[Federal Register Volume 62, Number 107 (Wednesday, June 4, 1997)]
[Proposed Rules]
[Pages 30485-30535]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-14284]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
Release No. 34-38672; International Series Release No. IS-1085;
File No. S7-16-97 Regulation of Exchanges
AGENCY: Securities and Exchange Commission.
ACTION: Concept release; request for comments.
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SUMMARY: The Securities and Exchange Commission (``SEC'' or
``Commission'') is reevaluating its approach to the regulation of
exchanges and other markets in light of technological advances and the
corresponding growth of alternative trading systems and cross-border
trading opportunities. Accordingly, the Commission is soliciting
comment on a broad range of questions concerning the oversight of
alternative trading systems, national securities exchanges, foreign
market activities in the United States, and other related issues.
Following receipt of public comment, the Commission will determine
whether rulemaking is appropriate.
DATES: Comments must be received on or before September 2, 1997.
ADDRESSES: Interested persons should submit three copies of their
written data, views, and opinions to Jonathan G. Katz, Secretary,
Securities and Exchange Commission, 450 Fifth Street, NW, Washington,
DC 20549. Comments may also be submitted electronically at the
following e-mail address: [email protected]. All comment letters
should refer to File No. S7-16-97; this file number should be included
on the subject line if comments are submitted using e-mail. All
submissions will be available for public inspection and copying at the
Commission's Public Reference Room, Room 1024, 450 Fifth Street, NW,
Washington DC 20549. Electronically submitted comment letters will be
posted on the Commission's Internet web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: For questions or comments regarding
this release, contact: Kristen N. Geyer, Special Counsel, at (202) 942-
0799; Gautam S. Gujral, Special Counsel, at (202) 942-0175; Marie
D'Aguanno Ito, Special Counsel, at (202) 942-4147; Paula R. Jenson,
Deputy Chief Counsel, at (202) 942-0073; or Elizabeth K. King, Special
Counsel, at (202) 942-0140, Division of Market Regulation, Securities
and Exchange Commission, Mail Stop 5-1, 450 Fifth Street, NW,
Washington, DC 20549. For questions or comments regarding corporate
disclosure and securities registration issues raised in this release,
contact David Sirignano, Associate Director, at (202) 942-2870,
Division of Corporation Finance, Securities and Exchange Commission,
Mail Stop 3-1, 450 Fifth Street, NW, Washington, DC 20549.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Executive Summary
A. Purpose of Concept Release
B. Alternatives for Revising Domestic Market Regulation
C. Alternatives for Revising Regulation Applicable to Foreign
Market Activities in the United States
D. Conclusion
II. Regulation of Domestic Markets
A. Technological Advances
B. Market Regulation
1. The Current Regulatory Approach Applies Inappropriate
Regulation to Alternative Trading Systems
2. The Current Regulatory Approach Impedes Effective Regulation
a. Market Access and Fairness
b. Market Transparency and Coordination
c. Market Surveillance
d. Market Stability and Systemic Risks
C. Conclusion
III. Approaches to Market Oversight
A. Regulatory Structure
B. Regulatory Tools
IV. Proposals Under Consideration to Integrate Alternative Trading
Systems into the Existing Regulatory Structure for Market Oversight
A. Integrating Alternative Trading Systems into the National
Market System Through Broker-Dealer Regulation
1. Fully Integrating the Orders of All Market Participants into
the Public Quotation System and Facilitating Public Access to Such
Orders
2. Improving the Surveillance of Trading Conducted on
Alternative Trading Systems
3. Ensuring Adequate Capacity of Alternative Trading Systems
4. Potential Problems with Regulating Alternative Trading
Systems Under the Broker-Dealer Regulatory Scheme
a. Alternative Trading Systems Would Not Be Subject to
Requirements Designed to Assure Fair Treatment of Investors
b. Broker-Dealers that Operate Alternative Trading Systems Will
Still Be Required to Comply with Potentially Inapplicable Regulation
and Be Subject to Oversight by SROs
c. Alternative Trading Systems Will Be Free to Engage in
Anticompetitive Activities
5. Conclusion
B. Integrating Alternative Trading Systems into Market
Regulation Through Exchange Regulation
1. Creating a New Category Called ``Exempted Exchanges'' for
Smaller and Passive Alternative Trading Systems
a. Low Impact Markets
b. Passive Markets
c. Requirements for Exempted Exchanges
2. The Application of Exchange Regulation to Alternative Trading
Systems That Are Not Exempted Exchanges
a. Using the Commission's Exemptive Authority to Encourage
Innovation and to Eliminate Barriers to Non-Traditional Exchanges
(i) The Commission Could Consider Permitting Institutional
Access to Exchanges
(ii) The Commission Could Consider Ways in Which Alternative
Exchanges Can Meet Fair Representation Requirements
3. Expanding the Commission's Interpretation of ``Exchange''
a. Effects of Expanding the Commission's Interpretation of
``Exchange'' on Selected Types of Alternative Trading Systems
(i) Broker-Dealer Activities
(ii) Organized Dealer Markets
(iii) Information Vendors and Bulletin Boards
(iv) Interdealer Brokers
4. Effect of Broadening the Definition of ``Exchange''
a. Regulation of Securities Trading on Alternative Trading
Systems
b. Integration with National Market System Mechanisms and
Existing Exchange Practices
[[Page 30486]]
(i) Inter-Market Plans
(A) Quotation and Transacting Reporting
(B) Intermarket Trading System
(ii) Uniform Trading Standards
c. Oversight of Non-Broker-Dealers That Have Access to Exchanges
and Clearance and Settlement of Non-Broker-Dealer Trades
d. Application of Broker-Dealer Regulation to Certain Exchanges
C. Conclusion
V. The Commission Could Consider Ways in Which Requirements Might Be
Reduced or Expedited for Registered Exchanges
A. Ways to Further Expedite Rule Filings
B. Surveillance and Enforcement
VI. Costs and Benefits of Revising the Regulation of Domestic
Markets
VII. Regulation of Foreign Market Activities in the United States
A. The Need for A Clear Regulatory Structure to Address U.S.
Investors' Electronic Cross-Border Trading
1. The Applicability of the U.S. Regulatory Structure to the
Activities of Access Providers Has Not Been Expressly Addressed
2. U.S. Investors' Ability to Trade Directly on a Foreign Market
And Investor Protection Concerns Under the Federal Securities Laws
B. Regulating Foreign Market Activities in the United States
1. Sole Reliance on Foreign Markets' Home Country Regulation
2. Requiring Foreign Markets to Register as National Securities
Exchanges
3. Regulating Access Providers to Foreign Markets
a. Access Providers to U.S. Members of Foreign Markets
b. Broker-Dealer Access Providers
c. Requirements Applicable to Access Providers
(i) Conditions Relating to the Type of Foreign Market
(ii) Conditions Relating to Type of Persons and Securities
(iii) Recordkeeping, Reporting, Disclosure, and Antifraud
Requirements
C. Addressing the Differences Between U.S. and Foreign Markets'
Listed Company Disclosure Standards
D. Costs and Benefits of Revising Regulation of Foreign Market
Activities in the United States
E. Conclusion
VIII. Summary of Requests for Comment
I. Executive Summary
A. Purpose of Concept Release
Stock markets play a critical role in the economic life of the
United States. The phenomenal growth of the U.S. markets over the past
60 years is a direct result of investor confidence in those markets.
Technological trends over the past two decades have also contributed
greatly to this success. In particular, technology has provided a
vastly greater number of investment and execution choices, increased
market efficiency, and reduced trading costs. These developments have
enhanced the ability of U.S. exchanges to implement efficient market
linkages and advanced the goals of the national market system
(``NMS'').
At the same time, however, technological changes have posed
significant challenges for the existing regulatory framework, which is
ill-equipped to respond to innovations in U.S. and cross-border
trading. Specifically, two key developments highlight the need for a
more forward-looking, flexible regulatory framework: (1) The
exponential growth of trading systems that present comparable
alternatives to traditional exchange trading; and (2) the development
of automated mechanisms that facilitate access to foreign markets from
the United States.
The Commission estimates that alternative trading systems
1 currently handle almost 20 percent of the orders
2 in over-the-counter (``OTC'') stocks and almost 4 percent
of orders in securities listed on the New York Stock Exchange
(``NYSE''). The explosive growth of alternative trading systems over
the past several years has significant implications for public
secondary market regulation. Even though many of these systems provide
essentially the same services as traditional markets, most alternative
trading systems are regulated as broker-dealers. As a result, they have
been subject to regulations designed primarily to address traditional
brokerage, rather than market activities. For example, these systems
are typically subject to oversight by self-regulatory organizations
(``SROs'') that themselves operate exchanges or quotation systems,
which raises inherent competitive concerns.
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\1\ Trading systems not registered as exchanges have been
referred to in previous Commission releases as ``proprietary trading
systems,'' ``broker-dealer trading systems,'' and ``electronic
communications networks.'' The latter two terms are defined in Rules
17a-23 and 11Ac1-1 under the Securities Exchange Act of 1934
(``Exchange Act''), 17 CFR 240.17a-23 and 240.11Ac1-1, respectively.
The term ``alternative trading systems'' will be used throughout
this release to refer generally to automated systems that
centralize, display, match, cross, or otherwise execute trading
interest, but that are not currently registered with the Commission
as national securities exchanges or operated by a registered
securities association.
\2\ For purposes of this release, the term ``order'' generally
means any firm trading interest, including both limit orders and
market maker quotations.
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At the same time, alternative trading systems are not fully
integrated into the national market system. As a result, activity on
alternative trading systems is not fully disclosed to, or accessible
by, public investors. The trading activity on these systems 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, nor do they have an obligation to ensure that they
have sufficient capacity to handle trading demand. These concerns
together with the increasingly important role of alternative trading
systems, call into question the fairness of current regulatory
requirements, the effectiveness of existing NMS mechanisms, and the
quality of public secondary markets.
The impact of technological change has not been limited to domestic
markets. Foreign markets, information vendors, and broker-dealers have
developed automated systems that enable U.S. persons to trade directly
on foreign markets from the United States. The Commission to date has
not addressed the regulatory status of entities that limit their
activities to providing U.S. investors access to foreign markets. As a
result, many foreign markets have been reluctant to provide these
services directly to U.S. investors. This has highlighted the need to
establish standards that can accommodate U.S. investors' growing
interest in cross-border trading, and better ensure that this type of
cross-border trading is subject to appropriate safeguards. At the same
time, improved foreign market access would mean that U.S. investors can
trade securities of companies listed solely on foreign markets as
easily as securities of companies that satisfy the Commission's
disclosure and reporting requirements. This would raise additional
questions as to how to craft a regulatory scheme that provides
sufficient information to investors about the securities they trade.
These and other questions raised by the application of the existing
regulatory approach to technologically changing markets are only likely
to multiply as technology facilitates ways of trading and enables the
creation of market structures that were unimaginable a few years ago.
In light of these issues, the Commission is now reevaluating its
regulation of the markets, particularly its oversight of alternative
trading systems, registered exchanges, and foreign market activities in
the United States. In doing so, the Commission seeks to develop a
forward-looking and enduring approach that will permit diverse markets
to evolve and compete, while preserving market-wide transparency,
fairness, and integrity. The issues raised by technology in the
domestic markets are summarized in Part B below and discussed in
greater detail in Sections II through VI. The issues raised by
technology in the foreign markets are summarized in Part
[[Page 30487]]
C below and discussed in greater detail in Section VII of this release.
B. Alternatives for Revising Domestic Market Regulation
The questions raised by technological developments in the U.S.
markets could be addressed in a variety of ways. As an initial matter,
the Commission is soliciting comment on whether the current statutory
and regulatory framework remains appropriate in light of the myriad new
means of trading securities made possible by emerging and evolving
technologies. The Commission is also soliciting comment on alternative
ways of addressing these issues within the existing securities law
framework. The release discusses two alternatives in particular that
would integrate alternative trading systems more fully into mechanisms
that promote market-wide transparency, investor protection, and
fairness.
First, the Commission could continue to regulate alternative
trading systems as broker-dealers and develop rules applicable to these
systems, and their supervising SROs that would more actively integrate
these systems into NMS mechanisms. The Commission could, for example,
require alternative trading systems to provide additional audit trail
information to SROs, to assist SROs in their surveillance functions,
and to adopt standard procedures for ensuring adequate system capacity
and the integrity of their system operations. The Commission could then
require SROs to integrate trading on alternative trading systems into
their ongoing, real-time surveillance for market manipulation and
fraud, and to develop surveillance and examination procedures
specifically targeted to alternative trading systems they supervise. In
addition, the Commission could require alternative trading systems to
make all orders in their systems available to their supervising SROs,
and require such SROs to incorporate those orders into the public
quotation system. The Commission could also require that alternative
trading systems provide the public with access to these orders on a
substantially equivalent basis as provided to system participants.
Alternatively, the Commission could integrate alternative trading
systems into the national market system as securities exchanges, by
adopting a tiered approach to exchange regulation. The first tier,
under this type of approach, could consist of the majority of
alternative trading systems, those that have limited volume or do not
establish trading prices, which could be exempt from traditional
exchange requirements. For example, exempt exchanges could be required
to file an application and system description with the Commission,
report trades, maintain an audit trail, develop systems capacity and
other operational standards, and cooperate with SROs that inspect their
regulated participants. Most alternative trading systems currently
regulated as broker-dealers would be exempt exchanges.
The second tier of exchanges under this approach could consist of
alternative trading systems that resemble traditional exchanges because
of their significant volume of trading and active price discovery.
These systems could be regulated as national securities exchanges. The
Commission could then use its exemptive authority to eliminate barriers
that would make it difficult for these non-traditional markets to
register as exchanges, by exempting such systems from any exchange
registration requirements that are not appropriate or necessary in
light of their business structure or other characteristics. For
example, the Commission could exempt alternative trading systems that
register as exchanges from requirements that exchanges have a
traditional membership structure, and from requirements that limit
exchange participation to registered broker-dealers. The Commission
could also use its exemptive authority to reduce or eliminate those
exchange requirements that are incompatible with the operation of for-
profit, non-membership alternative trading systems.
This approach could integrate these alternative trading systems
more fully into NMS mechanisms and the plans governing those systems,
potentially by requiring these systems to become members of those
plans. 3 Because alternative trading systems differ in
several key respects from currently registered exchanges, this could
require revision of those plans in order to accommodate diverse and
evolving trading systems.
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\3\ See infra notes 162 to 175 and accompanying text.
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Finally, a third tier of exchanges, consisting of traditional
membership exchanges, could continue to be regulated as national
securities exchanges. The Commission could then use its exemptive
authority to reduce overall exchange requirements. In this regard, the
Commission is considering ways to reduce unnecessary regulatory
requirements that make it difficult for currently registered exchanges
to remain competitive in a changing business environment. The
Commission, for example, could further accelerate rule filing and
approval procedures for national securities exchanges and securities
associations, and allow fully automated exchanges to meet their
regulatory requirements in non-traditional ways.
One way for the Commission to implement this tiered approach would
be to expand its interpretation of the definition of ``exchange.'' For
example, the Commission could reinterpret the term ``exchange'' to
include any organization that both: (1) Consolidates orders of multiple
parties; and (2) provides a facility through which, or sets material
conditions under which, participants entering such orders may agree to
the terms of a trade.
C. Alternatives for Revising Regulation Applicable to Foreign Market
Activities in the United States
The questions raised by the activities of foreign markets in the
United States could also be addressed in a number of ways. As an
initial matter, any proposal should address questions about the lack of
comparable information about securities of non-reporting foreign
companies. In addition, any approach to regulating access to foreign
markets from the U.S. should address the issue of whether sufficient
information is disclosed to U.S. investors regarding the risks of
trading on foreign markets and whether the Commission has the ability
to enforce the antifraud provisions of the U.S. securities laws.
This release describes a number of different ideas for addressing
foreign market activity in the United States, including applying
traditional exchange regulation to foreign markets that seek to enter
the United States. At the other extreme, the Commission could rely
solely on home country regulation of the foreign market. Alternatively,
the Commission could take an intermediate approach by establishing
regulatory requirements for entities that provide U.S. persons with
direct access to foreign markets (``access providers''), regardless of
whether the entity is the foreign market itself, a broker-dealer, or
another service provider. Such access providers could be required to
comply with limited recordkeeping, reporting, and disclosure
requirements, as well as the antifraud provisions of the federal
securities laws.
Under this type of approach, an access provider that provides a
U.S. member of a foreign market with direct access to that foreign
market's trading facilities would register as a securities information
processor (``SIP'') under section 11A of the Exchange Act. Foreign
markets, information vendors,
[[Page 30488]]
and other access providers could be required to register as SIPs, or to
conduct their U.S. activities through another registered SIP. As a
condition of registration, SIPs could also be limited to trading
foreign securities that are registered with the Commission under the
Exchange Act or limited to dealing with sophisticated parties.
Broker-dealers that act as access providers could be required to
comply with the same, limited recordkeeping, reporting, disclosure, and
antifraud requirements as SIPs. The Commission could also permit
broker-dealer access providers to provide both retail and sophisticated
investors with electronic links to foreign markets, and to provide such
links to foreign markets that trade U.S. and foreign securities,
regardless of whether those securities are registered with the
Commission. This approach might provide adequate protections to U.S.
investors trading on foreign markets, while facilitating greater
transparency.
In creating an appropriate regulatory scheme to address U.S.
investor access to unregistered foreign securities, the Commission
seeks to balance the desire to craft a forward-looking and enduring
approach to the oversight of the securities markets with concerns that
U.S. investors have access to full and complete disclosure about the
securities they trade. The Commission has been working directly with
fellow regulators around the world on a variety of initiatives to
improve the efficiency of cross-border capital flows.
D. Conclusion
Regulation should not be static. Changes in the markets should be
accompanied by corresponding changes in market regulation. In light of
the rapid pace of technological advancements during the past two
decades, it is critical to develop a regulatory framework that both
accommodates traditional market structures and provides sufficient
flexibility to ensure that markets of the future promote fairness,
efficiency, and transparency. The purpose of this release is to
facilitate a dialogue as to how this can best be achieved.
II. Regulation of Domestic Markets
A. Technological Advances
Securities markets serve several basic functions that are critical
to facilitating investment and, as a result, materially influence the
long-term financial security of a large segment of the
population.4 For example, markets provide the forum for
individuals to invest in securities and for financial instruments to be
readily converted into cash when needed. Securities markets also serve
as a fundamental indicator of national and international economic
health, in part because they reveal investors' judgments about the
potential earning capacity of corporations.5 They help to
raise and efficiently allocate capital by providing a reliable means of
valuing assets and facilitating the flow of capital into private
enterprise. They also allocate capital toward productive uses by
providing a forum where stocks can compete for investment
dollars.6 U.S. securities markets have been highly
successful at fulfilling these functions and are consistently the
world's largest, most liquid, efficient, and fair.7
Moreover, U.S. markets have continued to attract foreign listings and
investors even as other markets become more competitive.8
This success has come about, in part, because the strength and
stability of U.S. markets have allowed people throughout the world to
feel confident investing a large percentage of their personal wealth in
the future of companies trading on those markets.
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\4\ See generally 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, at 9 (1963) (hereinafter
Special Study).
\5\ Essentially, securities markets centralize information about
buying and selling interest, either by physically or electronically
centralizing order interaction, or by centralizing quote and trading
information. Because of this interaction of supply and demand, a
stock price is considered by many to be the best estimate by
investors of the present value of a company's future earnings. As a
result of such beliefs, stock prices influence investment
calculations, the allocation of resources, company business
decisions, and economic planning. See 2 Thomas Lee Hazen, Treatise
on the Law of Securities Regulation, Sec. 10.1, at 4 (3d ed. 1995);
U.S. Congress, Office of Technology Assessment, Pub. No. OTA-CIT-
469, Electronic Bulls & Bears: U.S. Securities Markets & Information
Technology at 3, 26 (1990) (hereinafter Electronic Bulls & Bears).
See generally Jack Clark Francis, Investment Analysis and Management
57, 196-97 (4th ed. 1986).
\6\ See generally ELECTRONIC BULLS & BEARS, supra note 5, at ch.
2; Francis, supra note 5, at 57.
\7\ As of December 31, 1996, there were 3,530 securities trading
on the NYSE, representing 2907 NYSE-listed companies. Market Records
Shattered in 1996, The Exchange (NYSE), Jan./Feb. 1997, at 1-2. In
addition, as of December 31, 1996, the Nasdaq Stock Market
(``Nasdaq'') listed over 6300 stocks of 5556 companies, and dollar
volume on that market has grown to almost equal that of the NYSE.
Conversation with staff of Corporate Communications, National
Association of Securities Dealers, Inc. (``NASD'') (Feb. 21, 1997).
In 1996, the average daily share volume on Nasdaq was 543,839,000
shares and the total dollar volume was $3,301.8 billion. During that
same period, the NYSE's average daily share volume was 409,893,000
shares and its total dollar volume was $4,063.7 billion. See Market
Records Shattered in 1996, The Exchange (NYSE), Jan./Feb. 1997, at
1-2.
\8\ Both the NYSE and Nasdaq have experienced significant growth
in foreign company listings. Foreign company listings on the NYSE
increased from 106 in 1991 to 290 as of the end of 1996. Similarly,
foreign listings on Nasdaq increased from 185 in 1991 to 320 as of
the end of 1996. Conversation with staff of NYSE (Feb. 21, 1997);
Conversation with staff of Corporate Communications, NASD (Feb. 21,
1997); New York Stock Exchange, Inc., 1995 Annual Report 3 (1995);
National Association of Securities Dealers, Inc., 1996 Nasdaq Fact
Book 37 (1996).
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The ability of U.S. markets to use technology to increase
efficiency, reduce the costs of trading, and respond to changing
investor demands has also contributed significantly to the success of
our markets. Over the past three decades, technology has transformed
U.S. markets. Investors, particularly the growing institutional
investor base, now have numerous alternatives to traditional exchange
trading and the OTC market. Similarly, market participants (including
broker-dealers, issuers, and service providers) have integrated
technological advancements into their trading and marketing
activities.9 For example, some broker-dealers have made
communications with retail customers more efficient by offering various
services through the Internet.10
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\9\ See, e.g., Letter from Catherine McGuire, Chief Counsel,
Division of Market Regulation, SEC, to Jere W. Glover, Chief Counsel
for Advocacy, U.S. Small Business Administration, and Gregory J.
Dean, Jr., Assistant Chief Counsel for Banking and Finance, U.S.
Small Business Administration (Oct. 26, 1996); Letter from Catherine
McGuire, Chief Counsel, Division of Market Regulation, SEC, to Bruce
D. Stuart, Esq. (Aug. 5, 1996); and Letter from Catherine McGuire,
Chief Counsel, Division of Market Regulation, SEC, to Barry Reder,
Esq. (June 24, 1996).
\10\ See Arthur M. Louis, Schwab Plays Catchup: Broker Faces
Tough Internet Competition, S.F. Chron., Nov. 26, 1996, at C1. See
also Letter from Richard R. Lindsey, Director, Division of Market
Regulation, SEC, to Scott W. Campbell, Vice President and Associate
General Counsel, Charles E. Schwab & Co. (Nov. 27, 1996).
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As technology has broadened the services that can be delivered by
both markets and market intermediaries, market services have become
unbundled from traditional brokerage or exchange services. While some
entities that perform brokerage services have also begun to perform
some of the traditional functions of a stock exchange, other entities
(including information vendors, service bureaus, and routing services)
now provide many of the services historically provided by exchanges and
broker-dealers. One significant example of this has been the
development and growing popularity of alternative trading systems, such
as the Real-Time Trading Service operated by Instinet Corporation
(``Instinet''), The Island System (``Island''),11 Portfolio
System
[[Page 30489]]
for Institutional Trading (``POSIT''),12 and the Arizona
Stock Exchange (``AZX''),13 which allow institutions and
other market participants to electronically execute trades in a variety
of ways.14 These and other alternative trading systems have
grown to account for a significant percentage of the trading volume of
the U.S. securities markets, particularly within the last five years.
In 1994, the Commission's Division of Market Regulation reported that
alternative trading systems accounted for 13 percent of the volume in
Nasdaq securities and 1.4 percent of the trading volume in NYSE-listed
securities.15 In comparison, the Commission estimates that
alternative trading systems currently handle almost 20 percent of the
orders in Nasdaq securities and almost 4 percent of orders in NYSE-
listed stocks.
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\11\ Island is operated by Datek Securities Corp., a registered
broker-dealer. Island, Instinet, and other ``matching'' systems
(such as Tradebook, which is operated by Bloomberg Tradebook LLC)
allow participants to display firm, priced orders to other
participants and to execute automatically against other orders in
the system.
\12\ POSIT is operated by ITG Inc., a registered broker-dealer.
POSIT and other ``crossing'' systems allow participants to enter
unpriced orders, which are then executed with matching interest at a
single price, typically derived from the primary public market for
each crossed security.
\13\ AZX and other ``single-price auction'' systems allow
participants to enter priced orders, which the system then compares
to determine the single price at which the largest volume of orders
can be executed. All orders are then matched and executed at that
price.
\14\ In addition to these systems, more than 140 broker-dealers
have notified the Commission that they operate some type of
alternative trading system, either internally for their own traders
or for their customers and other market participants. Registered
broker-dealers that operate or otherwise sponsor alternative trading
systems are required to comply with periodic reporting and
recordkeeping requirements pursuant to Rule 17a-23 under the
Exchange Act. 17 CFR 240.17a-23. See generally Division of Market
Regulation, Market 2000: An Examination of Current Equity Market
Developments app. IV (1994) (hereinafter Market 2000 Study) (general
description of proprietary trading systems).
\15\ See Market 2000 Study, supra note 14, at Study II-13.
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Technology has also significantly altered the operation of exchange
and OTC markets. For example, most exchanges have designed systems that
allow members to route orders electronically to the exchange for
execution.16 The NYSE has also established after-hours
crossing systems that automate the execution of single stock orders and
baskets of securities,17 and the Cincinnati Stock Exchange
(``CSE'') is now a fully automated exchange where members effect
transactions through computers located in their own
offices.18 Dealer markets have been similarly transformed.
Dealer markets traditionally consisted of loosely organized groups of
individual dealers that traded securities OTC, without formal
consolidation of orders or trading. As individual dealers and
associations of dealers have employed technology to make OTC markets
more efficient, however, dealer markets in certain instruments have
become organized to such an extent that they have assumed many of the
characteristics of exchange markets. This is particularly true in
markets that trade instruments that are also listed on registered
exchanges. For example, the Nasdaq market, operated by the National
Association of Securities Dealers, Inc. (``NASD''), consolidates
trading interest of multiple dealers on a computer screen that is
displayed in real-time to its members and provides a mechanism for
dealers to update displayed quotations.19 Additional
services, such as SelectNet, allow dealers in the Nasdaq market to
trade electronically. Through this technology, the NASD has been able
to coordinate the dealer market more efficiently.
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\16\ The NYSE's SuperDOT (Designated Order Turnaround) system
enables firms to transmit market and limit orders in all NYSE-listed
securities directly to the specialist post for execution. Some NYSE
members also allow selected institutional customers to route their
orders through the members' connection to SuperDOT. Similar systems
are operated by the following exchanges: the American Stock Exchange
(``Amex'') (Automated Post Execution Reporting System, or AutoPERS),
the Boston Stock Exchange (``BSE'') (BSE Automated Communication and
Order Routing Network, or BEACON), the Chicago Board Options
Exchange (``CBOE'') (the RAES system), the Chicago Stock Exchange
(``CHX'') (Midwest Automatic Execution System, or MAX), the Pacific
Exchange (``PCX'') (Pacific Computerized Order Access System, or P/
COAST), and the Philadelphia Stock Exchange (``Phlx'') (Phlx
Automated Communication and Execution System, or PACE).
\17\ See Securities Exchange Act Release No. 29237 (May 24,
1991), 56 FR 24853 (May 31, 1991); Securities Exchange Act Release
No. 32368 (May 25, 1993), 58 FR 31565 (June 3, 1993).
\18\ First organized in 1884, the CSE initially operated with a
physical trading floor which it began phasing out in 1976. SEC,
Report on the Practice of Preferencing Pursuant to Section 510(c) of
the National Securities Markets Improvement Act of 1996, 24 (1997)
(hereinafter Preferencing Report).
\19\ Like exchange markets, the NASD imposes obligations on
market makers to provide a continuous source of liquidity for
Nasdaq-traded securities, establishes minimum qualifications that
issuers must meet in order for their securities to be quoted on the
consolidated computer screen, and sets enforceable rules that govern
the priorities dealers must give to certain orders.
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Overall, these developments have benefited investors by increasing
efficiency and competition, reducing costs, and spurring further
technological advancement of the entire market. In particular, for
those market participants that have access to alternative trading
systems, these systems have provided opportunities for the direct
execution of orders without the active participation of an
intermediary. Alternative markets are likely to grow as technology
continues to drive the evolution of the equity markets.
B. Market Regulation
Whether trading electronically or through human intervention,
investors are more likely to trade on a market when prices are current
and reflect the value of securities, when they are confident that they
will be able to buy and sell securities easily and inexpensively, and
when they believe that they can trade on a market without being
defrauded or without other investors having an unfair advantage. The
competition for global investment capital among the world's exchanges
and the many opportunities available to U.S. and foreign investors make
it more important than ever for U.S. exchanges to protect these
investor interests in order to attract order flow. Appropriate
regulation is often necessary to protect these interests, by helping to
ensure fair and orderly markets, to prevent fraud and manipulation, and
to promote market coordination and competition for the benefit of all
investors.20
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\20\ Experience in both the United States and world markets has
repeatedly shown that commercial incentives alone are insufficient
to protect investors adequately and ensure fair markets. In adopting
the Exchange Act, Congress noted that, however zealously exchange
authorities may supervise the business conduct of their members, the
interests with which they are connected frequently conflict with the
public interest. H.R. Rep. No. 1383, 73rd Cong., 2d Sess. at 4
(1934); S. Rep. No. 792, 73rd Cong., 2d Sess. (1934). See also 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) (hereinafter Future Structure Statement). Legislative
history to key Exchange Act amendments adopted in 1975 also points
to the need for regulation. See, e.g., S. Rep. No. 75 and H.R. Rep.
No. 229, infra note 22. See also SEC, Report Pursuant to Section
21(a) of the Securities Exchange Act of 1934 Regarding the NASD and
the Nasdaq Market (1996) (hereinafter NASD 21(a) Report).
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In the United States, Congress decided that these goals should be
achieved primarily through the regulation of exchanges and through
authority it granted to the Commission in 1975 (``1975 Amendments'')
21 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.22 In promulgating the Exchange
Act, Congress gave the Commission means to achieve these and other
goals of regulation,23 by requiring
[[Page 30490]]
every market that meets the definition of ``exchange'' under the
Exchange Act to either register as a national securities exchange or be
exempted from registration on the basis of limited transaction
volume.24 Congress also gave the exchanges authority to
enforce their members' compliance with the goals of the securities laws
and, in 1983, required every broker-dealer to become a member of an
exchange 25 or securities association.26 As SROs,
every registered exchange and securities association is required to
assist the Commission in assuring fair and honest markets, to have
effective mechanisms for enforcing the goals of regulation, and to
submit their rules for Commission review. This statutory structure has
given the Commission ample authority to oversee securities markets and
ensure compliance with the Exchange Act. Although regulation cannot
prevent all manipulation, fraud, or collusion, it has proven effective
in ridding markets of the most egregious of these practices and
consequently in inspiring a high degree of investor confidence.
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\21\ Pub. L. No. 29, 89 Stat. 97 (1975).
\22\ See S. Rep. No. 75, 94th Cong., 1st Sess. 8 (1975); H.R.
Rep. No. 229, 94th Cong., 1st Sess. 92 (1975). See also Exchange Act
section 11A(a)(1), 15 U.S.C. 78k-1(a)(1).
\23\ Congress also directed the Commission in the 1975
Amendments to advance the concept of equal regulation so that
persons enjoying similar privileges, performing similar functions,
and having similar potential to affect markets would be treated
equally. The Commission was charged with ensuring that no member or
class of members had an unfair advantage over other members as a
result of a disparity in regulation not necessary or appropriate to
further the objectives of the Exchange Act. See H.R. Rep. No. 229,
supra note 22.
\24\ There are currently eight registered national securities
exchanges and one exempted exchange. AZX (formerly known as Wunsch
Auction Systems) was exempted from the registration requirements of
Sections 5 and 6 of the Exchange Act, 15 U.S.C. 78e and 78f, based
on the exchange's expected limited volume in trading of securities.
See Securities Exchange Act Release No. 28899 (Feb. 20, 1991), 56 FR
8377 (Feb. 29, 1991) (hereinafter AZX Exemptive Order). See also
Securities Exchange Act Release No. 37271 (June 3, 1996), 61 FR
29145 (June 7, 1996).
\25\ Markets operated by registered securities associations
serve many of the same functions as exchanges. Registered securities
associations are regulated under section 15A of the Exchange Act, 15
U.S.C. 78o-1, and are subject to requirements that are virtually
identical to those applicable to registered exchanges under the
Exchange Act.
\26\ See Pub. L. No. 38, 97 Stat. 205 (1983).
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As a result of the technologically-driven developments discussed
above, however, the distinctions among market service providers have
become blurred, making it more difficult to determine whether any
particular entity operates as an exchange, OTC market, broker, or
dealer. For example, alternative trading systems incorporate features
of both traditional markets and broker-dealers. Like traditional
exchanges, alternative trading systems centralize orders and give
participants control over the interaction of their orders. Like
traditional broker-dealers, alternative trading systems are proprietary
and, in some cases, maintain trading desks that facilitate participant
trading. Because the activities of alternative trading systems include
both traditional exchange and broker-dealer functions, it is often
unclear whether such systems should register as exchanges, broker-
dealers, or both. Under the existing statutory structure enacted by
Congress, however, exchanges and broker-dealers are subject to
significantly different obligations and responsibilities.
To date, the Commission has regulated many alternative markets as
broker-dealers, rather than as exchanges, in order to foster the
development of innovative trading mechanisms within the existing
statutory framework.27 The determination as to whether any
particular alternative trading system should be regulated as an
exchange or broker-dealer has been decided on a case-by-case
basis.28 This regulatory approach has had two significant,
unintended effects: (1) It has subjected alternative trading systems to
a regulatory scheme that is not particularly suited to their market
activities; and (2) it has impeded effective integration, surveillance,
enforcement, and regulation of the U.S. markets as a whole.
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\27\ See infra notes 120 to 124 and accompanying text.
\28\ Since 1991, the Commission staff has given operators of
trading systems assurances that it would not recommend enforcement
action if those systems operated without registering as exchanges.
As a result, to date, many automated trading markets have not been
required to register as exchanges and have instead been regulated as
broker-dealers. 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) (``Rule 17a-
23 Proposing Release''). See also Letters from the Division of
Market Regulation to: Tradebook (Dec. 31, 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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1. The Current Regulatory Approach Applies Inappropriate Regulation to
Alternative Trading Systems
As broker-dealers, alternative trading systems are subject to
regulation designed primarily to address traditional brokerage
activities rather than market activities.29 For example,
broker-dealers are required to become members of the Securities
Investor Protection Corporation (``SIPC''). While this membership is
designed to protect customer funds and securities held by brokers, few
alternative trading systems hold customer funds or
securities.30 In addition, broker-dealers are required to be
members of an SRO. Thus, alternative trading systems are subject to
oversight by exchanges and the NASD, which operate their own markets.
Because these markets often compete with alternative trading systems
for order flow, there is an inherent conflict between SROs' competitive
concerns as markets and their regulatory obligations to oversee
alternative trading systems.
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\29\ Broker-dealers have a responsibility under the Exchange Act
for ensuring their own (and their employees') compliance with the
federal securities laws and with the rules of all relevant SROs.
Broker-dealer requirements generally focus on ensuring adequate
employee supervision, financial responsibility and sufficient
capital, and fair dealing with customers, including protection of
customers' securities and funds, and monitoring sales practices.
\30\ Rather than hold customer funds or securities, most
alternative trading systems require their customers to arrange for
trades executed on the system to be cleared through another broker-
dealer. See, e.g., Letter from Brandon Becker, Director, Division of
Market Regulation, SEC, to Lloyd H. Feller, Esq., Morgan, Lewis &
Bockius (Sep. 9, 1993) (Lattice trading system to have trades
cleared and settled by a registered broker-dealer designated by
respective system participants); Letter from Larry E. Bergmann,
Associate Director, Division of Market Regulation, SEC, to Larry E.
Fondren, Intervest Financial Services, Inc. (Nov. 24, 1992)
(CrossCom Trading Network to use WFS Clearing Services, Inc.);
Letter from William H. Heyman, Director, Division of Market
Regulation, SEC, to Daniel T. Brooks, Cadwalader, Wickersham & Taft
(Nov. 25, 1991) (LIMITrader to use Mabon Securities Corp. as its
initial clearing broker); and Letter from William H. Heyman, (then)
Deputy Director, Division of Market Regulation, SEC, to Richard S.
Soroko, Esq., Lippenberger, Thompson & Welch (May 16, 1991)
(Portfolio Trading Services, Inc. to use Ernst & Company as its
clearing broker).
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Regulating alternative trading systems as traditional broker-
dealers, therefore, requires compliance by these systems with
obligations that, in many cases, are not pertinent to their principal
activities. As discussed below, traditional broker-dealer regulation
also fails to address concerns raised by alternative trading systems'
market activities.
2. The Current Regulatory Approach Impedes Effective Regulation
The Commission has repeatedly evaluated whether the case-by-case
no-action approach has permitted adequate Commission oversight of
secondary trading markets, particularly in light of the growth and
evolving market significance of such systems. Prior to 1993, the low
volume and relatively small number of alternative trading systems
appeared to justify such an approach. In 1993, for example, in an
attempt to evaluate the effects of regulating alternative trading
systems as broker-dealers, the Commission's Division of Market
Regulation conducted a study of the U.S. equity markets.31
This study concluded that, at that time, the Commission did not have
sufficient regular information to
[[Page 30491]]
evaluate the effects of alternative trading systems on the U.S.
securities markets. Therefore, the Division of Market Regulation
recommended that the Commission closely monitor the impact of the
proliferation of such systems. In response to this recommendation, the
Commission adopted a recordkeeping and reporting rule, Rule 17a-23,
specifically for broker-dealers that operate alternative trading
systems.32
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\31\ See Market 2000 Study, supra note 14.
\32\ 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 activity to the Commission 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).
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Because traditional broker-dealer regulation is not designed to
apply to markets such as alternative trading systems, gaps have
developed in the structures designed to ensure marketwide fairness,
transparency, integrity, and stability. As discussed in greater detail
below, the regulation of the most significant alternative trading
systems under traditional broker-dealer regulation calls into question
the accuracy of public quotation and trade information, and the
fairness of the public secondary markets.33 In addition,
such regulation may impair the detection and elimination of fraudulent
and manipulative trading, and the mechanisms to ensure fair and
equitable oversight and competition among markets.
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\33\ Commenters have repeatedly suggested that the regulatory
disparity between exchanges and broker-dealers gives a competitive
advantage to alternative trading systems. Concern about this
regulatory dichotomy has been voiced by many commenters. Industry
and congressional commenters at various times since 1991 have
questioned whether regulating alternative trading systems
differently from exchanges is advisable. The NYSE, for example, has
stated that: ``[R]egulation of participants in our securities
markets should be governed by the principle of ``functional
regulation'': entities that perform similar functions should be
subject to similar regulation * * * firms that establish a market
place for providing execution of transactions in securities pursuant
to their own trading rules should be regulated in a manner similar
to exchanges, regardless of whether they are also brokers and
dealers. The name given an entity should not control the manner in
which it is regulated.'' Testimony of Edward A. Kwalwasser, Exec.
V.P., NYSE, before the Telecommunications and Finance Subcommittee,
Committee on Energy and Commerce, U.S. House of Representatives, at
5-6 (May 26, 1993) (hereinafter Testimony of Edward A. Kwalwasser).
---------------------------------------------------------------------------
a. Market Access and Fairness
While institutional investors are now the dominant players in U.S.
financial markets,34 the United States still has the highest
percentage of direct individual participation in the stock
markets.35 Because the needs and interests of small
individual investors, money managers, wealthy speculators, and large
pension plans are not always the same,36 market regulation
is intended to ensure that these diverse investors are treated fairly
and have fair access to investment opportunities.
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\34\ In 1960, institutions owned only 14.2 percent of the total
$425 billion outstanding U.S. equity securities. By the end of the
third quarter of 1996, the percentage had grown to 52.3% of the
total $9,387 billion of outstanding U.S. equity securities.
Conversation with staff of the Securities Industry Association (Feb.
21, 1997).
\35\ From 1989 to 1995, the percentage of U.S. households having
direct or indirect stock holdings jumped from 31.7% to over 41%. See
Arthur B. Kennickell and Annika E. Sunden, Family Finances in the
U.S.: Recent Evidence from the Study of Consumer Finances, Fed.
Reserve Bull., Jan. 1997, at 1.
\36\ Electronic Bulls & Bears, supra note 5, at 29.
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Specifically, the Exchange Act requires registered exchanges and
securities associations to consider the public interest in
administering their markets, to allocate reasonable fees
equitably,37 and to establish rules designed to admit
members fairly.38 While these provisions are based on the
principle that qualified market participants should have fair access to
the nation's securities markets, they are not intended to limit
exchanges from having reasonable standards for access.39
Rather, fair access requirements are intended to prohibit unreasonably
discriminatory denials of access. A denial of access would be
reasonable, for example, if it were based on unbiased standards, such
as capital and credit requirements, and if these standards were applied
fairly.
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\37\ Exchange Act section 6(b)(4), 15 U.S.C. 78f(b)(4); Exchange
Act section 15A(b)(5), 15 U.S.C. 78o-3(b)(5).
\38\ Exchange Act sections 6(b)(2) and 6(c), 15 U.S.C. 78f(b)(2)
and (c); Exchange Act section 15A(b)(8); 15 U.S.C. 78o-3(b)(8).
\39\ ``[R]estraints 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).
---------------------------------------------------------------------------
The Exchange Act also requires registered exchanges and securities
associations to establish rules that assure fair representation of
members and investors in selecting directors and administering their
organizations.40 The purpose of this requirement is to
protect the rights and interests of the diverse members of registered
exchanges and securities associations. In addition, because registered
exchanges and securities associations are also SROs, they exercise
governmental powers, such as the imposition of disciplinary sanctions
on their members. Fair representation on the body responsible for
disciplining members is, therefore, critical to the impartial
enforcement of SRO rules.
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\40\ Exchange Act section 6(b)(3), 15 U.S.C. 78f(b)(3); Exchange
Act section15A(b)(4), 15 U.S.C. 78o-3(b)(4).
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Market regulation is also designed to remove barriers to fair
competition, by prohibiting the rules of registered exchanges and
securities associations from being anticompetitive,41 and by
providing for Commission review of the rules of registered exchanges
and securities associations.42 To further emphasize the goal
of vigorous competition, Congress required the Commission to consider
the competitive effects of exchange rules,43 as well as the
Commission's own rules.44
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\41\ Exchange Act section 6(b)(8), 15 U.S.C. 78f(b)(8); Exchange
Act section 15A(b)(9), 15 U.S.C. 78o-3(b)(9).
\42\ Exchange Act section 19(b)(1), 15 U.S.C. 78s(b)(1). See
infra notes 188 to 205 and accompanying text (discussion of
obligations of exchanges and securities associations to file rules
and rule changes with the Commission).
\43\ Exchange Act sections 6(b)(6), 15 U.S.C. 78f(b)(6).
\44\ Exchange Act section 23(a), 15 U.S.C. 78w(a)(2).
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The Commission's authority to review the actions of registered
exchanges and securities associations has prevented the implementation
of numerous rules that would have been anticompetitive or otherwise
detrimental to the market. For example, in December 1990, the American
Stock Exchange (``Amex'') submitted a rule proposal to the Commission
that would have excluded the orders of competing dealers (i.e.,
regional exchange specialists and third market makers) from its order
routing system and would have imposed trading restrictions on competing
dealers in Amex securities. Because the exclusions and restrictions
applied only to competing dealers and not to other off-floor broker-
dealers trading for their own accounts, the proposal raised market
access and competitive concerns.45 After receiving numerous
negative public comments regarding the Amex's proposal, the Commission
staff recommended that the Amex either amend or withdraw the
proposal.46 Similarly, several exchanges have proposed
prohibiting customer orders from being executed through the
[[Page 30492]]
exchanges' automated systems for guaranteed execution of small customer
orders, if those customers used computer and communications technology
to generate and transmit those orders. Such a proposal, if implemented,
would have had the effect of discouraging the use of new, innovative
technology. The tendency to try to discourage innovation in order to
protect existing practices is not new. In 1987, for example, the
Commission set aside the NYSE's denial of the requests of two of its
members for permission to install telephone connections on the floor to
enable the members to communicate with their customers.47
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\45\ Securities Exchange Act Release No. 28741 (Jan. 3, 1991),
56 FR 1038 (Jan. 10, 1991). The proposal would have required that
orders for the account of competing dealers: (1) Yield priority and
parity to all other off-floor orders; (2) accept parity with orders
for an account of an Amex specialist; and (3) be excluded from the
Amex's order routing system, the Post Executions Reporting system.
The Amex subsequently amended its proposal. Securities Exchange Act
Release No. 30161 (Jan. 7, 1992), 57 FR 1502 (Jan. 14, 1992).
\46\ See Market 2000 Study, supra note 14, at app. III, at 11.
In 1994, the Amex withdrew its proposal.
\47\ See In the Matter of the Application of William J. Higgins
and Michael D. Robbins, Admin. Proc. No. 3-6609, Securities Exchange
Act Release No. 24429 (May 6, 1987).
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The fair access and treatment requirements in the Exchange Act are
intended to ensure that exchanges and securities associations operating
markets treat investors and their participants fairly. Under the
current regulatory approach, however, there is no regulatory redress
for unfair denials or limitations of access by alternative trading
systems, or for unreasonably discriminatory actions taken against, or
retaliatory fees imposed upon, participants in these systems. The
availability of redress for such discriminatory actions may not be
critical when alternative trading systems disclose any discriminatory
practices to their participants and 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 no other
serious competitor, such as when it has a significantly large
percentage of the volume of trading, discriminatory actions may be
anticompetitive because market participants must use such trading
system to remain competitive. Similarly, significant changes in the
operations of alternative trading systems are not subject to either
Commission or SRO review--even those changes that may be
anticompetitive, unfair to a particular group of market participants,
or that have significant effects on the primary public markets.
b. Market Transparency and Coordination
Securities markets have become increasingly interdependent because
of the opportunities technology provides to link products, implement
complex hedging strategies across markets, and trade on multiple
markets simultaneously. While these opportunities benefit many
investors, they can also create misallocations of capital, widespread
inefficiency, and trading fragmentation if markets do not coordinate.
Moreover, a lack of coordination among markets can increase system-wide
risks. Congress adopted the 1975 Amendments, in part, to address these
potential negative effects of a proliferation of markets.48
In the 1975 Amendments, Congress specifically endorsed the development
of a national market system, and sought to clarify and strengthen the
Commission's authority to promote the achievement of such a system.
Because of uncertainty as to how technological and economic changes
would affect the securities markets, Congress explicitly rejected
mandating specific components of a national market system.49
Instead, Congress granted the Commission ``maximum flexibility in
working out the specific details'' and ``broad discretionary powers''
to implement the development of a national market system in accordance
with the goals of the 1975 Amendments.50 The SROs and the
Commission have worked hard to achieve these goals. 51
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\48\ See generally S. Rep. No. 75 and H.R. Rep. No. 229, 94th
Cong., supra note 22.
\49\ S. Rep. No. 75, supra note 22, at 2, 8; H.R. Rep. No. 229,
supra note 22. ``(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.'' S. Rep. No. 75, supra note 22, at 3.
\50\ S. Rep. No. 75 and H.R. Rep. No. 229, supra note 22.
\51\ For example, the Intermarket Communications Group links the
Commission, the Commodity Futures Trading Commission, and the SROs
for the major securities and futures markets. During periods of
market stress this interagency and intermarket coordination helps to
minimize uncertainty and improve communication for the benefit of
investors trading in all U.S. markets. In addition, market-wide
trading halts imposed by circuit breaker procedures limit credit
risk by providing a brief respite amid frenetic trading, which
allows market participants to ensure the solvency of their
counterparties. These planned, coordinated trading halts also
facilitate price discovery by providing an opportunity to publicize
order imbalances in order to attract value traders, and cushion the
impact of market movements that would otherwise damage a market's
infrastructure.
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Recent evidence suggests that the failure of the current regulatory
approach to fully coordinate trading on alternative trading systems
into national market systems mechanisms has impaired the quality and
pricing efficiency of secondary equity markets, particularly in light
of the explosive growth in trading volume on such alternative trading
systems. Although these systems are available to some institutions,
orders on these systems frequently are not available to the general
investing public. The ability of market makers and specialists to
display different and potentially superior prices on these alternative
trading systems than those displayed to the general public created, in
the past, the potential for a two-tiered market.52
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\52\ See Securities Exchange Act Release No. 36310 (Sept. 29,
1995), 60 FR 52792 (Oct. 10, 1995) (hereinafter Order Handling Rules
Proposing Release).
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For example, during the Commission's recent investigation of Nasdaq
trading,53 analyses of trading in the two most significant
trading systems for Nasdaq securities (Instinet and SelectNet) revealed
that the majority of bids and offers displayed by market makers in
these systems were better than those posted publicly on
Nasdaq.54 Moreover, the Commission found that, because they
could trade with other market professionals through non-public
alternative trading systems, market makers did not have a sufficient
economic incentive to adjust their public quotations to reflect more
competitive prices.55 Ultimately, the wider spreads quoted
publicly by market makers increased the transaction costs paid by
public customers, impaired the ability of some institutional investors
to obtain favorable prices in those securities, and placed institutions
at a potential disadvantage in price negotiations.56
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\53\ Following the filing of several class action lawsuits
alleging collusion among Nasdaq market makers and public allegations
that Nasdaq market makers routinely refused to trade at their
published quotes, intentionally reported transactions late in order
to hide trades from other market participants, and engaged in other
market practices detrimental to individual investors, the Commission
opened a formal inquiry to investigate the functioning of the Nasdaq
market and to determine whether the NASD was complying fully with
its obligations as an SRO. In 1996, as a result of the
investigation, the Commission instituted enforcement proceedings
against the NASD pursuant to section 19(h) of the Exchange Act and
issued a report under section 21(a) of the Exchange Act detailing
the Commission's findings. See NASD 21(a) Report, supra note 20.
\54\ These conclusions are based on Instinet and SelectNet data
for the months April through June 1994. See NASD 21(a) Report, supra
note 20, at notes 48 to 52 and accompanying text.
\55\ The Commission found that ``the ability of market makers to
attract trading interest through Instinet allowed them to trade
without using odd-eighth quotes and narrowing the Nasdaq spread.''
NASD 21(a) Report, supra note 20, at 20.
\56\ NASD 21(a) Report, supra note 20, at 18.
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In response to these findings, the Commission recently took steps
to bring greater transparency into the trading environment of certain
alternative trading systems. In September 1996, the Commission adopted
rules that require a market maker or specialist to make
[[Page 30493]]
publicly available any superior prices that it privately offers through
certain types of alternative trading systems known as electronic
communications networks, or ECNs.57 The new rules permit an
ECN to fulfill these obligations on behalf of market makers using its
system, by submitting its best market maker bid/ask quotations to an
SRO for inclusion into public quotation displays (``ECN Display
Alternative'').
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\57\ 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. See Securities Exchange Act Release No. 37619A (Sept. 6,
1996), 61 FR 48290 (Sept. 12, 1996) (hereinafter Order Handling
Rules Adopting Release). Currently, all ECNs are broker-dealer
trading systems, as defined in Exchange Act Rule 17a-23, and are
sponsored through registered broker-dealers.
---------------------------------------------------------------------------
These rules, however, were not intended to fully coordinate trading
on alternative trading systems with public market trading. While these
rules will help integrate orders on certain trading systems into the
public quotation system, they only affect trading that is conducted by
market makers and specialists; activity of other participants on
alternative trading systems remains undisclosed to the public market
unless the system voluntarily undertakes to disclose all of its best
bid/ask prices.58 Moreover, whether an ECN reflects the best
bid/ask quotations on behalf of market makers and specialists that
participate in its system is wholly voluntary.59
Specifically, ECNs are under no obligation to integrate orders
submitted into their systems into the public quotation system, and the
central quotation system is not currently required to accept ECNs as
participants.
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\58\ Because such trading interest 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 also disclosed
to the public, it could result in improved price opportunities for
public investors. There is already 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. Of the four ECNs
that are currently linked to Nasdaq, two ECNs display to the public
the best prices of any orders entered into their systems (including
both market makers and institutions). One ECN displays to the public
the best price of any visible order entered into its system by
market makers or institutions, but does not display any orders that
are designated as ``reserve orders'' (which may interact with orders
entered into the ECN's system, but are not generally displayed to
participants in the ECN). The fourth ECN displays to the public only
orders of market makers and those institutional customers that
affirmatively choose to have their orders so displayed.
\59\ To date, four trading systems have elected to display
quotes under the ECN alternative. See Letters dated January 17, 1997
from Richard R. Lindsey, Director, 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).
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Because a majority of 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 years ago when it noted that an essential
purpose of a national market system
is 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.60
\60\ Future Structure Statement, supra note 20, at 9-10
(emphasis added). See also, SEC, Policy Statement of the Securities
and Exchange Commission on the Structure of a Central Market System
25-28 (1973).
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This development also thwarts congressional goals for a national
market system, where the best trading opportunities are to be made
accessible to all customers, not just those customers who, due to their
size or sophistication, may avail themselves of prices in alternative
trading systems not currently available in the public quotation system.
c. Market Surveillance
Market regulation critically enhances the Commission's ability to
surveil market activity as a whole in order to prevent fraud and
manipulation, which can jeopardize market integrity and stability.
Exchanges and securities associations such as the NASD act as SROs and,
as such, are responsible not only for complying with the Exchange Act,
but also for carrying out the purposes of the Exchange Act, principally
by enforcing member compliance with the provisions of the Exchange Act
and the rules promulgated thereunder, as well as the exchanges' or
associations' own rules.61 This requires exchanges and
securities associations to establish rules and procedures to prevent
fraud and manipulation and promote just and equitable principles of
trade, typically by establishing audit trails, surveillance, and
disciplinary programs. It also requires exchanges and securities
associations to enforce the antifraud provisions of the federal
securities laws.62 These requirements are essential to
ensure that SROs implement the goals established by Congress vigilantly
and effectively. In addition, exchanges and securities associations
serve a critical regulatory function by establishing and enforcing just
and equitable principles of trade, and by providing a mechanism for
preventing inappropriate behavior that damages market integrity, even
if such behavior does not rise to the level of fraud under the Exchange
Act. As a result of these requirements, exchanges and securities
associations carry out much of the day-to-day surveillance for, and
initial investigation of, trading improprieties, rule violations, and
fraud.
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\61\ Exchange Act section 6(b) (1), (5), and (6), 15 U.S.C.
section 78f(b) (1), (5), and (6); Exchange Act 15A(b)(2), 15 U.S.C.
78o-3(b)(2).
\62\ Id.
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Although the broker-dealers that operate many of the alternative
trading systems have certain obligations to individual customers,
because these systems are not SROs, they do not have the same market-
wide enforcement and surveillance obligations as registered exchanges
and the NASD. Moreover, SROs' current programs to surveil their own
markets for fraud, insider trading, and market manipulation do not
extend to observing quote activity on alternative trading systems.
Specifically, although trades executed through certain alternative
trading systems are reported to the NASD by either broker-dealer
participants in such systems or by the broker-dealer operating the
market,63 the NASD may not receive a consolidated picture of
trading activity on alternative trading systems. Because activity on
alternative trading systems is only reported to an SRO after a trade
has been executed, SROs cannot fully supervise SROs' members'
activities on those systems.64 In addition, because
alternative trading systems are often reported as the counterparty to
all trades between institutions executed through their systems, SRO
surveillance mechanisms may not be able to identify the true
counterparties of those trades. As a result, fraudulent or manipulative
activity that an institution is carrying on through an alternative
trading system may be masked by the overall activities of the system's
other participants, and go uninvestigated. As more institutions use
alternative trading systems to trade with each other, rather than with
[[Page 30494]]
intermediaries, this could result in significant volume that is not
integrated into SRO surveillance operations. Finally, alternative
trading systems that compete with systems operated by SROs have
repeatedly questioned whether particular SRO actions were driven by
competitive, rather than regulatory motives. Thus, adequate oversight
of alternative trading systems by SROs may be hindered by competitive
concerns.
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\63\ Broker-dealers that operate trading systems have the same
reporting obligations as other broker-dealers. For trades executed
on an alternative trading system, this means that, depending on the
circumstances, market makers and broker-dealers trading on the
system will report their own trades, and that the broker-dealer
sponsor of the system will undertake to report trades between non-
broker-dealers.
\64\ See NASD 21(a) Report, supra note 20.
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d. Market Stability and Systemic Risks
SROs have substantial, ongoing commitments to maintain sufficient
system capacity, integrity, and security. The Commission has instituted
a program to monitor capacity planning at SROs, so that it can take
preemptive action if necessary, and meets with the SROs on a regular
basis and reviews various aspects of their computer operations. In
contrast, the Division of Market Regulation's experience in
administering the Order Handling Rules and other broker-dealer rules
has revealed that, in many cases, ECNs and other alternative trading
systems may have serious capacity problems.65 Even though
they have significant trading volume, under the current regulatory
scheme ECNs and other alternative trading systems are not required to
have sufficient computer capacity to meet ongoing trading demand or to
withstand periods of extreme market volatility or other short-term
surges in trading volume. Failure to integrate alternative trading
systems into the Commission's programs to review and enhance the
capacity of alternative trading systems jeopardizes efforts to ensure
that all trade execution centers will remain operational during periods
of market stress.
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\65\ The Commission is aware of several occasions on which
significant alternative trading systems had to stop disseminating
market maker quotations in order to keep from closing altogether due
to insufficient system capacity. In one recent occurrence, an
interruption in service at an ECN immediately following a key market
announcement appears to have seriously affected options market
makers' ability to trade the equities underlying their options.
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C. Conclusion
In sum, the current regulation of alternative trading systems does
not address the market activities performed by such systems. As a
result, such regulation may not have effectively met the congressional
goals of protecting market participants from fraud and manipulation,
promoting market coordination and stability, and ensuring regulatory
fairness and fair competition.
Question 1: The Commission seeks comment on the concerns identified
above and invites commenters to identify other issues raised by the
current approach to regulating alternative trading systems.
Question 2: Are the concerns raised in this release with regard to
the operation of alternative trading systems under the current
regulatory approach unique to such systems? To what extent could these
concerns be raised by broker-dealers that do not operate alternative
trading systems, such as a broker-dealer that matches customer orders
internally and routes them to an exchange for execution or a broker-
dealer that arranges for other broker-dealers to route their customer
orders to it for automated execution?
III. Approaches to Market Oversight
The Commission recognizes that, in order to promote efficiency,
competition, and capital formation in the securities industry, creation
of new markets or the evolution of existing ones must not be inhibited.
At the same time, the Commission continues to believe that fair and
measured market oversight is valuable to protect investors, ensure the
integrity and fairness of markets, and otherwise promote the goals
reflected in the Exchange Act.
As the problems discussed above illustrate, the current approach
for regulating alternative trading systems may not effectively
accomplish these objectives. New technologies are continually
facilitating innovative means of trading securities, resulting in
qualitatively different market structures. In the next decade, the
continued growth of the Internet will present even more opportunity for
change in financial services. This release solicits comment on whether
the current statutory and regulatory framework is appropriate in light
of these myriad developments and new means of trading securities made
possible by emerging technologies. The release then seeks comment on
specific alternatives for addressing these objectives within the
existing securities law framework.
A. Regulatory Structure
As technology continues to drive the evolution of markets, the
variety and combinations of services offered by markets and
intermediaries will continue to blur the distinctions among these
entities. Under the Exchange Act, such distinctions determine the
obligations and responsibilities of each entity towards customers and
the market as a whole. In particular, the Exchange Act categorizes
market participants based on their primary activities, such as an
``exchange'' function or a ``broker-dealer'' function. Although
Congress defined the terms ``exchange,'' ``broker,'' and ``dealer''
broadly enough to accommodate changes in how these entities carry out
their business, they could not anticipate the variety of entities that
would develop. The Commission invites commenters to analyze whether, in
light of technological advances, market participants might be
appropriately regulated without reference to distinctions between
markets and intermediaries. In the alternative, the Commission solicits
comment on whether new regulatory categories are needed for entities
that combine both market and intermediary functions. The Commission
also solicits comment on what oversight should apply to these
categories.
In addition, as explained above, exchanges and broker-dealer
intermediaries each play critical roles in supervising securities
activities. The Commission solicits comment on how any changes to the
regulatory approach would affect these roles.
Finally, the Commission solicits comment on how any changes to the
current statutory and regulatory structure made to accommodate market
innovations could be accomplished without undue cost to existing market
participants, which have invested significantly to comply with the
existing structure.
Question 3: What regulatory approaches would best address the
concerns raised by the growth of alternative trading systems and the
needs of the market? Is the current approach the most appropriate one?
Question 4: What should be the objectives of market regulation? Are
the goals and regulatory structure incorporated by Congress in the
Exchange Act appropriate in light of technological changes? Are
business incentives adequate to accomplish these goals?
Question 5: Are the regulatory categories defined in the Exchange
Act sufficiently flexible to accommodate changes in market structure?
If not, what other categories would be appropriate? How should such
categories be defined?
B. Regulatory Tools
Technological changes also have significant implications for the
tools the Commission relies on to achieve the goals incorporated by
Congress into the Exchange Act. As discussed in greater detail in
Sections IV and V below, the Commission currently regulates markets
largely through its registration, rule filing, examination, and
enforcement programs. In light of the changes
[[Page 30495]]
discussed above, the Commission solicits comment on whether these are
effective means of accomplishing congressional goals, and, if not, what
other means might be more appropriate.
For example, many Commission regulations require market
participants to deliver written documents. In order to give broker-
dealers and investment advisers the flexibility to comply with these
requirements in the most cost-effective and efficient manner, the
Commission has issued interpretative guidance regarding the use of
electronic communications to fulfill the delivery requirements of the
federal securities laws.66 Rather than specifying acceptable
types of electronic delivery, the Commission specified the standards
that entities had to achieve in meeting their delivery requirements
electronically, leaving it to each entity to determine the best way to
meet each standard. This approach allows broker-dealers and investment
advisers to avail themselves of technological innovations without first
obtaining regulatory approval. The Commission solicits comment on
whether such a standard-oriented approach would be appropriate for the
regulation of markets, and, if so, what these standards should be.
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\66\ See Securities Exchange Act Release No. 36345, 60 FR 53458
(Oct. 6, 1995); Securities Exchange Act Release No. 36346, 60 FR
53468 (Oct. 6, 1995); Securities Exchange Act Release No. 37183 (May
9, 1996), 61 FR 24652 (May 15, 1996).
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Question 6: Can the Commission regulate markets effectively through
standard-oriented regulation of the type described above?
Question 7: How could the Commission enforce compliance with the
Exchange Act under such a standard-oriented approach?
Question 8: Is the current regulatory framework an effective form
of oversight, in light of technological changes? Are there other
regulatory techniques that would be comparably effective? If so, would
the implementation of such techniques be consistent with congressional
goals reflected in the Exchange Act?
IV. Proposals Under Consideration To Integrate Alternative Trading
Systems into the Existing Regulatory Structure for Market Oversight
Within the existing regulatory framework, the issues currently
associated with alternative trading systems could be addressed in large
part by integrating alternative trading systems more effectively into
national market system mechanisms. Discussed below are two alternative
means of effecting such integration. First, the Commission could
continue to regulate alternative trading systems as broker-dealers and
attempt to integrate these systems more effectively into market
regulation mechanisms through a series of rules applicable to broker-
dealers operating such systems and to SROs overseeing such systems.
Second, the Commission could regulate alternative trading systems as
exchanges by expanding the interpretation of the term ``exchange'' to
cover those alternative trading systems that engage in many of the same
activities as currently registered exchanges, such as operating an
electronic limit order book, or matching or crossing participant
orders. The Commission could then follow a tiered approach to
regulating those alternative trading systems classified as exchanges.
The first tier under this approach would consist of those alternative
trading systems that have low volume or a passive pricing structure.
These trading systems would not be required to register as national
securities exchanges (or as broker-dealers, to the extent that such
trading systems do not also perform customary brokerage
functions),67 but would be subject to limited requirements.
The second tier under this approach would consist of those alternative
trading systems with a large volume of trading and active price
discovery, but that do not have membership structures. The Commission
could require these trading systems to register as exchanges, but would
use its new exemptive authority to eliminate unnecessary or
inappropriate requirements.68 Finally, the third tier under
this approach would consist of those traditional exchanges that have
membership governance structures.
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\67\ See infra notes 183 to 184 and accompanying text.
\68\ The National Securities Markets Improvement Act of 1996
(hereinafter 1996 Amendments), Pub. L. 104-290, added Section 36 to
the Exchange Act, 15 U.S.C. 78mm, which authorizes the Commission to
conditionally or unconditionally exempt any person, security, or
transaction, or any class thereof, from any provision of the
Exchange Act or rule thereunder, so long as the exemption is
necessary or appropriate in the public interest and is consistent
with the protection of investors. Section 36 of the Exchange Act
does not authorize the Commission to exempt persons, securities,
transactions, or classes thereof from section 15C of the Exchange
Act or rules and regulations issued under that section. Section 15C
establishes registration requirements for government securities
brokers and government securities dealers and gives the U.S.
Department of the Treasury authority to promulgate rules governing
the activities of these entities. All of the exemptions pursuant to
section 36 of the Exchange Act that the Commission is considering in
this concept release could be granted by rule or regulation. If the
Commission determined instead to issue orders granting exemptive
applications, it would need to adopt procedures for doing so
pursuant to section 36.
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Any new regulatory approach to oversight of alternative trading
systems should promote efficiency, competition, and capital formation
in the securities industry, without inhibiting the development of new
markets. At the same time, it is critical to address the problems
discussed above. The Commission solicits comment on the two
alternatives for addressing these issues discussed below, and on
whether there are other alternatives that may address the Commission's
concerns.
Question 9: Are there viable alternatives within the existing
Exchange Act structure, other than those discussed below, that would
address the concerns raised by the growth of alternative trading
systems and congressional goals in adopting the Exchange Act?
A. Integrating Alternative Trading Systems into the National Market
System Through Broker-Dealer Regulation
In order to rectify the shortcomings discussed in Section II of
this release, the Commission could build upon its current regulation of
alternative trading systems as broker-dealers. In particular,
alternative trading systems could be overseen and integrated into the
NMS through a combination of broker-dealer regulation and regulation of
the SROs that supervise these systems. The Commission took a similar
approach in its recent adoption of the Order Handling Rules (which are
designed to integrate a portion of the trading on ECNs into market
transparency mechanisms) and in its adoption of Rule 17a-23 (which
established recordkeeping and reporting requirements specifically
tailored to broker-dealers operating trading systems).
As discussed below, these broker-dealer regulations could include
requiring those broker-dealers that operate alternative trading systems
to make all orders of participants in those systems available to the
public quotation system. The Commission could also require alternative
trading systems to provide the public with access to such systems in
order to interact with the orders posted by participants of such
systems. In addition, the Commission could impose additional
requirements on both the broker-dealers that operate alternative
trading systems and their SROs in order to more effectively integrate
these systems into SRO surveillance mechanisms. For example, the
Commission could require broker-dealers that operate alternative
trading systems to provide more audit trail
[[Page 30496]]
information to their SROs, which would help SROs execute their
oversight functions, and could require SROs to use this additional
information to integrate these systems into their surveillance
programs. Finally, the Commission could adopt measures that would help
to ensure that alternative trading systems have adequate systems
capacity.
Question 10: What types of alternative trading systems would it be
appropriate to regulate in this manner?
1. Fully Integrating the Orders of All Market Participants into the
Public Quotation System and Facilitating Public Access to Such Orders
In its efforts to increase competition and transparency in the
market, the Commission has encouraged the development of NMS
mechanisms, such as the Consolidated Tape Association (``CTA''), the
Consolidated Quotation System (``CQS'') and the Intermarket Trading
System (``ITS''). These mechanisms make information about trading
interest, prices, and volume widely available to market participants.
The Commission has worked to continuously update and improve the NMS to
reflect technological advances. For example, the new Order Handling
Rules require market makers and specialists to make available publicly
any superior prices they privately offer through ECNs. As an
alternative, the new rules permit, but do not require, an ECN to
fulfill these obligations on behalf of the market maker or specialist
by submitting the ECN's best bid and offer to an SRO for inclusion into
the public quotation system.
As discussed above,69 however, these rules were not
intended to integrate all trading on alternative trading systems into
the NMS. These rules focus only on ensuring that market maker and
specialist activity on alternative trading systems is reflected in
their public quotations. As a result, institutional orders on ECNs
remain largely undisclosed to the public, thus hiding the aggregate
trading interest on alternative trading systems from public view.
Therefore, it might be appropriate to require broker-dealers that
operate alternative trading systems to report all orders 70
submitted by participants, including those of non-broker-dealer
participants, for integration into the public quotation system.
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\69\ See supra notes 57 to 60 and accompanying text.
\70\ Firm prices for securities, whether such firm prices are
labeled as ``orders,'' ``quotes,'' or otherwise, could be included
in the public quotation system. Priced orders entered into
alternative trading systems where the orders are widely disseminated
and executable could be viewed as the functional equivalent of
quotations, and like quotations, would play a key role in the price
discovery process. See also Order Handling Rules Adopting Release,
supra note 57, at 116.
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If alternative trading systems are required in some manner to
publicly display the orders of all participants, they could also be
required to provide the public with the ability to execute against
those orders. Under the Order Handling Rules, an ECN that voluntarily
displays market makers' and specialists' quotations to the public must
also provide an equal opportunity for participants and non-participants
to execute their orders against such quotations. Non-participants,
however, may only access market maker and specialist quotations on
those ECNs. Alternative trading systems could be required to provide
non-participants with the ability to execute against all orders in
their system, including those of institutions, in a manner equivalent
to that offered participants of the systems. Non-participants would be
granted access on a real-time basis under this approach and could be
charged reasonable fees for such access.
Question 11: If the Commission decided to further integrate
alternative trading systems into the NMS through broker-dealer
regulation, should it require alternative trading systems to submit all
orders displayed in their systems into the public quotation system? If
not, how should the Commission ensure adequate transparency?
Question 12: If the Commission requires alternative trading systems
to submit all orders displayed in their systems into the public
quotation system, how can duplicate reporting by alternative trading
systems and their participant broker-dealers be prevented?
Question 13: Are there other methods for integrating all orders
submitted into alternative trading systems into the public quotation
system?
Question 14: Are there any reasons that orders available in
alternative trading systems should not be available to the public?
Question 15: If the Commission requires alternative trading systems
to allow non-participants to execute against orders of system
participants, how should it ensure that non-participants are granted
equivalent access?
Question 16: If the Commission requires alternative trading systems
to allow non-participants to execute against orders of system
participants, how should it determine whether the fees charged to non-
participants by such systems are reasonable and do not have the effect
of denying access to orders?
Question 17: Are there any reasons that non-participants should not
be able to execute against orders of participants in alternative
trading systems?
2. Improving the Surveillance of Trading Conducted on Alternative
Trading Systems
As discussed below, alternative trading systems may not be subject
to real-time surveillance for market manipulation and fraud. Broker-
dealers that operate these systems are not required to actively surveil
the conduct of system participants to ensure against fraud and
manipulation. Instead, as discussed above, these surveillance
responsibilities lie with the SROs. SROs, however, do not actively
incorporate alternative trading systems into their real-time
surveillance programs, and broker-dealer trade reporting conventions
restrict SRO surveillance capabilities.
Trading by institutions on alternative trading systems is
effectively hidden from SRO programs designed to detect fraud and
manipulation. SRO surveillance systems generate ``alerts'' that, in
their most basic form, indicate when trading in a particular security
is outside of normal trading patterns, such as when a previously
inactive entity suddenly begins actively trading. Broker-dealers
operating alternative trading systems, however, are not required to
report the identities of the counterparties to a trade to their
supervising SRO. Instead, the broker-dealer may report the trade to the
SRO as its own trade. Therefore, SRO surveillance programs do not
``look through'' the alternative trading system to the actual
counterparties conducting the trading on such systems. Because the SRO
system views the broker-dealer operating the system as the counterparty
to trades, unusual trading activity of a participant in an alternative
trading system may not trigger an alert. While the anonymity provided
by the broker-dealer trading system reporting the trade may be
desirable to some because it allows traders to hide their trading
strategies from other market participants, it also represents an
opportunity for market manipulation that is increasingly difficult for
SROs to detect.
In addition, SRO surveillance programs typically are constructed
around activity in particular securities. Several alternative trading
systems are designed to provide a liquid market in securities that are
not traded on exchanges or Nasdaq, such as limited partnerships and
certain derivatives.
[[Page 30497]]
Because SRO surveillance currently focuses primarily on trading in
securities listed or approved for trading on the market operated by
that SRO, activity on systems trading other securities (particularly
non-equity securities) may not receive adequate surveillance for fraud
and market manipulation.
Finally, although a broker-dealer is generally obligated to report
a trade executed on an alternative trading system to its
SRO,71 the SRO does not receive a composite picture of
orders available on that alternative trading system on a real-time
basis. Consequently, the SRO is not able to integrate the activity on
an alternative trading system into its information about activity in
that security on its own market.
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\71\ See, e.g., NASD Manual Rules 4630-32.
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For these reasons, if alternative trading systems continue to be
regulated as broker-dealers, it may be appropriate to require such
systems to provide their SRO, on an automated basis, with real-time
information about trading on the systems (including, where appropriate,
parties to a trade), in order to enable the SRO to improve its
surveillance of such trading. The Commission notes that the identities
of the counterparties to a trade would not be made publicly available,
but would be provided solely to the market surveillance department of
an SRO. In addition, in order for SROs to incorporate the trading on
alternative trading systems into their real-time surveillance programs,
SROs would have to understand in much greater detail than they do today
the manner in which prices are established on alternative trading
systems. This would probably require SROs, for example, to examine the
trading algorithms, including the programming code, of alternative
trading systems. Alternative trading systems would also have to notify
SROs of changes to their system. Further, because alternative trading
systems that trade non-NMS securities are not currently included within
SROs' primary surveillance programs, SROs may have to broaden the scope
of their surveillance activities to include more active surveillance of
trading in securities not listed or quoted on the market operated by
the SRO.
Under this approach, the surveilling SRO would integrate the
additional data provided by the alternative trading systems into the
SRO's audit trail and real-time surveillance function. The SROs could
use this data to enhance their ongoing, real-time surveillance of these
alternative systems by developing specifically tailored surveillance
and examination procedures to detect fraud and manipulation on
particular systems and among systems.
Question 18: Should the Commission require alternative trading
systems to provide additional information (such as identifying
counterparties) to their SRO in order to enhance the SRO's audit trail
and surveillance capabilities?
Question 19: What other methods could the Commission use to enhance
market surveillance of activities on alternative trading systems?
Question 20: Should SROs be required to surveil trading by their
members in securities that are not listed or quoted on the market
operated by that SRO?
3. Ensuring Adequate Capacity of Alternative Trading Systems
As alternative trading systems play an increasingly important role
in the securities markets, their ability to continue to operate during
periods of high volume or volatility becomes critical. Existing
standards regarding the review of the capacities and other operational
requirements of markets could apply to alternative trading systems if
they continue to be regulated as broker-dealers.72
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\72\ In particular, the Commission is considering adopting
certain additional procedures, pursuant to section 15(b)(7) of the
Act, 15 U.S.C. 78o(b)(7), to ensure that alternative trading systems
have adequate facilities and operational capabilities for the
services they provide.
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The Commission currently receives limited information regarding the
operational procedures of alternative trading systems under Rule 17a-
23.73 Although that Rule requires system operators to
provide the Commission with a brief description of their trading
systems, including significant systems changes and procedures for
reviewing systems capacity, security, and contingency planning, it does
not require alternative trading systems to adopt such procedures. The
Commission in the past has issued guidance to SROs on developing and
implementing policies for assessing the capacity, security, and
contingency planning of their systems.74 To ensure that
alternative trading systems have adequate capacity for order execution
and other services they provide, the Commission could consider whether
broker-dealers that operate such systems should be required to follow
similar guidelines. For example, alternative trading systems could be
required to arrange for independent systems reviews, including an
assessment of anticipated capacity requirements, contingency protocols,
and processes for preventing, detecting, and controlling threats to
their systems. In addition, alternative trading systems could be
required to report significant systems outages to the Commission and
their SRO on a real-time basis.
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\73\ See Item 5, Part I of Form 17A-23, 17 CFR 249.636.
\74\ See Securities Exchange Act Release No. 29185 (May 9,
1991), 56 FR 22490 (May 15, 1991); Securities Exchange Act Release
No. 27445 (Nov. 16, 1989), 54 FR 48703 (Nov. 24, 1989). These
releases encourage SROs to establish comprehensive planning and
assessment programs that accomplish three objectives: (1) Each SRO
should establish current and future capacity estimates; (2) each SRO
should conduct capacity stress tests periodically; and (3) each SRO
should obtain an annual independent assessment of whether the
affected systems can perform adequately in light of estimated
capacity levels and possible threats to the systems. An
``independent review'' might be performed by any qualified party
that has the organizational status and objectivity such that it
operates separately from and is not controlled by the SRO's
technology staff. The Commission recommended that these independent
reviews evaluate the following areas: computer operations;
telecommunications; systems development methodology; capacity
planning and testing; and contingency planning. The Commission also
presented the SROs with guidelines for additional means for
providing the Commission with information regarding automation
developments or enhancements and system outages, specifically: (1)
Annual reports through which SRO technical staff would describe for
Division staff the current automated system operations and planned
changes; (2) SRO notification of the Division of significant changes
to automated systems; and (3) real-time notification of significant
interruptions of service in SRO automated trading systems.
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Question 21: Should alternative trading systems be required to
follow guidelines regarding the capacity and integrity of their
systems? If not, how should the Commission address systemic risk
concerns associated with potentially inadequate capacity of alternative
trading systems, particularly those systems with significant volume?
Question 22: With what types of standards regarding computer
security, capacity, and auditing of systems, should alternative trading
systems be required to comply?
Question 23: To what extent would complying with systems guidelines
similar to those implemented by exchanges and other SROs require
modification to the current procedures of alternative trading systems?
What costs would be associated with such modifications? How much time
would be required to implement the necessary modifications and systems
enhancements? Please provide a basis for these estimates.
4. Potential Problems with Regulating Alternative Trading Systems Under
the Broker-Dealer Regulatory Scheme
Although broker-dealer regulation provides a framework for
integrating alternative trading systems into the most significant
aspects of the NMS, such an
[[Page 30498]]
approach may not address certain of the regulatory gaps discussed above
in Section II. First, the broker-dealer approach may not ensure the
fair treatment of investors by alternative trading systems. Second, as
broker-dealers, these systems would continue to be required to comply
with regulations designed for more traditional brokerage activities.
For example, the operators of alternative trading systems would be
subject to oversight and heightened surveillance by SROs, which may
operate competing trading systems. Third, alternative trading systems,
even those with a significant share of trading volume, would not be
subject to provisions designed to address anticompetitive activities.
a. Alternative Trading Systems Would Not Be Subject to Requirements
Designed to Assure Fair Treatment of Investors
In contrast to national securities exchanges, no regulatory redress
exists for unreasonably discriminatory action taken by a broker-dealer
operating an alternative trading system against a system participant or
an applicant.75 As discussed above,76 the ability
of these systems to unreasonably discriminate can have adverse
ramifications for market participants. For example, if a significant
percentage of institutional orders are entered into an alternative
trading system, broker-dealers denied access to that system would lose
the opportunity to interact with that institutional trading interest.
They may also be denied the opportunity to display customer limit
orders in a forum where they are most likely to be executed. Similarly,
an alternative trading system that trades illiquid securities, such as
limited partnerships or real estate derivatives, may provide the only
efficient means of locating counterparties with which to trade in those
securities. Investors denied access to such a system may have limited
opportunity to trade those securities, particularly if other
participants in the market primarily trade those securities through the
alternative trading system.
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\75\ Rule 17a-23 requires a sponsor of a broker-dealer trading
system to provide the Commission with a description of the sponsor's
criteria for granting access to the system. The Rule does not
directly require meaningful disclosure of the underlying reasons for
particular denials of access.
\76\ See supra Section II.B.2.a.
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Fair treatment of potential and actual participants becomes more
important as alternative trading systems capture a larger percentage of
overall trading volume and display consistently superior prices,
particularly if there are no viable alternatives to trading on such
systems. The importance of fair treatment by such systems is heightened
during periods of significant market activity. Broker-dealer regulation
may not provide meaningful redress for unfairly discriminatory acts
taken by the operators of these systems. Even if the Commission were to
require reporting of denials of access to a system or its services,
investors might continue to be without regulatory redress for
discriminatory actions.
Question 24: Is access to alternative trading systems an important
goal that the Commission should consider in regulating such systems? If
so, are there circumstances in which alternative trading systems should
be able to limit access to their systems (for example, should the
Commission be concerned about access to an alternative trading system
that has arranged for its quotes to be displayed as part of the public
quotation system)?
Question 25: If alternative trading systems were to continue to be
regulated as broker-dealers and were subject to a fair access
requirement, should the Commission consider denial of access claims
brought by participants and non-participants in alternative trading
systems? If not, are there other methods that could adequately address
such claims?
Question 26: Are commenters aware of any unfair denials of access
by broker-dealers operating alternative trading systems, where there
were no alternative trading venues available to the entities denied
access?
b. Broker-Dealers that Operate Alternative Trading Systems Will Still
Be Required to Comply with Potentially Inapplicable Regulation and Be
Subject to Oversight by SROs
Alternative trading systems are currently required to comply with
regulation intended for traditional broker-dealer activities (e.g.,
recommending investment strategies and holding customer funds and
securities).77 Moreover, they are subject to surveillance by
SROs that operate their own trading systems that may compete with
alternative trading systems. In the past, broker-dealers that operated
alternative trading systems have been reluctant to comply with SRO
requests for compliance data because of their concern that the SRO will
use this confidential business data for purposes unrelated to
regulatory oversight.
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\77\ See supra Section II.B.1.
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The broker-dealer approach described above contemplates enhancement
of SRO oversight to integrate these systems into the mechanisms of the
NMS, provide for adequate market surveillance of trading activity on
these systems, and prevent fraud and manipulation. SROs may have
concerns about the resources that would have to be dedicated to enhance
surveillance of alternative trading systems. In addition, alternative
trading systems may object to surveillance by the regulatory arm of
those entities with which they compete for order flow. For example,
alternative trading systems may be reluctant to fully disclose
information about the operation of their trading systems to SROs that
operate competing markets. Strict separation of market and regulatory
functions within an SRO (which some SROs have already undertaken) may
help alleviate concerns over whether information provided to the
regulatory arm of an SRO could be used for competitive purposes.
It may be more desirable for alternative trading systems to be
surveilled by an SRO not under the control of an entity that also
operates a competing market. For example, under Section 15A of the
Exchange Act, an association of brokers and dealers could establish an
SRO that does not operate a market. Such an SRO could be established
solely for purposes of overseeing the activities of unaffiliated
markets. The Commission seeks comment on the advisability and
feasibility of such an approach.
Question 27: Would enhanced surveillance of alternative trading
systems by their SROs raise competitive concerns that could not be
addressed through separation of the market and regulatory functions of
the SROs?
Question 28: If alternative trading systems continue to be
regulated as broker-dealers, are there other ways to integrate the
surveillance of trading on alternative trading systems?
Question 29: What is the feasibility of establishing an SRO solely
for the purpose of surveilling the trading activities of broker-dealer
operated alternative trading systems, that does not also operate a
competing market?
c. Alternative Trading Systems Will Be Free to Engage in
Anticompetitive Activities
Broker-dealer regulation is not designed to address anticompetitive
activities. If a traditional broker-dealer acts in an anticompetitive
manner, investors and other market participants always have the option
of dealing with another broker-dealer. If an alternative trading system
operated by a broker-dealer captures a large market share and is a
major forum for price discovery in a particular security, however,
other
[[Page 30499]]
trading venues may not be comparable. As a result, anticompetitive
activities by that system may have significant effects on investors and
other markets.78
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\78\ For example, following adoption of the 1975 Amendments, the
Commission reviewed SRO rules to confirm that they were in
compliance with the Exchange Act as amended. Among other things, the
Commission identified several rules that it considered to be
anticompetitive in violation of the Exchange Act, such as rules that
restricted the types of entities with which their members could
trade. See Securities Exchange Act Release No. 13027 (Dec. 1, 1976),
41 FR 53557 (Dec. 7, 1976).
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Because broker-dealers, unlike SROs, are not subject to non-
discriminatory standards for access or fees, or prevented under the
Exchange Act from using their market position to impose anticompetitive
conditions, alternative trading systems that are regulated as broker-
dealers would not be restricted from engaging in anticompetitive
activities that have a negative impact on investors and other
markets.79
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\79\ Exchange regulation addresses potentially anticompetitive
activities through the Commission's oversight of SROs and through
the rule filing process. For example, a primary registered market
could institute an after-hours trading halt for purposes of news
dissemination, but fail to remove that halt until the re-opening of
its own facilities the following trading day, even if sufficient
time has passed to permit the dissemination of the news. In that
situation, the Commission could act to ensure that the registered
market was not instituting a trading halt to prevent competitors
from engaging in after-hours trading in its securities.
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Question 30: If alternative trading systems continue to be
regulated as broker-dealers, how can the Commission address
anticompetitive practices by such systems?
5. Conclusion
The approach to regulating alternative trading systems discussed
above, which would continue to regulate alternative trading systems as
broker-dealers, appears to address some of the Commission's concerns
regarding transparency, surveillance, and capacity of alternative
trading systems, while balancing business needs of the alternative
trading systems. In addition, regulation of the operators of
alternative trading systems as broker-dealers has in the past been
supported by sponsors of such systems as an appropriate way to
regulate, and as a means of fostering the development of, these
systems.80 Similarly, some SROs have expressed their support
for basing the regulation of alternative trading systems on the
regulation of their sponsors as broker-dealers.81
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\80\ See, e.g., Letter from Daniel T. Brooks, Cadwalader,
Wickersham & Taft (counsel to Instinet), to Jonathan G. Katz, SEC
(Aug. 2, 1989) at 29 (``When properly analyzed * * * market
structure concerns dictate that Instinet be regulated as a
broker.'')
\81\ See, e.g., Memorandum accompanying Letter from James E.
Buck, Senior V.P., NYSE, to Jonathan Katz, SEC (Aug. 2, 1989) at 2
(stating that a rule based approach to regulating alternative
trading systems ``strikes a near optimal balance. It represents a
significant improvement over the `no-action' approach, and is
significantly superior to the `no-filing' approach, in retaining
minimal regulatory `costs' and yet maximizing the benefit to the
markets.'').
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Question 31: Would this approach be an effective means of
addressing the issues raised by the growth of alternative trading
systems? What would be the benefits of such an approach? What would be
the drawbacks of such an approach?
B. Integrating Alternative Trading Systems into Market Regulation
Through Exchange Regulation
As discussed above, regulation of alternative trading systems as
broker-dealers may not address all of the issues raised by the
activities of such systems. A second approach might integrate such
systems more fully into market regulation: Rather than continuing to
regulate alternative trading systems as broker-dealers, the Commission
could use the exemptive authority granted under the 1996 Amendments
82 to explore new approaches to the regulation of
exchanges.83 In particular, under this approach, the
interpretation of the term ``exchange'' could be broadened to include
any organization that both: (1) Consolidates orders of multiple
parties; and (2) provides a facility through which, or sets material
conditions under which, participants entering such orders may agree to
the terms of a trade. This expanded interpretation would significantly
broaden the entities that are considered to be exchanges to include
currently registered exchanges, certain broker-dealer trading systems
(including matching and crossing systems), currently exempted
exchanges, certain dealer markets, and other alternative trading
systems. For example, this interpretation would capture systems such as
Instinet, Tradebook, Island, and Terra Nova's Archipelago system, that
operate as electronic limit order books, allowing participants to
display buy and sell offers in particular securities and to obtain
execution against matching offers contemporaneously entered or stored
in the system. In addition, systems that consolidate orders internally
for crossing or matching with display to participants such as POSIT,
and organized dealer markets (unless operated by a registered
securities association) that consolidate orders and set material
conditions under which orders can be executed, would also be
encompassed by such an interpretation. While interdealer brokers in
municipal and government securities could be exempted from any revised
interpretation of ``exchange,'' fully automated interdealer brokers
would be covered by this interpretation.84 Any such
reinterpretation of ``exchange'' presumably would not be intended to
include customary brokerage activities or the activities of information
vendors.
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\82\ See supra note 68.
\83\ In adopting the general exemptive authority included in the
1996 Amendments, the Report of the Senate Committee on Banking,
Housing and Urban Affairs made specific reference to alternative
trading systems: ``The Committee recognizes that the rapidly
changing marketplace dictates that effective regulation requires a
certain amount of flexibility. Accordingly, the bill grants the SEC
general exemptive authority under both the Securities Act and the
Securities Exchange Act. This exemptive authority will allow the
Commission the flexibility to explore and adopt new approaches to
registration and disclosure. It will also enable the Commission to
address issues related to the securities market more generally. For
example, the SEC could deal with the regulatory concerns raised by
the recent proliferation of electronic trading systems, which do not
fit neatly into the existing regulatory framework.'' S. Rep. No.
293, 104th Cong., 2d Sess. 15 (1996).
\84\ A more detailed discussion of the effects of a revised
interpretation of ``exchange'' is provided in Section IV.B.3 infra.
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The Commission could then use its exemptive authority under section
36 of the Exchange Act 85, as described below, to create a
new category of exchanges that are exempt from most statutory exchange
registration requirements and are subject only to limited obligations
designed to address specific concerns related to their market
activities. More significant alternative trading systems could be
integrated into the exchange regulatory scheme, with exemptions for
such systems from those exchange requirements that are unnecessary or
inappropriate for proprietary, automated systems.
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\85\ See supra note 68 for a discussion of the Commission's
exemptive authority under Section 36 of the Exchange Act.
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At the same time, this type of an approach could potentially open
the door for competing exchanges to use national market systems as a
vehicle to inhibit innovation by alternative trading systems. For
example, it is possible that existing exchanges could try to use
participation in joint national market system mechanisms to set
marketwide operational standards (as conditions of participation in the
national market system plans) that have the effect of inhibiting
innovation by alternative
[[Page 30500]]
trading systems.86 As discussed below,87 the
Commission would anticipate working with existing exchanges and Nasdaq
to integrate alternative trading systems into the national market
system without stifling their innovation.
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\86\ For example, as discussed below, national securities
exchanges participate in national market systems plans, which are
jointly drafted and operated, and the terms of these plans must be
approved by all of the markets that are plan participants. See infra
Section IV.B.4. By specifying operational requirements that each
exchange must meet in order to participate in the national market
system mechanisms, these plans can have the effect of setting
marketwide standards. As a result, these plans could be used to
require newly registered exchanges to comply with particular trading
increments, reporting methods, and fee arrangements, for example.
\87\ See infra notes 163 to 169 and accompanying text.
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Question 32: If the Commission reinterpreted the term ``exchange,''
are the factors described above (i.e., (1) consolidating orders of
multiple parties and (2) providing a facility through which, or setting
conditions under which, participants entering such orders may agree to
the terms of a trade) sufficient to include the alternative trading
systems described above?
Question 33: Is broadening the Commission's interpretation of
``exchange'' to cover diverse markets, and then exempting all but the
most significant of these new exchanges from registration, the most
appropriate way to address the regulatory gaps discussed above and
provide the Commission with sufficient flexibility to oversee changing
market structures?
1. Creating a New Category Called ``Exempted Exchanges'' for Smaller
and Passive Alternative Trading Systems
The Commission could create a new tier of exchange regulation for
most alternative trading systems by expanding its interpretation of the
term ``exchange,'' as discussed in greater detail in Section IV.B.3.
below, and by exempting from registration alternative trading systems
that, although captured within a broader interpretation of
``exchange,'' do not need to be subject to full exchange regulation
(``exempted exchanges''). The Commission could then establish limited
and narrowly tailored requirements for these exempted exchanges.
Regulation as exempted exchanges could be appropriate for two types of
alternative trading systems: (1) Systems that are small, start-up
entities; and (2) systems that match or cross orders at a price that is
primarily or wholly derived from trading on another market (``passive
markets''). To the extent that these types of alternative trading
systems have a sufficiently low impact on the market or do not
establish the price of securities, they should have an insignificant
effect on the market as a whole, which would not warrant exchange
regulation.88 At this time, all except the most significant
alternative trading systems would appear to fall within one of these
two categories.
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\88\ The integration of trading on exempted exchanges with
public trade and quote reporting mechanisms could be accomplished by
continuing to require broker-dealer participants in exempted
exchanges to report trades to the primary market on which a security
trades and to comply with the Commission's rules. Similarly, as a
condition of exemption, these exchanges could be required to report
trades between non-SRO member participants to an SRO designated by
the Commission.
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These exempted exchanges could then be subject to limited
requirements that are more appropriate than current broker-dealer
regulation for the market activities of such systems, as discussed in
Section IV.B.1.c. below. This approach also could address concerns
regarding system capacity, confidentiality, integrity, and would
clarify the regulatory treatment of alternative trading systems that
fall within such a structure. Moreover, treating smaller alternative
trading systems and systems with passive pricing mechanisms as exempted
exchanges would provide an environment conducive to innovation, which
could, in turn, reduce the cost of experimenting with innovative
trading techniques.
Question 34: Are there any other categories of alternative trading
systems that have sufficiently minimal effects on the public secondary
market that they should be treated as exempted exchanges?
a. Low Impact Markets
Small alternative trading systems could be regulated as exempted
exchanges under this approach. If the Commission expands its
interpretation of ``exchange'' to include alternative trading systems,
it would be able to exempt small markets from all exchange registration
requirements under either Section 5 or section 36 of the Exchange Act.
Under section 5 of the Exchange Act, the Commission has the
authority to exempt any exchange with a limited volume of transactions
from registration as a national securities exchange, provided that it
is not practicable and not necessary or appropriate in the public
interest or for the protection of investors to require
registration.89 As noted in the Commission's 1991 order
granting an exemption to AZX under this provision, the Exchange Act
does not provide specific guidance as to the standard to use in
determining whether an exchange has a limited volume of transactions.
In considering the limited volume test, the Commission looked to
anticipated transaction volume on AZX and compared this to the
transaction volume of fully regulated national securities
exchanges.90 While the Commission's AZX order provides
useful guidance, the Commission also is considering other ways of
assessing whether an exchange has a limited impact on the overall
market. In many circumstances, the impact that a particular volume has
on the market will depend upon a number of factors, including the size
and liquidity of the market for the type of security traded. For
example, the Commission could use its authority under the 1996
Amendments to exempt small exchanges based on a market's limited share
of the relevant market as a whole, rather than the number of its
transactions. Similarly, the Commission could base an exemption
determination on the dollar value of transactions effected on an
exchange, or on other factors.
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\89\ 15 U.S.C. 78(e). In 1991, the Commission used this
authority to exempt AZX from the requirement to register as an
exchange. See AZX Exemptive Order, supra note 24.
\90\ Id.
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While an exemption would allow a new market to develop without
unnecessary and costly regulatory burdens, if that market achieved a
greater market presence, its exemption would no longer apply. Once a
market has attained more than a significant level of business, such
that it no longer can be considered to have a low impact on the
securities market, it would no longer be eligible for treatment as an
exempted exchange. Instead, it would be required to register as a
national securities exchange and be subject to greater regulatory
responsibilities and oversight. In order to give exempted exchanges
that attain significant volume sufficient time to prepare for
registration as a national securities exchange, it might be appropriate
to allow exempted exchanges to delay registration as an exchange for up
to one year after they consistently attain more than de minimis volume.
Treatment of low impact markets as exempted exchanges could also allow
existing exchanges that consistently fall below minimum volume levels
for an extended period of time to deregister and instead comply with
any requirements applicable to exempted exchanges.
Question 35: Should low impact markets be regulated as exempted
exchanges, rather than as broker-dealers?
[[Page 30501]]
Question 36: What measure or measures should be used in determining
whether a market has a low impact? What is the level above which an
alternative trading system should not be considered to have a low
impact on the market? At what level should an already registered
exchange be able to deregister?
Question 37: Should an alternative trading system be considered to
have a low impact on the market and be treated as an exempted exchange
if it trades a significant portion of the volume of one security, even
if the trading system's overall volume is low in comparison to the
market as a whole?
Question 38: In determining whether an alternative trading system
has a low impact, what factors other than volume should the Commission
consider? Should this determination be affected if the operator of an
alternative trading system was the issuer of securities traded on that
system?
b. Passive Markets
The Commission also could treat passive markets as exempted
exchanges. Passive markets are alternative trading systems that match
or cross orders at a price that is primarily or wholly derived from
trading on another market. For example, the POSIT system allows
participants to enter unpriced orders, which other participants cannot
view, and periodically crosses the orders. Any orders that match other
trading interest in this periodic cross are executed at the mid-point
of the bid/ask spread on the primary market for the security. Like
traditional exchanges, these systems centralize orders and set the
conditions under which participants agree to trade. Unlike active
pricing markets, however, passive pricing systems do not establish the
price at which securities trade on the system through the interaction
of priced orders of sellers with priced orders of buyers, or through
participant dissemination of quotes.
Question 39: Should passive markets be regulated as exempted
exchanges, rather than as broker-dealers?
c. Requirements for Exempted Exchanges
As a general matter, regardless of their regulatory status, markets
should comply with certain minimum requirements designed to clarify
their obligations as markets and to prevent harm to investors or
overall market integrity. 91 These requirements could be
less burdensome than the broker-dealer regulation to which these
markets are currently subject. This would continue to encourage the
robust development of U.S. markets. In cases in which alternative
trading systems do not also conduct customary brokerage activities,
these conditions could replace the broker-dealer regulation to which
alternative trading systems are now subject.92
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\91\ The only currently exempted exchange, AZX, is subject to a
number of exemption conditions. Among other things, it is required
to provide the Commission with regular activity reports, adopt and
implement procedures to surveil for potential insider trading or
manipulative abuses by participants, and cooperate with the
registered SROs. See AZX Exemptive Order, supra note 24, 56 FR at
8383.
\92\ Based on the information that the Commission currently has
regarding the activities of alternative trading systems, it believes
that only a few of the systems that would be exempted exchanges also
conduct customary brokerage functions. Regulation of broker-dealer
activities and market activities being conducted by the same
alternative trading system could be integrated. See infra Section
IV.B.4.d.
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Specifically, alternative trading systems seeking an exemption from
exchange registration could file an application for exemption
(including a system description) with the Commission prior to
operation. The Commission could establish a time period in which an
alternative trading system's application would automatically become
effective, unless disapproved by the Commission. Under this procedure,
disapproval of a system's exemptive application would probably be rare
and limited to specific circumstances, such as where a controlling
person of the system is subject to a statutory disqualification or
where the system fails to meet one of the requirements to be an
exempted exchange. In addition to an initial application, an exempted
exchange could also be required to: (1) Notify the Commission in the
event of a material change in operations or control; (2) maintain a
record of trading through the system and make such information
available to the Commission upon request; (3) implement procedures for
surveillance of employees' trading comparable to those adopted by
existing SROs to ensure that employees do not misuse confidential
customer information for insider or manipulative trading; (4) cooperate
with registered SRO investigations and examinations of the exempted
exchange's participants; (5) report trades to one or more designated
SROs, unless a trade is reported by a trade participant pursuant to its
SRO membership obligations; and (6) require participants to make
adequate clearance and settlement arrangements prior to participation
in trading on the exempted exchange. 93
---------------------------------------------------------------------------
\93\ 15 U.S.C. 78l.
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Question 40: Are the requirements described above appropriate to
ensure the integrity of secondary market oversight?
Question 41: Should any other requirements be imposed upon exempted
exchanges, such as requirements that an exempted exchange provide fair
access or establish procedures to ensure adequate system capacity,
integrity, and confidentiality?
Question 42: Should requirements vary with the type of alternative
trading system (e.g., should passive systems be subject to different
conditions than systems exempted on the basis of low impact)?
Question 43: Should the Commission require that securities traded
on exempted exchanges be registered under section 12 of the Exchange
Act? Should different disclosure standards be applicable to such
securities if they are only traded on such exchanges?
2. The Application of Exchange Regulation to Alternative Trading
Systems That Are Not Exempted Exchanges
If the term ``exchange'' is expanded to include alternative trading
systems, alternative trading systems that have active pricing
mechanisms and significant volume could be required to register as
national securities exchanges.
In the past, the Commission avoided requiring alternative trading
systems to register as exchanges because it had limited authority to
tailor exchange regulation to diverse market structures and because the
volume and number of alternative trading systems was relatively
small.94 In particular, prior to the adoption of the 1996
Amendments, the Commission had limited authority to reduce or eliminate
the consequences of exchange registration for innovative
systems.95 In light of these limitations,
[[Page 30502]]
the Commission believed that regulating alternative trading systems as
exchanges would stifle the development of such systems.
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\94\ 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 prior to 1991, the Commission considered the
implications of evolving market conditions on exchange regulation.
See Securities Exchange Act Release No. 8661 (Aug. 4, 1969), 34 FR
12952 (initially proposing Rule 15c2-10); Securities Exchange Act
Release No. 11673 (Sep. 23, 1975), 40 FR 45422 (withdrawing then-
proposed Rule 15c2-10 and providing for registration of securities
information processors); Securities Exchange Act Release No. 26708
(Apr. 13, 1989), 54 FR 15429 (reproposing Rule 15c2-10); and
Securities Exchange Act Release No. 33621 (Feb. 14, 1994), 59 FR
8379 (withdrawing proposed Rule 15c2-10).
\95\ Prior to adoption of the 1996 Amendments, the Commission's
authority under the Exchange Act to reduce or eliminate negative
consequences of exchange registration was limited. For example, the
Commission could only exempt an exchange from registration if the
exchange had limited transaction volume. See Exchange Act section 5,
15 U.S.C. 78e. Once an exchange was registered, the Commission only
had authority to exempt an exchange from a limited number of
requirements relating to an exchange's obligations as an SRO.
Although the Commission has authority under various sections of the
Exchange Act (including Sections 17 and 19) to exempt a registered
exchange from specific provisions, its exemptive authority under
these sections relates only to an exchange's obligations as an SRO
to oversee its members. These sections do not give the Commission
flexibility with respect to other requirements, such as the
obligation of an exchange to file rule changes with the Commission
for approval. The Exchange Act also did not give the Commission the
flexibility or authority to tailor regulation to reflect
technological and economic differences among markets. For example,
although Congress gave the Commission greater flexibility to address
rapidly changing market and technological conditions when it added
Section 11A to the Exchange Act in the 1975 Amendments, that section
does not provide the Commission with authority to reduce or
eliminate existing exchange requirements for innovative trading
structures. S. Rep. No. 75, supra note 23, at 3.
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The 1996 Amendments, however, provide the Commission with
considerable authority to exempt markets from provisions of the
Exchange Act. Given this expanded authority, the Commission's past
concerns that classification as an exchange would stifle innovation may
no longer outweigh competing concerns regarding the need to establish a
consistent, long-term approach to the regulation of alternative trading
systems and to better integrate the most significant of these systems
into the NMS.
a. Using the Commission's Exemptive Authority To Encourage Innovation
and To Eliminate Barriers to Non-Traditional Exchanges
Alternative trading systems encompassed by a revised interpretation
of the term ``exchange'' and not eligible for treatment as an exempted
exchange could be subject to fundamental statutory requirements
applicable to national securities exchanges, in order to ensure that
the goals of market regulation are met. These non-traditional exchanges
could be required, for example, to file an application for
registration,96 be organized and have the capacity to carry
out the purposes of, and comply and enforce compliance with, the
Exchange Act, the rules thereunder, and their own rules. These non-
traditional exchanges may also need to ensure that they 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 burden on competition. In
addition, they could be required to assure regulatory oversight of
their participants, participate in national market systems, and take
the public interest into account in administering their markets.
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\96\ Pursuant to Section 19(a)(1) of the Exchange Act, when an
applicant submits an application to register as a national
securities exchange under section 6 of the Exchange Act, the
Commission must publish a notice of the filing and within ninety
days must either grant the registration or institute proceedings to
determine whether the registration should be denied. Proceedings for
a denial of registration must be concluded within one hundred eighty
days, with an extension period available of up to another ninety
days. 15 U.S.C. 78s(a)(1).
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The Commission recognizes that these responsibilities would have
significant consequences for non-traditional markets. For example,
imposing SRO oversight obligations on existing proprietary systems
would change the relationship between such systems and their
participants significantly, and could raise transaction costs for
participants. Alternative trading systems have adopted different
corporate structures than the traditional non-profit, membership
exchanges and generally have entered into primarily commercial
relationships with their participants.97 While expanding the
common understanding of how exchanges operate and the functions that
they perform, these developing market structures do not fit easily into
the current regulatory scheme, which has been designed and applied
primarily to non-profit, membership exchanges.
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\97\ This effect has not been limited to U.S. alternative
trading systems. In the seven years since the Delta Decision, see
infra note 124, a growing number of stock exchanges throughout the
world have adopted fully automated structures similar to those of
alternative trading systems and appear to conduct trading without a
specialist or market maker structure. The Commission determined in
the Delta Release, see infra note 121, that the definition of the
term exchange in section 3(a)(1) of the Exchange Act requires the
Commission to view an entity as an exchange only if, in ``bringing
together purchasers and sellers,'' the entity performs the functions
commonly understood to be performed by exchanges. This reading is
based on the view that the words ``bringing together purchasers and
sellers'' in the definition cannot be read in a vacuum, but must be
read in the context of how exchanges commonly operate. At the time
that the Delta Release was issued, few exchanges had adopted
structures similar to alternative trading systems.
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Prior to adoption of the 1996 Amendments, it was difficult to
reconcile the private, commercial structure of these markets with the
membership structure and public obligations traditionally assigned to
national securities exchanges under the Exchange Act. For example, one
reason the Commission has been hesitant to adopt an expansive
interpretation of the term ``exchange'' is that it would impose a
participant-controlled board of directors on these
markets.98 Applying exchange regulation to new markets could
dictate their structure and could prevent them from adopting innovative
means of carrying out exchange obligations.
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\98\ See Delta Release, infra note 121, at 1900. The court in
the Delta Decision 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.'' Delta Decision, infra
note 124, at 1272-73.
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There does not appear to be an overriding regulatory reason to
require markets to adopt homogenous structures. To the contrary,
Congress clearly intended the 1975 Amendments to encourage innovation
by exchanges and recognized that future exchanges may adopt diverse
structures.99 Accordingly, the Commission could use its
exemptive authority to relieve alternative markets from requirements it
does not believe are critical to achieving the objectives of the
Exchange Act. In particular, the Commission could permit institutions
to access registered exchange facilities directly. In addition, the
Commission could consider ways in which exchanges that are not
participant-owned can meet fair representation requirements.
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\99\ See S. Rep. No. 75, supra note 22, at 7-9.
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(i) The Commission Could Consider Permitting Institutional Access to
Exchanges
Without exemptive relief, exchange registration would prevent
alternative trading systems from serving their institutional customers.
Historically, exchange members were individuals (and broker-dealers and
other organizations affiliated with those individuals) that traded
directly on the exchange floor and had an ownership interest in the
exchange.100 In keeping with this structure, many
requirements applicable to registered exchanges pertain to their
relationship with their ``members.'' 101 In addition, in
order to
[[Page 30503]]
give the Commission adequate authority over persons trading on
exchanges under section 6(c)(1) of the Exchange Act, Congress
prohibited exchanges from granting membership to any person that is
not, or is not associated with, a registered broker-
dealer.102 Taken together, these statutory provisions have
traditionally been interpreted to mean that all persons trading on an
exchange would be members of that exchange, and would be registered as,
or associated with, broker-dealers.103
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\100\ See Special Study, supra note 4, at 11-13.
\101\ The Exchange Act defines an exchange `member' as: ``The
term ``member'' when used with respect to a national securities
exchange means (i) any natural person permitted to effect
transactions on the floor of the exchange without the services of
another person acting as broker, (ii) any registered broker or
dealer with which such a natural person is associated, (iii) any
registered broker or dealer permitted to designate as a
representative such a natural person, and (iv) any other registered
broker or dealer which agrees to be regulated by such exchange and
with respect to which the exchange undertakes to enforce compliance
with the provisions of this title, the rules and regulations
thereunder, and its own rules.'' 15 U.S.C. 78c(a)(3)(A). The
Commission notes that this definition does not require an entity to
participate in the ownership of an exchange in order to be
considered a statutory ``member'' of that exchange.
\102\ Section 6(c)(1), 15 U.S.C. 78f(c)(1), prohibits exchanges
from granting new memberships to non-broker-dealers. At the time
this Section was adopted in 1975, 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. Section
15(e) of the Exchange Act, 15 U.S.C. 78o(e), gives the Commission
authority to require any member of a registered exchange that is not
required to register with the Commission as a broker-dealer to
comply with any provision of the Exchange Act (other than section
15(a)) and rules thereunder that regulate or prohibit any practice
by a broker-dealer.
\103\ As discussed below, however, despite this prohibition on
non-broker-dealer membership in exchanges, Section 6(f) of the
Exchange Act, 15 U.S.C. 78f(f), grants the Commission authority to
require non-broker-dealers to comply with the rules of the exchange.
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Alternative trading systems do not fit neatly into this structure
for several reasons. Unlike traditional exchanges that restrict
membership to broker-dealers, most alternative trading systems give
comparable access and trading privileges to both institutions and
broker-dealers.104 If all entities that have access to an
alternative trading system are treated as ``members'' under the
Exchange Act, section 6(c)(1) would prevent these systems from
continuing to provide direct access to their institutional
participants. On the other hand, if institutional entities that have
access to an alternative trading system are not treated as members, the
system's statutory obligations that pertain expressly to its
``members'' under the Exchange Act would not apply to those
institutions, and provisions of the Exchange Act that apply primarily
to exchange members, such as prohibitions regarding the trading of
unlisted securities under section 12, would no longer apply to all
participants on an exchange. This could result in neither the
Commission nor the market having sufficient authority to enforce
trading rules against those participants. It could also lessen the
effectiveness of oversight of trading on those markets. In either case,
if such systems were registered as exchanges, the statute's reliance on
the term ``member'' and the prohibition against exchange members that
are not affiliated with a broker-dealer would make it difficult for
alternative trading systems to continue meeting the trading needs of
institutional investors. The Commission also notes that, as markets
evolve, exchanges may ultimately wish to not only allow institutions to
access their trading facilities along with broker-dealers, they may
wish to provide trading facilities exclusively to institutions or other
non-broker-dealer participants (such as retail investors).
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\104\ Alternative markets also do not have ``members'' as that
term has been traditionally understood and interpreted by existing
exchanges. In particular, most alternative markets do not give their
participants voting rights or other ownership interests. The
Commission does not consider a non-profit membership structure to be
an inherent requirement for performing the trading functions of an
exchange.
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There is no direct evidence that Congress intended these provisions
to prohibit institutional investors from accessing the facilities of an
exchange. On the contrary, in the course of adopting the 1975
Amendments, Congress saw no overriding regulatory reason to prohibit
non-broker-dealers from obtaining direct access to the execution
facilities of exchanges.105 There also does not appear to be
a regulatory need to require entities to register as broker-dealers in
order to obtain direct access to exchanges.106 Because
institutions primarily trade for their own account, do not execute
orders for unaffiliated customers, and do not undertake to maintain
orderly markets for the exchange, institutional trading on an exchange
does not necessarily raise the type of concerns that broker-dealer
regulation was designed to address.107
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\105\ In the legislative history of the 1975 Amendments,
Congress expressly noted that advances in communication technologies
could permit an entity to trade on an exchange without the services
of a member acting as a broker, and without itself becoming a member
of that exchange. Reports by both the House of Representatives
Committee on Interstate and Foreign Commerce and the Senate
Committee on Banking, Housing and Urban Affairs noted the potential
for technology to permit non-members (both broker-dealers and
institutions) to effect transactions on exchanges without the
intermediation of a broker. See S. Rep. No. 75, supra note 22, at 99
(1975) (``The Committee recognizes that it is impossible at this
time to define precisely the manner in which investors, particularly
large institutional investors will or should have access to
execution facilities in a national market system.''); H.R. Rep. No.
123, supra note 39, at 66 (``[I]t is conceivable, that the
regulatory reach could be extended to investors or money managers
who are not themselves brokers or dealers but who have been
permitted the means of making direct executions on an exchange'').
\106\ See, e.g., Securities Exchange Act Release No. 35030 (Nov.
30, 1994), 59 FR 63141 (Dec. 7, 1994) (order approving Chicago
Match, an electronic matching system operated by the CHX, which
provided for the crossing of orders entered by CHX members and non-
members, including institutional customers).
\107\ For example, expanding the Commission's interpretation of
what constitutes an exchange to include alternative trading systems
with institutional participants could subject such institutions to
the constraints of section 11(a) of the Exchange Act. Section 11(a)
generally prohibits exchange members from effecting transactions on
such exchanges for their own accounts or the accounts of their
associated persons, or for their own managed accounts or the managed
accounts of their associated persons. 15 U.S.C. 78k(a). Section
11(a) was intended to encourage fair dealing and fair access in the
exchange markets by restricting exchange members' proprietary
trading, which Congress believed created a conflict between a
member's interests as a principal and the member's fiduciary
obligations when representing customer trades. Both Congress and the
Commission provided exceptions to the rule to accommodate principal
trading that does not conflict with the public interest.
Section 11(a) also granted the Commission broad authority to
regulate exchange members' trading. Congress explained that it gave
the Commission broad authority under section 11(a) for two reasons.
First, Congress recognized that it lacked expertise in this area,
and thus believed that any doubts should be resolved in favor of
maintaining present business practices. Second, Congress wanted the
Commission to have sufficient flexibility to accomplish the purposes
of the Exchange Act. See S. Rep. No. 75, supra note 22, at 68.
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Congress did, however, provide the Commission and exchanges with
sufficient authority in such circumstances to oversee the trading of
non-members on exchanges. Section 6(f) of the Exchange Act authorizes
the Commission to require any non-member that is effecting transactions
on an exchange without the services of another person acting as broker
to comply with the rules of such exchange.108 In addition,
any person required by the Commission to comply with an exchange's
rules pursuant to section 6(f) would be deemed a ``member'' of such
exchange for most relevant provisions of the Exchange
Act.109 Congress therefore envisioned
[[Page 30504]]
that it would be possible to allow entities to have electronic access
to an exchange without becoming a member, and at the same time, to
ensure through section 6(f) that the exchange and the Commission have
adequate authority to regulate such electronic access participants.
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\108\ 15 U.S.C. 78f(f)(1).
\109\ Section 3(a)(3)(A) of the Exchange Act provides that:
``For purposes of sections 6(b)(1), 6(b)(4), 6(b)(6), 6(b)(7), 6(d),
17(d), 19(d), 19(e), 19(g), 19(h), and 21 of this title, the term
'member' when used with respect to a national securities exchange
also means, to the extent of the rules of the exchange specified by
the Commission, any person required by the Commission to comply with
such rules pursuant to section 6(f) of this title.'' 15 U.S.C.
78c(a)(3)(A). This would require a registered exchange that
permitted institutions to effect transactions without the services
of a broker, among other things, to: (1) Enforce compliance by such
institutions with the provisions of the Exchange Act, the rules and
regulations thereunder, and the rules of the exchange; (2) allocate
equitably its dues, fees, and other charges among its members,
issuers, and such institutions; and (3) provide fair procedures for
the disciplining of such institutions. Exchange Act sections
6(b)(1), (4), (7) and 19(g), 15 U.S.C. 78f(b)(1), (4), (7), and
19(g). Further, an exchange imposing any disciplinary sanction on,
denying participation to, or prohibiting or limiting access to any
institution would be required to file notice of such action with the
Commission. The Commission would have authority to review any such
action. Exchange Act sections 19(d) and 19(e), 15 U.S.C. 78s(d) and
78s(e). The Commission would have the same authority to allocate
among SROs regulatory responsibilities with respect to institutions
effecting transactions on an exchange without the services of a
broker as it currently does with respect to exchange members.
Exchange Act section 17(d), 15 U.S.C. 78q(d). The Commission would
also have the authority to sanction an exchange for failure to
enforce compliance with the Exchange Act, the rules thereunder, or
the exchange's rules by institutions that were permitted to effect
transactions on the exchange, and to commence an investigation under
section 21 to determine whether any such institution has violated
the Exchange Act. Exchange Act section 21, 15 U.S.C. 78u.
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The development of fully automated markets has revealed an
inconsistency in this scheme, however. Both the Commission and Congress
have recognized that the ``floor'' of an exchange could include a non-
physical trading system operated by such exchange.110 As a
result, any natural person with direct access to an exchange's
alternative trading system would appear to be effecting transactions on
the ``floor'' of such exchange and, therefore, would be a ``member'' of
that exchange under the statute. Despite congressional intent not to
unnecessarily restrict non-member access to exchanges under this
interpretation, there would appear to be no circumstances in which
institutions could electronically access an automated exchange without
being considered ``members'' of that exchange.
---------------------------------------------------------------------------
\110\ See Committee on Interstate and Foreign Commerce Report,
H.R. Rep. No. 123, supra note 39, at 66 (1975) (``As the market
systems make greater use of communications and data processing
techniques, the concept of a physical `floor' of an exchange will
disappear. Instead we will have a communications network which will
serve as the `floor' of the future marketplace'').
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In order to make it possible for alternative markets to register as
exchanges, therefore, congressional intent to allow entities to have
access to exchanges without becoming traditional members must be
reconciled with the existence of non-physical ``floors.'' Any method of
doing so must also ensure that, as Congress intended, exchanges and the
Commission have sufficient authority to supervise and oversee all
persons accessing an exchange's facilities.
There are at least two ways in which the Commission could achieve
this. First, the Commission could interpret the term ``member''
narrowly, to apply only to natural persons who are permitted to effect
transactions on a physical exchange floor.111 Under this
interpretation, no entity that accesses a fully automated exchange
would be deemed a ``member'' of that exchange. In addition, both
broker-dealers and institutions could electronically access exchanges
that maintain physical floors without being deemed members of those
exchanges. With respect to any such non-member participants on an
exchange, the Commission could exercise its authority under section
6(f) of the Exchange Act to require the non-member participants of an
exchange to comply with that exchange's rules to the extent
appropriate. In addition, these non-member participants could be deemed
members of such exchanges for certain purposes of the Exchange Act.
Depending upon the extent to which the Commission exercised its
authority under section 6(f), therefore, there may be little practical
difference in an exchange's obligations to surveil traditional members
and its obligation to surveil entities that are members by virtue of a
Commission order pursuant to section 6(f).112
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\111\ Persons trading on the physical floor of an exchange, such
as floor brokers and specialists, would continue to be ``members''
of that exchange under any construction of the Exchange Act.
\112\ In these circumstances, it is not clear how provisions of
the Exchange Act that are by their terms applicable only to exchange
members or broker-dealers would apply to non-broker-dealers that
access exchange facilities. For example, sections 11(a) and 9(b)
would not appear to apply directly to non-member participants in
exchanges.
---------------------------------------------------------------------------
In the alternative, the Commission could interpret the term
``member'' broadly, to apply to any natural persons that are permitted
to effect transactions through an exchange's facilities and any persons
associated with such natural persons. Under this interpretation, the
Commission could then use the exemptive authority granted by the 1996
Amendments to exempt exchanges from the prohibition on non-broker-
dealer membership in section 6(c)(1) of the Exchange Act. The
Commission could then allow exchanges to revise any rules that would
not appropriately apply to non-broker-dealer members. Using this
approach, the Commission would not be called upon to exercise its
authority under section 6(f).
Question 44: Should the Commission allow institutions to be
participants on registered exchanges to the same extent as registered
broker-dealers? If so, should the Commission adopt rules allowing
registered exchanges to have institutional participants, or should the
Commission issue exemptive orders on a case-by-case basis, upon
application for relief by registered exchanges?
Question 45: Should the Commission allow exchanges to provide
services exclusively to institutions?
Question 46: If the Commission allows institutions to participate
in exchange trading, should the Commission view all entities that have
electronic access to exchange facilities as ``members'' under the
Exchange Act and then exempt exchanges from section 6(c)(1)?
Question 47: Is it foreseeable that exchanges will wish to permit
retail investors to be participants in their markets? If so, should the
Commission allow retail participation on registered exchanges to the
same extent as registered broker-dealers?
Question 48: Should the Commission allow registered exchanges to
provide services exclusively to retail investors?
Question 49: Could exchanges have various classes of participants,
as long as admission criteria and means of access are applied and
allocated fairly? Would it be in the public interest if new or existing
exchanges sought to operate primarily or exclusively on a retail basis?
What would be the advantages and disadvantages if new or existing
exchanges were to admit as participants only highly capitalized
institutions or only highly capitalized institutions and broker-
dealers?
(ii) The Commission Could Consider Ways in Which Alternative Exchanges
Can Meet Fair Representation Requirements
An exchange's obligation to establish fair representation of
investors and participants in its decisionmaking process could also
significantly affect the structure of proprietary systems. Section
6(b)(3) of the Exchange Act compels an exchange to 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.'' 113 Securities associations have identical fair
representation requirements.114 Because many alternative
trading systems are operated as for-profit, non-membership
[[Page 30505]]
corporations, complying with these representation obligations would
potentially change the nature of their operations and relationship with
their participants.
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\113\ Exchange Act section 6(b)(3), 15 U.S.C. 78f(b)(3).
\114\ Exchange Act section 15A(b)(4), 15 U.S.C. 78o-3(b)(4).
---------------------------------------------------------------------------
With respect to the first requirement, the public's interest in
ensuring the fairness and stability of significant markets was of
paramount importance to Congress, which adopted a structure that seeks
to ensure this through public representation on an exchange's board of
directors. Under this structure, fair representation of the public on
an oversight body that has substantive authority and decisionmaking
ability therefore may be 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.115
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\115\ See NASD 21a Report, supra note 20.
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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,116 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 in this respect, because these actions
can have significant and far-reaching ramifications for broker-dealers.
Accordingly, under the Exchange Act structure, it may be essential to
give exchange participants equitable and enforceable input into
disciplinary and other key processes to prevent them from being
conducted in an inequitable, discriminatory, or otherwise inappropriate
fashion.
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\116\ See supra Section II.B.1.
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The Commission has not, however, 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, Pacific Exchange ``electronic access
members'' (``ASAP Members'') do not have voting rights, and therefore
are not represented on the board of that exchange.117 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.118 Other structures
may also provide independent, fair representation for an exchange's
constituencies in its material decisionmaking processes, for exchanges
that are not owned by their participants. For example, an 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 rule making processes for the exchange,
and ensuring that the governance of such subsidiary equitably
represents the exchange's participants.119
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\117\ 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 PSE, since renamed
PCX).
\118\ 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 (March 6, 1978), 43 FR 10288 (March 10,
1978). See also Securities Exchange Act Release No. 16900 (June 17,
1980), 45 FR 41920 (June 23, 1980).
\119\ The Commission notes that the proprietary 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.
---------------------------------------------------------------------------
Question 50: Should non-membership exchanges (including alternative
trading systems that may register as exchanges) be exempt from fair
representation requirements?
Question 51: Should all exchanges be required to comply with
section 6(b)(3) by having a board of directors that includes
participant representation?
Question 52: If not, are there alternative structures that would
provide independent, fair representation for all of an exchange's
constituencies (including the public)?
3. Expanding the Commission's Interpretation of ``Exchange''
To create a new category of exempted exchanges and to apply
exchange registration requirements to the most significant alternative
trading systems, the Commission would have to expand its current
interpretation of ``exchange'' to encompass many more trading systems
than are currently considered ``exchanges.'' Although the Exchange Act
definition of ``exchange'' is potentially quite broad,120
the Commission currently interprets this definition 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.''
121 The Commission analyzed how the definition of exchange
applies to alternative trading systems in a 1991 release, explaining
its decision not to register a government options trading system as an
exchange (``Delta Release'').122 The Commission concluded
that, in light of congressional emphasis on the ``generally
understood'' meaning of stock exchange and the Exchange Act as a whole,
the definition of exchange should be applied narrowly, to include only
those entities that enhanced liquidity in traditional ways through
market makers, specialists, or a single price auction
structure.123 Because most alternative
[[Page 30506]]
trading systems do not have these features, this narrow interpretation
effectively excluded most alternative trading systems from exchange
regulation.124 Thus, many alternative trading systems have
not been required to register as exchanges to date and have instead
been regulated as broker-dealers.
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\120\ The Exchange Act defines an ``exchange'' as: ``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 and
the market facilities maintained by such exchange.'' 15 U.S.C.
78c(a)(1).
\121\ See Securities Exchange Act Release No. 27611 (Jan. 12,
1990), 55 FR 1890, 1900 (Jan. 19, 1990).
\122\ Id. In 1988, the Commission granted Delta Government
Options Corporation (``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 v.
SEC, 883 F.2d 525 (7th Cir. 1989). 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. See Delta Release, supra note 121.
\123\ See Delta Release, supra note 121, at 1900. The Commission
stated: ``In summary, employing an expansive interpretation of
section 3(a)(1) results in potential conflicts with other central
regulatory definitions under the (Exchange) Act as well as adverse
effects on innovation and competition. Rather, each system must be
analyzed in light of the statutory objectives and the particular
facts and circumstances of that system. In conducting such an
analysis, the central focus of the Commission's inquiry should be
whether the system is 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.
The means employed may be varied, ranging from a physical floor or
trading system (where orders can be centralized and executed) 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).'' Id.
\124\ The Commission's authority to adopt this narrow
interpretation was subsequently upheld by the U.S. Court of Appeals
for the Seventh Circuit. Board of Trade of the City of Chicago v.
SEC, 923 F.2d 1270 (7th Cir. 1991), reh'g en banc, den'd, (7th Cir.
1991) (hereinafter Delta Decision). The court noted that ``the Delta
system differs only in degree and detail from an exchange . . .
Section 3(a)(1) (of the Exchange Act) is broadly worded. No doubt .
. . this was to give the Securities and Exchange Commission maximum
control over the securities industry. So the Commission could have
interpreted the section to embrace the Delta system. But we do not
think it was compelled to do so.'' Id. at 1273 (quoting Chevron v.
Natural Resources Defense Council, 467 U.S. 837, 844-45 (1984)). In
reaching its decision, the court gave weight to the Commission's
belief that classifying the Delta system as an exchange would have
destroyed its commercial viability. The court also relied in part on
the Commission's position that, because Delta would be registered as
a clearing agency and the system sponsor would be a registered
broker-dealer, there did not appear to be any overriding regulatory
need to regulate the system as an exchange. Delta Decision, supra at
1273. The court stated that the Commission ``can determine . . .
whether the protection of investors and other interests within the
range of the statute is advanced, or retarded, by placing the Delta
system in a classification that will destroy a promising competitive
innovation in the trading of securities.'' Id. Since 1991, the
Commission staff has given operators of trading systems assurances,
based on the interpretation upheld by the court in Delta, that it
would not recommend enforcement action if those systems operated
without registering as exchanges. 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 (Feb. 14, 1994), 59 FR 8368, 8369-71
(Feb. 18, 1994) (hereinafter Rule 17a-23 Proposing Release). See
also Letters from the Division of Market Regulation to: Niphix
Investments Inc. (Dec. 19, 1996); 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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There are, however, several alternative ways in which the
definition of ``exchange'' could be applied more broadly.125
For example, a large variety of services performed by existing markets
and intermediaries could be considered to be functions that are
commonly understood to be performed by exchanges within the meaning of
section 3(a)(1) of the Exchange Act. Those services include: (1)
Centralizing trading interest; (2) providing the opportunity for
multiple parties to participate in trading; (3) specifying time, price,
size, or other priorities governing the sequence or interaction of
orders; (4) providing an opportunity for active price formation (either
through interaction of buy and sell interest or through competing
dealer quotes); (5) specifying material conditions under which
participants may post quotations or trading interest (such as requiring
participants to maintain firm, two-sided, or continuous quotes); (6)
creating mechanisms for enhancing liquidity, such as giving certain
participants special privileges in exchange for assuming market
obligations; (7) giving participants control over setting the trading
rules; and (8) setting qualitative standards for listing instruments or
otherwise standardizing the material terms of instruments traded.
Various commenters have identified these and other functions as central
characteristics of exchanges.126
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\125\ The Exchange Act, coupled with relevant legislative
history, appears to provide the Commission with ample authority to
revise its interpretation of an exchange. 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)).
\126\ See, e.g., Robert A. Schwartz, Technology's Impact on the
Equity Markets (Future Markets: How Information Technology Shapes
Competition (C. Kremerer ed., forthcoming 1997)) (``In the U.S., an
exchange is an environment where broker/dealer intermediaries, not
natural buyers and sellers meet. In contrast, broker/dealer member
firms provide the services (information analysis and dissemination,
provision of dealer capital, order handling, account handling etc.)
that bring the customer to the market to trade.''); Ruben Lee, What
is an Exchange? (1992) (available from author) (regulators should
consider 25 attributes when determining whether a trading system is
an exchange, including price discovery, liquidity, competition of
orders, price priority, secondary priorities, information access,
and centralized order execution); Therese Maynard, What is an
``Exchange''?--Proprietary Electronic Securities Trading Systems and
the Statutory Definition of an Exchange, 49 Wash. & Lee L. Rev. 833
(1991); J. Harold Mulherin et al, Prices are Property: The
Organization of Financial Exchanges from a Transaction Cost
Perspective, 34 J. of Law & Econ. 591 (Oct. 1991) (the establishment
of property rights to price quotes is a central function of
financial exchanges, although the authors do not discount the fact
that exchanges accomplish many other functions); Lawrence Harris,
Liquidity, Trading Rules, and Electronic Trading Systems (1990)
(available from author) (exchanges provide services by creating an
environment that encourages traders to offer liquidity, often by
establishing a set of rules that provide liquidity suppliers
protection in proportion to the service that they provide to the
market); Jonathan Macey & Hideki Kanda, The Stock Exchange as a
Firm: The Emergence of Close Substitutes for the New York and Tokyo
Stock Exchanges, 75 Cornell L. Rev. 1007 (1990) (in addition to
liquidity, organized stock exchanges offer three other services
(monitoring, devising standard form contracts, and lending
reputational capital to listing firms) that listing firms view as
valuable); Ian Domowitz, An Exchange is a Many Splendored Thing: The
Classification and Regulation of Automated Trading Systems, in The
Industrial Organization and Regulation of the Securities Industry 93
(Andrew W. Lo ed., 1996) (the price discovery process with the
associated dissemination of price information, and centralization
for the purpose of trade execution are the basic functions of
trading systems). See also Ruben Lee & Ian Domowitz, The Legal Basis
for Stock Exchanges: The Classification and Regulation of Automated
Trading Systems (1996) (available from authors) (there should be no
distinction in the regulation of market structure issues between
institutions now classified as exchanges and those now classified as
broker-operated trading systems).
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Each of these functions is performed by existing exchanges and
could be incorporated into the Commission's interpretation of the term
``exchange.'' 127 Because alternative trading systems do not
always offer each of these services, however, if alternative trading
systems are integrated into market regulation mechanisms through
exchange regulation, a revised interpretation of the term ``exchange''
based on whether a market offers all, or many, of these functions would
continue to exclude many alterative trading systems. For example, the
application of the term exchange could be broadened to include those
entities that provide the opportunity for multiple parties to
participate in centralized trading. While many alternative trading
systems provide a central execution system, others organize trading by
centralizing the display of participant trading interest, and then
specifying the sequence or priorities under which participants must
trade with each other. Although orders may not directly interact on
such markets, the order and price at which they are executed is
determined by the market. The fairness of this procedure
[[Page 30507]]
will affect participants in those markets no less than the fairness of
procedures on an exchange that allows orders to interact centrally.
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\127\ For example, as noted above, the Commission's current
interpretation captures the functions of centralizing trading
interest, providing the opportunity for multiple parties to
participate in trading, and providing mechanisms to enhance
liquidity, such as giving certain participants special privileges in
return for assuming market obligations.
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Similarly, an exchange could be defined as only those entities that
provide an opportunity for active price formation (either through
interaction of buy and sell interest or through competing dealer
quotes). This criteria would capture automated matching systems, such
as Instinet, Tradebook, Island and Terra Nova's Archipelago system, but
would not include crossing systems that establish a price based on the
price already established in another market, such as POSIT, within the
term ``exchange.'' Whether or not a market engages in active price
formation, however, is not the sole factor that may determine a
market's potential to harm investors through unfair treatment or
vulnerability to manipulation. Moreover, markets without active price
discovery still have the potential to affect the integrity of trading
and surveillance on other markets. Depending upon its configuration,
for example, a passive pricing system can provide incentives for its
participants to manipulate prices in the market from which the passive
price is derived in order to affect the outcome of a cross. Finally,
while there is general consensus that active price formation occurs
through the interaction of orders, there is little consensus on whether
the interaction of orders through negotiation, such as occurs within a
broker-dealer, should also be considered to be price
formation.128 As market changes continue to affect how
securities trade, basing the interpretation of the term ``exchange'' on
whether a market engages in price discovery could generate significant
uncertainties for markets that develop innovative pricing
mechanisms.129 Therefore, if the Commission expands its
interpretation of the term ``exchange,'' it could be appropriate to
include passive markets in such an interpretation. Under such an
approach, passive markets could be integrated into market regulation by
regulating such systems as exempted exchanges.
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\128\ Compare Lawrence A. Cunningham, From Random Walks to
Chaotic Crashes: The Linear Genealogy of the Efficient Capital
Market Hypothesis, 52 Geo. Wash. L. Rev. 546, 597 (1994) (``price
discovery in capital markets arises solely as the result of
traders'' orders meeting in the market''); with M. Perry, A
Challenge Postponed: Market 2000 Complacency in Response to
Regulatory Competition for International Equity Markets, 34 Va. J.
Int'l L. 701, 740 (1994) (``It is not clear whether `price
discovery' means price negotiation between the trading parties or
price determination by the market'').
\129\ For example, one trading system currently in development,
OptiMark, allows participants to enter entire portfolios of
securities at a range of prices and sizes at which they would be
willing to trade if a variety of other factors are met. It is not
clear whether this type of contingent pricing mechanism could be
considered ``active price formation.''
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Reinterpreting the term ``exchange'' based on other traditional
exchange functions may have similar drawbacks. For example, unlike
existing exchanges, few alternative markets give certain participants
special privileges in return for assuming market obligations, give
participants control over setting the trading rules, or set listing
standards.130 Moreover, while many exchanges currently
provide the services noted above, it is not certain that exchanges will
always do so in the future.131 As a result, if alternative
trading systems were integrated into market regulation through exchange
regulation, rather than broker-dealer regulation, basing a revised
interpretation of ``exchange'' on these traditional functions could
result in the same regulatory gaps and lack of flexibility that the
current situation has created.
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\130\ Although many alternative trading systems limit trading to
securities traded on a registered exchange or Nasdaq, they do not
establish or enforce qualitative or quantitative independent listing
standards or require that securities be registered under the
Exchange Act.
\131\ See, e.g., Gerald Novak, A Failure of Communications: An
Argument for the Closing of the NYSE Floor, 26 U. Mich. J.L. Reform
485, 503 (1993) (while specialists may create enough benefit to the
market to allow them to exist within the current regime, the
benefits do not seem substantial enough to maintain the physical
exchanges solely for the purpose of perpetuating the role of the
specialist.) See also Norman S. Poser, Restructuring the Stock
Markets: A Critical Look at the SEC's National Market System, 56
N.Y.U.L. Rev. 883, 956-57 (1981) (arguing for the elimination of the
present specialist system in favor of an institutionalized
specialist function).
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For these reasons, if the Commission were to revise its
interpretation of ``exchange,'' it would also consider focusing such a
reinterpretation primarily on those essential functions commonly
provided by registered exchanges and alternative markets, in order to
achieve congressional intent to regulate central marketplaces for
securities trading. For example, the Commission could revise its
interpretation of the term ``exchange'' to include any organization
that both: (1) Consolidates orders 132 of multiple parties;
and (2) provides a facility through which, or sets material conditions
under which, participants entering such orders may agree to the terms
of a trade. This revised interpretation would closely reflect the
statutory concept of ``bringing together'' buying and selling
interests. It would also broaden the Commission's concept of what is
``generally understood'' to be an exchange to reflect changes in the
U.S. and world markets brought about by automated
trading.133
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\132\ As noted above, the term ``orders'' in this release is
intended to be read broadly, to include any firm trading interest.
This would include both limit orders and market maker quotations.
\133\ See, e.g., AZX Exemptive Order, supra note 24; Internet
Site of the Australian Stock Exchange, address: http://
www.azx.com.au (Dec. 5, 1996) (orders entered on the Australian
Stock Exchange are automatically matched and executed through SEATS,
a screen based trading system); Internet Site of SIMEX, address:
http://www.simex.com (Nov. 6, 1996) (the Singapore International
Monetary Exchange is a complete, integrated electronic trading
system, which uses an order matching system based upon the use of a
matching algorithm reflecting strict price/time priority for all
orders entered into the system). In addition, Tradepoint, a
recognized investment exchange in the United Kingdom, operates as an
order driven, automated system for the trading of shares of U.K.
issuers listed on the London Stock Exchange without the use of
market makers or specialists.
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Question 53: Would the revised interpretation of ``exchange'' being
considered by the Commission adequately and clearly include alternative
trading systems that operate open limit order execution systems (even
those that also provide brokerage functions)?
Question 54: In light of the decreasing differentiation between
market maker quotes and customer orders in trading, should the
Commission consider an ``order'' to include any firm trading interest,
including both limit orders and market maker quotes?
Question 55: What should the Commission consider to be ``material
conditions'' under which participants entering orders may agree to the
terms of a trade? For example, should an alternative trading system be
considered to be setting ``material conditions'' when it standardizes
the material terms of instruments traded on the market, such as
standardizing option terms or requiring participants that display
quotes to execute orders for a minimum size or to give priority to
certain types of orders?
a. Effects of Expanding the Commission's Interpretation of ``Exchange''
on Selected Types of Alternative Trading Systems
One of the principal advantages of expanding the Commission's
interpretation of the term ``exchange'' would be to provide sufficient
flexibility within the concept of an exchange to encompass both
currently registered exchanges and significant existing alternative
trading systems, as well as unforeseen alternative trading systems that
may arise in the future. At the same time, the Commission has
consistently maintained that the definition of exchange should not be
interpreted so
[[Page 30508]]
broadly as to overlap or interfere with other sections of the Exchange
Act, such as those governing broker-dealer activities or securities
associations. 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.134 Therefore, if the
Commission decides to broaden its interpretation of ``exchange'' to
encompass alternative trading systems, it would have to take into
account the potential effects of such an interpretation on entities
regulated under other sections of the Exchange Act. This may include
entities that provide traditional brokerage activities (e.g.,
traditional block trading desks or internal programs that allow traders
within a firm to search and match orders with customer orders of other
traders within the same firm), information vendors, and markets
operated by the NASD. For example, the Commission would not intend any
revised interpretation of ``exchange'' to capture traditional brokerage
activities or the internal automation of traditional brokerage
activities. Similarly, it may be inappropriate for a revised
interpretation of ``exchange'' to capture certain alternative trading
systems, such as interdealer brokers in exempted securities, that are
regulated under separate regulatory schemes. Discussed below are the
possible effects of an expanded interpretation of ``exchange'' on these
market participants.
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\134\ One key factor in the Commission's decision not to
regulate the Delta system as an exchange was the concern that,
absent greater exemptive authority, doing so would subject
traditional broker-dealer activities to exchange regulation. Delta
Release, supra note 121. Although some alternative trading systems
claim to be the modern analog of traditional brokerage activity, the
Commission believes that, while some are, the nature of systems that
combine the functions of brokers and exchanges cannot be so readily
simplified.
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(i) Broker-Dealer Activities
In light of the blurring distinctions between the services offered
by markets and market participants described above,135 the
differences between modern exchange and broker-dealer activities are
not easily articulated. Some firms have integrated technology into
their activities in ways that appear to have much in common with the
trading systems used by modern exchanges. Nonetheless, broker-dealer
activities can be distinguished from those of an exchange for several
reasons.
---------------------------------------------------------------------------
\135\ See supra notes 14 and 14 and accompanying text.
---------------------------------------------------------------------------
First, unlike organized markets, traditional broker-dealer
activities do not involve the systematic interaction of customer orders
where the customers themselves are informed of and have an opportunity
to agree to the terms of their trades (or agree to the priorities under
which the terms will be set). For example, broker-dealers may automate
part of their intermediary function (such as block trading desk
activity) by developing internal programs that allow traders within a
firm to search and match orders with customer orders of other traders
within the same firm, or with orders and quotes of other traders.
Similarly, technologically sophisticated firms may create an internal
process for centralizing information regarding customer orders. Such
systems, however, generally serve as a means of providing information
regarding a firm's customer orders solely to the employees of the
broker-dealer operating the system to facilitate the employees'
crossing of customer orders on a discretionary basis. In other words,
the only participant in such a system is the broker-dealer that
operates it. Similarly, while block trading desks provide a central
location where employees of a single broker-dealer trade side-by-side,
they do not systematically consolidate the customer orders handled by
those employees. Although an employee may ultimately match its customer
order with a customer order held by a trader sitting across the room,
this does not operate as an organized mechanism for ensuring that
customer orders are matched, crossed, or otherwise centralized.
Second, a broker-dealer traditionally retains discretion in
determining how to handle customer orders. Unlike an exchange, which
customers access in part to participate in a particular market or
market structure, a customer that gives its order to a broker-dealer
typically gives discretion to that broker-dealer regarding which market
the order will ultimately be executed in, how the order may be split up
or ``worked,'' or whether the broker-dealer will choose to execute the
order as principal or as agent. Although a broker-dealer may disclose
its standard practices to customers, ultimately these execution
decisions are left to the discretion of the broker-dealer, consistent
with the responsibilities imposed on broker-dealers. For example, a
block positioner may ``shop'' the order around to other traders in his
own firm in an attempt to find a contra-side order that has been placed
with another trader. In some cases, the block positioner may take the
other side of the order, keeping the block as a proprietary position.
This decision is dictated by market conditions and typically lies
within the block positioner's discretion. Unless otherwise agreed,
customers have no rights regarding the system other than the
expectation that the broker-dealer will handle the order according to
its broker-dealer obligations.
Finally, a sophisticated market maker that develops a system to
broadcast its own quotations to the public, or to allow its customers
to direct orders for execution solely against that market maker's
inventory, is conducting broker-dealer activity. 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. Single market maker systems merely
provide a more efficient means of communicating the trading interest of
separate customers to one dealer and thus would not be considered
exchange activities.
As noted above, much of this analysis assumes that these activities
are being engaged in ``systematically,'' or in a ``traditional'' or
``typical'' fashion. The Commission recognizes that these concepts are
not easily defined and that this approach will leave many issues and
gray areas to be resolved. The Commission is soliciting comment on how
any revised interpretation of the term exchange could clearly
distinguish between these activities and those of alternative trading
systems.
Question 56: Is it appropriate for the Commission to consider the
activities described above as broker-dealer activities?
Question 57: How should a revised interpretation of exchange
adequately and clearly distinguish broker-dealer activities, such as
block trading and internal execution systems, from market activities?
Question 58: Are the distinctions discussed above accurate
reflections of exchange and broker-dealer activities? Are there other
factors that may better distinguish a broker-dealer from an exchange?
(ii) Organized Dealer Markets
The term ``exchange,'' as articulated above, would encompass
organized dealer markets that operate systems to consolidate
participant orders for display, and set material conditions under which
orders can be executed (including automatically executing
[[Page 30509]]
orders).136 As discussed in the Delta Release, dealer
markets have traditionally consisted of loosely organized groups of
individual dealers that trade securities OTC, without formal
consolidation of orders or trading. Historically, the majority of
trading in corporate, government, and municipal debt instruments has
been conducted through such OTC dealers. Individual dealers in such
markets generally do not directly ``bring together'' public purchasers
and sellers. The court and the parties in the Delta
Decision137 assumed that the term ``exchange,'' as that term
is generally understood, would not apply to such a loosely organized
market. The approaches described above continue the notion that the
definition of ``exchange'' should not cover such loosely organized
traditional dealer markets and that broker-dealer regulation should
continue to govern individual dealers in those markets.138
As individual dealers and associations of dealers have employed
technology to make OTC markets more efficient, however, dealer markets
in certain instruments have become organized to such an extent that
they have assumed many of the characteristics of exchange markets. This
is particularly true in markets that trade instruments that are also
listed on registered exchanges, such as equity securities. For example,
Nasdaq consolidates trading interest of multiple dealers on a screen
that is displayed real-time to its members, and provides a mechanism
for dealers to update displayed quotations. The NASD also imposes
obligations on market makers in Nasdaq National Market and SmallCap
securities to provide a continuous source of liquidity in Nasdaq,
establishes minimum qualifications that issuers must meet in order for
their securities to be quoted on the consolidated screen, and sets
enforceable rules that govern the priorities dealers must give to
certain orders. Through additional services, such as SelectNet, Nasdaq
also allows dealers to trade with orders electronically. In other
words, a group of market participants, through Nasdaq, act in concert
to centralize and disseminate trading interest and establish the basic
rules by which securities will be traded on Nasdaq. Because the NASD is
already registered as a securities association, the Nasdaq market would
not need to be regulated as an exchange. The Commission, however, could
consider whether entities that operate similar markets in the United
States should be considered exchanges under any expanded interpretation
if they are not operated by a registered securities association.
---------------------------------------------------------------------------
\136\ The only dealer market in the United States that currently
appears to both consolidate participant quotes and set conditions
governing execution is the Nasdaq market, operated by the NASD. As
discussed below, because the NASD is already registered as a
securities association, the Commission would not intend for any
revised interpretation of ``exchange'' to include the Nasdaq market.
The Commission, however, could consider whether other entities that
operate similar markets in the United States should be considered
exchanges under any expanded interpretation, unless they were also
operated by a registered securities association.
\137\ See Delta Decision, supra note 124.
\138\ For example, commercial paper trades through several large
dealers that disseminate their own quotes to their customers and
make a two-sided market in the paper of various issuers. Trading in
the commercial paper market is highly concentrated among a few large
dealers, some of which provide automated quotation screens for their
customers. Unlike an exchange market, however, no entity currently
attempts to centralize trading interest by reflecting multiple
dealer quotes, or by setting conditions under which the commercial
paper of differing issuers may be traded by dealers.
---------------------------------------------------------------------------
Question 59: How should a revised interpretation of the term
``exchange'' adequately and clearly distinguish broker-dealer
activities, such as block trading and internal execution systems, from
market activities?
Question 60: What factors should the Commission consider in
determining whether an organization of dealers is sufficiently
``organized'' to require exchange registration?
(iii) Information Vendors and Bulletin Boards
The Commission is also concerned that any revised interpretation of
the term ``exchange'' not be so broad as to encompass those entities
that provide information, but do not provide a central facility for
executing trades or set conditions governing trading. Information
vendors and ``bulletin boards'' often provide a centralized display of
general trading interest, comments, or other information regarding
trading, but they generally do not enable customers to communicate
directly with each other, execute orders, or otherwise agree to the
terms of a trade through their facilities. These entities also do not
establish the conditions under which customers negotiate or trade based
on displayed information.139 Because these entities
centralize information without standardizing trading based on such
information, the approach described above would not regulate these
entities as exchanges if they do not allow for execution through their
system or set conditions of trading.
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\139\ Commission staff has previously indicated that it would
not recommend enforcement action if a system operated by an issuer
that does not allow transactions to be executed on the system, and
that is designed to provide limited information to buyers and
sellers of stock, does not register as an exchange. See Letter from
Catherine McGuire, Martin Dunn, and Jack Murphy, SEC, to Barry
Reder, Coblentz, Cahen, McCabe & Breyer, LLP (June 24, 1996)
(counsel to Real Goods Trading Corporation).
---------------------------------------------------------------------------
The Commission recognizes that the difference between an exchange
and an electronic bulletin board depends on the functions that they
make available. For instance, a passive bulletin board that merely
provides names and addresses of prospective buyers and sellers and the
prices at which they are willing to buy or sell would not be an
exchange because it would not set priorities that govern trades, and
transactions resulting from posted indications of interest, if any,
would be executed outside the system. If a system created an electronic
link between multiple potential buyers (e.g., a ``chat room''),
however, it could be considered to be providing a facility through
which participants entering orders may agree to the terms of a trade
(e.g., an exchange). The Commission requests comment on whether such a
system should be considered to be an exchange, particularly if the
customer orders displayed on the system are firm, or if the system
specifies the priorities for customer interaction through the
electronic linkage or ``chat room.'' 140
---------------------------------------------------------------------------
\140\ In addition, it is possible for an information vendor to
provide its services by linking its screens to execution facilities
provided by other entities with which the vendor has a contractual
arrangement. In these circumstances, the information vendor may be
captured by the proposed revised interpretation of the term
``exchange,'' depending upon the nature of the services provided.
---------------------------------------------------------------------------
Question 61: Does the revised interpretation of ``exchange''
described above clearly exclude information vendors, bulletin boards,
and other entities whose activities are limited to the provision of
trading information? How should the Commission distinguish between
information vendors, bulletin boards, and exchanges?
(iv) Interdealer Brokers
Certain markets that are not centrally organized by a single entity
are nonetheless informally organized around interdealer
brokers,141 which display the bids and offers of other
dealers anonymously. The importance and role of these interdealer
brokers has changed significantly in the past twenty years. While
interdealer brokers traditionally had relatively small volume, they are
now key players in the government and municipal securities
[[Page 30510]]
markets,142 and have begun to operate in other instruments
as well. Today, interdealer brokers provide liquidity by providing a
central mechanism to display the bids and offers of multiple dealers
and by allowing dealers and investors to trade large volumes of
securities anonymously and efficiently based on those bids and offers.
In the government securities market, for example, interdealer brokers
compile and display the anonymous bids and offers of other government
securities dealers and traders on screens located in the dealers'
offices. Dealers call an interdealer broker via telephone to display
their quote information or to execute against a displayed
quotation.143 Automated brokers' brokers in the secondary
market for municipal securities operate in a similar manner,
disseminating centralized quotation information and executing trades
for their customers by telephone.144
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\141\ As used in this release, the term ``interdealer brokers''
includes entities that are referred to as brokers'' brokers and
blind brokers in certain markets.
\142\ Trading by interdealer brokers began to become popular in
the government securities market, after trading had moved from the
NYSE to the over-the-counter market in the 1920s and the demise of
trading agreements in the mid-1950s that had previously provided a
foundation for interdealer business. See U.S. Congress, Joint
Economic Committee, a Study of the Dealer Market for Federal
Government Securities 21-26, 49-53 (1960); U.S. Department of the
Treasury and U.S. Federal Reserve, Treasury-Federal Reserve Study of
the Government Securities Markets 95-100 (1959). By 1972,
interdealer brokers handled approximately 14% of the trading of
government securities by dealers; by 1990, interdealer brokers
handled more than 50% of such business. See Marcia Stigum, The Money
Market 644-56 (3d ed. 1990).
\143\ Dealers and other customers have direct telephone lines to
the various individual brokers working at an interdealer broker. The
individual brokers typically handle one to three customers each,
depending upon activity levels. When customers wish to buy or sell a
security through an interdealer broker, they call the individual
broker assigned to them at that interdealer broker. Through their
assigned broker, customers can hit a bid or take an offer already
shown on the screen, tell the broker to post a new, better bid or
offer on the screen, or give the broker other information about
their activities and trading needs. When customers wish to hit a
quote on the screen or enter a new quote, the broker taking that
information announces the hit or new bid/offer to other brokers (who
are taking information from other customers), and the broker or
other staff enter the information so that it is displayed on
internal and customer screens. Trading supervisors within the
interdealer broker mediate disputes, such as which broker called out
an order first. See generally U.S. Department of the Treasury,
Report of the Secretary of the Treasury on Specialized Government
Securities Brokers and Dealers (1995) (hereinafter 1995 Treasury
Report); U.S. Securities and Exchange Commission, 1994 Annual Report
29-30 (1994); 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)
(hereinafter 1992 Joint Report); Stigum, supra note 142; U.S.
General Accounting Office, U.S. Government Securities: More
Transaction Information and Investor Protection Are Needed, 19, 97-
100 (1990); U.S. General Accounting Office, U.S. Government
Securities: An Examination of Views Expressed About Access to
Brokers' Services 28-35 (1987).
\144\ See Division of Market Regulation, U.S. Securities and
Exchange Commission, Staff Report on the Municipal Securities Market
17-22 (1993) (hereinafter Municipal Securities Report). See also
Securities Exchange Act Release No. 37998 (Nov. 29, 1996), 61 FR
64782 (Dec. 6, 1996) (Commission approval order for Municipal
Securities Rulemaking Board proposals to increase transparency in
the municipal securities market); U.S. Securities and Exchange
Commission, 1995 Annual Report 31 (1995).
---------------------------------------------------------------------------
Operating in this manner, interdealer brokers centralize trading
interest and provide a mechanism for agreeing to the terms of a trade
in much the same way as registered exchanges and alternative markets
do. Interdealer brokers in these markets may also determine certain
trading practices.145 This is a significant change from the
way interdealer brokers operated just 30 years ago, when they
disseminated last sale information to customers individually, rather
than centrally, and operated under less formalized procedures.
---------------------------------------------------------------------------
\145\ Generally, a broker considers a bid or offer placed with
it good until canceled, but the conditions under which they are
subject to variation is a matter left up to each interdealer broker.
For example, usually, ``when the (Federal Reserve) comes into the
market, all bids and offers (become subject to reaffirmation).
However, when some key economic number is released, some brokers
make the market (subject to reaffirmation), others don't; in this
area, there are no formal rules.'' Stigum, supra note 142, at 647.
---------------------------------------------------------------------------
Like block trading desks, interdealer brokers now have certain
elements in common with markets, but have also retained some of their
traditional characteristics. For example, although interdealer brokers
do not give advice, they exercise some discretion in matching and
executing orders of their dealer customers.146 Commenters
have suggested that these features should distinguish traditional
interdealer brokers to some extent from markets that establish
priorities for executing participant orders or that otherwise set
conditions governing trading between participants. Because interdealer
brokers have begun to display quotations in real-time to their
customers, centralize the negotiation of trading, and establish
conventions under which trading will occur, the issue is whether this
difference has become primarily one of degree.147 Individual
brokers at an interdealer broker, in many respects, perform similar
functions to exchange specialists. Moreover, if an interdealer broker
automated its activities fully, there would appear to be little
difference between its activities and those of existing alternative
trading systems. Given this evolution, the Commission could consider
whether interdealer brokers should be considered exchanges under a
revised interpretation.
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\146\ See 1992 Joint Report, supra note 143, at A9-A11.
\147\ ``The government brokers run what amounts to an unlicensed
exchange. In the 20-odd years that governments have been brokered,
the way in which that exchange operates has slowly changed. At the
outset, brokers phoned runs to dealers, then in 1977 to 1978, the
era of screens began.'' Stigum, supra note 142, at 655. The
following quote from a dealer also supports the Commission's view:
``Also, dealers came to view the brokers as just one more place,
along with the Chicago pits, to trade--just another place to get
business done.'' Id. at 652.
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If the Commission determines that the activities of interdealer
brokers should be encompassed by a revised interpretation of
``exchange,'' it could consider whether to use its exemptive authority
to exclude those interdealer brokers that trade exempted securities
148 from exchange registration requirements. As noted in the
Delta Release, Congress has given no indication that it intended to
subject traditional interdealer brokers in the government and municipal
securities markets to exchange regulation.149 Moreover,
regulation of traditional interdealer brokers in government and
municipal securities as exchanges may not be necessary or appropriate
in the public interest at this time, in light of the specialized
oversight structures for these markets. Both the government and
municipal securities markets are overseen through special regulatory
schemes that are tailored to the particular features of those debt
markets. Government securities broker-dealers are overseen jointly by
the U.S. Department of the Treasury (``Treasury''), the Commission, and
federal banking regulators, under the Exchange Act (particularly the
provisions of the Government Securities Act of 1986) and the federal
banking laws.150 Municipal securities broker-
[[Page 30511]]
dealers and transactions in municipal securities are overseen by the
Commission, the Municipal Securities Rulemaking Board (``MSRB''), the
NASD, and the federal banking regulatory authorities under the Exchange
Act (particularly section 15B) and the federal banking laws. Unlike
equities and other instruments traded primarily on registered
exchanges,151 surveillance of trading in government and
municipal securities is not conducted by entities that operate
competing markets in those instruments. Instead, surveillance of the
government securities market is coordinated among the Treasury, the
Commission, and the Board of Governors of the Federal Reserve System.
In the municipal securities market, Congress established the MSRB as an
SRO for broker-dealers in municipal securities; unlike SROs in other
markets, however, the MSRB does not operate a market and was not given
inspection or enforcement powers. Surveillance of the municipal
securities market for fraud and market manipulation is conducted by the
Commission and the NASD.152
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\148\ Exempted securities are defined in section 3(a)(12) of the
Exchange Act to include government securities and municipal
securities, among other things. 15 U.S.C. 78c(a)(12).
\149\ See Delta Release, supra note 121, at 1898 n.87.
\150\ See 1995 Treasury Report, supra note 143. ``Under the
regulatory structure established by the Government Securities Act of
1986, as amended in 1993, the Treasury was given rulemaking
authority over all brokers and dealers in government securities.
Specifically, the Treasury was designated by Congress as the sole
rulemaker for specialized government securities brokers and dealers
(33 firms as of March 1995) and was given rulemaking authority for
the government securities activities of financial institutions that
filed notice as government securities brokers and dealers
(approximately 300 as of January 1995). The Treasury and the SEC
have overlapping rulemaking responsibilities for the government
securities activities conducted by general securities brokers and
dealers (15(b) firms) which numbered about 2,231 as of March 1995.
The (Government Securities Act) granted the Treasury the authority
to promulgate rules and regulations for each of these entities
concerning financial responsibility, protection of investor
securities and funds, recordkeeping and financial reporting, and
audits.''
Id. at 3.
\151\ 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 1992 Joint Report, supra note 143.
\152\ Coordinated surveillance of secondary trading in municipal
securities is still developing. The MSRB, under the Commission's
supervision, has authority to issue rules governing, among other
things, professional qualifications, recordkeeping, quotations, and
advertising of municipal securities broker-dealers. Enforcement of
MSRB rules is divided between banking regulatory agencies (for
banks) and the NASD (for non-bank firms), with the Commission having
authority over all municipal securities dealers, as well as non-bank
municipal securities broker-dealers. See Municipal Securities
Report, supra note 144, at 37. Recently, the Commission approved an
MSRB rule change designed to increase the information available
about municipal securities and to provide a centralized audit trail
of municipal securities transactions. See Securities Exchange Act
Release No. 37998 (Nov. 29, 1996), 61 FR 64782 (Dec. 6, 1996).
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As a result of these specialized oversight structures, regulation
of particular market participants in the government and municipal
securities markets as broker-dealers, rather than as exchanges, is not
likely to weaken coordination of overall market oversight or create
competitive inequities among differently regulated entities that
perform similar functions. For these reasons, if the Commission expands
its interpretation of ``exchange'' to cover interdealer brokers
generally, it could consider expressly exempting traditional government
and municipal securities interdealer brokers that trade exempted
securities from exchange registration.
It should be noted that the above analysis is based on existing
mechanisms for supervising trading in government and municipal
securities markets, and on current trading practices of interdealer
brokers in such markets. In the event that an interdealer broker
automates its services more completely, or operates in a manner more
similar to an equity market, for example, this analysis could be
reevaluated. Similarly, the above analysis would not apply to
derivatives of government and municipal securities.
Question 62: If the Commission expands its interpretation of
``exchange,'' should the Commission exempt interdealer brokers that
deal only in exempted securities from the application of exchange
registration and other requirements?
Question 63: How could the Commission define interdealer brokers in
a way that would implement congressional intent not to regulate
traditional interdealer brokers as exchanges, without unintentionally
exempting other alternative trading systems operated by brokers?
4. Effect of Broadening the Definition of ``Exchange''
Reinterpreting the definition of ``exchange'' to apply to a broader
range of entities would have significant effects, not only on those
alternative trading systems classified as exchanges, but also on the
securities trading on those exchanges, currently registered exchanges,
the NMS, clearance and settlement mechanisms, and market participants.
In particular, substantial work would be necessary to ensure that newly
registered exchanges could be smoothly integrated into existing market
structures.
a. Regulation of Securities Trading on Alternative Trading Systems
Classifying alternative trading systems as exchanges could affect
the trading of securities on these systems, particularly on those
systems that are required to register as national securities exchanges.
Securities traded on a national securities exchange must be registered
with the Commission and approved for listing on the exchange, or traded
pursuant to Commission regulations governing trading of securities
listed on another exchange (``unlisted trading privileges'' or
``UTP''). These requirements are critical to ensuring that securities
trading on exchanges provide investors with adequate information and
that all relevant trading activity in a security is reported to, and
surveilled by, the exchange on which such security is listed.
Specifically, 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 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.153
Under this requirement, upon registration as exchanges, alternative
trading systems that are currently trading unregistered securities
could no longer freely trade those securities.154
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\153\ 15 U.S.C. 78l(a). Section 12(b), 15 U.S.C. 78l(b),
contains procedures for the registration of securities on a national
securities exchange.
\154\ Section 12(a) does not apply to exchanges that the
Commission has exempted from registration as national securities
exchanges, although the Commission could consider whether it would
be appropriate to limit trading on exempted exchanges to securities
registered under section 12 of the Exchange Act. See AZX Exemptive
Order, supra note 24. See also Securities Exchange Act Release No.
37271 (June 3, 1996), 61 FR 29145 (June 7, 1996).
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In addition, national securities exchanges are permitted to trade
securities listed on other exchanges and Nasdaq only pursuant to UTP
regulations, which limit the range of securities that they may
trade.155 Like all exchanges, a newly registered exchange
would be required to have in place rules for trading the class or type
of securities it seeks to trade.156 To trade Nasdaq/National
Market (``NM'') securities, a newly registered exchange would also be
required to become a signatory to an existing plan governing such
trading.157 Moreover, under section 12(f) of the Exchange
Act, exchanges cannot trade securities not registered on an exchange or
classified as NM securities (such as Nasdaq SmallCap or other OTC
securities) without Commission action. Section 12(f) of the Exchange
Act authorizes the Commission to permit the extension of UTP to any
security registered otherwise than on an exchange. The OTC-UTP
plan,158 which permits UTP for Nasdaq/NM securities, is the
only extension approved to date by the Commission.159 Thus,
exchanges cannot currently trade Nasdaq SmallCap, other OTC securities,
or exempted securities that are not separately listed on the exchange.
This restriction would also apply, absent Commission action, to
alternative
[[Page 30512]]
trading systems newly registered as exchanges.160
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\155\ Exchange Act Sec. 12(f), 15 U.S.C. 78l(f).
\156\ Exchange Act Rule 12f-5, 17 CFR 240.12f-5.
\157\ See OTC-UTP plan, infra note 168.
\158\ See infra note 168 and accompanying text.
\159\ Id.
\160\ National securities exchanges are also prohibited,
pursuant to Exchange Act Rule 12f-2, from extending UTP to a
security subject to an initial public offering (``IPO'') until the
trading day following commencement of the IPO. Currently, pursuant
to NASD rules, participants in the OTC market, including alternative
trading systems, may trade securities subject to an IPO immediately
after trading has opened on the listing exchange. NASD Manual
Section 6440(j). If registered as an exchange, such entities would
be subject to the one-day waiting period prior to trading securities
subject to an IPO.
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These restrictions would have a significant effect on newly
registered exchanges. Most alternative trading systems do not
independently list securities; securities traded on such systems are
generally unlisted or listed on another market. As a result, in order
to comply with Exchange Act requirements applicable to national
securities exchanges, such systems would need to establish listing
procedures and comply with Commission regulations governing unlisted
trading privileges. Under the tiered approach to regulating alternative
trading systems, the ability of such systems to trade a wide range of
securities would be subject to the same UTP conditions as currently
registered exchanges. In order to minimize some of these effects, the
Commission could consider expanding the category of securities that
would be available for UTP trading.
Integrating a broader range of entities into the UTP structure
could also affect existing exchange rules, such as NYSE Rule 390 and
similar offboard trading restrictions, designed to limit members from
effecting OTC transactions in exchange-listed stocks.161 For
example, transactions that are executed through alternative trading
systems currently may be considered to be OTC transactions. If
significant alternative trading systems were to register as exchanges,
activity on those systems could no longer be considered to be OTC.
Consequently, rules that expressly prohibit OTC transactions in listed
securities by their terms would no longer apply to activity on those
alternative trading systems and, as a result, the number of
transactions subject to the prohibition of such rules would decrease.
The Commission is soliciting comment on whether there would be any
customer protection or competitive reasons to preserve these offboard
trading restrictions if the interpretation of ``exchange'' is broadened
to include alternative trading systems and highly organized dealer
markets.
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\161\ For example, NYSE Rule 390 prohibits NYSE members from
effecting certain transactions in NYSE-listed stocks in the OTC
market. Exchange Act Rule 19c-1, however, prohibits the application
of off-board trading restrictions to trades effected by a member as
agent. 17 CFR 240.19c-1. Moreover, Exchange Act Rule 19c-3 prohibits
the application of off-board trading restrictions to securities
listed on an exchange after April 26, 1979. 17 CFR 240.19c-3.
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Question 64: How could the Commission foster the continued trading
of all securities currently traded on alternative trading systems if
these systems are classified as exchanges under the interpretation
described above and some of these systems are required to register as
national securities exchanges? For example, what would be the effect on
alternative trading systems that wish to trade securities exempted from
registration under Rule 144A if those systems are required to register
as national securities exchanges?
Question 65: How would the requirement to have rules in place for
trading unlisted securities affect the viability of alternative trading
systems that are required to register as national securities exchanges?
Question 66: Would the specifications in the OTC-UTP plan relating
to the trading of Nasdaq/NM securities pose particular problems for
systems that are required to register as national securities exchanges?
Question 67: Should the Commission extend UTP to securities other
than NM securities, such as Nasdaq SmallCap securities? What effect
would an inability to trade Nasdaq SmallCap and other non-Nasdaq/NM
securities have upon alternative trading systems that are required to
register as national securities exchanges?
Question 68: What effect would the prohibition on UTP trading of
newly listed stock until the day following an initial public offering
have upon systems that are required to register as national securities
exchanges?
Question 69: How should existing exchange rules designed to limit
members from effecting OTC transactions in exchange-listed stock be
applied, if the Commission's interpretation of exchange were expanded
to include alternative trading systems and organized dealer markets?
What customer protection and competitive reasons might there be to
preserve these rules if alternative trading systems are classified as
exchanges?
b. Integration with National Market System Mechanisms and Existing
Exchange Practices
A revised interpretation of the term ``exchange'' would not only
affect currently registered exchanges and alternative trading systems
required to register as exchanges, it could also have a significant
impact on the NMS, coordination of market-wide trading policies,
listing arrangements, and exchange rules governing member trading in
the OTC market. There could also be significant effects on coordination
of market-wide surveillance and enforcement efforts among national
securities exchanges.
Because alternative trading systems differ in several key respects
from currently registered exchanges, a number of issues would need to
be resolved before these systems could be integrated into national
market system mechanisms. Integrating newly registered national
securities exchanges into the NMS mechanisms should not cause the
homogenizing of all markets--to the contrary, it is as important today
as it was in 1975 to cultivate an atmosphere in which innovation is
welcome and possible. Such integration therefore could require revision
of NMS mechanisms so that they could accommodate diverse and evolving
markets. The Commission solicits comment, as discussed in greater
detail below, on what revisions to the structure of NMS mechanisms
might be necessary to accommodate alternative trading systems. The
Commission also solicits comment on the costs and potential effects on
innovation if alternative trading systems were linked to NMS
mechanisms. In addition, the Commission solicits comment on the costs
and potential effects if revisions to the NMS mechanisms were not
effective.
Question 70: What effects would linking alternative trading systems
to NMS mechanisms have on those systems? For example, how would such
linkages affect the ability of alternative trading systems to operate
with trading and fee structures that differ from those of existing
exchanges or to alter their structures? To what extent could revision
of the NMS plans alleviate these effects?
(i) Inter-Market Plans
If certain alternative trading systems were required to register as
national securities exchanges, these systems would be expected to
become participants in market-wide plans currently subscribed to and
operated by registered exchanges and the NASD. All of the currently
registered exchanges and the NASD participate in joint plans for
transaction and quotation reporting: the CQS, the CTA, the
ITS,162 the
[[Page 30513]]
Options Price Reporting Authority (``OPRA''),163 and the
Nasdaq/National Market System/Unlisted Trading Privileges (``OTC-
UTP'').164 These plans form an integral part of the NMS for
the trading of securities, and contribute greatly to the operation of
linked, transparent, efficient, and fair markets. In order for any
newly registered national securities exchanges to become fully
integrated into the NMS, it would be essential that the operations of
those new exchanges and the market linkage systems be compatible. If
the Commission revises its approach to regulation of alternative
trading systems by requiring those with active pricing mechanisms and
significant volume to register as national securities exchanges, it may
have to take action to ensure the suitable and timely inclusion of new
exchanges into the NMS.
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\162\ The CTA provides vendors and other subscribers (including
alternative trading systems) with consolidated last sale information
for stocks admitted to dealings on any exchange. The CQS gathers
quotations from all market makers in exchange-listed securities and
disseminates them to vendors and other subscribers. 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)
(Cincinnati Stock Exchange / 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) (Chicago Board Options Exchange /
ITS linkage).
\163\ See infra note 169 and accompanying text for a description
of the OPRA plan.
\164\ See infra note 168 and accompanying text for a description
of the OTC-UTP plan.
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(A) Quotation and Transacting Reporting
If certain alternative trading systems are required to register as
national securities exchanges, they would be required to have effective
quote and transaction reporting plans and procedures in place under
section 11A of the Exchange Act.165 The CTA and CQS plans,
which are now operated by the eight national securities exchanges and
the NASD, make quote and transaction information in exchange-listed
securities available to the public. Both the CTA and the CQS plans have
provisions governing the entry of participants to the
plans.166 According to the terms of the CTA plan, any
national securities exchange or registered national securities
association may become a participant of the CTA by subscribing to the
CTA plan 167 and paying to the existing participants an
appropriate amount for the ``tangible and intangible assets'' created
under the plans that will be made available to the new participant. The
CQS Plan has similar terms. Participants in the CTA and CQS plans share
in the income and expenses associated with the provision of quotation
information according to the terms of the plans.
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\165\ See also Exchange Act Rules 11Ac1-1(b)(1), 17 CFR
240.11Ac1-1(b)(1); 11Aa3-2(c), 17 CFR 240.11Aa3-2(c).
\166\ 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.
\167\ See Securities Exchange Act Release No. 37191 (May 9,
1996), 61 FR 24842 (May 16, 1996).
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Under the terms of the OTC-UTP plan governing trading of Nasdaq/NMS
securities, 168 any national securities exchange where
Nasdaq/NMS securities are traded may become a full participant
thereunder. The plan specifically states that a new signatory must pay
a share of development costs to become a participant in the plan. The
plan provides for the collection, consolidation, and dissemination of
quotation and transaction information for Nasdaq/NM securities, sets
forth specifications for transmission of data to Nasdaq, and
establishes procedures for market access, regulatory trading halts,
cost allocation, and revenue sharing. Similarly, the OPRA plan approved
by the Commission 169 provides for the collection and
dissemination of last sale and quotation information on options that
are traded on the participant exchanges. Under the terms of the 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.
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\168\ 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). Currently, the NASD, the CHX, and
the Phlx are participants in the OTC-UTP plan. The BSE is a limited
participant, and as such only reports quotation and transaction
information for Nasdaq/NM securities that are also listed on the
BSE. See Securities Exchange Act Release No. 36985, 61 FR 12122
(March 18, 1996).
\169\ 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) (hereinafter OPRA plan). The five
exchanges which are participants in the OPRA plan are the Amex, the
CBOE, the NYSE, the PCX, and the Phlx.
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Given the breadth of these plans, existing plan participants would
need to work expeditiously with newly registered exchanges to
facilitate inclusion of these new exchanges into the NMS plans.
Participation in these transaction reporting plans should not seriously
impair the functioning of most alternative trading systems. If the
Commission revised its approach to regulation of alternative trading
systems by requiring those with active pricing mechanisms and high
volume to register as national securities exchanges, it may have to
take action to ensure the suitable and timely inclusion of new
exchanges into these quotation and transaction reporting plans.
Question 71: Are there any insurmountable technical barriers to
admission of alternative trading systems into the CTA, CQS, OPRA, or
OTC-UTP plans?
Question 72: What costs are associated with the admission of new
applicants to these plans?
Question 73: Are there any CTA, CQS, OPRA, or OTC-UTP plan rules
that would prevent newly registered national securities exchanges from
obtaining fair and equal representation on these entities?
Question 74: What effect would the admission of newly registered
national securities exchanges to the CTA, CQS, OPRA, and OTC-UTP plans
have upon the governance and administration of those plans?
Question 75: Do admissions fees for new participants required by
the terms of the plans present a barrier to admission to the plans? Do
the plans' provisions that all participants are eligible to share in
the revenues generated through the sale of data affect commenters'
views on this issue?
(B) Intermarket Trading System
It has been the Commission's longstanding policy that market
centers trading listed stocks be linked. The current linkage, ITS,
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, by sending a commitment to execute with another market through
the system. 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. Finally, ITS rules
require that the members of participant markets avoid initiating a
purchase or sale at a worse price than that available on another ITS
[[Page 30514]]
participant market (``trade-throughs'').170 Participation in
the ITS will give users of these new exchanges full access to, and
enable them to execute transactions on other ITS participant markets.
Moreover, participation in ITS will require new exchanges to comply
with other applicable ITS rules and policies on matters such as, for
example, trade-throughs, locked markets, 171 and block
trades.172
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\170\ 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\. See ITS
plan, supra note 162, at Exhibit B. 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. See
ITS plan, supra note 162, at Exhibit B(b)(2).
\171\ 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.
\172\ 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).
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Under an approach that involved broadening the interpretation of
``exchange,'' entities newly registered as national securities
exchanges would be expected to sign the plan and become participants in
ITS, or an equivalent system if one were developed.173
Alternative trading systems, however, have developed differently than
exchanges and often serve different constituencies. Some practices of
alternative trading systems would undoubtedly conflict with the current
provisions of the ITS plan, or would be incompatible with participation
in ITS. For example, many alternative trading systems allow
participants to trade in smaller increments than those available on
current plan participants. Similarly, many alternative trading systems
have institutional participants who may prefer to trade at an inferior
price in order to trade in a larger size, resulting in a locked or
crossed market. These characteristics are potentially incompatible with
current ITS provisions. If the Commission were to adopt a revised
approach to the regulation of alternative trading systems, it likely
would be necessary to work with plan participants to accommodate
diverse market structures in the plan.
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\173\ 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 162, at
section 3(c).
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Question 76: What effect would the admission of new, highly
automated participants have upon the operation of the ITS?
Question 77: How would compliance with the current ITS rules and
policies affect trading on alternative systems that may be regulated as
exchanges? How appropriate are these rules and policies for alternative
trading systems?
Question 78: What costs would be associated with newly registered
exchanges joining ITS? Would those costs represent a barrier for newly
registered exchanges to join ITS?
Question 79: Are there any ITS plan rules or practices that would
prevent newly registered national securities exchanges from obtaining
fair and equal representation on the ITS?
Question 80: What effect would the admission of newly registered
national securities exchanges to the ITS plan have upon the governance
and administration of the plan?
(ii) Uniform Trading Standards
The Commission is also considering how policies governing market-
wide trading, such as trading halts and circuit breakers, would apply
to alternative trading systems that register as exchanges. Registered
national securities exchanges, the NASD, and the Commission each have
the authority to impose trading halts for individual securities, for
classes of securities, and on markets as a whole.174 There
are four types of trading halts: (1) Halts due to primary or regional
market order imbalance, or operational problems; (2) regulatory halts
(as a result of dissemination of material news); (3) halts due to data
processing or telecommunications problems (e.g., the inability to
disseminate quotations or trade reports); and (4) Commission ordered
halts. The existing registered exchanges and the NASD currently have
different rules and procedures in place for applying trading halts, and
a new interpretation of the term ``exchange'' would result in a broader
application of these trading halts in some instances. Because many
alternative trading systems are currently operated by registered
broker-dealers, they are subject to NASD rules, including rules
requiring them to comply with trading halts imposed by the NASD. If
registered as national securities exchanges, however, such systems
would be required to impose their own trading halts.175 In
addition, a trading system that was regulated as an exchange, would
need to implement circuit breaker rules for extraordinary market
volatility.
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\174\ See, e.g., Amex Rule 117, NASD Rule 4120(a)(3), NYSE Rules
80B and 717. Pursuant to Exchange Act sections 12(k)(1)(A) and (B),
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. 15 U.S.C. 78l(k)(1)(A) and (B).
\175\ For example, a newly registered exchange would be required
under Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1 (the ``Quote
Rule''), to halt trading when neither quotation nor transaction
information can be disseminated.
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Question 81: What effect would the requirements to impose trading
halts or circuit breakers in some circumstances have upon alternative
trading systems if such systems were regulated as exchanges?
c. Oversight of Non-Broker-Dealers That Have Access to Exchanges and
Clearance and Settlement of Non-Broker-Dealer Trades
As discussed above, Congress intended for an exchange that allowed
non-broker-dealers to access its facilities to be responsible for
overseeing the trading of such non-broker-dealers.176 The
scheme of self-regulation and market oversight codified in the Exchange
Act relies primarily on trading markets to implement and operate market
mechanisms for enforcing the federal securities laws and for ensuring
that all market participants have adequate access to market
information. This system may be able to function effectively only if
all significant trading activity and market participants are supervised
by an SRO. If entities can participate directly in the market in a
significant way without being overseen by an SRO, market mechanisms
designed to ensure transparency and to surveil for fraud and
manipulation may not be fully effective. The Commission's findings in
the NASD 21(a) Report, discussed above, demonstrate the problems that
arise when trading occurs on markets that are not subject to effective
market oversight.177 Therefore,
[[Page 30515]]
it would probably be necessary for any registered exchange to supervise
the trading of non-broker-dealer participants in the same manner as it
supervises broker-dealer trading. For example, as part of its
obligations under the Exchange Act, each exchange currently maintains
procedures to surveil for insider trading and manipulation on that
exchange. These procedures, while differing among exchanges, generally
identify trading anomalies based on historical and current data, review
trading data to isolate suspicious activity and, if suspicious activity
is found, refer the matter for enforcement proceedings.178
If an exchange permitted institutions to directly participate in
trading as members, the Commission, pursuant to its authority under
section 6(f) of the Exchange Act, could require that exchange to
enforce its rules with respect to such non-broker-dealers by conducting
equivalent surveillance procedures.
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\176\ As noted above, Congress adopted section 6(f) specifically
to ensure that the Commission and exchanges have sufficient
authority both to limit the ability of non-members to utilize
exchange facilities and to ensure that transactions on that exchange
are effected in accordance with applicable exchange rules regardless
of whether the particular transaction is brought to the exchange by
a broker-dealer that is not an exchange member or by an investor who
is not utilizing a broker. See supra section II.B.2.a.(i).
\177\ See NASD 21(a) Report, supra note 20.
\178\ An exchange's surveillance depends on the nature of
trading that occurs, and the type of securities that are traded on
the exchange.
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Nevertheless, it may not be appropriate to enforce exchange rules
for non-broker-dealers in precisely the same manner as for broker-
dealers. For example, although an exchange would have to maintain
surveillance procedures for all of its participants, an exchange may
require a non-broker-dealer participant to provide different
information in the course of cooperating with investigations than would
be required from broker-dealer participants. Similarly, in addition to
the Commission's net capital requirements for broker dealers,
179 each registered exchange currently requires their
broker-dealer members to maintain minimum levels of
capital.180 Exchanges could consider applying different
financial requirements to non-broker-dealer participants than they
currently apply to broker-dealers.
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\179\ 17 CFR 240.15c3-1. Capital requirements help to ensure
that broker-dealers maintain liquid assets in sufficient amounts to
enable them to satisfy their obligations promptly and to provide a
cushion of liquid assets to protect against potential market and
credit risks.
\180\ See, e.g., NYSE Rule 325.
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In any case, institutions that trade for accounts other than their
own, maintain custody of customer funds or securities, act as
specialists or market makers, or otherwise act as brokers or dealers
would be required to register as broker-dealers under the Exchange Act.
Entities that engage in broker-dealer activities would continue to be
required to comply with broker-dealer registration requirements,
Exchange Act and SRO capital and books and records requirements, as
well as prohibitions under section 11(a) and other provisions of the
Exchange Act designed to protect against conflicts of interest between
an exchange member trading for its own account on an exchange and its
trading on an agency basis for other accounts.181
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\181\ For example, broker-dealers are prohibited from trading
ahead of a customer's order, frontrunning, free-riding and
withholding, and maintaining accounts for the employees of other
broker-dealers without notifying such broker-dealers.
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In addition, integration of alternative trading systems that have
institutional participants into exchange registration will raise issues
regarding clearance and settlement of the trades of those participants.
Currently, institutions do not participate directly in the clearance
and settlement process at registered clearing agencies such as the
National Securities Clearing Corporation (``NSCC'') or The Depository
Trust Company (``DTC'').182 There is, however, no statutory
prohibition against the admission of institutions as members of
registered clearing agencies.183 Conversely, there are no
provisions under the Exchange Act, the rules thereunder, or current SRO
rules, that require a member conducting trades on an exchange to be a
direct member of a clearing agency. Currently, for example, broker-
dealer members of an exchange may use a clearing broker for processing
trades conducted on an exchange. Similarly, the Commission anticipates
that institutions that conduct trades on newly registered exchanges
could continue to use separate entities for clearance and settlement of
trades.
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\182\ Institutions will generally hire a bank or broker-dealer
that is a member of DTC to act as custodian on their behalf.
Institutions can be members of DTC's Institutional Delivery system
for purposes of the confirmation/affirmation process, but the actual
settlement of securities transactions (i.e., the transfer of money
and securities) at DTC occurs between the institutions' broker-
dealers and custodians. Similarly, NSCC is designed to process
street-side settlement between financial intermediaries such as
broker-dealers. Therefore, institutions are not members of NSCC for
the purposes of settlement of trades.
\183\ In fact, Section 17A of the Exchange Act requires that
registered investment companies and insurance companies be permitted
to become members of clearing agencies. 15 U.S.C. 78q-1(b)(3)(B).
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In order to provide future institutional members the same clearance
and settlement choices available to current broker-dealer exchange
members, it may be appropriate for clearing agency membership to be
open to institutions. Such admission would be subject to corresponding
clearing agency rules assuring appropriate safeguards and
qualifications.
Question 82: What impact would registration of an alternative
trading system as an exchange have on the institutional participants of
that trading system, including registered investment companies?
Question 83: If the Commission allows institutions to effect
transactions on exchanges without the services of a broker, to what
extent should an exchange's obligations to surveil its market and
enforce its rules and the federal securities laws apply to such
institutions?
Question 84: How could an exchange adequately supervise
institutions that effect transactions on an exchange without the
services of a broker?
Question 85: What, if any, accommodations should be made with
respect to an exchange's surveillance, enforcement, and other SRO
obligations with respect to institutions that transact business on that
exchange?
Question 86: How could institutions that directly access exchanges
be integrated into existing systems for clearance and settlement?
d. Application of Broker-Dealer Regulation to Certain Exchanges
Under the alternative discussed above, most alternative trading
systems would be regulated as exempted exchanges. A few alternative
trading systems, however, combine both the services of a market and
those of a broker-dealer. For example, some systems perform market
functions by operating electronic limit order books or crossing
sessions. These same systems employ persons to actively search for
buyers and sellers 184 or use their discretion in executing
orders.185
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\184\ The system employee, for example, negotiates or assists in
negotiating the terms of a particular trade on behalf of a
participant by initiating communications with potential
counterparties.
\185\ These additional broker-dealer services may include
directing the order to another market or broker-dealer for
execution, or executing the order as principal.
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Just as broker-dealer regulation has not effectively integrated
alternative trading systems into market regulation, the current
framework for regulating exchanges is not well-suited to address
concerns raised by traditional broker or dealer activities. As a
result, the Commission would consider whether markets that are
regulated as either exempted exchanges or as registered national
securities exchanges, but that also provide traditional brokerage
services, should be subject to broker-dealer regulation as well.
Application of broker-dealer regulation in such circumstances may not
be inappropriate or necessarily duplicative.
[[Page 30516]]
This approach is consistent with the way in which exchanges and the
persons that trade on those exchanges have traditionally been
regulated. For example, specialists are registered broker-dealers that
carry on a business for themselves while also serving the exchange as a
whole. Among other things, specialists help to ensure the maintenance
of a continuous and liquid market. They also often provide
individualized services to their customers, such as alerting customers
to market movements and forwarding orders to other markets. Although
they perform many services for exchanges, specialists are regulated as
broker-dealers. There is no reason, however, why an exchange could not
choose to perform these activities itself rather than rely on third
parties to perform them.
In such a situation, the Commission would have to consider how best
to integrate the regulation of these broker-dealer activities with the
regulation of the exchange's market activities. To the extent that
exchange and broker-dealer regulations overlap, the Commission could
determine which requirements a dually registered entity would
follow.186
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\186\ For example, certain broker-dealer trading systems, which
are subject to Exchange Act Rule 17a-23, would be exchanges under
the proposed new interpretation of the term ``exchange.'' To prevent
an alternative trading system from being subject to the requirements
of both Rule 17a-23 and an exempted exchange or a national
securities exchange, the Commission could amend Rule 17a-23 as
necessary to avoid duplicative regulation.
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The Commission does not anticipate that a revised interpretation of
the term ``exchange'' would include other entities that currently
provide services to participants in the U.S. securities markets without
being registered as broker-dealers or as exchanges. Examples of such
service providers are those that restrict their activities to providing
communication links between exchanges and broker-dealers and between
broker-dealers and customers. Entities that only provide such message
routing services likely would not be required under this approach to
register with the Commission as either broker-dealers or as national
securities exchanges.187 Entities that provide such
communication links and also have affiliates that use those links to
perform market functions, however, could be deemed to be facilities of
an exchange. In general, in determining whether broker-dealer or
exchange regulation would be appropriate for a particular entity,
communication links offered in conjunction with other services would
have to be viewed in their entirety.
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\187\ See, e.g., Letter from Richard R. Lindsey, Director,
Division of Market Regulation, SEC, to Scott W. Campbell, V.P. &
Assoc. General Counsel, Charles Schwab & Co., Inc. (Nov. 27, 1996).
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Question 87: Under what conditions should an entity be subject to
both exchange and broker-dealer regulation?
Question 88: Should a dually registered entity be required to
formally separate its exchange operations from its broker-dealer
operations (e.g., through use of separate subsidiaries)?
C. Conclusion
The exchange-based approach described above might address the gaps
created by the current approach to oversight of alternative trading
systems, as well as many of the concerns raised by the broker-dealer
based approach, and could result in more consistent market protections
over time. In addition, such an approach might contribute substantial
regulatory certainty and the application of fair and equitable
principles of trade to alternative trading systems. As noted above,
however, such an approach might also have significant effects on
existing exchanges, alternative trading systems, and market
participants. To some extent, many alternative trading systems that
would be considered exempted exchanges under this approach would be
subject to less regulation than they currently are, while the few
significant alternative trading systems would be subject to more
substantial regulatory requirements. This approach would also
potentially require greater adjustment to existing NMS mechanisms to
accommodate newly registered exchanges than would a broker-dealer based
approach.
Question 89: Would this approach be an effective means of
addressing the issues raised by the growth alternative trading systems?
What would be the benefits of such an approach? What would be the
drawbacks of such an approach?
V. The Commission Could Consider Ways in Which Requirements Might
Be Reduced or Expedited for Registered Exchanges
The effects of technology on domestic markets have not been limited
to alternative trading systems. Registered exchanges and Nasdaq are
also engaged in applying technology to respond to the fast changing
competitive pressures of modern securities markets. In addition to
considering the regulatory position of alternative trading systems, the
Commission could therefore consider whether there are other areas of
its approach to regulation of markets that would benefit from
reevaluation. Specifically, the Commission could examine ways to reduce
unnecessary regulatory requirements that make it difficult for these
registered entities to remain competitive in changing business
environments. The Commission has tried to fulfill its obligation under
the Exchange Act to oversee the activities of exchanges and securities
associations in a manner that is flexible and responsive to market
developments and that allows for innovation by these entities. This has
entailed ongoing consideration of additional ways in which the
obligations imposed by the Exchange Act on registered exchanges and
securities associations may be streamlined, without sacrificing
investor protection or market integrity.
The Commission could consider what changes might be made to
expedite exchanges' and securities associations' procedures for
changing their rules, and how automation might be used to lower the
costs and improve the effectiveness of their surveillance and
enforcement responsibilities. The Commission could also consider what
changes might be made to give exchanges and securities associations
greater flexibility in determining how to fulfill their regulatory
obligations. For example, while it is generally in the public interest
for each exchange to retain ultimate responsibility for fulfilling its
statutory obligations, it is clear that smaller SROs do not benefit
from the economies and efficiencies of scale available to SROs that
supervise larger memberships. In addition, larger SROs may obtain
greater cost efficiencies by offering their services to other SROs for
a fee. This type of ``outsourcing'' could be a useful tool for
exchanges and securities associations.
A. Ways to Further Expedite Rule Filings
Section 19(b)(1) of the Exchange Act requires SROs to file copies
of proposed rules and rule amendments with the Commission, accompanied
by a concise general statement of the basis and purpose of the proposed
rule change.188 Once a proposed rule change is filed, the
Commission is required to publish notice of it and provide an
opportunity for public comment. This process serves a critical role in
giving the Commission sufficient oversight authority to ensure
[[Page 30517]]
that exchanges and securities associations carry out their self-
regulatory obligations vigilantly and effectively.
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\188\ The scope of this requirement depends upon what
constitutes a ``rule'' under the Exchange Act. If something does not
rise to the level of a ``rule,'' section 19(b)(1) does not apply.
sections 3(a)(27) and (29) of the Exchange Act define the rules of
an SRO broadly to include not only the constitution, articles of
incorporation, and bylaws, but also any stated policies, practices,
and interpretations that the Commission, by rule, determines to be
rules of an SRO. See Exchange Act Rule 19b-4, 17 CFR 240.19b-4.
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Between 1934 and 1975, the Exchange Act did not give the Commission
adequate authority over SRO rulemaking to act promptly and effectively
where a rule or proposed rule might be injurious to the public
interest.189 During that time, the Commission carried out
this responsibility by relying on inspections and by conducting
administrative proceedings to effect needed changes in exchange
rules.190 The Commission had limited authority to prevent
the adoption of a particular exchange rule, or to amend rules once they
had been adopted; section 19(b) of the Exchange Act only gave the
Commission the authority to amend exchange rules related to certain
enumerated matters.191 As a result, with respect to the
majority of exchange rules, although exchanges would consider concerns
raised by the Commission or its staff, exchanges were not obligated to
address those concerns.192 Moreover, persons with a
significant stake were not provided with notice or an opportunity to
comment on a proposed rule change or on the need or justification for a
proposal.193
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\189\ See SEC, Study of Unsafe and Unsound Practices of Brokers
and Dealers, H.R. Rep. No. 231, 92d Cong., 1st Sess. 6 (1971).
\190\ The Commission's effort to eliminate fixed commission
rates is illustrative of this process and why it was problematic.
See Securities Exchange Act Release No. 11203 (Jan. 23, 1975), 40 FR
7394 (Feb. 20, 1975).
\191\ Before 1975, exchanges were allowed to adopt, without
Commission approval, any rule not inconsistent with either the
Exchange Act or a Commission rule, and were required to furnish the
Commission with copies of rule amendments only upon their adoption.
The Commission, however, could alter or supplement exchange rules
that related to certain enumerated matters pursuant to defined
procedures. In contrast, registered securities associations were
required to file rule changes with the Commission 30 days before
they became effective, and the Commission had the authority to
prevent proposals from taking effect. The Commission could also
alter, supplement, or abrogate an association's rule in certain
circumstances. See generally Special Study, supra note 4, at 703-06.
\192\ See Special Study, supra note 4, at 711.
\193\ See Securities Industry Study, Subcomm. on Securities,
Senate Committee on Banking, Housing & Urban Affairs, S. Doc. No.
13, 93d Cong., 1st Sess. 156-7, 198 (1973); Note, Informal
Bargaining Process: An Analysis of the SEC's Regulation of the New
York Stock Exchange, 80 Yale L.J. 832 (1971).
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The 1975 Amendments established a new uniform procedure for both
exchanges and securities associations that required SRO rule changes to
be justified to, and reviewed by, the Commission after an opportunity
for public comment.194 In addition, Congress expanded the
Commission's authority to permit it to amend all SRO
rules.195 The legislative history of the 1975 Amendments
indicates that Congress intended to clarify and strengthen the
Commission's oversight role with respect to SROs and, specifically, to
ensure that the Commission had the tools it needed to provide
meaningful oversight of SRO rules and the rulemaking
process.196 Congress intended that the Commission would
conduct a comprehensive review of proposed rule changes, including the
justification for the change, any burden on competition and the public
interest that the change may impose, and public comments received
concerning the rule change.197 The Commission staff fulfills
this responsibility by conducting a careful review of every rule filing
it receives. This review often requires the Commission staff to weigh
complex and serious issues raised by the proposed changes. The rule
filing process also gives the public an opportunity to express its
views as to the competitive and other effects of any significant rule
changes. For all these reasons, it may be appropriate for all
exchanges, including newly registered alternative trading systems, to
comply with the rule filing requirements of section 19(b).
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\194\ In order to provide interested persons with an opportunity
to obtain accurate information on rule proposals and to participate
in the review and evaluation of SROs' proposed rule changes, the
1975 Amendments required SROs to file an explanation or
justification for their proposals and the Commission to publish
notice of the SROs' proposed rule changes. Congress intended this
requirement to hold the SROs to the same standards of policy
justification that the Administrative Procedures Act imposes on the
Commission. See Exchange Act section 19(b)(1), 15 U.S.C. 78s(b)(1);
S. Rep. No. 75, supra note 22, at 29-32.
\195\ Exchange Act section 19(c), 15 U.S.C. 78s(c).
\196\ See, e.g., S. Rep. No. 75, supra note 22. ``In the new
regulatory environment created by this bill, self-regulation would
be continued, but the SEC would be expected to play a much larger
role than it has in the past to ensure that there is no gap between
self-regulatory performance and regulatory need, and, when
appropriate, to provide leadership for the development of a more
coherent and rational regulatory structure to correspond to and to
police effectively the new national market system.'' Id. at 2.
\197\ Id.
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Nonetheless, the Commission understands that the time required for
solicitation and review of public comments can delay exchanges' and
securities associations' implementation of innovative proposals and
administrative or non-controversial filings. In response to this
concern, the Commission has already streamlined its internal process
for reviewing and approving SRO rule filings. This has reduced the
average number of days between the filing of a proposed rule change by
an SRO and the approval, withdrawal, or disapproval of the rule filing
from 349 days at the beginning of fiscal year 1994 to 74 days at the
end of fiscal year 1996.
In addition, to respond to SRO requests that the rule review
process be expedited, in December 1994, the Commission adopted
amendments to Rule 19b-4, which expanded the scope of proposed rule
changes that may become effective immediately upon filing pursuant to
section 19(b)(3)(A) of the Exchange Act.198 These amendments
permitted SRO rule changes concerning routine procedural and
administrative modifications to existing order-entry and trading
systems to become effective immediately upon filing. Certain non-
controversial filings were also permitted to become operational 30 days
after filing with the Commission, provided the SRO gave written notice
to the Commission five business days prior to the filing.199
These amendments to Rule 19b-4, in part, were intended to enhance SROs'
ability to implement prompt, flexible, and innovative systems
changes.200 The Commission
[[Page 30518]]
staff has also taken a flexible approach in applying the expedited
procedures under Rule 19b-4. For example, filings that are virtually
identical to an SRO filing already approved by the Commission can often
be approved on an accelerated basis, particularly in the context of new
product listing standards that duplicate listing standards already
approved for an identical product on another exchange.201
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\198\ Section 19(b)(3)(A) of the Exchange Act sets forth certain
specified categories of rule changes that may become effective upon
filing. These include rule changes that: (1) Constitute a stated
policy, practice, or interpretation with respect to the meaning,
administration, or enforcement of an existing rule of the SRO; (2)
establish or change a due, fee, or other charge imposed by the SRO;
or (3) are concerned solely with the administration of the SRO. In
addition, consistent with the public interest and the purposes of
this subsection, the Commission may specify other categories of rule
filings that may become effective upon filing. 15 U.S.C.
78s(b)(3)(A).
\199\ See Securities Exchange Act Release No. 35123 (Dec. 20,
1994), 59 FR 66692 (Dec. 28, 1994). Particularly in the area
relating to new exchange-traded products, the Commission continues
to reduce the number of days between filing and allowed trading of
those products that do not raise significant regulatory issues or
concerns. For example, when an exchange seeks to trade a product
that meets generic criteria for listing options on narrow-based
indexes, the time period between filing and allowed trading of the
product can be shortened considerably. See, e.g., Securities
Exchange Act Release No. 38307 (Feb. 19, 1997), 62 FR 8469 (Feb. 24,
1997) (options on The de Jager Year 2000 Index); Securities Exchange
Act Release No. 38207 (Jan. 27, 1997), 62 FR 5268 (Feb. 4, 1997)
(options and LEAPS on the Phlx Oil Service Index); Securities
Exchange Act Release No. 37312 (June 14, 1996), 61 FR 31570 (June
20, 1996) (options on The Morgan Stanley Commodity Related Equity
Index); Securities Exchange Act Release No. 37115 (Apr. 15, 1996),
61 FR 17741 (Apr. 22, 1996) (options on the CBOE Gold Index);
Securities Exchange Act Release No. 37026 (Mar. 26, 1996), 61 FR
4502 (Apr. 3, 1996) (options on the Chicago Board Options Exchange
Computer Networking Index). The exchange may trade the new product
30 days after the date the rule change is filed with the Commission.
\200\ It appears that SROs, including exchanges, could take
better advantage of the expedited process available under section
19(b)(3)(A) of the Exchange Act. In fiscal year 1996, for example,
out of a total of 552 rule changes filed with the Commission, only
18 (or 3.5%) were filed under the expanded expedited process.
Similarly, in fiscal year 1995, only 12 out of a total of 593 rule
changes (2%) were filed under the expanded expedited process. SROs
could also facilitate the prompt publication of notices of proposed
rule changes by submitting rule filings in such a form that enables
the staff to expedite their review. The Commission strongly
encourages SROs to evaluate their internal procedures for drafting,
reviewing, and submitting rule filings to take greater advantage of
expedited procedures and to ensure complete filings that will enable
the Commission to respond promptly.
\201\ See Securities Exchange Act Release No. 36296 (Sept. 28,
1995), 60 FR 52234 (Oct. 5, 1995) (relating to listing and trading
of broad-based index warrants on Nasdaq); Securities Exchange Act
Release No. 36165 (Aug. 29, 1995), 60 FR 46653 (Sept. 7, 1995)
(establishing the NYSE's uniform listing and trading guidelines for
stock index, currency, and currency index warrants); Securities
Exchange Act Release No. 36166 (Aug. 29, 1995), 60 FR 46660 (Sept.
7, 1995) (establishing PCX's uniform listing and trading guidelines
for stock index, currency, and currency index warrants); Securities
Exchange Act Release No. 36167 (Aug. 29, 1995), 60 FR 46667 (Sept.
7, 1995) (establishing Phlx's uniform listing and trading guidelines
for stock index, currency, and currency index warrants); Securities
Exchange Act Release No. 36169 (Aug. 29, 1995), 60 FR 46644 (Sept.
7, 1995) (establishing CBOE's uniform listing and trading guidelines
for stock index, currency, and currency index warrants).
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Nonetheless, there may be additional ways in which the Commission
could reduce rule filing requirements to facilitate a rapid response by
SROs to changing market conditions and competitive pressures. For
example, the Commission could consider further expanding the scope of
proposed rule changes eligible for effectiveness immediately upon
filing to include, for example, any proposed changes to listing
standards to accommodate new products. In expanding the scope of rules
eligible for this treatment, it may be appropriate to require an SRO to
make an affirmative statement that it has undertaken a review of the
Commission's eligibility criteria for immediate effectiveness under
Rule 19b-4 and is satisfied that the rule filing being submitted
conforms to such requirements.
The Commission could also consider exempting certain SRO programs
designed to implement innovative new trading systems or mechanisms from
rule filing requirements during development and initial operating
stages. In the past several years, a few SROs have attempted to
implement innovative trading structures for their members. For example,
in 1991, the NYSE established after-hours crossing systems that
automate the execution of single stock orders and baskets of
securities,202 and in 1994, the CHX developed the Chicago
Match system.203 Although neither program has generated
significant trading activity, 204 in both cases, the
exchanges submitted rule filings prior to operation. Because of the
innovative nature of such systems for the sponsoring exchanges, the
approval process was protracted. Alternative trading systems that offer
similarly innovative, start-up services today are not required to
follow the same procedures prior to operation of the services. In
addition, SROs have indicated that revealing the business plans for
such innovative programs prior to operation makes it more difficult for
them to compete effectively with alternative trading systems in
offering start-up services to their members.
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\202\ See Securities Exchange Act Release No. 29237 (May 24,
1991), 56 FR 24853 (May 31, 1991); Securities Exchange Act Release
No. 32368 (May 25, 1993), 58 FR 31565 (June 3, 1993).
\203\ See, e.g., Securities Exchange Act Release No. 35030 (Nov.
30, 1994), 59 FR 63141 (Dec. 7, 1994) (order approving Chicago
Match, an electronic matching system operated by the CHX, which
provided for the crossing of orders entered by CHX members and non-
members, including institutional customers).
\204\ The NYSE's crossing sessions continue to generate volume
that is well below that of POSIT and the smallest registered
exchange. The CHX determined not to continue operating Chicago Match
in 1996. See Sarah Gates, Will Anyone Miss Chicago Match, Wall
Street & Technology, Apr. 1996, at 26.
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The Commission believes that markets should be encouraged to
innovate. One way of facilitating innovation by exchanges and
securities associations, as well as vigorous competition among these
markets, would be to enable exchanges and securities associations to
establish innovative trading programs, apart from their other
operations. For example, an exchange may wish to establish an
electronic book for the trading of securities not traded on the
exchange's primary system. Such programs could then be subject to
similar oversight as that applied to small, start-up alternative
trading systems, to the extent appropriate in light of investor
protection. Under such an approach, the Commission could exempt pilot
programs from rule filing requirements until such time as the program
obtained significant volume, was integrated with an exchange's or
securities association's other trading mechanisms, or otherwise began
to have significant market impact.
Any such proposal would require careful consideration as to the
types of programs that might be eligible for exemption, and other
conditions that might be appropriate in light of investor protection
concerns, national market system goals, and just and equitable
principles of trade. As noted above, one reason that Congress required
SROs to submit rule filings was to ensure that the interests of
investors were considered in SRO actions, and that persons with a
significant stake were provided with notice and an opportunity to
comment on a proposed rule change. For example, pilot programs that
might be eligible for exemption could potentially function as
alternatives to trading through a market's primary system. In such
circumstances, these programs would affect not only investors whose
orders are executed on such systems, but also investors and traders who
were not given the opportunity to use the pilot program. Moreover,
customers who placed orders in the exchange's main trading system could
also be affected, e.g., if their orders did not have an opportunity to
interact with orders executed through the pilot program. For these
reasons, it may not be appropriate to make a rule filing exemption
available for pilot programs that trade the same securities, operate
during the same time of day, or have similar trading structures as a
market's main trading system or are otherwise linked to a market's
primary operations.
In addition, the Commission could consider the appropriate
standards for determining whether a particular proposal would qualify
as a pilot program. Other issues to be considered would include whether
any exemption for pilot programs should be limited in duration, even if
the programs did not reach significant volume, and what would be the
appropriate measure for determining when a program would have limited
volume in light of all relevant factors.205 Finally, the
Commission could consider how SROs would notify the Commission and the
SROs' participants prior to implementing a pilot program, and disclose
to participants in the pilot program whether the quality or type of
execution capabilities of the pilot system differ from those of the
exchange's established systems.
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\205\ As discussed above, whether a trading system has enough
volume to have significant market impact will differ depending upon,
among other things, the size and liquidity of the market for the
instruments traded.
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Question 90: Would it be feasible for the Commission to expand the
scope of rules eligible for expedited treatment pursuant to Section
19(b)(3)(A) without jeopardizing the investor protection and
[[Page 30519]]
market integrity benefits of Commission oversight of exchange and other
SRO rule changes? If so, to what types of rule filings should immediate
effectiveness, pursuant to Section 19(b)(3)(A), be extended?
Question 91: If the Commission expands the scope of rule filings
eligible for treatment under Section 19(b)(3)(A) to include, for
example, certain types of new products, what conditions or
representations should be required of an SRO to ensure that the
proposed rule change is eligible for expedited treatment under Rule
19b-4?
Question 92: Should the Commission exempt markets' proposals to
implement new trading systems, separate from their primary trading
operations, from rule filing requirements? If so, should SROs be
permitted to operate pilot programs under such an exemption if they
trade the same securities, operate during the same hours, or utilize
similar trading procedures as the SRO's main trading system? Should
there be a limit on the number of pilot programs an SRO can operate
under an exemption at any one time? What other conditions should apply
to such exemption?
B. Surveillance and Enforcement
Technological advances have greatly increased an exchange's ability
to fulfill its enforcement obligations under the Exchange Act
efficiently and cost effectively. Some sponsors of trading systems have
suggested that automated trading activity requires less extensive
surveillance, and that markets with fully automated trading should not
be required to conduct the same surveillance as non-automated
exchanges. This suggestion may be based in part on the view that
automation of trading algorithms may make it more difficult for
participants to trade in violation of the trading rules embedded in
those algorithms. While automation and embedded algorithms alone cannot
prevent insider trading or market manipulation,206
automation may make it easier to detect potential and attempted abuses
by providing a full audit trail of trading activity. By circumscribing
participant trading activity, automation can also reduce the resources
that must be devoted to monitoring trading activities, which,
consequently, would reduce the costs of exchange regulation. For
example, failures by market makers to fulfill their obligation to honor
quotations are easier to detect in a fully automated
environment.207 Accordingly, the Commission is considering
whether fully automated markets may be able to fulfill their regulatory
obligations in non-traditional ways.
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\206\ While automation may reduce the cost and increase the
effectiveness of a market's surveillance program, a responsible
party must still be able to recognize potentially manipulative
activity and, in many cases, review trading records.
\207\ See NASD 21(a) Report, supra note 20, at 28 and 45 for
discussion of failures by market makers on the Nasdaq market to
honor their quotations or to ``back away,'' and steps that the NASD
undertook, as part of its settlement with the Commission, to upgrade
its capabilities to detect and prevent such backing away.
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Existing Commission initiatives and SRO plans that coordinate
supervision of broker-dealers that are members of more than one SRO
(``common members'') could also apply to newly registered exchanges.
For example, 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 oversight of common
members to particular exchanges, and to exempt exchanges from
enforcement obligations with respect to persons that are associated
with a member, but that are not engaged in the securities
business.208 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.209 When an
SRO has been named as a common member's DEA, all other SROs to which
the common member belongs are relieved of the responsibility to examine
the firm for compliance with applicable financial responsibility
rules.210 Consistent with past Commission action, the
Commission could continue to designate one SRO, such as the NASD or the
NYSE, as the primary DEA for common members of exchanges. The
Commission has also permitted existing SROs to contract with each other
to allocate non-financial regulatory responsibilities.211
For example, the Commission has approved a regulatory plan filed by the
Amex, CBOE, NASD, NYSE, PCX, and the Phlx that designates, with respect
to each common member, an SRO participating in the plan as a broker-
dealer's options examination authority. This designated SRO has sole
regulatory responsibility for certain options-related trading
matters.212 An SRO participating in a regulatory plan is
relieved of regulatory responsibilities with respect to a broker-dealer
member of such an SRO, if those regulatory responsibilities have been
designated to another SRO under the regulatory plan. These programs
could also be applicable to newly registered exchanges.
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\208\ See 17 CFR 240.17d-2; 17 CFR 240.19g2-1.
\209\ 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).
\210\ See Securities Exchange Act Release No. 23192 (May 1,
1986) 51 FR 17426 (May 12, 1986). Moreover, Section 108 of the 1996
Amendments, supra note 68, 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.
\211\ 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.
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 section 17(d) of the Exchange Act. 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 No. 13326
(Mar. 3, 1977), 42 FR 13878 (Mar. 14, 1977) (NYSE/Amex); Securities
Exchange Act Release No. 13536 (May 12, 1977), 42 FR 26264 (May 23,
1977) (NYSE/BSE); Securities Exchange Act Release No. 14152 (Nov. 9,
1977), 42 FR 59339 (Nov. 16, 1977) (NYSE/CSE); Securities Exchange
Act Release No. 13535 (May 12, 1977), 42 FR 26269 (May 23, 1977)
(NYSE/CHX); Securities Exchange Act Release No. 13531 (May 12,
1977), 42 FR 26273 (May 23, 1977) (NYSE/PSE); Securities Exchange
Act Release No. 14093 (Oct. 25, 1977), 42 FR 57199 (Nov. 1, 1977)
(NYSE/Phlx); Securities Exchange Act Release No. 15191 (Sep. 26,
1978), 43 FR 46093 (Oct. 5, 1978) (NASD/BSE, CSE, CHX and PSE); and
Securities Exchange Act Release No. 16858 (May 30, 1980), 45 FR
37927 (June 5, 1980) (NASD/BSE, CSE, CHX and PSE).
\212\ 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.
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These plans permit an SRO to allocate its oversight obligations
with respect to certain members' compliance with various requirements.
They do not permit an SRO to allocate its oversight obligations with
respect to the activities taking place on its market. Currently,
enforcement and disciplinary actions for
[[Page 30520]]
violations relating to transactions executed in an SRO's market or
rules unique to that SRO must be retained by that SRO. Existing
exchanges generally employ personnel and establish extensive programs
to fulfill this responsibility. Fully automated exchanges, however,
might be able to contract with other exchanges to perform these
activities while retaining ultimate responsibility for ensuring that
these activities are performed. Fully automated exchanges can produce
comprehensive, instantaneous automated records that can be monitored
remotely. As a result, it may be possible for such an exchange to
contract with another exchange to perform its day-to-day enforcement
and disciplinary activities. The Commission could consider whether
allowing an automated market to do so would be consistent with the
public interest.
Another approach would be for fully automated exchanges to form a
separate SRO solely for the purpose of overseeing the activities of
their markets. This SRO, rather than the automated exchanges, would
have the responsibility for bringing enforcement and disciplinary
actions for violations relating to transactions executed on those
exchanges. The Commission seeks comment on the advisability and
feasibility of such an approach.
Question 93: Do differences between automated and non-automated
trading require materially different types or degrees of surveillance
or enforcement procedures?
Question 94: Which Exchange Act requirements applicable to
registered exchanges, if any, could be minimized or eliminated without
jeopardizing investor protection and market integrity?
Question 95: If an automated exchange contracts with another SRO to
perform its day-to-day enforcement and disciplinary activities, should
this affect the exchange's requirement to ensure fair representation of
its participants and the public in its governance?
Question 96: If an exchange contracts with another entity to
perform its oversight obligations, should that exchange continue to
have responsibility under the Exchange Act for ensuring that those
obligations are adequately fulfilled?
VI. Costs and Benefits of Revising the Regulation of Domestic
Markets
The two alternatives discussed in Section IV could provide
significant benefits to U.S. securities markets and market
participants. By integrating all significant markets in the market
regulatory framework, these proposals would bolster the effectiveness
of the national market system by better protecting market participants.
For example, if the Commission were to continue to regulate alternative
trading systems as broker-dealers, but adopted additional regulations
(the first approach discussed in Section IV), the market as a whole
would benefit from the additional transparency provided by the public
reporting of all orders submitted to alternative trading systems.
Moreover, enhancing the surveillance of trading on alternative trading
systems would benefit the public by preventing fraud and manipulation.
Similarly, by regulating alternative trading systems under a tiered
approach to exchange regulation, investors and other market
participants could benefit because, as exchanges, significant
alternative trading systems would be prohibited from unfairly denying
access, taking discriminatory action against participants, imposing
unreasonably discriminatory fees, or establishing anticompetitive
rules. In addition, because significant alternative trading systems
would be required to directly participate in market-wide plans such as
the CQS, CTA, OPRA, and ITS, investors could benefit from reductions in
misallocations of capital, inefficiency, and trading fragmentation.
Moreover, under the proposed reinterpretation of ``exchange,''
investors and the integrity of the market generally could benefit from
alternative trading systems sharing SRO responsibilities with currently
registered exchanges. In particular, the Commission's ability to
prevent fraud and manipulation would be strengthened.
The Commission also recognizes that the proposals discussed in this
release would have a substantial impact on the allocation of regulatory
costs among market participants. In particular, the additional
obligations contemplated under both alternative proposals to revise
domestic market regulation could impose costs on alternative trading
systems. For example, alternative trading systems could be required to
adopt rules to prevent fraud and manipulation, promote just and
equitable principles of trade, and not impose any unnecessary or
inappropriate burden on competition. Alternative trading systems could
also be required to establish mechanisms to assure regulatory oversight
of their participants and review their listing procedures. In addition,
there would also be costs associated with joining market-wide plans,
such as the CQS, CTA, ITS, OPRA, and OTC-UTP. These costs, however,
would at least partially be offset because most alternative trading
systems would no longer be regulated as broker-dealers. In addition,
because alternative trading systems, as exchanges, would share the
responsibilities of self-regulation, the regulatory burden carried by
currently registered exchanges should be reduced. In contrast,
integrating these alternative trading systems into the mechanisms of
the national market system through broker-dealer regulation could
entail additional costs for the trading systems as well as their
supervising SROs.
Question 97: What costs to investors and other market participants
are associated with the current regulation of alternative trading
systems as broker-dealers? Specifically, what costs are associated with
the potential denial of access by an alternative trading system?
Question 98: What costs are associated with each of the
alternatives for revising market regulation discussed above? For
example, would either of the two principal alternatives discussed in
Section IV above impose costs by limiting innovation? Would these costs
be greater than those imposed by the current regulatory approach?
Question 99: What regulatory costs can be shared by markets
operating simultaneously as self-regulatory organizations, and what
regulatory costs must be borne by each market individually? What are
the relative magnitudes of these costs (as a proportion of total
costs)?
Question 100: Are there innovations or adjustments that can be made
to market wide plans such as CQS, CTA and ITS that will lead to lower
regulatory costs for exchanges under any of the alternatives for
regulating domestic markets?
Question 101: Total regulatory costs vary with a variety of factors
(e.g., volume of trade, degree of technology applied in trade). Of
these factors, which are most relevant in considering the alternatives
discussed above? For example, recognizing that some market mechanisms
may rely on some factors more than others, to what extent are
regulatory costs greater for particular mechanisms than others?
Question 102: What costs are associated with the responsibilities
of an SRO? Will the costs to existing SROs be reduced by registering
significant alternative trading systems as exchanges?
Question 103: What regulatory burdens currently inhibit innovation
of trading systems? How will the alternatives discussed above change
the incentives for innovation?
[[Page 30521]]
Question 104: Will the alternatives discussed above impose costs on
systems that differ depending on the nature of the trade? For example,
will the proposed regulatory revisions change the costs of trades
directly between customers relative to the costs of trades between a
customer and a dealer?
VII. Regulation of Foreign Market Activities in the United States
A. The Need for a Clear Regulatory Structure to Address U.S. Investors'
Electronic Cross-Border Trading
In addition to significantly changing the way domestic markets
operate, technology has given U.S. investors new and varied options for
accessing foreign markets. The desire of many investors to diversify
their portfolios through foreign investment has already resulted in an
exponential increase in trading in foreign securities by U.S.
persons.213 The use of advanced technology by broker-
dealers, markets, and other entities has the potential to greatly
increase institutions' and other U.S. investors' cross-border trading
opportunities, to make cross-border trading both more efficient and
more affordable, and to promote competition among global markets and
intermediaries.
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\213\ Between 1980 and 1995, the total activity by U.S. persons
in foreign securities grew from $53.1 billion to $2,573.6 billion,
representing over a 4700% increase. Securities Industry Association,
1996 Securities Industry Fact Book 67 (forthcoming June 1997).
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Until recently, in order to obtain current information regarding
foreign market activity and to purchase or sell securities on a foreign
market, a U.S. investor typically contacted a U.S. broker-dealer by
telephone or facsimile. The U.S. broker-dealer would then give the
investor current information and transmit the investor's order to a
foreign broker-dealer member of the foreign market 214 on
which the security was traded. Alternatively, the U.S. investor could
contact a foreign broker-dealer member of the foreign market directly.
Today, however, it is possible for U.S. investors to obtain real-time
information about trading on foreign markets from a number of different
sources and to enter and execute their orders on those markets
electronically from the United States.
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\214\ As used in this release, a ``member'' of a foreign market
includes any person to which a foreign market provides access for
the purpose of effecting transactions on that market. This would
include any person that is a full or limited member of a foreign
market or that the foreign market allows to electronically access
its trading facilities.
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For example, an investor that is not a member of a foreign market
can nonetheless trade directly on that market using electronic
interfaces, by linking to the market through a member of that market
(typically the investor's broker-dealer). The market member provides a
direct, automated link between the customer and the foreign market by
connecting the customer's computer system directly to its own, which is
also connected with the foreign market. This may be accomplished in a
variety of ways, including through the use of proprietary software,
leased lines or a public network such as the Internet. The member's
systems will then automatically distribute market information to the
U.S. investor and route the investor's orders directly to the market.
Through these types of ``pass-through'' linkages, the non-member
customer can enjoy electronic trading capabilities that are equivalent
to the trading privileges of a member of the foreign market. From the
broker-dealer's and customer's perspectives, this type of ``pass-
through'' service enables the investor to send orders through the
electronic interface without the broker-dealer having prior knowledge
of each order or manually interpositioning itself in the trading
process. As a result, orders routed electronically by a customer to the
exchange remain under the customer's control until the moment of
execution. This is in contrast to traditional brokerage activities
involving orders that are routed from a customer to a foreign market
member (or its affiliate), and from the member to the exchange. From
the perspective of the foreign market, orders sent by a broker-dealer
customer through a member's electronic interface may be
indistinguishable from orders placed directly by the
member.215 Some broker-dealers have also begun to facilitate
trading directly on the facilities of foreign markets in which those
broker-dealers are not members, for their U.S. customers or affiliates.
This is typically accomplished through agreement or affiliation with a
local member of that market.
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\215\ Although orders originate from a non-member, they are
electronically identified, or ``stamped,'' as coming from the member
providing the interface.
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In addition to allowing investors that are not members to trade
directly on foreign markets, technological advances have enabled market
members themselves to trade from remote locations outside of particular
markets' home countries. Many foreign markets have integrated new
technology into their trading processes in recent years, either by
using computers in combination with traditional floor trading
procedures,216 or by completely automating their trading
facilities.217 This enhanced technology enables members of
those markets to trade without being physically present on a market
``floor'' or establishing a physical
[[Page 30522]]
presence in a market's home country. As a result, several foreign
markets have begun to offer their members in non-U.S. jurisdictions
``remote'' access to their trading facilities, typically by installing
proprietary market terminals in the members' offices, by providing data
feeds or codes for use with software operated through the members' own
computers, or by allowing members to access a market's trading
facilities through third party service vendors or public networks (such
as the Internet). In recent years, several foreign markets have
proposed permitting U.S. broker-dealers and institutional investors to
become market members through similar remote access
arrangements.218 If this remote access were offered in the
United States, U.S. investors would have the ability to trade directly
on foreign markets and to bypass broker-dealers.
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\216\ For example, in September 1994, the Amsterdam Stock
Exchange introduced a new electronic trading system that permits
banks and broker-dealers to effect wholesale trades on-screen using
the Automatic Interprofessional Dealing System Amsterdam (``AIDA'').
This system permits exchange participants to enter bids and offers
and to execute trades via a remote computer located in their
offices. The Netherlands, Institutional Investor, Inc., Sept. 16,
1996, at 11; The Amsterdam Stock Exchange--An Overview--Amsterdam
Stock Exchange, Business Monitor, Mar. 30, 1995. Similarly,
Frankfurt's Deutsche Borse provides remote access in London,
Amsterdam, Paris, and Zurich, and has attracted 44 remote members.
The number of remote members of the Deutsche Borse is predicted to
swell to at least 100 within three to five years. Laura Covill,
Survival of the Fittest, ABI/INFORM, Aug. 1996, at 60. In addition,
the Athens Stock Exchange has installed an electronic trading system
that allows members to execute orders via exchange-owned terminals.
Internet Site of the Athens Stock Exchange, address: http://
www.ase.gr/waser.htm (Dec. 5, 1996).
\217\ For example, since 1989, OM Stockholm (formerly the
Stockholm Stock Exchange) has been completely electronic, and has
remote members in London, Denmark, Norway, Finland, and Switzerland.
OMLX, the London Securities & Derivatives Exchange, which is owned
by the same company as OM Stockholm, is also a completely electronic
trading system. See Laura Covill, Survival of the Fittest, ABI/
INFORM, Aug. 1996, at 60; Hugh Carnegy, Survey--Swedish Banking; Two
Dynamic Exchanges, Fin. Times, June 20, 1996, at 6. Tradepoint, a
London-based electronic stock exchange, started trading in September
1995. See Henry Harrington, Survey of European Stock Exchanges, Fin.
Times, Feb. 16, 1996. The Paris Bourse is now an entirely
computerized stock market. Supercac, a system linked to member firms
and other intermediaries collecting client orders, went on line in
April 1995 and allows for continuous, automated trade execution to
take place on the Paris Bourse. See Internet Site of The Paris Stock
Exchange, address: http://www.bourse-de-paris.fr (Nov. 6, 1996);
Henry Harrington, Survey of European Stock Exchanges, Fin. Times,
Feb. 16, 1996. The purchase by the Toronto Stock Exchange (``TSE'')
of the Paris Bourse's Supercac software enabled the TSE to close its
floor on April 24, 1997. See Toronto Stock Exchange Closes its
Trading Floor, The Wall Street J., Apr. 24, 1997, at C15. Other
examples of completely automated exchanges include the MEFF Renta
Fija and MEFF Renta Variable in Spain, the New Zealand Stock
Exchange, the Korean Stock Exchange, the Philippine Stock Exchange,
the Singapore Stock Exchange, and the Thailand Stock Exchange.
Foreign futures and options markets have also embraced electronic
trading systems. For example, the Tokyo International Financial
Futures Exchange, the Osaka Futures and Options Exchange, the Swiss
Options and Financial Futures Exchange, the Irish Futures and
Options Exchange, and the New Zealand Futures and Options Exchanges
are completely electronic. See Hughes Levecq & Bruce W. Weber,
Electronic Markets and Floor Markets: Competition for Trading
Volumes in Futures and Options Exchanges, Center for Research on
Information Systems, Working Paper Series No. IS-95-20, June 15,
1995; Allan D. Grody & Hughes Levecq, Past, Present and Future: The
Evolution and Development of Electronic Financial Markets, Center
for Research on Information Systems, Working Paper Series No. IS-95-
21, Nov. 1993.
\218\ For example, Deutsche Terminborse (``DTB''), Germany's
electronic futures and options market, installed computer terminals
in the United States for trading non-U.S. futures products. See
Letter from Andrea M. Corcoran, Director, Division of Trading and
Markets, Commodity Futures Trading Commission, to Lawrence H. Hunt,
Jr., Esq., Sidley & Austin (Feb. 29, 1996) (no-action letter
authorizing DTB to install and use computer terminals in the United
States in connection with the purchase and sale of certain futures
and options contracts). The no-action letter explicitly did not
address securities law issues. See also Mark J. Arend, Securities
Trading: How Electronic Markets Empower Institutional Investors,
Global Investment, Dec. 1996, at 30; The Netherlands, Institutional
Investor, Inc., Sept. 16, 1996, at 11; Laura Covill, Survival of the
Fittest, ABI/INFORM, Aug. 1996, at 60; Business, Legal News from
Around Europe, Buraff Publications, May 13, 1996.
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These are examples of ways in which U.S. investors might access
foreign markets. As technology evolves and investor comfort with
electronic trading increases, other types of access will likely develop
as well, including those that may make greater use of the Internet.
1. The Applicability of the U.S. Regulatory Structure to the Activities
of Access Providers Has Not Been Expressly Addressed
When a foreign market, broker-dealer, or other entity provides the
type of direct foreign market access described above to investors
located in the United States (hereinafter referred to as an ``access
provider''), its activities typically differ from both traditional
brokerage activities and the activities of exchanges. The Commission to
date has not expressly addressed the regulatory status of entities that
provide U.S. persons with the ability to trade directly on foreign
markets from the United States. While some access providers may be
registered as U.S. broker-dealers because of their other activities,
the lack of regulatory guidance in this context has discouraged other
parties from offering U.S. persons foreign market access. Similarly,
foreign markets have been reluctant to permit U.S. persons to become
members of their markets without assurances from the Commission that
they would not be required to register as national securities
exchanges.219 The Commission therefore is soliciting comment
on how best to address U.S. investors' increasing access to foreign
markets. Specifically, the Commission requests comment on whether
investors could benefit from a clearer regulatory framework for
entities that provide U.S. investors with the technological capability
to trade directly on foreign markets from the United States.
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\219\ Several foreign markets have proposed to provide U.S.
investors with direct electronic access to their trading systems. In
conjunction with these proposals, the foreign markets have requested
certain relief from U.S. exchange and broker-dealer registration
requirements.
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2. U.S. Investors' Ability to Trade Directly on a Foreign Market And
Investor Protection Concerns Under the Federal Securities Laws
In addressing issues raised by cross-border trading, it is
important to ensure that investors are provided with certain key
protections under the federal securities laws. From an investor's
perspective, trading on a foreign market through an access provider is
often indistinguishable from trading on a domestic market. These
similarities could lead many investors to expect that such trading
would be subject to the same protections provided by the U.S.
securities laws. There are, however, significant differences in the
protections available to investors trading on domestic U.S. markets,
and those available to investors trading on foreign markets from the
United States. For example, the U.S. securities laws provide
significant protections to investors trading on U.S. markets. These
protections include assurances that markets and intermediaries will
disclose information regarding the rules governing trading operations,
as well as requirements regarding transaction reporting and issuer
disclosure practices. In addition, U.S. securities laws provide the
Commission with the tools to detect and deter fraud and manipulation.
Because foreign securities laws are generally not designed to provide
these protections to U.S. investors that directly trade on their
markets, in the absence of disclosure these differences have the
potential to mislead U.S. investors that have come to rely on the U.S.
securities laws.
The Commission has been examining alternative regulatory frameworks
for addressing these concerns. As an initial matter, the optimal
framework for addressing these issues should not impose unnecessary
obligations on foreign markets that could effectively preclude U.S.
investors from taking advantage of an otherwise efficient, cost-
effective investment alternative. Cross-border trading opportunities
may raise concerns, however, that U.S. investors may not receive
sufficient disclosure about foreign markets or foreign issuers and
their securities. As foreign markets are made increasingly accessible
to U.S. investors through technological advances, therefore, the
Commission should examine how to ensure that investors will receive
sufficient information to make informed decisions.
B. Regulating Foreign Market Activities in the United States
The Commission's goal is to initiate a dialogue as to how to
develop a consistent, long-term approach that clarifies the application
of the U.S. securities laws to the U.S. activities of foreign markets.
Any such approach must not impose unnecessary regulatory costs on
cross-border trading and, at the same time, must allow the Commission
to oversee foreign markets' activities in the United States and protect
U.S. investors under the U.S. regulatory framework. There are several
ways to achieve these goals. As discussed below, for example, the
Commission could (1) rely solely on a foreign market's home country
regulator; (2) require all foreign markets to register as national
securities exchanges or apply for an exemption from registration; or
(3) develop a tailored regulatory scheme designed to regulate the
entity that provides U.S. investors with the ability to trade directly
on foreign markets, rather than regulating the foreign market itself.
The Commission solicits comments on whether any other alternatives
could achieve the goals discussed above.
Question 105: What regulatory approaches would best address the
concerns raised by the development of automated access to foreign
markets? Would these approaches differ if U.S. investors accessed
foreign markets in ways other than those described above, such as
through the Internet? Are there any other alternative approaches that
could be more appropriate?
1. Sole Reliance on Foreign Markets' Home Country Regulation
One option could be for the Commission to rely solely on the laws
of the primary regulators of foreign
[[Page 30523]]
markets, if those foreign markets are subject to regulation comparable
to U.S. securities regulation. Under this approach, the Commission
could specify foreign markets that it determines are subject to
comparable regulation. In determining whether a foreign market is
subject to comparable regulation, the foreign regulatory structure
could be viewed as a whole to determine whether it, in its design and
implementation, adequately addresses the key protections provided by
U.S. securities laws. The Commission could make this determination on a
case-by-case basis or it could establish certain standards governing
the determination. Under the latter approach, if a foreign market met
those enumerated standards, the foreign market could be considered
subject to ``comparable'' regulation.220
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\220\ It could be appropriate to permit foreign markets
regulated solely under the laws of their home country to trade only
foreign securities with U.S. persons. Possible definitions of the
term ``foreign securities'' are discussed below.
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This approach might have several advantages. First, it could
provide regulatory certainty to foreign markets entering the United
States. Second, it would not impose any additional regulatory costs on
foreign markets. As a result, foreign markets would be able to provide
their services to U.S. investors at lower cost. Third, this approach
would recognize that principles of international comity support
reasonable deference to a home country's governance of its own markets,
particularly with respect to trading in the securities of home country
issuers.
Despite these advantages, an approach that relies solely on foreign
regulation has significant drawbacks. As discussed above, a U.S.
investor trading on a foreign market through an access provider may
incorrectly assume that such trading is subject to the same protections
as trading on U.S. markets. Foreign laws, however, may differ
significantly from U.S. securities laws.221 For example,
under the federal securities laws, a registered exchange must establish
rules that describe its trading processes, file those rules with the
Commission (which publishes them for comment), and enforce those rules
fairly among its members. These requirements are designed to enable
investors to make informed decisions about the risks and benefits of
trading in a particular market. U.S. investors rely on the availability
and accuracy of the information provided by markets, as well as the
information provided by intermediaries, when making their investment
decisions. Many foreign markets, however, do not require a similar
level of disclosure.
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\221\ See supra Section VII.A.2.
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The practices of foreign markets in areas that affect market
integrity can also differ significantly from those of U.S. exchanges.
For example, some foreign markets are not subject to laws designed to
prevent insider trading or other forms of market manipulation that are
prohibited in the United States. In addition, U.S. securities laws
require market makers and specialists to have firm
quotes,222 and to display certain customer limit
orders.223 They also require U.S. markets and certain
participants to report most trades for public dissemination within 90
seconds.224 On the other hand, many foreign markets do not
require market participants to report trading activity as quickly as
under U.S. law,225 and do not publicly disseminate such
information as promptly as U.S. markets. Some foreign markets also do
not require companies to provide financial and other material
information to investors as often or as completely as is required under
U.S. law. Moreover, the methods of calculating and reporting financial
information that are used on foreign markets often differ from U.S.
standards. U.S. investors trading electronically on foreign markets
from the United States may not have access to complete information
regarding these transaction reporting and issuer disclosure practices
so as to evaluate whether published information is current.
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\222\ Exchange Act Rule 11Ac1-1, 17 CFR 240.11Ac1-1.
\223\ Exchange Act Rule 11Ac1-4, 17 CFR 240.11Ac1-4.
\224\ Pursuant to the terms of the CTA Plan, see supra notes 166
and 167, it is the responsibility of all participant exchanges and
the NASD to report all sales transactions as promptly as possible,
and establish collection procedures to ensure that 90% of such last
sale reports are provided within 90 seconds of execution. CTA Plan,
Section VIII. Market rules also require participants to report
trades within 90 seconds after execution or designate them as being
late. See, e.g., NASD Rule 4632. A pattern or practice of late
reporting without exceptional circumstances may be considered
inconsistent with high standards of commercial honor and just and
equitable principles of trade in violation of NASD Rule 2110.
\225\ Other foreign markets allow market participants to delay
reporting of certain trades. For example, the London Stock Exchange
allows members to delay publication of certain large block trades
for up to 60 minutes.
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Foreign markets also may not be subject to regulations designed to
provide regulators with the tools to detect and deter behavior that is
prohibited under U.S. securities laws, such as fraud, manipulation, or
insider trading. For example, unlike domestic exchanges, which are
required to comply with federal securities laws and to enforce
compliance with such laws by their members,226 foreign
markets may have less comprehensive surveillance, examination, or
enforcement capabilities. In addition, many foreign markets are not
required under the laws of their home countries to preserve the trading
information that would enable an investigation to be commenced under
U.S. law. Without adequate recordkeeping, it could be difficult for the
Commission to detect fraudulent or other illegal activity being
conducted through access providers.227
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\226\ See supra Section II.B.1.
\227\ As the Commission staff stated in its 1994 report on the
U.S. equity markets, the Commission also has a significant
regulatory interest in ensuring that foreign markets are not used by
U.S. broker-dealers to circumvent the application of U.S. regulatory
requirements to the detriment of U.S. persons complying with those
requirements. See Market 2000 Study, supra note 14, at VII-4.
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An equally important component of the Commission's ability to
detect and investigate violations of the federal securities laws is
access to trading information. Even if a foreign market maintains
comprehensive trading records, it may be constrained by local law from
sharing these records or other market information with U.S.
regulators.228 Unless the Commission has access to trading
records, its ability to fully investigate and bring enforcement actions
for violations of the U.S. securities laws could be undermined.
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\228\ See generally Technical Committee of the International
Organization of Securities Commissions (IOSCO), Report on Issues
Raised for Securities and Futures Regulators by Under-Regulated and
Uncooperative Jurisdictions 5 (Oct. 1994).
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U.S. investors may also expect that, because they are trading on
foreign markets from the United States, they will be able to file
private actions to recover losses arising from trading on those
markets. In reality, the foreign nature of such trading may prevent
U.S. investors from filing such claims in U.S. courts, from obtaining
evidence to support their claims, from serving process on defendants,
or from enforcing judgments.
In sum, although relying on foreign market regulation could provide
regulatory certainty and allow foreign markets and access providers to
provide their services to U.S. investors, it may not provide U.S.
investors with certain essential protections they have come to expect.
The Commission seeks comment on whether this option is feasible and
consistent with the federal securities laws.
Question 106: If the Commission were to rely solely on a foreign
market's primary regulator, how could it address the investor
protection and enforcement concerns discussed above?
[[Page 30524]]
2. Requiring Foreign Markets to Register as National Securities
Exchanges
A second option could be to require foreign markets with U.S.
activities to register as national securities exchanges under the
Exchange Act or to satisfy criteria for exemption from exchange
registration.229 Foreign markets that offer their services
to U.S. persons would have to comply with the same regulatory
obligations as U.S. exchanges. Under this approach, U.S. investors
trading on foreign markets would be provided with the same protections
they have when trading on U.S. markets. This could address the concern
that, because trading on a foreign market may be indistinguishable from
trading on a domestic market, investors may be led to expect that such
trading would be subject to the same protections provided by the U.S.
securities laws. This approach also could ensure that any foreign
markets that offer services to U.S. investors would provide the same
protections as registered or exempted exchanges, such as disclosure of
trading rules, transparency, timely transaction reporting, and T+3
clearance and settlement.
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\229\ Currently, the only available exemption from exchange
registration is based on limited volume of transactions. 15 U.S.C.
78(e). As discussed in Section IV.B. above, however, the Commission
is soliciting comment on using its exemptive authority under section
36 of the Exchange Act to create a new category of exempted
exchanges.
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The U.S. regulatory scheme applicable to exchanges, however, is not
necessarily designed to accommodate entities that only engage in
limited activities in the United States and that are primarily
regulated in foreign jurisdictions. It may not be feasible, therefore,
to regulate a foreign market's activities under a regulatory scheme
that applies to domestic markets, particularly if a foreign market's
only activity in the United States is to provide its U.S. members with
the ability to trade directly on its facilities or to allow its members
to provide U.S. persons with electronic linkages to trade outside of
the United States. For example, U.S. exchange regulation could conflict
with the regulation to which these markets are already subject in their
home countries or could subject these markets to unnecessarily
duplicative and expensive obligations. Any approach to regulating the
U.S. activities of these foreign markets should attempt to minimize
conflict with obligations imposed by their primary regulators. There
may also be limits on the Commission's jurisdiction to impose exchange
requirements on foreign markets that have remote access arrangements
with U.S. persons. The Commission seeks comment on whether this option
is feasible and consistent with the federal securities laws.
Question 107: Should the Commission require foreign markets with
only limited activities in the United States to register as national
securities exchanges or obtain an exemption from such registration? How
would this affect U.S. persons trading directly on foreign markets?
3. Regulating Access Providers to Foreign Markets
A third approach could be to regulate the access providers to
foreign markets, including broker-dealers, rather than regulating the
foreign markets themselves. Entities that provide U.S. investors with
the technological capability to trade directly on a foreign market's
facilities appear to fall into two basic categories. The first category
includes those entities that distribute or publish information
regarding transactions on a foreign market, and provide a direct
electronic link on behalf of the U.S. members of that foreign market.
This category of access providers could be regulated as
SIPs.230 Under this approach, foreign markets, information
vendors, and other parties that provide U.S. members with the ability
to trade directly on foreign markets could either register as SIPs
themselves, or could choose instead to have another registered SIP
provide this capability to U.S. persons. This approach could also
provide a safe harbor from exchange registration for foreign markets
regulated abroad that choose to conduct their limited U.S. activities
through a registered SIP.
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\230\ See infra note 235 and accompanying text for a discussion
of the statutory definition of SIP. Registered SIPs are required to
comply with Section 11A of the Exchange Act.
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The second category of access providers consists of those U.S. and
foreign broker-dealers that provide U.S. persons who are not members of
a foreign market with the technological capability to trade directly on
a foreign market. Through their own or another broker-dealer's
electronic linkage to a foreign market, broker-dealer access providers
enable their customers to trade directly on the facilities of those
foreign markets.231 Because this access is provided in a
manner that is functionally equivalent to that provided by SIP access
providers, it presents the same risks to U.S. investors. Therefore,
similar basic requirements, such as recordkeeping, reporting,
disclosure, and antifraud requirements, could be applied to both SIP
and broker-dealer access providers.
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\231\ A broker-dealer would not be considered an access provider
to a foreign market's trading facilities, however, if it handled the
execution of its customer orders on foreign markets as part of its
traditional brokerage activities.
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Such an approach, based on the regulation of access providers,
might have several advantages over the two alternatives discussed
above. First, regulating only the U.S. activities of foreign markets
and other entities might reduce the likelihood of conflict with foreign
markets' home country regulations. Second, creating a regulatory
framework tailored for foreign markets could ensure appropriate
protections for U.S. investors and clarify the regulatory status of
foreign markets and other entities with only limited activities in the
United States. Third, establishing a regulatory structure that focuses
on the limited activities occurring in the United States, rather than
on the activities that a foreign market or third party conducts
primarily in a foreign country, may be more consistent with the
Commission's mandate under the Exchange Act.232 Finally,
this approach recognizes that U.S. investors trade directly on foreign
markets through a variety of sources, and could permit the Commission
to regulate, in a similar manner, all entities that provide this
service.
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\232\ See generally 15 U.S.C. 78dd(b).
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Question 108: How can the Commission best achieve its goal of
regulating the U.S. activities of foreign markets? Commenters should
take into consideration that foreign markets are regulated abroad, that
there is a potential for international conflicts of law, and that the
Commission has jurisdictional limits. Given the difficulties of
surveilling public networks such as the Internet, would an access
provider approach be workable?
a. Access Providers to U.S. Members of Foreign Markets
Entities that provide U.S. members of foreign markets with the
technological capability to trade directly on these markets from remote
locations could be regulated as SIPs under section 11A of the Exchange
Act. Section 11A was enacted by Congress more than twenty years ago to
create a statutory framework for the integration of automation into the
securities markets.233 Through this section, Congress sought
to ensure that ``the securities markets and the regulations of the
securities industry remain strong
[[Page 30525]]
and capable of fostering [the] fundamental goals [of the Exchange Act]
under changing economic and technological conditions.'' 234
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\233\ Section 11A of the Exchange Act was adopted as part of the
1975 Amendments. Pub. L. No. 29, 89 Stat. 97 (1975).
\234\ S. Rep. No. 75, supra note 22, at 3.
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While Congress did not focus on cross-border trading specifically,
Section 11A provides a regulatory basis to address changes in the
markets that result from the development of a global, electronic
marketplace. Section 11A extended the Commission's oversight authority
to ``any person engaged in the business of (i) collecting, processing,
or preparing for distribution or publication, or assisting,
participating in, or coordinating the distribution or publication of,
information with respect to transactions in or quotations for any
security . . . or (ii) distributing or publishing . . . on a current
and continuing basis, information with respect to such transactions or
quotations.'' 235 Congress gave the Commission authority to
require such entities--referred to as SIPs--to register with the
Commission and to establish rules governing SIP activities. All
registered SIPs must carry out their functions in a manner consistent
with the Exchange Act and report to the Commission denials or
limitations of access to the services they provide. The Commission has
the authority to review those decisions in much the same manner as it
reviews denials or limitations of access to the services offered by
registered U.S. exchanges.
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\235\ Exchange Act section 3(a)(22), 15 U.S.C. 78c(a)(22).
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Because information processing and dissemination are critical
components of today's automated market, the definition of SIP
potentially covers a broad range of entities that facilitate
communications among investors, intermediaries, and markets. To date,
however, only SIPs that process information exclusively on behalf of a
U.S. exchange or securities association (known as ``exclusive
processors'') 236 have been required to register with the
Commission. Congress exempted non-exclusive SIPs from the Section 11A
registration requirements until such time as the Commission, by rule or
order, finds that the registration of such non-exclusive SIPs is
necessary or appropriate in the public interest, for the protection of
investors, or for the achievement of the purposes of section 11A. The
Commission has not yet promulgated any such rules or
orders.237
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\236\ Exchange Act section 3(a)(22)(B), 15 U.S.C. 78c(a)(22)(B).
An ``exclusive processor'' is any securities information processor
(which is defined in Section 3(a)(22)(A)) that: ``directly or
indirectly, engages on an exclusive basis on behalf of any national
securities exchange or registered securities association or, any
national securities exchange or registered securities association
which engages on an exclusive basis on its own behalf, in
collecting, processing, or preparing for distribution or publication
any information with respect to (i) transactions or quotations on or
effected or made by means of any facility of such exchange or (ii)
quotations distributed or published by means of any electronic
system operated or controlled by such association.'' Id.
\237\ Exchange Act section 11A(b)(1), 15 U.S.C. 78k-1(b)(1). In
1975, the Commission adopted Rule 11Ab2-1 and Form SIP, which
provide that each SIP that is required to be registered pursuant to
Section 11A(b)(1) of the Exchange Act (i.e., exclusive SIPs) must
file an application for registration on Form SIP. Securities
Exchange Act Release No. 11673 (Sept. 23, 1975), 40 FR 45448
(October 2, 1975). Currently, there are five exclusive processors
registered under Section 11A: (1) The Consolidated Tape Association,
(2) the Consolidated Quotation System, (3) the Securities Industry
Automation Corporation, (4) Nasdaq, and (5) the Options Price
Reporting Authority.
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The Commission could use its authority to register and oversee non-
exclusive SIPs in order to establish a regulatory framework that could
accommodate U.S. investors' and intermediaries' participation in
foreign markets from the United States. For example, any non-exclusive
SIP could be required to register with the Commission under section 11A
if it met the statutory definition of a SIP with respect to securities
traded or approved for trading on a foreign market and if it provided a
facility or means through which a U.S. person could transmit orders to
a foreign market of which the U.S. person is a member.
This approach may have several advantages. For example, it would
clarify the regulatory status of foreign markets that arrange for U.S.
investors to be members of their trading facilities from the United
States. As discussed above, several foreign markets have been reluctant
to provide U.S. persons with direct trading capability without
receiving assurances from the Commission that they would not be
required to register as national securities exchanges under section 5
of the Exchange Act. If the Commission's concerns regarding the effects
of U.S. investors' direct trading on foreign markets could be addressed
through SIP regulation, there might be no overriding interest in
regulating these limited activities of foreign exchanges in the United
States under section 5. The Commission therefore solicits comment on
the advantages of this approach. The Commission is also soliciting
comment on whether it would be appropriate to create a ``safe harbor''
from exchange registration for bona fide 238 foreign markets
that conduct all their securities activities in the United States
through a registered SIP.
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\238\ See infra Section VII.B.1.c.(i).
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Question 109: What would be the best way for the Commission to
regulate the limited U.S. activities of foreign markets that provide
remote access to U.S. members?
Question 110: When should an entity be required to register with
the Commission as a non-exclusive SIP under section 11A of the Exchange
Act? For example, should the activities described above require
registration as a SIP?
Question 111: If the SIP approach were adopted, is it likely that
U.S. members of foreign markets would wish to transmit their orders to
such markets through more than one SIP registered with the Commission?
If so, should all but one of those SIPs be exempt from registration?
Question 112: Under the SIP approach, should foreign markets that
allow their U.S. members to transmit their orders solely through a
registered SIP have a safe harbor from registration as national
securities exchanges?
Question 113: What type of activities should a registered SIP be
permitted to conduct on behalf of a foreign market without the SIP or
the foreign market registering as an exchange?
b. Broker-Dealer Access Providers
A U.S. or foreign broker-dealer that provides U.S. persons with
terminals, software, access codes, or other means of directly trading
on the facilities of a foreign market through a member's interface with
that market, provides those U.S. persons with trading capabilities that
are functionally equivalent to those of market members, as described
above. These types of arrangements therefore present the same risks to
U.S. investors and investor protection concerns as described above. An
example of this type of arrangement is where a broker-dealer's customer
is provided with the technological capability to direct the execution
of its orders by viewing a foreign exchange's central limit order book
and then transmitting, modifying, or subsequently cancelling an order
based on the information in the limit order book.239
Although the customer's trading on the foreign exchange may be
technically or legally considered to be routed by the foreign market
member, the customer has the ability to use the facilities of the
exchange as though it were a member. By providing U.S persons with the
capability to transmit directly, and to direct the execution of, orders
to a foreign market, the broker-dealer is providing services that go
[[Page 30526]]
beyond traditional brokerage services.240 Because these
services are a relatively recent development, it appears that only a
small number of registered broker-dealers provide this type of direct
automated service to their institutional customers.241 In
view of these developments, it may be appropriate to regulate, in the
manner just described for SIP access providers, both foreign and U.S.
broker-dealers that provide U.S. persons with access to an automated
facility or means through which they can directly transmit, and direct
the execution of, orders on a foreign market.
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\239\ This type of arrangement is commonly referred to in this
context as a broker-dealer ``give-up.''
\240\ This type of electronic ``pass-through'' arrangement would
not encompass customer orders executed on foreign markets by broker-
dealers on behalf of their customers as part of a broker-dealers'
traditional brokerage activities.
\241\ The principal additional requirement with which registered
broker-dealers that are access providers to foreign markets would
have to comply under this type of approach, would be disclosure of
the specific risks relating to the trading on foreign markets.
Registered broker-dealers are already subject to most of the
recordkeeping, reporting, and antifraud requirements discussed in
Section VII.B.1.c.(iii).
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In some cases, broker-dealers provide their customers with this
type of direct linkage to U.S. exchanges through systems such as the
NYSE's SuperDOT system.242 Although a U.S. exchange has
obligations under the federal securities laws and is subject to
Commission oversight, a foreign market does not have similar
obligations. The ability to trade directly on foreign markets,
therefore, may raise investor protection concerns.
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\242\ See supra note 16.
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U.S. registered broker-dealers are also subject to a panoply of
regulations and supervisory requirements intended to protect both the
capital markets and investors,243 and have general agency
obligations to their customers under the federal securities laws.
Nevertheless, these requirements, in their current form, do not
necessarily address concerns raised when broker-dealers provide
automated means for U.S. persons to trade directly on foreign markets.
Consequently, the Commission could separately regulate the activities
of U.S. broker-dealers that act as access providers.
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\243\ For example, a broker-dealer is required to register with
the Commission, become a member of an SRO and SIPC, maintain certain
minimum levels of net capital, segregate customer funds, maintain
certain books and records, and make periodic reports to the
Commission. In addition, broker-dealers are subject to statutory
disqualification standards and the Commission's disciplinary
authority. See Exchange Act section 15, 15 U.S.C. 78o; Securities
Investor Protection Act of 1970, 15 U.S.C. 78aaa. See also 17 CFR
240.15a-6.
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Foreign broker-dealers that engage in activities as broker-dealer
access providers are, in most cases, exempt from broker-dealer
registration pursuant to Rule 15a-6 under the Exchange
Act.244 These access providers therefore are not subject to
the same requirements under the U.S. securities laws as registered
broker-dealers. The question thus arises of whether the Commission
should require foreign broker-dealers to register as U.S. broker-
dealers if they act as access providers to foreign markets on behalf of
U.S. persons. Traditional broker-dealer regulation could subject
foreign broker-dealers to requirements that are not necessary to
address concerns raised by the activities of access providers. Such
requirements could include the maintenance of specified capital, and
SIPC and SRO membership. Under an approach that applied to broker-
dealer access providers, however, the Commission could subject foreign
broker-dealers that enable U.S. investors to trade directly on foreign
markets to a regulatory framework tailored to their access provider
activities.
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\244\ This release does not address any issues that may be
raised regarding the applicability of Rule 15a-6 under the Exchange
Act or a foreign broker-dealer's obligations thereunder. 17 CFR
240.15a-6.
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Question 114: What types of automated broker-dealer systems, both
operational and contemplated, would be encompassed within the above
description of access providers to foreign markets? How widespread are
these activities?
Question 115: Would the above description of broker-dealer access
providers adequately and clearly exclude traditional brokerage
activities, particularly handling the execution of customer orders on
foreign markets? If not, how should such activities be distinguished
from traditional brokerage activities, particularly traditional cross-
border activities? Should U.S. broker-dealers that provide investors
with access to foreign markets be subject to any additional
requirements?
Question 116: Should foreign broker-dealers that provide U.S.
investors with automated access to foreign markets be required to
register as broker-dealers on the basis of that activity?
c. Requirements Applicable to Access Providers
If the Commission were to regulate foreign market access providers,
there are a number of conditions that could be applied to these
entities. For example, as discussed further below, the Commission could
subject registered SIP and broker-dealer access providers to
recordkeeping, reporting, disclosure, or antifraud requirements.
Question 117: What types of conditions, if any, should the
Commission place on access providers if it were to pursue that
approach?
(i) Conditions Relating to the Type of Foreign Market
Any new regulatory approach developed by the Commission to address
the unique concerns raised by access providers would not be intended as
an alternative regulatory scheme for U.S. exchanges. Accordingly, any
such approach would be applicable only to bona fide foreign markets.
There are a variety of ways the Commission could define a bona fide
foreign market. For example, a bona fide foreign market could be any
entity that meets the definition of an exchange under Section 3(a)(1)
of the Exchange Act or that otherwise conducts the business of an
exchange, but that is organized and has its principal place of business
outside of the United States. Any national securities exchange,
national securities association, or exchange exempt from registration
pursuant to a Commission rule or order would not be considered a bona
fide foreign market. The Commission could also exclude from the
definition of a bona fide foreign market an exchange that operates a
trading facility or provides terminals in the United States.
Another issue is whether SIP and broker-dealer access providers
should be permitted to transmit orders for U.S. persons only to foreign
markets that would be able to share information with the Commission in
connection with an investigation. As discussed above, the ability to
access trading and other market information is an essential component
of the Commission's ability to detect and deter fraud. Therefore, the
Commission could require a level of information sharing that could
ensure that the Commission has the ability to obtain necessary
information from a foreign regulatory authority and to obtain
meaningful assistance in the case of fraud or manipulation involving
U.S. persons and a foreign market's participants.245 For
example, the Commission could require access providers to enter into
private contractual agreements with foreign markets to which orders are
transmitted, under which foreign markets represent
[[Page 30527]]
that they are not prohibited by local law from sharing information with
the Commission and, as a condition of registration, agree to provide
information to the Commission upon request. Alternatively, the
Commission could designate certain foreign markets that, in its
experience, are able to share information with the Commission.
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\245\ Some U.S. exchanges that trade derivative products based
on securities primarily traded on foreign markets already have
surveillance sharing agreements in place. These surveillance sharing
agreements typically require signatories to provide to each other,
upon reasonable request, information about market trading activity,
clearing activity, and, in some instances, the identities of the
purchasers and sellers of securities.
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Question 118: If the Commission decides to regulate access
providers to foreign markets, what criteria should the Commission use
in determining whether an exchange is a bona fide foreign market?
Should a market be required to have at least a majority of foreign
members in order to be a bona fide foreign market? Should the
Commission exclude exchanges that provide terminals in the United
States?
Question 119: Should the Commission regulate as a U.S. exchange any
market that, although organized and having its principal place of
business outside of the United States, is under common control with or
controlled by U.S. persons, or whose decisions regarding trading rules,
practices, or procedures are made by U.S. persons?
Question 120: What factors should the Commission use in determining
whether an exchange is operating a trading facility in the United
States and is not a bona fide foreign market? If exchange-owned
terminals are located in the United States, should this constitute
operating a trading facility in the United States?
Question 121: What effect would a reinterpretation of the term
``exchange'' under section 3(a)(1) of the Exchange Act have on any
Commission proposal to regulate SIP and broker-dealer access providers?
Question 122: If the Commission decides to regulate access
providers to foreign markets, should the Commission require access
providers to transmit orders only to foreign markets that are willing
to share, and capable of sharing, information with the Commission in
connection with investigations involving violations of U.S. securities
laws? If so, what standard should the Commission use in determining
whether a foreign market would provide meaningful assistance to the
Commission? If commenters believe that SIP and/or broker-dealer access
providers should be permitted to transmit orders to any foreign market,
indicate how the Commission could ensure that it has the ability to
enforce the applicable provisions of the federal securities laws.
Question 123: Should the Commission require access providers to
transmit orders only to foreign markets that are located in countries
that have entered into arrangements with the Commission to provide
enforcement and information sharing assistance?
(ii) Conditions Relating to Type of Persons and Securities
Access providers could be limited to providing their services only
to certain sophisticated U.S. institutional investors. Another
alternative could be to permit broker-dealer access providers to
provide their services to all U.S. investors, but restrict the type of
investors to which SIP access providers could provide their services.
The Commission is soliciting comment on whether both SIP and broker-
dealer access providers should provide their services only to certain
sophisticated U.S. institutional investors. In addition, the Commission
solicits comment on whether the additional customer protection
requirements to which registered broker-dealers are subject should mean
that broker-dealer access providers should be allowed to provide their
services to all U.S. investors.
Another issue to be considered is whether it would be appropriate
to permit SIP and broker-dealer access providers to transmit orders
from U.S. persons to foreign markets only for foreign securities. On
the whole, transactions in securities of domestic issuers have a
greater potential to affect the U.S. securities markets than
transactions in securities of non-U.S. issuers, where the primary
market is typically overseas. Moreover, when a U.S. access provider is
used to trade the securities of domestic issuers on a foreign market,
the foreign market could be required to register as a U.S. exchange
under section 5 of the Exchange Act.246
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\246\ U.S. courts have interpreted the extraterritorial
application of the Exchange Act more expansively when the securities
that are the subject of the transaction are issued by a U.S.
corporation. See ITT v. Cornfeld, 619 F.2d 909 (2d Cir. 1980); ITT
v. Vencap, Ltd., 519 F.2d 1001, 1017 (2d Cir. 1975) (``We believe
that Congress intended the Exchange Act to have extraterritorial
application in order . . . to protect the domestic securities market
from the effects of improper foreign transactions in American
securities.'') (quoting Schoenbaum v. Firstbrook, 405 F.2d 215, 206
(2d Cir. 1968)).
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Question 124: If the Commission regulated access providers through
the approach described above, should SIP access providers be limited to
providing their services to sophisticated institutions or should they
be allowed to provide any U.S. investor with the capability of directly
trading on foreign markets as members? If so, should broker-dealer
access providers be subject to similar requirements?
Question 125: If the Commission permits SIP access providers to
offer their services only to broker-dealers and certain sophisticated
institutions, how should this category of sophisticated institutions be
defined?
Question 126: Should the Commission permit SIP and broker-dealer
access providers to transmit orders to foreign markets for the
securities of U.S. issuers or only for the securities of non-U.S.
issuers?
Question 127: Should the Commission limit the ability of SIP and
broker-dealer access providers to transmit orders to foreign markets
for the securities of non-U.S. issuers if the ``principal market'' for
those securities is located in the United States? If so, how should the
Commission determine when the ``principal market'' of a non-U.S.
security is located in the United States?
Question 128: If the Commission permits SIP and broker-dealer
access providers to transmit orders to foreign markets only for
securities of non-U.S. issuers, how should the Commission distinguish
between U.S. and non-U.S. issuers?
(iii) Recordkeeping, Reporting, Disclosure, and Antifraud Requirements
Recordkeeping and reporting requirements, generally, are an
important component of the Commission's oversight role. Adequate
trading records are invaluable to the Commission's efforts to enforce
the antifraud provisions of the Exchange Act. Without adequate records
and reports, the Commission would be unable to effectively monitor,
evaluate, and examine the activities of registered SIP and broker-
dealer access providers.
If the Commission decides to adopt a regulatory framework for
access providers, such recordkeeping and reporting requirements could
be crucial elements in enhancing Commission oversight of their
activities, and in identifying areas where surveillance is needed to
detect fraudulent, deceptive, and manipulative practices. Records and
periodic reports could also assist the Commission in gaining an
understanding of the effects of foreign markets' activities in the
United States and with U.S. persons. For example, these recordkeeping
and reporting requirements could be similar to the requirements
currently imposed on broker-dealers under Exchange Act Rule 17a-
23.247 Specifically, the Commission could require access
providers to keep (i) records regarding the identity of their
[[Page 30528]]
U.S. users; (ii) records regarding daily summaries of trading and time-
sequenced records of each transaction effected through the access
provider; (iii) information disseminated to U.S. investors, such as
quotation and transaction information regarding foreign securities
traded on foreign markets; and (iv) copies of the membership standards
used by each foreign market to which the SIP provides the U.S. members
of the market with the ability to trade directly.
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\247\ 17 CFR 240.17a-23. To the extent that an access provider
that is a U.S. broker-dealer is already subject to Rule 17a-23, that
access provider would not be subject to duplicative requirements.
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In addition, access providers could be required to file periodic
reports. Such periodic reports could contain information regarding (i)
the types of securities for which orders are transmitted; (ii) the
names of users of the access provider; and (iii) certain transaction
information, such as the total volume, number, and monetary value of
transactions for each foreign market to which orders are transmitted.
If certain entities that provide U.S. investors with the ability to
trade directly on foreign markets were required to register as SIPs,
they would, by operation of section 11A of the Exchange Act, be
required to notify the Commission, and the Commission would be required
to review, any limitations or prohibitions of access to the services
offered by such SIPs.248 Pursuant to Section 11A, the
Commission would be required to set aside any action only if it
determined that such action was unfairly exclusionary.
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\248\ Exchange Act section 11A(b)(5), 15 U.S.C. 78k-1(b)(5). The
Senate Committee on Banking, Housing and Urban Affairs report on the
Securities Acts Amendments of 1975 indicates that one of the
purposes of expanding the Commission's regulatory authority over the
processors and distributors of market information was ``to assure
that these communications networks are not controlled or dominated
by any particular market center, to guarantee fair access to such
systems * * * and to prevent any competitive restriction on their
operation not justified by the purposes of the Exchange Act.'' S.
Rep. No. 75, 94th Cong., 1st Sess. 9 (1975). Under Section
11A(b)(5)(A) of the Exchange Act, registered SIPs are required to
file notices of denial or limitation of access with the Commission.
15 U.S.C. 78k-1(b)(5)(A).
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In addition to recordkeeping and reporting requirements, the
Commission is soliciting comment on whether access providers could be
required to make certain disclosures to U.S. investors. Disclosure has
always been a cornerstone of the Commission's efforts to protect
investors. The question becomes what types of specific disclosures are
needed to ensure that U.S. persons have sufficient information
regarding foreign securities traded on a particular foreign market
through an access provider. For example, SIP and broker-dealer access
providers could be required to disclose information about the material
risks of trading on foreign markets, as well as the risks of using
their own facilities. Such disclosure could include information about
trading priorities on a foreign market and notification that the nature
and timeliness of pre-trade and post-trade information provided by a
foreign market differs from that provided by U.S. registered securities
exchanges. In addition, access providers could be required to disclose
that there is no guarantee under U.S. law that clearance or settlement
of securities trades will occur. SIP and broker-dealer access providers
could also be required to disclose system-related risks, including
limitations affecting the access providers' capacity to disseminate
timely information or to handle users' orders during peak periods.
The Commission could also consider specific antimanipulation rules
for registered SIP and broker-dealer access providers in order to
clarify the obligations imposed upon these entities under the antifraud
provisions of the federal securities laws. The Commission has
promulgated rules applicable specifically to registered broker-dealers
that prohibit them from engaging in manipulative, deceptive, or other
fraudulent activities.249 It would initially appear that SIP
and broker-dealer access providers should be similarly prohibited from
engaging in fraudulent, deceptive, or manipulative activities. For this
reason, the Commission could consider the need for rules supplementing
the general prohibition against fraud in section 10(b) of the Exchange
Act, and Rule 10b-5 thereunder.250 For example, it could
specifically prohibit access providers from distributing or publishing
information that they have reasonable grounds to believe is fraudulent,
deceptive, or manipulative, or from colluding to promote certain stocks
without the knowledge of U.S. investors.
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\249\ See 17 CFR 240.15c1-2 through 240.15c1-9.
\250\ 15 U.S.C. 78j(b); 17 CFR 240.10b-5.
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Question 129: If the Commission decides to regulate access
providers to foreign markets, should they be required to make and keep
records? What records should registered SIP and broker-dealer access
providers be required to maintain?
Question 130: Should access providers be required to file periodic
reports? If so, what information should those contain?
Question 131: Should broker-dealer access providers be required to
keep records of denials of access to their services? Should they be
required to notify the Commission of such denials of access?
Question 132: What types of risks should be disclosed to users of
SIP and broker-dealer access providers? For example, should SIP and
broker-dealer access providers be required to disclose the listing and
maintenance standards of foreign markets to which they transmit orders
on behalf of U.S. persons? What would be the costs associated with such
a requirement?
Question 133: Should access providers be required to make
disclosures to sophisticated institutions?
Question 134: What market information should SIP and broker-dealer
access providers be required to provide to the users of their services?
C. Addressing the Differences Between U.S. and Foreign Markets' Listed
Company Disclosure Standards
As the Commission develops an approach to the appropriate
regulation of the U.S. activities of foreign markets, it must also
address the issues that arise because most securities traded on foreign
markets are not registered under the Securities Act or the Exchange
Act, and the issuers of those securities do not file reports with the
Commission. Section 5 of the Securities Act makes it unlawful for any
person, through the use of interstate commerce or the mails, to offer
or sell a security in a public distribution prior to the effective date
of the registration statement.251 Unless an exemption
applies, securities offered or sold in the United States by issuers
(whether domestic or foreign) must be registered with the Commission
pursuant to section 5 of the Securities Act.252 In some
cases, foreign securities issued abroad, but later sold in the United
States, may be eligible for the exemption under section 4(1) of the
Securities Act for ``transactions by any person, other than an issuer,
underwriter or dealer.'' 253 However, to the extent that a
foreign issuer effects a distribution over the facilities of a foreign
market, SIP access providers to that market could be required to ensure
that U.S. investors may not purchase
[[Page 30529]]
that security during the distribution, absent registration or an
available exemption under the Securities Act. Similarly, the Commission
requests comment on whether broker-dealer access providers should be
required to ensure that U.S. investors do not purchase the securities
of a foreign issuer effecting a distribution on a foreign market,
unless there is an effective registration statement or an applicable
exemption.
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\251\ Securities Act section 5, 15 U.S.C. 77e.
\252\ For example, section 3(a) of the Securities Act enumerates
12 categories of exempted securities to which the registration
requirements of section 5 do not apply, including securities issued
by the U.S. Government, religious and benevolent organizations,
savings and loan associations, and cooperative banks. 15 U.S.C.
77c(a). Securities of foreign private and sovereign issuers are not
exempted securities. In addition, section 4 of the Securities Act
sets forth a number of exempted transactions. 15 U.S.C. 77d.
\253\ Securities Act section 4(1), 15 U.S.C. 77d(1).
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As noted, U.S. investors historically have been able to purchase
unregistered securities traded on foreign markets by placing orders
through one or more domestic and foreign broker intermediaries, which
in turn have direct or indirect access to the foreign exchange or
market. U.S. and foreign broker-dealers are today providing certain
U.S. investors with automated links to foreign markets. As technology
facilitates the ability of U.S. investors to conduct transactions
directly on foreign securities exchanges and markets, the distinctions
between the domestic and foreign trading markets may quickly disappear.
In the Exchange Act, Congress has set the threshold for requiring
registration and reporting either upon a company's listing on a U.S.
exchange 254 or, in the case of a class of equity
securities, upon having at least 500 record holders (in the case of
foreign issuers, 300 of which are in the United States) and assets over
a specified dollar amount.255 These disclosure requirements
provide transparency with respect to the business, management,
operating results and financial condition of the issuers of the traded
securities. This is different from the market transparency provided by
the Commission's regulatory and disclosure requirements applicable to
markets and their members.
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\254\ Section 12(a) of the Exchange Act.
\255\ Section 12(g) of the Exchange Act, 15 U.S.C. 78l(g), and
Rules 12g-1 and 12g3-2(a), 17 CFR 240.12g-1 and 240.12g3-2(a).
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The Commission has accommodated the legitimate interest of foreign
issuers whose shares come to be held in the United States by providing
an exemption from registration under Exchange Act Rule 12g3-2(b)
256 if those shares are not listed on a U.S. exchange or
quoted on Nasdaq and if the issuer has not registered an offering of
securities under the Securities Act. These issuers need not register so
long as they provide the Commission with the information that they make
available to their securityholders in their home countries. The
exemption is grounded in the jurisdictional and comity concerns that
the Commission could not require a foreign company to register and file
reports if the company has not affirmatively taken steps to enter our
markets, regardless of the level of interest by U.S. investors in the
company's securities.
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\256\ 17 CFR 240.12g3-2(b).
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These concerns directly relate to issues raised by the extensive
trading in this country of unregistered foreign securities in the U.S.
over-the-counter markets, bulletin boards, and alternative trading
systems. Despite the extensive U.S. ownership and trading in these
foreign securities, registration under the Exchange Act is not required
by virtue of the Rule 12g3-2(b) exemption.
As noted in Section IV.B., if the Commission decides to regulate
certain domestic alternative trading systems as exchanges, foreign
securities traded on those exchanges would have to be registered. By
excluding foreign markets from the definition of exchange, however,
absent Commission action, Rule 12g3-2(b) would continue to provide an
exemption for the foreign issuers of the securities traded on those
markets from registration under the Exchange Act. By facilitating U.S.
investor access to foreign markets, the SIP or broker-dealer approach
described above could promote a real time market in the United States
for the securities of potentially thousands of foreign companies
without those companies meeting U.S. disclosure and accounting
standards. The question thus becomes whether the access provided by
SIPs to trading in foreign markets should be limited to securities that
are registered with the Commission pursuant to section 12 of the
Exchange Act. In addition, there is a question as to whether the
Commission should also limit broker-dealer access providers to
providing U.S. investors with access to securities trading in foreign
markets that are registered under section 12, or whether a distinction
should be made between SIP access providers and broker-dealer access
providers. The Commission is soliciting comment on whether the approach
described above adequately protects the interests of U.S. investors.
Question 135: Should direct trading in foreign listed companies be
limited to those that satisfy U.S. disclosure standards in order to
better protect U.S. investors?
Question 136: Is it sufficient to merely disclose to investors that
the information available about a foreign security may significantly
differ from the information that would be available about U.S.
securities? Do public policy concerns dictate that the Commission make
distinctions based on whether investors receive adequate information?
Question 137: Are there circumstances under which unregistered
foreign securities should be permitted to trade on foreign markets
through an access provider? For example, should the Commission
establish some de minimis threshold for a foreign security based on the
dollar value of the U.S. float or trading volume in that security, or
on the relative percentage of U.S. float or trading volume compared to
that of the home or worldwide markets?
Question 138: Should the exemption from registration under Exchange
Act Rule 12g3-2(b) be available if a significant portion of an issuer's
float is traded in the United States?
Question 139: Given that broker-dealers currently trade
unregistered securities for customers, should the Commission reconsider
its approach to securities registration requirements in this context?
Are there other viable alternatives that would ensure adequate
disclosure to U.S. investors trading on foreign markets?
Question 140: Is trading in unregistered foreign securities through
an access provider to a foreign market appropriate if access is limited
to sophisticated investors? For example, should access providers be
permitted to transmit orders for unregistered foreign securities to a
foreign market on behalf of qualified institutional buyers as defined
in Rule 144A of the Securities Act?
Question 141: Are there uniform procedures that the Commission
should impose on foreign markets or on access providers to assure that
securities are not sold to U.S. investors in circumstances that result
in a public distribution of securities in the United States that are
not registered under the Securities Act?
Question 142: What are the consequences to SEC reporting companies
if unregistered foreign securities listed on foreign markets are
available to be purchased or sold through access providers?
D. Costs and Benefits of Revising Regulation of Foreign Market
Activities in the United States
Direct U.S. investor access to foreign markets could provide
significant benefits to U.S. investors. Such access may provide these
investors with entirely new investment opportunities, and may
significantly reduce their transaction costs. The Commission generally
solicits comment on the expected costs and benefits of the three
alternative approaches to regulating the
[[Page 30530]]
activities of foreign markets in the United States, as discussed above.
E. Conclusion
The increasing globalization of the securities markets has created
new opportunities for U.S. investors. The establishment of new
securities markets coupled with the enhancement of corporate disclosure
and trade transparency in many stock exchanges throughout the world has
dramatically increased their range of viable investment opportunities.
At the same time, advancements in technology have made foreign
investment opportunities more accessible and affordable to U.S.
investors. Although these are positive developments, they also raise
concerns that the activities of foreign markets in the United States
could adversely affect not only U.S. investors, but also the U.S.
securities markets.
The Commission believes it is critical to address the regulatory
issues raised by U.S. investors' use of technology to trade directly on
foreign markets. The Commission hopes to develop a consistent, long-
term approach to address these issues, while ensuring that key
protections for U.S. investors, as well as U.S. markets, are in place.
Discussed above are three alternatives. The Commission is seeking
comment on each of these alternatives, along with commenters' ideas
about other viable alternatives.
Question 143: Would any of the approaches described above provide
an effective means of addressing the issues raised by foreign market
activities in the United States, including providing key protections
for U.S. investors? What would be the benefits of each approach? What
would be the drawbacks of each approach?
VIII. Summary of Requests for Comment
Following receipt and review of comments, the Commission will
determine whether rulemaking or other action is appropriate. Commenters
are invited to discuss the broad range of concepts and approaches
described in this release concerning the Commission's registration and
oversight of national securities exchanges, alternative trading
systems, and foreign market activities in the United States. In
addition to responding to the specific questions presented in this
release, the Commission encourages commenters to provide any
information to supplement the information and assumptions contained
herein regarding the functioning of secondary markets, the roles of
market participants, the advantages and disadvantages of the suggested
reforms, the expectations of investors, and cross-border trading. The
Commission also invites commenters to provide views and data as to the
cost and benefits associated with possible changes discussed above in
comparison to the costs and benefits of the existing statutory
framework. In order for the Commission to assess the impact of changes
to the Exchange Act's regulatory scheme, comment is solicited, without
limitation, from investors, broker-dealers, exchanges, and other
persons involved in the securities markets. In sum, the Commission
requests comment on the following questions:
Question 1: The Commission seeks comment on the concerns identified
above and invites commenters to identify other issues raised by the
current approach to regulating alternative trading systems.
Question 2: Are the concerns raised in this release with regard to
the operation of alternative trading systems under the current
regulatory approach unique to such systems? To what extent could these
concerns be raised by broker-dealers that do not operate alternative
trading systems, such as a broker-dealer that matches customer orders
internally and routes them to an exchange for execution or a broker-
dealer that arranges for other broker-dealers to route their customer
orders to it for automated execution?
Question 3: What regulatory approaches would best address the
concerns raised by the growth of alternative trading systems and the
needs of the market? Is the current approach the most appropriate one?
Question 4: What should be the objectives of market regulation? Are
the goals and regulatory structure incorporated by Congress in the
Exchange Act appropriate in light of technological changes? Are
business incentives adequate to accomplish these goals?
Question 5: Are the regulatory categories defined in the Exchange
Act sufficiently flexible to accommodate changes in market structure?
If not, what other categories would be appropriate? How should such
categories be defined?
Question 6: Can the Commission regulate markets effectively through
standard-oriented regulation of the type described above?
Question 7: How could the Commission enforce compliance with the
Exchange Act under such a standard-oriented approach?
Question 8: Is the current regulatory framework an effective form
of oversight, in light of technological changes? Are there other
regulatory techniques that would be comparably effective? If so, would
the implementation of such techniques be consistent with congressional
goals reflected in the Exchange Act?
Question 9: Are there viable alternatives within the existing
Exchange Act structure, other than those discussed below, that would
address the concerns raised by the growth of alternative trading
systems and congressional goals in adopting the Exchange Act?
Question 10: What types of alternative trading systems would it be
appropriate to regulate in this manner?
Question 11: If the Commission decided to further integrate
alternative trading systems into the NMS through broker-dealer
regulation, should it require alternative trading systems to submit all
orders displayed in their systems into the public quotation system? If
not, how should the Commission ensure adequate transparency?
Question 12: If the Commission requires alternative trading systems
to submit all orders displayed in their systems into the public
quotation system, how can duplicate reporting by alternative trading
systems and their participant broker-dealers be prevented?
Question 13: Are there other methods for integrating all orders
submitted into alternative trading systems into the public quotation
system?
Question 14: Are there any reasons that orders available in
alternative trading systems should not be available to the public?
Question 15: If the Commission requires alternative trading systems
to allow non-participants to execute against orders of system
participants, how should it ensure that non-participants are granted
equivalent access?
Question 16: If the Commission requires alternative trading systems
to allow non-participants to execute against orders of system
participants, how should it determine whether the fees charged to non-
participants by such systems are reasonable and do not have the effect
of denying access to orders?
Question 17: Are there any reasons that non-participants should not
be able to execute against orders of participants in alternative
trading systems?
Question 18: Should the Commission require alternative trading
systems to provide additional information (such as identifying
counterparties) to their SRO in order to enhance the SRO's audit trail
and surveillance capabilities?
Question 19: What other methods could the Commission use to enhance
[[Page 30531]]
market surveillance of activities on alternative trading systems?
Question 20: Should SROs be required to surveil trading by their
members in securities that are not listed or quoted on the market
operated by that SRO?
Question 21: Should alternative trading systems be required to
follow guidelines regarding the capacity and integrity of their
systems? If not, how should the Commission address systemic risk
concerns associated with potentially inadequate capacity of alternative
trading systems, particularly those systems with significant volume?
Question 22: With what types of standards regarding computer
security, capacity, and auditing of systems, should alternative trading
systems be required to comply?
Question 23: To what extent would complying with systems guidelines
similar to those implemented by exchanges and other SROs require
modification to the current procedures of alternative trading systems?
What costs would be associated with such modifications? How much time
would be required to implement the necessary modifications and systems
enhancements? Please provide a basis for these estimates.
Question 24: Is access to alternative trading systems an important
goal that the Commission should consider in regulating such systems? If
so, are there circumstances in which alternative trading systems should
be able to limit access to their systems (for example, should the
Commission be concerned about access to an alternative trading system
that has arranged for its quotes to be displayed as part of the public
quotation system)?
Question 25: If alternative trading systems were to continue to be
regulated as broker-dealers and were subject to a fair access
requirement, should the Commission consider denial of access claims
brought by participants and non-participants in alternative trading
systems? If not, are there other methods that could adequately address
such claims?
Question 26: Are commenters aware of any unfair denials of access
by broker-dealers operating alternative trading systems, where there
were no alternative trading venues available to the entities denied
access?
Question 27: Would enhanced surveillance of alternative trading
systems by their SROs raise competitive concerns that could not be
addressed through separation of the market and regulatory functions of
the SROs?
Question 28: If alternative trading systems continue to be
regulated as broker-dealers, are there other ways to integrate the
surveillance of trading on alternative trading systems?
Question 29: What is the feasibility of establishing an SRO solely
for the purpose of surveilling the trading activities of broker-dealer
operated alternative trading systems, that does not also operate a
competing market?
Question 30: If alternative trading systems continue to be
regulated as broker-dealers, how can the Commission address
anticompetitive practices by such systems?
Question 31: Would this approach be an effective means of
addressing the issues raised by the growth of alternative trading
systems? What would be the benefits of such an approach? What would be
the drawbacks of such an approach?
Question 32: If the Commission reinterpreted the term ``exchange,''
are the factors described above (i.e., (1) consolidating orders of
multiple parties and (2) providing a facility through which, or setting
conditions under which, participants entering such orders may agree to
the terms of a trade) sufficient to include the alternative trading
systems described above?
Question 33: Is broadening the Commission's interpretation of
``exchange'' to cover diverse markets, and then exempting all but the
most significant of these new exchanges from registration, the most
appropriate way to address the regulatory gaps discussed above and
provide the Commission with sufficient flexibility to oversee changing
market structures?
Question 34: Are there any other categories of alternative trading
systems that have sufficiently minimal effects on the public secondary
market that they should be treated as exempted exchanges?
Question 35: Should low impact markets be regulated as exempted
exchanges, rather than as broker-dealers?
Question 36: What measure or measures should be used in determining
whether a market has a low impact? What is the level above which an
alternative trading system should not be considered to have a low
impact on the market? At what level should an already registered
exchange be able to deregister?
Question 37: Should an alternative trading system be considered to
have a low impact on the market and be treated as an exempted exchange
if it trades a significant portion of the volume of one security, even
if the trading system's overall volume is low in comparison to the
market as a whole?
Question 38: In determining whether an alternative trading system
has a low impact, what factors other than volume should the Commission
consider? Should this determination be affected if the operator of an
alternative trading system was the issuer of securities traded on that
system?
Question 39: Should passive markets be regulated as exempted
exchanges, rather than as broker-dealers?
Question 40: Are the requirements described above appropriate to
ensure the integrity of secondary market oversight?
Question 41: Should any other requirements be imposed upon exempted
exchanges, such as requirements that an exempted exchange provide fair
access or establish procedures to ensure adequate system capacity,
integrity, and confidentiality?
Question 42: Should requirements vary with the type of alternative
trading system (e.g., should passive systems be subject to different
conditions than systems exempted on the basis of low impact)?
Question 43: Should the Commission require that securities traded
on exempted exchanges be registered under section 12 of the Exchange
Act? Should different disclosure standards be applicable to such
securities if they are only traded on such exchanges?
Question 44: Should the Commission allow institutions to be
participants on registered exchanges to the same extent as registered
broker-dealers? If so, should the Commission adopt rules allowing
registered exchanges to have institutional participants, or should the
Commission issue exemptive orders on a case-by-case basis, upon
application for relief by registered exchanges?
Question 45: Should the Commission allow exchanges to provide
services exclusively to institutions?
Question 46: If the Commission allows institutions to participate
in exchange trading, should the Commission view all entities that have
electronic access to exchange facilities as ``members'' under the
Exchange Act and then exempt exchanges from section 6(c)(1)?
Question 47: Is it foreseeable that exchanges will wish to permit
retail investors to be participants in their markets? If so, should the
Commission allow retail participation on registered exchanges to the
same extent as registered broker-dealers?
Question 48: Should the Commission allow registered exchanges to
provide services exclusively to retail investors?
Question 49: Could exchanges have various classes of participants,
as long as admission criteria and means of
[[Page 30532]]
access are applied and allocated fairly? Would it be in the public
interest if new or existing exchanges sought to operate primarily or
exclusively on a retail basis? What would be the advantages and
disadvantages if new or existing exchanges were to admit as
participants only highly capitalized institutions or only highly
capitalized institutions and broker-dealers?
Question 50: Should non-membership exchanges (including alternative
trading systems that may register as exchanges) be exempt from fair
representation requirements?
Question 51: Should all exchanges be required to comply with
section 6(b)(3) by having a board of directors that includes
participant representation?
Question 52: If not, are there alternative structures that would
provide independent, fair representation for all of an exchange's
constituencies (including the public)?
Question 53: Would the revised interpretation of ``exchange'' being
considered by the Commission adequately and clearly include alternative
trading systems that operate open limit order execution systems (even
those that also provide brokerage functions)?
Question 54: In light of the decreasing differentiation between
market maker quotes and customer orders in trading, should the
Commission consider an ``order'' to include any firm trading interest,
including both limit orders and market maker quotes?
Question 55: What should the Commission consider to be ``material
conditions'' under which participants entering orders may agree to the
terms of a trade? For example, should an alternative trading system be
considered to be setting ``material conditions'' when it standardizes
the material terms of instruments traded on the market, such as
standardizing option terms or requiring participants that display
quotes to execute orders for a minimum size or to give priority to
certain types of orders?
Question 56: Is it appropriate for the Commission to consider the
activities described above as broker-dealer activities?
Question 57: How should a revised interpretation of exchange
adequately and clearly distinguish broker-dealer activities, such as
block trading and internal execution systems, from market activities?
Question 58: Are the distinctions discussed above accurate
reflections of exchange and broker-dealer activities? Are there other
factors that may better distinguish a broker-dealer from an exchange?
Question 59: How should a revised interpretation of the term
``exchange'' adequately and clearly distinguish broker-dealer
activities, such as block trading and internal execution systems, from
market activities?
Question 60: What factors should the Commission consider in
determining whether an organization of dealers is sufficiently
``organized'' to require exchange registration?
Question 61: Does the revised interpretation of ``exchange''
described above clearly exclude information vendors, bulletin boards,
and other entities whose activities are limited to the provision of
trading information? How should the Commission distinguish between
information vendors, bulletin boards, and exchanges?
Question 62: If the Commission expands its interpretation of
``exchange,'' should the Commission exempt interdealer brokers that
deal only in exempted securities from the application of exchange
registration and other requirements?
Question 63: How could the Commission define interdealer brokers in
a way that would implement congressional intent not to regulate
traditional interdealer brokers as exchanges, without unintentionally
exempting other alternative trading systems operated by brokers?
Question 64: How could the Commission foster the continued trading
of all securities currently traded on alternative trading systems if
these systems are classified as exchanges under the interpretation
described above and some of these systems are required to register as
national securities exchanges? For example, what would be the effect on
alternative trading systems that wish to trade securities exempted from
registration under Rule 144A if those systems are required to register
as national securities exchanges?
Question 65: How would the requirement to have rules in place for
trading unlisted securities affect the viability of alternative trading
systems that are required to register as national securities exchanges?
Question 66: Would the specifications in the OTC-UTP plan relating
to the trading of Nasdaq/NM securities pose particular problems for
systems that are required to register as national securities exchanges?
Question 67: Should the Commission extend UTP to securities other
than NM securities, such as Nasdaq SmallCap securities? What effect
would an inability to trade Nasdaq SmallCap and other non-Nasdaq/NM
securities have upon alternative trading systems that are required to
register as national securities exchanges?
Question 68: What effect would the prohibition on UTP trading of
newly listed stock until the day following an initial public offering
have upon systems that are required to register as national securities
exchanges?
Question 69: How should existing exchange rules designed to limit
members from effecting OTC transactions in exchange-listed stock be
applied, if the Commission's interpretation of exchange were expanded
to include alternative trading systems and organized dealer markets?
What customer protection and competitive reasons might there be to
preserve these rules if alternative trading systems are classified as
exchanges?
Question 70: What effects would linking alternative trading systems
to NMS mechanisms have on those systems? For example, how would such
linkages affect the ability of alternative trading systems to operate
with trading and fee structures that differ from those of existing
exchanges or to alter their structures? To what extent could revision
of the NMS plans alleviate these effects?
Question 71: Are there any insurmountable technical barriers to
admission of alternative trading systems into the CTA, CQS, OPRA, or
OTC-UTP plans?
Question 72: What costs are associated with the admission of new
applicants to these plans?
Question 73: Are there any CTA, CQS, OPRA, or OTC-UTP plan rules
that would prevent newly registered national securities exchanges from
obtaining fair and equal representation on these entities?
Question 74: What effect would the admission of newly registered
national securities exchanges to the CTA, CQS, OPRA, and OTC-UTP plans
have upon the governance and administration of those plans?
Question 75: Do admissions fees for new participants required by
the terms of the plans present a barrier to admission to the plans? Do
the plans' provisions that all participants are eligible to share in
the revenues generated through the sale of data affect commenters'
views on this issue?
Question 76: What effect would the admission of new, highly
automated participants have upon the operation of the ITS?
Question 77: How would compliance with the current ITS rules and
policies affect trading on alternative systems that may be regulated as
exchanges? How
[[Page 30533]]
appropriate are these rules and policies for alternative trading
systems?
Question 78: What costs would be associated with newly registered
exchanges joining ITS? Would those costs represent a barrier for newly
registered exchanges to join ITS?
Question 79: Are there any ITS plan rules or practices that would
prevent newly registered national securities exchanges from obtaining
fair and equal representation on the ITS?
Question 80: What effect would the admission of newly registered
national securities exchanges to the ITS plan have upon the governance
and administration of the plan?
Question 81: What effect would the requirements to impose trading
halts or circuit breakers in some circumstances have upon alternative
trading systems if such systems were regulated as exchanges?
Question 82: What impact would registration of an alternative
trading system as an exchange have on the institutional participants of
that trading system, including registered investment companies?
Question 83: If the Commission allows institutions to effect
transactions on exchanges without the services of a broker, to what
extent should an exchange's obligations to surveil its market and
enforce its rules and the federal securities laws apply to such
institutions?
Question 84: How could an exchange adequately supervise
institutions that effect transactions on an exchange without the
services of a broker?
Question 85: What, if any, accommodations should be made with
respect to an exchange's surveillance, enforcement, and other SRO
obligations with respect to institutions that transact business on that
exchange?
Question 86: How could institutions that directly access exchanges
be integrated into existing systems for clearance and settlement?
Question 87: Under what conditions should an entity be subject to
both exchange and broker-dealer regulation?
Question 88: Should a dually registered entity be required to
formally separate its exchange operations from its broker-dealer
operations (e.g., through use of separate subsidiaries)?
Question 89: Would this approach be an effective means of
addressing the issues raised by the growth alternative trading systems?
What would be the benefits of such an approach? What would be the
drawbacks of such an approach?
Question 90: Would it be feasible for the Commission to expand the
scope of rules eligible for expedited treatment pursuant to section
19(b)(3)(A) without jeopardizing the investor protection and market
integrity benefits of Commission oversight of exchange and other SRO
rule changes? If so, to what types of rule filings should immediate
effectiveness, pursuant to section 19(b)(3)(A), be extended?
Question 91: If the Commission expands the scope of rule filings
eligible for treatment under section 19(b)(3)(A) to include, for
example, certain types of new products, what conditions or
representations should be required of an SRO to ensure that the
proposed rule change is eligible for expedited treatment under Rule
19b-4?
Question 92: Should the Commission exempt markets' proposals to
implement new trading systems, separate from their primary trading
operations, from rule filing requirements? If so, should SROs be
permitted to operate pilot programs under such an exemption if they
trade the same securities, operate during the same hours, or utilize
similar trading procedures as the SRO's main trading system? Should
there be a limit on the number of pilot programs an SRO can operate
under an exemption at any one time? What other conditions should apply
to such exemption?
Question 93: Do differences between automated and non-automated
trading require materially different types or degrees of surveillance
or enforcement procedures?
Question 94: Which Exchange Act requirements applicable to
registered exchanges, if any, could be minimized or eliminated without
jeopardizing investor protection and market integrity?
Question 95: If an automated exchange contracts with another SRO to
perform its day-to-day enforcement and disciplinary activities, should
this affect the exchange's requirement to ensure fair representation of
its participants and the public in its governance?
Question 96: If an exchange contracts with another entity to
perform its oversight obligations, should that exchange continue to
have responsibility under the Exchange Act for ensuring that those
obligations are adequately fulfilled?
Question 97: What costs to investors and other market participants
are associated with the current regulation of alternative trading
systems as broker-dealers? Specifically, what costs are associated with
the potential denial of access by an alternative trading system?
Question 98: What costs are associated with each of the
alternatives for revising market regulation discussed above? For
example, would either of the two principal alternatives discussed in
section IV above impose costs by limiting innovation? Would these costs
be greater than those imposed by the current regulatory approach?
Question 99: What regulatory costs can be shared by markets
operating simultaneously as self-regulatory organizations, and what
regulatory costs must be borne by each market individually? What are
the relative magnitudes of these costs (as a proportion of total
costs)?
Question 100: Are there innovations or adjustments that can be made
to market wide plans such as CQS, CTA and ITS that will lead to lower
regulatory costs for exchanges under any of the alternatives for
regulating domestic markets?
Question 101: Total regulatory costs vary with a variety of factors
(e.g., volume of trade, degree of technology applied in trade). Of
these factors, which are most relevant in considering the alternatives
discussed above? For example, recognizing that some market mechanisms
may rely on some factors more than others, to what extent are
regulatory costs greater for particular mechanisms than others?
Question 102: What costs are associated with the responsibilities
of an SRO? Will the costs to existing SROs be reduced by registering
significant alternative trading systems as exchanges?
Question 103: What regulatory burdens currently inhibit innovation
of trading systems? How will the alternatives discussed above change
the incentives for innovation?
Question 104: Will the alternatives discussed above impose costs on
systems that differ depending on the nature of the trade? For example,
will the proposed regulatory revisions change the costs of trades
directly between customers relative to the costs of trades between a
customer and a dealer?
Question 105: What regulatory approaches would best address the
concerns raised by the development of automated access to foreign
markets? Would these approaches differ if U.S. investors accessed
foreign markets in ways other than those described above, such as
through the Internet? Are there any other alternative approaches that
could be more appropriate?
Question 106: If the Commission were to rely solely on a foreign
market's primary regulator, how could it address the investor
protection and enforcement concerns discussed above?
Question 107: Should the Commission require foreign markets with
only limited activities in the
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United States to register as national securities exchanges or obtain an
exemption from such registration? How would this affect U.S. persons
trading directly on foreign markets?
Question 108: How can the Commission best achieve its goal of
regulating the U.S. activities of foreign markets? Commenters should
take into consideration that foreign markets are regulated abroad, that
there is a potential for international conflicts of law, and that the
Commission has jurisdictional limits. Given the difficulties of
surveilling public networks such as the Internet, would an access
provider approach be workable?
Question 109: What would be the best way for the Commission to
regulate the limited U.S. activities of foreign markets that provide
remote access to U.S. members?
Question 110: When should an entity be required to register with
the Commission as a non-exclusive SIP under section 11A of the Exchange
Act? For example, should the activities described above require
registration as a SIP?
Question 111: If the SIP approach were adopted, is it likely that
U.S. members of foreign markets would wish to transmit their orders to
such markets through more than one SIP registered with the Commission?
If so, should all but one of those SIPs be exempt from registration?
Question 112: Under the SIP approach, should foreign markets that
allow their U.S. members to transmit their orders solely through a
registered SIP have a safe harbor from registration as national
securities exchanges?
Question 113: What type of activities should a registered SIP be
permitted to conduct on behalf of a foreign market without the SIP or
the foreign market registering as an exchange?
Question 114: What types of automated broker-dealer systems, both
operational and contemplated, would be encompassed within the above
description of access providers to foreign markets? How widespread are
these activities?
Question 115: Would the above description of broker-dealer access
providers adequately and clearly exclude traditional brokerage
activities, particularly handling the execution of customer orders on
foreign markets? If not, how should such activities be distinguished
from traditional brokerage activities, particularly traditional cross-
border activities? Should U.S. broker-dealers that provide investors
with access to foreign markets be subject to any additional
requirements?
Question 116: Should foreign broker-dealers that provide U.S.
investors with automated access to foreign markets be required to
register as broker-dealers on the basis of that activity?
Question 117: What types of conditions, if any, should the
Commission place on access providers if it were to pursue that
approach?
Question 118: If the Commission decides to regulate access
providers to foreign markets, what criteria should the Commission use
in determining whether an exchange is a bona fide foreign market?
Should a market be required to have at least a majority of foreign
members in order to be a bona fide foreign market? Should the
Commission exclude exchanges that provide terminals in the United
States?
Question 119: Should the Commission regulate as a U.S. exchange any
market that, although organized and having its principal place of
business outside of the United States, is under common control with or
controlled by U.S. persons, or whose decisions regarding trading rules,
practices, or procedures are made by U.S. persons?
Question 120: What factors should the Commission use in determining
whether an exchange is operating a trading facility in the United
States and is not a bona fide foreign market? If exchange-owned
terminals are located in the United States, should this constitute
operating a trading facility in the United States?
Question 121: What effect would a reinterpretation of the term
``exchange'' under section 3(a)(1) of the Exchange Act have on any
Commission proposal to regulate SIP and broker-dealer access providers?
Question 122: If the Commission decides to regulate access
providers to foreign markets, should the Commission require access
providers to transmit orders only to foreign markets that are willing
to share, and capable of sharing, information with the Commission in
connection with investigations involving violations of U.S. securities
laws? If so, what standard should the Commission use in determining
whether a foreign market would provide meaningful assistance to the
Commission? If commenters believe that SIP and/or broker-dealer access
providers should be permitted to transmit orders to any foreign market,
indicate how the Commission could ensure that it has the ability to
enforce the applicable provisions of the federal securities laws.
Question 123: Should the Commission require access providers to
transmit orders only to foreign markets that are located in countries
that have entered into arrangements with the Commission to provide
enforcement and information sharing assistance?
Question 124: If the Commission regulated access providers through
the approach described above, should SIP access providers be limited to
providing their services to sophisticated institutions or should they
be allowed to provide any U.S. investor with the capability of directly
trading on foreign markets as members? If so, should broker-dealer
access providers be subject to similar requirements?
Question 125: If the Commission permits SIP access providers to
offer their services only to broker-dealers and certain sophisticated
institutions, how should this category of sophisticated institutions be
defined?
Question 126: Should the Commission permit SIP and broker-dealer
access providers to transmit orders to foreign markets for the
securities of U.S. issuers or only for the securities of non-U.S.
issuers?
Question 127: Should the Commission limit the ability of SIP and
broker-dealer access providers to transmit orders to foreign markets
for the securities of non-U.S. issuers if the ``principal market'' for
those securities is located in the United States? If so, how should the
Commission determine when the ``principal market'' of a non-U.S.
security is located in the United States?
Question 128: If the Commission permits SIP and broker-dealer
access providers to transmit orders to foreign markets only for
securities of non-U.S. issuers, how should the Commission distinguish
between U.S. and non-U.S. issuers?
Question 129: If the Commission decides to regulate access
providers to foreign markets, should they be required to make and keep
records? What records should registered SIP and broker-dealer access
providers be required to maintain?
Question 130: Should access providers be required to file periodic
reports? If so, what information should those contain?
Question 131: Should broker-dealer access providers be required to
keep records of denials of access to their services? Should they be
required to notify the Commission of such denials of access?
Question 132: What types of risks should be disclosed to users of
SIP and broker-dealer access providers? For example, should SIP and
broker-dealer access providers be required to disclose the listing and
maintenance standards of foreign markets to which they transmit orders
on behalf of U.S. persons? What
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would be the costs associated with such a requirement?
Question 133: Should access providers be required to make
disclosures to sophisticated institutions?
Question 134: What market information should SIP and broker-dealer
access providers be required to provide to the users of their services?
Question 135: Should direct trading in foreign listed companies be
limited to those that satisfy U.S. disclosure standards in order to
better protect U.S. investors?
Question 136: Is it sufficient to merely disclose to investors that
the information available about a foreign security may significantly
differ from the information that would be available about U.S.
securities? Do public policy concerns dictate that the Commission make
distinctions based on whether investors receive adequate information?
Question 137: Are there circumstances under which unregistered
foreign securities should be permitted to trade on foreign markets
through an access provider? For example, should the Commission
establish some de minimis threshold for a foreign security based on the
dollar value of the U.S. float or trading volume in that security, or
on the relative percentage of U.S. float or trading volume compared to
that of the home or worldwide markets?
Question 138: Should the exemption from registration under Exchange
Act Rule 12g3-2(b) be available if a significant portion of an issuer's
float is traded in the United States?
Question 139: Given that broker-dealers currently trade
unregistered securities for customers, should the Commission reconsider
its approach to securities registration requirements in this context?
Are there other viable alternatives that would ensure adequate
disclosure to U.S. investors trading on foreign markets?
Question 140: Is trading in unregistered foreign securities through
an access provider to a foreign market appropriate if access is limited
to sophisticated investors? For example, should access providers be
permitted to transmit orders for unregistered foreign securities to a
foreign market on behalf of qualified institutional buyers as defined
in Rule 144A of the Securities Act?
Question 141: Are there uniform procedures that the Commission
should impose on foreign markets or on access providers to assure that
securities are not sold to U.S. investors in circumstances that result
in a public distribution of securities in the United States that are
not registered under the Securities Act?
Question 142: What are the consequences to SEC reporting companies
if unregistered foreign securities listed on foreign markets are
available to be purchased or sold through access providers?
Question 143: Would any of the approaches described above provide
an effective means of addressing the issues raised by foreign market
activities in the United States, including providing key protections
for U.S. investors? What would be the benefits of each approach? What
would be the drawbacks of each approach?
Dated: May 23, 1997.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-14284 Filed 6-3-97; 8:45 am]
BILLING CODE 8010-01-P