[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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \52\ See Securities Exchange Act Release No. 36310 (Sept. 29, 
1995), 60 FR 52792 (Oct. 10, 1995) (hereinafter Order Handling Rules 
Proposing Release).
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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'').
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \71\ See, e.g., NASD Manual Rules 4630-32.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \77\ See supra Section II.B.1.
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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.'').
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \85\ See supra note 68 for a discussion of the Commission's 
exemptive authority under Section 36 of the Exchange Act.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \99\ See S. Rep. No. 75, supra note 22, at 7-9.
---------------------------------------------------------------------------

(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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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'').
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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
---------------------------------------------------------------------------

    \115\ See NASD 21a Report, supra note 20.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \116\ See supra Section II.B.1.
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.''
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

(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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \215\ Although orders originate from a non-member, they are 
electronically identified, or ``stamped,'' as coming from the member 
providing the interface.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \221\ See supra Section VII.A.2.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \232\ See generally 15 U.S.C. 78dd(b).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \235\ Exchange Act section 3(a)(22), 15 U.S.C. 78c(a)(22).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \242\ See supra note 16.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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)).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \249\ See 17 CFR 240.15c1-2 through 240.15c1-9.
    \250\ 15 U.S.C. 78j(b); 17 CFR 240.10b-5.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \256\ 17 CFR 240.12g3-2(b).
---------------------------------------------------------------------------

    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

[[Page 30534]]

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

[[Page 30535]]

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