been inaccurate when filed. Rule
301(b)(2)(iv), 17 CFR 242.301(b)(2)(iv).
\171\ Rule 301(b)(2)(v), 17 CFR 301(b)(2)(v). An alternative
trading system is required to provide a duplicate of each of these
filings to surveillance personnel designated by the SRO of which it
is a member. Rule 301(b)(2)(vii), 17 CFR 301(b)(2)(vii).
---------------------------------------------------------------------------
In the Proposing Release,\172\ the Commission requested comment on
the notice requirements and Form ATS. The Commission specifically
requested comment on whether such requirements would be burdensome for
alternative trading systems, and if so, whether the burden is
inappropriate. The Commission also sought comment on the frequency of
filings and whether more or less frequent filings would be preferable.
Finally, the Commission sought comment on whether it would be
appropriate to permit or to require electronic filing of Form ATS and
all subsequent amendments.
---------------------------------------------------------------------------
\172\ See supra note 3.
---------------------------------------------------------------------------
Most of the commenters did not comment directly on the notice
requirements or Form ATS. One commenter recommended that the Commission
allow for filing of the initial operation report on Form ATS within
twenty days after commencing operation, rather than twenty days before
commencing operation as proposed.\173\ This commenter stated that such
a change would ease the regulatory burden on new systems that often
have uncertain timelines and would avoid the possibility that a new
trading system would be prevented from operating solely because of the
need to wait for a twenty-day regulatory time period to run.
---------------------------------------------------------------------------
\173\ SIA Letter at 17-18.
---------------------------------------------------------------------------
The Commission, however, believes that twenty days is a short
enough period of time that alternative trading systems would not be
inconvenienced by the requirement. If a system were only required to
provide notice after it commenced operations, the Commission would have
no notice of potential problems that might impact investors before the
system begins to operate. The Commission also notes that currently
broker-dealer trading systems have an identical requirement to file
Form 17A-23 with the Commission twenty days prior to commencing
operation. The Commission knows of no broker-dealer trading system that
was unable to start operating because of the twenty day period.
Consequently, the Commission believes the Rule, as adopted, is a
reasonable means for the Commission to carry out its functions and
imposes no unnecessary burdens on respondents.
The Commission also requested comment on whether the information in
Form ATS should remain confidential. Two commenters supported the
Commission's proposal to keep confidential the information contained in
Form ATS,\174\ and one commenter encouraged the public availability of
filed information.\175\ The Commission continues to believe that notice
reports filed with the Commission and the alternative trading system's
SRO pursuant to Regulation ATS should be kept confidential. Information
required on Form ATS may be proprietary and disclosure of such
information could place alternative trading systems in a
disadvantageous competitive position. Further, because the Commission
wishes to encourage candid and complete filings in order to make
informed decisions and track market changes, preserving confidentiality
provides respondents with the necessary comfort to make full and
complete filings. Finally, based on the Commission's experience with
Rule 17a-23 filings, the Commission believes that confidentiality is
appropriate.
---------------------------------------------------------------------------
\174\ See SIA Letter at 17-18; American Century Letter at 6.
\175\ IBEX Letter at 5.
---------------------------------------------------------------------------
Finally, the Commission solicited comment on the possibility of
permitting Form ATS to be filed electronically. Several commenters
supported the acceptance of electronic filings by the Commission as a
way to reduce the regulatory burden of filing Form ATS and in light of
the technological nature of alternative trading systems.\176\ The
Commission agrees that electronic filing is an important goal and plans
to work toward it. Currently, however, legal and technological
limitations--primarily relating to security and authentication--make an
electronic filing system infeasible. At this time, the Commission is
capable of, and plans to, provide alternative trading systems with the
ability to access Form ATS and Form ATS-R on-line, through the
Commission's web site, so that the form can be downloaded. Alternative
trading systems would then have to submit these forms to the Commission
by mail or facsimile. Ultimately, the Commission anticipates that
current technological barriers will be overcome, and a system able to
electronically accept Forms ATS and ATS-R will be available.
---------------------------------------------------------------------------
\176\ See IBEX Letter at 5; SIA Letter at 18; American Century
Letter at 6.
---------------------------------------------------------------------------
c. Market Transparency
(i) Importance of Market Transparency
In 1997, the Commission implemented rules that require a market
maker or specialist to make publicly available any superior prices that
it privately offers through certain types of alternative trading
systems known as ECNs.\177\ The rules permit an ECN to fulfill these
obligations on behalf of market makers or specialists using its system,
by submitting the ECN's best priced market maker or specialist
quotations to an SRO for inclusion into
[[Page 70865]]
public quotation displays (``ECN Display Alternative'').\178\
---------------------------------------------------------------------------
\177\ ECNs include any automated trading mechanism that widely
disseminates market maker orders to third parties and permits such
orders to be executed through the system, other than crossing
systems. Rule 11Ac-1-1, 17 CFR 240.11Ac1-1. See also Securities
Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 48290 (Sept.
12, 1996) (``Order Handling Rules Adopting Release'').
\178\ Presently, nine alternative trading systems have elected
to display quotes under the ECN Display Alternative. See Letters
dated Jan. 17, 1997 from Richard R. Lindsey, Director, Division of
Market Regulation, SEC to: Charles R. Hood, Senior V.P. and General
Counsel, Instinet Corporation (recognizing Instinet as an ECN);
Joshua Levine and Jeffrey Citron, Smith Wall Associates (recognizing
the Island System as an ECN); Gerald D. Putnam, President, Terra
Nova Trading, LLC (recognizing the TONTO System, now known as
Archipelago, as an ECN); and Roger D. Blanc, Wilkie Farr & Gallagher
(counsel to Bloomberg) (recognizing Bloomberg Tradebook as an ECN).
See also Letter dated October 6, 1997 from Richard R. Lindsey,
Director, Division of Market Regulation, SEC to Matthew G. Maloney,
Dickstein Shapiro Morin & Oshinsky LLP (counsel to Spear, Leeds &
Kellogg) (recognizing the REDI System as an ECN); Letter dated
February 4, 1998 from Robert L.D. Colby, Deputy Director, Division
of Market Regulation, SEC, to Linda Lerner, General Counsel, All-
Tech Investment Group, Inc. (recognizing the Attain System as an
ECN); Letter dated April 21, 1998 from Richard R. Lindsey, Director,
Division of Market Regulation, SEC to Mark Dorsey, Fried, Frank,
Harris, Shriver & Jacobsen (counsel to The Brass Utility, LLC)
(recognizing BRUT as an ECN); and Letters dated Nov. 13, 1998 from
Robert L.D. Colby, Deputy Director, Division of Market Regulation,
SEC to: Lloyd H. Feller, Morgan, Lewis & Bockius LLP (counsel to
Strike Technologies LLC) (recognizing the Strike System as an ECN);
John M. Schaible, PIM Global Equities, Inc. (recognizing the Trading
System as an ECN).
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Since the Order Handling Rules were implemented, the spread between
bids and offers in covered securities has narrowed dramatically.\179\
This has benefited investors, including retail investors, who have
enjoyed significant cost savings when trading covered securities.\180\
---------------------------------------------------------------------------
\179\ Quoted spreads, which measure the difference between the
inside ask and the inside bid, have declined by forty-one percent.
The effective spread, which takes into account that trades may occur
inside or outside the quoted spread, declined by twenty-four
percent. The lower decline in the effective spread is due to a
decline in trading inside the spread. See NASD Economic Research,
Market Quality Monitoring: Overview of 1997 Market Changes (Mar. 17,
1998).
\180\ A covered security is defined in the same way as it is
under Rule 11Ac1-1(a)(6), 17 CFR 240.11Ac1-1. Specifically, a
``covered security'' is any security reported by an effective
transaction reporting plan and any other security for which a
transaction report, last sale data, or quotation information is
disseminated through an automated quotation system as described in
section 3(a)(51)(A)(ii) of the Exchange Act, 15 U.S.C.
78c(a)(51)(A)(ii). See Rule 300(g). Accordingly, a covered security
includes all exchange-listed securities, Nasdaq NM securities, and
Nasdaq SmallCap securities.
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These rules, however, were not intended to fully coordinate trading
on alternative trading systems with public market trading.\181\ While
these rules have helped integrate orders on certain alternative trading
systems into the public quotation system, they only disclose the orders
market makers and specialists enter into ECNs, unless the system
voluntarily undertakes to disclose institutional prices.\182\ In many
cases, institutional orders, as well as other non-market maker orders,
remain undisclosed to the public.\183\ Moreover, it is voluntary for an
ECN to reflect the best priced quotations in the public quotation
system on behalf of market makers and specialists that participate in
its system.
---------------------------------------------------------------------------
\181\ See Order Handling Rules Adopting Release, supra note 177,
at 87-96.
\182\ There is divergence among ECNs in the extent to which they
have chosen to integrate non-market maker orders into the prices
they display to the public. Several of the nine ECNs that are
currently linked to Nasdaq display to the public the best prices of
any orders entered into their systems (including both market makers
and institutions).
\183\ Because such trading interest frequently remains
undisclosed, within certain alternative trading systems non-market
maker participants are able to display prices that lock and cross
the public quotations. If the quotes of such participants were
disclosed to the public, the Commission believes it would result in
improved price opportunities for public investors.
---------------------------------------------------------------------------
Because certain trading interest on alternative trading systems is
not integrated into the national market system, price transparency is
impaired and dissemination of quotation information is incomplete.
These developments are contrary to the goals the Commission enunciated
over twenty-five years ago when it noted that an essential purpose of a
national market system:
[I]s to make information on prices, volume, and quotes for
securities in all markets available to all investors, so that buyers
and sellers of securities, wherever located, can make informed
investment decisions and not pay more than the lowest price at which
someone is willing to sell, and not sell for less than the highest
price a buyer is prepared to offer.\184\
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\184\ See SEC, Statement of the Securities and Exchange
Commission on the Future Structure of the Securities Markets (Feb.
2, 1972), 37 FR 5286 (Feb. 4, 1972) (emphasis added).
---------------------------------------------------------------------------
(ii) Integration of Orders Into the Public Quotation System
Alternative trading systems are becoming increasingly popular
venues for trading securities. Because these systems are not registered
exchanges and do not participate in the national market system, there
is a possibility that our securities markets could become less
transparent over time.\185\ The Commission believes that it is
inconsistent with congressional goals for a national market system if
the best trading opportunities are made accessible only to those market
participants who, due to their size or sophistication, can avail
themselves of prices in alternative trading systems. The vast majority
of investors may not be aware that better prices are disseminated to
alternative trading system subscribers and many do not qualify for
direct access to these systems and do not have the ability to route
their orders, directly or indirectly, to such systems. As a result,
many customers, both institutional and retail, do not always obtain the
benefit of the better prices entered into an alternative trading
system. As the American Association of Individual Investors pointed
out, ``(s)imply stated, investors benefit, as do markets, from knowing
the full array of best-priced orders from all sources * * * It is in
the best interests of individual investors that alternative trading
systems disseminate best-priced orders into quotation systems that are
available to the public.'' \186\
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\185\ In the Concept Release, supra note 2, the Commission
considered whether to require certain alternative trading systems to
register as exchanges. This approach would have addressed the
Commission's concerns about lack of transparency by requiring
certain significant alternative trading systems to participate
directly in the national market system plans. Commenters to the
Concept Release, however, expressed concerns about requiring
alternative trading systems to register as exchanges, and that a
much more workable and realistic approach would be to enhance the
system of broker-dealer regulation under which alternative trading
systems are currently regulated. For example, in recommending that
the Commission consider allowing alternative trading systems to
continue to be regulated as broker-dealers, the SIA commented that
``additional steps to integrate aggregate trading interest on
alternative trading systems to public view would be a sensible way
of addressing concerns that may exist in the aftermath of the Order
Handling Rules.'' See letter from A. B. Krongard, Chairman,
Securities Industry Association Task Force on Alternative Trading
System Concept Release to Jonathan G. Katz, Secretary, SEC, received
Oct. 6, 1997.
\186\ Letter from John Markese, President, American Association
of Individual Investors, to Jonathan G. Katz, Secretary, SEC, dated
Nov. 24, 1998 (``AAII Letter'') at 1.
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(A) New Requirements for Alternative Trading Systems
The Commission is adopting Exchange Act Rule 301(b)(3) to further
enhance transparency of orders displayed on alternative trading
systems, and to ensure that publicly displayed prices better reflect
market-wide supply and demand. Specifically, this rule requires
alternative trading systems with five percent or more of the trading
volume in any ``covered security'' \187\ to publicly disseminate their
best priced orders in those securities. These orders will then be
included in the quotation data made available to quotation vendors by
national securities exchanges and national securities
associations.\188\ Only those orders that are displayed to more than
one alternative trading system subscriber would be subject to the
[[Page 70866]]
public display requirement. As discussed in Section IV.A.2.c.iii.
below, alternative trading systems are also required to provide all
registered broker-dealers with access to these displayed orders.
---------------------------------------------------------------------------
\187\ See supra note 180.
\188\ 17 CFR 240.11Ac1-1.
---------------------------------------------------------------------------
Importantly, the public display requirement in Rule 301(b)(3)
applies only to orders in ``covered securities.'' The term ``covered
securities'' includes only exchange-listed, Nasdaq NM, and Nasdaq
SmallCap securities. Accordingly, alternative trading systems trading
equity securities not included within the definition of ``covered
security,'' or debt securities, would not be subject to the public
display requirement under Regulation ATS.
In the Proposing Release, the Commission proposed a public display
requirement substantially similar to the one it is adopting today. The
proposal, however, would have only required alternative trading systems
to publicly display their best priced orders in a covered security when
the system represents ten percent of the trading volume in that
security. The Commission decided instead to adopt a five percent
threshold in light of the comment letters, many of which supported the
public display requirement and recommended that the volume threshold be
lower than ten percent.
In the Proposing Release, the Commission proposed that the display
requirement be applied on a security-by-security basis and would not
have required an alternative trading system to publicly display orders
for any securities in which its trading volume accounted for less than
ten percent of the total volume for such security. The Commission,
however, requested comment on whether an alternative trading system
should be required to display the best priced orders in all securities
traded in its system, if it reaches the volume threshold in a specified
number or percentage of the securities it trades.
After considering the comments on the issue, the Commission is
adopting the security-by-security approach as proposed. Although a
system that trades more than the volume threshold in a substantial
number of securities could be considered a significant market whose
best prices in all securities should be transparent, for now the
Commission has decided to take the security-by-security approach with a
lower volume threshold (five percent) than proposed. The security-by-
security approach, among other things, will more readily enable the
phase-in of securities subject to the transparency requirements as
discussed below.
The Commission emphasizes that, as proposed, Rule 301(b)(3) only
requires alternative trading systems to publicly display subscribers'
orders that are displayed to more than one other system subscriber.
Thus, if an alternative trading system, like some crossing systems, by
its design does not display orders to other subscribers, the rules do
not require those orders to be integrated into the public quote
stream.\189\ Similarly, if a portion of a subscriber's order is not
displayed to other alternative trading system subscribers, that hidden
portion is not subject to the public display requirement in Rule
301(b)(3). Thus, the Commission's rules allow institutions and non-
market makers to guard the full size of their orders by using the
``reserve size'' features offered by some alternative trading systems,
which allow subscribers to display orders incrementally. For example, a
subscriber that wishes to sell 100,000 shares of a given security could
place its order in an alternative trading system and specify that only
10,000 shares are to be displayed to other alternative trading system
subscribers at a time. In this instance, Rule 301(b)(3) requires that
only 10,000 shares be reflected in the public quote. The ability to
continue to control how much of their own orders to reveal was a
concern of several institutions who commented.\190\ Finally,
alternative trading systems are not required to provide to the public
quote stream orders displayed to only one other alternative trading
system subscriber, such as through use of a negotiation feature.
---------------------------------------------------------------------------
\189\ One commenter (who does not internally display orders)
expressed its support for this aspect of the proposed transparency
requirement, stating that, while exchanges and broker-dealers should
be subject to the same public display requirement, if an alternative
trading system did not display any orders to subscribers, it should
not be required to publicly display those orders to non-subscribers
through the public quotation stream. See OptiMark Letter at 4.
\190\ See infra notes 206-207 and accompanying text.
---------------------------------------------------------------------------
The Commission believes that in light of the significant trading
volume on some alternative trading systems, integration of
institutional and non-market maker broker-dealer orders into the
national market system is essential to prevent the development of a
two-tiered market. Trading anonymity will be preserved because an
alternative trading system will comply with any public display
requirement by identifying itself, rather than the subscriber that
placed the order. Thus, the Commission's proposal, much like the ECN
Display Alternative, is designed to preserve the benefits associated
with anonymity. Moreover, the Commission believes that the continued
ability of institutions to retain their anonymity and to use features
within alternative trading systems to shield the full size of their
orders gives institutions the ability to keep their full trading
interest private. The Commission recognizes that anonymity is often
important to institutional investors so that when they are unwinding or
building security holdings they do not signal their trading strategy
and negatively impact their own market position.\191\
---------------------------------------------------------------------------
\191\ The Commission plans to monitor the effects of the reserve
function on market liquidity and transparency.
---------------------------------------------------------------------------
Requiring alternative trading systems to furnish to the public
quotation system the full size of the best displayed buy and sell
orders will ensure that the public quote better reflects true trading
interest in a particular security. Furthermore, the Commission believes
that institutional investors' orders entered into alternative trading
systems provide valuable liquidity, and that displaying such trading
interest will substantially strengthen the national market system.
Moreover, this public display requirement levels the playing field
between market makers--who, when they send customer limit orders to
ECNs, the ECN must publicly display that order--and those ECNs, who do
not have to display customer limit orders sent directly to the ECN.
In order to monitor the effects of the public display requirement,
however, the rules will permit affected alternative trading systems to
phase-in institutional orders in covered securities.\192\ Before April
21, 1999, the Commission will publish a schedule for the phase-in of
individual securities. Fifty percent of the securities subject to the
transparency requirement will be phased-in on April 21, 1999 and the
remainder of the securities will be phased-in on August 30, 1999.\193\
---------------------------------------------------------------------------
\192\ In addition to phasing in the transparency requirements
for institutional orders, affected alternative trading systems may
also choose to phase-in the access requirements for the covered
securities. See infra notes 216-217 and accompanying text.
\193\ The Commission notes that the later date will fall within
the moratorium to facilitate Year 2000 conversion. Securities
Exchange Act Release No. 40377 (Aug. 27, 1998), 63 FR 47051 (Sept.
3, 1998). The Commission believes that the phase-in will not require
major reprogramming, however, and consequently is not subject to the
moratorium. In addition, alternative trading systems may voluntarily
publicly display all non-market maker broker-dealer and
institutional orders covered by the requirement on or before April
21, 1999.
---------------------------------------------------------------------------
(B) Response to Comments
The Commission requested comment on whether a ten percent volume
[[Page 70867]]
threshold would effectively ensure that alternative trading systems
comprising a significant percentage of the market are subject to basic
market transparency requirements. The commenters that responded to this
issue were split on whether a ten percent volume threshold was too high
or too low, although most felt it was too high and should be
lowered.\194\ A few commenters, however, stated that they believed the
volume thresholds were too low.\195\
---------------------------------------------------------------------------
\194\ See AAII Letter at 1 (suggesting that the volume threshold
be much lower than ten percent), NYSE Letter at 5 (stating that it
believed a more appropriate level would be five percent of the
aggregate daily volume in a security in any two of the three most
recent months, because very few registered markets (exchanges and
associations) accounted for more than ten percent of the volume in
any security); CHX Letter at 8 (suggesting that the Commission
require all alternative trading systems to display their best orders
regardless of trading volume); NASD Letter at 1 (suggesting a volume
threshold of one percent); American Century Letter at 5 (stating
opposition to any volume threshold, as volume in any alternative
trading system may be sporadic over time). See also ICI Letter at 3;
IBEX Letter at 7-8; Ashton Letter at 4; TBMA Letter pp. 21-22
(stating that it concurred that display of equity securities trading
on alternative trading systems was beneficial to the market as a
whole).
\195\ See SIA Letter at 12 (stating that a volume level of ten
percent had the potential to capture insignificant market players
and therefore recommending that the Commission consider a level of
twenty percent).
---------------------------------------------------------------------------
As discussed above, the transparency requirement the Commission is
adopting in Rule 301(b)(3) obligates an alternative trading system to
disseminate into the public quote the best priced orders in each
covered security in which the trading on such system represents more
than five percent of total trading volume. The Commission is persuaded
by commenters that stated that a ten percent threshold would exclude
trading on too many alternative trading systems. The Commission
believes that lowering the threshold to five percent will provide more
benefits to investors, promote additional market integration, and
further discourage two-tier markets. At the same time, the Commission
believes that those alternative trading systems with less than five
percent of the volume would not add sufficiently to transparency to
justify the costs associated with linking to a market.
The Commission requested comment on whether an alternative trading
system should be required to display the best priced orders in all
securities traded in its system, if it reaches the volume threshold in
a specified number or percentage of the securities it trades. Of those
commenters addressing this issue, most were in favor of display of the
best priced orders in all securities traded on an alternative trading
system once that alternative trading system exceeded the volume
threshold in some fixed number of securities.\196\ The NYSE stated that
if an alternative trading system developed a ``general presence'' in
the market, for example by reaching the volume threshold in ten or more
securities, that alternative trading system should display the best
priced orders in all securities it trades. One commenter, however,
specifically opposed the display of all securities traded on an
alternative trading system rather than mandating display on a security-
by-security basis.\197\ This commenter also noted that even display on
a security-by-security basis may capture a system that trades a
significant amount of one security, despite the fact that that security
was a minor part of the overall trading in the system. As discussed
above, however, the Commission is adopting the rule as proposed.
---------------------------------------------------------------------------
\196\ See ICI Letter at 2, n.5 (stating that the display
requirement should apply to all securities and to all alternative
trading systems, regardless of volume. The ICI stated that this
would avoid the practice of routing to a particular system simply to
avoid display); NYSE Letter at 5 (stating that if an alternative
trading system developed a ``general presence'' in the market, for
example by reaching the volume threshold in ten or more securities,
that alternative trading system should display the best priced
orders in all securities it traded); Ashton Letter at 4 (stating
that once an alternative trading system achieved one percent in a
given ``category'' of securities over a six month period, the system
should be required to display its best orders in all the securities
in that category); CHX Letter at 8 (stating that any volume
threshold should be applied on an alternative trading system as a
whole, not on a security-by-security basis, because of the burden of
tracking security-by-security); American Century Letter at 5
(commenting that a rule requiring public display of all orders
displayed in an alternative trading system was preferable). See also
IBEX Letter at 8; NASD Letter at 11. But see SIA Letter at 12.
\197\ See SIA Letter at 13-14 (supporting display of orders on a
security-by-security basis and recommending that the volume
threshold be raised to twenty percent of the trading volume in that
security nationwide; also stating that no orders should be required
to be displayed in the public quotation stream unless the trading
volume in that security on the alternative trading system exceeded
twenty percent of the alternative trading system's overall trading
activity). Of course, the Commission assumes that those commenters
who opposed display of non-market maker orders generally would also
oppose the display of all securities as well, rather than only those
above a certain volume threshold. See infra notes 204-205.
---------------------------------------------------------------------------
The Commission also requested comment on whether alternative
trading systems should be required to display the full size of the best
priced order, even if the full size is hidden from alternative trading
system subscribers through use of a ``reserve size'' or similar
feature. All commenters directly addressing this issue \198\ stated
that the reserve feature should be maintained, especially if the
Commission's rules as adopted required displayed institutional orders
to be integrated into the public quotation stream. The Commission
agrees that the reserve features are critical to institutions' ability
to minimize the market impact of their orders. Further, when orders are
not displayed to anyone, the Commission's concerns about a two-tiered
market--where some market participants have information others do not--
are absent. Accordingly, Rule 301(b)(3) only requires alternative
trading systems to publicly disseminate the best priced orders that are
displayed to other alternative trading system subscribers.
---------------------------------------------------------------------------
\198\ See ICI Letter at 3 (stating that the ICI supports display
of institutional orders provided that the reserve size feature is
retained, and provided that orders are displayed in the public
quotation system under the name of the alternative trading system,
and not the name of the subscriber placing the order, thereby
preserving anonymity); IBEX Letter at 8-9 (stating that the
``reserve size'' feature permitted alternative trading system
subscribers to avoid adverse market impact and negotiate a larger
transaction with a single counter-party, two features IBEX believes
to be of considerable value. IBEX stated, however, that reserve size
availability to subscribers to an alternative trading system should
be contingent on an initial increment being publicly displayed; non-
subscribers being able to execute against the reserve size; and the
full size and price of each increment being immediately reported, as
executed, to the public quotation system); Ashton Letter at 6
(stating that all orders up to 10,000 shares should be displayed,
and that orders in excess of 10,000 shares, should have a minimum of
10,000 shares publicly displayed; also stating that negotiation and
reserve size features should be available to non-subscribers, as
well as subscribers); American Century Letter at 5 (stating that it
was ``imperative'' that the reserve feature be maintained, because
it provided depth of supply and demand at a price, while protecting
the order from being used as a ``free option'' by other participants
in the market). See also Instinet Letter at 11-13 (arguing against
total pre-trade transparency); Bloomberg Letter at 19 n.32 (noting
reserve feature in the Tradebook System); Letter from Daniel G.
Weaver, Associate Professor of Finance, Zicklin School of Business,
Barauch College to Jonathan G. Katz, Secretary, SEC, dated Nov. 23,
1998 (``Weaver Letter'') (stating that institutions will move their
trading upstairs even if the full size of their orders is hidden
from alternative trading system subscribers through their use of a
``reserve size'' feature).
---------------------------------------------------------------------------
The Commission requested comment on whether it would be more
appropriate to adopt an alternative to Rule 301(b)(3) that would
permit, but not require, the public display of the best-priced
institutional orders displayed in a high volume alternative trading
system. Under this alternative, an alternative trading system meeting
the requirements of Rule 301(b)(3)(i) would only be required to provide
to a national securities exchange or national securities association
the best-priced orders in covered securities displayed in the
alternative trading system by any broker or dealer and by any other
subscriber that elects to make its orders available for public display.
The
[[Page 70868]]
Commission requested comment on whether such an alternative would
sufficiently address the Commission's concerns with transparency and
fragmentation in the markets. The Commission is concerned, however,
that this alternative could exacerbate the competitive disparities
between broker-dealers and ECNs. Under the Order Handling Rules,
different order display requirements are imposed on limit orders
received by a market maker and forwarded to an ECN, than are imposed on
orders entered directly into an ECN. One commenter expressed concern
that this differential treatment could serve as a disincentive for
customers to place orders with a broker-dealer that acts as a market
maker in a security.\199\
---------------------------------------------------------------------------
\199\ See Letter from Wessels, Arnold & Henderson, LLC to
Jonathan G. Katz, Secretary, SEC, dated Nov. 12, 1997 (commenting on
the Concept Release).
---------------------------------------------------------------------------
Most commenters that expressed support for the display of
institutional and non-market maker broker-dealer orders did so because
the display of these orders would increase transparency and liquidity
in the market. The Investment Company Institute (``ICI'') stated that
it would support the display of institutional orders because it
believed display of those orders would improve the overall transparency
and liquidity of the market. This support, however, was contingent upon
the continued availability of the ``reserve'' feature offered by some
alternative trading systems.\200\ Another commenter, similarly,
supported disclosure of institutional orders because displayed orders
``are good for markets,'' and stated that there was no cause for
concern that requiring institutions to display in the public quotation
stream would lead to a decrease in orders displayed through alternative
trading systems. In fact, this commenter stated its belief that the
opposite would occur, and pointed to the proliferation of ECNs as
evidence.\201\ The NYSE also commented that requiring display of
institutional orders in the market would add transparency and
liquidity. The NYSE added that it strongly believes all orders of high
volume alternative trading systems, including orders of 10,000 shares
or more, should be required to be publicly displayed.\202\ Ashton
suggested that orders of up to 10,000 shares on all alternative trading
systems should be fully displayed, and orders exceeding 10,000 shares
should have at least 10,000 shares publicly displayed. Ashton stated
that it believed this would strike the appropriate balance between
displaying such orders and minimizing their market impact.\203\
---------------------------------------------------------------------------
\200\ 7/28/98 ICI Letter at 2-3. In a later letter, the ICI
requested clarification of whether certain orders the ICI described
as ``non-firm'' would be subject to display under the Commission's
rules. See Letter from Craig S. Tyle, General Counsel, ICI, to
Jonathan G. Katz, dated November 13, 1998 (``11/13/98 ICI Letter'').
See also the discussion supra at Section III.A.3.
\201\ American Century Letter at 4-5.
\202\ NYSE Letter at 6.
\203\ Ashton Letter at 6.
---------------------------------------------------------------------------
The commenters who opposed display of non-market maker broker-
dealer and institutional orders did so because of the market impact
they felt such orders would have if displayed. Instinet stated that
requiring the display of institutional orders would have several
negative effects on the market. In particular, Instinet claimed that
public display of institutional orders could have a ``significant
negative impact'' on the price and volatility of a security, would
divert this order flow to entities not subject to Regulation ATS or to
offshore markets, and would curtail the ability of institutions to
manage the securities transactions of the individual investors for whom
they act as proxy.\204\ Instinet also stated that institutional and
other non-market maker investors do not perform specialized market
functions, and therefore should not be subject to mandatory display in
the public quotation system. Finally, Instinet stated it believed that
customers should be able to determine the transparency of their orders
whether they were placed with a ``traditional brokerage firm'' or a
firm ``that offers both traditional and electronic execution
opportunities.'' \205\
---------------------------------------------------------------------------
\204\ Instinet Letter at 3, 12, and 14.
\205\ Id. at n.18 and n.23. See also Letter from David K.
Whitcomb, Professor of Finance and Economics, Rutgers University to
Jonathan G. Katz, Secretary, SEC, dated July 27, 1998 (``Whitcomb
Letter'') at 2-3 (stating that institutions may, in some instances,
feel strongly that displaying their orders more widely than to other
participants in the alternative trading system is undesirable, and
that, as a result, institutions may be induced to spread their
business among firms on the basis of whether the alternative trading
system has reached the volume threshold for public display of
orders, rather than on the basis of quality of service.); Letter
from Ruben Lee, Oxford Finance Group to Jonathan G. Katz, Secretary,
SEC, dated July 28, 1998 (``Lee Letter'') at 2-3 (stating that while
mandatory transparency might help retail investors monitor the
quality of their executions and reduce the inequality in access to
information that retail investors face, it could compromise
efficiency and liquidity).
---------------------------------------------------------------------------
The Commission is not persuaded by commenters that suggest that
institutions currently willing to use alternative trading systems to
display their orders to other alternative trading system subscribers,
including other institutions, market-makers, and broker-dealers, will
be less willing to use alternative trading systems that must display
those orders to the public market. Our reasons are as follows. The
primary group of market participants that will benefit from the public
display of institutional orders is retail investors. Retail investors
are not currently alternative trading system subscribers. To avoid
market impact, institutions try to avoid signaling other institutions
and market professionals, not retail investors. Almost all market
professionals and a significant number of institutions already
subscribe to alternative trading systems. Thus, the Commission believes
that the additional exposure to the market should not affect
institutions' behavior in their use of alternative trading systems.
Moreover, to the extent that institutions want to display small sized
orders in the public market, rather than their entire order, they will
still be able to make use of an alternative trading system's ``reserve
size'' feature. This will enable institutions to avoid exposing the
total size of their order to the public market.
The Commission also received numerous comment letters from
institutions who expressed similar concerns. Some of these commenters
appeared to be concerned that they might be forced to display all
orders sent to alternative trading systems, even those orders, or those
portions of orders, that are not displayed to any other alternative
trading system subscribers.\206\ To the extent that these letters are
concerned with ``full disclosure,'' that concern is misplaced. Instead,
the Commission proposed, and is adopting, a public display requirement
that applies only to those orders (or those portions of orders) that
alternative trading system subscribers
[[Page 70869]]
have already decided to display to the large number of other
alternative trading system subscribers. Institutions will remain free
to use a reserve feature, if an alternative trading system has one, to
not display full size of their orders to other alternative trading
system subscribers. That non-display of total order size will also
apply if that order is displayed in the public quote.
---------------------------------------------------------------------------
\206\ See 7/28/98 ICI Letter; 11/13/98 ICI Letter; Letter from
Rick Dahl, Chief Investment Officer, Missouri State Employees'
Retirement System to Jonathan G. Katz, Secretary, SEC, dated Nov.
12, 1998 (``Mosers Letter''); Letter from Russell Rhoads, Director
of Equity Trading, and Michael B. Orkin, Chairman and CEO, Caldwell
& Orkin, Inc. to Jonathan G. Katz, Secretary, SEC, dated Nov. 20,
1998 (``Caldwell Letter''); Letter from Todd M. Sheridan, Senior
Portfolio Manager, Caterpillar Investment Management Ltd. to
Jonathan G. Katz, Secretary, SEC, dated Nov. 19, 1998; Letter from
Praveen K. Gottipalli, Director of Investments, Symphony Asset
Management to Jonathan G. Katz, Secretary, SEC, dated Nov. 20, 1998
(``Symphony Letter''); Letter from Cinda A. Carmer, Senior
Securities Trader, Heartland Capital Management, Inc. to Jonathan G.
Katz, Secretary, SEC, dated Nov. 17, 1998; Letter from Patrick J.
McCloskey, Senior Vice President, Wellington Management Company, LLP
to Jonathan G. Katz, Secretary, SEC, dated Nov. 23, 1998
(``Wellington Letter''); Letter from Carrie Canter, Principal,
Equity Trading, Barrow, Hanley, Mewhinney & Strauss, Inc. to
Jonathan G. Katz, Secretary, SEC, dated Nov. 12, 1998 (``Barrow
Letter''). See also Weaver Letter (stating that if the Commission
required institutions to display the full size of their orders, even
if the full size is hidden from alternative trading system
subscribers through their use of a ``reserve size'' feature,
institutions will move their trading upstairs).
---------------------------------------------------------------------------
Other commenters generally expressed concerns similar to those
expressed by Instinet, emphasizing concerns about best execution for
institutional orders, and expressing concern about increased market
volatility.\207\ The Commission believes that display of institutional
orders in the public quote stream will not harm best execution--if
anything--best execution will be enhanced as all market participants
will have an opportunity to execute against these orders. The
Commission also believes that the experience with display of market
maker orders under the Order Handling Rules suggests that display of
institutional orders will not lead to increased market volatility. Many
of the largest market participants already have access to alternative
trading system institutional orders; therefore, their display in the
public quote stream should not necessarily lead to increased market
volatility. It will, however, allow those market participants who do
not have access to these alternative trading systems to have the
opportunity to execute against these orders.
---------------------------------------------------------------------------
\207\ See Letter from Gary E. Shugrue, General Partner, Argos
Partners Ltd., to Jonathan G. Katz, Secretary, SEC, dated Nov. 11,
1998 (``Argos Letter''); Letter from Stacey Matthews, Chelsey
Capital, to Jonathan G. Katz, Secretary, SEC, dated Nov. 16, 1998,
(``Chelsey Letter''); Letter from John D. Race, Partner, DePrince,
Race & Zollo, Inc., to Jonathan G. Katz, Secretary, SEC, dated Nov.
16, 1998, (``DePrince Letter''); Letter from Michael W. Masters,
Portfolio Manager, Masters Capital Investments, LLC, to Jonathan G.
Katz, Secretary, SEC, dated Nov. 16, 1998, (``Masters Letter'');
Letter from Denise O'Brien, Head of Equity Trading, Wanger Asset
Management, LP, to Jonathan G. Katz, Secretary, SEC, received Nov.
19, 1998, (``Wanger Letter''); Letter from Gerald N. Brown, Becker
Capital Management, to Jonathan G. Katz, Secretary, SEC, received
Nov. 19, 1998 (``Becker Letter''); Letter from Della L. Hood-Laster,
V.P. Equity Trading, Loomis Sayles & Company, LP, to Jonathan G.
Katz, Secretary SEC, dated Nov. 12, 1998, (``Loomis Letter''). See
also Barrow Letter and Mosers Letter.
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Some of the letters the Commission has received since the beginning
of November also express a concern that if institutional orders were
publicly displayed, institutions would lose their anonymity.\208\ The
Commission did not propose, nor is it adopting, any requirement that
would jeopardize an institution's anonymity. Similar to the way in
which ECNs currently display orders in the public quote, alternative
trading systems would display their best priced orders in the public
quote, but would not indicate which of their subscribers had entered
the order.
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\208\ See Letter from Susan Ellis, Vice President, Trading,
Granahan Investment Management, Inc. to Jonathan G. Katz, Secretary,
SEC dated Nov. 16, 1998; Letter from Genrald N. Brown, Becker
Capital Management to Jonathan G. Katz, Secretary, SEC received Nov.
19, 1998; Letter from Teresa M. Brandt, Head Equity Trader, Advantus
Capital Management, Inc. to Jonathan G. Katz, Secretary, SEC dated
Nov. 19, 1998; Letter from Kristen Straubel, Head Trader and Robert
T. Lutts, President, Cabot Money Management, Inc. to Jonathan G.
Katz dated Nov. 20, 1998; Letter from Tracy Altebrando, Senior
Equity Trader, Metropolitan Capital Advisors, Inc. to Jonathan G.
Katz, Secretary, SEC, dated Nov. 25, 1998. See also Wanger Letter,
Caldwell Letter, Symphony Letter, Wellington Letter.
---------------------------------------------------------------------------
In addition, a number of institutional commenters suggested if
Nasdaq had implemented its proposed limit order file, they would not
oppose a requirement that alternative trading systems publicly display
institutional orders, if those orders represent the best priced order
in the alternative trading system they use.\209\ Unfortunately, none of
these commenters explained why they would be willing to publicly
display their orders through a Nasdaq sponsored central limit order
file, but not publicly display orders they have chosen to display to
other alternative trading system subscribers.
---------------------------------------------------------------------------
\209\ See, e.g., Loomis Letter, Chelsey Letter.
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Finally, one commenter expressed concern that the order display
rule would mean that retail investors would increasingly observe trades
taking place below the bid and above the ask, and would be frustrated
by their lack of access to these trades.\210\ Because certain
institutions' orders will now be displayed in the public quote,
however, retail investors will have access to them. The lack of access
retail investors currently have to alternative trading systems is one
of the reasons the Commission believes that the display of
institutional orders in the public quote stream is particularly
important. In addition, this commenter stated that requiring public
display of institutional orders would tilt the playing field in favor
of dealers who do not have to display institutional orders.\211\ Under
the Order Handling Rules, however market makers are required to display
all customer limit orders that improve their quote.
---------------------------------------------------------------------------
\210\ Letter from Ed Restrepo, Head Trader, VanWagoner Capital
Management to Jonathan G. Katz, Secretary, SEC, dated Nov. 16, 1998
(``VanWagoner Letter'').
\211\ See VanWagoner Letter. See also Letter from Stacey Carter
Fleece, Chief Financial Officer, Brookhaven Capital Management to
Jonathan G. Katz, Secretary, SEC dated Nov. 18, 1998 (stating that
institutional orders submitted to dealers do not have to be
published); Letter from John D. Robinson, Head Trader, Longwood
Asset Management to Jonathan G. Katz, Secretary, SEC, dated Nov. 25,
1998.
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For these reasons, the Commission agrees with those commenters who
believe that institutional orders that are displayed to subscribers of
an alternative trading system should be integrated into the public
quotation system if they represent the top of the book in the
alternative trading system.\212\ The Commission believes that any
market impact that results from such display will be vitiated by the
retention of the reserve feature, as discussed above. The Commission
notes that such institutional orders are currently displayed to the
subscribers of alternative trading systems, who may number in the
thousands. These subscribers are often the market makers and other
active traders in the security. As a result, prices displayed only on
alternative trading systems are immediately known to key market players
who can adjust their trading to take advantage of their information
advantage. Moreover, the Commission believes that these orders will
provide enhanced transparency and liquidity when integrated into the
public quotation stream, and will further curtail the development of a
two-tiered market.
---------------------------------------------------------------------------
\212\ Under Rule 301(b)(3), non-market maker broker-dealer
orders entered into alternative trading systems must also be
displayed. 17 CFR 242.302(b)(3).
---------------------------------------------------------------------------
Nonetheless, the Commission is concerned about commenters'
statements that institutions may react to the transparency requirement
by shipping more orders upstairs or overseas. The Commission intends to
closely monitor the impact of this requirement, and will modify it if
harm appears to result.
(iii) Access to Publicly Displayed Orders
(A) Application of Access Requirements Under Regulation ATS
The Commission believes that in addition to the display of better
alternative trading system prices in the public quotation system, the
availability of such trading interest to public investors is an
essential element of the national market system. Therefore, the
Commission proposed that alternative trading systems afford all non-
subscriber broker-dealers equivalent access to the alternative trading
system orders displayed in the public quote, similar to the manner in
which ECNs currently comply with the ECN Display
[[Page 70870]]
Alternative under the Quote Rule.\213\ The Commission agrees with those
commenters who stressed the importance of equivalent access for non-
participants and who stated that simply requiring alternative trading
systems to display prices in the public quotation system does not go
far enough to facilitate the best execution of customer orders without
a mechanism to access orders at those prices.\214\ Accordingly, the
Commission is adopting the requirement as proposed.\215\ Specifically,
with respect to any security in which an alternative trading system is
required to publicly display its best priced orders because it has five
percent or more of all trading in that security, such alternative
trading system must provide for members of the SRO with which it is
linked the ability to effect a transaction with those orders. As
discussed above, the Commission is phasing in the public display
requirement.\216\ In addition, alternative trading systems are not
required to provide access to a security until the public display
requirement is effective for that security.\217\
---------------------------------------------------------------------------
\213\ Rule 11Ac1-1(c)(5)(ii), 17 CFR 240.11Ac1-1(c)(5)(ii)
(``Quote Rule''). See also Order Handling Rules Adopting Release,
supra note 177.
\214\ See infra note 218 and accompanying text.
\215\ Rule 301(b)(5), 17 CFR 242.301(b)(5).
\216\ See supra notes 192-193 and accompanying text.
\217\ The Commission emphasizes that, as with the transparency
phase-in, alternative trading systems may voluntarily provide access
to non-subscribers on or before April 21, 1999 in all securities
covered by the rule.
---------------------------------------------------------------------------
The Commission believes that non-subscribing broker-dealers should
be able to execute against those alternative trading system orders that
are publicly displayed to the same extent as if that price had been
reflected in the public quote by a national securities exchange or
national securities association. Thus, an alternative trading system
should respond to orders entered by non-participants no slower than it
responds to orders entered directly by subscribers. The Commission
believes that, under current NASD rules, any alternative trading system
that allows non-subscribing broker-dealers to execute against publicly
displayed alternative trading system orders in the same manner as ECNs
linked to the Nasdaq market currently do would comply with this
requirement. The NASD does not currently require ECNs to automatically
execute orders sent to the ECN through the NASD's SelectNet linkage
with the ECN. Any SRO to which alternative trading systems may be
linked, may determine that it is necessary for the fair and orderly
operation of its market to require that publicly displayed alternative
trading system orders be subject to automatic execution. Any such
proposed rule change, of course, would have to be filed with the
Commission by the SRO, published for comment, and approved by the
Commission. The Commission would not approve any such SRO rule unless
it finds that such rule is consistent with the Exchange Act.
(B) Response to Comments
The Commission asked for comment on whether alternative trading
systems should be required to provide non-subscribers with equivalent
access to displayed orders. Several commenters responded to this issue.
Most of these commenters stated that non-subscribers should be given
equivalent access.\218\ Only one commenter cautioned against granting
such access. This commenter argued that alternative trading systems and
traditional broker-dealers engage in the same business and, therefore,
it would impede innovation as well as be unfair to require fair access
to trading opportunities on alternative trading systems when the
Commission is not proposing to require such access to more traditional
broker-dealers.\219\ The Commission does not believe that alternative
trading systems and traditional broker-dealers engage in the same
business.\220\ As discussed above, the Commission believes that the
public display of orders on alternative trading systems that are
currently displayed only to the subscribers of those alternative
trading systems will improve the public securities markets. Without a
mechanism to access these orders, any public display requirement is
insufficient. Accordingly, the Commission is adopting the fair access
requirement.
---------------------------------------------------------------------------
\218\ See ICI Letter at 3; IBEX Letter at 9-10; Ashton Letter at
6; American Century Letter at 2; OptiMark Letter at 4.
\219\ Instinet Letter at 10.
\220\ See supra notes 205-212 and accompanying text.
---------------------------------------------------------------------------
In the Proposing Release, the Commission also stated that it
believes that for an alternative trading system to comply with this
equivalent execution access requirement, the publicly displayed
alternative trading system orders would need to be subject to automatic
execution through small order execution systems operated by the SRO to
which the alternative trading system is linked. One commenter strongly
urged the Commission to eliminate the automatic execution access
requirements from its proposal. This commenter was opposed to such a
linkage, because it believed it would effectively eliminate pure agency
brokers from markets in covered securities, because brokers would be
required to commit capital if automatic execution resulted in multiple
executions against client orders. This commenter also noted that the
Commission's Order Handling Rules do not require automatic execution,
but require only that response times for non-subscriber trade requests
are no slower than response times for subscribers, and believed this to
be a more balanced approach to execution access issues. \221\
Similarly, American Century, while supporting equivalent access to non-
subscribers, stated that automatic execution access requirements were
risky as well, because of the possibility of double execution.\222\ The
Commission does not expect--by operation of its rules alone--that
alternative trading systems will be subject to automatic execution
through SROs' small order execution systems. Nevertheless, the
Commission believes that an SRO to which an alternative trading system
is linked should be able to establish rules regarding how that
alternative trading system is integrated into its market. The
Commission notes that any change to SRO rules regarding automatic
execution would have to be approved by the Commission after notice and
the opportunity for the public to comment, and subject to Commission
review for competitive fairness and consistency with the Exchange Act.
---------------------------------------------------------------------------
\221\ Instinet Letter at 16-17.
\222\ American Century Letter at 2.
---------------------------------------------------------------------------
In addition, the Commission asked if there was a feasible way to
allow market-wide interaction without linkage to SRO order execution
systems, and whether there was a feasible way to grant equivalent non-
subscriber access to institutions that are not broker-dealers.
(iv) Execution Access Fees
(A) Limitations on Alternative Trading System Fees Charged to Non-
Subscribers
In the Proposing Release, the Commission stated that an alternative
trading system's fee schedules should not be used to circumvent the
ability of non-participants to access a system's publicly displayed
orders.\223\ Because reasonable fees are a component of equal access,
the rules the Commission is adopting today prohibit an alternative
trading system from setting fees that are inconsistent with the
principle of equivalent access to the alternative trading system quotes
by members of the SRO to which the alternative trading
[[Page 70871]]
system is linked. The rules also require an alternative trading system
to comply with the rules or standards governing fees established by the
national securities exchange or national securities association through
which non-subscribers have access.\224\
---------------------------------------------------------------------------
\223\ See Proposing Release, supra note 3, at n. 108.
\224\ Rule 301(b)(4), 17 CFR 242.301(b)(4).
---------------------------------------------------------------------------
The Commission believes that fees charged by an alternative trading
system would be inconsistent with equivalent access if they have the
effect of creating barriers to access for non-subscribers. As the
Commission stated in adopting the Order Handling Rules, any ECN fees
should be similar to the communications or systems charges imposed by
various markets.\225\ In addition, the Commission believes that the
national securities exchange or national securities association to
which the alternative trading system provides the prices and sizes of
its best priced orders should have further authority to assure that
fees charged by alternative trading systems to non-subscribers are
disclosed or otherwise consistent with fees typically charged by the
members of the exchange or association for access to displayed orders.
There are a number of ways the exchange or association could address
the issue of fees charged by alternative trading systems. For example,
subject to Commission review and approval, an exchange or association
could establish a standard for what constitutes a fair and reasonable
fee for non-subscriber access to an alternative trading system,
consistent with the effective operation of the self regulatory
organization's market and the Commission's equivalent access
requirement. The exchange or association may also require alternative
trading system fees to be charged in a manner consistent with the
exchange's or association's market, such as requiring the fee to be
incorporated in the displayed quote.
---------------------------------------------------------------------------
\225\ See Order Handling Rules Adopting Release, supra note 177,
at n.272.
---------------------------------------------------------------------------
At such time as quotations in the national market system are
reflected in decimals rather than in fractions, the Commission will
reconsider the rule's limitation on alternative trading systems
charging fees only as permitted by the national securities exchange or
national securities association to which they are linked. At that time,
the Commission will also consider whether alternative trading systems
should be permitted or required to reflect any fee charged in their
quotations.
Any rules the exchange or association develops will of course need
to be consistent with the goals of promoting competition and protecting
investors. The Commission encourages SROs that accept alternative
trading system quotes to work with alternative trading systems to
develop uniform standards regarding display and execution access by SRO
members to alternative trading systems linked to the SRO.\226\ In
addition, to foster equivalent access to alternative trading systems
for exchange-listed securities, the Commission expects Intermarket
Trading System (``ITS'') participants to modify ITS Plan requirements
where necessary to accommodate alternative trading system participation
in the markets of ITS participants, and access to those alternative
trading systems through ITS. If the SROs and ITS participants cannot
come to terms with affected alternative trading systems within a
reasonable time, the Commission will consider exercising its authority
to mandate the necessary linkages.
---------------------------------------------------------------------------
\226\ See, e.g., NASD Rule 4623. Securities Exchange Act Release
Nos. 38156 (Jan. 10, 1997), 62 FR 2415 (Jan. 16, 1997); 38008 (Dec.
2, 1996), 61 FR 64550 (Dec. 5, 1996).
---------------------------------------------------------------------------
(B) Response to Comments
The Commission requested comment on the fees that alternative
trading systems should be permitted to charge non-subscribers under the
proposed rules. In addition, the Commission requested comment on
whether there were alternatives for assuring fair execution access for
non-subscribers other than limiting fees, or another test for
determining whether non-subscriber fees assure equal access.
Ten comment letters addressed the issue of fees charged by
alternative trading systems for access by non-subscribers. Of these,
seven were generally in favor of permitting alternative trading systems
to charge some fee to non-subscribers,\227\ two were opposed,\228\ and
one felt the issue needed to be addressed in a separate release by the
Commission.\229\
---------------------------------------------------------------------------
\227\ See ICI Letter at 3; Instinet Letter at 17-18; NASD Letter
at 12; American Century Letter at 2; OptiMark Letter at 5. See also
IBEX Letter at 11 (opposing allowing SROs to dictate a fee schedule
for alternative trading systems, in which fees charged non-
subscribers are lower than those charged subscribers), Ashton Letter
at 6, n.7 (opposed to the idea that non-subscribers be linked
through an SRO execution system only).
\228\ See NYSE Letter at 7; CHX Letter at 8-10.
\229\ SIA Letter at 17 (stating that fees imposed by alternative
trading systems raised a number of procedural, structural and policy
issues, and recommending that the Commission make these the subject
of a separate release).
---------------------------------------------------------------------------
Most of the commenters who were in favor of allowing fees stated
that fees should be ``reasonable,'' or should not exceed the fees
typically charged to subscriber broker-dealers. The NASD, while not
opposing such fees, stated that the Commission should reconsider the
benchmark for an alternative trading system's fees, because it believed
that for many alternative trading systems, non-subscriber orders were
of primary importance. Because of this, the NASD stated that any fees
should be set at the low end of the threshold, rather than at the level
that a ``substantial proportion'' of an alternative trading system's
broker-dealer customers were paying. The NASD supported permitting SROs
to regulate fees, so that such issues could be discussed at the SRO
level. The NASD also recommended that the Commission discuss ``the
practical issues related to billing disputes and refusals to trade,''
because billing disputes have led to locked and crossed markets.\230\
Finally, the NASD asked the Commission to address the best execution
obligations of market participants when a fee is not included in the
publicly displayed price of an order. A broker-dealer's duty of best
execution requires it to seek the most favorable terms reasonably
available under the circumstances for a customer's transaction. While
price is the predominant element of best execution, the traditional
non-price factors of executions should also be considered.\231\
---------------------------------------------------------------------------
\230\ NASD Letter at 12. See also ICI Letter at 3 (recommending
that alternative trading systems be required to comply with any SRO
rules limiting fees).
\231\ See Order Handling Rules Adopting Release, supra note 177,
at nn.347-65 and accompanying text; Division of Market Regulation,
Division of Market Regulation, Market 2000: An Examination of
Current Equity Market Developments App V (1994) (``Market 2000
Study'').
---------------------------------------------------------------------------
Instinet commented that market forces should determine the
appropriate fees that broker-dealers can charge for their services.
Consequently, Instinet opposed any proposal to limit (or eliminate
entirely) access fees charged by a broker-dealer subject to Regulation
ATS if the rules of the national securities exchange or association to
which the broker-dealer is linked limits (or prohibits) such fees. The
Commission will, of course, review any proposed SRO rules relating to
access fees. To be approved by the Commission, any such rules must be
necessary to maintain consistency within the SRO's market, as well as
being designed to promote just and equitable principles of trade, to
promote fair competition, to facilitate transactions in securities,
and, in general, to protect investors and the public interest.\232\
Instinet also stated,
[[Page 70872]]
however, that it would urge the Commission to ensure that all public
execution access fee requirements were handled in such a way that all
orders integrated into the public quote stream were treated
consistently, and so that all broker-dealers were able to set
appropriate fees for the services they performed, subject to SRO
rules.\233\
---------------------------------------------------------------------------
\232\ While SRO proposed rule changes relating to fees imposed
by the SRO are eligible to become effective upon filing under
section 19(b)(3)(A)(ii) of the Exchange Act, and Rule 19b-4(e)(2) of
the Exchange Act, the Commission continues to require SROs to file
proposed rule changes regarding fees applicable to non-members or
non-participants under section 19(b)(2) for full notice and comment.
See Securities Exchange Act Release No. 35123 (Dec. 20, 1994), 59 FR
66692 (Dec. 28, 1994). Thus, a proposed SRO rule relating to fees
that alternative trading systems charge would not be eligible to
become effective upon filing.
\233\ Instinet Letter at 17-18 (also stating that the SRO to
which an alternative trading system belonged should not be
authorized to set fees).
---------------------------------------------------------------------------
American Century stated that all market participants who posted
bids and offers, not just alternative trading systems, should be
permitted to charge fees. American Century recommended that
participants who provide liquidity be permitted to charge a fee for
that liquidity, and that those who took liquidity should pay fees.\234\
OptiMark stated that the Commission should consider what economic
incentive it would be creating by permitting alternative trading
systems that register as broker-dealers to charge fees, but not
permitting those that register as exchanges to do so.\235\
---------------------------------------------------------------------------
\234\ American Century Letter at 2 (also agreeing that
decimalization will provide a more valid framework for this pricing
structure). See also ICI Letter at 3, n.8 (stating that market
makers should be able to assess liquidity fees when their quotes are
``hit'').
\235\ OptiMark Letter at 4-5.
---------------------------------------------------------------------------
The Commission also requested comment on whether fees should be
included in the price of an order quoted to the public, particularly
once orders are quoted in decimals. In this regard, the NYSE and the
Chicago Stock Exchange (``CHX'') stated that fees made it difficult to
determine the true cost of executing an order and indicated that this
would change if fees could be included in the quote.\236\ As discussed
above, when quotations in the national market system are reflected in
decimals rather than fractions, the Commission will reconsider whether
alternative trading systems should reflect any fees charged in their
quote, and if so, whether they should be subject to SRO requirements.
---------------------------------------------------------------------------
\236\ NYSE Letter at 7 (stating that such fees could make it
impossible for market participants to determine the true cost of
executing orders, but indicating that if fees were included in the
disseminated quotation that would be acceptable); CHX Letter at 8-10
(alternatively, CHX suggested the Commission allow firms to ignore
alternative trading system quotes at the NBBO if the next price
available after payment of the access fee is worse than the next
best available execution). But see IBEX Letter at 11 (opposing
including fees in the public quote).
---------------------------------------------------------------------------
(v) Amendment to Rule 11Ac1-1 Under the Exchange Act
The Commission also proposed an amendment to Rule 11Ac1-1 under the
Exchange Act.\237\ The amendment would expand the ECN Display
Alternative to allow alternative trading systems that display orders
and provide equal execution access to those orders under Rule 301(b)(3)
of Regulation ATS to fulfill market makers' and specialists'
obligations under the Quote Rule. Only two comment letters addressed
the proposed amendment to the Quote Rule, both of which supported
it.\238\
---------------------------------------------------------------------------
\237\ See supra note 213.
\238\ See Ashton Letter at 6 (suggesting that the Commission
consider amending the Quote Rule to require all exchanges, over-the-
counter dealers, and alternative trading systems to disseminate to
the public quote the actual size behind the best bid and offer
quotations). See also IBEX Letter at 11.
---------------------------------------------------------------------------
The Commission is adopting the amendment to the Quote Rule as
proposed.\239\ The Quote Rule currently requires all market makers and
specialists to make publicly available any superior prices that it
privately offers through ECNs. The ECN Display Alternative in the Quote
Rule permits an ECN to fulfill these obligations on behalf of market
makers and specialists using its system by submitting the ECN's best
market maker or specialist priced quotation to an SRO for inclusion
into the public quotation.\240\ Today's amendment to the Quote Rule is
intended to expand the ECN Display Alternative to allow alternative
trading systems that display orders and provide equal execution access
to those orders under Rule 301(b)(3) of proposed Regulation ATS to
fulfill market makers' and specialists' obligations under the Quote
Rule.
---------------------------------------------------------------------------
\239\ Rule 11Ac1-1(c)(5)(ii)(A) and (B), 17 CFR 11Ac1-
1(c)(5)(ii)(A) and (B).
\240\ See supra notes 177-183 and accompanying text.
---------------------------------------------------------------------------
d. Fair Access
(i) Importance of Fair Access
The Exchange Act requires registered exchanges and national
securities associations to consider the public interest in
administering their markets and to establish rules designed to admit
members fairly.\241\ These requirements are intended to ensure that
markets treat investors and other market participants fairly.\242\
Alternative trading systems that choose to register as exchanges will
be subject to these requirements. Under the current regulatory
approach, however, there is no mechanism to prevent unfair denials or
limitations of access by alternative trading systems or regulatory
oversight of such denials or limitations of access. Access to
alternative trading systems may not be critical when market
participants are able to substitute the services of one alternative
trading system with those of another. However, when an alternative
trading system has a significantly large percentage of the volume of
trading, unfairly discriminatory actions hurt investors lacking access
to the system.
---------------------------------------------------------------------------
\241\ Sections 6(b)(2) and 6(c) of the Exchange Act, 15 U.S.C.
78f(b)(2) and (c); section 15A(b)(8) of the Exchange Act, 15 U.S.C.
78o-3(b)(8).
\242\ ``Restraints on membership cannot be justified as
achieving a valid regulatory purpose and, therefore, constitute an
unnecessary burden on competition and an impediment to the
development of a national market system.'' H.R. Rep. No. 123, 94th
Cong., 1st Sess. 53 (1975).
---------------------------------------------------------------------------
Fair treatment by alternative trading systems of potential and
current subscribers is particularly important when an alternative
trading system captures a large percentage of trading volume in a
security, because viable alternatives to trading on such a system are
limited. Although the Commission is adopting rules to require
alternative trading systems with significant trading volume to publicly
display their best bid and offer and provide equal access to those
orders,\243\ direct participation in alternative trading systems offers
benefits in addition to execution against the best bid and offer. For
example, participants can enter limit orders into the system, rather
than just execute against existing orders on a fill-or-kill basis.
Participants in an alternative trading system can view all orders, not
just the best bid or offer, which provides important information about
the depth of interest in a particular security. Participants also have
access to unique features of alternative trading systems, such as
``negotiation'' features, whereby one participant can send orders to
another participant proposing specific terms to a trade, without either
participant revealing its identity. Some alternative trading systems
also allow participants to enter ``reserve'' orders which hide the full
size of an order from view. Because of these advantages to participants
in an alternative trading system, access to the best bid and offer
through an SRO is an incomplete substitute. Therefore, the rules the
Commission is adopting today require most alternative trading systems
that are registered as broker-dealers and that have a significant
percentage of overall trading volume in a particular security to comply
with fair access standards, as described in more detail below.\244\
---------------------------------------------------------------------------
\243\ See supra Section IV.A.2.c.(ii).
\244\ Rule 301(b)(5), 17 CFR 242.301(b)(5). Alternative trading
systems that derive their prices for securities from prices for
those same securities on another market are not subject to this
requirement.
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[[Page 70873]]
(ii) Fair Access Requirement
The Commission is adopting Exchange Act Rule 301(b)(5) to ensure
that qualified market participants have fair access to the nation's
securities markets. As the Commission proposed, an alternative trading
system registered as a broker-dealer and subject to Regulation ATS will
be required to establish standards for access to its system and apply
those standards fairly to all prospective subscribers, if the
alternative trading system, during four of the preceding six months,
accounts for twenty percent or more of the trading volume.\245\ This
twenty percent volume threshold will be applied on a security-by-
security basis for equity securities.\246\ Accordingly, if an
alternative trading system accounted for twenty percent or more of the
share volume in any equity security, it must comply with the fair
access requirements in granting access to trading in that security.
---------------------------------------------------------------------------
\245\ The Commission notes that this twenty percent volume
threshold is based on current market conditions. If there is a
change in these market conditions, or if the Commission believes
that alternative trading systems with less than twenty percent of
the trading volume are engaging in inappropriate exclusionary
practices or in anticompetitive conduct, the Commission may revisit
these fair access thresholds. The Commission intends to monitor the
impact and effect of these fair access rules, as well as the
practices of alternative trading systems, and will consider changing
these rules if necessary to prevent anticompetitive behavior and
ensure that qualified investors have access to significant sources
of liquidity in the securities markets.
\246\ The term ``equity security'' is defined in section
3(a)(11) of the Exchange Act, 15 U.S.C. 78c(a)(11) and Rule 3a1-1,
17 CFR 240.3a1-1. Options and limited partnerships are included
within the definition of an equity security.
---------------------------------------------------------------------------
For debt securities, the Commission proposed that if an alternative
trading system accounted for twenty percent or more of the volume in
any category of debt security, the alternative trading system would be
subject to the fair access requirements in granting access to trading
in securities in that category. The Commission solicited comment on the
appropriate categories of debt securities. Specifically, the Commission
asked whether categories such as mortgage and asset-backed securities,
municipal securities, corporate debt securities, foreign corporate debt
securities, and foreign sovereign debt securities would be appropriate.
After considering the comments, the Commission is adopting rules that
require alternative trading systems with twenty percent or more of the
volume in municipal securities, investment grade corporate debt
securities, and non-investment grade corporate debt securities to meet
the fair access requirements with respect to that category. The
Municipal Securities Rulemaking Board's transaction reporting plan now
provides information on the aggregate trading in municipal
securities.\247\ The fair access requirement will be effective for
alternative trading systems with twenty percent or more of the volume
in municipal securities on April 21, 1999.
---------------------------------------------------------------------------
\247\ See supra Section IV.A.1.d.
---------------------------------------------------------------------------
Because similar information for investment grade and non-investment
grade corporate debt, however, is not currently available, the fair
access requirements in Rule 301(b)(5)(D) and (E) will not be made
effective until April 1, 2000 with the expectation that further
information will be available at that time.\248\ The Commission is
deferring action on the fair access standards for alternative trading
systems trading a substantial portion of the market in foreign
corporate debt and foreign sovereign debt until such time as reliable
data is available by which alternative trading systems may determine
their relative portion of the market.
---------------------------------------------------------------------------
\248\ See supra note 146 (discussing the April 1, 2000 effective
date).
---------------------------------------------------------------------------
The Commission is excluding from the fair access requirement those
alternative trading systems that match customer orders for securities
with other customer orders, at prices for those same securities
established outside such system.\249\ Thus, regardless of their trading
volume, systems that, for example, match customer orders prior to the
market opening and then execute those orders at the opening price for
the securities are not required to comply with the fair access
requirement. In addition, systems that match unpriced orders at the
mid-point of the bid and ask, or at a value weighted average or prices
on another market are not subject to the fair access requirements. The
Commission, however, would not consider an alternative trading system
to be excluded from the fair access requirements in paragraph (b)(5) of
Rule 301 if that system priced any security traded on that system using
prices established outside such system for instruments other than the
particular security being executed. Therefore, a system would not be
excluded if it traded options or other derivatives based on prices
established on the primary market for the underlying security.
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\249\ Rule 301(b)(5)(iii), 17 CFR 242.301(b)(5)(iii).
---------------------------------------------------------------------------
Alternative trading systems subject to this fair access requirement
must comply with the requirements in paragraph (b)(5)(ii) of Rule 302.
Specifically, these alternative trading systems must establish
standards for granting access to trading on their systems,\250\ and
maintain these standards in their records.\251\ An alternative trading
system must apply these standards fairly and is prohibited from
unreasonably prohibiting or limiting any person with respect to trading
in any equity securities, or in certain categories of debt securities,
when that trading exceeds the twenty percent volume threshold. For
example, the Commission will consider it a denial of access by an
alternative trading system if the alternative trading system refuses to
open an account for a customer, thereby denying that customer the use
of its trading facilities.\252\ In addition, if an alternative trading
system grants, denies or limits access to trading to any person, the
alternative trading system is required to keep records of each action,
including the reasons for such action.\253\ Each alternative trading
system will also be required to provide a list of all grants, denials
or limitations of access to the Commission on Form ATS-R each quarter.
For each grant, denial or limitation of access, alternative trading
systems must provide the name of the person, nature and effective date
of the decision, and any other information that the alternative trading
system deems relevant. For denials or limitations of access,
alternative trading systems must provide information describing the
reasons for the decision.\254\ For example, if an applicant has a
relevant disciplinary history, has insufficient financial resources, or
refuses to agree to abide by the rules of the alternative trading
system, an alternative trading
[[Page 70874]]
system should include such reasons in its filing with the Commission.
The Commission intends to enforce the fair access rules by reviewing
these reports and investigating any possible violations of the
rule.\255\
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\250\ Several commenters agreed with the Commission that an
alternative trading system should be required to establish standards
for granting access to trading in its system. See IBEX Letter at 12;
Ashton Letter at 6; SIA Letter at 4, 14.
\251\ Rule 303(a)(1)(iii), 17 CFR 242.303(a)(1)(iii). The
Commission expects an alternative trading system to maintain a
record of its standards at each point in time. If the alternative
trading system amends or modifies its access standards, the records
kept should reflect historic standards, as well as current
standards.
\252\ Moreover, if an alternative trading system requires
subscribers to open an account with another broker-dealer with which
the alternative trading system has a clearing arrangement, the
alternative trading system is responsible for ensuring that the
clearing broker-dealer does not unfairly deny access to any person.
Thus, the alternative trading system--as part of its agreement with
the clearing firm--must ensure that the clearing firm establishes
standards for customers opening an account and that notices are sent
to any prospective customer denied an account.
\253\ Rule 301(b)(5)(ii), 17 CFR 242.301(b)(5)(ii).
\254\ Rule 301(b)(5)(ii)(D), 17 CFR 242.301(b)(5)(ii)(D).
\255\ Rule 301(b)(9), 17 CFR 242.301(b)(9); Form ATS-R, 17 CFR
249.638.
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The fair access requirements the Commission is adopting today are
based on the principle that qualified market participants should have
fair access to the nation's securities markets. Alternative trading
systems remain free to have reasonable standards for access. Such
standards should act to prohibit unreasonably discriminatory denials of
access. A denial of access is reasonable if it is based on objective
standards. For example, an alternative trading system may establish
minimum capital or credit requirements for subscribers.\256\ Similarly,
an alternative trading system may reasonably deny access to investors
based on a relevant, unfavorable disciplinary history. In addition, an
alternative trading system could allow institutional subscribers the
option of refusing to trade with broker-dealer subscribers, as long as
the alternative trading system grants this option to subscribers based
on objective and fairly applied standards. Provided that these or other
standards were applied consistently to all subscribers, an alternative
trading system would be considered to be granting and denying access
fairly. A denial of access might be unreasonable, however, if it were
discriminatorily applied among similar subscribers or if it were based
solely on the trading strategy of a potential participant.
---------------------------------------------------------------------------
\256\ For example, the Commission has recognized that the
creditworthiness of a counterparty is a legitimate concern of market
participants. See Letter from Richard R. Lindsey, Director, Division
of Market Regulation, SEC, to Richard Grasso, Chairman and Chief
Executive Officer, NYSE, dated Nov. 22, 1996 at 17. The Commission
also requested comment on what might be appropriate reasons for an
alternative trading system to deny market participants access. Most
commenters also stated that objective standards, such as
creditworthiness, would be appropriate, provided that these
standards were applied in a non-discriminatory manner. See IBEX
Letter at 12 (stating that credit-worthiness would be the most
significant standard); ICI Letter at 4 (requesting that the
Commission clarify that the standards for access can take into
account factors that are relevant to credit or other forms of
counterparty risk); SIA Letter at 14 (recommending that the
Commission allow alternative trading systems to limit access to any
category of its choosing, provided that the standands are not
applied in a discriminatory manner, and stating that an alternative
trading system should be permitted to select its standards, publish
them, and apply them as stated in a non-discriminatory manner); TBMA
Letter at 26 (requesting that the Commission clarify that an
alternative trading system would still be allowed to set standards
describing the customers with whom it wishes to do business,
provided its standards are applied in a non-discriminatory manner).
See also OptiMark Letter at 4, n.8 (stating that non-subscribers who
wished to become subscribers should not be ``unreasonably denied'').
---------------------------------------------------------------------------
The proposed rules included a right of appeal to the Commission of
any denial or limitation of access, as well as a requirement that an
alternative trading system notify a person denied or limited access of
their right of appeal. The Commission has decided not to adopt these
provisions. The Commission is concerned that such a right of appeal
would prove burdensome to the alternative trading system, the party
denied or limited access, and Commission staff. In addition, commenters
generally approved of the goals of fair access, but were not supportive
of providing a right of appeal to the Commission.
(iii) Response to Comments
Commenters who addressed the proposed fair access requirement
generally agreed with the Commission's goal of ensuring that
alternative trading systems with significant volume establish criteria
for fairly determining access.\257\ Two commenters, for various
reasons, did not believe that a requirement ensuring fair access by
alternative trading systems was necessary.\258\ Another commenter
argued that alternative trading systems that do not display to
subscribers should not be required to grant access to non-
subscribers.\259\
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\257\ See, e.g., IBEX Letter at 12 (stating that reasonable
credit or capital requirements or past bad faith dealings should be
the only basis for denying access); Ashton Letter at 6 (arguing that
alternative trading systems should be required to provide equivalent
access through nondiscriminatory system fees).
\258\ See TBMA Letter at 26 (stating that it would support a
fair access requirement for exchanges, but not for alternative
trading systems); ICI Letter at 4 (stating that it was not aware of
any material barriers to entry to the existing ECNs, and so did not
believe that the fair access requirement was necessary).
\259\ OptiMark Letter at 4.
---------------------------------------------------------------------------
The Commission solicited comment on the level of volume at which
fair access requirements should be applied. Of those commenters who
addressed the Commission's proposed threshold of twenty percent, three
believed that the level should be raised,\260\ two believed it should
be lowered,\261\ and one believed twenty percent was appropriate.\262\
One of the commenters that recommended the Commission lower the
threshold from twenty percent stated that fair access should be ensured
regardless of volume, because volume levels are subject to variation
over time, and because unfair denials of access by even small systems
could make access to quotes in illiquid securities particularly
difficult.\263\
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\260\ See TBMA Letter at 22-23 (recommending that the threshold
level be raised to thirty-five percent to avoid capturing
insignificant market participants, particularly in regard to the
bond market); SIA Letter at 3-4 (recommending that the threshold
level be raised to forty percent); ICI Letter at 4 (recommending
raising the threshold level to fifty percent).
\261\ See IBEX Letter at 12 (recommending that the threshold
level be lowered to ten percent); American Century Letter at 3.
\262\ NASD Letter at 12 (stating that twenty percent is an
appropriate level).
\263\ American Century Letter at 3.
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The Commission agrees with this commenter that fair access is an
important element of fair markets. Nevertheless, in balancing the need
for fair access with the costs that may be associated with such a
requirement, the Commission believes that a twenty percent threshold
strikes the right balance. As discussed above, the rules the Commission
is adopting today require that an alternative trading system subject to
Regulation ATS comply with fair access requirements if, during at least
four of the preceding six months, the alternative trading system
accounted for twenty percent or more of the average daily share volume
in any equity security or certain categories of debt.\264\
---------------------------------------------------------------------------
\264\ Rule 301(b)(5)(i), 17 CFR 242.301(b)(5)(i).
---------------------------------------------------------------------------
The Commission also requested comment on whether persons denied
access to an alternative trading system should have the right to appeal
this action to the Commission, what form the appeal should take, and
what the appropriate standard for Commission review should be. Five
comment letters directly addressed the issue of appeal to the
Commission of denials of access.
One commenter favored a right to appeal a denial of access, but
stated that the appeal process should begin at the SRO level.\265\ This
commenter stated that appeal to the Commission should occur only if the
SRO fails to resolve the dispute. Another commenter, similarly, stated
that it believes denials or limitations of access should be handled
through current SRO complaint and disciplinary procedures, rather than
through procedures used to appeal SRO determinations to the Commission.
This commenter stated that it believes formal Commission procedures
could blur the allocation of supervisory authority over broker-dealers
and could lead to duplicative or inconsistent review proceedings in
some cases. Moreover, this commenter was concerned that a
[[Page 70875]]
right to appeal to the Commission could lead to the frequent filing of
frivolous or vexatious complaints against the broker-dealer, thereby
impeding its ability to screen out potentially unqualified
customers.\266\ As discussed above, the Commission has decided not to
adopt the proposed right of appeal to the Commission.
---------------------------------------------------------------------------
\265\ IBEX Letter at 13. See also ICI Letter at 4 (stating that
the Commission should not provide a right to appeal denial of
access, but that complaints should be handled as any other complaint
against broker-dealers were handled: through the appropriate SRO or
the Commission).
\266\ Instinet Letter at 19.
---------------------------------------------------------------------------
One commenter opposed a right to appeal denial of access, on the
basis that there was no need for it. If, however, the Commission did
implement its proposal to provide those denied access with the right to
appeal to the Commission, this commenter recommended that the
Commission ensure that this process did not become a means to dictate
with whom a proprietary system may contract and that the allowable
relief not be so expansive as to allow the Commission to alter the
alternative trading system's published access standards.\267\
---------------------------------------------------------------------------
\267\ SIA Letter at 14-15. See also TBMA Letter at 26.
---------------------------------------------------------------------------
e. Capacity, Integrity, and Security Standards
As discussed in the Proposing Release,\268\ in November 1989 and
May 1991, the Commission published two policy statements regarding the
use of technology in the securities markets.\269\ These policy
statements established the automation review program and called for the
SROs to establish, on a voluntary basis, comprehensive planning,
testing, and assessment programs to determine systems' capacity and
vulnerability. The Commission recommended that SROs: (1) establish
current and future capacity estimates; (2) conduct capacity stress
tests; and (3) obtain annual independent assessments of systems to
determine whether they can perform adequately.\270\ In addition, the
Commission staff conducts oversight reviews of the SROs' systems
operations. All SROs currently participate in the Commission's
automation review program, which has been a significant force in
stimulating the SROs to upgrade their systems technology.\271\
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\268\ See Proposing Release, supra note 3, at Section III.A.2.e.
\269\ Securities Exchange Act Release No. 27445 (Nov. 16, 1989),
54 FR 48704 (``ARP I''); Securities Exchange Act Release No. 29185
(May 9, 1991), 56 FR 22489 (``ARP II''). ARP I and ARP II were
published in response to operational difficulties experienced by SRO
automated systems during the October 1987 market break. These
releases predicted future capacity requirements, emphasized the need
to maintain accurate trade and quote information, and discussed the
degree to which computer automation has become, and is likely to
increase as, an integral part of securities trading.
\270\ ARP II, supra note 269, set forth guidance concerning the
nature of these independent reviews.
\271\ The Commission notes that the United States General
Accounting Office (``GAO'') has conducted several studies on the
subject of computer systems and their role in the financial markets.
Generally, the GAO has recommended that the Commission take steps to
improve systems capacity, integrity, and security, See GAO, Stronger
System Controls and Oversight Needed to Prevent NASD Computer Outage
(Dec. 1994) (regarding Nasdaq system outages); GAO, Stock Markets:
Information Vendors Need SEC Oversight to Control Automation Risks
(Jan. 1992) (regarding risk assessments of automated operations of
stock market information dissemination vendors); GAO, Computer
Security Controls at Five Stock Exchanges Ned Strengthening (Aug.
1991) (regarding systems related risks at stock markets); GAO,
Active Oversight of Market Automation by SEC and CFTC Needed (Apr.
1991) (regarding automation risks of the securities and futures
markets); GAO, Tighter Computer Security Needed (Jan. 1990)
(regarding the Common Message Switch System and the Intermarket
Trading System operated by the Securities Industry Automation
Corporation and the Nasdaq system operated by the NASD).
---------------------------------------------------------------------------
The automation review program was established because of ``the
impact that systems failures have on public investors, broker-dealer
risk exposure, and market efficiency.'' \272\ While this program did
not directly apply to alternative trading systems, the Commission noted
that all broker-dealers should engage in systems testing and use the
policy statement as a guideline.\273\ Because some alternative trading
systems now account for a significant share of trading in the U.S.
securities markets, failures of their automated systems have as much of
a potential to disrupt the securities markets as failures of SROs'
automated systems. For this reason, the Commission proposed to require
alternative trading systems with significant volume to meet certain
systems capacity, integrity, and security standards.\274\ The proposed
requirements were similar to those standards SROs currently follow
under the automation review program.
---------------------------------------------------------------------------
\272\ ARP I, supra note 269, 54 FR at 48705; ARP II, supra note
269, 56 FR at 22490.
\273\ See ARP I, supra note 269, 54 FR at 48706, at n.17; ARP
II, supra note 269, 56 FR at 22493, at n.15.
\274\ With regards to system capacity, integrity, and security
standards, the Commission notes that during the past year, Instinet,
Island, Bloomberg, and Archipelago (operated by Terra Nova) have all
experienced system outages due to problems with their automated
systems. On a number of occasions, ECNs have had to stop
disseminating market maker quotations in order to keep from closing
altogether, including during the market decline of October 1997 when
one significant ECN withdrew its quotes from Nasdaq because of lack
of capacity. Similarly, a major interdealer broker in non-exempt
securities experienced serious capacity problems in processing the
large number of transactions in October 1997 and had to close down
temporarily. As a result, the Commission believes that the volume
thresholds discussed above are necessary to ensure that trading
systems have developed systems capacity, integrity, and security
standards that are adequate to prevent such system outages.
---------------------------------------------------------------------------
(i) Application of Capacity, Integrity, and Security Standards
The Commission is adopting Exchange Act Rule 301(b)(6) to reduce
the likelihood that alternative trading systems that play a significant
role in our national market system will disrupt the securities markets
due to failures of their automated systems. This rule requires
alternative trading systems trading twenty percent or more of the
volume in any equity security or in certain categories of debt
securities \275\ to comply with standards regarding the capacity,
integrity, and security of their automated systems. As for the fair
access requirements discussed above, the volume thresholds are on a
security-by-security basis for equity securities. Accordingly, if any
one equity security traded on an alternative trading system accounts
for more than twenty percent of the total share volume in that security
during four of the preceding six months, the alternative trading system
is required to meet the capacity, integrity, and security requirements
for that security, although in practice this may cause compliance with
the standards for all securities traded in that system. With respect to
debt securities, an alternative trading system is required to meet the
systems capacity, integrity, and security standards if it trades twenty
percent or more of the volume during four of the preceding six months
in any of the following categories: municipal securities, non-
investment grade corporate debt, and investment grade corporate
debt.\276\
---------------------------------------------------------------------------
\275\ Rule 301(b)(6) applies to the same categories of debt
securities as Rule 301(b)(5), discussed supra note 248 and
accompanying text. Specifically, the categories are investment grade
corporate debt securities, non-investment grade corporate debt
securities, and municipal securities. 17 CFR 242.301(b)(6).
\276\ See supra Section IV.A.2.d.
---------------------------------------------------------------------------
The Municipal Securities Rulemaking Board's transaction reporting
plan now provides information on the aggregate trading in municipal
securities.\277\ Because similar information for investment grade and
non-investment grade corporate debt, however, is not currently
available, the system capacity, integrity, and security requirements in
Rule 301(b)(6)(D) and (E) will not be made effective until April 1,
2000.\278\ The Commission is deferring action on the system reliability
standards for alternative trading systems trading a substantial portion
of the market in foreign corporate debt and foreign
[[Page 70876]]
sovereign debt until such time as reliable data is available by which
alternative trading systems may determine their relative portion of the
market.
---------------------------------------------------------------------------
\277\ See supra Section IV.A.1.e.
\278\ See supra note 146 (discussing the April 1, 2000 effective
date).
---------------------------------------------------------------------------
As for the fair access requirement, the Commission is excluding
from the systems capacity, integrity, and security requirement those
alternative trading systems that match customer orders for securities
with other customer orders, at prices for those same securities
established outside such system.\279\ Thus, regardless of their trading
volume, systems that, for example, match customer orders prior to the
market opening and then execute those orders at the opening price for
the securities are not required to comply with these systems
reliability requirements. In addition, systems that match unpriced
orders at the mid-point of the bid and ask, or at a value weighted
average or prices on another market are not subject to the fair access
requirements. The Commission, however, would not consider an
alternative trading system to be excluded from the requirements in
paragraph (b)(6) of Rule 301 if that system priced any security traded
on that system using prices established outside such system for
instruments other than the particular security being executed.
Therefore, a system would not be excluded if it traded options or other
derivatives based on prices established on the primary market for the
underlying security.
---------------------------------------------------------------------------
\279\ Rule 301(b)(6)(iii), 17 CFR 242.301(b)(6)(iii).
---------------------------------------------------------------------------
An alternative trading system that meets these volume thresholds
will be required to: (1) Establish reasonable current and future
capacity estimates; (2) conduct periodic capacity stress tests of
critical systems to determine such system's ability to process
transactions in an accurate, timely, and efficient manner; (3) develop
and implement reasonable procedures to monitor system development and
testing methodology; (4) review the vulnerability of its systems and
data center computer operations to internal and external threats,
physical hazards, and natural disasters; and (5) establish adequate
contingency and disaster recovery plans. An alternative trading system
is required to meet these proposed standards with respect to all its
systems that support order entry, order handling, execution, order
routing, transaction reporting, and trade comparison in the particular
security.\280\ In addition, alternative trading systems subject to this
provision are required to notify the Commission staff of material
systems outages and material systems changes.\281\ This information
will enable Commission staff to better understand the operation of the
alternative trading system and to identify potential problems and
trends that may require attention.
---------------------------------------------------------------------------
\280\ Rule 301(b)(6)(ii)(A)-(F), 17 CFR 242.301(b)(6)(ii)(A)-
(F).
\281\ Rule 301(b)(6)(ii)(G), 17 CFR 242.301(b)(6)(ii)(G).
---------------------------------------------------------------------------
Finally, under Regulation ATS, alternative trading systems that
meet the volume levels set forth above are required to perform an
annual independent review of the systems that support order entry,
order handling, execution, order routing, transaction reporting and
trade comparison.\282\ As discussed in greater detail in the
Commission's May 1991 Policy Statement,\283\ an independent review
should be performed by competent, independent audit personnel following
established audit procedures and standards. If internal auditors are
used by an alternative trading system to complete the review, these
auditors should comply with the standards of the Institute of Internal
Auditors and the Electronic Data Processing Auditors Association
(``EDPAA''). If external auditors are used, they should comply with the
standards of the American Institute of Certified Public Accountants
(``AICPA'') and the EDPAA.
---------------------------------------------------------------------------
\282\ Rule 301(b)(6), 17 CFR 242.301(b)(6). Regulation ATS also
requires alternative trading systems to preserve documentation
relating to their efforts to meet the requirements of this rule. See
Rule 303(a)(1)(iv), 17 CFR 242.303(a)(iv).
\283\ See ARP II, supra note 269.
---------------------------------------------------------------------------
(ii) Response to Comments
In the Proposing Release,\284\ the Commission requested comment on
its proposal to require significant alternative trading systems to
satisfy systems capacity, integrity, and security standards. While most
commenters did not specifically address this proposed requirement,
those that did comment generally supported it.\285\
---------------------------------------------------------------------------
\284\ See Proposing Release, supra note 3, at Section III.A.2.e.
\285\ See Ashton Letter at 5; NASD Letter at 11; TBMA Letter at
27 (but only if a system plays some role in price discovery such as
a traditional exchange does).
---------------------------------------------------------------------------
The Commission asked whether the twenty percent volume threshold
proposed was appropriate. In this regard, the NASD supported the twenty
percent proposed volume threshold.\286\ Two other commenters, however,
suggested that the Commission's proposed threshold was too low.\287\
Specifically, one of these commenters argued that the Commission should
raise the volume threshold from twenty percent to thirty-five percent
to avoid including debt market participants with no significant role in
price discovery. This commenter stated that, given the decentralized
and fungible nature of the debt markets, an alternative trading system
trading debt securities would need twenty percent or more of the
relevant market to materially affect the markets in the manner in which
the Commission is concerned.\288\ Another commenter, similarly,
suggested that these requirements not be imposed until an alternative
trading system had forty percent of the market in any security. In
addition, before the capacity, integrity, and security requirements are
triggered, this commenter recommended that any security (or category of
debt) in which the alternative trading system reached forty percent of
aggregate daily volume also represent twenty percent or more of the
alternative trading system's overall trading activity.\289\ One
commenter, however, argued that the Commission's proposed threshold was
too high, and that it should instead be applicable to alternative
trading systems with one percent of the consolidated volume in a
category of equity securities, such as listed or Nasdaq
securities.\290\
---------------------------------------------------------------------------
\286\ NASD Letter at 11.
\287\ See TBMA Letter at 22-23; SIA Letter at 13.
\288\ See TBMA Letter at 22-23.
\289\ SIA Letter at 13.
\290\ Ashton Letter at 5.
---------------------------------------------------------------------------
In addition, while the ICI stated its belief that competitive
pressures will generally suffice to ensure that alternative trading
systems have the capacity to execute trades in a timely manner, the ICI
also stated that it would not oppose such requirements as long as the
Commission applied them in a flexible manner and did not dictate how
alternative trading systems structure their operations.\291\
---------------------------------------------------------------------------
\291\ ICI Letter at 4.
---------------------------------------------------------------------------
The Commission believes that alternative trading systems that have
a significant role in the marketplace should be able to handle
reasonably foreseeable volume surges and be prepared for reasonably
anticipated future volume increases. As a result, the Commission
continues to believe that the volume thresholds above are appropriate.
Investors and other market participants increasingly rely on
alternative trading systems to buy and sell securities. The ability of
these markets to meet the demands of market participants is directly
related to the reliability of their automated systems. The Commission
realizes that alternative trading systems have significant business
incentives to ensure that their systems have adequate capacity so that
participants' orders do not experience unnecessary delays. The
[[Page 70877]]
systems capacity, integrity, and security rules are intended as a back-
up to ensure that alternative trading systems that have a significant
role in the market maintain sufficient systems and procedures to
minimize the effects of potential systems problems in the secondary
markets.
f. Examination, Inspection, and Investigations of Subscribers
The Commission proposed that an alternative trading system be
required to cooperate with the Commission's or an SRO's inspection,
examination, or investigation of the alternative trading system or any
of the alternative trading system's subscribers. Presently, the
Commission has the authority to inspect and examine any member of any
national securities exchange or any national securities association
directly. This is because all such members are broker-dealers.
Alternative trading systems, however, also could have certain other
subscribers, such as institutions or individuals, to which the
Commission's inspection authority does not extend. Because alternative
trading systems could be used by subscribers to manipulate the market
in a security,\292\ it is imperative that alternative trading systems
cooperate in all inspections, examinations, and investigations.
Although neither the Commission nor the SROs has the authority to
directly inspect non-broker-dealer subscribers of alternative trading
systems, any relevant trading information involving such subscribers
would be maintained by the alternative trading system under its
recordkeeping requirements, and would be required to be made available
upon request to its SRO or the Commission. Under the rules the
Commission is adopting today, an alternative trading system's exemption
from exchange registration is conditioned on it cooperating with the
Commission's or an SRO's inspection, examination, or investigation of
the alternative trading system or any of its subscribers.\293\
---------------------------------------------------------------------------
\292\ The Commission is aware of several incidents involving the
manipulation of quotations through alternative trading systems. The
participants who engaged in the manipulation were able to profit as
a result. See supra note 5.
\293\ Rule 301(b)(7), 17 CFR 242.301(b)(7).
---------------------------------------------------------------------------
g. Recordkeeping
The Commission proposed that alternative trading systems be
required to keep certain records. The Commission is adopting these
recordkeeping requirements as proposed. As adopted, Regulation ATS
requires alternative trading systems to make and keep the records
necessary to create a meaningful audit trail.\294\ Specifically,
alternative trading systems are required to maintain daily summaries of
trading and time-sequenced records of order information, including the
date and time the order was received, the date, time, and price at
which the order was executed, and the identity of the parties to the
transaction. In addition, alternative trading systems are required to
maintain a record of subscribers and any affiliations between
subscribers and the alternative trading system.\295\ While some of the
information that is required by the Regulation ATS will also be
required under the NASD's Order Audit Trail System (``OATS''),\296\
OATS is an NASD rule and does not cover all securities traded through
alternative trading systems.
---------------------------------------------------------------------------
\294\ Rule 301(b)(8), 17 CFR 242.301(b)(8).
\295\ Rule 302(a), 17 CFR 242.302(a).
\296\ Securities Exchange Act Release No. 39729 (Mar. 6, 1998),
63 FR 12559 (Mar. 13, 1998).
---------------------------------------------------------------------------
These recordkeeping requirements also require alternative trading
systems to keep records of all notices provided to subscribers,
including notices addressing hours of operation, system malfunctions,
changes to system procedures, and instructions pertaining to access to
the alternative trading system.\297\ In addition, alternative trading
systems are required to keep documents made (if any) in the course of
complying with the systems capacity, integrity, and security standards
in Rule 301(b)(6). These documents include all reports to an
alternative trading system's senior management, and records concerning
current and future capacity estimates, the results of any stress tests
conducted, procedures used to evaluate the anticipated impact of new
systems when integrated with existing systems, and records relating to
arrangements made with a service bureau to operate any automated
systems. These records will allow the Commission to examine whether
alternative trading systems are complying with the requirements under
Proposed Rule 301(b)(6). Finally, an alternative trading system subject
to the fair access requirements discussed above is required to keep a
record of its access standards.\298\
---------------------------------------------------------------------------
\297\ Rule 303(a)(1)(ii), 17 CFR 242.303(a)(1)(ii).
\298\ See supra Section IV.A.2.d.
---------------------------------------------------------------------------
Regulation ATS requires that these records be kept for at least
three years, the first two years in an easily accessible place. Some
records, such as partnership articles and articles of incorporation,
must be kept for the life of the alternative trading system.\299\
Alternative trading systems are permitted to keep records in any form
broker-dealers are permitted to keep records under Rule 17a-4(f) under
the Exchange Act.\300\
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\299\ Rule 303(a)(2), 17 CFR 242.303(a)(2).
\300\ Rule 303(b), 17 CFR 242.303(b). Rule 17a-4(f) provides for
the maintenance of records on microfilm, microfiche, or electronic
storage media. The Commission recognizes that alternative trading
systems may generate much of the information in electronic form and
generally may wish to keep records in electronic format. 17 CFR
240.17a-4(f).
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The Commission recognizes that alternative trading systems subject
to Regulation ATS are subject to the recordkeeping requirements for
broker-dealers under Rules 17a-3 and 17a-4 of the Exchange Act,\301\
which may require that some of the same records be made and kept.
Regulation ATS does not require an alternative trading system to
duplicate trading records maintained in the course of its normal
recordkeeping operations, provided that the alternative trading system
can sort and retrieve system records separately upon request. In
addition, as broker-dealers are currently permitted to do,\302\
Regulation ATS permits an alternative trading system to retain a
service bureau, depository, or other recordkeeping service to maintain
required records on behalf of the alternative trading system as long as
the designated party agrees to make the records available to the
Commission upon request.\303\
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\301\ 17 CFR 240.17a-3 and 17 CFR 240.17a-4.
\302\ 17 CFR 240.17a-4(i).
\303\ Rule 303(d), 17 CFR 242.303(d).
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The Commission solicited comment on these recordkeeping
requirements. In general, the comments received on this provision were
mixed. Two commenters supported requiring alternative trading systems
to keep the records necessary to create a meaningful audit trail.\304\
On the other hand, one commenter expressed concern that the
Commission's proposal would impose the same recordkeeping requirements
on both small and large alternative trading systems. Instead, this
commenter argued that smaller systems should be subject to none or only
minimal regulation generally, and that even the recordkeeping
requirements may serve as a significant barrier to market entry and
innovation.\305\
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\304\ See ICI Letter at 4; Ashton Letter p. 5.
\305\ TBMA Letter at 16. TBMA suggested exempting alternative
trading systems that do not exceed fifteen percent of the relevant
market from Regulation ATS and, thus, from the recordkeeping
requirements. TBMA stated that the additional recordkeeping
requirements would not provide the Commission significant new
information beyond what is currently included within broker-dealer
recordkeeping requirements. Id.
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The Commission believes that, for the most part, the records it is
requiring alternative trading systems to make and keep are records that
alternative trading
[[Page 70878]]
systems would otherwise keep as part of their business, and that
therefore these requirements will not place undue burdens upon
alternative trading systems. In addition, the Commission believes that
the highly automated nature of alternative trading systems will help
facilitate the construction and maintenance of an audit trail. The
Commission also believes that these recordkeeping requirements are
necessary to permit surveillance and examination to help assure fair
and orderly markets.
One commenter recommended that an alternative trading system's
records and reports only be available to an alternative trading
system's SRO on a confidential, need-to-know basis.\306\ Regulation ATS
provides that alternative trading systems are required to permit
inspections and examinations of their records by the Commission or the
SRO of which they are a member.\307\ The Commission noted in the
Proposing Release that, while potential conflicts of interest in
overseeing alternative trading systems may arise, the Commission
believes these conflicts can be managed using the Commission's
oversight authority. The Commission also recognized that some market
participants might be concerned that SROs could abuse their regulatory
authority, but noted that the Commission has oversight responsibility
over SROs to prevent such activity. In this regard, the Commission
expects SROs to carefully assess, and revise where necessary, their
internal policies and procedures for protecting the confidentiality of
sensitive information obtained in the course of fulfilling their SRO
regulatory responsibilities.\308\
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\306\ Ashton Letter at 5. Ashton pointed out that, because SRO-
sponsored systems compete directly with alternative trading systems,
SROs should not be able to gain confidential information through the
regulatory reporting process. Id.
\307\ Rule 301(b)(7), 17 CFR 242.301(b)(7).
\308\ See also Securities Exchange Act Release No. 35124 (Dec.
20, 1994), 59 FR 66702 (Dec. 28, 1994) (addressing similar concerns
in the context of Rule 17a-23).
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Finally, one commenter asked that the Commission consider the
relationship of any new recordkeeping requirements with applicable SRO
recordkeeping rules, such as the NASD's recently-adopted OATS.\309\ The
Commission notes that, while some of the information required by
Regulation ATS will also be required by SRO rules, such rules do not
have the same scope and are not designed to meet the same goals.
Moreover, SRO rules may not apply to all alternative trading system
activities. In addition, the Commission is only requiring that records
of certain information be made and kept, but is not dictating in what
form those records are maintained. This means that alternative trading
systems have flexibility in how they comply with SRO and Commission
rules. Further, if duplicative rules exist, the same alternative
trading system practices should serve to satisfy both sets of rules.
---------------------------------------------------------------------------
\309\ Instinet Letter at 20-21. Instinet stated that the
Commission should work with SROs to establish recordkeeping
requirements that minimize duplication and inconsistency as well as
providing alternative trading systems substantial flexibility in
structuring their recordkeeping operations. Id.
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h. Reporting and Form ATS-R
The Commission proposed that alternative trading systems be
required to periodically report certain information about their
activities. The Commission is adopting these requirements as proposed.
Regulation ATS, as adopted, requires alternative trading systems to
file with the Commission transaction reports within 30 calendar days of
the end of each calendar quarter on Form ATS-R.\310\ Specifically, Form
ATS-R requires alternative trading systems to report total volume in
terms of number of units traded and dollar value for the following
categories of securities: (1) Listed equity securities, (2) Nasdaq NM
securities, (3) Nasdaq SmallCap securities, (4) equity securities that
are eligible for resale pursuant to Rule 144A under the Securities Act
of 1933,\311\ (5) penny stocks, (6) equity securities not included in
(1)-(5), (7) rights and warrants, (8) listed options, and (9) unlisted
options. In addition, alternative trading systems are required to
report the total settlement value in U.S. dollars for: (1) Corporate
debt securities (separately for investment grade and non-investment
grade), (2) government securities, (3) municipal securities, (4)
mortgage related securities, and (5) debt securities not included in
(1)-(4). Alternative trading systems are required to file after-hours
trading information in listed equity, Nasdaq NM, and Nasdaq Small Cap
securities, as well as listed options. This information will permit the
Commission to monitor the trading on alternative trading systems. In
addition, alternative trading systems subject to the fair access
requirements in Rule 301(b)(5), as discussed above,\312\ must report
quarterly on Form ATS-R the persons to whom they grant, deny or limit
access to the alternative trading systems, as well as the date of the
action, the effective date of the action, and the nature of the denials
or limitations of access.
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\310\ Rule 301(b)(9), 17 CFR 242.301(b)(9).
\311\ 17 CFR 230.144A. Brokers and others who use alternative
trading systems to trade Rule 144A eligible securities and other
types of restricted securities should ensure those systems are
structured to permit the traders' compliance with their obligations
under Rule 144A and under the Securities Act of 1933.
\312\ See supra notes 253-255 and accompanying text.
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Because Rule 17a-23 \313\ will be eliminated, data filed by
alternative trading systems on Form ATS-R will replace the information
currently filed on Form 17A-23 by broker-dealers operating trading
systems. Unlike Part II of Form 17A-23, Form ATS provides a template on
which alternative trading systems are required to file the requested
information with the Commission. This template should allow alternative
trading systems to file the required information in a more uniform
format that will be more useful to the Commission. For example, the
Commission anticipates using this information to develop examination
modules for the inspection of alternative trading systems. The
Commission also expects to use the information to further understand
the effect of alternative trading systems on the securities markets.
---------------------------------------------------------------------------
\313\ See infra Section V. Rule 17a-23 under the Exchange Act
generally requires U.S. broker-dealers that sponsor broker-dealer
trading systems to provide a description of their systems to the
Commission and report transaction volume and other information on a
quarterly basis. This rule also requires that such broker-dealers
keep records regarding system activity and to make such records
available to the Commission. 17 CFR 240.17a-23. See also Securities
Exchange Act Release No. 35124 (Dec. 20, 1994), 59 FR 66702 (Dec.
28, 1994).
---------------------------------------------------------------------------
Another difference between Part II of Form 17A-23 and Form ATS is
that Form ATS requires alternative trading systems to provide
information about the volume of particular types of securities that are
not listed on an exchange or traded on Nasdaq. These new reporting
requirements on Form ATS-R will improve the quality of the data that
the Commission has available to consider the effectiveness of its
regulatory program. Due to the highly automated nature of alternative
trading system operations and the experiences with Rule 17a-23, the
Commission does not anticipate that gathering and submitting the data
required on Form ATS-R will be overly burdensome. Alternative trading
systems are also required to make reports on Form ATS-R available to
surveillance personnel of any SRO of which they are a member.\314\
---------------------------------------------------------------------------
\314\ Rule 301(b)(2)(vii), 17 CFR 242.301(b)(2).
---------------------------------------------------------------------------
The Commission solicited comment on the transaction reporting
requirements and Form ATS-R. In particular, the Commission solicited
comment on the frequency and scope of transaction reporting
requirements
[[Page 70879]]
proposed in Regulation ATS. No commenters responded to the Commission's
request for comments on the information requested on Form ATS-R.
The Commission received no comments opposing the proposed reporting
requirements. Several commenters generally supported the Commission's
proposal to require alternative trading systems to report their trading
volume.\315\ One commenter, however, commented that the Commission
should require monthly reporting instead of the proposed quarterly
reporting requirement.\316\ The Commission believes that quarterly
reporting under Regulation ATS, as adopted, will provide sufficiently
frequent reporting to the Commission. In view of the Commission's
desire to minimize respondent reporting burdens, the Commission
believes that more frequent reporting would not provide materially
improved investor protections. Based on the Commission's experience
with reporting requirements under Rule 17a-23, the Commission believes
that a quarterly filing requirement of Form ATS-R is appropriate.
---------------------------------------------------------------------------
\315\ See ICI Letter at 4 (supporting the proposal to require
reports quarterly); Ashton Letter at 5; IBEX Letter at 5.
\316\ Ashton Letter at 5.
---------------------------------------------------------------------------
The Commission also requested comment on the appropriateness of
permitting Form ATS-R to be filed electronically. Two commenters
thought that if the Commission were to accept filings electronically it
would be faster and less expensive.\317\
---------------------------------------------------------------------------
\317\ See IBEX Letter at 5; American Century Letter at 6.
---------------------------------------------------------------------------
Finally, one commenter recommended that an alternative trading
system's records and reports only be available to an alternative
trading system's SRO on a confidential, need-to-know basis.\318\ As
described above with respect to the recordkeeping requirements,\319\
the Commission believes that the separation between the market and
regulatory functions of an SRO and the Commission's oversight of SROs
are sufficient to maintain an appropriate level of confidentiality of,
and access to, alternative trading system information. The Commission
believes that SROs need to have access to relevant information in order
to carry out their oversight responsibilities. The Commission expects
that SROs will maintain and enforce appropriate internal policies and
procedures to protect against misuse of such information.
---------------------------------------------------------------------------
\318\ Ashton Letter at 5. Ashton pointed out that, because SRO-
sponsored systems compete directly with alternative trading systems,
SROs should not be able to gain confidential information through the
regulatory reporting process. Id.
\319\ See supra Section IV.A.2.g.
---------------------------------------------------------------------------
i. Procedures To Ensure Confidential Treatment of Trading Information
The Commission requested comment on proposed Rule 301(b)(10)
requiring alternative trading systems to have in place safeguards and
procedures to protect trading information and to separate alternative
trading system functions from other broker-dealer functions, including
proprietary and customer trading. The Commission did not propose
specific procedures, but encouraged commenters to express their views
on the requirements, including how to prevent the misuse by alternative
trading systems of confidential customer information. The Commission
received only three comment letters which directly addressed this
issue. All supported the Commission's proposal, although one also
requested clarification on what the confidentiality provisions
covered.\320\
---------------------------------------------------------------------------
\320\ See ICI Letter at 4-5 (stating that it agreed that the
failure to keep trading information confidential created the
potential for abuse); Instinet Letter at 21 (requesting that the
Commission clarify whether or not the proposed confidentiality
provisions would prohibit registered representatives from providing
customers with information (other than confidential customer
information) regarding the trading activity of the alternative
trading system); American Century Letter at 1-2 (stating that agency
broker-dealer functions should be separate from intermediated
broker-dealer functions that allow an alternative trading system
employee to ``work'' an order on behalf of customers, and that these
employees should not have access to the orders of customers who
choose to work their orders without the assistance of employees of
the alternative trading system).
---------------------------------------------------------------------------
The rules the Commission is adopting today require alternative
trading systems to have in place safeguards and procedures to protect
trading information and to separate alternative trading system
functions from other broker-dealer functions, including proprietary and
customer trading. The Commission believes that the sensitive nature of
the trading information subscribers send to alternative trading systems
requires such systems to take certain steps to ensure the
confidentiality of such information. For example, unless subscribers
consent, registered representatives of alternative trading systems
should not disclose information regarding trading activities of such
subscribers to other subscribers that could not be ascertained from
viewing the alternative trading system's screens directly at the time
the information is conveyed.
The Commission's concern regarding confidentiality grew out of its
inspections of some ECNs, during which the Commission staff found that
some of the broker-dealers operating ECNs used the same personnel to
operate the ECN as they did for more traditional broker-dealer
activities, such as handling customer orders that were received by
telephone. These types of situations create the potential for misuse of
the confidential trading information in the ECN, such as customers'
orders receiving preferential treatment, or customers receiving
material confidential information about orders in the ECN. The rules
concerning confidentiality that the Commission is adopting today are
designed to eliminate the potential for abuse of the confidential
trading information that subscribers send to alternative trading
systems. The Commission recognizes that some alternative trading
systems provide traditional brokerage services as well as access to
their alternative trading systems. The proposed rules are not intended
to preclude these services; rather, they are designed to prevent the
misuse of private customer information in the system for the benefit of
other customers, the alternative trading system operator, or its
employees.
Therefore, the Commission is adopting rules which require that: (1)
Information, such as the identity of subscribers and their orders, be
available only to those employees of the alternative trading system who
operate the system or are responsible for its compliance with the
proposed rules; (2) the alternative trading system has in place
procedures to ensure that all its employees are unable to use any
confidential information for proprietary or customer trading, unless
the customer agrees; and (3) procedures exist to ensure that employees
of the alternative trading system cannot use such information for
trading in their own accounts.\321\
---------------------------------------------------------------------------
\321\ Rule 301(b)(10), 17 CFR 242.301(b)(10).
---------------------------------------------------------------------------
The Commission intends the rules to prevent the disclosure or the
use of information about a customer's trading orders. Many of the
alternative trading systems operating today are anonymous; one of the
reasons ECNs are popular with investors is that they permit wide
dissemination of orders but provide anonymity. The broker-dealers
operating these systems, under the rules the Commission is adopting
today, cannot disclose any confidential customer information (including
the identity of the subscriber entering an order) to other customers,
or use that information for proprietary or agency trades.
The Commission expects that existing alternative trading systems
will
[[Page 70880]]
implement procedures such as these as quickly as possible, if they do
not already have them in place. These procedures should be clear and
unambiguous and presented to all employees, regardless of whether they
have direct responsibility for the operation of the alternative trading
system. Presently, many broker-dealers employ various means to ensure
that sensitive information does not flow from one division to another.
These methods include physical separation, written procedures, separate
personnel, and restricted access. The Commission believes that
firewalls such as these could be used by broker-dealers that operate
alternative trading systems to ensure that sensitive information
regarding the alternative trading system is contained in the proper
unit of the broker-dealer.
The Commission is not adopting specific procedures because it
believes that the broker-dealers who operate the alternative trading
systems are in the best position to know what procedures would best
prevent abuses. Experience has demonstrated, however, potential for
abuse and the Commission regards these procedures as important.
B. Registration as a National Securities Exchange
Trading systems that fall within Rule 3b-16 are only required to
comply with Regulation ATS if they wish to be exempt from the
definition of ``exchange.'' Such systems may choose instead to register
as national securities exchanges. The Commission expects that some
trading systems will find that registration as a national securities
exchange provides attractive benefits that make this option more
suitable to their business objectives. In particular, registered
exchanges enjoy more autonomy in their daily operations than do broker-
dealers that are members of SROs. Because any trading system that
registers as an exchange would be an SRO, it would not be subject to
oversight by a competing national securities exchange or national
securities association.\322\ Similarly, as a national securities
exchange, a trading system would be able to establish its own rules of
conduct, trading rules, and fee structures for access. An alternative
trading system registered as a broker-dealer, on the other hand, would
have to comply with the rules of the SRO to which it belongs, including
any rules regarding fees or the automatic execution of orders.
---------------------------------------------------------------------------
\322\ Alternative trading systems that continue to be regulated
as broker-dealers would remain subject to oversight by national
securities exchanges and the NASD, in their self-regulatory
capacities. See supra Section IV.A.2.a.
---------------------------------------------------------------------------
In addition, systems that elect to register as exchanges may
benefit from the added prestige and investor confidence associated with
status as a registered exchange. Registered exchanges are also able to
establish listing standards, which may promote investor confidence in
the quality of the securities traded on the exchange. Registered
exchanges may also become direct participants in the national market
system mechanisms, such as the ITS, Consolidated Tape Association
(``CTA''), and the Consolidated Quotation System (``CQS''). Direct
participation in these systems may provide a higher degree of
transparency and execution opportunities for subscribers to a trading
system. As direct participants in the national market system
mechanisms, registered exchanges are also entitled to share in the
revenues generated by the national market system systems, such as
revenue from CTA fees. Moreover, as the Commission noted in the
Proposing Release, only registered exchanges are eligible to be
participants of the Options Clearing Corporation (``OCC'').\323\
Consequently, any trading system that wants to trade standardized
options issued by the OCC would have to register as an exchange and
become a member of the OCC.
---------------------------------------------------------------------------
\323\ Options Clearing Corporation By-laws, Art. VII, Sections 1
and 4. Registered exchanges that are members of the OCC determine
such matters as listing, registration, clearance, issuance and
exercise of options contracts. Exchange members of the OCC are also
able to use registration and disclosure materials tailored for
standardized options.
---------------------------------------------------------------------------
Finally, if a trading system chooses to register as an exchange, it
could allow broker-dealers that are members of exchanges with off-board
trading restrictions to trade certain securities on the trading system
pursuant to unlisted trading privileges. The Commission believes that
if a trading system is registered and regulated as an exchange, it
should be considered to be an exchange, rather than an over-the-counter
market, for purposes of exchange off-board trading.\324\
---------------------------------------------------------------------------
\324\ The Commission has the authority to review final
disciplinary sanctions imposed by SROs on members or associated
persons of members, including sanctions imposed for violations of
SRO rules. The Commission may only affirm a sanction imposed by an
SRO on one of its members, participants or associated persons of its
members for a violation an SRO's rules, if the Commission finds
that: (1) The member, participant, or associated person of the
member engaged in the acts or practices that the SRO found were
engaged in; (2) such acts or practices are in violation of the SRO's
rules; and (3) the SRO's rules, and the application by the SRO of
its rules, are consistent with the purposes of the Exchange Act.
Sections 19(d)(2) and 19(e) of the Exchange Act, 15 U.S.C. 78s(d)(2)
and 78s(e).
---------------------------------------------------------------------------
As discussed in the Proposing Release, the Commission views certain
obligations of exchanges as fundamental to fair and efficient operation
in the marketplace and critical for the protection of investors. The
Commission did not propose any relief from the current obligations of
registered exchanges under the Exchange Act. Nevertheless, the
Commission requested comment on whether any exemptions from exchange
regulatory provisions would be necessary or appropriate to enable
alternative trading systems to register as exchanges. Commenters,
however, generally thought that any trading system that chooses to
register as an exchange should be subject to the same requirements as
currently registered exchanges and cautioned the Commission against
relieving registered exchanges from any requirements because of their
for-profit structure. Consequently, at this time the Commission has
determined that those trading systems choosing to register as exchanges
should satisfy all requirements that apply to national securities
exchanges under the Exchange Act.\325\
---------------------------------------------------------------------------
\325\ 15 U.S.C. 78f.
---------------------------------------------------------------------------
Many, if not all, alternative trading systems currently operating
are proprietary, rather than not-for-profit entities. The Commission
does not believe that there is any overriding regulatory reason to
require exchanges to be not-for-profit membership organizations, and
believes that alternative trading systems may retain their proprietary
structure even if they choose to register as exchanges. The Exchange
Act does not require national securities exchanges to be not-for-profit
organizations. As the Commission stated in the Proposing Release, it
believes that Congress clearly intended the 1975 Amendments to
encourage innovation by exchanges and recognized that future exchanges
may adopt diverse structures.\326\ The Commission believes that it is
possible for a for-profit exchange to meet the standards set forth in
section 6(b) of the Exchange Act.
---------------------------------------------------------------------------
\326\ See S. Rep. No. 75, supra note 107.
---------------------------------------------------------------------------
Any system meeting the definition set forth in Rule 3b-16 may apply
for registration as a national securities exchange by filing an
application with the Commission on Form 1.\327\ The Commission, in Rule
6a-1, set forth the procedure for filing such an application.\328\ All
Exhibits must accompany Form 1, including audited
[[Page 70881]]
financial statements prepared in accordance with United States
Generally Accepted Accounting Principles.
---------------------------------------------------------------------------
\327\ Section 6(a) of the Exchange Act, 15 U.S.C. 78f(a).
\328\ 17 CFR 240.6a-1.
---------------------------------------------------------------------------
The Commission has adopted an amendment to its rules of practice
regarding the processing of filings. Applications for registration as a
national securities exchange, as well as applications for exemption
from registration due to the limited volume of transactions, will not
be considered filed until all necessary information, including
financial statements and other required documents, have been furnished
in the proper form.\329\ Further, under section 6(b) of the Exchange
Act, the Commission must make certain determinations before registering
an exchange.\330\ In reviewing applications for registration as a
national securities exchange, the Commission will not register an
exchange unless it is satisfied that the exchange meets the
requirements discussed below.
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\329\ 17 CFR 202.3(b)(2). The Commission is not required to
propose changes to its Rules of Practice prior to adoption. See 5
U.S.C. 553(b)(3)(A).
\330\ Section 6(b) of the Exchange Act, 15 U.S.C. 78f(b).
---------------------------------------------------------------------------
1. Self-Regulatory Responsibilities
As a prerequisite for the Commission's approval of an exchange's
application for registration, the exchange must be organized and have
the capacity to carry out the purposes of the Exchange Act.
Specifically, an exchange must be able to enforce compliance by its
members, and persons associated with its members, with the federal
securities laws and the rules of the exchange.\331\ The Commission
believes that the self-regulatory role of registered exchanges is
fundamental to the enforcement of the federal securities laws. Congress
has delegated to the SROs certain quasi-governmental functions and
responsibilities, and has charged the Commission with overseeing the
SROs to make sure they have the ability and resources to comply with
those obligations. In this regard, the Commission believes that persons
responsible for operating an SRO should not have a disciplinary
history, and will seriously question the ability of an exchange to
carry out its SRO functions if the founders or prospective managers of
an applicant for registration as a national securities exchange are
subject to a statutory disqualification, as that term is defined in
section 3(a)(39) of the Exchange Act.\332\ The Commission believes that
persons who, for example, have willfully violated the federal
securities laws or have been convicted within the past ten years of a
felony or misdemeanor involving misappropriation of funds, or
securities fraud, larceny, theft, robbery, extortion, or other related
crimes would be inappropriate selections to fill the role of director,
officer, or manager of an exchange.
---------------------------------------------------------------------------
\331\ Section 6(b)(1) of the Exchange Act, 15 U.S.C. 78f(b)(1).
\332\ 15 U.S.C. 78c(a)(39). See also 15 U.S.C. 78o(b).
---------------------------------------------------------------------------
An alternative trading system wishing to register as a national
securities exchange may choose to set listing standards for its system.
If an applicant chooses to set listing standards, it must have written
listing and maintenance standards, as well as an adequate regulatory
staff to apply those standards.\333\ The applicant must also have rules
restricting the listing of securities issued in a limited partnership
rollup transaction.\334\ The ability to carry out these functions must
be adequately represented on an exchange's application for registration
before the Commission will register the exchange.
---------------------------------------------------------------------------
\333\ See Section 12(d) of the Exchange Act, 15 U.S.C. 78l(d);
Rule 12d2-2, 17 CFR 240.12d2-2 (requiring national securities
exchanges to file an application with the Commission to strike a
security from listing and registration).
\334\ See 15 U.S.C. 78f(b)(9).
---------------------------------------------------------------------------
An applicant for registration as an exchange must also have rules
designed to prevent fraudulent and manipulative acts and practices, to
promote just and equitable principles of trade, and to refrain from
imposing any unnecessary or inappropriate burdens on competition, among
other things.\335\ For example, an exchange must maintain procedures to
surveil for securities law violations, such as insider trading and
manipulation on the exchange. The Commission understands that
surveillance procedures can vary and will depend on the nature of, and
types of securities traded, on a particular exchange. Thus, while the
Commission will require all applicants for registration as an exchange
to have adequate measures in place, they will not have to use the same
procedures. The Commission will also require an applicant for
registration as a national securities exchange to show that it has
sufficient resources, including both staff expertise and capital, to
support its surveillance function.\336\ Consistent with these
requirements, an applicant should, at a minimum, demonstrate that the
officers charged with day-to-day management of the exchange are
familiar with the federal securities laws and the role of a registered
exchange as an SRO. In addition, an applicant for registration as a
national securities exchange must demonstrate that it has the
capability to maintain an audit trail of the transactions on its
system. Furthermore, an applicant must establish rules providing for
the allocation of fees for the use of its system.\337\
---------------------------------------------------------------------------
\335\ Section 6(b)(5) of the Exchange Act, 15 U.S.C. 78f(b)(5).
See also Section 6(b)(8) of the Exchange Act, 15 U.S.C. 78f(b)(6).
\336\ The Commission notes that, according to the audited
financial statements for 1997, the NYSE had total assets of
$1,174,887,000 and total expenses of $488,811,000; the Amex had
total assets of $195,547,000 and total expenses of $173,742,000; the
PCX had total assets of $67,622,000 and total expenses of
$60,636,000; the CSE had total assets of $13,124,585 and total
expenses of $5,343,403; and the Boston Stock Exchange (``BSE'') had
total assets of $33,339,961 and total expenses of $16,106,837.
\337\ Section 6(b)(4) of the Exchange Act, 15 U.S.C. 78f(b)(4).
---------------------------------------------------------------------------
An exchange must also have general conflict of interest rules
regarding, for example, trading on the exchange by its employees,
owners, or exchange officials. Moreover, an exchange must have rules
that ensure that no member's order is unfairly disadvantaged. For
example, if an exchange has priority rules, those rules need to treat
all exchange members fairly. Finally, an exchange must have rules
establishing procedures for the clearance and settlement of trades
effected on the exchange. Alternatively, an exchange must have rules
requiring members to make their own arrangements for clearance and
settlement of trades.
While exchanges are required to enforce compliance by their
members, and persons associated with their members, with applicable
laws and rules, the Commission has used its authority under sections 17
and 19 of the Exchange Act to allocate to particular SROs oversight of
broker-dealers that are members of more than one SRO (``common
members'').\338\ For example, in order to avoid unnecessary regulatory
duplication, the Commission appoints a single SRO as the designated
examining authority (``DEA'') to examine common members for compliance
with the financial responsibility requirements.\339\ When an SRO has
been named as a common member's DEA, all other SROs to which the common
member belongs are relieved of the responsibility to examine the firm
for compliance with applicable
[[Page 70882]]
financial responsibility rules.\340\ Consistent with past Commission
action, the Commission may continue to designate one SRO, such as the
NASD or the NYSE, as the primary DEA for common members of exchanges.
---------------------------------------------------------------------------
\338\ 15 U.S.C. 78q and 78s. See also 17 CFR 240.17d-2; 17 CFR
240.19g2-1.
\339\ With respect to a common member, section 17(d)(1) of the
Exchange Act authorizes the Commission, by rule or order, to relieve
an SRO of the responsibility to receive regulatory reports, to
examine for and enforce compliance with applicable statutes, rules,
and regulations, or to perform other specified regulatory functions.
15 U.S.C. 78q(d)(1).
\340\ See Securities Exchange Act Release No. 23192 (May 1,
1986) 51 FR 17426 (May 12, 1986). Moreover, section 108 of NSMIA,
supra note 7, adds a provision to section 17 of the Exchange Act
that calls for improving coordination of supervision of members and
elimination of any unnecessary and burdensome duplication in the
examination process.
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In addition, the Commission has previously permitted existing SROs
to contract with each other to allocate non-financial regulatory
responsibilities.\341\ Rule 17d-2 under the Exchange Act permits SROs
to establish joint plans for allocating the regulatory responsibilities
imposed by the Exchange Act with respect to common members.\342\ An SRO
participating in a regulatory plan is relieved of regulatory
responsibilities with respect to a broker-dealer member of such SRO, if
those regulatory responsibilities have been designated to another SRO
under the regulatory plan. Alternative trading systems registered as
exchanges would also be able to establish joint plans with respect to
common members.
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\341\ For example, the Commission has approved a regulatory plan
filed by the Amex, CBOE, NASD, NYSE, PCX, and the Philadelphia Stock
Exchange (``Phlx'') that divides the oversight responsibilities
among these SROs for common members, by designating each
participating SRO as the options examination authority for a portion
of the common members. This designated SRO has sole regulatory
responsibility for certain options-related trading matters. See
Securities Exchange Act Release No. 20158 (Sept. 8, 1983), 48 FR
41265 (Sept. 14, 1983). The SRO designated under the plan as a
broker-dealer's options examination authority is responsible for
conducting options-related sales practice examinations and
investigating options-related customer complaints and terminations
for cause of associated persons. The designated SRO is also
responsible for examining a firm's compliance with the provisions of
applicable federal securities laws and the rules and regulations
thereunder, its own rules, and the rules of any SRO of which the
firm is a member. Id.
\342\ 17 CFR 240.17d-2. Securities Exchange Act Release No.
12935 (Oct. 28, 1976), 41 FR 49093 (Nov. 8, 1976). In addition to
the regulatory responsibilities it otherwise has under the Exchange
Act, the SRO to which a firm is designated under these plans assumes
regulatory responsibilities allocated to it. Under Rule 17d-2(c),
the Commission may declare any joint plan effective if, after
providing notice and opportunity for comment, it determines that the
plan is necessary or appropriate in the public interest and for the
protection of investors, to foster cooperation and coordination
among the SROs, to remove impediments to, and foster the development
of, a national market system and a national clearance and settlement
system, and in conformity with the factors set forth in Exchange Act
section 17(d). 15 U.S.C. 78q(d). The Commission has approved plans
filed by the equity exchanges and the NASD for the allocation of
regulatory responsibilities pursuant to Rule 17d-2. See, e.g.,
Securities Exchange Act Release Nos. 13326 (Mar. 3, 1977), 42 FR
13878 (Mar. 14, 1977) (NYSE/Amex); 13536 (May 12, 1977), 42 FR 26264
(May 23, 1977) (NYSE/BSE); 14152 (Nov. 9, 1977), 42 FR 59339 (Nov.
16, 1977) (NYSE/CSE); 13535 (May 12, 1977), 42 FR 26269 (May 23,
1977) (NYSE/CHX); 13531 (May 12, 1977), 42 FR 26273 (May 23, 1977)
(NYSE/PSE); 14093 (Oct. 25, 1977), 42 FR 57199 (Nov. 1, 1977) (NYSE/
Phlx); 15191 (Sept. 26, 1978), 43 FR 46093 (Oct. 5, 1978) (NASD/BSE,
CSE, CHX and PSE); and 16858 (May 30, 1980), 45 FR 37927 (June 5,
1980) (NASD/BSE, CSE, CHX and PSE).
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A registered exchange would also be expected to maintain an audit
trail of trading. A fully automated exchange, however, can produce
comprehensive, instantaneous automated records that can be monitored
remotely. Therefore, fully automated exchanges might be able to
contract with other SROs to perform certain oversight activities, while
retaining ultimate responsibility for ensuring that these activities
are performed.
Further, the Commission also believes that the ultimate
responsibility for enforcement and disciplinary actions for violations
relating to transactions executed in an SRO's market or rules unique to
that SRO should continue to be retained by that SRO. In addition, these
exchanges must establish a disciplinary process including appropriate
sanctions for violations of the rules and a fair procedure for
administering the disciplinary process.\343\ Existing exchanges
generally employ personnel and establish extensive programs to fulfill
this responsibility. However, it may be possible for an exchange to
contract with another SRO to perform its day-to-day enforcement and
disciplinary activities. Nevertheless, a registered exchange would
retain ultimate responsibility for this function.\344\ In considering
an exchange's application for registration the Commission will consider
whether allowing the exchange to contract with another SRO to perform
its day-to-day enforcement and disciplinary activities would be
consistent with the public interest.
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\343\ See section 6(b)(6) of the Exchange Act, 15 U.S.C.
78f(b)(6). See also section 6(b)(7) of the Exchange Act, 15 U.S.C.
78f(b)(7).
\344\ See, e.g. section 19 of the Exchange Act, 15 U.S.C. 78s
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2. Fair Representation
Section 6(b)(3) of the Exchange Act requires that registered
exchanges have rules that: (1) Provide that one or more directors is
representative of issuers and investors, and not associated with a
member of the exchange, or with any broker-dealer; and (2) ``assure a
fair representation of its members in the selection of its directors
and administration of its affairs.'' \345\
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\345\ Section 6(b)(3) of the Exchange Act, 15 U.S.C. 78f(b)(3).
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(i) Public Directors
Congress adopted the requirement that at least one director be
representative of issuers and investors because of the public's
interest in ensuring the fairness and stability of significant
markets.\346\ Public representation on an exchange's board of directors
helps to achieve this goal. The Commission believes that, under this
structure, representation of the public on an oversight body that has
substantive authority and decision making ability is critical to ensure
that an exchange actively works to protect the public interest and that
no single group of investors has the ability to systematically
disadvantage other market participants through use of the exchange
governance process.\347\ Therefore, the Commission would expect
alternative trading systems that apply for registration as exchanges to
have public representation on their boards of directors.
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\346\ Id.
\347\ See NASD 21(a) Report, supra note 4.
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(ii) Fair Representation of Exchange Members
The second requirement, that of fair representation of an
exchange's members, also serves to ensure that an exchange is
administered in a way that is equitable to all market members and
participants. Because a registered exchange is not solely a commercial
enterprise, but also has significant regulatory powers with respect to
its members, competition between exchanges may not be sufficient to
ensure that an exchange carries out its regulatory responsibilities in
an equitable manner. The fair application of an exchange's authority to
bring and adjudicate disciplinary procedures may be particularly
important, because these actions can have significant and far-reaching
ramifications for broker-dealers.
Historically, the fair representation requirement was one of the
major obstacles to the regulation of alternative trading systems as
exchanges because of the concern that it would be incompatible with
their proprietary structures.\348\ In the Proposing Release,
[[Page 70883]]
however, the Commission proposed to allow non-membership, for-profit
alternative trading systems that choose to register as exchanges some
flexibility in satisfying this ``fair representation'' requirement.
---------------------------------------------------------------------------
\348\ See Delta Release, supra note 32, at 1900. In Board of
Trade of the City of Chicago v. Securities and Exchange Commission,
923 F.2d 1270 (7th Cir. 1991) (``Delta II''), the court stated that:
The Delta system cannot register as an exchange because the
statute requires that an exchange be controlled by its participants,
who in turn must be registered brokers or individuals associated
with such brokers. So all the financial institutions that trade
through the Delta system would have to register as brokers, and (the
system sponsors) would have to turn over the ownership and control
of the system to the institutions. The system would be kaput.
Id. at 1272-73.
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The Commission notes that it has not, in the past, interpreted an
exchange's obligation to provide fair representation of its members to
mean that all members must have equal rights. Instead, the Commission
has allowed registered SROs a degree of flexibility in complying with
this requirement. For example, PCX ``electronic access members''
(``ASAP Members'') do not have voting rights, and therefore are not
represented on the board of that exchange.\349\
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\349\ See Securities Exchange Act Release No. 28335 (Aug. 13,
1990), 55 FR 34106 (Aug. 21, 1990) (order approving rule change
establishing electronic access memberships on the PCX).
---------------------------------------------------------------------------
More recently, the Commission approved the merger between the Amex
and the NASD. As a result of the merger, Amex, reorganized as New Amex
LLC (``New Amex''), is now a subsidiary of the NASD. In reviewing the
merger, the Commission considered several fair representation issues.
Specifically, the Commission considered, among other things, Amex
member representation on the Board of Governors of New Amex, Amex
member representation on the Board of the NASD, the voting rights of
the Amex membership, and representation of the Amex membership in the
disciplinary process.
The Commission found that the composition of the New Amex Board
satisfied the fair representation requirement by providing the Amex
membership with the opportunity to nominate four Amex floor governors
to the New Amex Board.\350\ Further, the Commission found that the
inclusion of one New Amex floor governor on the NASD Board \351\ helped
to fulfill the fair representation requirement by providing for New
Amex input on the parent Board.\352\ In addition, the Commission
believes that the fair representation requirement was furthered by the
corporate governance provisions of New Amex's constitution that require
the consent of either Amex (through a Membership vote), the Amex
Committee (a committee designed specifically to represent the interests
of the Amex membership), or both, in situations impacting certain
membership interests or material market changes to New Amex. Lastly,
the Commission found that the disciplinary procedures of New Amex met
the fair representation requirement by providing for review of all
disciplinary matters by a committee composed of both Amex members and
public representatives. Specifically, the Amex Adjudicatory Council,
which is empowered to act for the full New Amex Board in reviewing
appeals from disciplinary proceedings, is composed of three Public
Members and three Floor Governors, all of whom are nominated by the
Amex Nominating Committee (or by petition signed by twenty-five
Members) and elected by a full Amex Membership vote.\353\
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\350\ The New Amex Board consists of eighteen total governors.
Floor governor nominees will be proposed by either the Amex
Nominating Committee (consisting of three floor members and two
public members) or a petition signed by twenty five members and will
be selected by a plurality of the Amex Regular and Options Principal
members voting together as a single class. The Amex membership
elects the members of the Amex Nominating Committee.
\351\ The Chief Executive Officer of New Amex will also be a
governor on the NASD Board.
\352\ The New Amex Floor Governor is nominated by the Amex
Membership and will be able to directly express the Amex members'
viewpoint and concerns within the NASD Board forum. In addition, the
Chief Executive Officer of New Amex will be able to provide
information about, and communicate the needs of, New Amex to the
NASD Board.
\353\ See Securities Exchange Act Release No. 40622 (Oct. 30,
1998), 63 FR 59819 (Nov. 5, 1998).
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In addition, with respect to clearing agencies, the Commission has
stated that registered clearing agencies may employ several methods to
comply with the fair representation standard.\354\ The Commission
believes that other structures may also provide independent, fair
representation for an exchange's constituencies in its material
decision making processes if the exchange is not owned by its
participants. For example, a proprietary alternative trading system
that registers as an exchange might be able to fulfill this requirement
by establishing an independent subsidiary that has final, binding
responsibility for bringing and adjudicating disciplinary proceedings
and making rules for the exchange, and ensuring that the governance of
such subsidiary equitably represents the exchange's participants.\355\
As another possibility, certain directors appointed to the board to
represent the interests of trading members or participants could be
limited to considering certain topics relating to system use and rules,
while consideration of ownership issues could be restricted to board
members representing the interests of the owners or stockholders.\356\
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\354\ 15 U.S.C. 78q-1(b)(3)(c). These methods include: (1)
Solicitation of board of directors nominations from all
participants; (2) selection of candidates for election to the board
of directors by a nominating committee which would be composed of,
and selected by, the participants or representatives chosen by
participants; (3) direct participation by participants in the
election of directors through the allocation of voting stock to all
participants based on their usage of the clearing agency; or (4)
selection by participants of a slate of nominees for which
stockholders of the clearing agency would be required to vote their
share. See Securities Exchange Act Release No. 14531 at 24 (Mar. 6,
1978), 43 FR 10288 (Mar. 10, 1978). See also Securities Exchange Act
Release No. 16900 (June 17, 1980), 45 FR 41920 (June 23, 1980).
\355\ The proprietary foreign exchange Easdaq, a recognized
secondary market in Belgium, has established a ``regulatory
authority'' that has a degree of independence from Easdaq's board of
directors.
\356\ The Commission in the past has approved exchange rules
limiting the voting rights of ``special access'' or non-equity
members as consistent with section 6(b)(3) of the Exchange Act, 15
U.S.C. 78f(b)(3). See, e.g., Securities Exchange Act Release No.
22959 (Feb. 28, 1986), 51 FR 8060 (Mar. 7, 1986) (approving rule
change by NYSE establishing ``electronic access membership'' with
restricted voting rights).
---------------------------------------------------------------------------
Some commenters expressed concern that the flexibility afforded
alternative trading systems in complying with their ``fair
representation'' requirement not extend so far as to result in unequal
regulation of alternative trading systems registered as exchanges and
traditional exchanges. In addition, these commenters expressed concern
that the efficiency of the markets not be compromised.\357\ American
Century also expressed its support for structures in which an
alternative trading system's board included both owners and
participants.\358\ On the other hand, several commenters stated that
members (or participants) of a proprietary exchange should not have any
right to participate in the governance of the exchange and that
imposing constraints on the manner in which alternative trading systems
are governed may undermine the factors that lead to their efficiency
and innovativeness.\359\
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\357\ See CBOE Letter at 5-6; NASD Letter at 4-5.
\358\ American Century Letter at 6.
\359\ See Ashton Letter at 4 (for-profit exchanges should be
afforded considerable flexibility in their formative business stages
in meeting fair representation obligations); OptiMark Letter at 3-4
(users of alternative trading systems should be treated fairly, but
are not entitled to exercise any formal rights in regard to the
management of the system, and are adequately protected through a
combination of regulatory safeguards and market forces); Lee Letter
at 1-2 (owners of exchanges already have incentives to create
suitable governance structures).
---------------------------------------------------------------------------
The Commission believes alternative trading systems should be
required to assure fair representation of their members if they choose
to register as exchanges. As discussed above, registered exchanges have
special responsibilities under the Exchange Act, regardless of whether
they are not-for-profit or for-profit. Accordingly, the Commission
continues to believe that exchange participants--including
[[Page 70884]]
participants in a for-profit exchange--need to have substantive input
into disciplinary and other key processes to prevent these processes
from being conducted in an inequitable, discriminatory, or otherwise
inappropriate fashion.
The NASD asked the Commission to provide more specific guidance on
the details of the flexibility the Commission proposes to allow
alternative trading systems applying for registration as
exchanges.\360\ The Commission has provided several examples of ways in
which fair representation requirements can be met in non-traditional
ways and believes that there may be other acceptable ways. The
Commission, however, does not believe it is necessary to specify in
greater detail what types of structures would be acceptable to it. What
constitutes fair representation for a particular exchange will be
determined in the context of that system's application for registration
under sections 6(a) and 19(a) of the Exchange Act. Under section 19(a)
of the Exchange Act, notice of an application for registration as an
exchange is published for comment before approval.\361\ This will
provide interested persons with notice of, and an opportunity to
comment on, the manner in which a particular exchange proposes to meet
its fair representation obligations.\362\
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\360\ NASD Letter at 4-5.
\361\ 15 U.S.C. 78s(a).
\362\ 15 U.S.C. 78f(a) and 78s(a). See NASD Letter at 4-5
(commenting that the public should have an opportunity to comment on
the proposed governance structure of an exchange before the
Commission approves its application for registration).
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3. Membership on a National Securities Exchange
An applicant for registration as a national securities exchange
must have rules to admit members and persons associated with those
members.\363\ Section 6(c)(1) of the Exchange Act \364\ prohibits
exchanges from granting new membership to any person not registered as
a broker-dealer, or associated with a broker-dealer. In the Concept
Release, the Commission solicited commenters' views on whether to allow
institutional membership on national securities exchanges. Because most
commenters were opposed to institutional membership on exchanges, the
Commission did not propose to exempt registered exchanges from the
limitations in section 6(c)(1). Nevertheless, in the Proposing Release,
the Commission asked for comment on whether institutions should be
permitted to be members of national securities exchanges.
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\363\ 15 U.S.C. 78f(b)(3)-(4) and 78f(c).
\364\ 15 U.S.C. 78f(c)(1). Section 6(c)(1), adopted in 1975,
prohibits exchanges from granting new memberships to non-broker-
dealers. At the time this Section was adopted, one non-broker-dealer
maintained membership on an exchange. This non-broker-dealer was not
affected by the prohibition and continues to maintain its
membership.
---------------------------------------------------------------------------
Most commenters expressing a view on institutional membership on
registered exchanges agreed that such exchanges should be prohibited
from having non-broker-dealer members.\365\ One commenter, however,
believed that direct institutional access to exchanges is a choice that
would benefit market participants by providing lower execution costs
for the shareholders of institutional funds. Although this commenter
noted the Commission's concerns about the regulatory burden an
institution might face if it chose to be a direct member of an
exchange, it thought that membership should be a choice available to
those institutions that feel they have the economies of scale to
warrant direct access or believe that anonymity is worth the regulatory
cost of membership.\366\
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\365\ CBOE Letter at 6 (``it would be difficult, if not
impossible, for the Commission to adequately regulate or oversee the
array of non-broker-dealer institutions that currently are, or may
become, participants on (alternative trading systems)''); NASD
Letter at 8 (institutions should not be members of alternative
trading systems that register as exchanges); IBEX Letter at 13
(institutional and individual investors should be granted exchange
access through the sponsorship of discount or full-service broker-
dealers).
\366\ American Century Letter at 4.
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As discussed in the Proposing Release, the Commission believes
that, in order to ensure the central goals of exchange regulation,
direct institutional members or participants in exchanges would have to
be subject to the majority of rules and regulations to which broker-
dealers are currently subject.\367\ Moreover, because institutions that
were granted exchange membership or direct access to exchanges would
likely need to become members in one or more of the national clearance
and settlement corporations in order to clear and settle their trades,
these institutions would need to demonstrate and maintain financial
creditworthiness. Insufficient net capital and incomplete books and
records could compromise financial soundness, audit trails, and other
general risk management objectives that are critical to sound markets
and clearance and settlement systems. Consequently, the Commission
would need to require non-broker-dealer institutions to comply with
financial responsibility obligations, including the requirements to
maintain certain minimum levels of net capital and appropriate books
and records.\368\ Without such requirements, institutional membership
on an exchange may also conflict with an exchange's obligation to have
rules that foster the efficient clearance and settlement of securities
transactions.
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\367\ Sections 6(f) and 15(e) of the Exchange Act, 15 U.S.C.
78f(f) and 78o(e), would permit the Commission to subject
institutional members to all exchange rules and relevant Exchange
Act provisions.
\368\ The Commission could adopt such requirements pursuant to
its authority under Section 15(c) of the Exchange Act, 15 U.S.C.
78o(e).
---------------------------------------------------------------------------
The Commission believes that non-broker-dealer institutions
essentially would be required to comply with the same requirements
imposed on registered broker-dealers and, therefore, undermine most
benefits an institution receives by virtue of not registering as a
broker-dealer.\369\ Thus, the Commission does not believe that allowing
institutional membership on exchanges would be any less costly to an
institution than establishing a broker-dealer affiliate, which can
become a member in a registered exchange. At the same time, it would
impose ad-hoc regulatory burdens on the Commission and the exchanges as
they tried to impose critical rules and regulations on institutions.
Further, the Commission does not believe that it is currently practical
or serves the best interests of investors or the markets generally to
allow non-broker-dealers to be members of national securities
exchanges, because of the potential lack of regulatory oversight the
Commission would have over these entities. Therefore, just as currently
registered exchanges are required to limit membership to broker-
dealers, alternative trading systems that choose to register as
exchanges would be prohibited from extending membership to non-broker-
dealers.
---------------------------------------------------------------------------
\369\ The Commission notes that institutions currently have the
option to establish a broker-dealer affiliate, which can become a
member in an exchange. The institution can then direct its order
flow through its affiliated entity. Many investment companies
already have affiliated broker-dealers.
---------------------------------------------------------------------------
Accordingly, the Commission believes that exchange membership
should continue to be limited to registered broker-dealers and persons
associated with registered broker-dealers in accordance with section
6(c)(1) of the Exchange Act.\370\ Institutions, however, would be able
to access alternative trading systems registered as exchanges through a
registered broker-dealer member of such a trading system, including an
affiliate of the institution. Institutions currently have efficient
access to the NYSE through SuperDOT
[[Page 70885]]
terminals given to them by NYSE members,\371\ and the OptiMark System
\372\ will enable institutions to directly enter orders in the OptiMark
System through use of an exchange member give-up. Access of this nature
should not impose significant costs or burdens on institutions or on
broker-dealers providing the access. The Commission believes if
institutions continue to have indirect access to exchanges, their needs
can be met without compromising important regulatory objectives.
---------------------------------------------------------------------------
\370\ 15 U.S.C. 78f(c)(1).
\371\ Exchange members are subject to regulatory action by the
NYSE for violations of NYSE rules by their customers entering orders
through the members' SuperDOT terminals.
\372\ See infra note 452.
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Finally, while the NASD agreed with the Commission's views that
institutions should not be ``members'' of registered exchanges, it
asked the Commission to provide guidance on whether a registered
exchange may set up a broker-dealer subsidiary to provide sponsored
access to retail and institutional customers. Further, the NASD asked
whether the registered exchange could be the SRO for its broker-dealer
subsidiary. The NASD believes that there is an inherent conflict of
interest in such an arrangement and that the Commission should explain
its views and provide SROs with guidance on the responsibilities for
oversight of the broker-dealer in such circumstances.\373\
---------------------------------------------------------------------------
\373\:NASD Letter at 8.
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In this regard, a registered exchange is not explicitly prohibited
from establishing a broker-dealer subsidiary through which it can
provide sponsored access to its non-broker-dealer customers.
Nonetheless, the Commission recognizes concerns about the potential
conflict of interest if a registered exchange were the SRO for its
subsidiary, and believes that it may be difficult for an exchange to
fulfill its obligations under sections 6(b)(6), 6(b)(7), and 19(g) with
respect to such a subsidiary.\374\
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\374\ 15 U.S.C. 78f(b)(6)-(7) and 15 U.S.C. 78s(g). These
provisions require that a registered exchange be able to enforce
compliance by its members with the federal securities laws,
appropriately discipline its members for violations of such laws,
and provide a fair disciplinary procedure. The Commission notes,
however, that unless a broker-dealer effects transactions in
securities solely on a national securities exchange of which it is a
member, it must become a member of a national securities association
or another national securities exchange. Section 15(b)(8) of the
Exchange Act, 15 U.S.C. 78o(b)(8).
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4. Fair Access
Sections 6(b)(2) \375\ and 6(c) \376\ of the Exchange Act prohibit
registered exchanges from denying access to, or discriminating against,
members. The obligation to ensure fair access for members does not,
however, restrict the authority of a national securities exchange to
maintain reasonable standards for access.\377\ The securities industry
and the general public need access to exchanges to ensure the best
execution of orders. Exchanges are venues for trading that should be
open to all qualified persons. The Commission stated in the Proposing
Release that alternative trading systems that register as exchanges
would be required to comply with section 6(b)(2) and section 6(c) of
the Exchange Act. IBEX was the only commenter to express a view on this
requirement and its comment was favorable.\378\ Thus, the Commission
would require any alternative trading system registered as an exchange
to ensure the fair access of registered broker-dealers.
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\375\ 15 U.S.C. 78f(b)(2).
\376\ 15 U.S.C. 78f(c).
\377\ A denial of access would be reasonable, for example, if it
were based on objective standards, such as capital and credit
requirements, and if these standards were applied fairly.
\378\ IBEX Letter at 13-14.
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In a similar vein, exchanges are prohibited from adopting any anti-
competitive rules.\379\ To further emphasize the goal of vigorous
competition, Congress requires the Commission to consider the
competitive effects of exchange rules,\380\ as well as the Commission's
own rules.\381\ The fair access and fair competition requirements in
the Exchange Act are intended to ensure that national securities
exchanges treat investors and their participants fairly, consistent
with the expectations of the investing public. For example, as
discussed above, an exchange's rules, including its rules of priority,
must treat all members fairly. Accordingly, before granting an
application for registration as an exchange, the Commission would
review the exchange's rules for compliance with these requirements.
---------------------------------------------------------------------------
\379\ Section 6(b)(8) of the Exchange Act, 15 U.S.C. 78f(b)(8);
section 15A(b)(9) of the Exchange Act, 15 U.S.C. 78o-3(b)(9).
\380\ Section 6(b)(6) of the Exchange Act, 15 U.S.C. 78f(b)(6).
\381\ Section 23(a) of the Exchange Act, 15 U.S.C. 78w(a).
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5. Compliance With ARP Guidelines
All national securities exchanges are expected to maintain
sufficient systems capacity to handle foreseeable trading volume.
Applicants for registration as a national securities exchange must have
adequate computer system capacity, integrity and security to support
the operation of an exchange. The Commission believes that adequate
capacity is vital to the efficient operation of exchanges, particularly
during periods of high volume or volatility, such as have been
experienced in the past year. To this end, all exchanges and the NASD
currently participate in the Commission's automation review program
(``ARP'').\382\ Given the highly automated nature of most alternative
trading systems, the Commission stated in the Proposing Release that it
would expect any exchange applying for registration as a national
securities exchange to comply with the policies and procedures outlined
by the Commission in its policy statements concerning the automation
review program, including cooperation with any reviews conducted by the
Commission. In this regard, the Commission would consider the resources
and ability of an applicant for registration as an exchange to meet the
standards set forth in the automation review program. In particular,
the Commission would consider whether the applicant had sufficient
capital to maintain its automated systems, and staff with technical
expertise.
---------------------------------------------------------------------------
\382\ See supra notes 269-273 and accompanying text.
---------------------------------------------------------------------------
The Commission received one comment letter addressing this issue.
The PCX commented that registered exchanges should only have to comply
with the ARP guidelines if they reach the threshold level that triggers
these requirements for alternative trading systems registered as
broker-dealers. The PCX noted that, although many exchanges do not
account for twenty percent, or even ten percent, of the trading in ITS
eligible equity securities, all exchanges are required to comply with
the ARP guidelines. The PCX commented that these regulatory
requirements impose substantial costs on exchanges and that there is no
basis for imposing these types of requirements on exchanges when such
requirements are not imposed on alternative trading systems registered
as broker-dealers that have substantially greater trading volume.\383\
---------------------------------------------------------------------------
\383\ PCX Letter at 7-8.
---------------------------------------------------------------------------
The Commission notes that today it is adopting a requirement that
alternative trading systems with twenty percent or more of the volume
in any equity security, or certain categories of debt, comply with
certain systems capacity, integrity, and security requirements. While
some registered exchanges may have less than twenty percent of the
volume in similar securities, the Commission nevertheless believes that
these exchanges' direct participation in the national market system
necessitates
[[Page 70886]]
participation in the automation review program. Moreover, while there
are costs associated with capacity planning and testing, contingency
planning, stress testing, and independent reviews, as well as ensuring
that automated systems have sufficient capacity, these are costs that
all highly automated business must bear and not merely regulatory
costs.\384\ The Commission's ARP guidelines are intended only to ensure
that short-term cost cutting by registered exchanges does not
jeopardize the operation of the securities markets.
---------------------------------------------------------------------------
\384\ In this regard, those exchanges applying for registration
in 1999 should also be prepared to demonstrate that their systems
are year 2000 compliant.
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6. Registration of Securities
Under the Exchange Act, securities traded on a national securities
exchange must be registered with the Commission and approved for
listing on the exchange.\385\ In addition, national securities
exchanges are permitted to trade securities listed on other exchanges
and Nasdaq pursuant to unlisted trading privileges (``UTP'').\386\
These requirements ensure that investors have adequate information and
that all relevant trading activity in a security is reported to, and
surveilled by, the exchange on which it is listed. The Commission
discussed in the Proposing Release that an alternative trading system
choosing to register as an exchange would be subject to these
requirements and would be required to have rules for trading the class
or type of securities it seeks to trade pursuant to UTP.\387\ Moreover,
to trade Nasdaq NM securities, such a system would have to become a
signatory to an existing plan governing such trading.\388\
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\385\ Section 12(a) of the Exchange Act makes it unlawful for
any member, broker, or dealer to effect any transaction in any
security (other than an exempted security) on a national securities
exchange unless a registration statement has been filed with the
Commission and is in effect as to such security for such exchange in
accordance with the provisions of the Exchange Act and the rules and
regulations thereunder. 15 U.S.C. 78l(a). Section 12(b) of the
Exchange Act, 15 U.S.C. 78l(b), contains procedures for the
registration of securities on a national securities exchange.
Section 12(a) does not apply to an exchange that the Commission has
exempted from registration as a national securities exchange. See,
e.g., Securities Exchange Act Release No. 28899 (Feb. 20, 1991), 56
FR 8377 (Feb. 29, 1991). See also Securities Exchange Act Release
No. 37271 (June 3, 1996), 61 FR 29145 (June 7, 1996).
\386\ Section 12(f) of the Exchange Act, 15 U.S.C. 78l(f). Under
section 12(f) of the Exchange Act, 15 U.S.C. 78l(f), exchanges
cannot trade securities not listed on an exchange or classified as
Nasdaq NM securities (such as Nasdaq SmallCap or OTC securities)
without Commission action. Section 12(f) of the Exchange Act
authorizes the Commission to permit the extension of UTP to any
security listed otherwise than on an exchange. The OTC-UTP plan
which provides UTP for Nasdaq NM securities, is the only extension
to date approved by the Commission. See OTC-UTP plan, infra note
401. Thus, registered exchanges cannot currently trade Nasdaq
SmallCap securities or exempted securities that are not separately
listed on the exchange.
\387\ Rule 12f-5, 17 CFR 240.12f-5.
\388\ See OTC-UTP plan, infra note 401 and accompanying text.
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With regard to these securities registration requirements, OptiMark
commented that they would preclude, as a practical matter, those
alternative trading systems that trade privately placed securities or
unregistered foreign securities from choosing to register as exchanges.
In addition, the various conditions and limited scope of the Nasdaq/
National Market System/Unlisted Trading Privileges (``OTC-UTP'') plan
\389\ would impair the ability of alternative trading systems that
offer competing facilities for securities listed on existing exchanges
to register as exchanges. For example, UTP may be extended for Nasdaq
NM securities, but this does not include Nasdaq SmallCap securities or
other over-the-counter securities. Moreover, formally amending the OTC-
UTP plan to admit any new member and to allocate expenses and revenues
among competing market centers is a time-consuming process.
---------------------------------------------------------------------------
\389\ The OTC-UTP plan provides for the collection,
consolidation, and dissemination of quotation and transaction
information for Nasdaq NM securities by its participants. Any
registered Exchange where Nasdaq NM securities are traded may become
a full participant in the OTC-UTP plan. See infra note 401. See also
Securities Exchange Act Release Nos. 24407 (Apr. 27, 1987), 52 FR
17349 (May 7, 1987); 36985 (Mar. 18, 1996), 61 FR 12122 (Mar. 25,
1996).
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Consequently, OptiMark recommended that the Commission exercise its
exemptive authority to reduce the differences in regulatory treatment
between alternative trading systems registered as exchanges and those
registered as broker-dealers. In particular, OptiMark suggested that,
regardless of whether they are registered exchanges or broker-dealers,
alternative trading systems that limit their screen availability to
certain qualified persons be permitted to trade unregistered
securities, including private placements and foreign securities.
Similarly, OptiMark believed that alternative trading systems that seek
to compete for order flow with existing exchanges should be able to do
so in all securities listed on those exchanges, regardless of the
alternative trading system's registration status.\390\
---------------------------------------------------------------------------
\390\ OptiMark Letter at 3.
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The issue of trading unregistered securities, and in particular
unregistered foreign securities, on exchanges raises many difficult
issues. Registration of securities provides public information for
investors that is prepared in accordance with U.S. accounting and
auditing standards. This assures that the issuer's disclosures are
consistently presented and can be easily compared to the information
provided by other issuers. For this reason, the Exchange Act requires
securities to be registered if they trade on national securities
exchanges.
The Commission has maintained the current structure in the final
rules: continuing to require registered exchanges to trade only
registered securities, but not extending this requirement to
alternative trading systems not registered as exchanges. The Commission
is continuing to review on a broader basis the issuing and trading of
unregistered foreign securities in the U.S. and, as part of that
review, will specifically consider whether unregistered foreign
securities should continue to be freely traded on alternative trading
systems that are not registered as exchanges.
7. National Market System Participation
As discussed in the Proposing Release, any alternative trading
system that elects to register as a national securities exchange would
also be expected to become a participant in the market-wide transaction
and quotation reporting plans currently operated by registered
exchanges and the NASD. These plans--the CQS,\391\ the CTA,\392\ the
ITS,\393\ the Options Price Reporting Authority (``OPRA''),\394\ and
OTC-
[[Page 70887]]
UTP \395\--link trading, quotation, and reporting for all registered
exchanges and the NASD and are responsible for the transparent,
efficient, and fair operation of the securities markets. These plans
form the backbone of the national market system and participation in
these plans by all registered exchanges is vital to the success of the
national market system.
---------------------------------------------------------------------------
\391\ The CTA provides vendors and other subscribers (including
alternative trading systems) with consolidated last sale information
for stocks admitted to dealings on any exchange pursuant to a plan
approved by the Commission (``CTA plan''). See, e.g., Securities
Exchange Act Release Nos. 10787 (May 10, 1974), 39 FR 17799 (final
rules approving CTA plan); 16983 (July 16, 1980), 45 FR 49414 (July
24, 1980); 37191 (May 9, 1996), 61 FR 24842 (May 16, 1996).
\392\ The CQS gathers quotations from all market makers in
exchange-listed securities and disseminates them to vendors and
other subscribers pursuant to a plan approved by the Commission
(``CQ plan''). Securities Exchange Act Release No. 16518 (Jan. 22,
1980), 45 FR 6521 (final rules approving CQ plan); 37191 (May 9,
1996), 61 FR 24842 (May 16, 1996).
\393\ The ITS is a communications system designed to facilitate
trading among competing markets by providing each market
participating in the ITS pursuant to a plan approved by the
Commission (``ITS plan'') with order routing capabilities based on
current quotation information. See, e.g. Securities Exchange Act
Release Nos. 37191 (May 9, 1996), 61 FR 24842 (May 16, 1996); 17532
(Feb. 10, 1981), 46 FR 12919 (Feb. 18, 1981); 23365 (June 23, 1986),
51 FR 23865 (July 1, 1986) (CSE/ITS linkage); 18713 (May 6, 1982) 47
FR 20413 (May 12, 1982) (NASD's CAES/ITS linkage); 28874 (Feb. 12,
1991), 56 FR 6889 (Feb. 20, 1991) (CBOE/ITS linkage).
\394\ See infra note 401 and accompanying text for a description
of the OPRA plan.
\395\ See infra note and accompanying text for a description of
the OTC-UTP plan.
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Participation in effective quote and transaction reporting plans
and procedures would, therefore, be mandatory for any newly registered
exchange, as it is now for currently registered exchanges.\396\ The CTA
and the CQS, which make quote and transaction information in exchange-
listed securities available to the public,\397\ both have provisions
governing the entry of participants to the plans,\398\ and allow any
national securities exchange or registered national securities
association to become a participant.\399\ New participants are required
to pay certain entry fees to the existing participants.\400\
Participants in these plans share in the income and expenses associated
with the plans' operations.\401\ Because national securities exchanges
are required to participate in an effective quote and transaction
reporting plan, the Commission expects the participants of existing
plans to include them in the plans under reasonable conditions adapted
to the situations of the new exchanges.
---------------------------------------------------------------------------
\396\ See Rules 11Ac1-1(b)(1) and 11Aa3-2(c), 17 CFR 240.11Ac1-
1(b)(1) and 240.11Aa3-2(c).
\397\ Both the CTA and the CQS are presently operated by the
eight national securities exchanges and the NASD.
\398\ The CTA plan also contains a provision for entities other
than participants to report directly to the CTA as ``other reporting
parties.'' Pursuant to this provision, parties other than a national
securities exchange or association may be permitted to provide
transaction data directly to the CTA. Alternative trading systems
that do not elect to register as exchanges would be eligible for
participation in the CTA plan pursuant to this provision; however,
as non-member participants, these systems would neither be obligated
to pay the required fees and expenses to the plan, nor able to share
in the plan's profits.
\399\ See Securities Exchange Act Release No. 37191 (May 9,
1996), 61 FR 24842 (May 16, 1996).
\400\ These fees represent the ``tangible and intangible
assets'' provided by the plans to the new participant. See Proposing
Release, supra note 3 at nn.342-43 (discussing entry fees for the
CTA, CQS, and ITS plans).
\401\ Similar to the CTA and CQ plans, the OTC-UTP plan
governing trading of Nasdaq NM securities provides for the
collection, consolidation, and dissemination of quotation and
transaction information for Nasdaq NM securities by its
participants. Any national securities exchange where Nasdaq NM
securities are traded may become a full participant of the OTC-UTP
plan. The plan also provides that new participants pay a share of
development costs, share ongoing operating costs, and are entitled
to share in the plan's profits. See Joint Self-Regulatory
Organization Plan Governing the Collection, Consolidation and
Dissemination of Quotation and Transaction Information for Exchange-
listed Nasdaq/National Market System Securities and for Nasdaq/
National Market System Securities Traded on Exchanges on an Unlisted
Trading Privilege Basis (``OTC-UTP plan''). Securities Exchange Act
Release No. 24407 (Apr. 29, 1987), 52 FR 17349 (May 7, 1987). See
also Securities Exchange Act Release No. 36985 (Mar. 18, 1996), 61
FR 12122 (Mar. 25, 1996).
The OPRA plan also provides for the collection and dissemination
of last sale and quotation information with respect to options that
are traded on the participant exchanges. Under the terms of this
plan, any national securities exchange whose rules governing the
trading of standardized options have been approved by the Commission
may become a party to the OPRA plan. The plan provides that any new
party, as a condition of becoming a party, must pay a share of
OPRA's start-up costs. It also provides for revenue sharing among
all parties. The OPRA plan was approved pursuant to Section 11A of
the Exchange Act and Rule 11a3-2 thereunder. See Securities Exchange
Act Release No. 17638 (Mar. 18, 1981) (``OPRA plan'').
---------------------------------------------------------------------------
In addition to requiring participation by newly registered
exchanges in quote and transaction reporting plans, the Commission
would expect newly registered exchanges to participate in ITS,\402\ or
an equivalent system if one were developed. ITS provides trading links
between market centers and enables a broker or dealer who participates
in one market to execute orders, as principal or agent, in an ITS
security at another market center, through the system.\403\ The ITS
plan requires that the members of participant markets avoid initiating
a purchase or sale at a worse price than that available on another ITS
participant market (``trade-throughs'').\404\ Participation in ITS
would give users of these new exchanges access to other ITS participant
markets. Moreover, participation in ITS would require new exchanges to
adopt rules to comply with other applicable ITS plan provisions and
policies on matters such as, for example, trade-throughs, locked
markets,\405\ and block trades.\406\ As with the quote and transaction
reporting plans, alternative trading systems that register as exchanges
would have to be integrated into ITS, or another system that links
markets for trading purposes would have to be created to accomplish
full integration of the newly registered exchanges into the national
market system.
---------------------------------------------------------------------------
\402\ To become a participant in ITS, an exchange or association
must subscribe to, and agree to comply and to enforce compliance
with, the provisions of the plan. See ITS plan, supra note 393, at
section 3(c).
\403\ ITS also establishes a procedure that allows specialists
to solicit pre-opening interest in a security from specialists and
market makers in other markets, thereby allowing these specialists
and market makers to participate in the opening transaction.
Participation in an opening transaction can be especially important
when the price of a security has changed since the previous close.
\404\ A trade-through occurs when an ITS participant purchases
securities at a lower price or sells at a higher price than that
available in another ITS participant market. For example, if the
NYSE is displaying a bid of 20 and an offer of 20\1/8\ for an ITS
security, the prohibition on trade-throughs would prohibit another
ITS participant market from buying that security from a customer at
19\7/8\ or selling that security to a customer at 20 \1/2\. In
addition, each participant market has in place rules to implement
the ITS Trade-Through Rule. See, e.g. NASD Rule 5262. The plan also
provides a mechanism for satisfying a market aggrieved by another
market's trade-through.
\405\ A locked market occurs when an ITS participant
disseminates a bid for an ITS security at a price that equals or
exceeds the price of the offer for the security from another ITS
participant or disseminates an offer for an ITS security at a price
that equals or is less than the price of the bid for the security
from another ITS participant. The plan provides a mechanism for
resolving locked markets.
\406\ The ITS block trade policy provides that the member who
represents a block size order shall, at the time of execution of the
block trade, send or cause to be sent, through ITS to each
participating ITS market center displaying a bid (or offer) superior
to the execution price a commitment to trade at the execution price
and for the number of shares displayed with that market center's
better priced bid (or offer).
---------------------------------------------------------------------------
The Commission solicited comment on what issues were raised by the
possible integration of new exchanges into ITS. One commenter strongly
believed that the current voting structure of ITS establishes barriers
to entry, which leads to barriers to innovation. This commenter was
concerned that the network supporting ITS may not be strong enough to
handle sharply higher volumes of securities transactions and that, in
an environment with multiple exchanges, the failure of these linkages
would impede market participants' quest for best prices.\407\ Another
commenter, similarly, expressed concern that the means of access to,
and participation in, the national market system plans more generally
was not clearly defined and, therefore, provided the current
participants in these plans an opportunity to delay and to set
unreasonable terms and conditions for entry of new participants.\408\
The Commission realizes that integrating new exchanges into the
national market system plans may require amendments to these plans and
notes that national market system plans may be amended
[[Page 70888]]
either by vote of the participants, or by Commission action.\409\
---------------------------------------------------------------------------
\407\ American Century Letter at 3 (citing instances of downtime
on alternative trading systems that are attributable to SelectNet,
rather than the alternative trading system).
\408\ Ashton Letter at 4 (also stating that the Commission
should be sensitive to the ``veiled anti-competitive motives'' of
the existing plan participants and be prepared to direct any new
qualified exchanges to be accepted into all national market system
plans).
\409\ Securities Exchange Act Release No. 40204 (July 15, 1998),
63 FR 390306 (July 22, 1998) (proposal providing for the linkage of
the PCX application of the OptiMark system to the ITS system);
Securities Exchange Act Release No. 40260 (July 24, 1998), 63 FR
40748 (July 30, 1998) (proposal expanding the ITS/CAES linkage to
all listed securities, including non-Rule 19c-3 securities).
---------------------------------------------------------------------------
The Commission also requested comment on whether any changes were
necessary to incorporate alternative trading systems registered as
exchanges into the national market system plans. In this regard, the
Chicago Board Options Exchange (``CBOE'') and the NYSE stated that they
did not believe that there would need to be significant changes to
these plans, and that any changes that would be necessary to
accommodate alternative trading systems registered as exchanges into
ITS would be relatively easy to resolve.\410\ The CBOE, however, did
state that alternative trading systems registered as exchanges should
be subject to the same requirements regarding access to the national
market system plans as are applicable to traditional exchanges,
including payment of participation entry fees.\411\
---------------------------------------------------------------------------
\410\ See CBOE Letter at 4-5; NYSE Letter at 8-9. The NYSE also
stated that consideration of this issue can be better evaluated at
the time an alternative trading system registers as an exchange and
seeks to become a member of ITS. Id. But see CHX Letter at 7
(expressing concern about a for-profit exchange becoming a full
participant in the national market system plans because such
exchanges would be subject to pressures not to expend significant
resources on maintaining surveillance and enforcement capability and
would not have the same commitment to the public interest and the
investing public as traditional not-for-profit exchanges).
\411\ CBOE Letter at 4-5.
---------------------------------------------------------------------------
The NASD suggested that, before the Commission approves an
alternative trading system's application for registration as an
exchange, the Commission address more completely the manner in which
such an alternative trading system registered as an exchange may
participate in national market system plans. The NASD noted three areas
in which the Proposing Release was silent. First, the Commission did
not address what mechanism would be used for access among any new
exchange and other exchanges or markets. For example, in the context of
Nasdaq securities, the NASD thought it was unclear whether the existing
approach to linkage and execution should continue to occur through
Nasdaq's SelectNet system or its successor, or whether there should be
a new ITS-like entity formed with a completely new approach to access.
The NASD expressed a preference for using the current approach to
linkages. Second, the NASD noted that the Commission did not address
whether alternative trading systems registered as exchanges could
continue to charge an access fee, and believed strongly that such
alternative trading systems should not be allowed to charge for another
market accessing displayed interest. Third, the Commission did not
address the intermarket linkage issues raised by access to traditional
exchanges by non-broker-dealers that have indirect access to
alternative trading systems registered as exchanges.\412\
---------------------------------------------------------------------------
\412\ NASD Letter at 7.
---------------------------------------------------------------------------
OptiMark asked the Commission to consider the effect of an
alternative trading system's ability to charge an execution fee on its
choice to register as an exchange or as a broker-dealer. OptiMark noted
that the Proposing Release only contemplated that alternative trading
systems operating as broker-dealers would be able to charge a fee to
non-subscribers; alternative trading systems registered as exchanges
and participating in ITS would not.\413\
---------------------------------------------------------------------------
\413\ OptiMark Letter at 4-5 (also asking that the Commission
consider how members of exchanges, other than the exchange through
which an alternative trading system registered as a broker-dealer
disseminates its quotations, could access such alternative trading
system's quotes).
---------------------------------------------------------------------------
Susquehanna Investment Group (``Susquehanna'') expressed concern
about potentially integrating many alternative trading systems
registered as exchanges into the national market system mechanisms.
Susquehanna commented that integrating new exchanges' quotations into
the national market system should be done only with careful
consideration for the preservation of the ITS trade-through rule.\414\
Instinet also stated that in order for an alternative trading system to
make a determination about the feasibility of registering as an
exchange, the Commission needs to address those unresolved issues
relating to ITS, including the rules governing time/price priority
within a multiple exchange structure. In addition, Instinet stated that
inter-exchange rules need to be set forth for both the listed and over-
the-counter securities markets.\415\
---------------------------------------------------------------------------
\414\ Letter from Gerald D. O'Connell, Susquenhanna Investment
Group to Jonathan G. Katz, Secretary, SEC, dated July 23, 1998
(``Susquehanna Letter'') at 1-2. See also OptiMark Letter at 4
(asking the Commission to clarify that participation in national
market system plans is not conditioned on any universal public
display requirement).
\415\ Instinet Letter at 1-2, 3, 6.
---------------------------------------------------------------------------
The Commission agrees that access to national market system systems
is of key importance. It currently has outstanding proposals for
incorporation of one linkage into ITS of an alternative trading
system--OptiMark--and a traditional exchange--PCX--and has sought
comment on organizational and other changes to ITS to make it more
responsive to changing conditions.\416\ The precise arrangements for
inclusion of new exchanges into these plans depends on the structure of
these exchanges, and will be addressed when an applicant seeks
registration as an exchange.
---------------------------------------------------------------------------
\416\ See supra note 409.
---------------------------------------------------------------------------
8. Uniform Trading Standards
In addition to participation in national market system mechanisms,
an alternative trading system that registers as an exchange would be
required to comply with any Commission-instituted trading halt relating
to securities traded on or through its facilities.\417\ Newly
registered exchanges would be required in some instances to adopt
trading halt rules to comply with certain Commission rules.\418\ A
newly registered exchange would also have the authority and be expected
to impose trading halts for individual securities, for classes of
securities, and for its system as a whole under the appropriate
circumstances.\419\ The Commission does not believe that this
requirement would present any undue burden for alternative trading
systems that elect to register as national securities exchanges because
most alternative trading systems are already subject to the imposition
of trading halts as members of the NASD.
---------------------------------------------------------------------------
\417\ The Commission may suspend trading in any security for up
to 10 days, and all trading on any national securities exchange or
otherwise, for up to 90 days pursuant to sections 12(k)(1)(A) and
(B) of the Exchange Act, 15 U.S.C. 78l(k)(1)(A) and (B).
\418\ For example, a newly registered exchange would be required
under Rule 11Ac1-1, 17 CFR 240.11Ac1-1, to halt trading when neither
quotation nor transaction information can be disseminated.
\419\ The Commission has found that trading halt rules
instituted by a national securities exchange or a national
securities association are consistent with the objectives of Section
6(b)(5) of the Exchange Act, 15 U.S.C. 78f(b)(5). See, e.g.,
Securities Exchange Act Release Nos. 39582 (Jan. 26, 1998), 63 FR
5408 (Feb. 2, 1998); 26198 (Oct. 19, 1988), 53 FR 41637 (Oct. 24,
1988). See, e.g., Amex Rule 117, NASD Rule 4120(a)(3), and NYSE
Rules 80B and 717. There is no requirement that exchanges or
associations of securities dealers employ identical trading halt
rules, and these rules may vary according to the needs of the
individual market.
---------------------------------------------------------------------------
In addition, to promote the orderly operation of the securities
markets in accordance with Section 6 of the Exchange Act,\420\ the
Commission would expect all newly registered national securities
exchanges to implement circuit breaker rules to temporarily halt
trading during periods
[[Page 70889]]
of extraordinary market volatility or unusual market declines. The
Commission believes that for circuit breakers to be effective, all
markets must impose corresponding circuit breakers.\421\
---------------------------------------------------------------------------
\420\ 15 U.S.C. 78f.
\421\ If circuit breakers are imposed in one market, but not in
another, overall market disruptions caused by trading imbalances can
migrate from one market to the next, and efforts to stabilize such
imbalances during periods of heavy trading and extreme volatility
would be subverted. See also Securities Exchange Act Release No.
39846 (Apr. 9, 1998), 63 FR 18477 (Apr. 15, 1998) (approving
proposed changes to SRO rules regarding circuit breakers).
---------------------------------------------------------------------------
9. Proposed Rule Changes
Under Section 19(b)(1) of the Exchange Act, SROs are required to
file all proposed rule changes with the Commission.\422\ Thus, once
registered as an exchange, an alternative trading system would have to
submit copies of any proposed rule changes to the Commission for
approval.
---------------------------------------------------------------------------
\422\ Section 19(b) of the Exchange Act, 15 U.S.C. 78s(b).
---------------------------------------------------------------------------
C. Application for Registration as an Exchange
The Commission proposed to revise Rules 6a-1, 6a-2 and 6a-3 under
the Exchange Act \423\ to clarify the requirements for registration as
an exchange and to accommodate the registration as exchanges of
automated and proprietary trading systems. Additionally, the Commission
proposed to revise Form 1, the application used by exchanges to
register or to apply for an exemption based on limited volume, and to
repeal Form 1-A. After considering the comments, the Commission is
adopting the amendments to Rule 6a-1, Rule 6a-2, Rule 6a-3 and Form 1
as proposed.
---------------------------------------------------------------------------
\423\ 17 CFR 240.6a-1, 240.6a-2 and 240.6a-3.
---------------------------------------------------------------------------
1. Revisions to and Repeal of Form 1-A
The Commission is adopting the revisions to Form 1 and repealing
Form 1-A as proposed. Form 1 is revised by reorganizing and
redesignating the Statements and the exhibits. Because the Commission
expects most future applicants for registration as an exchange to be
fully or partially automated, the Commission revised some of the
information requested in Form 1 to be more applicable to automated
exchanges. Specifically, the Commission is adding two new exhibits
requiring an applicant for registration as an exchange to describe the
way any of its electronic trading systems operate, and the criteria
used by the exchange in admitting members.\424\ In addition, the
Commission is adding a new exhibit to Form 1 to reflect the possibility
that an exchange is owned by shareholders, rather than members.\425\
The Commission is also adopting other changes to the information
requested on Form 1 to reflect the fact that a for-profit exchange
would have participants or subscribers trading, rather than members.
---------------------------------------------------------------------------
\424\ Exhibit E requires an exchange to describe, among other
things, the means of access to the electronic trading system, the
procedures governing display of quotes and/or orders, execution,
reporting, clearance, and settlement. Exhibit L requires an exchange
to describe its criteria for membership, conditions under which
members may be subject to suspension or termination, and procedures
that would be involved in such suspension or termination.
\425\ Exhibit K requires non-member owned exchanges to provide a
list of direct owners and control persons.
---------------------------------------------------------------------------
Both the NYSE and the Amex expressed concern that these new
Exhibits would require new and additional information.\426\ Exhibits E
and L, however, need only accompany the application for registration as
an exchange and, therefore, are inapplicable to currently registered
exchanges. In addition, Exhibit K applies only to non-member owned
exchanges. Therefore, because all currently registered exchanges are
member-owned, new Exhibit K does not apply to them. The Commission has
clarified that Exhibit K exclusively applies to non-member owned
exchanges. If, however, a currently registered, member-owned exchange
were to convert to a for-profit structure, it would have to comply with
the requirement to update Exhibit K.
---------------------------------------------------------------------------
\426\ See NYSE Letter at 11; Amex Letter at 6.
---------------------------------------------------------------------------
Exchanges currently registered with the Commission are required to
use amended Form 1 in complying with Rules 6a-2 and 6a-3. The
information registered exchanges are required to update under Rules 6a-
2 and 6a-3 is not substantially different from what registered
exchanges are required to update today. The Commission has provided the
chart below to assist currently registered exchanges in complying with
the filing obligations under amended Rules 6a-2 and 6a-3.
----------------------------------------------------------------------------------------------------------------
Corresponding part of former Form
Amended form 1 Filing requirements under amended 1 on which information was
rules 6a-2 and 6a-3 requested
----------------------------------------------------------------------------------------------------------------
Questions 1-7 of the Execution Page. File an amendment within 10 days after Questions 1-6 of the Statement.
any action is taken that renders the
information previously filed
inaccurate (Rule 6a-2((a)(1)).
Exhibit A........................... File an amendment every three years Exhibit A(1).
(Rule 6a-2(c)) or make information
available by publication, upon
request, or via an Internet Web site
(Rule 6a-2(d)).
Exhibit B........................... File an amendment every three years Exhibit A(2).
(Rule 6a-2(c)) or make information
available by publication, upon
request, or via an Internet Web site
(Rule 6a-2(d)).
Exhibit C........................... File an amendment every three years Question 7 of the Statement.
(Rule 6a-2(c)) or make information
available by publication, upon
request, or via an Internet Web site
(Rule 6a-2(d)).
File an amendment within 10 days after Exhibit A(3) Exhibit H.
any action is taken that renders the
information previously filed
inaccurate (Rule 6a-2(a)(2)).
Exhibit D........................... File an annual amendment (Rule 6a- Exhibit F.
2(b)(1)).
Exhibit E........................... No requirement to update; only
required on application for
registration.
Exhibit F........................... File an amendment within 10 days after Exhibit B.
any action is taken that renders the
information previously filed
inaccurate (Rule 6a-2(a)(2)).
Exhibit G........................... File an amendment within 10 days after Exhibit C.
any action is taken that renders the
information previously filed
inaccurate (Rule 6a-2(a)(2)).
Exhibit H........................... File an amendment within 10 days after Exhibit D.
any action is taken that renders the
information previously filed
inaccurate (Rule 6a-2(a)(2)).
Exhibit I........................... File an annual amendment (Rule 6a- Exhibit E.
2(b)(1)).
[[Page 70890]]
Exhibit J........................... File an amendment every three years Exhibit G.
(Rule 6a-2(c)) or make information
available by publication, upon
request, or via an Internet Web site
(Rule 6a-2(d)). File an amendment
within 10 days after any action is
taken that renders the information
previously filed inaccurate (Rule 6a-
2(a)(2)).
Exhibit K........................... Only for-profit exchanges are required
to file an annual amendment (Rule 6a-
2(b)(2)) or make information
available by publication, upon
request, or via an Internet Web site
(Rule 6a-2(d)), and to file an
amendment within 10 days after any
action is taken that renders the
information previously filed
inaccurate (Rule 6a-2(a)(2)).
Exhibit L........................... No requirement to update; only
required on application for
registration as an exchange.
Exhibit M........................... File an amendment (Rule 6a-2(b)(2)) or Question 8 of the Statement.
make information available by
publication, upon request, or via an
Internet Web site (Rule 6a-2(d)).
File an amendment within 10 days after Question 9(a) of the Statement.
any action is taken that renders the Exhibit I.
information previously filed Exhibit J.
inaccurate (Rule 6a-2(a)(2)).
Exhibit N........................... File an amendment (Rule 6a-2(b)(2)) or Exhibit K.
make information available by Exhibit L.
publication, upon request, or via an Exhibit M.
Internet Web site (Rule 6a-2(d)).
Deleted............................. ...................................... Question 9(b) of the Statement.
----------------------------------------------------------------------------------------------------------------
2. Amendments to Rules 6a-1, 6a-2, and 6a-3 Under the Exchange Act
In order to reduce some of the filing burdens for exchanges and to
allow exchanges to comply with the filing requirements by posting
information on an Internet web page, the Commission is amending Rules
6a-1, 6a-2, and 6a-3 under the Exchange Act.
a. Rule 6a-1 Application for Registration as an Exchange or Exemption
Based on Limited Volume of Transactions
The Commission proposed to amend Rule 6a-1 to clarify that Form 1
should only be used by an exchange to apply for registration as a
national securities exchange or for an exemption from registration
under section 5 of the Exchange Act based on such exchange's limited
volume of transactions. The Commission received no comments on these
proposed changes and is adopting them as proposed.
b. Rule 6a-2 Periodic Amendments
Paragraph (a) of amended Rule 6a-2 requires an exchange to file an
amendment to Form 1 within 10 days of changes to: (1) Information filed
on the Execution Page of Form 1, or amendment thereto; (2) information
regarding all affiliates and subsidiaries (Exhibit C); (3) application
for membership, participation or subscription to the exchange or for a
person associated with a member, participant, or subscriber of the
exchange (Exhibit F); (4) financial statements, reports or
questionnaires required of members, participants or subscribers
(Exhibit G); (5) listing applications, any agreements required to be
executed in connection with listing and a schedule of listing fees
(Exhibit H); \427\ (6) officers, governors, members of all standing
committees, or persons performing similar functions, who presently hold
or have held their offices or positions during the previous year
(Exhibit J); (7) persons with direct ownership and control for non-
member owned exchanges (Exhibit K); and (8) any members, participants,
subscribers or other users and the information pertaining thereto
(Exhibit M).\428\ Additionally, rather than exchanges filing these
changes in the form of a notice, as is currently required under
paragraph (a) of Rule 6a-3, the changes will be filed in the form of an
amendment on Form 1.
---------------------------------------------------------------------------
\427\ A technical modification was made to the amendments as
proposed to include Exhibit H in Rule 6a-2(a)(2).
\428\ Rule 6a-2(a), 17 CFR 240.6a-2(a).
---------------------------------------------------------------------------
These amendments to Rule 6a-2 relieve exchanges from some of the
filing requirements to which exchanges are currently subject.
Specifically, a registered exchange no longer has to file notice within
10 days of changes to: (1) Its constitution, articles of incorporation
or association, or by-laws (Exhibit A); (2) written rulings or settled
practices of any governing board or committee of the exchange that have
the effect of rules or interpretations (Exhibit B); and (3) the
schedule of securities listed on the exchange (Exhibit N).
Paragraph (b) of amended Rule 6a-2 requires an exchange to file
annually an amendment to Form 1 with the following information: (1)
Unconsolidated financial statements for each subsidiary or affiliate or
the exchange for latest fiscal year (Exhibit D); (2) audited
consolidated financial statements for last fiscal year of the exchange
prepared in accordance with, or reconciled to, United States generally
accepted accounting principals (Exhibit I); \429\ (3) a list of persons
with direct ownership and control for non-member exchanges (Exhibit K);
(4) a list of all members, participants, subscribers or other users and
the information pertaining thereto (Exhibit M); and (5) a schedule of
securities listed on the exchange, securities admitted to unlisted
trading privileges and securities admitted to trading on the exchange
which are exempt from registration under Section 12(a) of the Act
(Exhibit N).\430\ These amendments remove exchanges' obligations to
include the following as part of the annual amendment: (1) The
exchange's affiliates and subsidiaries (Exhibit C) and (2) a list of
officers, governors, and members of standing committees be
[[Page 70891]]
included as part of an annual amendment (Exhibit J).
---------------------------------------------------------------------------
\429\ A technical modification was made to the amendments as
proposed to remove Exhibit I from Rule 6a-2(a)(2) and to include
Exhibit I in Rule 6a-2(b)(1).
\430\ A technical modification was made to the amendments to
include Exhibit N in Rule 6a-2(b)(2).
---------------------------------------------------------------------------
Paragraph (c) of amended Rule 6a-2 requires an exchange to file an
amendment to Form 1 every three years with the following information:
(1) A copy of the constitution, articles or incorporation or
association and by-laws (Exhibit A); (2) a copy all written rulings,
settled practices having effect of rules and interpretations of any
governing board or committee of the exchange (Exhibit B); (3)
information regarding all affiliates and subsidiaries (Exhibit C); and
(4) a list of officers, governors, members of all standing committees,
or persons performing similar functions, who presently hold or have
held their offices or positions during the previous year (Exhibit
J).\431\
---------------------------------------------------------------------------
\431\ A technical modification was made to the amendments to
include Exhibit J in Rule 6a-2(c).
---------------------------------------------------------------------------
Paragraph (d) of amended Rule 6a-2 provides exchanges with
alternatives to the annual filing requirement for Exhibits K, M, and N,
and to the three year filing requirement for Exhibits A, B, C, and J.
Pursuant to Rule 6a-2(d) exchanges have the following options, in lieu
of paper filing: (1) To publish or cooperate in the publication of this
information on an annual or more frequent basis, and to certify to the
accuracy of the information; (2) to keep the information up to date,
and certify that the information is up to date and available to the
Commission and the public upon request; or (3) to make the information
available continuously on an Internet web site controlled by an
exchange, indicate the location of the Internet Web site where such
information may be found, and to certify that the information available
at such location is accurate as of its date.\432\
---------------------------------------------------------------------------
\432\ Rule 6a-2(d), 17 CFR 240.6a-2(d).
---------------------------------------------------------------------------
Comments from the NYSE and the Amex suggested that the amendments
to Rule 6a-2 and Form 1, as adopted, reimpose some of the annual filing
requirements previously eliminated.\433\ As discussed above, Rule 6a-2
and Form 1, as adopted, relax the current filing burdens without
reimposing any filing requirements. The technical modifications to the
amendments to Rule 6a-2 clarify the operation of the rule, as adopted.
---------------------------------------------------------------------------
\433\ Securities Exchange Act Release No. 35123 (Dec. 20, 1994),
59 FR 66692 (Dec. 28 1994).
---------------------------------------------------------------------------
c. Rule 6a-3 Supplemental Material
Paragraph (b) of Rule 6a-3 currently requires registered exchanges,
or exchanges exempt from registration based on their limited volume of
transactions, to furnish to the Commission copies of all materials
issued or made available to members. The Commission proposed to
continue to require exchanges to provide the Commission with the
information currently required under the rule. However, as an
alternative to filing such information on paper, the Commission
proposed to permit exchanges to make the information available on an
Internet web site and provide the Commission with the location of the
web site. The Commission did not receive comments addressing these
proposed changes, and is adopting the amendments to Rules 6a-3(b) as
proposed.\434\
---------------------------------------------------------------------------
\434\ 17 CFR 240.6a-3. This rule is now found at paragraph (c)
of Rule 6a-3.
---------------------------------------------------------------------------
D. National Securities Exchanges Operating Alternative Trading Systems
National securities exchanges could, under the rules the Commission
is adopting today, form subsidiaries or affiliates that operate
alternative trading systems registered as broker-dealers.\435\ If a
national securities exchange chose to form such a subsidiary or
affiliate, the exchange itself could remain registered as a national
securities exchange, while the subsidiary or affiliate operated as a
broker-dealer. Such subsidiaries or affiliates would of course be
required to become members of a national securities association or
another national securities exchange.\436\ In addition, any subsidiary
or affiliate of a registered exchange could not integrate, or otherwise
link the alternative trading system with the exchange, including using
the premises or property of such exchange for effecting or reporting a
transaction, without being considered a ``facility of the exchange.''
\437\
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\435\ In addition, the owner of the alternative trading system
would continue to be liable for securities law violations.
\436\ But see supra note 374.
\437\ Section 3(a)(2) of the Exchange Act, 15 U.S.C. 78c(a)(2).
See also supra note 48 (discussing the OptiMark System as a facility
of the PCX); 35030 (Nov. 30, 1994), 59 FR 63141 (Dec. 7, 1994)
(discussing the Chicago Match system as a facility of the CHX);
29237 (May 24, 1991), 56 FR 24853 (May 31, 1991) (discussing the
Off-Hours Trading system as a facility of the NYSE).
---------------------------------------------------------------------------
V. Broker-Dealer Recordkeeping and Reporting Obligations
A. Elimination of Rule 17a-23
Under the regulatory framework adopted in this release, alternative
trading systems are required to register as exchanges or broker-
dealers, and comply with the requirements under Regulation ATS. These
systems are currently subject to recordkeeping and reporting
requirements under Rule 17a-23 of the Exchange Act.\438\ Because these
alternative trading systems are now subject to recordkeeping and
reporting requirements relating to their operations, either as
registered exchanges or as broker-dealers under proposed Regulation
ATS, the Commission is eliminating duplicative recordkeeping and
reporting obligations for these systems by repealing Rule 17a-23. Only
the recordkeeping requirements in Rule 17a-23 as they apply to broker-
dealers that are not also alternative trading systems, are being moved
to the broker-dealer recordkeeping rules, Rules 17a-3 and 17a-4 under
the Exchange Act.
---------------------------------------------------------------------------
\438\ 17 CFR 240.17a-23.
---------------------------------------------------------------------------
B. Amendments to Rules 17a-3 and 17a-4
Certain trading systems operated by broker-dealers are not
alternative trading systems, and therefore are not required to register
as exchanges or comply with Regulation ATS under the framework the
Commission is adopting today. This group of internal broker-dealer
systems \439\ will continue to be regulated under the traditional
broker-dealer regulatory scheme. The Commission is amending Rules 17a-3
and 17a-4 under the Exchange Act \440\ to require broker-dealers to
continually make and keep records regarding the activities of internal
broker-dealer systems for non-alternative trading systems. These
recordkeeping requirements are similar to the recordkeeping
requirements under Rule 17a-23, which the Commission today is
repealing.\441\ The Commission believes that these recordkeeping
requirements continue to be valuable to the oversight and inspections
of internal broker-dealer systems by the Commission and the SROs.
---------------------------------------------------------------------------
\439\ The term ``internal broker-dealer system'' is defined as
``any facility, other than a national securities exchange, an
exchange exempt from registration based on limited volume, or an
alternative trading system as defined in Regulation ATS * * * that
provides a mechanism, automated in full or in part, for collecting,
receiving, disseminating, or displaying system orders and
facilitating agreement to the basic terms of a purchase or sale of a
security between a customer and the sponsor, or between two
customers of the sponsor, through use of the internal broker-dealer
system or through the broker or dealer sponsor of such system.''
Rule 17a-3(a)(16)(ii)(A), 17 CFR 240.17a-3(a)(16)(ii)(A).
\440\ 17 CFR 240.17a-3 and 240.17a-4.
\441\ Only one commenter addressed the Commission's proposal to
repeal Rule 17a-23 and amend Rules 17a-3 and 17a-4. This commenter
agreed that amended Rules 17a-3 and 17a-4 would impose similar
obligations as current Rule 17a-23. TBMA Letter at 25-26.
---------------------------------------------------------------------------
These amendments ensure that broker-dealers continue to keep
records of any of their customers that have access to their internal
broker-dealer system, as well as any affiliations between those
customers and the
[[Page 70892]]
broker-dealer. Broker-dealers are also required to keep daily trading
summaries, including information on the types of securities for which
transactions have been executed through the internal broker-dealer
system, and transaction volume information.\442\ In addition, to
clarify the application of Rule 17a-3, the Commission is defining, for
the purposes of the rule, the terms ``internal broker-dealer system,''
\443\ ``sponsor,'' \444\ and ``system order.'' \445\
---------------------------------------------------------------------------
\442\ Rules 17a-3(a)(16)(i)(B) and (C), 17 CFR 240.17a-
3(a)(16)(i)(B) and (C).
\443\ See supra note 439.
\444\ The term ``sponsor'' is defined as ``any broker or dealer
that organizes, operates, administers, or otherwise directly
controls an internal broker-dealer system or, if the operator of the
internal broker-dealer system is not a registered broker or dealer,
any broker or dealer that, pursuant to contract, affiliation, or
other agreement with the system operator, is involved materially on
a regular basis with executing transactions in connection with use
of the internal broker-dealer system, other than solely for its own
account or as a customer with access to the internal broker-dealer
system.'' Rule 17a-3(a)(16)(ii)(B), 17 CFR 240.17a-3(a)(16)(ii)(B).
\445\ The term ``system order'' is defined as ``any order or
other communication or indication submitted by any customer with
access to the internal broker-dealer system for entry into a trading
system announcing an interest in purchasing or selling a security,''
but specifically excludes ``inquiries or indications of interest
that are not entered into the internal broker-dealer system.'' Rule
17a-3(a)(16)(ii)(C), 17 CFR 240.17a-3(a)(16)(ii)(C).
---------------------------------------------------------------------------
The Commission is also amending Rule 17a-4 under the Exchange Act
to require that the records required under the amendments to Rule 17a-3
be preserved for three years, the first two years in an accessible
place.\446\ This amendment also requires the preservation of all
notices regarding an internal broker-dealer system provided to its
participants, whether communicated in writing, through the internal
broker-dealer system, or by other automated means. Such notices include
notices concerning the internal broker-dealer system's hours of
operations, malfunctions, procedural changes, maintenance of hardware
and software, and instructions for accessing the system.
---------------------------------------------------------------------------
\446\ Rules 17a-4(b)(1) and (10), 17 CFR 240.17a-4(b)(1) and
(10).
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VI. Temporary Exemption of Pilot Trading System Rule Filings
A. Introduction
The Commission recognizes that registered exchanges, unlike
alternative trading systems registered as broker-dealers, must submit
rule filings for Commission approval. In the Concept Release, the
Commission generally sought comment on ways to expedite the rule filing
process and specifically sought comment on whether the Commission
should exempt new SRO trading systems or mechanisms from rule filing
requirements.\447\ Commenters pointed out that, under the current
regulatory structure, registered exchanges and alternative trading
systems compete on a ``playing field that is far from level,'' \448\
and attributed this, in part, to exchanges' inability to implement new
trading systems before submitting a rule filing and receiving
Commission approval.\449\ In response to commenters' concerns and to
make existing markets more competitive, the Commission proposed Rule
19b-5, a temporary exemption for SROs that would defer the rule filing
requirements of Section 19(b) under the Exchange Act \450\ for pilot
trading systems (``pilot trading system rule'').\451\
---------------------------------------------------------------------------
\447\ See Concept Release, supra note 2, 62 FR at 30518-19.
\448\ See Proposing Release, supra note 3 (discussing comments
responding to the Concept Release).
\449\ Id. at n.252.
\450\ 15 U.S.C. 78s(b).
\451\ The Commission is also adopting measures to relieve SROs
of the requirement to file rule changes with the Commission when an
SRO wishes to list or trade new derivative securities products.
Securities Exchange Act Release No. 40761 (Dec. 8, 1998).
---------------------------------------------------------------------------
In formulating the pilot trading system rule, the Commission drew
on its prior experience with SROs' attempts to operate new pilot
trading systems for their members.\452\ In the Proposing Release, the
Commission sought comment on whether the proposed pilot trading system
rule would provide appropriate regulation and would level the
competitive playing field between SROs and alternative trading systems.
As an alternative, the Commission sought comment on the benefits and
disadvantages of allowing SROs to file proposed rule changes relating
to pilot trading systems under an expedited approval process pursuant
to section 19(b)(3)(A) of the Exchange Act. Overall, comments on the
proposed pilot trading system rule were supportive of it as a way to
ease the regulatory disparity between registered exchanges and
alternative trading systems.
---------------------------------------------------------------------------
\452\ For example, in November 1990, the NYSE submitted a rule
filing proposing an after-hours crossing system to automate the
execution of single stock orders and baskets of securities and
received Commission approval in May 1991. See Securities Exchange
Act Release Nos. 29237 (May 24, 1991), 56 FR 24853 (May 31, 1991);
32368 (May 25, 1993), 58 FR 31565 (June 3, 1993). In August 1993,
the CHX submitted a rule filing to operate the Chicago Match system,
an electronic matching system that crossed orders entered by the
CHX's members and non-members including institutional customers, and
obtained Commission approval in November 1994. See Securities
Exchange Act Release No. 35030 (Nov. 30, 1994), 59 FR 63141 (Dec. 7,
1994). More recently, in May 1997, the PCX submitted a rule filing
for approval of the OptiMark System and received Commission approval
in September 1997. See Securities Exchange Act Release No. 39086
(Sept. 17, 1997), 62 FR 50036 (Sept. 24, 1997).
---------------------------------------------------------------------------
The Commission received no comments opposing proposed Rule 19b-5.
In general, commenters supported the proposal, stating that it would
encourage further innovation and reduce some of the regulatory burdens
that make it difficult for SROs to compete with broker-dealer operated
trading systems. Some commenters, while generally supporting the
temporary exemption, suggested modifying proposed Rule 19b-5. These
comments focused on the proposed definition of a pilot trading system,
the types of securities the Commission proposed to allow SROs to trade
on pilot trading systems, and the confidential treatment of information
filed by SROs regarding their pilot trading systems.\453\ After
considering the comments, the Commission is adopting Rule 19b-5
substantially as proposed.
---------------------------------------------------------------------------
\453\ See ICI Letter at 5; Corporate Capital Letter at 2; CBOE
Letter at 8; CHX Letter at 11; NASD Letter at 13; Amex Letter at 1-
2; NYSE Letter at 9; American Century Letter at 6. See also Ashton
Letter at 2; CME Letter at 4; SIA Letter at 15; PCX Letter at 8.
---------------------------------------------------------------------------
Currently, SROs are required to submit a rule filing to the
Commission and undergo a public notice, comment, and approval process
before they operate any new trading system.\454\ As adopted, the pilot
trading system rule permits SROs that develop separate, new systems
that qualify as ``pilot trading systems,'' \455\ to begin their
operation shortly after submitting new Form PILOT to the Commission is
merely an informational filing and an SRO does not need to await
Commission approval to begin operating its pilot trading system.\456\
During the operation of the pilot trading system, the
[[Page 70893]]
sponsoring SRO must submit to the Commission quarterly reports, as well
as amendments to Form PILOT concerning any material changes to the
pilot trading system. Rule 19b-5 exempts an SRO from the requirement to
file rule changes for the pilot trading system with the Commission for
two years. Before two years expire, the SRO must submit a rule filing
to obtain from the Commission permanent approval of the pilot trading
system or must cease operation of the trading system.\457\ In addition,
the temporary exemption under Rule 19b-5 expires sixty days after a
pilot trading system exceeds certain volume levels. A pilot trading
system that exceeds these volume levels must file for permanent
approval before the two-year period expires.\458\
---------------------------------------------------------------------------
\454\ Section 19(b)(1) of the Exchange Act, 15 U.S.C. 78s(b)(1),
requires an SRO to file with the Commission any proposed rule or any
proposed rule change (``proposed rule change'') accompanied by a
concise general statement of the basis and purpose of the proposal.
Once a proposed rule change has been filed, the Commission is
required to publish notice of it and provide an opportunity for
public comment. The proposed rule change may not take effect unless
it is approved by the Commission or is otherwise permitted to become
effective under Section 19(b) of the Exchange Act. Section 19(b)(2)
of the Exchange Act, 15 U.S.C. 78s(b)(2), sets forth the standards
and time periods for Commission action either to approve a proposed
rule change or to institute and conclude a proceeding to determine
whether a proposed rule change should be disapproved. The Commission
may also approve a proposed rule change on an accelerated basis if
the Commission finds good cause for so doing and publishes its
reasons for so finding. Section 19(b)(2) of the Exchange Act, 15
U.S.C. 78s(b)(2)(B).
\455\ See paragraph (c) of Rule 19b-5, 17 CFR 240.19b-5(c), for
the definition of ``pilot trading system.''
\456\ 17 CFR 249.821.
\457\ Rule 19b-5(f)(1) and (f)(2), 17 CFR 240.19b-5(f)(1) and
(f)(2). See also infra Section VI.C.
\458\ Rule 19b-5(c)(3), 17 CFR 240.19b-5(c)(3).
---------------------------------------------------------------------------
The Commission believes the pilot trading system rule addresses
many of the concerns raised by commenters.\459\ Inherent in the rule
filing process is public disclosure of SROs' business plans for trading
systems prior to their operation. Consequently, SROs' competitors are
informed about the proposed pilot trading system and have an avenue to
copy, delay, or obstruct implementation of the trading system before it
can be tested in the marketplace.\460\ The rule filing process also
hinders innovation because registered exchanges do not realize the full
competitive benefits of their efforts.\461\ In contrast, alternative
trading systems that offer similarly innovative, start-up services do
not have the same rule filing obligations and, thus, have a significant
advantage in their flexibility to devise, implement, and modify new
pilot trading systems. Comments to the Proposing Release echo these
concerns.\462\ By deferring the rule filing process, the pilot trading
system rule allows SROs to better compete with alternative trading
systems, while continuing to ensure that investors are protected and
the pilot trading system is operated in a manner consistent with the
Exchange Act.
---------------------------------------------------------------------------
\459\ See infra Section VI.B.
\460\ See Proposing Release, supra note 3, at ns.256-61 and
accompanying text.
\461\ See Proposing Release, supra note 3, at n.261.
\462\ See Ashton Letter at 2; SIA Letter at 15; CME Letter at 3;
Amex Letter at 1; Bloomberg Letter at 6.
---------------------------------------------------------------------------
Finally, the Commission recognizes that domestic markets must
compete with less regulated foreign markets and broker-dealers. The
Commission agrees with commenters that excessive regulation of
traditional exchanges, alternative trading systems, or other markets
hinders these exchanges' ability to compete and survive in the global
arena. The pilot trading system rule responds to SROs' need for a more
balanced competitive playing field.
B. Rule 19b-5
The Commission is adopting Rule 19b-5 to provide a temporary
exemption from Section 19(b) of the Exchange Act for SRO proposed rule
changes concerning the operation of pilot trading systems.
1. Types of Systems Eligible for Exemption Under Rule 19b-5
a. Definition of Pilot Trading System. The Commission is adopting
the definition of pilot trading system substantially as proposed. Under
paragraph (c) of Rule 19b-5, a trading system operated by an SRO would
be a ``pilot trading system'' if it met one of two definitions. First,
a trading system would be a ``pilot trading system,'' even if it traded
the same securities or operated during the same hours as an SRO's
existing trading system, if the SRO operated it for less than two
years, and during at least two of the last four consecutive calendar
months, it traded no more than one percent of the U.S. average daily
trading volume of each security traded on the trading system. In
addition, the trading system could not have an aggregate share trading
volume of more than twenty percent of the average daily trading volume
of all trading systems operated by the SRO.\463\ Second, a trading
system would also be considered a ``pilot trading system'' if it were
independent \464\ of any other trading system operated by the SRO, the
SRO operated it for less than two years, and, during at least two of
the last four consecutive calendar months, it traded no more than five
percent of the U.S. average daily trading volume of each security
traded on the trading system. In addition, under this second
definition, the trading system would have to have aggregate share
trading no more than twenty percent of the average daily trading volume
of all trading systems operated by the SRO.\465\
---------------------------------------------------------------------------
\463\ Rule 19b-5(c)(2), 17 CFR 240.19b-5(c)(2).
\464\ A pilot trading system is ``independent'' of other trading
systems if it meets one of the standards set forth in paragraph (d)
of Rule 19b-5.
\465\ Rule 19b-5(c)(1), 17 CFR 240.19b-5(c)(1).
---------------------------------------------------------------------------
If at any time within the two-year period a pilot trading system
exceeds the volume thresholds, it would be allowed to continue to
operate for 60 more days under this exemption.\466\ During this 60 day
period, if the SRO intended to continue operating the trading system,
it would have to file for permanent approval under Section 19(b) of the
Exchange Act of the rules related to the trading system.
---------------------------------------------------------------------------
\466\ Rule 19b-5(c)(3), 17 CFR 240.19b-5(c)(3). See also infra
Section VI.C.
---------------------------------------------------------------------------
The Commission received several comments asking the Commission to
relax or eliminate the proposed requirement that, to be a pilot trading
system with five percent of the trading volume in a security, the pilot
trading system would have to be ``independent.'' As proposed, a pilot
trading system would be independent if it trades securities different
from the issues of securities traded on any other trading system that
is operated by the same SRO and that has been approved by the
Commission. A pilot trading system would also be deemed independent if
it does not operate during the same trading hours as any other trading
system that is operated by the same SRO and that has been approved by
the Commission. Finally, a pilot trading system would be deemed
independent if no market maker or specialist on any other trading
system operated by the SRO trades on the pilot trading system the same
securities in which they act as a market maker or specialist.\467\ The
Commission emphasized that a pilot trading system need only satisfy one
of the three criteria to qualify the pilot trading system as
independent. After considering the comments, the Commission continues
to believe such criteria are not unduly restrictive and are necessary
for the protection of investors, and is adopting it as proposed.
---------------------------------------------------------------------------
\467\ Rule 19b-5(d), 17 CFR 240.19b-5(d). For purposes of the
pilot trading system rule, a specialist means any member subject to
a requirement of an SRO that such member regularly maintain a market
in a particular security. Rule 19b-5(a), 17 CFR 240.19b-5(a).
---------------------------------------------------------------------------
b. Response to Comments on the Proposed Definition of Pilot Trading
System. In its proposed definition of a pilot trading system, the
Commission sought to impose limits that were in the public interest and
for the protection of investors, while still providing SROs with the
flexibility to innovate. The Commission requested comment on this
proposed definition, and specifically asked whether the proposed two-
year time period, trading volume limits, and independence criteria were
appropriate. Commenters were asked to provide specific reasons for any
concerns about the proposed definition and to suggest alternatives.
Several commenters focused on particular aspects of the proposed pilot
trading system definition.
The NYSE commented that the specific provisions of proposed Rule
[[Page 70894]]
19b-5 were carefully crafted. In addition, the NYSE agreed with the
Commission's proposal to distinguish between systems that are
``independent'' of other SRO trading systems and systems that work
together with existing SRO trading systems.\468\ The ICI supported the
proposed limited exemption for pilot trading systems. The ICI, however,
discouraged any further expansion of the criteria that would constitute
a pilot trading system and encouraged the Commission to carefully
monitor pilot trading systems as they operate under the exemption.\469\
---------------------------------------------------------------------------
\468\ NYSE Letter at 9.
\469\ ICI Letter at 5.
---------------------------------------------------------------------------
On the other hand, several commenters stated that Rule 19b-5 should
be liberalized to provide SROs with a meaningful opportunity to develop
pilot trading systems on a comparable basis to alternative trading
systems.\470\ For example, the CME generally asserted that the numerous
proposed restrictions on what would qualify as a pilot trading system
would render the proposal of little practical value to exchanges.\471\
With regard to the volume thresholds proposed by the Commission, the
NASD and the PCX stated that the volume thresholds were too low. \472\
The PCX stated that the volume restrictions did not make sense because
they limited the ability of registered exchanges to introduce new
trading systems--particularly when neither alternative trading systems
nor third market makers are subject to similar volume limitations.
Instead, the PCX stated that Rule 19b-5 should treat exchange pilot
trading systems as though they were alternative trading systems for two
years, provided the trading systems did not exceed a fairly high
percentage (perhaps ten percent) of total trading volume in any
security.\473\ Moreover, the Amex said the volume thresholds for
individual securities would limit the utility of the exemption for
primary markets. In particular, the Amex suggested that the Commission
apply only an aggregate volume threshold whereby volume in an SRO pilot
trading system could not exceed a specified percentage of total volume
in all such SRO's trading systems. This approach, the Amex believed,
would eliminate the administrative burden on SROs monitoring the one
percent or five percent thresholds and would avoid the potentially
adverse impact on the operation and success of a pilot trading system
that could occur by removing securities from the system that exceeded a
specified threshold.\474\
---------------------------------------------------------------------------
\470\ See CBOE Letter at 2, 9; CHX Letter at 11; CME Letter at
4; PCX Letter at 8-10.
\471\ See CME Letter at 4; PCX Letter at 9-10.
\472\ See NASD Letter at 13; PCX Letter at 9-10.
\473\ PCX Letter at 9-10.
\474\ Amex Letter at 1, 3.
---------------------------------------------------------------------------
Other commenters thought the criteria establishing the independence
of a pilot trading system from other trading systems operated by the
same SRO were too restrictive.\475\ In particular, the CBOE and NASD
asserted that the independence criteria unnecessarily precluded
exchange specialists and market makers from participating in pilot
trading systems.\476\ Similarly, the CHX stated that it was too
limiting to require a pilot trading system to trade different
securities or operate during different hours than the sponsoring SRO's
other trading systems in order to be ``independent.'' \477\
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\475\ See CBOE Letter at 9; CHX Letter at 11.
\476\ See CBOE Letter at 9; NASD Letter at 2, 14.
\477\ CHX Letter at 11.
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c. Adopted Definition of Pilot Trading System. The Commission has
considered these comments. As discussed above, it believes that,
because the proposed definition of a pilot trading system, including
the proposed volume thresholds and independence criteria is novel and
untried, the criteria are appropriate. The Commission notes that,
pursuant to paragraph (b)(5) under section 6 of the Exchange Act, rules
of a registered exchange should be designed, among other things, to
prevent fraudulent and manipulative acts and practices, to promote just
and equitable principles of trade and, in general, to protect investors
and the public interest.\478\ The Commission believes that the desire
of the registered exchanges to innovate and compete with alternative
trading systems must be balanced with their statutory obligations under
section 6 of the Exchange Act. Therefore, the volume thresholds and
other standards are designed to ensure that once a pilot trading
system's activities reach a significant level, the pilot trading system
will be subject to the public notice and comment process under section
19(b) of the Exchange Act. The Commission recognizes that the
definition of ``pilot trading system'' is more narrow than some SROs
would prefer, but notes that this does not prevent registered exchanges
from developing trading systems that do not meet the definition of
``pilot trading system'' and filing proposed rule changes relating to
those systems under section 19(b) of the Exchange Act.
---------------------------------------------------------------------------
\478\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------
Similarly, through the independence criteria, the Commission
identified characteristics that render pilot trading systems
sufficiently distinct from the sponsoring SRO's other trading systems
so that a five percent, rather than one percent volume level, is
acceptable. ``Independent'' pilot trading systems pose less risk of
substantially changing the existing markets in a manner detrimental to
investors and, therefore, the Commission believes should be able to
operate under the exemption at higher volume thresholds than their
``non-independent'' counterparts before having to submit proposed rule
filings under section 19(b) of the Exchange Act.\479\ The Commission
will monitor use of the pilot trading system exemption, and will
consider modifying these criteria in the future based on its experience
with SRO's use of the exemption.
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\479\ See supra note 467 and accompanying text.
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2. Scope of Pilot Trading Rule Exemption
The Commission is adopting Rule 19b-5 to provide a temporary
exemption from Section 19(b) of the Exchange Act for SRO proposed rule
changes concerning the operation of pilot trading systems. This
temporary exemption includes all rules related to the operation of
pilot trading systems. The Commission defines trading system in
paragraph (b) of Rule 19b-5 to include the rules of a self-regulatory
organization that: (i) Determine how the orders of multiple buyers and
sellers are brought together; and (ii) establish non-discretionary
methods under which such orders interact with each other and under
which the buyers and sellers entering such orders agree to the terms of
trade.\480\ The Commission intends this exemption to provide SROs with
flexibility to establish and modify the pilot trading system without
obtaining prior approval from the Commission. However, this exemption
does not include any SRO rules that would fundamentally affect the
relationship between an SRO's members and those members' customers, or
an SRO's oversight of its members.
---------------------------------------------------------------------------
\480\ Rule 19b-5(b), 17 CFR 240.19b-5(b).
---------------------------------------------------------------------------
The Commission notes that Rule 19b-5 does not relieve SROs from any
obligation under the federal securities laws, other than the
requirement to file proposed rule changes relating to the operation of
a pilot trading system. Rule 19b-5, therefore, does not provide an
exemption for SRO rules relating to other requirements imposed under
other provisions of the Exchange Act, such as sections 11(a) and 10(a),
and Rule 10a-1 thereunder. In addition, an SRO must ensure that
securities listed and traded on any pilot trading system comply
[[Page 70895]]
with, among other things, the registration requirements of the Exchange
Act.\481\ An SRO also continues to be required to enforce compliance
with its own rules and the federal securities laws, including members'
compliance with the Order Handling Rules.\482\ SROs, similarly, are
expected to operate the pilot trading systems in compliance with rules
governing market-wide trading halts.
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\481\ See supra notes 504-505 and accompanying text.
\482\ See Section 6(b)(2) of the Exchange Act, 15 U.S.C. 78f(2).
See also Order Handling Rules Adopting Release, supra note.
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3. SROs' Continuing Obligations Regarding Pilot Trading Systems
In order to ensure that pilot trading systems are operated in a
manner consistent with the Exchange Act, the Commission proposed
requiring SROs to comply with certain conditions before a pilot trading
system would be eligible for the temporary exemption. In particular,
the Commission proposed that SROs comply with the following with regard
to pilot trading systems: (1) Notify and periodically file information
about the pilot trading system with the Commission, (2) implement
trading rules and procedures, (3) establish effective surveillance, (4)
establish reasonable clearance and settlement procedures, (5) limit the
types of securities traded, (6) cooperate with inspections and
examinations by the Commission, and (7) have procedures to ensure the
confidential treatment of trading information.\483\
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\483\ The Commission is not adopting the requirement concerning
the procedures to ensure the confidential treatment of trading
information because SROs are not currently required to do this with
regard to their other trading systems.
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The Commission sought comment on whether there were any additional
conditions with which SROs should be required to comply in order to be
temporarily exempt from the rule filing requirements under Rule 19b-5.
Commenters did not recommend any additional conditions. The Commission
notes, however, that, as discussed below, it is adding a requirement
that SROs make publicly available the rules relating to the operation
of the pilot trading system.\484\
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\484\ See discussion infra VI.B.3.i.
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In the Proposing Release, the Commission stated that SROs would
have to ``ensure'' that these conditions were satisfied in order to
rely on the temporary exemption under proposed Rule 19b-5. One
commenter raised concerns regarding the requirement that SROs
``ensure'' that the conditions were met in order to rely on the
proposed pilot trading system rule. Specifically the CBOE requested
that an SRO be allowed to rely on proposed Rule 19b-5 if the SRO acts
in good faith in determining that the requirements of the pilot trading
system rule have been met.\485\ Based upon the Commission's experience
with reviewing new pilot trading system proposals submitted by SROs,
the Commission continues to believe that SROs operating pilot trading
systems should satisfy the proposed requirements in order to operate
such systems in a manner consistent with the Exchange Act. Nonetheless,
the Commission recognizes that full compliance with some of the
conditions may be beyond the SROs' control. The Commission agrees it is
not practical to hold SROs strictly liable for the failure of
unaffiliated entities to satisfy certain requirements of the proposed
pilot trading system rule. Therefore, the Commission will consider an
SRO exempt from rule filing requirements under Rule 19b-5 if the SRO
acts in good faith in determining that the operation of the pilot
trading system meets the conditions set out in paragraph (e) of that
rule, and in operating the pilot trading system.
---------------------------------------------------------------------------
\485\ CBOE Letter at 10.
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a. Notice and Filings to the Commission. The Commission proposed
that SROs be required to provide written notice of, and information
about, the operation of a pilot trading system to the Commission on new
Form PILOT. On Form PILOT, an SRO would have to provide general
information about the pilot trading system, including: (1) The date the
SRO expects to commence operation of the pilot trading system; (2) a
list of securities to be traded; (3) a list of anticipated members to
the pilot trading system; and (4) the names of entities assisting in
the operation of the pilot trading system.\486\ The SRO could start
operation of the pilot trading system twenty days after this filing is
complete. If the SRO materially changes its proposed pilot trading
system prior to commencing operation, the SRO would be required to file
an amendment to Form PILOT and wait twenty days before commencing
operation. The Commission is adopting the notice requirement and Form
PILOT as proposed.\487\
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\486\ Examples include computer companies that design and
maintain systems and clearing agencies.
\487\ Rule 19b-5(e)(1), 17 CFR 240.19b-5(e)(1).
---------------------------------------------------------------------------
The twenty day period following an SRO's filing of Form PILOT is
intended to provide the Commission with time to review the form for
compliance by the SRO with the pilot trading system rule. In addition,
after reviewing Form PILOT the Commission may determine, after notice
to the SRO and an opportunity for the SRO to respond, that the
operation of a particular pilot trading system would not be necessary
or appropriate in the public interest or consistent with the protection
of investors without the SRO filing proposed rule changes under section
19(b) of the Exchange Act.\488\
---------------------------------------------------------------------------
\488\ Rule 19b-5(g), 17 CFR 240.19b-5(g).
---------------------------------------------------------------------------
The Commission also proposed to require an SRO to file an amendment
to Form PILOT at least twenty days before it implements any material
change to the operation of the pilot trading system. The Commission
would consider a material change to the pilot trading system to include
the addition of new types of securities, or a new date for commencing
operation of the pilot trading system. The Commission proposed that an
SRO also submit quarterly reports on Form PILOT that would include
information about the trading volume effected on the pilot trading
system during the most recent calendar quarter. The Commission received
no comments on these requirements and is adopting them as
proposed.\489\
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\489\ Rule 19b-5(e)(1), 17 CFR 240.19b-5(e)(1). The Commission
requires that SROs identify filings made pursuant to Rule 19b-5 by
including a file number on Form PILOT that appears as follows:
PILOT--name of SRO--year--file number.
---------------------------------------------------------------------------
The Commission proposed that all notices and reports filed on Form
PILOT be kept confidential. The Commission, however, requested comment
on whether all information on Form PILOT should be publicly available
or whether, as an alternative, information on Form PILOT should be
publicly available, unless an SRO specifically requests confidential
treatment. The Commission received several comments on the confidential
treatment of information on Form PILOT. The CBOE recommended that all
information about a pilot trading system filed quarterly on Form PILOT
be deemed confidential.\490\ The NYSE suggested only limited
confidentiality for filings on Form PILOT, that is, pilot trading
system information should be publicly available shortly prior to, or on
the date of, launch of a new system.\491\ Another commenter offered
that the Commission make public only certain information on Form
PILOT.\492\ One commenter suggested that the confidential treatment of
Form PILOT information be at the filer's discretion.\493\
---------------------------------------------------------------------------
\490\ CBOE Letter at 9.
\491\ NYSE Letter at 9.
\492\ Amex Letter, p. 2.
\493\ American Century Letter, p. 6.
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[[Page 70896]]
After considering commenters' suggestions, the Commission has
determined that the confidential treatment of Form PILOT information is
an important element in reducing the disparate regulatory treatment of
SROs and alternative trading systems and that such confidentiality is
critical in the period prior to a pilot trading system commencing
operations. However, the Commission also considers important the
public's interest in having access to accurate information about the
pilot trading system. Accordingly, the Commission is modifying proposed
Rule 19b-5, so that information reported by an SRO on Form PILOT is
confidential until the pilot trading system commences operation.\494\
Thereafter, Form PILOT information will be made available to the
public. b. Fair Access
---------------------------------------------------------------------------
\494\ Rule 19b-5(e)(11), 17 CFR 240.19b-5(e)(11).
---------------------------------------------------------------------------
b. Fair Access. Because information and access advantages of
certain SRO members could subvert the fair and orderly trading of
securities on a pilot trading system or the primary market, the
Commission is adding a specific condition to the pilot trading system
rule requiring that the SRO provide fair access to the pilot trading
system to all members of the SRO. The Commission is adding this fair
access requirement in order to ensure that markets treat their members
fairly.\495\ In particular, the SRO shall establish written standards
for granting access to the pilot trading system and apply those
standards fairly to all members. Fair access does not require an SRO to
allow every member to trade on a pilot trading system or to give each
member trading on the pilot trading system the same privileges.
However, this requirement does prohibit an SRO from unfairly
discriminating in the access it does give its members to the pilot
trading system. In addition, the SRO must ensure that information
regarding orders on the pilot trading system is equally available to
all members of the SRO with access to the pilot trading system.\496\
However, a specialist may have preferred access to information
regarding orders it represents in its capacity as specialist on the
pilot trading system.\497\ This means that such SRO rules need not
require a member acting as a specialist on the pilot trading system to
expose its orders to all members, that is maintain an ``open book.''
Such rules established by the SRO will be considered part of the pilot
trading system for purposes of the temporary exemption.\498\
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\495\ The Commission notes that registered exchanges and
national securities associations already have obligations to ensure
that their markets treat investors and other market participants
fairly. The Exchange Act requires registered exchanges and national
securities associations to consider the public interest in
administering their markets and to establish rules designed to admit
members fairly. Sections 6(b)(2) and 6(c) of the Exchange Act, 15
U.S.C. 78f(b)(2) and (c); section 15A(b)(8) of the Exchange Act, 15
U.S.C. 78o-3(b)(8). See also supra notes 241-244 and accompanying
text.
\496\ Rule 19b-5(e)(2)(i), 17 CFR 240.19b-5(e)(2)(i).
\497\ Rule 19b-5(e)(2)(ii), 17 CFR 240.19b-5(e)(2)(ii).
\498\ Rule 19b-5(e)(2)(iii), 17 CFR 240.19b-5(e)(2)(iii).
---------------------------------------------------------------------------
c. Trading Rules and Procedures. The Commission proposed to require
SROs operating pilot trading systems under Rule 19b-5 to adopt and
implement trading rules and procedures necessary to operate the pilot
trading system in a manner consistent with the Exchange Act. The
Commission received no comments specifically addressing this condition
and is adopting it substantially as proposed. As adopted, an SRO must
have appropriate trading rules and procedures to promote the fair and
orderly trading of securities on the pilot trading system, including:
(1) Margin requirements; (2) listing standards; (3) sales practice
guidelines, such as rules regarding communications with the public; and
(4) disclosure requirements. The trading rules and procedures should be
appropriate for, and ensure the fair and orderly trading of, each type
of security to be traded on the pilot trading system.\499\
---------------------------------------------------------------------------
\499\ Rule 19b-5(e)(3), 17 CFR 240.19b-5(e)(3).
---------------------------------------------------------------------------
d. Surveillance. Under the proposal, an SRO would have to establish
procedures for the effective surveillance of trading activity on a
pilot trading system. In the Proposing Release, the Commission noted
the importance of an SRO being able to obtain information necessary to
detect and deter market manipulation, illegal trading, and other
trading abuses. To satisfy this requirement, the Commission proposed
that an SRO have to develop and implement internal surveillance
procedures to monitor transactions effected on the pilot trading
system, and obtain surveillance information from other markets, both
domestic and foreign.
Specifically, in the Proposing Release, the Commission discussed
its expectation that there be a comprehensive information sharing
agreement (``ISA'') in place between the SRO operating a pilot trading
system and any other market trading the securities, or trading the
underlying securities of derivative securities products, traded on such
pilot trading system.\500\ Such agreements provide a necessary
deterrent to manipulation because they facilitate the availability of
information needed to fully investigate a potential manipulation. An
SRO operating a pilot trading system trading U.S. securities, or new
derivative securities products overlying U.S. securities, would have to
continue to ensure that all exchanges on which the U.S. securities
trade are members of the Intermarket Surveillance Group (``ISG'').\501\
The ISG was formed to coordinate, among other things, effective
surveillance and investigative information sharing arrangements in the
stock and options markets.
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\500\ The Commission believes that a comprehensive ISA requires
that the parties provide to each other, upon request, information
about market trading, clearing activity, and the identity of the
ultimate purchasers and sellers of securities. See Securities
Exchange Act Release No. 31529 (Nov. 27, 1992), 57 FR 57248 (Dec. 3,
1992). Similarly, an SRO that operates a pilot trading system that
trades securities, or derivatives of securities that are listed or
traded on a foreign market, should have a comprehensive ISA with
such foreign markets. In addition, the SRO should ensure there are
no blocking or secrecy laws in the foreign country that would
prevent or interfere with the transfer of information under the
comprehensive ISA. If securing a comprehensive ISA is not possible,
the SRO should contact the Commission. In such instances, the
Commission may determine that it is appropriate instead to rely on a
Memorandum of Understanding (``MOU'') between the Commission and the
foreign regulator. Generally, the Commission has permitted an SRO to
rely on an MOU in the absence of a comprehensive ISA only if the SRO
receives an assurance from the Commission that such an MOU can be
relied on for surveillance purposes and includes, at a minimum, the
transaction, clearing, and customer information necessary to conduct
an investigation. See Securities Exchange Act Release No. 35184
(Dec. 30, 1994), 60 FR 2616 (Jan. 10, 1995). In addition, an SRO
should endeavor to develop comprehensive ISAs with foreign exchanges
even if the SRO receives prior Commission approval to rely on an MOU
in place of a comprehensive ISA.
\501\See ISG Agreement, dated July 14, 1983, amended Jan. 29,
1990. The ISG members are: Amex, BSE, CBOE, CHX, NASD, NYSE, PCX,
and Phlx. The major stock index futures exchanges joined the ISG as
affiliate members in 1990.
---------------------------------------------------------------------------
The Commission received no comments specifically addressing the
surveillance requirement under the proposed pilot trading system rule.
The Commission continues to believe that in order for an SRO to operate
a pilot trading system in a manner consistent with the Exchange Act,
the SRO must be able to obtain information necessary to detect and
deter market manipulation, illegal trading, and other trading abuses.
Therefore, the Commission is adopting, as proposed, the requirement
that an SRO develop and implement internal surveillance procedures to
monitor transactions effected on the pilot trading system, and obtain
surveillance information from other markets, both
[[Page 70897]]
domestic and foreign by means of an ISA.\502\
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\502\ Rule 19b--5(e)(4), 17 CFR 240.19b-5(e)(4).
---------------------------------------------------------------------------
e. Clearance and Settlement. In the Proposing Release, the
Commission observed that the integrity of the trading markets depends
on the prompt and accurate clearance and settlement of securities
transactions. For this reason, the Commission proposed that, as a
condition of the exemption under Rule 19b-5, an SRO establish
reasonable clearance and settlement procedures for transactions
effected on the pilot trading system. For example, to ensure that
adequate linkages have been formed, part of the user agreement should,
at a minimum, request information about the name of the clearing agency
member through which the user will clear its trades. The Commission
received no comments specifically addressing the clearance and
settlement requirement under the proposed pilot trading system rule.
Therefore, the Commission is adopting as proposed, the requirement that
an SRO operating a pilot trading system ensure that the necessary
linkages to clearing agencies exist for all pilot trading system
users.\503\
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\503\ Rule 19b-5(e)(5), 17 CFR 240.19b-5(e)(5).
---------------------------------------------------------------------------
f. Types of Securities. The Commission proposed to limit the types
of securities an SRO could trade on a pilot trading system. Two
separate limitations were proposed. First, under the proposal a pilot
trading system would only be permitted to trade securities listed on a
national securities exchange or to which unlisted trading privileges
was extended pursuant to a rule, regulation, or order of the Commission
under section 12(f) of the Exchange Act. In general, section 12 of the
Exchange Act requires an exchange to trade only those securities that
the exchange lists, except that section 12(f) of the Exchange Act
provides UTP under certain circumstances.\504\ For example, under the
OTC-UTP plan, exchanges are permitted to trade certain over-the-counter
securities pursuant to a Commission order.\505\ As proposed, a pilot
trading system operated by a registered exchange or a national
securities association would be limited to trading listed securities or
securities to which UTP has been extended under section 12(f) of the
Exchange Act. Because national securities associations currently trade
securities that are neither exchange listed or subject to UTP, this
provision was unnecessarily restrictive. Consequently, the Commission
is modifying the limitation on the types of securities a pilot trading
system may trade from that proposed. In particular, Rule 19b-5(e)(6),
as adopted, only restricts pilot trading systems by requiring that
securities traded be registered under section 12 of the Exchange
Act.\506\ Registered exchanges will still be required to comply with
sections 12(a) and 12(f) of the Exchange Act, and therefore, can only
trade securities listed on that exchange, or securities it is permitted
to trade under the OTC-UTP Plan.
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\504\ 15 U.S.C. 78l(f).
\505\ See Securities Exchange Act Release No. 39505 (Dec. 31,
1997), 63 FR 1515 (Jan. 9, 1998 ).
\506\ Rule 19b-5(e)(6), 17 CFR 240.19b-5(e)(6).
---------------------------------------------------------------------------
g. Activities of Specialists. As proposed, an SRO's pilot trading
system would not be eligible for the exemption in Rule 19b-5 if it
traded derivative securities, such as options, warrants, or hybrid
products, the value of which were based, in whole or in part, upon the
performance of any security traded on another trading system operated
by that SRO. Similarly, the proposed exemption excluded SRO pilot
trading systems that traded any security or instrument, such as an
equity security, the derivative of which traded on another trading
system operated by that SRO. The Commission, in proposing these
limitations, intended to preclude an SRO from relying on the temporary
exemption if a pilot trading system simultaneously traded a security
overlying or underlying a security traded on that SRO's primary market.
The Commission has always considered this type of trading to raise
special concerns that should be resolved through the normal rule filing
process.\507\
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\507\ See, e.g., Securities Exchange Act Release Nos. 21759
(Feb. 14, 1985), 50 FR 7250 (Feb. 21, 1985) (order approving NYSE
proposal to trade options on NYSE-listed stocks in a separate
physical location from the equity trading floor); 26147 (Oct. 3,
1988), 53 FR 39556 (Oct. 7, 1988) (order approving the trading on
the Amex of options on Amex-listed stocks, concluding that side-by-
side trading or integrated market-making issues did not arise
because the Amex proposed to trade stocks and related options in
physically separate locations); and 28556 (Oct. 19, 1990), 55 FR
43233 (Oct. 26, 1990) (order approving rule changes to establish
rules governing the trading of stocks, warrants, and other
securities instruments and contracts on the CBOE conditioned on the
fact that trading in securities other than options will take place
on a trading floor separate from the location where options are
traded).
---------------------------------------------------------------------------
In commenting on proposed Rule 19b-5, the CBOE and the Amex
considered these limitations overly restrictive. The Amex suggested
removing this limitation and instead requiring SROs to specify on Form
PILOT their rules and procedures for trading such securities on the
pilot trading system.\508\ The CBOE suggested an alternative to the
limitation that pilot trading systems may not trade securities that
overlie or underlie securities traded on another trading system
operated by the same SRO. In particular, the CBOE suggested requiring
the SRO to create firewalls or other safeguards between persons trading
the derivative and the underlying or overlying securities, rather than
flatly prohibiting it.\509\
---------------------------------------------------------------------------
\508\ Amex Letter at 4.
\509\ CBOE Letter at 10.
---------------------------------------------------------------------------
After considering the commenters' recommendations, the Commission
has determined that SROs may operate pilot trading systems under Rule
19b-5 that simultaneously trade a security that is overlying or
underlying a security traded on another trading system operated by that
market, provided that such trading remains separate. This means that,
as part of the SRO's general requirement to have written trading rules
and procedures to operate the pilot trading system,\510\ an SRO must
have adequate rules and procedures to trade related securities
simultaneously. In addition, the Commission is adopting a more narrow
prohibition than it proposed, which prohibits a member firm that is a
specialist in a security from acting as a specialist on a pilot trading
system operating during the same hours in a related security.\511\ For
example, a member firm may not be a specialist in a security, such as
an equity security, on the pilot trading system when it is also a
specialist in a derivative of that security, such as an option or
equity-linked note, whose value, in whole or significant part, is based
on the performance of that security.\512\ The Commission would not
consider listed options in a single underlying instrument to be related
securities, for purposes of the pilot trading system exemption. The
[[Page 70898]]
limitation under Rule 19b-5(e)(7)(ii) does not preclude any member firm
from being a specialist on a pilot trading system in a security related
to a security in which the member firm is a specialist on the SRO's
other trading systems, when such related securities trade at different
times.\513\ Also, a member may be a specialist in related securities
that, the Commission, upon application by the SRO, later determines is
necessary or appropriate in the public interest and consistent with the
protection of investors.\514\
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\510\ Rule 19b-5(e)(3), 17 CFR 240.19b-5(e)(3).
\511\ Rule 19b-5(e)(7)(iii), 17 CFR 240.19b-5(e)(7)(iii),
defines related securities to mean any two securities in which the
value of one security is determined, in whole or significant part,
by the performance of the other security; or the value of both
securities is determined, in whole or significant part, by the
performance of a third security, combination of securities, index,
indicator, interest rate or other common factor.
\512\ A specialist, for purposes of the pilot trading system
rule, means any member that is subject to an SRO requirement to
regularly maintain a market in a particular security. Rule 19b-5(a),
17 CFR 240.19b-5(a). The definition of specialist is meant to
preclude member firms with exclusive information about buy and sell
orders from using unfairly such non-public material market
information to their competitive advantage. For instance, a member
acting as a specialist on the NYSE also could not simultaneously act
as a specialist in related securities on a pilot trading system
sponsored by the NYSE. Similarly, a member acting as a designated
primary market maker on the CBOE also could not simultaneously act
as a designated primary market maker in related securities on a
pilot trading system sponsored by the CBOE.
\513\ An SRO also may request an exemption from the limitation
under Rule 19b-5(e)(7)(i) by filing an application for an order for
exemptive relief under section 36. See 17 CFR 240.0-12.
\514\ Rule 19b-5(e)(7), 17 CFR 240.19b-5(e)(7).
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The Commission notes that Rule 19b-5 does not prohibit an SRO from
developing a trading system that permits a member firm to be a
specialist in related securities that trade simultaneously on trading
systems operated by the same SRO. However, the SRO could not avail
itself of the Rule 19b-5 temporary exemption, and instead would have to
file proposed rule changes with the Commission under Section 19(b) of
the Exchange Act for public notice and comment and obtain Commission
approval prior to operating such trading system.
h. Inspections and Examinations. As a condition to the exemption,
the Commission proposed that an SRO cooperate with any examination or
inspection by the Commission of persons effecting transactions on the
pilot trading system. The Commission received no comments on this
requirement and is adopting it as proposed.\515\ As adopted, the SRO
shall cooperate with the examination, inspection, or investigation by
the Commission of transactions effected on the pilot trading system.
The Commission staff will review SRO compliance with the conditions in
Rule 19b-5 through its routine inspections. In order for the Commission
staff to determine whether an SRO has properly relied on the exemption
under Rule 19b-5, the SRO must maintain at its principal place of
business all relevant records and information pertaining to the pilot
trading system and the basis for which the SRO relied on the exemption
from the rule filing requirement.\516\ The Commission notes that if an
SRO outsources the operation or maintenance of any aspect of a pilot
trading system, such vendor would be considered to be operating a
facility of an SRO and therefore would also be subject to Commission
examination or inspection.
---------------------------------------------------------------------------
\515\ Rule 19b-5(e)(8), 17 CFR 240.19b-5(e)(8).
\516\ Rule 19b-5(e)(9), 17 CFR 240.19b-5(e)(9).
---------------------------------------------------------------------------
i. Public Availability of Pilot Trading System Rules. Although
pilot trading system rules do not need to be approved by the
Commission, the Commission believes the current trading rules and
procedures of the pilot trading system should be publicly available.
Accordingly, the Commission is adopting a requirement that the SRO make
its trading rules and procedures of the pilot trading system publicly
available.\517\
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\517\ Rule 19b-5(e)(10), 17 CFR 240.19b-5(e)(10). This specific
requirement is necessary because Rule 6a-2, as amended, requires
exchanges to file its trading rules and procedures only once every
three years, while national securities associations have no such
publication requirement except through the rule filing process under
section 19(b) of the Exchange Act.
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C. Rule Filing Under Section 19(b)(2) of the Exchange Act Required
Within Two Years
Within two years of a pilot trading system commencing operation, an
SRO must submit a rule filing under section 19(b)(2) of the Exchange
Act to obtain approval for the pilot trading system to operate on a
permanent basis.\518\ In accordance with section 19(b) of the Exchange
Act, after a formal notice and comment period, the Commission will
decide whether to approve the proposed rule changes relating to a pilot
trading system on a permanent basis or whether to institute proceedings
to disapprove the proposed rule changes. Simultaneous with its request
for Commission approval under to section 19(b)(2) of the Exchange Act,
an SRO may request Commission approval pursuant to Section 19(b)(3)(A)
of the Exchange Act, effective immediate upon filing, to continue to
operate the trading system for a period not to exceed six months.\519\
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\518\ Rule 19b-5(f)(1), 17 CFR 240.19b-5(f)(1).
\519\ Rule 19b-5(f)(1) and (f)(2), 17 CFR 240.19b-5(f)(1) and
(f)(2).
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VII. The Commission's Interpretation of the ``Exchange'' Definition
A. The Commission's Interpretation in Delta
In the Exchange Act, Congress provided a broad definition of the
term ``exchange,'' permitting the Commission to apply the definition
flexibly as the securities markets evolve over time.\520\ Section
3(a)(1) of the Exchange Act provides that:
\520\ It was recognized at the time the Exchange Act was enacted
that a regulatory structure for securities exchanges would ``be of
little value tomorrow if it is not flexible enough to meet new
conditions immediately as they arise and demand attention in the
public interest.'' See SEC, Report of the Special Study of the
Securities Markets of the Securities and Exchange Commission, H.R.
Doc. No. 95, 88th Cong., 1st Sess. Pt. 1 (1963) (``Special Study''),
at 6. See also S. Rep. No. 792, 73rd Cong., 2d Sess. (1934) at 5
(noting that ``exchanges cannot be regulated efficiently under a
rigid statutory program,'' and that ``considerable latitude is
allowed for the exercise of administrative discretion in the
regulation of both exchanges and the over-the-counter market.'')
---------------------------------------------------------------------------
The term ``exchange'' means any organization, association, or
group of persons, whether incorporated or unincorporated, which
constitutes, maintains, or provides a market place or facilities for
bringing together purchasers and sellers of securities or for
otherwise performing with respect to securities the functions
commonly performed by a stock exchange as that term is generally
understood, and includes the market place or market facilities
maintained by such exchange.\521\
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\521\ 15 U.S.C. 78c(a)(1).
Although the statutory definition of ``exchange'' is quite broad,
in the 1990 Delta Release,\522\ the Commission interpreted the
definition narrowly to include only those organizations that are
``designed, whether through trading rules, operational procedures or
business incentives, to centralize trading and provide buy and sell
quotations on a regular or continuous basis so that purchasers and
sellers have a reasonable expectation that they can regularly execute
their orders at those price quotations.'' \523\ Based on this
[[Page 70899]]
interpretation, which was upheld by the Seventh Circuit on review,\524\
the Commission staff has given operators of trading systems that do not
enhance liquidity in traditional ways through market makers,
specialists, or a single price auction structure, assurances that it
would not recommend enforcement action if those systems operated
without registering as exchanges.\525\
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\522\ Delta Release, supra note 32. In 1988, the Commission
granted Delta temporary registration as a clearing agency to allow
it to issue, clear, and settle options executed through a trading
system operated by RMJ Securities (``RMJ''). Concurrently, the
Commission's Division of Market Regulation issued a letter stating
that the Division would not recommend enforcement action against RMJ
if its system did not register as a national securities exchange.
Subsequently, the Board of Trade of the City of Chicago and the
Chicago Mercantile Exchange petitioned the U.S. Court of Appeals for
the Seventh Circuit for review of the Commission's actions. Both
challenges were premised on the view that RMJ's system unlawfully
failed to register as an exchange or obtain an exemption from
registration. The Seventh Circuit vacated Delta's temporary
registration as a clearing agency, pending publication of a reasoned
Commission analysis of whether or not RMJ's system was an exchange
within the meaning of the Exchange Act. Board of Trade of the City
of Chicago v. Securities and Exchange Commission, 883 F.2d 525 (7th
Cir. 1989) (``Delta I''). In 1989, the Commission solicited comment
on the issue, and in 1990 published its interpretation of the term
``exchange'' and its determination that RMJ's system did not meet
that interpretation.
\523\ See Delta Release, supra note 32. The Commission also
identified the following factors as supporting the conclusion that
the system in Delta should not be classified as an exchange. Unlike
a traditional exchange, the system (1) was not open to the
participation of retail investors on an agency basis; (2) did not
offer limit order protection; and (3) provided a forum for trading
instruments that lacked certain indicia of standardization. These
factors were admittedly outside the Commission's ``central focus''
in Delta. Id. Moreover, most alternative trading systems that will
fall now under the Commission's new interpretation in Rule 3b-16
allow broker-dealer subscribers to act on behalf of retail customers
in placing and executing orders on the system; function as limit
order books where orders are executed according to time, price, and
size priority; and trade standard securities.
\524\ Board of Trade of the City of Chicago v. SEC, 923 F.2d
1270 (7th Cir. 1991).
\525\ For a list of no-action letters issued to system sponsors
until the end of 1993 and a short history of the Commission's
oversight of such systems, see Securities Exchange Act Release No.
33605, 59 FR 8368, 8369-71 (Feb. 18, 1994). See also Letters from
the Division of Market Regulation to: Tradebook (Dec. 3, 1996); The
Institutional Real Estate Clearinghouse System (May 28, 1996);
Chicago Board Brokerage, Inc. and Clearing Corporation for Options
and Securities (Dec. 13, 1995).
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Several concerns compelled the Commission in 1990 to narrowly
interpret the definition of the term ``exchange.'' First, the
Commission was concerned that a broad interpretation would place
``evolving (alternative) trading systems within the `strait jacket' of
exchange regulation,'' thus stifling innovation.\526\ Second, the
Commission was concerned that a broad definition would subject brokers,
dealers, and other statutorily defined entities to the regulatory
scheme prescribed for exchanges.\527\ Third, the Commission was
concerned that ``an expansive definition of the term `exchange' would
force a non-member, for-profit, proprietary trading system into a
regulatory scheme for which it is ill-suited, thus ignoring the
Congressional and judicial mandate to apply flexibly the definition of
the term `exchange' to the economic realm.'' \528\ These concerns,
however, are largely eliminated by Congress' broad grant of exemptive
authority in 1996,\529\ which has permitted the Commission to craft a
regulatory framework for markets which excludes other statutorily
defined entities (e.g., broker-dealers operating internal matching
systems) and flexibly regulate markets to accommodate their diverse
business structures. In addition, while the Delta interpretation was
appropriate at the time, its emphasis on the ``expectation'' of regular
execution of orders at quoted prices no longer reflects today's markets
where alternative trading systems compete directly with registered
exchanges and Nasdaq. The Delta approach has resulted in the anomaly of
regulating as exchanges small volume entities that raise an expectation
of liquidity within their system (such as AZX), while regulating as
broker-dealers higher volume entities (such as Instinet).
---------------------------------------------------------------------------
\526\ Delta Release, supra note 32, at 1899.
\527\ Id.
\528\ Id.
\529\ See supra note 7.
---------------------------------------------------------------------------
More fundamentally, although traditional exchanges still provide
liquidity through two-sided quotations and, hence, raise an expectation
of execution at the quoted price, this is no longer the essential
characteristic of a securities market where stock and other securities
exchange hands. Today's technology enables market participants and
investors to tap simultaneous and multiple sources of liquidity from
remote locations. Market makers and specialists may be important
liquidity providers on a particular exchange, but liquidity now comes
from many sources across multiple markets.\530\ For example, the public
exposure of investor limit orders means that it is now easier to access
liquidity in trading venues that do not have market makers or
specialists.\531\ Today, through their computer terminals and other
communication links, brokers acting on behalf of their customers or
institutions trading for themselves can see what the quoted price is on
an exchange or Nasdaq and check it against the price available for the
same security on one or more alternative trading systems.\532\
---------------------------------------------------------------------------
\530\ The rules adopted today reflect and facilitate multiple
sources of liquidity. Increasing the linkages among markets where
significant trading activity occurs--both exchanges and alternative
trading systems--will make the overall market for securities more
transparent and liquid.
\531\ See Order Handling Rules Adopting Release, supra note 177
at Section III.
\532\ In fact, an alternative trading system that posts firm
orders to buy or sell a security does raise a certain expectation of
execution at those quoted prices. The expectation is based on the
life of the outstanding orders in the system, rather than on
continuous two-sided quotations published by specialists or market
makers.
---------------------------------------------------------------------------
Notably, in Delta, the Commission indicated that the Exchange Act
does not preclude an alternative trading system from coming within the
``exchange definition.'' \533\ The Commission recognized that its
interpretation of the term ``exchange'' could be subject to change as
the securities markets continued to change:
\533\ See Delta Release, supra note 32, at 1900.
---------------------------------------------------------------------------
In order to permit the Commission to apply flexibly the
(Exchange) Act's definition of the term ``exchange'' to innovative
trading systems in securities, Congress imbued the (Exchange) Act's
definition of the term ``exchange'' with a certain ``plasticity'' *
* *; ``it invites reinterpretation as the way the term * * *
`generally understood' evolves.'' \534\
\534\ Delta Release, supra note 32, at 1895 (quoting Delta I,
supra note 522, at 535).
---------------------------------------------------------------------------
Moreover, on review, although the United States Court of Appeals
for the Seventh Circuit Court accepted the Commission's interpretation
of the term ``exchange'' and affirmed the Commission's determination
that Delta was not an ``exchange,'' the court nevertheless stated that
the ``Commission could have interpreted the section to embrace the
Delta System'' but that it was not compelled to do so.\535\
---------------------------------------------------------------------------
\535\ Delta II, supra note 348, at 1273. The court held that,
because the statutory provision is ambiguous, the Commission had the
discretion to interpret the definition the way it did.
---------------------------------------------------------------------------
B. The Growing Significance of Alternative Trading Systems in the
National Market System
Within the past six years, the significance of alternative trading
systems in the securities markets has increased dramatically. In 1994,
the Commission's Division of Market Regulation reported that
alternative trading systems accounted for thirteen percent of the
volume in Nasdaq securities and 1.4 percent of the trading volume in
NYSE-listed securities.\536\ In the Proposing Release, the Commission
estimated that, as of the end of 1996, the trading volume on
alternative trading systems amounted to almost twenty percent of the
trades in Nasdaq stocks, and almost four percent of orders in
securities listed on the NYSE.
---------------------------------------------------------------------------
\536\ See Division of Market Regulation, Market 2000: An
Examination of Current Equity Market Developments app IV (1994)
(``Market 2000 Study'').
---------------------------------------------------------------------------
In addition to the general increase in the volume of trading
occurring on alternative trading systems, the actual number of
alternative trading systems has skyrocketed. In 1991, the Commission
was aware of only a few such systems. Today, over forty such systems
are currently operating. The viability of this number of alternative
trading systems indicates that these systems account for an increasing
proportion of trading and that a growing number of investors use these
systems. Moreover, the arrival of trading services on the Internet
portends an increasing level of retail interest in alternative means
for trading.
As more alternative trading systems have developed to offer varying
services to diverse customer bases, the availability of trading
information and the accessibility of trading opportunities have become
increasingly fragmented. The national market system relies on
centralized sources of trading
[[Page 70900]]
opportunities and trading information. Exchange regulation is designed
to facilitate centralization and enhance the general public's
opportunities to obtain trading information and to access trading
interest.
The narrow interpretation of the term ``exchange'' in Delta has
eroded the effectiveness of the Commission's oversight of markets. For
example, as discussed in the Concept Release, it is clear that
regulatory concerns may be raised by entities that constitute a market
where buyers and sellers interact, but do not necessarily ensure a two-
sided market by design.\537\ Moreover, the Commission's traditional
approach to broker-dealer regulation is not designed to substitute for
market regulation. Consequently, these alternative trading systems are
not fully integrated into the mechanisms that promote market fairness,
efficiency, and transparency. In addition to raising regulatory
fairness concerns, this lack of integration into the national market
system has had a negative impact on the quality and pricing efficiency
of secondary markets.\538\
---------------------------------------------------------------------------
\537\ See Proposing Release, supra note 3, at n.290.
\538\ For example, the evidence in the Commission's report on
the NASD and the Nasdaq market pursuant to section 21(a) of the
Exchange Act suggests that widespread use of Instinet by market
makers as a private market has had a significant impact on public
investors and the operation of the Nasdaq market. See NASD 21(a)
Report, supra note 4.
---------------------------------------------------------------------------
C. The Revised Interpretation of ``Exchange''
For purposes of effectively regulating the securities markets,
including alternative trading systems, the Commission believes a
revised interpretation of what constitutes an exchange is in
order.\539\ Although the Commission has considered many characteristics
of the modern exchange in revising its interpretation,\540\ it believes
two elements most accurately reflect the functions and uses of today's
exchange markets. Under the interpretation in Rule 3b-16, the first
essential element of an exchange is the bringing together of orders of
multiple buyers and sellers. This reflects the statutory concept of
bringing together purchasers and sellers and also reflects the reality
of today's marketplace--where supply and demand originate from a
variety of sources, not simply from individual brokers and
dealers.\541\ The second essential element is that trading on an
exchange takes place according to established, non-discretionary rules
or procedures. As discussed above, an essential indication of the non-
discretionary status of rules and procedures is that those rules and
procedures are communicated to the system's users. Thus, participants
have an expectation regarding the manner of execution--that is, if an
order is entered, it will be executed in accordance with those
procedures and not at the discretion of a counterparty or
intermediary.\542\
---------------------------------------------------------------------------
\539\ Courts have consistently upheld an agency's discretion to
revise earlier interpretations when a revision is reasonably
warranted by changed circumstances. See, e.g., Rust v. Sullivan, 500
U.S. 173, 186 (1991). In Rust, the Court stated that ``an initial
agency interpretation is not instantly carved in stone, and the
agency, to engage in informed rulemaking, must consider varying
interpretations and the wisdom of its policy on a continuing
basis.'' Id. at 186 (quoting Chevron v. Natural Resources Defense
Council, 467 U.S. 837, 844-45 (1984)). The Court also stated that
``an agency is not required to `establish rules of conduct to last
forever,' but rather `must be given ample latitude to adapt its
rules and policies to the demands of changing circumstances.' '' Id.
at 186-87 (quoting Motor Vehicles Mfrs. Ass'n of United States v.
State Farm Mut. Automobile Ins. Co., 463 U.S. 29, 42 (1983)). See
also Arkansas AFL-CIO v. FCC, 11 F.3rd 1430, 1441 (8th Cir. 1993)
(deferring to Federal Communications Commission decision to alter
its interpretation of the statutory term ``operated in the public
interest'' to meet the changing realities of the broadcast
industry).
\540\ See Concept Release, supra note 2, at nn.125-133 and
accompanying text.
\541\ This broad conception of ``bringing together'' buyers and
sellers is consistent with the Delta Release, which emphasized that
the means employed for bringing together buyers and sellers ``may be
varied, ranging from a physical floor or trading system * * * to
other means of intermediation (such as a formal market making system
or systemic procedures such as a consolidated limit order book or
regular single price auction).'' Delta Release, supra note 32, at
1899.
\542\ The elements of the interpretation are discussed in
greater detail in Section III, supra.
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Some commenters thought the Commission should retain its current
interpretation of an exchange. For example, TBMA advocated a less
expansive definition of exchange, and recommended that the Commission
continue to regulate alternative trading systems within the broker-
dealer framework, crafting appropriate regulations to address
particular issues presented by unique operations as they develop.\543\
TBMA also raised a question about whether, by eliminating the
requirement that a system provide a reasonable expectation of liquidity
to be considered an exchange, the Commission's proposal conflicted with
the statutory definition of ``exchange'' because liquidity is
``generally understood'' to be a fundamental characteristic of an
exchange. As noted above, however, today's technology gives market
participants the ability to access multiple markets for liquidity at
any given time. As a result, assuring liquidity within a single market
by posting continuous two-sided quotations is no longer the essential
characteristic of a market where securities exchange hands.\544\
---------------------------------------------------------------------------
\543\ See TBMA Letter at 3-4.
\544\ The Commission also notes that the statutory definition of
``exchange'' is written in the disjunctive: facilities for bringing
together purchasers and sellers or facilities performing functions
commonly performed by stock exchanges. Section 3(a)(1) of the
Exchange Act, 15 U.S.C. 78c(a)(1). See TBMA Letter, at 8-9
(recommending that the Commission continue to rely on its
interpretation in the Delta Release); SIA Letter at 2, 6-7 (a
significant characteristic of exchanges is structural features that
create a reasonable expectation of the regular execution of orders
at posted prices). See also Letter from Christopher J. Carroll,
Managing Director, Deutsche Bank Securities, Inc. to Jonathan G.
Katz, Secretary, SEC, dated July 31, 1998 (``DBSI Letter'') at 2;
NYSE Letter at 2-3, 4-5, 8 (commenting that only alternative trading
systems meeting the Delta interpretation of exchange should have the
ability to register with the Commission as an exchange); Instinet
Letter at 8 (recommending that the Commission retain its current
interpretation of ``exchange''); CBB Letter at 3 (recommending that
if the Commission believed its current interpretation of
``exchange'' in the Delta Release was inadequate, that the
Commission should simply withdraw that interpretation and rely
solely on the statutory definition of ``exchange'').
---------------------------------------------------------------------------
Accordingly, the Commission believes that new Rule 3b-16 more
accurately describes the range of markets that perform exchange
functions as understood today. At the same time, the Commission's
exemption from the exchange definition for many alternative trading
systems provides a flexible framework, permitting each participant to
choose the regulatory approach that best serves its own business needs.
D. Other Practical Reasons for Revising the Current Interpretation
1. Additional Flexibility Provided by the National Securities Markets
Improvement Act of 1996
As stated above, one principal reason the Commission, to date, has
interpreted the term ``exchange'' narrowly has been to avoid the
imposition of unnecessary and burdensome regulatory obligations on
small and emerging trading systems, which could stifle innovation.\545\
The enactment of NSMIA,\546\ however, alleviates the concern that an
expanded interpretation of the term exchange will inhibit
innovation.\547\ Specifically,
[[Page 70901]]
NSMIA added section 36(a)(1) to the Exchange Act, which provides that:
\545\ For example, at the time of the Delta Release, the
Commission sought to avoid interpreting the term ``exchange'' in a
way that could unintentionally and inappropriately subject many
broker-dealers to exchange regulation. One key factor in the
Commission's decision not to regulate the Delta system as an
exchange was the concern that doing so would subject traditional
broker-dealer activities to exchange regulation. Delta Release,
supra note 32.
\546\ Pub. L. 104-290, 110 Stat. 3416 (1996). 15 U.S.C. 78mm.
\547\ Throughout the past 60 years, the Commission has attempted
to accommodate market innovations within the existing statutory
framework to the extent possible in light of investor protection
concerns, without imposing regulation that would stifle or threaten
the commercial viability of such innovations. For example, at
various times, the Commission considered the implications of
evolving market conditions on exchange regulation. See Securities
Exchange Act Release Nos. 8661 (Aug. 4, 1969), 34 FR 12952
(initially proposing Rule 15c2-10); 11673 (Sept. 23, 1975), 40 FR
45422 (withdrawing then-proposed Rule 15c2-10 and providing for
registration of securities information processors); 26708 (Apr. 13,
1989), 54 FR 15429 (reproposing Rule 15c2-10); 33621 (Feb. 14,
1994), 59 FR 8379 (withdrawing proposed Rule 15c2-10).
---------------------------------------------------------------------------
the Commission, by rule, regulation, or order, may conditionally or
unconditionally exempt any person, security, or transaction, or any
class or classes of persons, securities, or transactions, from any
provision or provisions of (the Exchange Act) or of any rule or
regulation thereunder, to the extent that such exemption is
necessary or appropriate in the public interest, and is consistent
with the protection of investors.\548\
\548\ 15 U.S.C. 78mm(a)(1).
---------------------------------------------------------------------------
Prior to adoption of NSMIA, the Commission's authority under the
Exchange Act to reduce or eliminate certain consequences of exchange
registration was limited.\549\ Section 36, however, allows the
Commission greater flexibility in regulating new trading systems by
giving the Commission broad authority to exempt any person from any
provision of the Exchange Act. As a result, the Commission now has
greater authority to adopt a more consistent regulatory approach to
securities markets in general, and particularly for alternative trading
systems that do not neatly fit into the existing regulatory
framework.\550\
---------------------------------------------------------------------------
\549\ Prior to the addition of section 36 to the Exchange Act,
the Commission could only exempt an exchange from the registration
provisions of sections 5 and 6 on the basis of an exchange's limited
volume of transactions. See Section 5 of the Exchange Act, 15 U.S.C.
78e.
\550\ See S. Rep. No. 104-293, 104th Cong. 2d Sess. 15 (1996).
---------------------------------------------------------------------------
2. No-action Approach to Alternative Trading Systems Is No Longer
Workable
The Commission also believes that the proliferation of new trading
systems necessitates the revision of the interpretation of the term
``exchange.'' The no-action review process that the Commission has used
to date to address hybrid systems that incorporate features of both
exchanges and broker-dealers worked well and was consistent with the
protection of investors when relatively few systems applied for no-
action treatment. The no-action process allowed the Division to review
the system's services and mechanisms and to monitor the impact of such
systems on a case-by-case basis. This is no longer practicable. Absent
a revised interpretation of ``exchange,'' the Commission would have to
continue to respond to an increasing volume of no-action requests from
developing alternative trading systems that seek to avoid the burdens
associated with registration as a national securities exchange. The
Commission's revised interpretation eliminates the need for this no-
action approach. By codifying a regulatory framework that does not rely
on Commission staff review of each novel system development, the
Commission believes that technological improvements and enhanced
services will become available more rapidly.
3. More Rational Treatment of Regulated Entities
The Commission believes that the revised interpretation of the term
exchange, in combination with the adoption of Regulation ATS, which
allows alternative trading systems to register as broker-dealers,\551\
is consistent with other goals and provisions of the Exchange Act. The
new regulatory framework, including the revised interpretation of
``exchange'' avoids the need for the Commission to draw what are now
arbitrary distinctions between organizations that perform similar
functions, avoids classifying alternative trading systems in a manner
that does not fit the structure of these systems, and squarely
addresses the regulatory concerns raised by these systems.
---------------------------------------------------------------------------
\551\ See supra Section IV.A.
---------------------------------------------------------------------------
Moreover, the Commission's new framework helps assure consistency
with existing broker-dealer regulations. For those alternative trading
systems that wish to participate in the markets as exchanges,
regulation as a national securities exchange is available. However, the
Commission expects that many alternative trading systems will not elect
to register as national securities exchanges. Under the Commission's
proposal, these systems would have to maintain a structure more akin to
that of traditional broker-dealers and comply with regulatory
obligations more appropriately tailored to their chosen business
structure. These obligations include the new requirements for more
significant alternative trading systems to address the transparency,
fair access, and systems capacity, integrity, and security concerns
raised by these particular systems.\552\
---------------------------------------------------------------------------
\552\ See supra IV.A.2.
---------------------------------------------------------------------------
VIII. Effective Dates and Compliance Dates
The rules and rule amendments adopted in this release are effective
on April 21, 1999, except for Exchange Act Rules 301(b)(5)(D) and (E)
and Rules 301(b)(6)(D) and (E), which shall become effective on April
1, 2000. Alternative trading systems, however, will only have to comply
with the public display requirement in Rule 301(b)(3) for fifty percent
of the securities subject to this requirements on April 21, 1999.
Alternative trading systems will have to comply with Rule 301(b)(3) for
all such securities by August 30, 1999.\553\ Prior to April 21, 1999,
the Commission will publish a schedule of those securities for which
alternative trading systems must comply with Rule 301(b)(3) on April
21, 1999.
---------------------------------------------------------------------------
\553\ Because the rules and rule amendments regarding Regulation
ATS, exchange registration, and Rule 19b-5 constitute ``major
rules'' within the meaning of the Small Business Regulatory
Enforcement Act of 1996, 5 U.S.C. 801 et seq., the rules and rule
amendments cannot take effect until 60 days after the date of
publication in the Federal Register. Although the amendments to
Rules 17a-3 and 17a-4 and repeal of Rule 17a-23 and Form 17A-23 do
not constitute ``major rules,'' they will become effective at the
same time as Regulation ATS because they operate in an integrated
fashion with Regulation ATS.
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IX. Costs and Benefits of the Rules and Amendments
To assist the Commission in its evaluation of the costs and
benefits that may result from the rules and amendments, commenters were
requested to provide analysis and data, if possible, relating to the
costs and benefits associated with the proposals. The Commission
initially identified certain costs and benefits associated with its
changes in the Proposing Release. Although the Commission received
seventy comment letters, as of December 1, 1998 concerning the proposed
rules, none of the commenters responded specifically to the request for
comment on the cost/benefit analysis. Some commenters did raise related
issues and the Commission will address those comments in this analysis.
After considering the comments, the Commission continues to believe
that the benefits of the rules and amendments justify the associated
costs.
A. Costs and Benefits of the Rules and Amendments Regarding Alternative
Trading Systems
The Commission identified several benefits and costs to investors
and market participants in the Proposing Release with regard to
alternative trading systems. The Commission is not making any changes
to the rules or amendments that increase the cost estimates for
alternative trading system notice, reporting and recordkeeping
obligations. The most significant change
[[Page 70902]]
the Commission is making in the rules as adopted is to revise the fair
access provisions. The rules and amendments in the Proposing Release
provided investors with a right of appeal to the Commission and
required alternative trading systems to provide investors denied or
limited access to the system with notice of that action and their right
to appeal the decision to the Commission. The Commission has decided
not to adopt the right of appeal provisions and the requirement of
notice to investors denied or limited access. Instead, alternative
trading systems with significant volume will be required to provide
quarterly notices to the Commission on Form ATS-R of all grants,
denials, and limitations of access as well as descriptive information
regarding those access decisions. The net effect of these changes to
the fair access requirements is a decrease, relative to the original
proposal, in the burdens on alternative trading systems with
significant volume. Several commenters objected to the proposed fair
access rules on various grounds.\554\
---------------------------------------------------------------------------
\554\ See ICI Letter at 4 (stating that requirements would be
overly burdensome for alternative trading systems); IBEX Letter at
13 (arguing that appeal process should begin at the SRO level);
Instinet Letter at 19 (stating that a right of appeal to the
Commission could lead to frequent frivolous appeals).
---------------------------------------------------------------------------
Several commenters had general comments with regard to the burdens
imposed on respondents under Regulation ATS. One commenter argued that
the Commission should impose only minimal requirements on start-up or
smaller trading systems.\555\ The alternative trading system rules have
been tailored to minimize their burden on alternative trading systems
generally and small systems specifically. Because many of the
provisions in the rules are triggered by a volume threshold, the
Commission expects that small alternative trading systems will not have
sufficient volume to trigger those thresholds and will, therefore, not
have to comply with those provisions. The recordkeeping and reporting
requirements with which smaller, lower volume alternative trading
systems will have to comply under Regulation ATS are substantially
similar to those with which alternative trading systems currently
comply. Consequently the costs for smaller alternative trading systems
should remain unchanged.
---------------------------------------------------------------------------
\555\ TBMA Letter at 16.
---------------------------------------------------------------------------
One commenter argued that material changes on Form ATS should be
reported twenty days after such a change is made rather than twenty
days before.\556\ The Commission believes that is important to have
some advance notice of significant changes in order to permit it to
carry out its market oversight and investor protection functions. By
requiring notice before such changes are made, the Commission has an
opportunity to make inquiries to clarify any questions that might
arise. Currently, alternative trading systems are required to give
twenty days prior notice of material changes on Part 1-A of Form 17A-
23. This burden remains unchanged under the new rules.
---------------------------------------------------------------------------
\556\ SIA Letter at 17-18. But see IBEX Letter at 5 (stating
that the reporting requirements under proposed Regulation ATS were
not inappropriately burdensome).
---------------------------------------------------------------------------
Several commenters pointed out areas for possible reductions of
regulatory overlap. One commenter argued that the Commission should
eliminate those broker-dealer requirements that would be irrelevant for
alternative trading systems.\557\ The Commission, however, does not
believe that the broker-dealer requirements as they apply to
alternative trading systems, are irrelevant or overly burdensome.
Another commented that recordkeeping burdens should be coordinated with
the NASD's OATS program.\558\ These recordkeeping rules do not specify
the manner in which such records must be maintained, but only that they
must be made available upon request. Such records may be required for
other purposes, but it is important to assure that all alternative
trading systems maintain records sufficient to construct an audit
trail.
---------------------------------------------------------------------------
\557\ CBB Letter at 4.
\558\ Instinet Letter at 20.
---------------------------------------------------------------------------
One commenter argued that the Commission's rules and amendments
impose costs and burdens on market innovators rather than encouraging
such systems.\559\ As discussed above, however, the Commission does not
intend its new regulatory framework to impose a penalty on systems
because of their use of technology. The Commission's new framework is
based on the functions performed by a trading system, not on its use of
technology.
---------------------------------------------------------------------------
\559\ Instinet Letter at 10.
---------------------------------------------------------------------------
Finally, a large number of institutional subscribers to alternative
trading systems submitted comments within the last two weeks. These
commenters expressed a number of concerns about the public display
requirement. Among the concerns voiced by these commenters was a
concern about decreasing liquidity, limiting a potentially advantageous
trading strategy, being able to provide best execution for their
clients, and increasing costs to execute trades. The Commission
responds to these concerns below.\560\
---------------------------------------------------------------------------
\560\ See supra Section IV.A.2.c.
---------------------------------------------------------------------------
The Commission solicited comment on the feasibility of permitting
alternative trading systems to file forms electronically. Three
commenters supported electronic filing as an option to reduce the
burdens on respondents.\561\ While not feasible at this time, the
Commission intends to make electronic filing an option when it is
possible.
---------------------------------------------------------------------------
\561\ See IBEX Letter at 5; SIA Letter at 18; American Century
Letter at 6.
---------------------------------------------------------------------------
Three commenters argued that the Commission's rules should not
apply to debt securities, in part, due to the burdens that such
requirements would place on a largely decentralized market.\562\ Other
commenters supported including debt securities within Regulation
ATS.\563\ The Commission continues to believe that many of the same
concerns about the trading of equity securities on alternative trading
systems apply equally to the trading of fixed income securities on
alternative trading systems. Debt securities are increasingly being
traded on alternative trading systems, similar to the way that equity
securities are traded. Accordingly, the Commission's new regulatory
framework would require alternative trading systems trading debt
securities, other than alternative trading systems trading solely
government and related securities, to register as an exchange or
register as a broker-dealer and comply with Regulation ATS. If an
alternative trading system chooses to register as a broker-dealer,
Regulation ATS applies the same notice, recordkeeping, and reporting
requirements on debt alternative trading systems as apply to equity
alternative trading systems. Because of the way the debt market
currently operates, however, the transparency provisions do not apply
to alternative trading systems that trade debt securities. Only those
alternative trading systems that trade at least twenty percent of
certain categories of debt are be subject to the fair access
requirements \564\ and the provisions governing systems capacity,
security, and integrity.\565\
---------------------------------------------------------------------------
\562\ See TBMA Letter at 6-7, 21; SIA Letter at 3, 11; DBSI
Letter at 1; MSDW Letter at 13.
\563\ See NYSE Letter at 6; IBEX Letter at 2-3.
\564\ Rule 301(b)(5), 17 CFR 242.301(b)(5).
\565\ Rule 301(b)(6), 17 CFR 242.301(b)(6).
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Under the rules and amendments in this release, alternative trading
systems have a choice between registering as a national securities
exchange or registering as a broker-dealer and complying with
Regulation ATS. The choice between these two options is
[[Page 70903]]
complex and each alternative trading system will make a choice based on
its business plan and the role it wishes to play in the market. There
are several factors that will have an impact on each alternative
trading system's decision.
First, the regulatory costs associated with registering and
operating as a national securities exchange are higher than the
regulatory costs associated with registering as a broker-dealer and
complying with Regulation ATS. Second, registered exchanges have
national market system obligations that require those exchanges to bear
the expenses associated with joining the CTA, CQS, and ITS plans. To
offset some of those costs, however, registered exchanges also
participate in the revenue generated from the sale of quotation
information. Third, registered exchanges are SROs and, therefore, have
obligations to surveil trading activity and member conduct on the
exchange. These obligations can be significant in terms of time,
personnel, and financial resources. However, a significant advantage to
a registered exchange of being an SRO is that it is not subject to
oversight by a competitor. Fourth, registered exchanges are subject to
the statutory requirement to provide fair access, which requires a
commitment of resources to consider membership applications and to
report denials to the Commission and defend any denial decisions before
the Commission if an appeal is made.
Because of the range of obligations of registered exchanges,
operation as an exchange requires a significant investment of financial
resources. A relatively high volume of trading may be required to
justify this financial investment. While the advent of for-profit and
non-member owned exchanges may make it easier to raise the financial
resources necessary to operate as a registered exchange, the Commission
does not expect that many alternative trading systems will choose to
register as exchanges.
On the other hand, alternative trading systems that register as
broker-dealers must comply with the filing and conduct obligations
associated with being a registered broker-dealer including membership
in an SRO and compliance with that SRO's rules. They must also comply
with Regulation ATS, which includes filing, recordkeeping and reporting
obligations. Unlike registered exchanges, alternative trading systems
are subject to oversight by an SRO, which may operate a competing
market. Regulation ATS is designed to impose few requirements on lower
volume alternative trading systems. Only alternative trading systems
with significant volume are required to link to an SRO and publicly
display orders, provide investors with fair access, and comply with
systems capacity, integrity, and security requirements. These
obligations for alternative trading systems with significant volume are
similar, although not identical, to obligations of registered
exchanges. Therefore, it is more likely that a high volume alternative
trading system will consider the costs and benefits of registering as
an exchange to be more comparable to the costs and benefits of
regulation as a broker-dealer alternative trading system. The costs
associated with regulation as a registered exchange, and with operating
as a broker-dealer and complying with Regulation ATS are discussed more
fully below.
1. Benefits
a. Improved Market Transparency. The Commission's amendments and
rules enhance transparency of trading on alternative trading systems.
Transparency of orders helps ensure that publicly available prices
fully reflect overall supply and demand and helps reduce the negative
consequences of market fragmentation (e.g., the chance that an order
for a security in one market will be executed at a price inferior to
that available at the same time in another market). The Commission has
been particularly concerned that the development of so-called ``hidden
markets,'' in which a market participant privately publishes quotations
at prices superior to the quotation information it disseminates
publicly, impedes national market system objectives. Some systems that
permit this activity have become significant markets in their own
right, but are not currently required to integrate their orders into
the public quote because they are not registered as national securities
exchanges or national securities associations.
For alternative trading systems choosing to register as broker-
dealers, the Commission's amendments and rules improve the transparency
of orders in systems that account for a significant portion of the
trading volume in any security. The amendments and rules help to
incorporate alternative trading system quotes into the national market
system, thus reducing fragmentation, improving liquidity, facilitating
price discovery, and narrowing the quoted spread.\566\
---------------------------------------------------------------------------
\566\ The Office of Management and Budget has recognized that
although it may be difficult to quantify the benefits of price
transparency, ``[t]here is a strong consensus among economists that
regulations requiring the disclosure of information about the price
and quality of products and services can produce significant
benefits for consumers and improve the functioning of markets when
this information would not otherwise be available.'' Office of
Management and Budget, Draft Report to Congress on the Costs and
Benefits of Federal Regulations, 63 FR 44034 (Aug. 17, 1998).
---------------------------------------------------------------------------
Because non-market maker broker-dealers and institutions at times
enter the best priced orders in an alternative trading system, the
Commission expects that display of these orders in the public quote
will also improve the NBBO. For example, of all orders on ECNs by non-
market maker broker-dealers and institutions that could improve the
NBBO if included in the public quote stream, only about six percent of
those orders were actually entered into the public quote stream.
Consequently, about ninety-four percent of those orders that could have
improved the NBBO were not included in the public quote stream and thus
did not impact the NBBO. These orders were therefore unavailable to
some investors, in particular, retail investors, who do not have direct
access to ECNs. The unavailability of these quotes continues to
effectively result in a two-tiered market. While the Commission is
unable to precisely quantify the market impact of these changes, it
does believe that the benefit for investors will be significant based
on preliminary estimates.
Based on an analysis of ECN trading activity during a four day
period in June 1997 (June 23, 1997 to June 27, 1997), the staff
estimates that spreads could decrease by as much as four percent for
Nasdaq issues when non-market maker broker-dealer and institutional
orders are displayed in the public quote. In making this estimate, the
staff has assumed an average spread of 35 cents per share, a maximum
increase of eleven percent for the times that ECNs could narrow the
inside, and a maximum of 12.5 cents per share improvement. In addition
to the effects on the bid-ask spread, retail investors and other non-
subscribers will gain access to the liquidity and better prices now
available only to alternative trading system subscribers. Moreover,
because many broker-dealers offer retail customers automatic execution
of their small orders at the publicly quoted price, a better price in
the public quote potentially improves the price received by thousands
of broker-dealer customers. Larger orders negotiated between
institutions and broker-dealers also potentially benefit because the
price negotiated will reflect a smaller spread. For these reasons, the
Commission believes that new display and access requirements will
result in significant benefits to investors.
[[Page 70904]]
The above data is consistent with the results of the transparency
improvements achieved through the implementation of the Order Handling
Rules.\567\ The NASD studied the effect of the Order Handling Rules on
the Nasdaq market by comparing various measures between a pre-period of
twenty days in the beginning of 1997 (December 18, 1997 to January 17,
1998) and a post-period of twenty days in the beginning of 1998
(January 5, 1998 to February 2, 1998). The success of the Order
Handling Rules further supports the view that the amendments and rules
the Commission is adopting today will further investors' opportunities
to trade at the best prices.
---------------------------------------------------------------------------
\567\ See supra note 177. Under the Order Handling Rules, market
makers who enter orders on ECNs are required to reflect those prices
in their public quotations. In the alternative, the ECN can make the
best market maker prices publicly available through an SRO.
---------------------------------------------------------------------------
In its study, the NASD also found that quoted spreads in the Nasdaq
market decreased by an average of forty-one percent. The NASD estimates
that this reduction in spreads resulted in annual savings to investors
of between $284 million and $673 million. Because of the increased
market transparency provided by the display of institutional and non-
market maker broker-dealer orders, the Commission believes that the
rules and amendments in this release will also further shrink spreads.
Finally, the Commission believes that improved transparency of
orders in alternative trading systems will reduce the potential for
alternative trading system subscribers to manipulate the public market.
It has been alleged that institutions and non-market makers
intentionally influence the market by displaying an order in an
alternative trading system that locks the price displayed in the public
market. For example, if the public market is displaying a bid of 20 and
an offer of 21, an institution or non-market maker might display an
offer of 20 in an alternative trading system. Market participants often
then assume that the order in the alternative trading system indicates
the direction in which the market is moving and begin selling to market
makers bidding 20, pushing the public market lower. The price in the
alternative trading system is then canceled and the institution or non-
market maker buys securities at a lower price. This type of activity is
possible only because institution and non-market maker orders in
alternative trading systems are not displayed to the public market. The
Commission believes that the integrity of the public markets is
threatened when institutions and non-market makers can affect the
public markets without participating in them.
The transparency of trading on alternative trading systems that
choose to register as exchanges will also improve. All registered
exchanges are expected to participate in the national market system
plans, such as the CTA, CQS, and ITS. These plans form an integral part
of the national market system, and contribute greatly to the operation
of linked, transparent, efficient, and fair markets. In addition to
improving transparency, alternative trading system participation in
these market-wide mechanisms will benefit investors by reducing trading
fragmentation.
b. Improved Investor Protections. The Commission's amendments and
rules provide benefits to investors by improving the surveillance of
trading on alternative trading systems. Adequate surveillance of the
trading on alternative trading systems is critical to the continued
integrity of our markets. This is particularly the case with regard to
alternative trading systems that have a significant percentage of the
trading volume in one or many issues of securities. The oversight of
trading activities on alternative trading systems that choose to
register as broker-dealers will improve because the proposals clarify
the relationship between SROs and alternative trading systems.
The notice, reporting, and recordkeeping requirements under
Regulation ATS also contribute to the Commission's and the SROs'
ability to effectively oversee alternative trading systems regulated as
broker-dealers. The Commission believes that these enhancements to the
surveillance and oversight of alternative trading systems regulated as
broker-dealers benefit the public by helping to prevent fraud and
manipulation.
The surveillance of trading on alternative trading systems that
choose to register as exchanges under the Commission's proposal will
also be improved. All registered exchanges are SROs, which have direct
obligations to surveil the trading on their own markets. The Commission
believes that, through improved surveillance mechanisms, it will be
better able to detect fraud and manipulation that could occur on
alternative trading systems. For example, alternative trading systems
can be used to artificially narrow the NBBO spreads for the sole
purpose of trading through a broker-dealer's automatic execution system
at the artificial prices.\568\ The Commission and the SROs will be able
to more readily detect such activity through enhanced surveillance. The
Commission believes that this more direct oversight of trading
activities will therefore benefit investors and the market generally by
helping to prevent fraud and manipulation.
---------------------------------------------------------------------------
\568\ See supra note 5.
---------------------------------------------------------------------------
c. Fair Access. The Commission's rules require alternative trading
systems with significant volume to provide a fair opportunity to
participate in alternative trading systems. Fair and non-discriminatory
treatment of potential and current subscribers by alternative trading
systems is important, especially when an alternative trading system
captures a large percentage of trading volume in a security. Although
an alternative trading system with significant volume is required to
provide access to orders that it is required to display in the public
quote stream, there are other benefits to direct participation on an
alternative trading system. In particular, participation on an
alternative trading system allows an investor to enter its own orders,
view contingent orders not publicly displayed (such as all or none
orders) and use special features of an alternative trading system, such
as a negotiation feature or reserve size feature. Accordingly, the
rules prevent discriminatory denials of access and ensure that market
participants are not prevented from gaining access to significant
sources of liquidity.
d. Systems Capacity, Integrity, and Security. The Commission
believes that its rules regarding systems capacity, integrity, and
security of alternative trading systems provide several benefits to the
marketplace and to investors. Marketplaces are increasingly reliant on
technology and most of their functions are becoming highly automated.
Alternative trading systems are subject only to business incentives to
avoid system breakdowns that may disrupt the market. In the past,
alternative trading system failures have affected the public market,
particularly during periods of high trading volume. Some alternative
trading systems have had prolonged shut-downs during the busiest
trading sessions due to systems problems. For example, during the past
year, Instinet, Island, Bloomberg, and Archipelago (operated by Terra
Nova) have all experienced systems outages due to problems with their
automated systems. On a number of occasions, ECNs have had to stop
disseminating market maker quotations in order to keep from closing
altogether, including during the market decline of October 1997 when
one significant ECN withdrew its quotes from Nasdaq because of lack of
capacity. Similarly, a major IDB in non-exempt
[[Page 70905]]
securities experienced serious capacity problems in processing the
large number of transactions in October 1997 and had to close down
temporarily.
The Commission's rules require alternative trading systems that
handle a significant volume of trades to establish reasonable capacity
estimates, conduct stress tests, implement procedures to monitor system
development, review systems vulnerability, and establish adequate
contingency plans. Investors will benefit from the rules because
significant systems will be less likely to shut down as a result of
systems failures and will be better equipped to handle market demand
and provide liquidity during periods of market stress. The ability of
alternative trading systems to provide more reliable and consistent
service in the market benefits investors and the public markets
generally. The Commission also believes that investors will benefit
from robust system security provided by ensuring that significant
alternative trading systems maintain sufficient security measures to
prevent unauthorized access.
All currently registered exchanges participate in the Commission's
automation review program. Alternative trading systems that choose to
register as exchanges will similarly be expected to participate in this
program. Under the automation review program, exchanges are expected to
maintain sufficient systems capacity to meet current and anticipated
volume levels. The benefits to investors and the public generally, as
with significant alternative trading systems, will be the assurance
that systems are reasonably equipped to handle market demand and
provide liquidity during periods of market stress.
2. Costs
The alternative trading system rules and amendments have been
tailored to minimize their burden on alternative trading systems and
especially small systems. Many of the provisions in the rules and
amendments are triggered by a volume threshold. The Commission expects
that small alternative trading systems will not have sufficient volume
to trigger those thresholds and will therefore not have to comply with
those provisions. The recordkeeping and reporting requirements with
which smaller, lower volume alternative trading systems have to comply
under Regulation ATS are substantially similar to those with which
alternative trading systems currently comply. Consequently the costs
for smaller alternative trading systems should remain materially
unchanged. The paperwork, filing, and recordkeeping costs are discussed
in the Paperwork Reduction Act section below.
a. Notice, Reporting, and Recordkeeping. All alternative trading
systems that will be subject to notice, reporting, and recordkeeping
requirements under the Commission's new rules are currently subject to
similar requirements under Rule 17a-23. The requirements under
Regulation ATS, however, require some additional information that is
not currently required under Rule 17a-23.
Under Regulation ATS, alternative trading systems file an initial
operation report, notices of material systems changes, and quarterly
reports. The rules also include new Forms ATS and ATS-R to standardize
reporting of such information and make it more useful for the
Commission. The rules require information that is not currently
required under Rule 17a-23, such as greater detail about the system
operations, the volume and types of securities traded, criteria for
granting access to subscribers, procedures governing order execution,
reporting, clearance and settlement, procedures for reviewing systems
capacity and contingency procedures, and the identity of any other
entities involved in operating the system.
Regulation ATS requires staff time to comply with the initial
notice and amendment requirements. While the Commission has designed
the requirements in an effort to balance the costs of filing with the
benefits to be gained from the information, some effort will be
necessary to gather and file this information. Most of the information,
however, already exists. Alternative trading systems will only be
required to gather this information and supply it in the required
format to the Commission. The periodic updating requirements will also
require staff time over the life of the alternative trading system to
comply with the rules.
The Commission estimates that there are currently about forty-five
alternative trading systems that will be required to register as
exchanges or register as broker-dealers and comply with Regulation
ATS.\569\ The Commission also estimates that, over time, there will be
approximately three new alternative trading systems each year that
choose to register as broker-dealers and comply with Regulation
ATS.\570\ The Commission also estimates that, over time, there will be
approximately three alternative trading systems that file cessation of
operations reports each year. Thus, the Commission anticipates that,
over time, if all forty-five current alternative trading systems choose
to register as broker-dealers and comply with Regulation ATS, there
will be approximately forty-five alternative trading systems operating
each year.
---------------------------------------------------------------------------
\569\ This estimate is based on filings made with the Commission
under Rule 17a-23. At the time of the Proposing Release, the
Commission estimated that forty-three alternative trading systems
would be required to register as exchanges or broker-dealers and
comply with Regulation ATS. The Commission now estimates that there
are forty-five alternative trading systems operating.
\570\ Based on the Commission's experience over the last three
years with Rule 17a-23, it appears that there are more than three
new alternative trading systems per year. However, we expect that in
the future, there will be approximately three new alternative
trading systems per year. The rapid growth experienced over the last
several years is unlikely to continue in perpetuity.
---------------------------------------------------------------------------
b. Public Display of Orders and Equal Execution Access. Regulation
ATS requires that alternative trading systems with significant volume
display their best-priced orders for securities in which they have 5
percent or more of total trading volume in the public quote. The
Commission identified the anticipated benefits of this requirement
above. Below is a discussion of possible costs associated with this
requirement.
One possible cost is the impact on institutional order flow to
alternative trading systems generally. Institutions have several
options available to them to execute trades. They can send orders to
block trading desks, a number of different types of alternative trading
systems, or directly to registered exchanges through broker-dealer
give-ups. Although not currently displayed to the public, orders sent
to an alternative trading system by institutions are displayed to other
alternative trading system subscribers.\571\ Thus, placing large
orders, or a series of successive small orders, in an alternative
trading system signals to a large number of sophisticated market
participants the interest in a particular security.
---------------------------------------------------------------------------
\571\ A number of ECNs, however, currently display the best
order in their system in the public quote, regardless of whether
that order is entered by an institution, market maker or another
broker-dealer although the Commission's Order Handling Rules only
require the display of market maker orders. Thus, institutional
orders sent to these systems are already displayed to the public.
---------------------------------------------------------------------------
The Commission is not persuaded by commenters that suggest that
institutions currently willing to use alternative trading systems to
display their orders to other alternative trading system subscribers,
including other institutions, market-markers, and broker-dealers, will
be less willing to use alternative trading systems that must display
those orders to the public market. Our reasons are as follows. The
primary group of market participants
[[Page 70906]]
that will benefit from the public display of institutional orders is
retail investors. Retail investors are not currently alternative
trading system subscribers. To avoid market impact, institutions try to
avoid signaling other institutions and market professionals, not retail
investors. Almost all market professionals and a significant number of
institutions already subscribe to alternative trading systems. Thus,
the Commission believes that the additional exposure to the market
should not affect institutions' use of alternative trading systems.
Moreover, to the extent that institutions want to display small sized
orders in the public market, rather than their entire order, they will
still be able to make use of an alternative trading system's ``reserve
size'' feature. This will enable institutions to avoid exposing the
total size of their order to the public market.
Nonetheless, assuming institutions do have a preference for showing
their sized orders to other alternative trading system subscribers but
not the public market, there may be two reactions by institutions.
First, institutions could choose to move their orders to more opaque
venues, such as block trading desks. The cost of this movement of
orders would be a loss of transparency to the limited group of
alternative trading system subscribers who now benefit from the display
of institutional orders on alternative trading systems, and the loss of
business to alternative trading systems. While block trading desks
would benefit from the increased business, it likely would increase
institutions' transaction costs. For this reason, as well as those
discussed above, the Commission believes it unlikely for institutions
to react this way. Second, because the public display requirement only
applies to alternative trading systems with five percent or more of the
volume in a particular security, there is a possibility that
institutions may move their order flow to smaller alternative trading
systems in order to avoid the public display requirement. Such
movements of order flow could benefit some alternative trading systems
in the form of increased revenue and be a cost to other alternative
trading systems who lose revenue.
Currently, alternative trading systems are able to attract
subscribers because prices in their systems are often better than the
prices available in the public markets. Because alternative trading
systems are now required to publicly display their best priced orders
for securities in which they represent five percent or more of the
trading volume, the best priced orders for certain securities will also
be available through the public markets. Alternative trading systems
will no longer be able to provide subscribers with the unlimited
ability to avoid public display in the NBBO and possible interaction
with non-subscribers. Consequently, some subscribers could leave an
alternative trading system if they think there are fewer advantages
than before in having direct access to the alternative trading system.
However, the growth of ECNs since the Order Handling Rules were
implemented indicates that alternative trading systems can, and are,
attracting subscribers.\572\ As mentioned above, there are still
significant benefits to being a subscriber to an alternative trading
system, including, but not limited to: the ability to enter orders and
the use of such features as a negotiation feature or a ``reserve size''
feature; the ability to access the best priced orders for securities in
which an alternative trading system represents less than 5 percent of
the trading volume and therefore is not subject to the transparency
requirements; and access to the entire ``book,'' not merely the ``top
of the book,'' that contains important real-time market information
regarding depth of trading interest. All of these benefits will be
retained under the new display requirement.
---------------------------------------------------------------------------
\572\ When the Order Handling Rules were implemented on January
17, 1997, four ECNs linked to Nasdaq. Today there are a total of
nine ECNs linked to the public quote stream. See supra note 178.
---------------------------------------------------------------------------
Despite the impact on high volume alternative trading systems,
integrating their best-priced orders into the public market is critical
to the national market system. Section 11A of the Exchange Act directs
the Commission to facilitate a national market system and to carry out
Congress' objectives of, among other things, assuring ``the
practicability of brokers executing investors' orders in the best
market.'' \573\ The public display requirement adopted today furthers
the objectives in Section 11A of the Exchange Act by ensuring that the
public markets reflect the best priced orders displayed in alternative
trading systems that have a significant trading market in particular
securities.
---------------------------------------------------------------------------
\573\ Section 11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k-
1(a)(1)(C).
---------------------------------------------------------------------------
Several commenters also expressed concern about whether or not
alternative trading systems will be permitted to continue charging fees
to non-subscribers that access alternative trading systems publicly
displayed orders. Currently, alternative trading systems charge a range
of fees to subscribers. In particular, alternative trading systems may
allow institutional subscribers to select higher fees and then have
soft-dollars rebated in an amount equal to the excess above the actual
cost for execution of a trade. Because of the presence of soft dollars,
it is difficult to estimate the amount of revenue that alternative
trading systems receive from institutional subscribers. The Commission
notes, however, that it is not requiring alternative trading systems to
change their fee structures. The Commission is merely limiting
alternative trading systems to charging non-subscribers fees that are
consistent with equivalent access.\574\ The Commission does not believe
that such limitations will substantially affect an alternative trading
system's revenues. In fact, some alternative trading systems may have
increased revenues from the fees charged to non-subscribers.
---------------------------------------------------------------------------
\574\ Under the Order Handling Rules, ECNs are limited to
charging non-subscribers fees consistent with equivalent access.
---------------------------------------------------------------------------
The rules the Commission is adopting today prohibit an alternative
trading system from charging fees that would effectively deny non-
subscribers equivalent access to an alternative trading system's
publicly displayed orders. As long as a fee does not deny equivalent
access, it would be permissible under these rules. The SROs will be
able to establish rules to ensure that alternative trading system fees
are not inconsistent with the standard of equivalent access. Any SRO
rule impacting an alternative trading system's access fees would have
to be filed with the Commission for public comment, review, and
approval. The Commission cannot approve any SRO rule unless it finds
that such rule is consistent with the Exchange Act, including whether
the rule will promote ``efficiency, competition, and capital
formation.'' \575\
---------------------------------------------------------------------------
\575\ Section 3(f) of the Exchange Act, 15 U.S.C. 78c(f).
---------------------------------------------------------------------------
As discussed above, one of the expected benefits of displaying the
best-priced orders in alternative trading systems to all investors is
that spreads will shrink. The success of the Order Handling Rules
indicates that the Commission's current proposal should further enhance
liquidity and price improvement opportunities in the public markets.
Because non-market maker broker-dealers and institutions at times enter
the best priced orders in an alternative trading system, the Commission
expects that display of these orders in the public quote will improve
the NBBO. As a result, some market markers may experience a loss of
revenue. For example, a market maker
[[Page 70907]]
may currently be at the NBBO even when an alternative trading system is
better than that market maker's bid or offer. Accordingly, if the
better priced institutional or non-market maker broker-dealer order
were displayed in the public quote, that market maker would not execute
an order unless it improved its quote. While reduced spreads may
represent a cost to market makers, as discussed above, it represents a
corresponding benefit to investors. Moreover, reduced spreads make the
overall market more efficient by reducing transaction costs. If trading
is less expensive, all other things being equal, investors can be
expected to trade more.
The staff also notes that a market maker is not required to execute
a customer order at the NBBO if the best available price is represented
by an alternative trading system quote. Instead, a market maker may
attempt to execute that customer order against the alternative trading
system quote. If the market maker acts as agent in effecting the
customer's trade, it may be entitled to a brokerage fee. Therefore,
market makers may be able to offset, at least partially, the loss of
trading profits with additional brokerage revenues.
c. Fair Access. Under Regulation ATS, alternative trading systems
with significant volume are required to establish and maintain
standards for granting access to their system and keep records of such
standards. In addition, such alternative trading systems must apply
those standards in a fair and non-discriminatory manner and submit
certain information regarding grants, denials, and limitations of
access with their quarterly reports on Form ATS-R. Based on current
volume estimates, at most two alternative trading systems will be
initially subject to this requirement. The Paperwork Reduction Act
section of this release summarizes the filing and recordkeeping costs
associated with the fair access requirement.
The fair access requirement, as adopted, differs from that
proposed. The proposal would have provided market participants who
believe they had been unfairly denied or limited access to an
alternative trading system subject to the fair access requirement with
a right to appeal that alternative trading system's action to the
Commission. Alternative trading systems subject to the fair access
requirement would also have been required to provide investors with
notice of a denial or limitation of access and their right to appeal
that action to the Commission. The fair access requirement being
adopted today does not include any right to appeal an alternative
trading system's access decisions to the Commission. Instead, the
Commission intends to enforce the prohibition on alternative trading
systems with significant volume unfairly denying access through its
inspection and enforcement authority. The Commission believes the fair
access requirement it is adopting will be less costly to alternative
trading systems than the one proposed because alternative trading
systems will not be required to defend their access decisions in
appeals before the Commission. Moreover, the requirement adopted does
not require alternative trading systems to send notice of their
decisions to market participants.
d. Systems Capacity, Integrity, and Security. The Commission does
not believe that its amendments and rules requiring alternative trading
systems to meet certain systems related standards imposes significant
costs. The standards the Commission is adopting are general standards
that are consistent with good business practices. In addition, smaller
alternative trading systems will not be subject to the proposed
requirements. For those alternative trading systems that do not, for
business reasons alone, ensure adequate capacity, integrity, and
security of their systems, there will be costs associated with
complying with the requirements. The costs associated with upgrading
systems to an adequate level may include, for example, investing in
computer hardware and software. In addition, alternative trading
systems will incur costs associated with the independent review of
their systems on an annual basis. An independent review should be
performed by competent, independent audit personnel following
established audit procedures and standards. If internal auditors are
used by an alternative trading system to complete the review, these
auditors should comply with the standards of the EDPAA. If external
auditors are used, they should comply with the standards of the AICPA
and the EDPAA. The review must be conducted according to established
procedures and standards. The costs involved may vary widely depending
on the business of the alternative trading system. Alternative trading
systems will also be subject to paperwork burdens and recordkeeping and
reporting requirements. These requirements are necessary for the
Commission and the appropriate SROs to ensure compliance with systems
related requirements. In addition, keeping such records permits
alternative trading systems to effectively analyze systems problems
that occur. While alternative trading systems are not required to file
such documentation with the Commission on a regular basis, the
Commission recognizes that generating and maintaining such
documentation will impose some additional costs.
The notification requirement for material systems outages should
impose relatively little additional costs on alternative trading
systems. Moreover, the Commission believes that this small burden is
justified by the need to keep Commission staff abreast of systems'
developments and problems. The Paperwork Reduction Act section of this
release summarizes the costs associated with the recordkeeping and
reporting burdens of compliance with the systems capacity, integrity,
and security requirements.
e. Costs of Exchange Registration. The framework the Commission is
adopting today for alternative trading systems is designed to allow
such systems the option of registering as national securities
exchanges. If an alternative trading system chooses to register as an
exchange, corresponding regulatory obligations could impose costs on
such systems, however, the elective nature of exchange regulation under
the framework the Commission is adopting today ensures that only those
entities for whom it is cost-effective will choose exchange
registration and therefore bear the costs.
For example, exchange-registered alternative trading systems will
have to be organized to, and have the capacity to, carry out the
purposes of the Exchange Act, including their own compliance and the
ability to enforce member compliance with the securities laws.
Consequently, any newly registered exchange will have to establish
appropriate surveillance and disciplinary mechanisms. In addition,
newly registered exchanges will incur certain start-up costs associated
with this obligation, such as writing rule manuals.
National securities exchanges currently operating have significant
assets and expenses in order to carry out their functions. The cost of
acquiring the necessary assets and the operating funds required to
carry out the day-to-day functions of a national securities exchange
are significant. For example, for the fiscal year 1997, the NYSE had
total assets of $1,174,887,000 and total expenses of $488,811,000. The
Cincinnati Stock Exchange (``CSE''), currently the only completely
automated national securities exchange, had total assets of $13,124,585
and total expenses of $5,343,403. Due to these costs, it appears that
an alternative trading system will need to have
[[Page 70908]]
significant volume in order to make the benefits of exchange
registration outweigh the costs.
As registered exchanges, alternative trading systems will also be
subject to more frequent inspection by the Commission. As broker-
dealers, alternative trading systems will be inspected on a regular
basis by any SRO of which they are a member, and by the Commission only
on an intermittent basis. As registered exchanges, these systems will
be inspected more regularly by Commission staff, but will, of course,
no longer be subject to examinations by SROs.
The Commission inspects different SRO programs on independent
review cycles. For example, separate inspections are conducted for an
SRO's surveillance, arbitration, listings, and financial soundness
programs. Where appropriate, SROs will be examined for other programs
they may operate, such as index programs. Each type of examination will
be performed at regular intervals, which are typically two to three
years. An SRO, however, may expect several examinations throughout a
particular year, each in a different program. Each examination
typically involves three to four attorneys and/or accountants from the
Commission, who spend one week at the SRO, or up to two weeks for
particularly large programs, to examine records and interview SRO
personnel. In order to comply with section 17(b) under the Exchange
Act, an SRO must expend resources to provide copies of relevant
documents to, and answer questions from, the Commission staff. The cost
to an SRO of each examination varies greatly depending on the scope of
the examination and the size or complexity of the SRO's particular
program.
In addition, there will also be costs associated with meeting the
obligations set forth in section 11A of the Exchange Act and the rules
thereunder. These costs include the costs of joining, or creating new,
market-wide plans, such as the CQS, CTA, ITS, and OTC-UTP, although
some of these costs will be offset by the right to share in the
revenues generated by these plans. For example, to join the CTA plan,
applicants will be asked to pay, as a condition to entry into the plan,
an amount that reflects the value of the tangible and intangible assets
created by the CTA plan that will be available to the applicant. \576\
Similarly, new participants in ITS will have to pay a share of the
development costs, which will reflect a share of the initial
development costs, which were $721,631, and a share of costs incurred
after June 30, 1978. \577\ These costs will also include the costs of
complying with Rule 11Ac1-1(b) under the Exchange Act, \578\ which
requires national securities exchanges and national securities
associations to make the best bid, best offer, and aggregate quotation
size for each security traded on its facilities available to quotation
vendors for public dissemination.\579\
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\576\ The amount to be paid to the CTA plan will vary on a case-
by-case basis and may reflect a current independent valuation of the
CTA facilities, prior valuations, an assessment of costs contributed
to the plan by existing members, the estimated usage of the plan
facilities by the applicant, costs for anticipated system
modifications to accommodate the applicant, and other relevant
factors as determined by the current participants. CTA Plan: Second
Restatement of Plan Submitted to the Securities and Exchange
Commission Pursuant to Rule 11Aa3-1 under the Securities Exchange
Act of 1934, May 1974 as restated March 1980 and December 1995, at
8-9. See supra note 391. The terms of the CQ plan are substantially
similar with respect to the assessment of a payment upon entry into
the system. CQ Plan: Restatement of Plan Submitted to the Securities
and Exchange Commission Pursuant to Rule 11Ac1-1 under the
Securities Exchange Act of 1934, July 1978, as restated December
1995, at 8-9. See supra note 392.
\577\ Plan for the Purpose of Creating and Operating an
Intermarket Communication Linkage Pursuant to Section 11A(a)(3)(B)
of the Securities Exchange Act of 1934, Composite: Amendments
through May 30, 1997, at 78-79.
\578\ 17 CFR 240.11Ac1-1.
\579\ The Commission estimates that each national securities
exchange or national securities association will submit information
to vendors approximately 24,266,000 times per year, which reporting
is generally done through automated facilities that conduct the
reporting on a continuous basis. Due to the continuous nature of the
information feeds, the Commission does not believe that it is
feasible to estimate the average cost per response or annual burdens
hours involved in complying with Rule 11Ac1-1(b) for a new
registered exchange. 17 CFR 240.11Ac1-1(b).
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The Commission notes that the remaining costs will be partially
offset because the alternative trading systems assuming the costs of
exchange registration will no longer be regulated as broker-dealers.
Consequently, they will no longer be obligated to comply with the
broker-dealer requirements, such as filing and updating Form BD,
maintaining books and records in accordance with Rules 17a-3 and 17a-4
under the Exchange Act, and paying fees for membership in an SRO. In
addition, because exchange-registered alternative trading systems share
the responsibilities of self-regulation, the regulatory burden carried
by currently registered exchanges should be reduced. Other benefits
include the freedom from oversight by a competing SRO, no obligation to
comply with net capital requirements, the right to establish trading
and conduct rules, the right to establish fee schedules, the ability to
directly participate in the national market system mechanisms, and the
right to share in the profits and benefits produced by the national
market system mechanisms such as the CQS, CTA, ITS and OTC-UTP
plans.\580\
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\580\ See supra Section III.B.1.
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The costs of exchange registration also include certain paperwork,
filing, and recordkeeping requirements. These costs are discussed in
the Paperwork Reduction Act section below.
The Commission anticipates that only a few of the existing
alternative trading systems would consider registering as a national
securities exchange. For most of the alternative trading systems
currently in existence, the Commission believes that the costs and
obligations discussed above potentially make registering as a national
securities exchange less commercially viable than registering as a
broker-dealer and complying with Regulation ATS.
B. Amendments to Application and Related Rules for Registration as an
Exchange
The Commission identified several costs and benefits to investors
and market participants in the Proposing Release with respect to
amendments to the application and rules for exchange registration. Only
two commenters identified areas of concern regarding exchange
registration. These commenters suggested that the Commission was
seeking to reimpose annual filing requirements previously eliminated in
1994.\581\ In response, the Commission has made technical modifications
to Rule 6a-2 to clarify the operation of the rule. The Commission does
not believe that these filing burdens are reimposed under the rules as
adopted. These commenters also questioned the value of requiring
exchanges to compile and submit amendments to Form 1 that contain
information that has been provided to the Commission throughout the
year in other contexts. The Commission continues to believe that it is
important to have all the required information gathered in one place in
order to make it useful for Commission staff. In addition, the
additional costs should be minimal because the respondents are required
only to compile existing documents rather than generate new material.
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\581\ See NYSE Letter at 10; Amex Letter at 5-6.
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1. Benefits
The Commission believes that the amendments provide benefits to
organizations that are currently
[[Page 70909]]
registered, or in the future will apply for registration, as national
securities exchanges. Generally, the Commission expects that the
regulatory framework discussed in this release accommodates automated
and for-profit exchanges and makes registering as a national securities
exchange more commercially viable for possible future exchanges.\582\
First, the amendments to Rules 6a-1, 6a-2, and 6a-3 ease compliance
burdens by simplifying the rule. By simplifying the rule language
itself, the Commission anticipates that parties attempting to comply
with Rules 6a-1, 6a-2, and 6a-3 will be better able to understand the
rules' requirements and comply with them. Much of the information
required on Form 1 will not change, but the revised form recasts the
questions and exhibits in a different format that will ease compliance
and make the responses more relevant to investors and the Commission.
While national securities exchanges have traditionally been membership-
owned, Form 1 also is revised to accommodate proprietary national
securities exchanges.
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\582\ For example, the International Securities Exchange, which
announced its intentions to register as a national securities
exchange on November 10, 1998, would not be able to register as a
national securities exchange without the changes to the rules as
adopted today. See International Securities Exchange Will be First
Fully Electronic Options Exchange in U.S., International Securities
Exchange Press Release, Nov. 10, 1998.
---------------------------------------------------------------------------
Second, the amendments give national securities exchanges the
option of complying with certain ongoing filing requirements by posting
information on an Internet web site and supplying the location to the
Commission, instead of filing a complete paper copy with the
Commission. The Commission anticipates that exchanges will choose to
use the Internet to comply with Rules 6a-2 and 6a-3 rather than filing
many exhibits on paper. The availability of such information on the
Internet will also provide the public with easier and less expensive
access to the information than requesting paper copies from the
Commission or the national securities exchanges as currently required.
In addition, permitting exchanges to use the Internet as a means of
compliance will reduce expenses associated with clerical time, postage,
and copying.
The amended rules also reduce the frequency of certain ongoing
filings to update the information in Form 1, directly reducing the
compliance burden on national securities exchanges while still meeting
investors' and the Commission's need for reasonably current
information. Specifically, the amendments eliminate exchanges'
requirement to submit changes to their constitution, their rules, or
the securities listed on the exchange within ten days. The amendments
also permit exchanges to file certain information regarding
subsidiaries and affiliates every three years rather than annually.
These amendments will conserve registered exchanges' staff time to
comply with the rules.
2. Costs
The amendments are intended to simplify the filing requirements and
reduce the compliance burdens for national securities exchanges and
will likely impose few additional costs on national securities
exchanges. Initially, there may be some additional personnel costs
required to review the proposed rules and revised Form 1, but the
Commission believes that the simplified requirements will reduce
overall compliance burdens and costs over time. Reducing the frequency
of filings for some requirements may result in some information being
less current. The Commission, however, believes that much of this type
of information does not change frequently. Moreover, the option of
posting such information on an Internet web site should encourage more
frequent updating of current information. Compliance with Rules 6a-1,
6a-2, and 6a-3 also include certain paperwork costs, which are
discussed as ``burdens'' in the Paperwork Reduction Act section below.
C. Costs and Benefits of the Repeal of Rule 17a-23 and the Amendments
to Rules 17a-3 and 17a-4
The Commission identified several costs and benefits to investors
and market participants in the Proposing Release with respect to Rules
17a-23, 17a-3, and 17a-4. One commenter stated that the transfer of
recordkeeping burdens would impose no additional burdens.\583\
---------------------------------------------------------------------------
\583\ TBMA Letter at 25-26.
---------------------------------------------------------------------------
Approximately forty-five of the broker-dealer trading systems
currently filing reports under Rule 17a-23 will be alternative trading
systems under the amendments and rules in this release. These trading
systems will not fall within the definition of ``internal broker-dealer
system,'' and will, therefore, not be required to maintain records
under the new provisions of Rules 17a-3(a)(16) and 17a-4(b)(10). In its
Paperwork Reduction Act analysis, the Commission notes that annual
aggregate burdens for the recordkeeping obligations under Rule 17a-23
will be eliminated. Although the reporting requirements under Rule 17a-
23 will be eliminated, alternative trading systems will be subject to
similar recordkeeping requirements under Regulation ATS.\584\ These
paperwork ``burdens'' are discussed below in the Paperwork Reduction
Act section.
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\584\ The costs and benefits associated with these recordkeeping
requirements are discussed in Section IX.A.2.a. supra.
---------------------------------------------------------------------------
D. SRO Pilot Trading System
The Commission identified several costs and benefits to investors
and market participants in the Proposing Release with respect to Rule
19b-5. While the Commission solicited comment on the costs and benefits
of Rule 19b-5, no comments were received specifically on that point.
Several commenters did, however, address the Commission's proposal. One
commenter agreed that Rule 19b-5 would reduce regulatory costs and
encourage innovation, but believed that the rule's limitations should
be reduced.\585\ Two other commenters expressed support for the goals
of Rule 19b-5, but argued that burdens wouldn't be reduced as a
practical matter due to the limitations of the rule.\586\ In response,
the Commission notes that it has adopted the rule with some changes
that should permit SROs more flexibility in taking advantage of the
temporary exemption from rule filing requirements.
---------------------------------------------------------------------------
\585\ CBOE Letter at 8-9.
\586\ See CME Letter at 3-4; PCX Letter at 8.
---------------------------------------------------------------------------
By permitting SROs to begin operating eligible pilot trading
systems immediately and to continue operating for two years under a
flexible regulatory scheme, the Commission believes that Rule 19b-5
will benefit SROs and investors. Rule 19b-5 will enhance competition in
the trading markets without imposing significant SRO compliance
burdens.\587\ Rule 19b-5 will permit the timely implementation of pilot
trading systems without the widespread dissemination of critical
business information. Therefore, Rule 19b-5 will reduce SRO costs
associated with the Commission approval process and improve the
competitive balance between SROs and alternative trading
[[Page 70910]]
systems that are regulated as broker-dealers.\588\ Moreover, the
Commission believes that Rule 19b-5 will foster innovation and create a
streamlined procedure for SROs to operate pilot trading systems and
will reduce filing costs for SROs pilot trading systems.
---------------------------------------------------------------------------
\587\ The Commission estimates that the current preparation and
filing of proposed rule changes pursuant to section 19(b)(2) of the
Exchange Act to operate a pilot trading system constitute major
market impact filings requiring approximately 100 hours and $10,000
to $15,000 of SRO time and money, respectively, for each proposal.
This does not include the cost to the SRO of any delay in obtaining
Commission approval or in disclosing business information; nor does
this include the benefit to an SRO of bringing its new pilot trading
system to market in a shorter amount of time. The cost per hour and
per filing is derived from information supplied by the SROs. For the
purposes of our estimates, we have valued related overhead at
thirty-five percent of the value of legal work. See GSA Guide to
Estimating Reporting Costs (1973).
\588\ The Commission estimates that under current procedures, a
rule filing for a new pilot trading system takes 90 days, on
average, from the date of the original submission to be approved. In
contrast, the expedited treatment of SRO rule changes for pilot
trading systems in this release permits SROs to operate a pilot
trading system twenty days after submitting an initial operation
report on Form PILOT, so long as such system complies with Rule 19b-
5 under the Exchange Act.
---------------------------------------------------------------------------
The costs of complying with Rule 19b-5 includes certain paperwork,
filing, and recordkeeping requirements that are discussed below in the
Paperwork Reduction Act section.
X. Effects on Competition, Efficiency and Capital Formation
Section 23(a)(2)\589\ of the Act requires that the Commission, when
promulgating rules under the Exchange Act, to consider the impact any
rule would have on competition and to not adopt any rule that would
impose a burden on competition that is not necessary or appropriate in
the public interest. In the Proposing Release, the Commission solicited
comment on the effects on competition, efficiency and capital formation
of the rules and amendments. Specifically, the Commission requested
commenters to address how the proposed rules and amendments would
affect competition between and among alternative trading systems,
broker-dealers, exchanges, investors, and other market participants.
The Commission received no comments specifically regarding these
issues.
---------------------------------------------------------------------------
\589\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
The Commission has considered the rules and rule amendment in light
of the standards cited in section 23(a)(2) of the Act and believes they
would not likely impose any significant burden on competition not
necessary or appropriate in furtherance of the Exchange Act. As
discussed above in the Cost-Benefit Section, the Commission recognizes
that some alternative trading systems and their institutional users
will be affected competitively by the rules adopted today. Nonetheless,
the Commission believes that the rules and amendments will encourage
innovation, accommodate the growing role of technology in the
securities markets, improve transparency for market participants and
ensure the stability of trading systems with a significant role in the
markets, thereby furthering the development of a national market system
in accordance with the goals under section 11A of the Exchange Act. In
particular, as discussed above in the Cost-Benefit Section, the
Commission believes that the rules and amendments will significantly
reduce spreads, thereby benefiting all investors.
In adopting these rules and amendments, the Commission has
considered whether the action will protect investors, and promote
efficiency, competition, and capital formation.\590\ The Commission
believes that the rules and amendments will allow the Commission to
better oversee the activities of alternative trading systems and
integrate alternative trading systems into the national market system.
The rules and amendments will also better accommodate automated and
for-profit exchanges and permit SROs to operate pilot trading systems
temporarily without Commission approval. These steps will help to
protect investors by preventing discriminatory denials or limitations
of access, preventing systems related failures, and permitting access
to best-priced orders. In addition, alternative trading systems should
continue to compete based on innovation, price, and service rather than
access to ``hidden markets.''
---------------------------------------------------------------------------
\590\ 15 U.S.C. 78c(f).
---------------------------------------------------------------------------
Rules 3a1-1, 3b-16, and Regulation ATS adopted today are intended
to provide a choice between registering as a broker-dealer and
registering as an exchange for markets operated as alternative trading
systems.\591\ In addition, the amendments to Rules 6a-1, 6a-2, and 6a-3
adopted today are intended to update the requirements for registered or
exempt exchanges in order to accommodate different forms of
organization and methods of operation. The Commission believes that
these changes will create a more efficient market, encourage
competition among alternative trading systems, and stimulate capital
formation by making the regulatory framework sufficiently flexible to
accommodate new or different approaches to exchange formation and
operation, including automated and for-profit exchanges. The Commission
further believes that the costs identified in the above analysis are
not substantial enough to deter any market participants from attempting
to become an alternative trading system.\592\
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\591\ The Commission further believes that repealing Rule 17a-23
and amending Rules 17a-3 and 17a-4 under the Act will help to create
a more efficient market, encourage competition, and stimulate
capital formation innovation.
\592\ As previously stated, alternative trading systems are able
to attract subscribers because prices in their systems are often
better than the prices available in the public markets. Because
alternative trading systems are now required to publicly display
their best priced orders for securities in which they represent more
than 5 percent of the trading volume, the best priced orders for
certain securities will also be available through the public
markets. Consequently, some subscribers could leave an alternative
trading system if they think there are fewer advantages than before
in having direct access to the alternative trading system. However,
the growth of ECNs since the Order Handling Rules were implemented
indicates that alternative trading systems can, and are, attracting
subscribers. As mentioned above, there are still significant
benefits to being a subscriber to an alternative trading system,
including, but not limited to: the ability to enter orders and the
use of such features as a negotiation feature or a ``reserve size''
feature; the ability to access the best priced orders for securities
in which an alternative trading system represents less than 5
percent of the trading volume and therefore is not subject to the
transparency requirements; and access to the entire ``book,'' not
merely the ``top of the book,'' that contains important real-time
market information regarding depth of trading interest.
---------------------------------------------------------------------------
In addition, Rule 19b-5 and Form Pilot are intended to provide SROs
the opportunity to develop and operate pilot trading systems with less
cost and time delay. As previously stated, currently, SROs are required
to submit a rule filing to the Commission and undergo a public notice,
comment, and approval process, before they operate a new pilot trading
system. Rule 19b-5 would permit SROs that develop pilot trading systems
to begin operation shortly after submitting Form PILOT to the
Commission. One of the consequences of SROs filing rule changes before
implementation is that the rule filing process informs SROs'
competitors about the proposed pilot trading system and provides an
avenue for those competitors to copy, delay, or obstruct implementation
of a pilot trading system before it can be tested in the marketplace.
As a result, the Commission believes that proposed Rule 19b-5 and Form
Pilot should help create a more efficient market, encourage competition
between SROs and alternative trading systems, and stimulate capital
formation by creating a streamlined procedure for SROs to operate pilot
trading systems and reducing filing costs for SROs generally.
XI. Summary of Final Regulatory Flexibility Analysis
A Final Regulatory Flexibility Analysis (``FRFA'') has been
prepared in accordance with section 4 of the Regulatory Flexibility Act
(``RFA'').\593\ The FRFA relates to the adoption of new rules 3a1-
1,\594\ 3b-16,\595\ 19b-5,\596\ Regulation ATS,\597\ new Forms
ATS,\598\
[[Page 70911]]
ATS-R,\599\ PILOT,\600\ amendments to rules 6a-1,\601\ 6a-2,\602\ 6a-
3,\603\ 11Ac1-1,\604\ 17a-3,\605\ 17a-4,\606\ the Commission's rules of
practice,\607\ to Form 1, and the repeal of Rule 17a-23\608\ under the
Exchange Act.\609\ The FRFA notes the potential costs of operation and
procedural changes that may be necessary to comply with the new rules
and rule amendments (``new regulatory framework''). A summary of the
Initial Regulatory Flexibility Analysis (``IRFA'') appeared in the
Proposing Release.\610\
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\593\ 5 U.S.C. 604.
\594\ 17 CFR 240.3a1-1.
\595\ 17 CFR 240.3b-16.
\596\ 17 CFR 240.19b-5.
\597\ 17 CFR 242.300 et seq.
\598\ 17 CFR 242.637.
\599\ 17 CFR 242.638.
\600\ 17 CFR 249.821.
\601\ 17 CFR 240.6a-1.
\602\ 17 CFR 240.6a-2.
\603\ 17 CFR 240.6a-3.
\604\ 17 CFR 240.11Ac1-1.
\605\ 17 CFR 240.17a-3.
\606\ 17 CFR 240.17a-4.
\607\ 17 CFR 202.3.
\608\ 17 CFR 240.17a-23.
\609\ 15 U.S.C. 78a et seq.
\610\ See supra note .
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As more fully discussed in the FRFA, market participants have
developed a variety of alternative trading systems that furnish
services traditionally provided solely by registered exchanges. Our
current regulatory framework, designed more than six decades ago,
however, did not foresee many of these trading and business functions.
Alternative trading systems now handle twenty percent or more of the
orders in securities listed on Nasdaq, and almost four percent of
orders in listed securities. Even though these systems provide services
that are similar to those provided by the registered exchanges and
Nasdaq, the current regulatory framework largely ignores the market
functions of alternative trading systems. This creates disparities that
affect investor protection, market intermediaries, and other markets.
For example, activity on alternative trading systems is not fully
disclosed to, or accessible by, public investors and may not be
adequately surveilled for market manipulation and fraud. Moreover,
these trading systems have no obligation to provide investors a fair
opportunity to participate in their systems or to treat their
participants fairly. In addition, they do not have an obligation to
ensure that their capacity is sufficient to handle trading demand.
Because of the increasingly important role of alternative trading
systems, these differences call into question not only the fairness of
current regulatory requirements, but also the efficacy of the existing
national market system structure.
As described in the FRFA, under the new regulatory framework, the
Commission will offer trading systems a choice between broker-dealer
regulation and exchange regulation. Specifically, the Commission
proposed to allow alternative trading systems to choose whether to
register as national securities exchanges, or to register as broker-
dealers and comply with additional requirements under proposed
Regulation ATS depending on their activities and trading volume. In
conjunction with this proposal, the Commission proposed to repeal Rule
17a-23, which currently requires alternative trading systems--as well
as broker-dealer trading systems that are not alternative trading
systems--to maintain certain records and file reports with the
Commission. The Commission also proposed amendments to Form 1, which
securities markets file to register as national securities exchanges,
and related rules. Finally, to enable registered exchanges and national
securities associations to better compete in the fast changing
marketplace, the Commission proposed to temporarily exempt certain
pilot trading systems operated by such exchanges and associations from
the rule filing requirements of the Exchange Act.
In the Proposing Release, the Commission solicited public comment
on the proposed new rules and rule amendments which were designed to
resolve many of the concerns raised by alternative trading systems. As
discussed in the FRFA, commenters generally supported the Commission's
proposals and welcomed the regulatory flexibility these proposals
offered. While no public comments were received in response to the
IRFA, several of the comments were related to the IRFA. Several
commenters encouraged the Commission to accept electronic filings as a
means of reducing the burden on market participants. The Commission is,
in fact, working toward the goal of accepting filings in electronic
form. One commenter suggested that the Commission impose only minimal
regulatory requirements, if any, on alternative trading systems that
trade only minimal volume in order to avoid erecting significant
barriers to entry and innovation. The Commission believes that the
requirements of Regulation ATS are minimal for new alternative trading
systems, especially as compared to the current no-action letter
process. Regulation ATS sets forth concrete requirements for a system
to operate, imposes only notice filings, and reserves more burdensome
requirements for high volume systems. Another commenter stated that the
reporting requirements under proposed Regulation ATS are similar to
current Rule 17a-23 and, thus, are not inappropriately burdensome. The
Commission agrees and notes that most current potential respondents
under Regulation ATS already have experience with the requirements and
burdens associated with Rule 17a-23, so Regulation ATS will not impose
significant new burdens on currently operating alternative trading
systems.
The Commission is adopting new Regulation ATS substantially in the
form it was proposed.
The FRFA addresses how the proposal would affect broker-dealers
that operate alternative trading systems and internal broker-dealer
trading systems that are small entities. As more fully explained in the
FRFA, the Commission believes that the improved regulatory framework
provided by Regulation ATS justifies the costs incurred by industry
participants to comply with Regulation ATS. The FRFA also describes the
Commission's consideration of significant alternatives to Regulation
ATS. The FRFA concludes that the alternatives, in the context of a new
regulatory framework, would not accomplish the stated objectives of
Regulation ATS. A copy of the FRFA may be obtained by contacting Denise
Landers, Attorney, Division of Market Regulation, Securities and
Exchange Commission, 450 Fifth Street, NW., Mail Stop 10-1, Washington
D.C. 20549.
XII. Paperwork Reduction Act
As explained in the Proposing Release, certain provisions of the
rules and rule amendments contain ``collection of information''
requirements within the meaning of the Paperwork Reduction Act of 1995
(44 U.S.C. 3501 et seq.) (``PRA''). Accordingly, the Commission
submitted the collection of information requirements contained in the
rules and rule amendments to the Office of Management and Budget
(``OMB'') for review and were approved by OMB which assigned the
following control numbers: Form 1, Rules 6a-1 and 6a-2, control number
3235-0017; Rule 6a-3, control number 3235-0021; Rule 17a-3(a)(16),
control number 3235-0508; Rule 17a-4(b)(10), control number 3235-0506;
Rule 19b-5 and Form PILOT, control number 3235-0507; Rule 301, Form ATS
and Form ATS-R, control number 3235-0509; Rule 302, control number
3235-0510; and Rule 303, control number 3235-0505. The collections of
information are in accordance with Section 3507 of the
[[Page 70912]]
PRA.\611\ With regard to Rule 301, Form ATS, and Form ATS-R, Rule 302,
and Rule 303, the Commission staff has changed its estimate of the
paperwork burdens slightly due to an increase in the estimated number
of respondents that will be affected and a change to the fair access
rules. Accordingly, the Commission has submitted a PRA change worksheet
to OMB.\612\
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\611\ 44 U.S.C. 3507.
\612\ For a further discussion of the changes, see the
discussions of Rule 301, Form ATS, Form ATS-R, Rule 302, and Rule
303, infra.
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The collection of information obligations imposed by the rules and
rule amendments are mandatory. However, it is important to note that an
alternative trading system operating as a broker-dealer is optional,
operation of a national securities exchange is optional, and operating
a pilot trading system is optional. The information collected,
retained, and/or filed pursuant to the rules and rule amendments under
Regulation ATS will be kept confidential to the extent permitted by the
Freedom of Information Act (5 U.S.C. Sec. 552 et seq.). The information
collected, retained, and/or filed pursuant to the rules for
registration as a national securities exchange will not be confidential
and will be available to the public. The information collected,
retained, and/or filed pursuant to the rules for operation of pilot
trading systems will not be confidential and will be made available to
the public when the pilot trading system starts to operate. An agency
may not conduct or sponsor, and a person is not required to comply
with, a collection of information unless it displays a currently valid
OMB control number.
The collections of information are necessary for persons to obtain
certain benefits or to comply with certain requirements. As described
in the Proposing Release, the rules and rule amendments to which the
collections of information are related allow the Commission to respond
to the impact of technological developments in the securities markets
and permit the Commission to more effectively oversee the growing
number of alternative trading systems. The collections of information
are also necessary to permit the Commission to effectively oversee SRO
pilot trading systems. With the exception of two changes to the final
rules, there are no material changes to the rules and amendments as
adopted that affect the burden estimates in the Proposing Release. The
Commission is adopting different fair access requirements from those it
published in the Proposing Release. The Commission has determined to
not adopt the fair access requirements that would have required
investors denied or limited access to have a right to appeal to the
Commission and alternative trading systems making access denial or
limitation decisions to notify such investors of the decision and their
right of appeal to the Commission. Instead, the Commission has decided
to adopt rules that require alternative trading systems to report
quarterly to the Commission a record of all grants, denials, and
limitations of access as well as other descriptive information
surrounding the decision. These changes eliminate the proposed
paperwork burden of providing notice to investors and adds a compliance
burden on Form ATS-R to report such information to the Commission.
Aggregate paperwork burdens have also been revised to reflect updated
information regarding the estimated number of alternative trading
systems that will be subject to the rules. In the Proposing Release,
the Commission staff estimated that there were approximately forty-
three alternative trading systems operating. The Commission staff now
estimates that there are forty-five alternative trading systems
operating, so the aggregate paperwork burdens have been revised to
reflect this change.
The Commission solicited public comment on the collection of
information requirements contained in the Proposing Release. While the
Commission received no comments that specifically addressed the PRA
portion of the release, it did receive several comments that touched on
PRA related issues.
Several commenters encouraged the Commission to accept electronic
filings as a means of reducing the burden on market participants. The
Commission is, in fact, working toward the goal of accepting filings in
electronic form. The Commission anticipates that the option of
electronic filing will be made available to respondents at some point
in the relatively near future. Several commenters also suggested that
the Commission reduce the burden on national securities exchanges by
relieving them of the obligation to file annual amendments to Form 1
due to the same information being submitted to the Commission in other
forms periodically throughout the year. The Commission believes that it
is important to have one complete annual filing that compiles all the
changes to the information contained on Form 1 throughout the year and
all other required SRO information. Additionally, the Commission
believes that such a filing represents only a compilation of existing
information, so the additional burden of requiring an annual filing is
largely clerical and generally minimal.
One commenter suggested that the Commission impose only minimal
regulatory requirements, if any, on alternative trading systems that
trade only minimal volume in order to avoid erecting significant
barriers to entry and innovation. The Commission believes that the
requirements of Regulation ATS are minimal for new alternative trading
systems, especially as compared to the current no-action letter
process. Regulation ATS sets forth concrete requirements for a system
to operate, imposes only notice filings, and reserves more burdensome
requirements for high volume systems. Another commenter stated that the
reporting requirements under proposed Regulation ATS are similar to
current Rule 17a-23 and, thus, are not inappropriately burdensome. The
Commission agrees and notes that most current potential respondents
under Regulation ATS already have experience with the requirements and
burdens associated with Rule 17a-23, so Regulation ATS will not impose
significant new burdens on currently operating alternative trading
systems.
As noted above in the Cost-Benefit section, below is a summary of
the paperwork burdens that were identified in the Proposing Release.
Although not mandated by the PRA, to give regulated entities and others
an understanding of the paperwork costs, the discussion below provides
dollar estimates assuming certain labor costs.
A. Form 1, Rules 6a-1 and 6a-2
These amendments are intended to simplify the filing requirements
and reduce the compliance burdens for national securities exchanges and
will likely impose few additional costs on national securities
exchanges. Initially, there may be some additional personnel costs
required to review the proposed rules and revised Form 1, but the
Commission believes that the simplified requirements will reduce
overall compliance burdens and costs over time. Reducing the frequency
of filings for some requirements may result in some information being
less current. The Commission, however, believes that much of this type
of information does not change frequently. Moreover, the option of
posting such information on an Internet web site should encourage more
frequent updating of current information.
The Commission staff has estimated that each respondent will incur
an average burden of forty-seven hours to comply with Rule 6a-1 and
file an
[[Page 70913]]
initial application for registration on Form 1. This represents a two
hour increase from the current average burden due to the estimated
additional burden of the added exhibits. The Commission staff has
estimated that the average additional cost per response will be
approximately $30.\613\ Because the Commission receives applications
for registration as an exchange on Form 1 from time to time, and not on
a predictable basis, it cannot estimate the annual aggregate costs and
burden hours associated with such filings.\614\
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\613\ The estimated average additional cost per response of $30
is derived from two additional hours of clerical work at $15 per
hour.
\614\ Since 1991, the Commission has received three total
applications for registration as a national securities exchange.
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The Commission notes that it is making no material changes to Rule
6a-1, Rule 6a-2, or Form 1 from the Proposing Release. Thus, the
collection of information burdens are not changing from those proposed.
B. Rule 6a-3
The Commission anticipates that the amendments will not change the
paperwork burden associated with complying with Rule 6a-3. The
Commission staff has estimated that the average burden for each
respondent to comply with Rule 6a-3 is one-half hour per response
because compliance only requires photocopying existing documents. The
Commission also estimates that each respondent will file supplemental
information under Rule 6a-3 approximately twenty-five times per year.
The estimated average cost per response for each individual respondent
is $9.50, resulting in an estimated annual average cost burden for each
respondent of $237.50.\615\
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\615\ The estimated average cost per response of $9.50 is
composed of $7.50 for clerical work (0.5 hours at $15 per hour) and
$2 for printing, supplies, copying, and postage (approximately
thirty-five percent of the total labor costs). The Commission staff
has estimated overhead for this collection of information burden,
and all other collection of information burdens discussed below,
based on thirty-five percent of total labor costs based on the GSA
Guide to Estimating Reporting Costs (1973). The estimated average
annual cost of $237.50 is derived from twenty-five annual filings at
a cost of $9.50 per filing.
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C. Rule 17a-3(a)(16)
No additional recordkeeping burdens will be imposed on internal
broker-dealer systems under the amendments to Rule 17a-3. The
amendments apply only to systems that are presently subject to the
recordkeeping requirements of Rule 17a-23. Because the Commission is
repealing Rule 17a-23 and amending Rules 17a-3 and 17a-4 by
transferring the recordkeeping requirements from Rule 17a-23, the
Commission does not anticipate any new recordkeeping costs or burdens
for respondents.
Based on Commission experience with the burdens associated with
Rule 17a-23, the Commission has estimated the burdens that will be
associated with Rule 17a-3(a)(16). The Commission staff has estimated
that there will be approximately ninety-four broker-dealers operating
one hundred twenty-three internal broker-dealer systems that will have
to make the records described in Rule 17a-3(a)(16). The Commission
staff has estimated that each respondent will spend approximately
twenty-seven hours per year keeping the required records under Rule
17a-3(a)(16) at an annual cost of $1,298.16.\616\ The aggregate burden
for approximately ninety-four broker-dealers operating internal broker-
dealer trading systems is estimated to be 2,619 hours for a total
average cost of $122,027.04.\617\
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\616\ The Commission staff has estimated that an employee of a
broker-dealer charged to ensure compliance with Commission
regulations receives annual compensation of $100,000. This
compensation is the equivalent of $48.08 per hour ($100,000 divided
by 2,080 payroll hours per year). The estimated annual cost of
$1,298.16 is derived from twenty-seven burden hours per respondent
at $48.08 per hour.
\617\ The estimated aggregate burden of 2,619 hours is derived
from ninety-four broker-dealer respondents incurring an average
burden of twenty-seven hours each. The estimated aggregate cost of
$122,027.04 is derived from ninety-four broker-dealer respondents
incurring an average burden of $1,298.16 each.
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D. Rule 17a-4(b)(10)
No additional recordkeeping burdens will be imposed on internal
broker-dealer systems under the amendments to Rule 17a-4. The
amendments apply only to systems that are presently subject to the
recordkeeping requirements of Rule 17a-23. Because the Commission is
repealing Rule 17a-23 and amending Rules 17a-3 and 17a-4 by
transferring the recordkeeping requirements from Rule 17a-23, the
Commission does not anticipate any new recordkeeping costs or burdens
for respondents.
Based on Commission experience with the burdens associated with
Rule 17a-23, the Commission has estimated the burdens that will be
associated with Rule 17a-4(b)(10). The Commission staff has estimated
that there will be approximately ninety-four broker-dealers operating
one hundred twenty-three internal broker-dealer systems that will have
to keep the records described in Rule 17a-4(b)(10). The Commission
staff has estimated that each respondent will spend approximately three
hours to preserve the required records under Rule 17a-4(b)(10) at an
annual cost of $144.24.\618\ The aggregate burden for approximately
ninety-four broker-dealers operating internal broker-dealer trading
systems is estimated to be two hundred eighty two hours for a total
average cost of $13,558.56.\619\
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\618\ The Commission staff has estimated that an employee of a
broker-dealer charged to ensure compliance with Commission
regulations receives annual compensation of $100,000. This
compensation is the equivalent of $48.08 per hour ($100,000 divided
by 2,080 payroll hours per year). The estimated annual cost of
$144.24 is derived from three burden hours per respondent at $48.08
per hour.
\619\ The estimated aggregate burden of two hundred eighty-two
hours is derived from ninety-four broker-dealer respondents
incurring an average burden of three hours each. The estimated
aggregate cost of $13,558.56 is derived from ninety-four broker-
dealer respondents incurring an average burden of $144.24 each.
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E. Rule 19b-5 and Form PILOT
For SROs that choose to operate pilot trading systems and avail
themselves of the provisions of Rule 19b-5, compliance with Rule 19b-5
and the filings required on Form PILOT are mandatory. Initial filings
on Form PILOT are confidential until the pilot system is operational
and subsequent filings are not confidential. Thus, after a pilot
trading system starts to operate, all filings on Form PILOT are
available to the public. Rule 19b-5 reiterates SROs' existing
recordkeeping obligations under Rule 17a-1, which requires that such
records be kept for not less than five years, the first two years in an
easily accessible place.
The Commission anticipates receiving approximately 6 notices per
year regarding pilot trading systems on Form PILOT.\620\ An SRO will be
required to submit a Form PILOT providing detailed operational data and
update this information quarterly. The Commission staff has estimated
that an SRO will expend twenty-four hours to file an initial operation
report and three hours to file a quarterly report and a systems change
notice.\621\ The Commission also estimates that an SRO will file two
amendments per year to report changes to the system.\622\ The
Commission staff has estimated that an SRO will expend $1,242 per
initial Form PILOT filing and $155 for each quarterly Form PILOT and
system
[[Page 70914]]
change notice filed.\623\ Thus, the total estimated annual burden for
SROs to comply with Rule 19b-5 by filing an initial notice on Form
PILOT is estimated to be one hundred forty-four hours for a total
average cost of $7,452.\624\ The total estimated annual burden for SROs
to file systems change notices and quarterly reports on Form PILOT is
estimated to be one hundred eight hours for a total average cost of
$5,580.\625\
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\620\ This estimate is based on a review of past SRO filings
under section 19(b) of the Exchange Act. The Commission staff has
estimated that approximately 6 rule filings per year in the past
could have been filed under Rule 19b-5.
\621\ The estimates for burden hours involved with filing Form
PILOT are based on the Commission's experience with similar
reporting requirements under Rule 17a-23.
\622\ This estimate is based on the Commission's experience with
collection of similar information under Rule 17a-23.
\623\ The estimated average cost of $1,242 to file an initial
Form PILOT is composed of $800 for in-house professional work
(sixteen hours at $50 per hour), $120 for clerical work (eight hours
at $15 per hour) and $322 for printing, supplies, copying, and
postage (approximately thirty-five percent of the total labor
costs).
The total estimated average cost of $155 to file quarterly
reports and system change notices on Form PILOT is composed of $100
for in-house professional work (two hours at $50 per hour), $15 for
clerical work (one hour at $15 per hour) and $40 for printing,
supplies, copying and postage (approximately thirty-five percent of
the total labor costs).
\624\ The estimated average burden of one hundred forty-four
hours is derived from six SRO respondents incurring an average
burden of twenty-four hours per filing. The estimated average cost
of $7,452 is derived from six SRO respondents making six initial
Form PILOT filings at $1,242 per filing.
\625\ The estimated average burden of one hundred eight hours is
derived from six SRO respondents filing four quarterly reports and
two systems change notices at three burden hours per filing. The
estimated average cost of $5,580 is derived from six SRO respondents
filing four quarterly reports and two systems change notices at $155
per filing.
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F. Rule 301, Form ATS and Form ATS-R
For alternative trading systems that choose to register as a
broker-dealer, the requirements of Rule 301, Form ATS and Form ATS-R
are mandatory. All filings required under Rule 301, Form ATS and Form
ATS-R are considered confidential and are not available to the public.
All records required to be made under the Rule are required to be
preserved for three years, the first two years in an easily accessible
place.
The alternative trading system amendments and rules have been
tailored to minimize their burden on alternative trading systems and
especially small systems. Many of the provisions in the proposed rules
are triggered by a volume threshold. The Commission expects that small
alternative trading systems will not have sufficient volume to trigger
those thresholds and will therefore not have to comply with those
provisions. The recordkeeping and reporting requirements with which
smaller, lower volume alternative trading systems have to comply under
proposed Regulation ATS are substantially similar to those with which
alternative trading systems currently comply. Consequently the costs
for smaller alternative trading systems should remain unchanged.
1. Notice, Reporting, and Recordkeeping
All alternative trading systems that will be subject to notice,
reporting, and recordkeeping requirements under the Commission's rules
as adopted today are currently subject to similar requirements under
Rule 17a-23. The requirements under Regulation ATS, however, require
some additional information that is not currently required under Rule
17a-23.
Under Regulation ATS, alternative trading systems file an initial
operation report, notices of material systems changes, and quarterly
reports. The rules also include new Forms ATS and ATS-R to standardize
reporting of such information and make it more useful for the
Commission. The rules require information that is not currently
required under Rule 17a-23, such as greater detail about the system
operations, the volume and types of securities traded, criteria for
granting access to subscribers, procedures governing order execution,
reporting, clearance and settlement, procedures for reviewing systems
capacity and contingency procedures, and the identity of any other
entities involved in operating the system.
Regulation ATS requires staff time to comply with the initial
notice and amendment requirements. While the Commission has designed
the requirements in an effort to balance the costs of filing with the
benefits to be gained from the information, some effort will be
necessary to gather and file this information. Most of the information,
however, already exists. Alternative trading systems will only be
required to gather this information and supply it in the required
format to the Commission. The periodic updating requirements will also
require staff time over the life of the alternative trading system to
comply with the rules.
The Commission staff has estimated that there are currently about
forty-five alternative trading systems that will be required to
register as exchanges or register as broker-dealers and comply with
Regulation ATS.\626\ The Commission also estimates that, over time,
there will be approximately three new alternative trading systems each
year that choose to register as broker-dealers and comply with
Regulation ATS.\627\
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\626\ This estimate is based on filings made with the Commission
under Rule 17a-23. At the time of the Proposing Release, the
Commission estimated that forty-three alternative trading systems
would be required to register as exchanges or broker-dealers and
comply with Regulation ATS. Since that time, two such alternative
trading systems have started to operate.
\627\ Based on the Commission's experience over the last three
years with Rule 17a-23, it appears that there are more than three
new alternative trading systems per year. However, we expect that in
the steady state over time, there will be approximately three new
alternative trading systems per year. The rapid growth experienced
over the last several years is unlikely to continue at such a high
rate in perpetuity.
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The Commission also estimates that, over time, there will be
approximately three alternative trading systems that file cessation of
operations reports each year. Thus, the Commission anticipates that,
over time, if all forty-five current alternative trading systems choose
to register as broker-dealers and comply with Regulation ATS, there
will be approximately forty-five alternative trading systems operating
each year.
The Commission staff has estimated that the average burden per
respondent to file the initial operations report on Form ATS will be
twenty hours. This burden is computed by estimating that completing the
report will require an average of thirteen hours of professional work
and seven hours of clerical work.\628\ The Commission staff has
estimated that the average cost per response will be $1,019
representing the twenty hours and cost of supplies.\629\ If all forty-
five alternative trading systems opt to register as broker-dealers and
comply with Regulation ATS, the total, one time cost to comply with the
proposed requirements to file initial operation reports is estimated to
be $45,855.\630\ The Commission also estimates that, over time,
approximately three new alternative trading systems will register as
broker-dealers per year, incurring an annual aggregate burden of sixty
hours for an average total cost of $3,057 after the first year
following adoption of Regulation ATS.\631\
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\628\ This estimate for burden hours of filing Form ATS is based
on the burdens associated with filing Form 1, adjusted for
differences between Form 1 and Form ATS. The division between
professional and clerical time is based on estimates of the
proportions used in the estimates of burdens for filing Form 1.
\629\ The estimated average cost per response of $1,019 is
composed of $650 for in-house professional work (thirteen hours at
$50 per hour), $105 for clerical work (seven hours at $15 per hour)
and $264 for printing, supplies, copying, and postage (approximately
thirty-five percent of the total labor costs).
\630\ This estimated cost of $45,855 is derived from forty-five
alternative trading systems filing at an average cost of $1,019
each.
\631\ This estimated cost of $3,057 is derived from three new
alternative trading systems filing at an average cost of $1,019
each.
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In addition, the rules require alternative trading systems to amend
their initial operations report to notify the Commission of material
systems changes and other changes to the
[[Page 70915]]
information contained in the initial operations report. The Commission
staff has estimated that each respondent will file six such amendments
per year.\632\ The Commission staff has estimated that each respondent
will incur an average burden of two hours per response and incur an
average cost of $111.50 for each amendment to the initial operation
report that it submits.\633\ If all forty-five alternative trading
systems opt to comply with Regulation ATS rather than to register as
exchanges, the total aggregate cost per year to comply with the
proposed requirement to file amendments to the initial operation
reports is estimated to be $30,105.\634\
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\632\ This estimate is based on the Commission's experience with
collection of similar information under Rule 17a-23.
\633\ The estimated average cost per response of $111.50 is
composed of $75 for in-house professional work (1.5 hours at $50 per
hour), $7.50 for clerical work (0.5 hours at $15 per hour), and $29
for printing, supplies, copying, and postage (approximately thirty-
five percent of the total labor costs).
\634\ This estimated cost of $30,105 is composed of $111.50 cost
per amendment for forty-five alternative trading systems filing six
times per year.
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Alternative trading systems registering as broker-dealers will also
be required to file quarterly reports on Form ATS-R, reporting
participating system subscribers, the securities traded on the system,
and aggregate volume information. The Commission staff has estimated
that the quarterly reports will cause each respondent to incur an
average burden of 4 hours per response and incur an average cost of
$223 for each Form ATS-R that it submits.\635\ The annual burden per
respondent is estimated to be $892.\636\ If all forty-five alternative
trading systems opt to register as broker-dealers and comply with
Regulation ATS, the total cost per year to comply with the requirement
to file quarterly reports is estimated to be $40,140.\637\
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\635\ The estimated cost of $223 per response is composed of
$150 for in-house professional work (three hours at $50 per hour),
$15 for clerical work (one hour at $15 per hour) and $58 for
printing, supplies, copying, and postage (approximately thirty-five
percent of the total labor costs).
\636\ The estimated annual cost of $892 to file Form ATS-R is
derived from four quarterly reports at an estimated annual cost of
$223 per filing.
\637\ This estimated cost of $40,140 is derived from forty-five
alternative trading systems with an estimated annual filing cost for
each of $892.
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Finally, alternative trading systems registered as broker-dealers
will be required to submit a notice and a report on Form ATS when they
cease operations. The Commission anticipates a total of three such
filings per year. The Commission staff has estimated that individual
respondents will incur a burden of two hours to file the cessation
notice. The Commission staff has estimated that individual respondents
will incur a cost of $111.50 to file the cessation of operations report
on Form ATS.\638\ The annual aggregate burden for three alternative
trading systems to file cessation of operations reports is estimated to
be $334.50.\639\
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\638\ The estimated cost of $111.50 per response is composed of
$75 for in-house professional work (1.5 hours at $50 per hour),
$7.50 for clerical work (0.5 hours at $15 per hour), and $29 for
printing, supplies, copying and postage (approximately thirty-five
percent of the total labor costs).
\639\ The estimated cost of $334.50 is derived from an average
of three alternative trading systems filing one cessation of
operations report per year on Form ATS at an estimated cost of
$111.50 each.
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2. Fair Access
Under Regulation ATS, alternative trading systems with significant
volume are required to establish and maintain standards for granting
access to their system and keep records of such standards. In addition,
alternative trading systems with significant volume are required to
submit certain information regarding grants, denials, and limitations
of access with their quarterly reports on Form ATS-R. The Commission
staff has estimated that each respondent obligated to establish and
maintain such records will incur a burden of seventeen hours per year
to make and keep standards for granting access for a total estimated
cost of $958.50.\640\
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\640\ The estimated burden of seventeen hours is derived from
five hours for establishing and maintaining standards for fair
access and twelve hours to report fair access information on Form
ATS-R on a quarterly basis (four responses at three hours per
response). The estimated cost of $958.50 is derived from $650 for
professional work (thirteen hours at $50 per hour), $60 for clerical
work (four hours at $15 per hour), and $248.50 for printing,
supplies, copying, and postage (approximately thirty-five percent of
the total labor costs). The Commission staff has estimated overhead
based on thirty-five percent of total labor costs based on the GSA
Guide to Estimating Reporting Costs (1973). The estimated burden of
thirteen hours of professional work is derived from five hours for
establishing and maintaining standards for fair access and eight
hours (two hours for four quarterly reports on Form ATS-R) to
compile and report fair access information. The estimated burden of
four hours of clerical work is derived from one hour per quarter to
compile and send information on Form ATS-R.
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Although these estimates reflect a program change from the
Proposing Release, the total burdens on respondents are decreasing
slightly as a result of the program changes. The Commission is
eliminating the proposal to require alternative trading systems that
deny investors access to the system to provide them with notice of the
denial and their right of appeal to the Commission. Under the rules as
adopted, there is no right of appeal to the Commission. In the
Proposing Release, the Commission estimated that the burden to comply
with the notice requirement would be approximately twenty-seven hours
per year for each respondent. Under the rules as adopted, such
alternative trading systems are required to submit fair access
information on Form ATS-R on a quarterly basis. The burden for this
requirement is only twelve hours per year for each respondent. Thus,
the changes from the Proposing Release are anticipated to reduce the
burden on each respondent by approximately fifteen hours per year. The
Commission staff has estimated that only two respondents will be
affected by this program change, resulting in an aggregate reduction of
thirty burden hours for all respondents. This reduction, however, is
offset by an increase in the estimated number of respondents.
Specifically, the aggregate paperwork burden for Rule 301, Form ATS,
and Form ATS-R is increasing by one hundred sixty hours due to updating
the estimate of the number of potential respondents from forty-three in
the Proposing Release to forty-five currently.
3. Systems Capacity, Integrity, and Security
The notification requirement for material systems outages should
impose relatively little additional costs on alternative trading
systems. Moreover, the Commission believes that this small burden is
justified by the need to keep Commission staff abreast of systems'
developments and problems.
The Commission staff has estimated that each respondent will incur
an average annual burden of fifteen hours to comply with the
recordkeeping requirements associated with the systems capacity,
integrity, and security provisions of Regulation ATS. The Commission
staff has estimated that each respondent will make an average of five
system outage notices per year, for an estimated average burden of 1.25
hours per year.\641\ The Commission staff has estimated that the total
estimated average cost of compliance for each respondent will be $85
per year.\642\ Such alternative trading systems will
[[Page 70916]]
also be required to keep records relating to the steps taken to comply
with systems capacity, integrity, and security requirements under
Regulation ATS. The Commission staff has estimated that each respondent
will incur a burden of ten hours per year to comply with such
recordkeeping requirements for a total estimated cost of $675 per
year.\643\ The Commission staff has estimated that two alternative
trading systems will be required to comply with the systems capacity,
integrity, and security provisions of Regulation ATS due to their
significant volume. The estimated aggregate cost for these alternative
trading systems chose to comply with the systems capacity, integrity,
and security requirements is $1,520.\644\
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\641\ The Commission notes that compliance with the notice
provision can be achieved by a telephone call, so the burden for
each notice is minimal. The Commission staff has estimated only 0.25
hours per notice will be required. The estimate of five system
outage notices per year is based on the Commission's experience with
the Automated Review Program.
\642\ The estimated average cost per response of $17 is composed
of $12.50 for in-house professional work (0.25 hours at $50 per
hour) and $4.50 for printing, supplies, copying, and postage
(approximately thirty-five percent of the total labor costs). The
estimated annual cost of $85 is derived from five notices at $17 per
notice.
\643\ The total estimated cost of $675 is composed of $500 for
in-house professional work (ten hours at $50 per hour) and $175 for
printing, supplies, copying, and postage (approximately thirty-five
percent of the total labor costs).
\644\ The estimated aggregate cost of $1,520 is derived from two
alternative trading systems incurring an estimated annual cost of
$760 each ($85 for providing systems outage notices and $675 for
recordkeeping requirements).
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G. Rule 302
Rule 302 requires alternative trading systems to make certain
records with respect to trading activity through the alternative
trading systems. This collection of information will permit the
Commission to detect and investigate potential market irregularities
and to ensure investor protection. Such information is not available in
any other form from any other sources.
For alternative trading systems that choose to register as a
broker-dealer, the requirements of Rule 302 are mandatory. All records
required to be made under Rule 302 are considered confidential and are
not available to the public. All records required to be made under the
Rule are required to be preserved for three years, the first two years
in an easily accessible place.
The Commission staff has estimated that each alternative trading
system that chooses to register as a broker-dealer will be required to
expend an average of thirty-six hours to comply with Rule 302 at an
average cost of $1,730.88.\645\ If all forty-five alternative trading
systems opt to register as broker-dealers, rather than as exchanges,
the total cost for recordkeeping under Rule 302 is estimated to be
$77,889.60 per year.\646\
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\645\ The estimated cost of $1,730.88 is derived from an average
of thirty-six hours of compliance time at $48.08 per hour. The value
of compliance time is estimated as follows: an employee of a broker-
dealer charged to ensure compliance with Commission regulations
receives estimated annual compensation of $100,000. This
compensation is the equivalent of $48.08 per hour ($100,000 divided
by 2,080 payroll hours per year).
\646\ This estimated cost of $77,889.60 is derived from forty-
five alternative trading systems incurring an annual cost of
$1,730.88 each.
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The Commission notes that it is making no material changes to Rule
302 from the Proposing Release. The collection of information burdens
are increasing slightly due to an updated estimate of the number of
respondents and not due to any changes to the rule as proposed.
H. Rule 303
Rule 303 requires alternative trading systems registered as broker-
dealers to preserve certain records produced under Rule 302, as well as
standards for granting access to the system and records generated in
complying with the systems capacity, integrity and security
requirements for alternative trading systems with significant trading
volume. Alternative trading systems registered as broker-dealers are
not required to file such information, but merely to retain it in an
organized manner and make it available to the Commission upon request.
For alternative trading systems that choose to register as a
broker-dealer, the requirements of Rule 303 are mandatory. All records
required to be made under Rule 303 are considered confidential and are
not available to the public. All records required to be made under the
Rule are required to be preserved for three years, the first two years
in an easily accessible place.
The Commission staff has estimated that each alternative trading
system that chooses to register as a broker-dealer will be required to
expend an average of four hours per year to comply with Rule 303 at an
average cost of $192.32.\647\ If all forty-five alternative trading
systems opt to register as broker-dealers, rather than as exchanges,
the total cost for record preservation is estimated to be $8,654.40 per
year.\648\
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\647\ The estimated cost of $192.32 is derived from an average
of four hours of compliance time at $48.08 per hour. The value of
compliance time is estimated as follows: An employee of a broker-
dealer charged to ensure compliance with Commission regulations
receives estimated annual compensation of $100,000. This
compensation is the equivalent of $48.08 per hour ($100,000 divided
by 2,080 payroll hours per year).
\648\ This estimated cost of $8,654.40 is derived from forty-
five alternative trading systems incurring an annual cost of $192.32
each.
---------------------------------------------------------------------------
The Commission notes that it is making no material changes to Rule
302 from the Proposing Release. The collection of information burdens
are increasing slightly due to an updated estimate of the number of
respondents and not due to any changes to the rule as proposed.
XIII. Statutory Authority
The rules and rule amendments in this release are being adopted
pursuant to 15 U.S.C. 78 et seq., particularly sections 3(b), 5, 6,
11A, 15, 17(a), 17(b), 19, 23(a), and 36 of the Exchange Act, 15 U.S.C.
78c, 78e, 78f, 78k-1, 78o, 78q(a), 78q(b), 78s(b), 78w(a), and 78mm.
List of Subjects
17 CFR Part 202
Administrative practice and procedure, Securities.
17 CFR Part 240
Brokers-dealers, Fraud, Issuers, Reporting and recordkeeping
requirements, Securities.
17 CFR Part 242
Securities.
17 CFR Part 249
Reporting and recordkeeping requirements, Securities.
For the reasons set out in the preamble, Title 17, Chapter II of
the Code of Federal Regulations is amended as follows.
PART 202--INFORMAL AND OTHER PROCEDURES
1. The authority citation for part 202 continues to read in part as
follows:
Authority: 15 U.S.C. 77s, 77t, 78d-1, 78u, 78w, 7811(d), 79r,
79t, 77sss, 77uuu, 80a-37, 80a-41, 80b-9, and 80b-11, unless
otherwise noted.
* * * * *
2. Paragraph (b) of Sec. 202.3 is revised to read as follows:
Sec. 202.3 Processing of filings.
(a) * * *
(b)(1) Applications for registration as brokers, dealers,
investment advisers, municipal securities dealers and transfer agents
are submitted to the Office of Filings and Information Services where
they are examined to determine whether all necessary information has
been supplied and whether all required financial statements and other
documents have been furnished in proper form. Defective applications
may be returned with a request for correction or held until corrected
before being accepted as a filing. The files of the Commission and
other sources of information are considered to determine whether any
person connected with the applicant appears to have engaged in
activities which would warrant commencement of proceedings on the
question of denial of registration. The staff confers with applicants
and makes suggestions in
[[Page 70917]]
appropriate cases for amendments and supplemental information. Where it
appears appropriate in the public interest and where a basis therefore
exists, denial proceedings may be instituted. Within forty-five days of
the date of the filing of a brokerudealer, investment adviser or
municipal securities dealer application (or within such longer period
as to which the applicant consents), the Commission shall by order
grant registration or institute proceedings to determine whether
registration should be denied. An application for registration as a
transfer agent shall become effective within 30 days after receipt of
the application (or within such shorter period as the Commission may
determine). The Office of Filings and Information Services is also
responsible for the processing and substantive examination of
statements of beneficial ownership of securities and changes in such
ownership filed under the Securities Exchange Act of 1934, the Public
Utility Holding Company Act of 1935, and the Investment Company Act of
1940, and for the examination of reports filed pursuant to Sec. 230.144
of this chapter.
(2) Applications for registration as national securities exchanges,
or exemption from registration as exchanges by reason of such
exchanges' limited volume of transactions filed with the Commission are
routed to the Division of Market Regulation, which examines these
applications to determine whether all necessary information has been
supplied and whether all required financial statements and other
documents have been furnished in proper form. Defective applications
may be returned with a request for correction or held until corrected
before being accepted as a filing. The files of the Commission and
other sources of information are considered to determine whether any
person connected with the applicant appears to have engaged in
activities which would warrant commencement of proceedings on the
question of denial of registration. The staff confers with applicants
and makes suggestions in appropriate cases for amendments and
supplemental information. Where it appears appropriate in the public
interest and where a basis therefore exists, denial proceedings may be
instituted. Within 90 days of the date of the filing of an application
for registration as a national securities exchange, or exemption from
registration by reason of such exchanges' limited volume of
transactions (or within such longer period as to which the applicant
consents), the Commission shall by order grant registration, or
institute proceedings to determine whether registration should be
denied as provided in Sec. 240.19(a)(1) of this chapter.
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
3. The authority citation for part 240 continues to read in part as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee,
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k,
78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d),
78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and
80b-11, unless otherwise noted.
* * * * *
4. Section 240.3a1-1 is added before the undesignated center
heading ``Definition of `Equity Security' as Used in Sections 12(g) and
16'' to read as follows:
Sec. 240.3a1-1 Exemption from the definition of ``Exchange'' under
Section 3(a)(1) of the Act.
(a) An organization, association, or group of persons shall be
exempt from the definition of the term ``exchange'' under section
3(a)(1) of the Act, (15 U.S.C. 78c(a)(1)), if such organization,
association, or group of persons:
(1) Is operated by a national securities association;
(2) Is in compliance with Regulation ATS, 17 CFR 242.300 through
242.303; or
(3) Pursuant to paragraph (a) of Sec. 242.301 of Regulation ATS, 17
CFR 242.301(a), is not required to comply with Regulation ATS, 17 CFR
242.300 through 242.303.
(b) Notwithstanding paragraph (a) of this section, an organization,
association, or group of persons shall not be exempt under this section
from the definition of ``exchange,'' if:
(1) During three of the preceding four calendar quarters such
organization, association, or group of persons had:
(i) Fifty percent or more of the average daily dollar trading
volume in any security and five percent or more of the average daily
dollar trading volume in any class of securities; or
(ii) Forty percent or more of the average daily dollar trading
volume in any class of securities; and
(2) The Commission determines, after notice to the organization,
association, or group of persons, and an opportunity for such
organization, association, or group of persons to respond, that such an
exemption would not be necessary or appropriate in the public interest
or consistent with the protection of investors taking into account the
requirements for exchange registration under section 6 of the Act, (15
U.S.C. 78f), and the objectives of the national market system under
section 11A of the Act, (15 U.S.C 78k-1).
(3) For purposes of paragraph (b) of this section, each of the
following shall be considered a ``class of securities'':
(i) Equity securities, which shall have the same meaning as in
Sec. 240.3a11-1;
(ii) Listed options, which shall mean any options traded on a
national securities exchange or automated facility of a national
securities exchange;
(iii) Unlisted options, which shall mean any options other than
those traded on a national securities exchange or automated facility of
a national securities association;
(iv) Municipal securities, which shall have the same meaning as in
section 3(a)(29) of the Act, (15 U.S.C. 78c(a)(29));
(v) Investment grade corporate debt securities, which shall mean
any security that:
(A) Evidences a liability of the issuer of such security;
(B) Has a fixed maturity date that is at least one year following
the date of issuance;
(C) Is rated in one of the four highest ratings categories by at
least one Nationally Recognized Statistical Ratings Organization; and
(D) Is not an exempted security, as defined in section 3(a)(12) of
the Act, (15 U.S.C. 78c(a)(12));
(vi) Non-investment grade corporate debt securities, which shall
mean any security that:
(A) Evidences a liability of the issuer of such security;
(B) Has a fixed maturity date that is at least one year following
the date of issuance;
(C) Is not rated in one of the four highest ratings categories by
at least one Nationally Recognized Statistical Ratings Organization;
and
(D) Is not an exempted security, as defined in section 3(a)(12) of
the Act, (15 U.S.C. 78o);
(vii) Foreign corporate debt securities, which shall mean any
security that:
(A) Evidences a liability of the issuer of such debt security;
(B) Is issued by a corporation or other organization incorporated
or organized under the laws of any foreign country; and
(C) Has a fixed maturity date that is at least one year following
the date of issuance; and
(viii) Foreign sovereign debt securities, which shall mean any
security that:
[[Page 70918]]
(A) Evidences a liability of the issuer of such debt security;
(B) Is issued or guaranteed by the government of a foreign country,
any political subdivision of a foreign country, or any supranational
entity; and
(C) Does not have a maturity date of a year or less following the
date of issuance.
5. Section 240.3b-16 is added before the undesignated center
heading ``Registration and Exemption of Exchanges'' to read as follows:
Sec. 240.3b-16 Definitions of terms used in Section 3(a)(1) of the
Act.
(a) An organization, association, or group of persons shall be
considered to constitute, maintain, or provide ``a market place or
facilities for bringing together purchasers and sellers of securities
or for otherwise performing with respect to securities the functions
commonly performed by a stock exchange,'' as those terms are used in
section 3(a)(1) of the Act, (15 U.S.C. 78c(a)(1)), if such
organization, association, or group of persons:
(1) Brings together the orders for securities of multiple buyers
and sellers; and
(2) Uses established, non-discretionary methods (whether by
providing a trading facility or by setting rules) under which such
orders interact with each other, and the buyers and sellers entering
such orders agree to the terms of a trade.
(b) An organization, association, or group of persons shall not be
considered to constitute, maintain, or provide ``a market place or
facilities for bringing together purchasers and sellers of securities
or for otherwise performing with respect to securities the functions
commonly performed by a stock exchange,'' solely because such
organization, association, or group of persons engages in one or more
of the following activities:
(1) Routes orders to a national securities exchange, a market
operated by a national securities association, or a broker-dealer for
execution; or
(2) Allows persons to enter orders for execution against the bids
and offers of a single dealer; and
(i) As an incidental part of these activities, matches orders that
are not displayed to any person other than the dealer and its
employees; or
(ii) In the course of acting as a market maker registered with a
self-regulatory organization, displays the limit orders of such market
maker's, or other broker-dealer's, customers; and
(A) Matches customer orders with such displayed limit orders; and
(B) As an incidental part of its market making activities, crosses
or matches orders that are not displayed to any person other than the
market maker and its employees.
(c) For purposes of this section the term order means any firm
indication of a willingness to buy or sell a security, as either
principal or agent, including any bid or offer quotation, market order,
limit order, or other priced order.
(d) For the purposes of this section, the terms bid and offer shall
have the same meaning as under Sec. 240.11Ac1-1.
(e) The Commission may conditionally or unconditionally exempt any
organization, association, or group of persons from the definition in
paragraph (a) of this section.
6. Section 240.6a-1 is amended by revising the section heading and
paragraphs (a) and (b) to read as follows:
Sec. 240.6a-1 Application for registration as a national securities
exchange or exemption from registration based on limited volume.
(a) An application for registration as a national securities
exchange, or for exemption from such registration based on limited
volume, shall be filed on Form 1 (Sec. 249.1 of this chapter), in
accordance with the instructions contained therein.
(b) Promptly after the discovery that any information filed on Form
1 was inaccurate when filed, the exchange shall file with the
Commission an amendment correcting such inaccuracy.
* * * * *
7. Section 240.6a-2 is revised to read as follows:
Sec. 240.6a-2 Amendments to application.
(a) A national securities exchange, or an exchange exempted from
such registration based on limited volume, shall file an amendment to
Form 1, (Sec. 249.1 of this chapter), which shall set forth the nature
and effective date of the action taken and shall provide any new
information and correct any information rendered inaccurate, on Form 1,
(Sec. 249.1 of this chapter), within 10 days after any action is taken
that renders inaccurate, or that causes to be incomplete, any of the
following:
(1) Information filed on the Execution Page of Form 1, or amendment
thereto; or
(2) Information filed as part of Exhibits C, F, G, H, J, K or M, or
any amendments thereto.
(b) On or before June 30 of each year, a national securities
exchange, or an exchange exempted from such registration based on
limited volume, shall file, as an amendment to Form 1, the following:
(1) Exhibits D and I as of the end of the latest fiscal year of the
exchange; and
(2) Exhibits K, M, and N, which shall be up to date as of the
latest date practicable within 3 months of the date the amendment is
filed.
(c) On or before June 30, 2001 and every 3 years thereafter, a
national securities exchange, or an exchange exempted from such
registration based on limited volume, shall file, as an amendment to
Form 1, complete Exhibits A, B, C and J. The information filed under
this paragraph (c) shall be current as of the latest practicable date,
but shall, at a minimum, be up to date within 3 months as of the date
the amendment is filed.
(d)(1) If an exchange, on an annual or more frequent basis,
publishes, or cooperates in the publication of, any of the information
required to be filed by paragraphs (b)(2) and (c) of this section, in
lieu of filing such information, an exchange may:
(i) Identify the publication in which such information is
available, the name, address, and telephone number of the person from
whom such publication may be obtained, and the price of such
publication; and
(ii) Certify to the accuracy of such information as of its
publication date.
(2) If an exchange keeps the information required under paragraphs
(b)(2) and (c) of this section up to date and makes it available to the
Commission and the public upon request, in lieu of filing such
information, an exchange may certify that the information is kept up to
date and is available to the Commission and the public upon request.
(3) If the information required to be filed under paragraphs (b)(2)
and (c) of this section is available continuously on an Internet web
site controlled by an exchange, in lieu of filing such information with
the Commission, such exchange may:
(i) Indicate the location of the Internet web site where such
information may be found; and
(ii) Certify that the information available at such location is
accurate as of its date.
(e) The Commission may exempt a national securities exchange, or an
exchange exempted from such registration based on limited volume, from
filing the amendment required by this section for any affiliate or
subsidiary listed in Exhibit C of the exchange's application for
registration, as amended, that either:
(1) Is listed in Exhibit C of the application for registration, as
amended,
[[Page 70919]]
of one or more other national securities exchanges; or
(2) Was an inactive subsidiary throughout the subsidiary's latest
fiscal year.
Any such exemption may be granted upon terms and conditions the
Commission deems necessary or appropriate in the public interest or for
the protection of investors, provided however, that at least one
national securities exchange shall be required to file the amendments
required by this section for an affiliate or subsidiary described in
paragraph (e)(1) of this section.
8. Section 240.6a-3 is revised to read as follows:
Sec. 240.6a-3 Supplemental material to be filed by exchanges.
(a)(1) A national securities exchange, or an exchange exempted from
such registration based on limited volume, shall file with the
Commission any material (including notices, circulars, bulletins,
lists, and periodicals) issued or made generally available to members
of, or participants or subscribers to, the exchange. Such material
shall be filed with the Commission within 10 days after issuing or
making such material available to members, participants or subscribers.
(2) If the information required to be filed under paragraph (a)(1)
of this section is available continuously on an Internet web site
controlled by an exchange, in lieu of filing such information with the
Commission, such exchange may:
(i) Indicate the location of the Internet web site where such
information may be found; and
(ii) Certify that the information available at such location is
accurate as of its date.
(b) Within 15 days after the end of each calendar month, a national
securities exchange or an exchange exempted from such registration
based on limited volume, shall file a report concerning the securities
sold on such exchange during the calendar month. Such report shall set
forth:
(1) The number of shares of stock sold and the aggregate dollar
amount of such stock sold;
(2) The principal amount of bonds sold and the aggregate dollar
amount of such bonds sold; and
(3) The number of rights and warrants sold and the aggregate dollar
amount of such rights and warrants sold.
9. Section 240.11Ac1-1 is amended by redesignating paragraph
(c)(5)(ii)(A) as paragraph (c)(5)(ii)(A)(l), paragraph (c)(5)(ii)(B),
introductory text, as paragraph (c)(5)(ii)(A)(2), paragraph
(c)(5)(ii)(B)(1) as paragraph (c)(5)(ii)(A)(2)(i), paragraph
(c)(5)(ii)(B)(2) as paragraph (c)(5)(ii)(A)(2)(ii), in newly designated
paragraph (c)(5)(ii)(A)(2)(ii) by removing the period and adding in its
place ``; or'', and adding new paragraph (c)(5)(ii)(B) to read as
follows:
Sec. 240.11Ac1-1 Dissemination of quotations.
* * * * *
(c) * * *
(5) * * *
(ii) * * *
(A)(1) * * *
(B) Is an alternative trading system that:
(1) Displays orders and provides the ability to effect transactions
with such orders under Sec. 242.301(b)(3) of this chapter; and
(2) Otherwise is in compliance with Regulation ATS, Sec. 242.300
through Sec. 242.303 of this chapter.
* * * * *
10. Section 240.17a-3 is amended by adding paragraph (a)(16) to
read as follows:
Sec. 240.17a-3 Records to be made by certain exchange members, brokers
and dealers.
(a) * * *
(16)(i) The following records regarding any internal broker-dealer
system of which such a broker or dealer is the sponsor:
(A) A record of the broker's or dealer's customers that have access
to an internal broker-dealer system sponsored by such broker or dealer
(identifying any affiliations between such customers and the broker or
dealer);
(B) Daily summaries of trading in the internal broker-dealer
system, including:
(1) Securities for which transactions have been executed through
use of such system; and
(2) Transaction volume (separately stated for trading occurring
during hours when consolidated trade reporting facilities are and are
not in operation):
(i) With respect to equity securities, stated in number of trades,
number of shares, and total U.S. dollar value;
(ii) With respect to debt securities, stated in total settlement
value in U.S. dollars; and
(iii) With respect to other securities, stated in number of trades,
number of units of securities, and in dollar value, or other
appropriate commonly used measure of value of such securities; and
(C) Time-sequenced records of each transaction effected through the
internal broker-dealer system, including date and time executed, price,
size, security traded, counterparty identification information, and
method of execution (if internal broker-dealer system allows
alternative means or locations for execution, such as routing to
another market, matching with limit orders, or executing against the
quotations of the broker or dealer sponsoring the system).
(ii) For purposes of paragraph (a) of this section, the term:
(A) Internal broker-dealer system shall mean any facility, other
than a national securities exchange, an exchange exempt from
registration based on limited volume, or an alternative trading system
as defined in Regulation ATS, Secs. 242.300 through 242.303 of this
chapter, that provides a mechanism, automated in full or in part, for
collecting, receiving, disseminating, or displaying system orders and
facilitating agreement to the basic terms of a purchase or sale of a
security between a customer and the sponsor, or between two customers
of the sponsor, through use of the internal broker-dealer system or
through the broker or dealer sponsor of such system;
(B) Sponsor shall mean any broker or dealer that organizes,
operates, administers, or otherwise directly controls an internal
broker-dealer trading system or, if the operator of the internal
broker-dealer system is not a registered broker or dealer, any broker
or dealer that, pursuant to contract, affiliation, or other agreement
with the system operator, is involved on a regular basis with executing
transactions in connection with use of the internal broker-dealer
system, other than solely for its own account or as a customer with
access to the internal broker-dealer system; and
(C) System order means any order or other communication or
indication submitted by any customer with access to the internal
broker-dealer system for entry into a trading system announcing an
interest in purchasing or selling a security. The term ``system order''
does not include inquiries or indications of interest that are not
entered into the internal broker-dealer system.
* * * * *
11. Section 240.17a-4 is amended by revising paragraph (b)(1) and
adding paragraph (b)(10) to read as follows:
Sec. 240.17a-4. Records to be preserved by certain exchange members,
brokers and dealers.
* * * * *
(b) * * *
(1) All records required to be made pursuant to paragraphs (a)(4),
(a)(6), (a)(7), (a)(8), (a)(9), and (a)(10) of Sec. 240.17a-3.
* * * * *
[[Page 70920]]
(10) All notices relating to an internal broker-dealer system
provided to the customers of the broker or dealer that sponsors such
internal broker-dealer system, as defined in paragraph (a)(16)(ii)(A)
of Sec. 240.17a-3. Notices, whether written or communicated through the
internal broker-dealer trading system or other automated means, shall
be preserved under this paragraph (b)(10) if they are provided to all
customers with access to an internal broker-dealer system, or to one or
more classes of customers. Examples of notices to be preserved under
this paragraph (b)(10) include, but are not limited to, notices
addressing hours of system operations, system malfunctions, changes to
system procedures, maintenance of hardware and software, and
instructions pertaining to access to the internal broker-dealer system.
* * * * *
Sec. 240.17a-23 [Removed]
12. Section 240.17a-23 is removed and reserved.
13. Section 240.19b-5 is added to read as follows:
Sec. 240.19b-5 Temporary exemption from the filing requirements of
Section 19(b) of the Act.
Preliminary Notes
1. The following section provides for a temporary exemption from
the rule filing requirement for self-regulatory organizations that file
proposed rule changes concerning the operation of a pilot trading
system pursuant to section 19(b) of the Act (15 U.S.C. 78s(b), as
amended). All other requirements under the Act that are applicable to
self-regulatory organizations continue to apply.
2. The disclosures made pursuant to the provisions of this section
are in addition to any other applicable disclosure requirements under
the federal securities laws.
(a) For purposes of this section, the term specialist means any
member subject to a requirement of a self-regulatory organization that
such member regularly maintain a market in a particular security.
(b) For purposes of this section, the term trading system means the
rules of a self-regulatory organization that:
(1) Determine how the orders of multiple buyers and sellers are
brought together; and
(2) Establish non-discretionary methods under which such orders
interact with each other and under which the buyers and sellers
entering such orders agree to the terms of trade.
(c) For purposes of this section, the term pilot trading system
shall mean a trading system operated by a self-regulatory organization
that is not substantially similar to any trading system or pilot
trading system operated by such self-regulatory organization at any
time during the preceding year, and that:
(1)(i) Has been in operation for less than two years;
(ii) Is independent of any other trading system operated by such
self-regulatory organization that has been approved by the Commission
pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b));
(iii) With respect to each security traded on such pilot trading
system, during at least two of the last four consecutive calendar
months, has traded no more than 5 percent of the average daily trading
volume of such security in the United States; and
(iv) With respect to all securities traded on such pilot trading
system, during at least two of the last four consecutive calendar
months, has traded no more than 20 percent of the average daily trading
volume of all trading systems operated by such self-regulatory
organization; or
(2)(i) Has been in operation for less than two years;
(ii) With respect to each security traded on such pilot trading
system, during at least two of the last four consecutive calendar
months, has traded no more than 1 percent of the average daily trading
volume of such security in the United States; and
(iii) With respect to all securities traded on such pilot trading
system, during at least two of the last four consecutive calendar
months, has traded no more than 20 percent of the average daily trading
volume of all trading systems operated by such self-regulatory
organization; or
(3)(i) Has been in operation for less than two years; and
(ii)(A) Satisfied the definition of pilot trading system under
paragraph (c)(1) of this section no more than 60 days ago, and
continues to be independent of any other trading system operated by
such self-regulatory organization that has been approved by the
Commission pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b)); or
(B) Satisfied the definition of pilot trading system under
paragraph (c)(2) of this section no more than 60 days ago.
(d) A pilot trading system shall be deemed independent of any other
trading system operated by a self-regulatory organization if:
(1) Such pilot trading system trades securities other than the
issues of securities that trade on any other trading system operated by
such self-regulatory organization that has been approved by the
Commission pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b));
(2) Such pilot trading system does not operate during the same
trading hours as any other trading system operated by such self-
regulatory organization that has been approved by the Commission
pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b)); or
(3) No specialist or market maker on any other trading system
operated by such self-regulatory organization that has been approved by
the Commission pursuant to section 19(b) of the Act, (15 U.S.C.
78s(b)), is permitted to effect transactions on the pilot trading
system in securities in which they are a specialist or market maker.
(e) A self-regulatory organization shall be exempt temporarily from
the requirement under section 19(b) of the Act, (15 U.S.C. 78s(b)), to
submit on Form 19b-4, 17 CFR 249.819, proposed rule changes for
establishing a pilot trading system, if the self-regulatory
organization complies with the following requirements:
(1) Form PILOT. The self-regulatory organization:
(i) Files Part I of Form PILOT, 17 CFR 249.821, in accordance with
the instructions therein, at least 20 days prior to commencing
operation of the pilot trading system;
(ii) Files an amendment on Part I of Form PILOT at least 20 days
prior to implementing a material change to the operation of the pilot
trading system; and
(iii) Files a quarterly report on Part II of Form PILOT within 30
calendar days after the end of each calendar quarter in which the
market has operated after the effective date of this section.
(2) Fair access.
(i) The self-regulatory organization has in place written rules to
ensure that all members of the self-regulatory organization have fair
access to the pilot trading system, and that information regarding
orders on the pilot trading system is equally available to all members
of the self-regulatory organization with access to such pilot trading
system.
(ii) Notwithstanding the requirement in paragraph (e)(2)(i) of this
section, a specialist on the pilot trading system may have preferred
access to information regarding orders that it represents in its
capacity as specialist.
(iii) The rules established by a self-regulatory organization
pursuant to paragraph (e)(2)(i) of this section will be considered
rules governing the pilot trading system for purposes of the temporary
exemption under this section.
[[Page 70921]]
(3) Trading rules and procedures and listing standards.
(i) The self-regulatory organization has in place written trading
rules and procedures and listing standards necessary to operate the
pilot trading system.
(ii) The rules established by a self-regulatory organization
pursuant to paragraph (e)(3)(i) of this section will be considered
rules governing the pilot trading system for purposes of the temporary
exemption under this section.
(4) Surveillance. The self-regulatory organization establishes
internal procedures for the effective surveillance of trading activity
on the self-regulatory organization's pilot trading system.
(5) Clearance and settlement. The self-regulatory organization
establishes reasonable clearance and settlement procedures for
transactions effected on the self-regulatory organizations pilot
trading system.
(6) Types of securities. The self-regulatory organization permits
to trade on the pilot trading system only securities registered under
section 12 of the Act, (15 U.S.C. 78l).
(7) Activities of specialists.
(i) The self-regulatory organization does not permit any member to
be a specialist in a security on the pilot trading system and a
specialist in a security on a trading system operated by such self-
regulatory organization that has been approved by the Commission
pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b)), or on another
pilot trading system operated by such self-regulatory organization, if
such securities are related securities, except that a member may be a
specialist in related securities that the Commission, upon application
by the self-regulatory organization, later determines is necessary or
appropriate in the public interest and consistent with the protection
of investors;
(ii) Notwithstanding paragraph (e)(7)(i) of this section, a self-
regulatory organization may permit a member to be a specialist in any
security on a pilot trading system, if the pilot trading system is
operated during trading hours different from the trading hours of the
trading system in which such member is a specialist.
(iii) For purposes of paragraph (e)(7) of this section, the term
related securities means any two securities in which:
(A) The value of one security is determined, in whole or
significant part, by the performance of the other security; or
(B) The value of both securities is determined, in whole or
significant part, by the performance of a third security, combination
of securities, index, indicator, interest rate or other common factor.
(8) Examinations, inspections, and investigations. The self-
regulatory organization cooperates with the examination, inspection, or
investigation by the Commission of transactions effected on the pilot
trading system.
(9) Recordkeeping. The self-regulatory organization shall retain at
its principal place of business and make available to Commission staff
for inspection, all the rules and procedures relating to each pilot
trading system operating pursuant to this section for a period of not
less than five years, the first two years in an easily accessible
place, as prescribed in Sec. 240.17a-1.
(10) Public availability of pilot trading system rules. The self-
regulatory organization makes publicly available all trading rules and
procedures, including those established under paragraphs (e)(2) and
(e)(3) of this section.
(11) Every notice or amendment filed pursuant to this paragraph (e)
shall constitute a ``report'' within the meaning of sections 11A,
17(a), 18(a), and 32(a), (15 U.S.C. 78k-1, 78q(a), 78r(a), and
78ff(a)), and any other applicable provisions of the Act. All notices
or reports filed pursuant to this paragraph (e) shall be deemed to be
confidential until the pilot trading system commences operation.
(f)(1)A self-regulatory organization shall request Commission
approval, pursuant to section 19(b)(2) of the Act, (15 U.S.C.
78s(b)(2)), for any rule change relating to the operation of a pilot
trading system by submitting Form 19b-4, 17 CFR 249.819, no later than
two years after the commencement of operation of such pilot trading
system, or shall cease operation of the pilot trading system.
(2) Simultaneous with a request for Commission approval pursuant to
section 19(b)(2) of the Act, (15 U.S.C. 78s(b)(2)), a self-regulatory
organization may request Commission approval pursuant to section
19(b)(3)(A) of the Act, (15 U.S.C. 78s(b)(3)(A)), for any rule change
relating to the operation of a pilot trading system by submitting Form
19b-4, 17 CFR 249.819, effective immediate upon filing, to continue
operations of such trading system for a period not to exceed six
months.
(g) Notwithstanding paragraph (e) of this section, rule changes
with respect to pilot trading systems operated by a self-regulatory
organization shall not be exempt from the rule filing requirements of
section 19(b)(2) of the Act, (15 U.S.C. 78s(b)(2)), if the Commission
determines, after notice to the SRO and opportunity for the SRO to
respond, that exemption of such rule changes is not necessary or
appropriate in the public interest or consistent with the protection of
investors.
PART 242--REGULATIONS M AND ATS
14. The authority citation for part 242 is revised to read as
follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78i(a), 78j,
78k-1(c), 78l, 78m, 78mm, 78n, 78o(b), 78o(c), 78o(g), 78q(a),
78q(b), 78q(h), 78w(a), 78dd-1, 80a-23, 80a-29, and 80a-37.
15. The part heading for part 242 is revised as set forth above.
16. Part 242 is amended by adding Regulation ATS, Secs. 242.300
through 242.303 to read as follows:
Regulation ATS--Alternative Trading Systems
Sec.
242.300 Definitions.
242.301 Requirements for alternative trading systems.
242.302 Recordkeeping requirements for alternative trading systems.
242.303 Record preservation requirements for alternative trading
systems.
Regulation ATS--Alternative Trading Systems
Preliminary Notes
1. An alternative trading system is required to comply with the
requirements in this Regulation ATS, unless such alternative trading
system:
(a) Is registered as a national securities exchange;
(b) Is exempt from registration as a national securities
exchange based on the limited volume of transactions effected on the
alternative trading system; or
(c) Trades only government securities and certain other related
instruments.
All alternative trading systems must comply with the antifraud,
antimanipulation, and other applicable provisions of the federal
securities laws.
2. The requirements imposed upon an alternative trading system
by Regulation ATS are in addition to any requirements applicable to
broker-dealers registered under section 15 of the Act, (15 U.S.C.
78o).
3. An alternative trading system must comply with any applicable
state law relating to the offer or sale of securities or the
registration or regulation of persons or entities effecting
transactions in securities.
4. The disclosures made pursuant to the provisions of this
section are in addition to any other disclosure requirements under
the federal securities laws.
Sec. 242.300 Definitions.
For purposes of this section, the following definitions shall
apply:
[[Page 70922]]
(a) Alternative trading system means any organization, association,
person, group of persons, or system:
(1) That constitutes, maintains, or provides a market place or
facilities for bringing together purchasers and sellers of securities
or for otherwise performing with respect to securities the functions
commonly performed by a stock exchange within the meaning of
Sec. 240.3b-16 of this chapter; and
(2) That does not:
(i) Set rules governing the conduct of subscribers other than the
conduct of such subscribers' trading on such organization, association,
person, group of persons, or system; or
(ii) Discipline subscribers other than by exclusion from trading.
(b) Subscriber means any person that has entered into a contractual
agreement with an alternative trading system to access such alternative
trading system for the purpose of effecting transactions in securities
or submitting, disseminating, or displaying orders on such alternative
trading system, including a customer, member, user, or participant in
an alternative trading system. A subscriber, however, shall not include
a national securities exchange or national securities association.
(c) Affiliate of a subscriber means any person that, directly or
indirectly, controls, is under common control with, or is controlled
by, the subscriber, including any employee.
(d) Debt security shall mean any security other than an equity
security, as defined in Sec. 240.3a11-1 of this chapter, as well as
non-participatory preferred stock.
(e) Order means any firm indication of a willingness to buy or sell
a security, as either principal or agent, including any bid or offer
quotation, market order, limit order, or other priced order.
(f) Control means the power, directly or indirectly, to direct the
management or policies of an alternative trading system, whether
through ownership of securities, by contract, or otherwise. A person is
presumed to control an alternative trading system, if that person:
(1) Is a director, general partner, or officer exercising executive
responsibility (or having similar status or performing similar
functions);
(2) Directly or indirectly has the right to vote 25 percent or more
of a class of voting security or has the power to sell or direct the
sale of 25 percent or more of a class of voting securities of the
alternative trading system; or
(3) In the case of a partnership, has contributed, or has the right
to receive upon dissolution, 25 percent or more of the capital of the
alternative trading system.
(g) Covered security shall have the meaning provided in
Sec. 240.11Ac1-1(a)(6) of this chapter, provided, however, that a debt
or convertible debt security shall not be deemed a covered security for
purposes of Regulation ATS.
(h) Effective transaction reporting plan shall have the meaning
provided in Sec. 240.11Aa3-1(a)(3) of this chapter.
(i) Exchange market maker shall have the meaning provided in
Sec. 240.11Ac1-1(a)(9) of this chapter.
(j) OTC market maker shall have the meaning provided in
Sec. 240.11Ac1-1(a)(13) of this chapter.
(k) Investment grade corporate debt security shall mean any
security that:
(1) Evidences a liability of the issuer of such security;
(2) Has a fixed maturity date that is at least one year following
the date of issuance;
(3) Is rated in one of the four highest ratings categories by at
least one Nationally Recognized Statistical Ratings Organization; and
(4) Is not an exempted security, as defined in section 3(a)(12) of
the Act (15 U.S.C. 78c(a)(12)).
(l) Non-investment grade corporate debt security shall mean any
security that:
(1) Evidences a liability of the issuer of such security;
(2) Has a fixed maturity date that is at least one year following
the date of issuance;
(3) Is not rated in one of the four highest ratings categories by
at least one Nationally Recognized Statistical Ratings Organization;
and
(4) Is not an exempted security, as defined in section 3(a)(12) of
the Act (15 U.S.C. 78c(a)(12)).
(m) Commercial paper shall mean any note, draft, or bill of
exchange which arises out of a current transaction or the proceeds of
which have been or are to be used for current transactions, and which
has a maturity at the time of issuance of not exceeding nine months,
exclusive of days of grace, or any renewal thereof the maturity of
which is likewise limited.
Sec. 242.301 Requirements for alternative trading systems.
(a) Scope of section. An alternative trading system shall comply
with the requirements in paragraph (b) of this section, unless such
alternative trading system:
(1) Is registered as an exchange under section 6 of the Act, (15
U.S.C. 78f);
(2) Is exempted by the Commission from registration as an exchange
based on the limited volume of transactions effected;
(3) Is operated by a national securities association;
(4)(i) Is registered as a broker-dealer under sections 15(b) or 15C
of the Act (15 U.S.C. 78o(b), and 78o-5), or is a bank, and
(ii) Limits its securities activities to the following instruments:
(A) Government securities, as defined in section 3(a)(42) of the
Act, (15 U.S.C. 78c(a)(42));
(B) Repurchase and reverse repurchase agreements solely involving
securities included within paragraph (a)(4)(ii)(A) of this section;
(C) Any put, call, straddle, option, or privilege on a government
security, other than a put, call, straddle, option, or privilege that:
(1) Is traded on one or more national securities exchanges; or
(2) For which quotations are disseminated through an automated
quotation system operated by a registered securities association; and
(D) Commercial paper.
(5) Is exempted, conditionally or unconditionally, by Commission
order, after application by such alternative trading system, from one
or more of the requirements of paragraph (b) of this section. The
Commission will grant such exemption only after determining that such
an order is consistent with the public interest, the protection of
investors, and the removal of impediments to, and perfection of the
mechanisms of, a national market system.
(b) Requirements. Every alternative trading system subject to this
Regulation ATS, pursuant to paragraph (a) of this section, shall comply
with the requirements in this paragraph (b).
(1) Broker-dealer registration. The alternative trading system
shall register as a broker-dealer under section 15 of the Act, (15
U.S.C. 78o).
(2) Notice. (i) The alternative trading system shall file an
initial operation report on Form ATS, Sec. 249.637 of this chapter, in
accordance with the instructions therein, at least 20 days prior to
commencing operation as an alternative trading system, or if the
alternative trading system is operating as of April 21, 1999, no later
than May 11, 1999.
(ii) The alternative trading system shall file an amendment on Form
ATS at least 20 calendar days prior to implementing a material change
to the operation of the alternative trading system.
(iii) If any information contained in the initial operation report
filed under paragraph (b)(2)(i) of this section becomes inaccurate for
any reason and has not been previously reported to the
[[Page 70923]]
Commission as an amendment on Form ATS, the alternative trading system
shall file an amendment on Form ATS correcting such information within
30 calendar days after the end of each calendar quarter in which the
alternative trading system has operated.
(iv) The alternative trading system shall promptly file an
amendment on Form ATS correcting information previously reported on
Form ATS after discovery that any information filed under paragraphs
(b)(2)(i), (ii) or (iii) of this section was inaccurate when filed.
(v) The alternative trading system shall promptly file a cessation
of operations report on Form ATS in accordance with the instructions
therein upon ceasing to operate as an alternative trading system.
(vi) Every notice or amendment filed pursuant to this paragraph
(b)(2) shall constitute a ``report'' within the meaning of sections
11A, 17(a), 18(a), and 32(a), (15 U.S.C. 78k-1, 78q(a), 78r(a), and
78ff(a)), and any other applicable provisions of the Act.
(vii) The reports provided for in paragraph (b)(2) of this section
shall be considered filed upon receipt by the Division of Market
Regulation, Stop 10-2, at the Commission's principal office in
Washington, DC. Duplicate originals of the reports provided for in
paragraphs (b)(2)(i) through (v) of this section must be filed with
surveillance personnel designated as such by any self-regulatory
organization that is the designated examining authority for the
alternative trading system pursuant to Sec. 240.17d-1 of this chapter
simultaneously with filing with the Commission. Duplicates of the
reports required by paragraph (b)(9) of this section shall be provided
to surveillance personnel of such self-regulatory authority upon
request. All reports filed pursuant to this paragraph (b)(2) and
paragraph (b)(9) of this section shall be deemed confidential when
filed.
(3) Order display and execution access. (i) An alternative trading
system shall comply with the requirements set forth in paragraph
(b)(3)(ii) of this section, with respect to any covered security in
which the alternative trading system:
(A) Displays subscriber orders to any person (other than
alternative trading system employees); and
(B) During at least 4 of the preceding 6 calendar months, had an
average daily trading volume of 5 percent or more of the aggregate
average daily share volume for such covered security as reported by an
effective transaction reporting plan or disseminated through an
automated quotation system as described in section 3(a)(51)(A)(ii) of
the Act, (15 U.S.C. 78c(a)(51)(A)(ii)).
(ii) Such alternative trading system shall provide to a national
securities exchange or national securities association the prices and
sizes of the orders at the highest buy price and the lowest sell price
for such covered security, displayed to more than one person in the
alternative trading system, for inclusion in the quotation data made
available by the exchange or association to quotation vendors pursuant
to Sec. 240.11Ac1-1 of this chapter.
(iii) With respect to any order displayed pursuant to paragraph
(b)(3)(ii) of this section, an alternative trading system shall provide
to any broker-dealer that has access to the national securities
exchange or national securities association to which the alternative
trading system provides the prices and sizes of displayed orders
pursuant to paragraph (b)(3)(ii)(A) of this section, the ability to
effect a transaction with such orders that is:
(A) Equivalent to the ability of such broker-dealer to effect a
transaction with other orders displayed on the exchange or by the
association; and
(B) At the price of the highest priced buy order or lowest priced
sell order displayed for the lesser of the cumulative size of such
priced orders entered therein at such price, or the size of the
execution sought by such broker-dealer.
(4) Fees. The alternative trading system shall not charge any fee
to broker-dealers that access the alternative trading system through a
national securities exchange or national securities association, that
is inconsistent with equivalent access to the alternative trading
system required by paragraph (b)(3)(iv) of this section. In addition,
if the national securities exchange or national securities association
to which an alternative trading system provides the prices and sizes of
orders under paragraphs (b)(3)(ii) and (b)(3)(iii) of this section
establishes rules designed to assure consistency with standards for
access to quotations displayed on such national securities exchange, or
the market operated by such national securities association, the
alternative trading system shall not charge any fee to members that is
contrary to, that is not disclosed in the manner required by, or that
is inconsistent with any standard of equivalent access established by
such rules.
(5) Fair access. (i) An alternative trading system shall comply
with the requirements in paragraph (b)(5)(ii) of this section, if
during at least 4 of the preceding 6 calendar months, such alternative
trading system had:
(A) With respect to any covered security, 20 percent or more of the
average daily volume in that security reported by an effective
transaction reporting plan or disseminated through an automated
quotation system as described in section 3(a)(51)(A)(ii) of the Act (15
U.S.C. 78c(a)(51)(A)(ii));
(B) With respect to an equity security that is not a covered
security and for which transactions are reported to a self-regulatory
organization, 20 percent or more of the average daily volume in that
security as calculated by the self-regulatory organization to which
such transactions are reported;
(C) With respect to municipal securities, 20 percent or more of the
average daily volume traded in the United States;
(D) With respect to investment grade corporate debt, 20 percent or
more of the average daily volume traded in the United States;
(E) With respect to non-investment grade corporate debt, 20 percent
or more of the average daily volume traded in the United States.
(ii) An alternative trading system shall:
(A) Establish written standards for granting access to trading on
its system;
(B) Not unreasonably prohibit or limit any person in respect to
access to services offered by such alternative trading system by
applying the standards established under paragraph (b)(5)(ii)(A) of
this section in an unfair or discriminatory manner; and
(C) Make and keep records of:
(1) All grants of access including, for all subscribers, the
reasons for granting such access;
(2) All denials or limitations of access and reasons, for each
applicant, for denying or limiting access.
(D) Report the information required on Form ATS-R, Sec. 249.638 of
this chapter, regarding grants, denials, and limitations of access.
(iii) Notwithstanding paragraph (b)(5)(i) of this section, an
alternative trading system shall not be required to comply with the
requirements in paragraph (b)(5)(ii) of this section, if such
alternative trading system:
(A) Matches customer orders for a security with other customer
orders;
(B) Such customers' orders are not displayed to any person, other
than employees of the alternative trading system; and
(C) Such orders are executed at a price for such security
disseminated by an effective transaction reporting plan or through an
automated quotation system as described in section 3(a)(51)(A)(ii) of
[[Page 70924]]
the Act, (15 U.S.C. 78c(a)(51)(A)(ii)), or derived from such prices.
(6) Capacity, integrity, and security of automated systems. (i) The
alternative trading system shall comply with the requirements in
paragraph (b)(6)(ii) of this section, if during at least 4 of the
preceding 6 calendar months, such alternative trading system had:
(A) With respect to any covered security, 20 percent or more of the
average daily volume reported by the effective transaction reporting
plan or disseminated through an automated quotation system as described
in Section 3(a)(51)(A)(ii) of the Act, (15 U.S.C. 78c(a)(51)(A)(ii));
(B) With respect to equity securities that are not covered
securities and for which transactions are reported to a self-regulatory
organization, 20 percent or more of the average daily volume as
calculated by the self-regulatory organization to which such
transactions are reported;
(C) With respect to municipal securities, 20 percent or more of the
average daily volume traded in the United States;
(D) With respect to investment grade corporate debt, 20 percent or
more of the average daily volume traded in the United States;
(E) With respect to non-investment grade corporate debt, 20 percent
or more of the average daily volume traded in the United States.
(ii) With respect to those systems that support order entry, order
routing, order execution, transaction reporting, and trade comparison,
the alternative trading system shall:
(A) Establish reasonable current and future capacity estimates;
(B) Conduct periodic capacity stress tests of critical systems to
determine such system's ability to process transactions in an accurate,
timely, and efficient manner;
(C) Develop and implement reasonable procedures to review and keep
current its system development and testing methodology;
(D) Review the vulnerability of its systems and data center
computer operations to internal and external threats, physical hazards,
and natural disasters;
(E) Establish adequate contingency and disaster recovery plans;
(F) On an annual basis, perform an independent review, in
accordance with established audit procedures and standards, of such
alternative trading system's controls for ensuring that paragraphs
(b)(6)(ii)(A) through (E) of this section are met, and conduct a review
by senior management of a report containing the recommendations and
conclusions of the independent review; and
(G) Promptly notify the Commission staff of material systems
outages and significant systems changes.
(iii) Notwithstanding paragraph (b)(6)(i) of this section, an
alternative trading system shall not be required to comply with the
requirements in paragraph (b)(6)(ii) of this section, if such
alternative trading system:
(A) Matches customer orders for a security with other customer
orders;
(B) Such customers' orders are not displayed to any person, other
than employees of the alternative trading system; and
(C) Such orders are executed at a price for such security
disseminated by an effective transaction reporting plan or through an
automated quotation system as described in section 3(a)(51)(A)(ii) of
the Act, (15 U.S.C. 78c(a)(51)(A)(ii)), or derived from such prices.
(7) Examinations, inspections, and investigations. The alternative
trading system shall permit the examination and inspection of its
premises, systems, and records, and cooperate with the examination,
inspection, or investigation of subscribers, whether such examination
is being conducted by the Commission or by a self-regulatory
organization of which such subscriber is a member.
(8) Recordkeeping. The alternative trading system shall:
(i) Make and keep current the records specified in Sec. 242.302;
and
(ii) Preserve the records specified in Sec. 242.303.
(9) Reporting. The alternative trading system shall:
(i) File the information required by Form ATS-R (Sec. 249.638 of
this chapter) within 30 calendar days after the end of each calendar
quarter in which the market has operated after the effective date of
this section; and
(ii) File the information required by Form ATS-R within 10 calendar
days after an alternative trading system ceases to operate.
(10) Procedures to ensure the confidential treatment of trading
information.
(i) The alternative trading system shall establish adequate
safeguards and procedures to protect subscribers' confidential trading
information. Such safeguards and procedures shall include:
(A) Limiting access to the confidential trading information of
subscribers to those employees of the alternative trading system who
are operating the system or responsible for its compliance with these
or any other applicable rules;
(B) Implementing standards controlling employees of the alternative
trading system trading for their own accounts; and
(ii) The alternative trading system shall adopt and implement
adequate oversight procedures to ensure that the safeguards and
procedures established pursuant to paragraph (b)(10)(i) of this section
are followed.
(11) Name. The alternative trading system shall not use in its name
the word ``exchange,'' or derivations of the word ``exchange,'' such as
the term ``stock market.''
Sec. 242.302 Recordkeeping requirements for alternative trading
systems.
To comply with the condition set forth in paragraph (b)(8) of
Sec. 242.301, an alternative trading system shall make and keep current
the following records:
(a) A record of subscribers to such alternative trading system
(identifying any affiliations between the alternative trading system
and subscribers to the alternative trading system, including common
directors, officers, or owners);
(b) Daily summaries of trading in the alternative trading system
including:
(1) Securities for which transactions have been executed;
(2) Transaction volume, expressed with respect to equity securities
in:
(i) Number of trades;
(ii) Number of shares traded; and
(iii) Total settlement value in terms of U.S. dollars; and
(3) Transaction volume, expressed with respect to debt securities
in:
(i) Number of trades; and
(ii) Total U.S. dollar value; and
(c) Time-sequenced records of order information in the alternative
trading system, including:
(1) Date and time (expressed in terms of hours, minutes, and
seconds) that the order was received;
(2) Identity of the security;
(3) The number of shares, or principal amount of bonds, to which
the order applies;
(4) An identification of the order as related to a program trade or
an index arbitrage trade as defined in New York Stock Exchange Rule
80A;
(5) The designation of the order as a buy or sell order;
(6) The designation of the order as a short sale order;
(7) The designation of the order as a market order, limit order,
stop order, stop limit order, or other type or order;
(8) Any limit or stop price prescribed by the order;
(9) The date on which the order expires and, if the time in force
is less than one day, the time when the order expires;
(10) The time limit during which the order is in force;
[[Page 70925]]
(11) Any instructions to modify or cancel the order;
(12) The type of account, i.e., retail, wholesale, employee,
proprietary, or any other type of account designated by the alternative
trading system, for which the order is submitted;
(13) Date and time (expressed in terms of hours, minutes, and
seconds) that the order was executed;
(14) Price at which the order was executed;
(15) Size of the order executed (expressed in number of shares or
units or principal amount); and
(16) Identity of the parties to the transaction.
Sec. 242.303 Record preservation requirements for alternative trading
systems.
(a) To comply with the condition set forth in paragraph (b)(9) of
Sec. 242.301, an alternative trading system shall preserve the
following records:
(1) For a period of not less than three years, the first two years
in an easily accessible place, an alternative trading system shall
preserve:
(i) All records required to be made pursuant to Sec. 242.302;
(ii) All notices provided by such alternative trading system to
subscribers generally, whether written or communicated through
automated means, including, but not limited to, notices addressing
hours of system operations, system malfunctions, changes to system
procedures, maintenance of hardware and software, instructions
pertaining to access to the market and denials of, or limitations on,
access to the alternative trading system;
(iii) If subject to paragraph (b)(5)(ii) of Sec. 242.301, at least
one copy of such alternative trading system's standards for access to
trading, all documents relevant to the alternative trading systems
decision to grant, deny, or limit access to any person, and all other
documents made or received by the alternative trading system in the
course of complying with paragraph (b)(5) of Sec. 242.301; and
(iv) At least one copy of all documents made or received by the
alternative trading system in the course of complying with paragraph
(b)(6) of Sec. 242.301, including all correspondence, memoranda,
papers, books, notices, accounts, reports, test scripts, test results,
and other similar records.
(2) During the life of the enterprise and of any successor
enterprise, an alternative trading system shall preserve:
(i) All partnership articles or, in the case of a corporation, all
articles of incorporation or charter, minute books and stock
certificate books; and
(ii) Copies of reports filed pursuant to paragraph (b)(2) of
Sec. 242.301 of this chapter and records made pursuant to paragraph
(b)(5) of Sec. 242.301 of this chapter.
(b) The records required to be maintained and preserved pursuant to
paragraph (a) of this section must be produced, reproduced, and
maintained in paper form or in any of the forms permitted under
Sec. 240.17a-4(f) of this chapter.
(c) Alternative trading systems must comply with any other
applicable recordkeeping or reporting requirement in the Act, and the
rules and regulations thereunder. If the information in a record
required to be made pursuant to this section is preserved in a record
made pursuant to Sec. 240.17a-3 or Sec. 240.17a-4 of this chapter, or
otherwise preserved by the alternative trading system (whether in
summary or some other form), this section shall not require the sponsor
to maintain such information in a separate file, provided that the
sponsor can promptly sort and retrieve the information as if it had
been kept in a separate file as a record made pursuant to this section,
and preserves the information in accordance with the time periods
specified in paragraph (a) of this section.
(d) The records required to be maintained and preserved pursuant to
this section may be prepared or maintained by a service bureau,
depository, or other recordkeeping service on behalf of the alternative
trading system. An agreement with a service bureau, depository, or
other recordkeeping service shall not relieve the alternative trading
system from the responsibility to prepare and maintain records as
specified in this section. The service bureau, depository, or other
recordkeeping service shall file with the Commission a written
undertaking in a form acceptable to the Commission, signed by a duly
authorized person, to the effect that such records are the property of
the alternative trading system required to be maintained and preserved
and will be surrendered promptly on request of the alternative trading
system, and shall include the following provision: With respect to any
books and records maintained or preserved on behalf of (name of
alternative trading system), the undersigned hereby undertakes to
permit examination of such books and records at any time, or from time
to time, during business hours by representatives or designees of the
Securities and Exchange Commission, and to promptly furnish to the
Commission or its designee a true, correct, complete and current hard
copy of any, all, or any part of, such books and records.
(e) Every alternative trading system shall furnish to any
representative of the Commission promptly upon request, legible, true,
and complete copies of those records that are required to be preserved
under this section.
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
17. The authority citation for part 249 continues to read in part
as follows:
Authority: 15 U.S.C. 78a, et seq., unless otherwise noted;
* * * * * *
18. Section 249.1 and Form 1 are revised to read as follows:
Sec. 249.1 Form 1, for application for, and amendments to applications
for, registration as a national securities exchange or exemption from
registration pursuant to Section 5 of the Exchange Act.
The form shall be used for application for, and amendments to
applications for, registration as a national securities exchange or
exemption from registration pursuant to Section 5 of the Act, (15
U.S.C. 78e).
Note: Form 1 does not and the amendments will not appear in the
Code of Federal Regulations.
OMB APPROVAL
OMB Number: 3235-0017
Expires: 8/31/2001
Estimated Average burden hours per form: 30
Form 1--Application for, and Amendments to Application for,
Registration as a National Securities Exchange or Exemption From
Registration Pursuant to Section 5 of the Exchange Act
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Sec. 249.1a and Form 1-A [Removed]
19. Section 249.1a and Form 1-A are removed.
Sec. 249.636 and Form 17A-23 [Removed and reserved]
20. Section 249.636 and Form 17A-23 are removed and reserved.
21. Section 249.637 and Form ATS are added to read as follows:
Sec. 249.637 Form ATS, information required of alternative trading
systems pursuant to Sec. 242.301(b)(2) of this chapter.
This form shall be used by every alternative trading system to file
required notices, reports and amendments under Sec. 242.301(b)(2) of
this chapter.
Note: Form ATS does not and the amendments will not appear in
the Code of Federal Regulations.
OMB APPROVAL
OMB Number: 3235-0509
Expires: 8/31/2001
Estimated Average burden hours per form: 8
Form ATS--Intial Operation Report, Amendment to Initial Operation
Report and Cessation of Operations Report of Alternative Trading
System Activities
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22. Section 249.638 and Form ATS-R are added to read as follows:
Sec. 249.638 Form ATS-R, information required of alternative trading
systems pursuant to Sec. 242.301(b)(8) of this chapter.
This form shall be used by every alternative trading system to file
required reports under Sec. 242.301(b)(8) of this chapter.
Note: Form ATS-R does not and the amendments will not appear in
the Code of Federal Regulations.
OMB APPROVAL
OMB Number: 3235-0509
Expires: 8/31/2001
Estimated Average burden hours per form: 3.5
Form ATS-R--Quarterly Report of Alternative Trading System
Activities
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23. Section 249.821 and Form PILOT are added to read as follows:
Sec. 249.821 Form PILOT, information required of self-regulatory
organizations operating pilot trading systems pursuant to Sec. 240.19b-
5 of this chapter.
This form shall be used by all self-regulatory organizations, as
defined in section 3(a)(26) of the Act, (15 U.S.C 78c(a)(26)), to file
required information and reports with regard to pilot trading systems
pursuant to Sec. 240.I20240.19b-5 of this chapter.
Note: Form PILOT does not and the amendments will not appear in
the Code of Federal Regulations.
OMB APPROVAL
OMB Number: 3235-0507
Expires: 8/31/2001
Estimated Average burden hours per form: 6
Form PILOT--Initial Operation Report, Amendment to Initial
Operation Report and Quarterly Report for Pilot Trading Systems
Operated by Self-Regulatory Organizations
BILLING CODE 8010-01-M
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By the Commission.
Dated: December 8, 1998.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-33299 Filed 21-21-98; 8:45 am]
BILLING CODE 8010-01-C