[Federal Register Volume 63, Number 82 (Wednesday, April 29, 1998)]
[Proposed Rules]
[Pages 23504-23583]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-10945]
[[Page 23503]]
_______________________________________________________________________
Part II
Securities and Exchange Commission
_______________________________________________________________________
17 CFR Parts 201, 240, 242, and 249
Regulations of Exchanges and Alternative Trading Systems and Proposed
Amendment to Rule 19b-4; Proposed Rules
Federal Register / Vol. 63, No. 82 / Wednesday, April 29, 1998 /
Proposed Rules
[[Page 23504]]
SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 201, 240, 242 and 249
[Release No. 34-39884; File No. S7-12-98]
RIN 3235-AH41
Regulation of Exchanges and Alternative Trading Systems
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rules.
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SUMMARY: The Securities and Exchange Commission today is proposing new
rules and rule amendments to allow alternative trading systems to
choose whether to register as national securities exchanges, or to
register as broker-dealers and comply with additional requirements
under proposed Regulation ATS depending on their activities and trading
volume. The Commission is also proposing amendments to Form 1 and
related rules regarding registration as a national securities exchange.
Finally, the Commission is proposing to exclude from the rule filing
requirements certain pilot trading systems operated by national
securities exchanges and national securities associations. These
proposals would more effectively integrate the growing number of
alternative trading systems into the national market system,
accommodate the registration of proprietary alternative trading systems
as exchanges, and provide an opportunity for registered exchanges to
better compete.
DATES: Comments should be submitted on or before July 28, 1998.
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 also may be submitted electronically at the
following E-mail address: [email protected]. All comment letters
should refer to File No. S7-12-98. All submissions will be made
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: Elizabeth King, Senior Special
Counsel, at (202) 942-0140, Marianne Duffy, Special Counsel, at (202)
942-4163, Constance Kiggins, Special Counsel, at (202) 942-0059, Lauren
Mullen, Special Counsel, at (202) 942-0196, Kevin Ehrlich, Attorney, at
(202) 942-0778, and Denise Landers, Attorney, at (202) 942-0137,
Division of Market Regulation, Securities and Exchange Commission, Stop
10-1, 450 Fifth Street, NW., Washington, DC 20549. For questions or
comments regarding securities registration issues raised in this
release, contact David Sirignano, Associate Director, at (202) 942-
2870, Division of Corporation Finance, Securities and Exchange
Commission, Stop 3-1, 450 Fifth Street, NW., Washington, DC 20549.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Executive Summary
A. Introduction
B. Need for a New Regulatory Framework for Alternative Trading
Systems
C. The Concept Release
D. Current Proposal
E. Conclusion
II. Proposed Rule 3b-12 under the Exchange Act
A. Consolidates the Orders of Multiple Parties
B. Non-discretionary Material Conditions
1. Non-discretionary Material Conditions Established by a
Trading Facility
2. Non-discretionary Material Conditions Established by Setting
Rules
C. Systems Not Included in Proposed Rule 3b-12
1. Order Routing Systems
2. Dealer Quotation Systems
3. Internal Broker-dealer Order Management and Execution Systems
D. Exemption from the Definition of ``Exchange'' for Certain
Alternative Trading Systems
III. Regulation of Alternative Trading Systems
A. Regulation ATS
1. Scope of Regulation ATS
2. Requirements for Alternative Trading Systems Subject to
Regulation ATS
a. Membership in an SRO
b. Notice of Operation as an Alternative Trading System and
Amendments
c. Market Transparency
(i) Integration of Orders into the Public Quotation System
(ii) Access to Publicly Displayed Orders
(iii) Execution Access Fees
(iv) Amendment to Rule 11Ac1-1 under the Exchange Act
d. Fair Access
e. Capacity, Integrity, and Security Standards
f. Examination, Inspection, and Investigations of Subscribers
g. Recordkeeping
h. Reporting and Form ATS-R
i. Procedures to Ensure Confidential Treatment of Trading
Information
j. Name of Alternative Trading Systems
B. Registration as a National Securities Exchange
1. Benefits of Registration as a National Securities Exchange
2. Responsibilities of Registered National Securities Exchanges
a. Self-Regulatory Responsibilities
b. Fair Representation
c. Membership on a National Securities Exchange
d. Fair Access
e. Compliance with ARP Guidelines
f. Registration of Securities
g. NMS Participation
h. Uniform Trading Standards
3. Application for Registration as an Exchange
a. Revisions to Form 1
b. Amendments to Rules 6a-1, 6a-2, and 6a-3 under the Exchange
Act
(i) Application for Registration as an Exchange or Exemption
Based on Limited Volume of Transactions
(ii) Periodic Amendments
(iii) Supplemental Material
IV. Broker-Dealer Recordkeeping and Reporting Obligations
A. Elimination of Rule 17a-23
B. Amendments to Rules 17a-3 and 17a-4
V. Temporary Exemption of Pilot Trading System Rule Filings
A. Introduction
B. Proposed Rule 19b-5
1. Proposed Definition of a Pilot Trading System
2. SROs' Continuing Obligations Regarding Pilot Trading Systems
a. Notice and Filings to the Commission
b. Trading Rules and Procedures
c. Surveillance
d. Clearance and Settlement
e. Types of Securities
f. Procedures to Ensure the Confidentiality of Trading
g. Inspections and Examinations
C. Rule Filing Under Section 19(b)(2) of the Exchange Act
Required Within Two Years
D. Compliance With Other Federal Securities Laws
E. Request for Comment on Proposed Rule 19b-5
VI. The Commission's Interpretation of the ``Exchange'' Definition
A. The Commission's Interpretation in Delta
B. The Growing Significance of Alternative Trading Systems in
the National Market System
C. The Proposed Reinterpretation of ``Exchange''
D. Other Practical Reasons for Revising the Current
Interpretation
1. Additional Flexibility Provided by the National Securities
Markets Improvement Act of 1996
2. No-action Approach to Alternative Trading Systems is No
Longer Workable
3. More Rational Treatment of Regulated Entities
VII. Approaches Not Proposed
A. Tiered Exchange Approach
B. SIP Approach
VIII. Request for Public Comments
IX. Costs and Benefits of the Proposed Rules and Amendments
A. Costs and Benefits of the Proposals Regarding Alternative
Trading Systems
1. Benefits
[[Page 23505]]
a. Improved Surveillance on Alternative Trading Systems
b. Improved Market Transparency
c. Fair Access
d. Systems Capacity, Integrity, and Security
2. Costs
a. Notice, Reporting, and Recordkeeping
b. Public Display of Orders and Equal Execution Access
c. Fair Access
d. Systems Capacity, Integrity, and Security
e. Costs of Exchange Registration
B. Proposed Amendments to Application and Related Rules for
Registration as an Exchange
1. Benefits
2. Costs
C. Costs and Benefits of the Proposed Repeal of Rule 17a-23 and
the Proposed Amendments to Rules 17a-3 and 17a-4
1. Benefits
2. Costs
D. SRO Pilot Trading System
1. Benefits
2. Costs
E. Request for Comment
X. Effects on Efficiency, Competition, and Capital Formation
XI. Initial Regulatory Flexibility Analysis
XII. Paperwork Reduction Act
A. Form 1, Rules 6a-1 and 6a-2
B. Rule 6a-3
C. Rule 17a-3(a)(16)
D. Rule 17a-4(b)(10)
E. Rule 19b-5 and Form PILOT
F. Rule 301, Form ATS and Form ATS-R
G. Rule 302
H. Rule 303
I. Request for Comment
XIII. Statutory Authority
I. Executive Summary
A. Introduction
Technological developments have changed our markets in many ways.
They have greatly expanded the number of investment and execution
choices, increased market efficiency, and reduced trading costs. Market
participants have incorporated technology into their businesses to
provide investors with an increasing array of services, and to furnish
these services during more hours, often at lower prices. Many of these
trading and business functions, however, were not foreseen by a
regulatory framework designed more than six decades ago. In particular,
market participants have developed a variety of alternative trading
systems \1\ that furnish services traditionally provided solely by
registered exchanges. Consequently, the distinctions between markets,
intermediaries, and service providers have blurred.
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\1\ The Commission used the term ``alternative trading system''
in the Concept Release, see infra note 2, to describe trading
systems not registered as exchanges. This term encompasses some
systems that previous Commission releases called ``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 Exchange Act, 17 CFR
240.17a-23 and 240.11Ac1-1, respectively, and trigger specific
regulatory obligations under those rules. In this release, the
Commission is proposing to define the term ``alternative trading
system.'' See Proposed Rule 300(a).
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In light of these changes, in May 1997, the Securities and Exchange
Commission (``Commission'' or ``SEC'') published a Concept Release,\2\
which requested comment on ways to update the regulatory framework for
alternative trading systems. In the Concept Release, the Commission
considered two principal alternatives for the regulation of alternative
trading systems. First, the Concept Release solicited comment on
incorporating these systems into a tiered-exchange regulation
framework, under which alternative trading systems would be subject to
requirements tailored to their size and role in the market. Second,
comment was solicited on increasing the Commission's oversight of
alternative trading systems through enhanced broker-dealer regulation.
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\2\ Securities Exchange Act Release No. 38672, 62 FR 30485 (May
23, 1997) (``Concept Release'').
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After reviewing the comment letters and current market conditions,
the Commission is proposing to address the activities of alternative
trading systems by combining the two approaches discussed in the
Concept Release. Under today's proposal, alternative trading systems
would be able to choose whether to: (1) Register as national securities
exchanges under sections 5 and 6 of the Exchange Act; or (2) register
as broker-dealers and comply with the additional requirements being
proposed as new Regulation ATS.
B. Need for a New Regulatory Framework for Alternative Trading Systems
The federal securities laws have served the markets well. This
basic regulatory structure has enabled the United States to have the
safest, most liquid securities markets in the world. One of the
principal reasons for these markets' success is the widely acknowledged
benefit of securities markets that are free from fraud and
manipulation. Moreover, the securities laws--to a great extent--have
provided a level playing field so that competition among market
participants can thrive. In addition, the Commission has worked to
apply and implement the federal securities laws in a way that
encourages our securities markets to take advantage of the many
benefits of technology.
As a result, investors have available a wide range of options for
executing their securities trades. In particular, alternative trading
systems now handle more than twenty percent of the orders in securities
listed on The Nasdaq Stock Market (``Nasdaq''), which represents an
almost one percent increase from the previous year. Alternative trading
systems also continue to trade almost four percent of orders in listed
securities. Even though these systems provide services that are similar
to those provided by the registered exchanges and Nasdaq, most
alternative trading systems are regulated as broker-dealers. This
creates disparities that affect investors, market intermediaries, and
other markets. For example, activity on alternative trading systems is
not fully disclosed to, or accessible by, public investors and may not
be adequately surveilled for market manipulation and fraud. Moreover,
these trading systems have no obligation to provide investors a fair
opportunity to participate in their systems or to treat their
participants fairly. In addition, they do not have an obligation to
ensure that their capacity is sufficient to handle trading demand.
Because of the increasingly important role of alternative trading
systems, these differences call into question not only the fairness of
current regulatory requirements, but also the efficacy of the existing
national market system (``NMS'') structure.
In 1996 Congress provided the Commission with greater flexibility
in regulating new trading systems by adding Section 36 to the
Securities Exchange Act of 1934 (``Exchange Act''). This Section gives
the Commission broad authority to exempt any person from any of the
provisions of the Exchange Act.\3\ As a result, the Commission now has
a greater ability to adopt a regulatory approach more tailored to
today's securities markets, which will allow the Commission to
integrate trading on alternative markets more fully into the NMS,
without jeopardizing the commercial viability of these markets. The
Commission is also now able to exempt registered exchanges from
requirements that are unnecessary or inappropriate.
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\3\ Section 36 of the Exchange Act, 15 U.S.C. 78mm, was enacted
as part of the National Securities Markets Improvement Act of 1996,
Pub. L. 104-290 (``NSMIA''). See infra Section VI.D.1.
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C. The Concept Release
On May 23, 1997, the Commission issued the Concept Release
soliciting comment on ways to update the regulatory framework in light
of the dramatic changes in the U.S. securities
[[Page 23506]]
markets brought about by new and evolving technology.\4\ The Concept
Release began a dialogue about how the Commission should best respond
to the legal and regulatory challenges created by both existing--and
future--technological developments. In particular, the Commission asked
for comment on how to effectively oversee alternative trading systems
in general, and especially those that are becoming increasingly
significant market centers. Although these alternative trading systems
perform the functions of a market, they are not required to surveil
their markets for manipulative activity, to make all of their quotes
public, to treat participants fairly, or to maintain adequate capacity
to prevent outages. Thus, as these alternative trading systems are
increasingly used for trade execution, the existing regulations fail to
provide investors with access to the best prices, or to integrate these
systems fully into the NMS, including the surveillance and enforcement
mechanisms operated by the registered exchanges and the National
Association of Securities Dealers, Inc. (``NASD'').
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\4\ See Concept Release, supra note 2. The Concept Release also
solicited comment on the Commission's regulation of foreign market
activities in the United States. The proposals discussed in this
release, however, do not address issues relating to foreign market
activities in the U.S.
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The Concept Release solicited commenters' views on two principal
approaches to address these concerns. Under the first approach,
alternative trading systems would be incorporated into the Commission's
regulation of exchanges under a three-tiered framework. Under the
second approach, alternative trading systems would continue to be
regulated as broker-dealers, but would be required to comply with rules
designed to improve their transparency and surveillance, as well as
their systems capacity, integrity, and security. A wide variety of
market participants, including self-regulatory organizations
(``SROs''), traditional broker-dealers, and alternative trading
systems, provided the Commission with thoughtful comments on both of
these approaches.\5\
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\5\ The comment letters and a summary of comments have been
placed in Public File S7-16-97, which is available for inspection in
the Commission's Public Reference Room.
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In general, commenters supported the Commission's efforts to make
the regulatory structure more responsive to technological innovation
and agreed that the current structure should be revised to apply
enhanced linkage, surveillance, and other requirements to alternative
trading systems. A number of commenters agreed that technology has made
the line between broker-dealers and exchanges more difficult to draw
and that the roles of broker-dealers and exchanges are becoming
increasingly interchangeable. Many commenters emphasized the need to
make any new regulatory scheme flexible enough to accommodate the
varying needs and structures of these market participants. Commenters
differed considerably, however, on what the Commission's goals should
be in enhancing the oversight of alternative trading systems, the
extent of change necessary, and how to best achieve enhanced oversight.
Consequently, there were few instances in which commenters were in
consensus. Nevertheless, commenters did, generally, express a
preference for continuing to regulate alternative trading systems as
broker-dealers, rather than incorporating them into exchange
regulation.
While some commenters argued that the importance of some electronic
markets as trading venues justifies the imposition of exchange
regulation, several regional exchanges and other market participants
were not convinced that the exchange approach would fulfill the
regulatory goals outlined in the Concept Release. Many commenters
believed integrating alternative trading systems into existing
surveillance mechanisms could impose burdens on both the market as a
whole and the Commission. Many commenters noted that this approach
could potentially lead to uneven and fragmented market oversight. At
the heart of many of these objections was the fear that alternative
trading systems would be forced to submit to some degree of exchange
regulation, albeit modified for most systems, which could lead to
structural changes. Commenters also feared that an exchange-based
regulatory approach could frustrate innovation and reduce the benefits
offered by alternative trading systems.
D. Current Proposal
Technological developments continue to change market structure. The
Commission firmly believes that there should be a regulatory framework
in place that makes sense both for current and future securities
markets. This regulatory framework should encourage market innovation
without compromising basic investor protections.
After considering the comment letters, the Commission is proposing
to address the activities of alternative trading systems by combining
the two approaches discussed in the Concept Release. This combined
approach should allay commenters' concerns that a new regulatory scheme
would not be flexible enough to accommodate the business objectives of,
and the benefits provided by, alternative trading systems.
Specifically, the Commission is proposing to allow an alternative
trading system to choose whether to: (1) Register as a national
securities exchange under sections 5 and 6 of the Exchange Act; or (2)
register as a broker-dealer and comply with the additional requirements
being proposed as new Regulation ATS.\6\ The proposal set forth in this
release is intended--to the extent consistent with the federal
securities laws--to allow alternative trading systems to choose the
market role that works best for them.\7\ At the same time, this
proposal is designed to preserve the benefits of a competitive market
structure that has greatly enhanced market liquidity, transparency, and
efficiency.
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\6\ See infra Section III.A. As discussed in the Concept
Release, the government securities market is subject to its own
specialized oversight structure. For this reason, the Commission
does not believe it is necessary to change the regulation of
alternative trading systems to the extent that they exclusively
trade government securities. See infra notes 70 and 71 accompaning
text.
\7\ The Commission notes that organizations that conduct a
regulatory function with respect to their members are excluded from
the definition of alternative trading system. Consequently, such
system would have to register as national securities exchanges. See
infra notes 65 and 66 and accompanying text.
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To implement this approach, the Commission is proposing Rule 3b-12
under the Exchange Act, which would define terms used in the statutory
definition of ``exchange'' \8\ to encompass most alternative trading
systems. This new rule would include any organization, association,
person, group of persons, or system that: (1) Consolidates orders of
multiple parties; and (2) sets non-discretionary material conditions
(whether by providing a trading facility or by setting rules) under
which subscribers entering such orders agree to the terms of a trade.
Proposed Rule 3b-12 would specifically exclude those systems that only:
(1) Route orders to a registered exchange, a market operated by a
national securities association, or any broker-dealer; (2) display the
quotes of a single dealer and allows persons to enter orders for
execution against such dealer's quotes; \9\ or (3) provide the means
for a single broker-dealer to internally manage its customers' orders,
including crossing or
[[Page 23507]]
matching such orders with each other provided that (i) those orders are
not displayed to any person other than the broker-dealer and its
employees and (ii) those orders are not executed according to a
predetermined procedure that is communicated to the customers. Because
most alternative trading systems are not encompassed by the
Commission's current interpretation of ``exchange,'' \10\ the
Commission is also proposing to revise its interpretation to better
reflect the ever-evolving securities markets and to give alternative
trading systems the option of registering as national securities
exchanges.
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\8\ The statutory definition of ``exchange'' appears in section
3(a)(1) of the Exchange Act, 15 U.S.C. 78c(a)(1).
\9\ The Commission would consider a customer order displayed by
a dealer in its quote to be the ``dealer's quote'' for purposes of
this exclusion, if a customer order were displayed solely to comply
with a Commission or SRO rule.
\10\ The Commission's current interpretation of ``exchange'' is
set forth in Securities Exchange Act Release No. 27611 (Jan. 12,
1990), 55 FR 1980, 1900 (Jan. 19, 1990) (``Delta Release''). See
infra Section II for a discussion of proposed Rule 3b-12.
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For alternative trading systems that choose to register as national
securities exchanges, the Commission is proposing to accommodate their
proprietary structure by amending the application for registration and
providing guidance on ways for proprietary markets to meet their fair
representation requirements as non-membership national securities
exchanges.\11\
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\11\ See infra Section III.B.
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For alternative trading systems that choose to register as broker-
dealers, the Commission is proposing new Regulation ATS, which would
require alternative trading systems to comply with additional
requirements designed to address the concerns raised by their market
activities. To provide for continuing innovation and competition
through the introduction of new alternative trading systems, the
Commission proposes that systems with limited volume be required only
to: (1) File with the Commission a notice of operation and quarterly
reports; and (2) maintain records, including an audit trail of
transactions. If, however, an alternative trading system with
significant trading volume chooses to register as a broker-dealer--
instead of as an exchange--the Commission believes it is in the public
interest to integrate its activities into the NMS. Therefore, in
addition to the requirements for smaller alternative trading systems,
significant volume alternative trading systems that trade NMS
securities would be required to link with a registered market in order
to disseminate the best priced orders displayed in their systems
(including institutional orders) into the public quote stream. They
would also be required to comply with the same market rules governing
execution priorities and obligations that apply to members of the
registered market.\12\ In addition, alternative trading systems with
significant volume in any security, whether equity or debt, would be
required to: (1) Grant or deny access based on standards established by
the trading system and applied in a non-discriminatory manner; and (2)
establish procedures to ensure adequate systems capacity, integrity,
and contingency planning. These requirements would more actively
integrate those significant alternative trading systems into NMS
mechanisms. Moreover, because alternative trading systems that choose
to register as broker-dealers would not be required to surveil
activities on their markets, the Commission intends to work with the
SROs to improve the SROs' ongoing, real-time surveillance for market
manipulation and fraud and to develop surveillance and examination
procedures specifically targeted to alternative trading systems they
supervise.
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\12\ This linkage requirement would not apply to alternative
trading systems that do not display participant orders to anyone,
including other system participants. In addition, this requirement
would not apply to alternative trading systems to the extent that
they trade securities other than NMS securities. See infra Section
III.A.2.c.(i).
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The Commission is also proposing to repeal Rule 17a-23.\13\ This
rule was adopted to provide the Commission with certain information
about the activities of automated markets operated by broker-dealers.
Alternative trading systems would continue to provide the Commission
with information about their activities either as registered exchanges
or as registered broker-dealers subject to Regulation ATS. Some broker-
dealer trading systems that are currently subject to Rule 17a-23,
however, would not be alternative trading systems. The Commission
believes that these internal broker-dealer systems should,
nevertheless, continue to keep records of trading conducted through
these systems. Therefore, the Commission is proposing to amend Rules
17a-3 \14\ and 17a-4 \15\ under the Exchange Act to require that
records of these transactions be maintained. Internal broker-dealer
trading systems would, however, no longer have to report any
information to the Commission.\16\
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\13\ 17 CFR 240.17a-23.
\14\ 17 CFR 240.17a-3.
\15\ 17 CFR 240.17a-4.
\16\ See infra Section IV.
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Finally, the Commission is proposing to allow SROs, without filing
for approval with the Commission, to operate pilot trading systems for
no more than two years. These pilot trading systems would be subject to
specific conditions, including limitations on their trading
volumes.\17\
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\17\ See infra Section V.
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E. Conclusion
The explosive growth of alternative trading systems over the past
several years has significant implications for market regulation. The
Commission believes it is critical to develop a regulatory framework
that both accommodates traditional market structures and provides
sufficient flexibility to ensure that new markets promote fairness,
efficiency, and transparency. While the questions raised by
technological developments in the U.S. markets could be addressed in a
variety of ways, the Commission preliminarily believes that the
regulatory approach proposed today would be the most effective way to
facilitate these goals.
II. Proposed Rule 3b-12 Under the Exchange Act
As part of this new approach, the Commission is proposing new Rule
3b-12 under the Exchange Act. This rule would define terms used in the
statutory definition of ``exchange,'' found in section 3(a)(1) of the
Exchange Act.\18\ The statutory definition of ``exchange'' includes a
``market place or facilities for bringing together purchasers and
sellers of securities or for otherwise performing with respect to
securities the functions commonly performed by a stock exchange.'' The
new rule would define these terms to be any organization, association,
or group of persons that: (1) Consolidates orders of multiple parties;
and (2) sets non-discretionary material conditions (whether by
providing a trading facility or by setting rules) under which parties
entering such orders agree to the terms of a trade.\19\ The Commission
recognizes that the proposed rule would revise the current
interpretation of the term ``exchange,'' as set forth in the Delta
Release.\20\
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\18\ 15 U.S.C. 78c(a)(1).
\19\ Proposed Rule 3b-12(a).
\20\ See Delta Release supra note 10. The basis and purpose of
the revised interpretation is set forth infra Section VI.
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The Commission believes that the proposed rule is an important
element of its proposed new regulatory framework for alternative
trading systems. As discussed above, the rapid growth and technological
advancements of alternative trading systems have eroded the
distinctions between the roles played by alternative trading systems
and by traditional exchanges. Many alternative trading systems provide
services more akin to exchange functions than broker-dealer functions,
[[Page 23508]]
such as matching counterparties' orders, executing trades, operating
limit order books, and facilitating active price discovery. For many of
these systems, regulation as a market would more appropriately fit
their economic functions. Thus, a broader interpretation of exchange is
needed to cover markets that engage in activities functionally
equivalent to markets currently registered as national securities
exchanges. Moreover, because in some cases exchange regulation may
better meet these systems' business objectives, the Commission believes
that alternative trading systems should have the option to register as
national securities exchanges.\21\ The proposed rule would help
modernize the Commission's approach to these systems because it would
adapt the concept of what is ``generally understood'' to be an exchange
to reflect changes in the markets brought about by automated trading.
In addition, proposed Rule 3b-12 would closely reflect the statutory
concept of ``bringing together'' buying and selling interests.
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\21\ See infra Section III.B. (discussing registration as a
national securities exchanges).
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The Concept Release set forth a similar interpretation.\22\ In
response to commenters' concerns that any revised interpretation of
exchange should not be so broad as to include traditional brokerage
activities, proposed Rule 3b-12 would specifically exclude certain
systems whose activities the Commission does not believe rise to the
level of being an ``exchange.'' \23\ These specific exclusions are
designed to clarify the types of activities the Commission would not
consider to be exchange activities under proposed Rule 3b-12.
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\22\ In the Concept Release, the Commission suggested expanding
its interpretation of 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.'' See Concept Release, supra note 2, at 50.
\23\ See infra Section II.C. (discussing paragraph (b) of
proposed Rule 3b-12).
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A. Consolidates the Orders of Multiple Parties
In order to be an exchange, a system must satisfy the first part of
proposed Rule 3b-12(a)--consolidate orders of multiple parties. This
incorporates the concept of ``bringing together purchasers and sellers
of securities'' set forth in the definition of ``exchange'' in section
3(a)(1) of the Exchange Act. A system would be consolidating orders if
it displayed trading interest entered on the system to system users.
This would include consolidated quote screens, such as the system
operated by Nasdaq.\24\ A system would also be consolidating orders if
it receives subscribers' orders centrally for future processing and
execution. For example, limit order matching book systems that allow
subscribers to display buy and sell offers in particular securities and
to obtain execution against matching offers contemporaneously entered
or stored in the system would be considered to consolidate orders. This
type of consolidation is currently performed by systems that
consolidate orders internally for crossing \25\ or matching,\26\ as
well as floor based markets that impose trading rules. In addition,
interdealer brokers \27\ would be considered to consolidate orders,
regardless of their level of automation.\28\ On the other hand, systems
that merely provide information, such as information vendors, would not
be viewed as consolidating orders. Consolidation thus means that each
order entered in the system for a given security has the opportunity to
interact with other orders entered into the system for the same
security.
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\24\ An electronic bulletin board on which subscribing broker-
dealers may post indications of interest in securities they wish to
trade, and advertise trades they have recently conducted, would be
considered to consolidate orders. For example, AutEx operates such a
bulletin board. AutEx, however, would not be an exchange under the
proposed interpretation because it does not set non-discretionary
material conditions under which parties entering orders agree to the
terms of a trade. AutEx does not require that the price and quantity
quoted on the screen be firm, nor does AutEx set priorities that
govern trades. Further, transactions resulting from posted
indications of interest, if any, are executed outside AutEx. See
infra Section II.B. discussing paragraph (a)(2) of proposed Rule 3b-
12.
\25\ A crossing system is, typically, one that allows
participants to enter unpriced orders to buy and sell securities.
Orders are crossed at specified times at a price derived from
another market.
\26\ Matching systems allow participants to enter limit orders
and match those orders with other orders in the system. Participants
are able to view unmatched limit orders in the system's book. The
sponsor of a matching system typically acts as riskless principal
with respect to matched orders, or contracts with another broker-
dealer to perform this function.
\27\ Currently, debt markets are not centrally organized by a
single entity, but are nonetheless informally organized around
interdealer brokers. Interdealer brokers (also called blind brokers
and brokers' brokers) display, on an anonymous basis, the offers to
buy and sell securities that are placed with them by subscribers. In
order to place a bid or offer, a subscriber typically telephones the
interdealer broker, which enters the order into its system and
displays it to other subscribers. Some interdealer brokers display
all bids and offers; others display only the best bid and offer. To
execute against an offer displayed on the computer screen, a
subscriber telephones the interdealer broker, although sometimes
execution may be electronic. The identities of the counterparties
are, generally, kept confidential through clearance and settlement
of the trade. Some interdealer brokers, however, reveal the names of
each counterparty after execution. Traditionally interdealer brokers
facilitated trading only between dealers. Increasingly, however,
interdealer brokers are permitting non-dealers to participate in
their systems.
\28\ But see infra notes 70 and 71 and accompanying text
(discussing the exemption for systems that trade exclusively
government securities).
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In addition, the system's consolidation of orders must be of
multiple parties--i.e., multiple buyers and multiple sellers. Systems
designed for the purpose of executing orders against a single
counterparty, such as the dealer operating the system, would not be
considered to have multiple parties. Thus a single counterparty that
buys and sells securities through a system, where other parties
entering orders only execute against the single designated
counterparty, would not meet the requirements of the first part of
proposed Rule 3b-12.\29\ However, the mere interpositioning of a
designated counterparty as riskless principal for settlement purposes
after the purchasing and selling counterparties to a trade have been
matched would not, by itself, mean that the system does not have
multiple parties. In addition, a system that has multiple sellers, but
only one seller for each instrument, and multiple buyers for that
instrument would not be considered to meet the ``multiple parties''
requirement.\30\
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\29\ This type of system also would be expressly excluded from
proposed Rule 3b-12 under paragraph (b)(2). See infra Section
II.C.2.
\30\ An example of this type of system is CP Direct in which
issuers offer to sell their commercial paper to the customers of CS
First Boston. See Bruce Rule, PSA Panels Embrace Internet for
Institutional Trading; and Regulators Love the Audit Trail,
Investment Dealers' Digest, Nov. 18, 1996 (discussing CP Direct).
The converse situation--i.e., where there is one buyer and multiple
sellers for a given instrument--would also not meet the ``multiple
parties'' requirement. The Commission, however, is not aware of any
system that currently operates this way.
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Finally, the proposed rule would make clear that the consolidation
must be of participants' ``orders.'' The term ``order'' would be
defined in paragraph (c) of proposed Rule 3b-12 to include any firm
indication of a willingness to buy or sell a security, whether made on
a principal or agency basis.\31\ Firm indications of buying or selling
interest would specifically include bid or offer quotations, market
orders, limit orders, and any other priced order.
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\31\ Proposed Rule 3b-12(c).
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B. Non-Discretionary Material Conditions
In addition to consolidating the orders of multiple parties, in
order to be an ``exchange'' under proposed Rule 3b-12, a system would
have to set non-discretionary material conditions under which parties
entering orders agree to
[[Page 23509]]
the terms of the trade. A system may establish non-discretionary
material conditions either by providing a trading facility or by
setting rules governing trading among subscribers. The Commission
intends for ``non-discretionary material conditions'' to include any
conditions that dictate the terms of trading among the multiple
counterparties entering orders into the system. In other words, such
conditions would include those that set procedures or priorities under
which open terms of the trade will later be determined. For example, a
system that trades limited partnership units might set non-
discretionary material conditions even though approval from the general
partner is required prior to settlement. Similarly, systems that allow
the trading price to be determined at some designated future date on
the basis of pre-established criteria (such as the weighted average
trading price for the security on the specified date in a specified
market) would be setting non-discretionary material conditions.
Trading rules or trading facilities that do not determine the
manner of execution or the means for agreeing to the terms of a trade
would not be considered to set non-discretionary material conditions.
Similarly, rules that merely address the means of communication with a
system (for example, software or hardware tools that subscribers may
use in accessing the system), would not satisfy this element of
proposed Rule 3b-12. Further, conditions would not be deemed material
and non-discretionary unless they were communicated to subscribers.
Thus, broker-dealers' internal order management and execution systems
would not be exchanges.\32\
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\32\ See infra Section II.C.3. (discussing the exclusion of
internal broker-dealer systems from the coverage of proposed Rule
3b-12).
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1. Non-Discretionary Material Conditions Established by a Trading
Facility
A trading facility that sets non-discretionary material conditions
would include a traditional exchange floor where specialists are
available to receive orders, or a computer system (whether comprised of
software, hardware, protocols, or any combination thereof) through
which orders may interact, or any other trading mechanism that provides
a means or location for the execution of orders. For example, the
Commission would consider the use of an algorithm by an electronic
trading system that sets trading procedures and priorities to be a
trading facility that sets non-discretionary material conditions.
The Commission would attribute the activities of a trading facility
to a system if that facility is offered by the system directly or
indirectly (such as where a system arranges for a third party or
parties to offer the trading facility). Thus, if a system arranges for
a third party vendor to distribute software to enable persons to access
the system, that system would be deemed to have established a trading
facility, even though system participants gained access via a third
party provider. Similarly, if a bulletin board operator contracted with
another party to provide execution facilities for the bulletin board
users, the bulletin board would be deemed to have established a trading
facility because it took affirmative steps to arrange for the necessary
exchange functions for its users.\33\ In addition, if an organization
arranged for separate entities to provide different pieces of a trading
system which together met the definition contained in paragraph (a) of
proposed Rule 3b-12, the organization responsible for arranging the
collective efforts would be deemed to have established a trading
facility. For example, the arrangement between the Delta Government
Options Corporation (``Delta''), RMJ Options Trading Corporation, and
Security Pacific National Trust Company, as described in a 1990
Commission release,\34\ would together be an exchange. In this case,
the arranging organization, Delta, would be considered the exchange
under proposed Rule 3b-12.
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\33\ Whether or not a bulletin board would be considered an
exchange under the proposed rule would also depend on whether it met
the other elements of the definition.
\34\ See Delta Release, supra note 10.
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2. Non-Discretionary Material Conditions Established by Setting Rules
Alternatively, a system can establish non-discretionary material
conditions through the imposition of rules under which parties entering
orders on the system may agree to the terms of a trade. For example,
the NASD imposes basic rules by which securities will be traded on
Nasdaq. Specifically, it imposes affirmative obligations on market
makers in Nasdaq National Market (``Nasdaq NM'') and SmallCap
securities, including obligations to post firm and two-sided quotes.
In addition, the Commission would consider rules imposing execution
priorities, such as time and price priority rules, to be non-
discretionary material conditions. Similarly, the Commission would
consider a system that standardizes the material terms of instruments
traded on the system, such as the system operated by Delta at the time
the Commission published the Delta Release, \35\ to set non-
discretionary material conditions.
---------------------------------------------------------------------------
\35\ See Delta Release, supra note 10, at 1897.
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The Commission believes it is appropriate to include markets, such
as that operated by the NASD, in proposed Rule 3b-12, although it
comprises a dealer market. Through Nasdaq, market participants act in
concert to centralize and disseminate trading interest and establish
the basic rules by which securities will be traded. The Commission
believes that Nasdaq performs what today is generally understood to be
the functions commonly performed by a stock exchange. Nasdaq, however,
is currently registered as a securities information processor under
Section 11A of the Exchange Act \36\ and is operated by the NASD, a
registered securities association under Section 15A of the Exchange
Act.\37\ Because the requirements currently applicable to a registered
securities association are virtually identical to the requirements
applicable to registered exchanges, the Commission does not believe it
is necessary or appropriate in the public interest to require Nasdaq to
register as an exchange.\38\ Under the proposal, however, Nasdaq could
choose to register under Section 6 of the Exchange Act as an
exchange.\39\
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\36\ 15 U.S.C. 78k-1.
\37\ 15 U.S.C. 78o-3. As a registered securities information
processor, Nasdaq does not have SRO responsibilities itself. The
NASD delegates to NASD Regulation, Inc. (``NASDR''), the wholly
owned regulatory subsidiary of the NASD, its SRO responsibilities to
surveil trading conducted on Nasdaq and the OTC Bulletin Boards, and
to enforce compliance by its members (and persons associated with
its members) with applicable laws and rules. If Nasdaq registered as
an exchange, it would have its own SRO responsibilities, but the
Commission does not expect this to increase Nasdaq's current burden.
Nasdaq also surveils trading conducted on its market and refers
potential violations to NASDR. The Commission is prepared to use its
authority under sections 17 and 19 of the Exchange Act, 15 U.S.C.
78q and 78s, to allocate any obligations Nasdaq would have to
enforce compliance by its members (and persons associated with its
members) with the federal securities laws to NASDR. See also infra
note 166.
\38\ See infra notes 51-53 and accompanying text (discussing
Proposed Rule 3a1-1(a)(1), which explicitly exempts any systems
operated by a national securities association from the definition of
the term ``exchange'').
\39\ 15 U.S.C. 78f.
---------------------------------------------------------------------------
C. Systems Not Included in Proposed Rule 3b-12
The Commission also asked in the Concept Release whether certain
specific brokerage functions should be excluded from any revised
exchange regulatory scheme. The Concept Release
[[Page 23510]]
noted that 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). The Concept Release specifically
mentioned several types of activities that could be considered
traditional brokerage activities, including routine intermediary
functions performed by brokers, such as block positioning, the
automation of internal order management where the matching of customer
orders is incidental to the order management activities, the automation
of order routing and execution for a single market maker, and other
types of trading where the broker has discretion as to the means of
execution.
Commenters widely agreed that automated brokerage functions should
not be encompassed by the meaning of the term ``exchange.'' \40\ The
Commission agrees. The Commission has included paragraph (b) of
proposed Rule 3b-12 to clarify those types of systems that the
Commission does not believe should be encompassed within paragraph (a)
of proposed Rule 3b-12. Paragraph (b) of Rule 3b-12 would expressly
exclude: (1) Systems that merely route orders to other execution
facilities; (2) systems that allow customers of a dealer to execute
solely against the dealer's inventory; \41\ and (3) systems that allow
a broker-dealer to cross or match customer orders internally at the
broker-dealer's discretion. These exclusions are intended to make clear
that paragraph (a) of proposed Rule 3b-12 does not cover customary
brokerage activity.
---------------------------------------------------------------------------
\40\ A number of commenters named specific brokerage activities
that they believed should not be considered exchange activities.
Commenters specifically feared that the revised interpretation of
exchange set forth in the Concept Release would capture internal
crossing networks, block trading desks, third market makers, OTC
market makers, and dealer markets.
\41\ See supra note 9.
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1. Order Routing Systems
Systems that merely route orders to an exchange or broker-dealer
for execution, like the New York Stock Exchange's (``NYSE's'') SuperDOT
\42\ system and BRASS,\43\ would be explicitly excluded from proposed
Rule 3b-12,\44\ because they do not consolidate orders. Instead, all
orders entered into a routing system are sent to another facility that
consolidates orders. In addition, routing systems do not set non-
discretionary material conditions under which parties entering orders
agree to the terms of the trade.
---------------------------------------------------------------------------
\42\ 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. A similar system
is operated by the American Stock Exchange (``Amex'') (Automated
Post Execution Reporting system, or AutoPERS).
\43\ BRASS is an order routing system operated by Automated
Securities Clearance, Ltd. (``ASC''). ASC provides system users with
software and hardware that enables users to enter orders into the
system which are then routed to an exchange for execution.
\44\ Proposed Rule 3b-12(b)(1).
---------------------------------------------------------------------------
2. Dealer Quotation Systems
A sophisticated market maker that develops a system to disseminate
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. Because single market maker systems merely provide a
more efficient means of communicating the trading interest of separate
customers to one dealer, they should not be considered exchanges.
Therefore, the Commission proposes that systems that display the quotes
of a single dealer and allow customers to execute solely against those
quotes be excluded under paragraph (b) of proposed Rule 3b-12. \45\
---------------------------------------------------------------------------
\45\ Proposed Rule 3b-12(b)(2).
---------------------------------------------------------------------------
3. Internal Broker-Dealer Order Management and Execution Systems
Finally, a system that provides the means for a single broker-
dealer to internally manage its customers' orders, including crossing
or matching such orders with each other, would be specifically excluded
from paragraph (a) of proposed Rule 3b-12, if : (1) No orders were
displayed to persons other than the broker-dealer's employees; and (2)
customer orders were not executed according to a predetermined
procedure that is communicated to the customer.\46\ For example,
broker-dealers may automate part of their intermediary function 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. 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, as described below.
---------------------------------------------------------------------------
\46\ Proposed Rule 3b-12(b)(3).
---------------------------------------------------------------------------
While these internal systems automate traditional brokerage
functions, they still require a broker-dealer to use its discretion to
handle customer orders. In this situation, a customer that gives its
order to a broker-dealer typically gives discretion to that broker-
dealer to select the market where the order will ultimately be
executed, how the order may be split up or ``worked,'' and whether the
broker-dealer will execute the order as 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 its statutory responsibilities.\47\
Unless otherwise agreed, customers have no other expectations that the
broker-dealer will handle the order in accordance with its general
broker-dealer obligations. The Commission views this type of system as
merely automating traditional broker-dealer functions and not as a
means for consolidating the orders of multiple parties.
---------------------------------------------------------------------------
\47\ For example, a block positioner may ``shop'' the order
around 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.
---------------------------------------------------------------------------
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 a customer order
with another customer order from 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.
The Commission is seeking comment on whether paragraph (a) of
proposed Rule 3b-12 accurately captures the fundamental features of an
exchange as that term is commonly understood, and whether the proposed
exclusions from the definition are appropriate. In addition, the
Commission seeks comment on whether there are other types of activities
or organizations that should be specifically excluded from proposed
Rule 3b-12.
[[Page 23511]]
D. Exemption From the Definition of ``Exchange'' for Certain
Alternative Trading Systems
Section 36 of the Exchange Act \48\ gives the Commission broad
authority to exempt any person, security, or transaction from
provisions of the Exchange Act and the rules thereunder. Such an
exemption may be subject to conditions. Using this authority, the
Commission is proposing Rule 3a1-1, which would exempt any alternative
trading system that complies with Regulation ATS from the definition of
``exchange.'' \49\ The Commission believes that this proposed exemption
is in the public interest and will promote efficiency, competition, and
capital formation because it has the effect of providing alternative
trading systems with the option of positioning themselves in the
marketplace as either registered exchanges or as broker-dealers. The
Commission believes that allowing alternative trading systems to make a
business decision about how to register with the Commission would
encourage the development of new and innovative trading facilities. The
Commission also believes that the proposed exemption is consistent with
the protection of investors.
---------------------------------------------------------------------------
\48\ 15 U.S.C. 78mm.
\49\ Proposed Rule 3a1-1(b). See infra note 65 for the
definition of an alternative trading system.
---------------------------------------------------------------------------
The Commission intends for the exemption provided by proposed Rule
3a1-1 to make clear that alternative trading systems that register as
broker-dealers and comply with proposed Regulation ATS should not be
treated as national securities exchanges. The Commission believes that
the proposed requirements in Regulation ATS would address the market-
like functions of alternative trading systems without treating them as
exchanges under the Exchange Act, with the attendant requirements
applicable to exchanges. An alternative way that the Commission could
accomplish this would be to create an exclusion from the definition in
paragraph (a) of proposed Rule 3b-12 for alternative trading systems
that register as broker-dealers and comply with the provisions of
proposed Regulation ATS. The Commission requests comment on whether
this alternative is preferable to today's proposed exemption from the
definition of ``exchange'' under Rule 3a1-1.
As described more fully below, an alternative trading system exempt
from the definition of ``exchange'' under proposed Rule 3a1-1 would
still have to meet certain requirements in proposed Regulation ATS,
including broker-dealer registration, notice of operations, and
recordkeeping and reporting. Trading systems with significant volume
would also have requirements regarding market transparency, fair
access, and systems capacity, integrity, and security. Paragraph (b)(1)
of proposed Rule 3a1-1 would also condition the exemption on the
absence of a Commission determination that the exemption in a
particular case would not be necessary or appropriate in the public
interest or consistent with the protection of investors.\50\ If the
Commission determined to exercise this authority, it would be required
to provide notice to the affected alternative trading system and an
opportunity for that alternative trading system to respond. The
Commission would not expect to exercise this authority on a regular
basis, but intends for it to be used only in extraordinary
circumstances. The Commission requests comment on the scope, form, and
conditions of the proposed exemption in Rule 3a1-1.
---------------------------------------------------------------------------
\50\ Proposed Rule 3a1-1(b).
---------------------------------------------------------------------------
In addition, because national securities associations are subject
to requirements virtually identical to those applicable to national
securities exchanges,\51\ proposed Rule 3a1-1 would also exempt from
the definition of ``exchange'' any system operated by a national
securities association.\52\ The Commission believes that the regulation
of alternative trading systems operated by a national securities
association is adequate, and therefore, that such systems should not be
required to register either as exchanges, or as broker-dealers and
comply with Regulation ATS. Consequently, under the proposals in this
release, alternative trading systems operated by national securities
associations could continue to operate as they do now.\53\
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\51\ Registration as a national securities association under
Section 15A of the Exchange Act is voluntary. 15 U.S.C. 78o-3.
Currently the only national securities association is the NASD,
which operates Nasdaq.
\52\ Proposed Rule 3a1-1(a)(1) See also Proposed Rule 301(a)(3)
(excluding alternative trading systems operated by a national
securities association from the scope of proposed Regulation ATS.)
\53\ Any alternative trading system, however, currently operated
by a national securities association could choose to register as an
exchange.
---------------------------------------------------------------------------
III. Regulation of Alternative Trading Systems
Securities markets have become increasingly interdependent. The use
of technology permits market participants to link products, implement
complex hedging strategies across markets and across products, and
trade on multiple markets simultaneously. While these opportunities
benefit many investors, they may also create misallocations of capital,
widespread inefficiency, and trading fragmentation if markets are not
coordinated. In addition, a lack of coordination among markets has the
potential to increase system-wide risks. Congress adopted the 1975
Amendments, in part, to address these negative effects of potentially
fragmented markets.\54\ The Commission believes that it is consistent
with Congress' goals to integrate significant alternative trading
systems into the NMS.
---------------------------------------------------------------------------
\54\ See S. Rep. No. 75, 94th Cong., 1st Sess. 8 (1975) at 2, 8;
H.R. Rep. No. 229, 94th Cong., 1st Sess 92 (1975).
---------------------------------------------------------------------------
In the 1975 Amendments, Congress specifically endorsed the
development of an NMS, and sought to clarify and strengthen the
Commission's authority to promote the achievement of such a system.\55\
Because of uncertainty as to how technological and economic changes
would affect the securities markets, Congress explicitly rejected
mandating specific components of an NMS.\56\ Instead, Congress
recognized that the securities markets dynamically change and,
accordingly, granted the Commission broad authority to oversee the
implementation, operation, and regulation of the NMS in accordance with
Congressional goals and objectives.\57\
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\55\Pub. L. 94-29, 89 Stat. 97 (1975).
\56\ See S. Rep. No. 75, supra note 54. ``[T]he increasing tempo
and magnitude of the changes that are occurring in our domestic and
international economy make it clear that the securities markets are
due to be tested as never before,'' and that it was, therefore,
important to assure ``that the securities markets and the
regulations of the securities industry remain strong and capable of
fostering (the) fundamental goals (of the Exchange Act) under
changing economic and technological conditions.'' Id. at 3.
\57\ S. Rep. No. 75 supra note 54, at 8-9.
---------------------------------------------------------------------------
Congress identified two paramount objectives in the development of
an NMS: The maintenance of stable and orderly markets with maximum
capacity, and the centralization of all buying and selling interest so
that each investor has the opportunity for the best possible execution
of his or her order, regardless of where the investor places the
order.\58\ In addition, Congress directed the Commission to remove
present and future competitive restrictions on access to market
information and order systems, and to assure the equal regulation of
markets, exchange members, and broker-dealers effecting transactions in
the national market system.\59\ In particular, Congress found that it
was in the public interest
[[Page 23512]]
to assure ``fair competition * * * between exchange markets and markets
other than exchange markets.'' \60\
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\58\ S. Rep. No. 75 supra note 54, at 7; see Section
11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k-1(a)(1)(C).
\59\ See S. Rep. No. 75 supra note 54, at 104-05.
\60\ Section 11A(a)(1)(C)(ii) of the Exchange Act, 15 U.S.C.
78k-1(a)(1)(C)(ii). A fundamental goal of an NMS was to ``achieve a
market characterized by economically efficient executions, fair
competition, (and the) broad dissemination of basic market
information.'' S. Rep. No. 75 supra note 54, at 101.
---------------------------------------------------------------------------
To further NMS goals, Congress granted the Commission broad
authority to make rules, including those to: (i) Prevent the use and
publication of deceptive trade and order information; (ii) assure the
prompt, accurate, and reliable distribution of quotation and
transaction information; (iii) enable non-discriminatory access to such
information; and (iv) assure that all broker-dealers transmit and
direct orders for securities in a manner consistent with the operation
of an NMS.\61\ Moreover, Congress recognized that in order to implement
NMS goals, the Commission would need to classify markets, firms, and
securities and facilitate the development of ``subsystems within the
national market system.'' \62\
---------------------------------------------------------------------------
\61\ See Section 11A(c)(1) of the Exchange Act, 15 U.S.C. 78k-
1(c)(1).
\62\ S. Rep. No. 75 supra note 54, at 7.
---------------------------------------------------------------------------
The Commission believes its proposal today advances NMS goals. At
present, alternative trading systems are not fully integrated into the
national market system, leaving gaps in market access and fairness,
systems capacity, transparency, and surveillance. These concerns,
together with the increasing significance of alternative trading
systems, call into question the fairness of current regulatory
requirements, the effectiveness of existing NMS mechanisms, and the
quality of public secondary markets. Under the Commission's proposal,
those alternative trading systems that have the most significant effect
on our markets would be required to integrate their trading into NMS
mechanisms. Alternative trading systems could choose to register either
as national securities exchanges or as broker-dealers. Systems that
elect broker-dealer regulation would be integrated into the NMS under
proposed Regulation ATS if they have significant trading volume.\63\
Discussed in Section III.A. below are the requirements for alternative
trading systems that choose to register as broker-dealers and comply
with Regulation ATS. Any alternative trading system that registers as a
national securities exchange would be obligated--like currently
registered exchanges--to participate in the NMS mechanisms. Section
III.B. contains a discussion of the requirements applicable to
alternative trading systems that choose to register as exchanges.
---------------------------------------------------------------------------
\63\ In addition to its authority under Section 11A of the
Exchange Act, 15 U.S.C. 78k-1, the Commission is proposing
Regulation ATS pursuant to its rulemaking power under other parts of
the Exchange Act, including Sections 3(b) (power to define terms),
15(b)(1) (registration and regulation of broker-dealers), 15 (c)(2)
(prescribing means reasonably designed to prevent fraud), 17(a)
(books and records requirements), 17(b) (inspection of records),
23(a)(1) (general power to make rules and classify persons,
securities, and other matters), and 36 (general exemptive
authority). 15 U.S.C. 78c(b), 78o(b)(1), 78o(c)(2), 78q(a), 78q(b),
78w(a)(1), and 78mm, respectively. For a discussion on the general
exemptive authority in section 36 of the Exchange Act, 15 U.S.C.
78mm, see supra Section VI.D.1.
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A. Regulation ATS
1. Scope of Regulation ATS
The Commission is proposing Rule 300(a) under Regulation ATS, which
would define the term ``alternative trading system'' as any system
that: (1) Would constitute, maintain, or provide a marketplace or
facilities for bringing together purchasers and sellers of securities
or for otherwise performing with respect to securities the functions
commonly performed by a stock exchange under proposed Rule 3b-12 of the
Exchange Act; \64\ and (2) would not regulate its members or surviel
its own market.\65\ This proposed definition excludes trading systems
that conduct a regulatory function because the Commission believes that
self-regulatory systems should be registered as exchanges.\66\
---------------------------------------------------------------------------
\64\ See supra Section II. (discussing proposed Rule 3b-12).
\65\ Specifically, the proposed definition of ``alternative
trading system'' is any ``organization, association, person, group
of persons, or system (1) (t)hat constitutes, maintains, or provides
a market place or facilities for bringing together purchasers and
sellers of securities or for otherwise performing with respect to
securities the functions commonly performed by a stock exchange
within the meaning of (Rule) 3b-12 of [the Exchange Act]; and (2)
[t]hat does not: (A) (s)et rules governing the conduct of
subscribers other than the conduct of such subscribers' trading on
such organization, association, person, group of persons, or system,
or (B) [d]iscipline subscribers other than by exclusion from
trading.'' Proposed Rule 300(a).
\66\ Nothing, however, prevents a registered exchange from
giving up its self-regulatory functions to register as a broker-
dealer.
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Under proposed Regulation ATS, alternative trading systems would
have to register as broker-dealers and comply with certain additional
requirements depending on their volume. Any alternative trading system
that is registered as an exchange or that is exempt from such
registration either because of its limited volume or because it is
operated by a national securities association would be excluded from
the scope of the proposed regulation. In addition, any alternative
trading system that trades only government securities,\67\ Brady
Bonds,\68\ and repurchase and reverse repurchase agreements involving
government securities or Brady Bonds would be excluded as long as the
alternative trading system is registered as a broker-dealer.\69\
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\67\ The term ``government security'' is defined in section
3(a)(42) of the Exchange Act. 15 U.S.C. 78c(a)(42).
\68\ In 1989 Treasury Secretary Nicholas F. Brady announced an
initiative for the reduction of third world indebtedness. Under the
Brady Plan, U.S. creditor banks and a debtor country agree to
convert some of the country's existing debt, which generally carries
a floating market interest rate, into a bond that carries a fixed,
often below market, interest rates. These bonds are referred to as
Brady Bonds.
\69\ In other words, these systems would not be required to
register as either an exchange or to comply with the requirements of
Regulation ATS. Proposed Rule 301(a)(4).
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In the Concept Release, the Commission solicited comment on whether
it would be appropriate to exempt government securities broker-dealers
from any new regulatory scheme for alternative trading systems.
Government securities broker-dealers are currently regulated jointly by
the Commission, U.S. Department of the Treasury (``Treasury''), and
federal banking regulators, under the Exchange Act (particularly the
provisions of the Government Securities Act of 1986) and the federal
banking laws.\70\ Unlike
[[Page 23513]]
surveillance of trading in equities and other instruments traded
primarily on registered exchanges,\71\ surveillance of trading in
government securities is coordinated among the Treasury, the
Commission, and the Board of Governors of the Federal Reserve System.
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\70\ See generally Department of the Treasury, Securities and
Exchange Commission, and Board of Governors of the Federal Reserve
System, Joint Study of the Regulatory System For Government
Securities (March 1998); Department of the Treasury, Report of the
Secretary of the Treasury on Specialized Government Securities
Brokers and Dealers (July 1995) (``1995 Treasury Report'').
The Government Securities Act of 1986 (``GSA'') amended the
Exchange Act to incorporate new Section 15C, which, among other
things, established registration and notice requirements for
government securities brokers and dealers. Section 15C generally
requires government securities brokers and dealers (i.e., 15C firms
or specialized government securities brokers and dealers) to
register with the Commission and to become members of an SRO (22
firms as of March 1998). Firms that are registered with the
Commission as general securities brokers or dealers (i.e.,
traditional broker-dealers registered under Section 15(b) of the
Exchange Act) are required to file notice with the Commission of
their government securities business (3,023 firms as of April 1998).
In addition, financial institutions that engage in government
securities broker or dealer activities as required to file notice of
such activities with their appropriate regulatory agency (120
institutions as of March 1998).
Under the regulatory structure established by the GSA, the
Treasury was granted authority to adopt regulations for all
government securities brokers and dealers concerning financial
responsibility, protection of investors' funds and securities,
recordkeeping, reporting, and audit requirements, and to adopt
regulations governing the custody of government securities held by
depository institutions. The Government Securities Act Amendments of
1993 (``GSAA'') expanded the authority of the federal regulators and
the SROs over government securities transactions. The GSAA, among
other things, reauthorized the Treasury's rulemaking
responsibilities, granted the Treasury authority to prescribe large
position recordkeeping and reporting rules, extended the
Commission's antifraud and antimanipulation authority to all
government securities brokers and dealers, required government
securities brokers and dealers to provide to the Commission on
request records of government securities transactions to reconstruct
trading in the course of a particular inquiry or investigation,
removed the statutory restrictions on the authority of the NASD to
extend sales practice rules to its members' transactions in
government securities, and provided the bank regulatory agencies
with the authority to issue sales practice rules for financial
institutions engaged in government securities broker or dealer
activities.
The GSA also strengthened the ability of federal regulators to
examine, and to bring enforcement actions against, government
securities brokers and dealers. The Commission and the SROs have
examination and enforcement authority over government securities
brokers and dealers registered under Section 15C and over the
government securities activities of general securities brokers and
dealers. The Commission's enforcement authority includes the power
to censure, place limitations on the activities, functions, or
operations of, suspend for a period not exceeding 12 months, or
revoke the registration of the entity. For financial institutions
that are government securities brokers or dealers, the institution's
appropriate regulatory agency has examination and enforcement
authority over the institution. The appropriate regulatory agency
must notify the Commission of any sanctions imposed on such
institutions, and the Commission must maintain a record of the
sanctions.
\71\ Although all marketable Treasury notes, bonds, and zero-
coupon securities are listed on the NYSE, exchange trading volume is
a small fraction of the total over-the-counter volume in these
instruments. See U.S. Department of the Treasury, U.S. Securities
and Exchange Commission, and Board of Governors of the Federal
Reserve System, Joint Report on the Government Securities Market 26
(1992).
---------------------------------------------------------------------------
The Commission believes that any further regulation of alternative
trading systems that trade these types of government and other related
securities is not necessary in light of the specialized oversight
structures for these markets. Because of this specialized oversight
structure, excluding alternative trading systems that solely trade
government securities and other related securities from this proposal
should not weaken coordination of overall market oversight or create
competitive inequities among differently regulated entities that
perform similar functions.
The Commission requests comment on its proposal to exempt
alternative trading systems that trade solely government and other
related securities from the proposed regulatory framework described in
this release. The Commission also requests comments on whether other
alternative trading systems that exclusively trade securities with
special characteristics should be exempt from Regulation ATS.
2. Requirements for Alternative Trading Systems Subject to Regulation
ATS
Discussed below are the proposed requirements for alternative
trading systems that would be subject to Regulation ATS.
a. Membership in an SRO. Because alternative trading systems that
choose to register as broker-dealers would not themselves have self-
regulatory responsibilities, the Commission believes it is important
for such systems to be members of an SRO. Most alternative trading
systems are currently registered as broker-dealers and, therefore, are
also members of an SRO.\72\ The Commission believes it is appropriate
to continue to require alternative trading systems that register as
broker-dealers to be SRO members. While the Commission understands that
SROs operate competing markets and, therefore, have potential conflicts
of interest in overseeing alternative trading systems, the Commission
believes these conflicts can be managed using the Commission's
oversight.\73\ The Commission understands some alternative trading
systems may have concerns about SROs abusing their regulatory authority
for competitive reasons. The Commission considers it part of its own
oversight responsibility over SROs to prevent such actions by SROs.\74\
Further, an alternative trading system that wished to avoid potential
conflicts of interest altogether could choose to register as an
exchange. The Commission notes that section 15A of the Exchange Act
would permit an association of brokers and dealers to establish an SRO
that does not operate a market.\75\ Such a national securities
association could be established solely for purposes of overseeing the
activities of alternative trading systems.
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\72\ Section 15(b)(8) of the Exchange Act, 15 U.S.C. 78o(b)(8).
\73\ For example, the structural reforms undertaken by the NASD
since August 1996 should aid in ensuring the independence of NASDR
and insulating its staff from the commercial interests of Nasdaq.
\74\ See infra note 84.
\75\ Section 15A of the Exchange Act, 15 U.S.C. 78o-3.
---------------------------------------------------------------------------
The Commission expects SROs to enhance their current surveillance
of alternative trading systems to provide a consolidated view of the
market through an integrated audit trail. SROs should also incorporate
relevant information regarding the entities trading on such systems
into their existing surveillance programs. The proposed enhanced
recordkeeping requirements for alternative trading systems should aid
SRO oversight considerably in this regard.\76\
---------------------------------------------------------------------------
\76\ Proposed Rule 301(b)(8).
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b. Notice of operation as an alternative trading system and
amendments. Under proposed Regulation ATS, alternative trading systems
would be required to file an initial operation report with the
Commission on Form ATS at least 20 days prior to commencing
operation.\77\ Form ATS requests information about the alternative
trading system, including how it will operate, its prospective
subscribers, and the securities it intends to trade. In addition, the
alternative trading system would have to describe procedures for
reviewing systems capacity, security, and contingency planning. Form
ATS is not an application and the Commission would not ``approve'' an
alternative trading system before it began to operate. Form ATS would,
instead, be a notice to the Commission. Because alternative trading
systems would be required to register as broker-dealers under
Regulation ATS, proposed Form ATS would request only information about
an alternative trading system's market activities that would not be
included in the information filed on Form BD. Alternative trading
systems are currently required to report most of this information on
Part I of Form 17a-23, which the Commission is proposing to repeal.\78\
---------------------------------------------------------------------------
\77\ Proposed Rule 301(b)(2)(i) and Proposed Form ATS.
\78\ 17 CFR 240.17a-23. See infra Section IV.A.
---------------------------------------------------------------------------
An alternative trading system would also be required to notify the
Commission of material changes to its operation by filing an amendment
to Form ATS at least 20 calendar days prior to implementing such
changes.\79\ A material change would include, among other things, any
change to the operating platform of an alternative trading system.
Further, changes to the types of securities traded on, or to the types
of subscribers to an alternative trading system would be material
changes. Alternative trading systems would be required to notify the
Commission in quarterly amendments of any changes to the information on
Form ATS that had not been reported in a previous amendment.\80\
Finally, if an
[[Page 23514]]
alternative trading system ceases operations, it would be required to
promptly file a notice with the Commission.\81\
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\79\ Proposed Rule 301(b)(2)(ii).
\80\ Proposed Rule 301(b)(2)(iii). Alternative trading systems
would also be required to file an amendment to Form ATS to correct
any previously filed information that has been discovered to have
been inaccurate when filed. Proposed Rule 301(b)(2)(iv).
\81\ Proposed Rule 301(b)(2)(v).
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An alternative trading system would be required to provide a
duplicate of each of these filings to surveillance personnel designated
by the SRO of which it is a member.\82\ The Commission is also
proposing that the initial operation report, any amendments, and the
report filed when an alternative trading system ceases operation be
kept confidential. The Commission, however, requests comment on whether
the information filed on Form ATS should be public.
---------------------------------------------------------------------------
\82\ Proposed Rule 301(b)(2)(vii).
---------------------------------------------------------------------------
The Commission solicits comment on the notice requirements in
proposed Form ATS. Specifically, the Commission seeks comment on
whether such requirements would be burdensome for alternative trading
systems, and if so, whether the burden is inappropriate. The Commission
also seeks comment on the proposed frequency of filings and whether
more or less frequent filings would be preferable. Finally, the
Commission seeks comment on whether it would be appropriate to permit
or to require electronic filing of Form ATS and all subsequent
amendments.
c. Market transparency. The Commission for many years has been
concerned that the development of so-called ``hidden markets,'' in
which a market maker or specialist privately publishes quotations at
prices superior to the quotation information it disseminates publicly,
impedes NMS objectives. Over the course of the last decade, certain
alternative trading systems that allow subscribers to disseminate
significant trading interest to other system subscribers without making
this trading interest known to the public market have become
significant markets in their own right. Because these systems are not
registered as national securities associations or national securities
exchanges, they are not currently required to integrate into the public
quote the prices at which their subscribers are willing to trade. The
use of these systems to facilitate transactions in securities at prices
not incorporated into the NMS has resulted in fragmented and incomplete
dissemination of quotation information.
Recent evidence suggests that the failure of the current regulatory
approach to fully integrate trading on alternative trading systems into
NMS 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 market participants, they frequently are
not available to the general investing public. The ability of market
makers and specialists to display different and potentially superior
prices on alternative trading systems than those displayed on markets
available to the general public created, in the past, the potential for
a two-tiered market.\83\
---------------------------------------------------------------------------
\83\ See Securities Exchange Act Release No. 36310 (Sept. 29,
1995), 60 FR 52792 (Oct. 10, 1995) (``Order Handling Rules Proposing
Release'').
---------------------------------------------------------------------------
For example, during the Commission's recent investigation of Nasdaq
trading,\84\ 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.\85\ Moreover,
the Commission found that, because market makers could trade with other
market professionals through non-public alternative trading systems,
they did not have a sufficient economic incentive to adjust their
public quotations to reflect more competitive prices.\86\ 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 some
securities, and placed institutions at a potential disadvantage in
price negotiations.\87\
---------------------------------------------------------------------------
\84\ 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. 15 U.S.C. 78s and 78u(a). See SEC, Report
Pursuant to Section 21(a) of the Securities Exchange Act of 1934
Regarding the NASD and the Nasdaq market (1996) (``NASD 21(a)
Report'').
\85\ These conclusions are based on Instinet and SelectNet data
for the months April through June 1994. See NASD 21(a) Report, supra
note 84, at notes 48 to 52 and accompanying text.
\86\ 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 84, at 20.
\87\ NASD 21(a) Report, supra note 84, at 18.
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In response to these findings, the Commission took steps to bring
greater transparency into the trading environment of certain
alternative trading systems. In 1997, the Commission implemented rules
that require a market maker or specialist to make publicly available
any superior prices that it privately offers through certain types of
alternative trading systems known as electronic communications networks
(``ECNs'').\88\ The new rules permit an ECN to fulfill these
obligations on behalf of market makers or specialists using its system,
by submitting the ECN's best priced market maker or specialist
quotations to an SRO for inclusion into public quotation displays
(``ECN Display Alternative'').\89\
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\88\ 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) (``Order Handling Rules Adopting
Release'').
\89\ To date, six trading systems have elected to display quotes
under the ECN Display Alternative. See Letters dated Jan. 17, 1997
from Richard R. Lindsey, Director, Division of Market Regulation,
SEC to: Charles R. Hood, Senior V.P. and General Counsel, Instinet
Corporation (recognizing Instinet as an ECN); Joshua Levine and
Jeffrey Citron, Smith Wall Associates (recognizing the Island System
as an ECN); Gerald D. Putnam, President, Terra Nova Trading, LLC
(recognizing the TONTO System, now known as Archipelago, as an ECN);
and Roger D. Blanc, Wilkie Farr & Gallagher (counsel to Bloomberg)
(recognizing Bloomberg Tradebook as an ECN). See also Letter dated
October 6, 1997 from Richard R. Lindsey, Director, Division of
Market Regulation, SEC to Matthew G. Maloney, Dickstein Shapiro
Morin & Oshinsky LLP (counsel to Spear, Leeds & Kellogg)
(recognizing the REDI System as an ECN); and Letter dated February
4, 1998 from Robert L.D. Colby, Deputy Director, Division of Market
Regulation, SEC, to Linda Lerner, General Counsel, All-Tech
Investment Group, Inc. (recognizing the Attain System as an ECN).
---------------------------------------------------------------------------
These rules, however, were not intended to fully coordinate trading
on alternative trading systems with public market trading.\90\ While
these rules have helped integrate orders on certain alternative trading
systems into the public quotation system, they only affect trading that
is conducted by market makers and specialists, unless the system
voluntarily undertakes to disclose institutional orders that reflect
the best prices.\91\ In many cases, institutional orders, as well as
non-market maker orders, remain undisclosed to the public.\92\
Moreover,
[[Page 23515]]
whether an ECN reflects the best priced quotations in the public
quotation system on behalf of market makers and specialists that
participate in its system is voluntary.
---------------------------------------------------------------------------
\90\ See Order Handling Rules Adopting Release, supra note 88,
at 87-96.
\91\ There is divergence among ECNs in the extent to which they
have chosen to integrate non-market maker orders into the prices
they display to the public. Of the six ECNs that are currently
linked to Nasdaq, three ECNs display to the public the best prices
of any orders entered into their systems (including both market
makers and institutions). The other three ECNs display to the public
only orders of market makers, unless institutional customers of
these ECNs choose to have their orders so displayed.
\92\ Because such trading interest frequently remains
undisclosed, within certain alternative trading systems non-market
maker participants are able to display prices that lock and cross
the public quotations. If the quotes of such participants were
disclosed to the public, the Commission believes it would result in
improved price opportunities for public investors.
---------------------------------------------------------------------------
Because certain trading interest on alternative trading systems is
not integrated into the NMS, price transparency is impaired and
dissemination of quotation information is incomplete. These
developments are contrary to the goals the Commission enunciated over
twenty-five years ago when it noted that an essential purpose of a
national market system:
[I]s to make information on prices, volume, and quotes for
securities in all markets available to all investors, so that buyers
and sellers of securities, wherever located, can make informed
investment decisions and not pay more than the lowest price at which
someone is willing to sell, and not sell for less than the highest
price a buyer is prepared to offer.\93\
\93\ See SEC, Statement of the Securities and Exchange
Commission on the Future Structure of the Securities Markets (Feb.
2, 1972), 37 FR 5286 (Feb. 4, 1972) (emphasis added).
In addition, the Commission believes that it may be inconsistent
with congressional goals for an NMS that the best trading opportunities
are made accessible only to those customers who, due to their size or
sophistication, can avail themselves of prices in alternative trading
systems not currently available in the public quotation system. The
vast majority of investors may not be aware that better prices are
disseminated to alternative trading system subscribers and many do not
qualify for direct access to these systems and do not have the ability
to route their orders, directly or indirectly, to such systems. As a
result, many customers, both institutional and retail, do not always
obtain the benefit of the better prices entered into an alternative
trading system.
Accordingly, as described in more detail below, the Commission is
proposing to further enhance transparency of orders displayed on
alternative trading systems to ensure that publicly displayed prices
more fully reflect market-wide supply and demand. Specifically, the
Commission proposes that alternative trading systems with significant
volume be required to disseminate their best priced orders (including
institutional and non-market maker orders) into the public quotation
system. Further, the Commission is proposing that alternative trading
systems subject to these display requirements provide brokers and
dealers with access to displayed orders.
(i) Integration of Orders Into the Public Quotation System
Under Proposed Rule 301(b)(3), the Commission proposes to further
integrate alternative trading system quotes (priced orders) into the
NMS. To accomplish this, an alternative trading system that displays
subscriber orders to more than one person (other than alternative
trading system employees) would be required to disseminate in the
public quotation system the best priced orders in a covered security
\94\ in which, during at least four of the last six months, it traded
more than ten percent of the aggregated average daily share volume for
such security.\95\ The Commission requests comment on whether the
proposed volume threshold would effectively ensure that alternative
trading systems comprising a significant percentage of the market are
subject to basic market transparency requirements. In particular, the
Commission requests comment on whether different volume thresholds are
more appropriate for certain securities or types of alternative trading
systems. Should the volume threshold be more or less than ten percent,
or calculated on a basis other than four of the preceding six months?
---------------------------------------------------------------------------
\94\ A covered security would be defined in the same way as it
is under Rule 11Ac1-1(a)(6) under the Exchange Act. 17 CFR
240.11Ac1-1. Specifically, a ``covered security'' would be any
security reported by an effective transaction reporting plan and any
other security for which a transaction report, last sale data, or
quotation information is disseminated through an automated quotation
system as described in section 3(a)(51)(A)(ii) of the Exchange Act,
15 U.S.C. 78c(a)(51)(A)(ii). See Proposed Rule 300(g). Accordingly,
a covered security would include all exchange-listed securities,
Nasdaq NM securities, and Nasdaq SmallCap securities.
\95\ Proposed Rule 301(b)(3)(ii)(A). These orders would then be
included in the quotation data made available to quotation vendors
by national securities exchanges and national securities
associations pursuant to Rule 11Ac1-1 under the Exchange Act, 17 CFR
240.11Ac1-1.
---------------------------------------------------------------------------
The Commission is proposing that the display requirement be applied
on a security-by-security basis. Thus, an alternative trading system
would not have to display the best orders for any securities in which
its trade volume accounted for less than ten percent of the total
volume for such security. The Commission, however, requests comment on
whether an alternative trading system should be required to display the
best priced orders in all securities traded in its system, if it
reaches the volume threshold in a specified number or percentage of the
securities it trades. If commenters believe this type of requirement
would be appropriate, the Commission requests comment on what number or
percentage of securities would be an appropriate threshold to mandate
display of the best priced orders of all securities. It should also be
noted that the Commission is not proposing to require alternative
trading systems to publicly display orders for securities in which no
quotation data is disseminated. This means that trading systems--
regardless of their size--would not have to publicly disseminate orders
for fixed-income securities or equity securities that are not traded on
an exchange or through Nasdaq.
The Commission is proposing today only to require alternative
trading systems to publicly display subscribers' orders that are
displayed to more than one other system subscriber. Thus, if an
alternative trading system, like some crossing systems, by its design
does not display orders to other subscribers, this proposal would not
require those orders to be integrated into the public quote stream. In
addition alternative trading systems would not be required to provide
to the public quote stream orders displayed to only one other
alternative trading system subscriber, such as through use of a
negotiation feature.
In this regard, the Commission's proposal would allow institutions
and non-market makers to guard the full size of their orders by using
the ``reserve size'' features offered by some alternative trading
systems which allow these subscribers to display orders incrementally.
For example, such a subscriber that wished to sell 100,000 shares of a
given security could place its order in an alternative trading system
and specify that only 10,000 shares were to be displayed to other
alternative trading system subscribers at a time. In this situation,
only 10,000 shares would be required to be reflected in the public
quote. Because the Commission would only require that an alternative
trading system publicly display those orders that are displayed to
alternative trading system participants, these subscribers could shield
their orders from public view if they chose not to display their orders
to other participants.
However, if the institution or non-market maker subscriber
specified that the entire 100,000 share order were to be displayed to
all subscribers at once, the order would have to be publicly displayed
if it were the best priced order in the alternative trading system. The
Commission, however, requests comment on whether alternative trading
systems should be required to display
[[Page 23516]]
the full size of the best priced order, even if the full size is hidden
from alternative trading system subscribers through use of a ``reserve
size'' or similar feature.
This proposal is consistent with many commenters' recommendation
that alternative trading systems be required to display all orders in
the public quotation system and that alternative trading systems be
more fully incorporated into the NMS.\96\ For example, the NYSE
suggested that the Commission extend the Order Handling Rules to
further integrate alternative trading system trading interest into the
NMS, perhaps by matching an alternative trading system with an SRO to
reflect that alternative trading system's trading interest in the SRO's
quotation.\97\ The NASD similarly suggested that transparency could be
improved and market fragmentation minimized by requiring the inclusion
of non-market maker order information in the NBBO. The NASD pointed out
the continued existence of a ``two-tier market,'' despite the new Order
Handling Rules, because of the absence of any requirement for ECNs to
display orders from institutions and other non-market makers in the
public quote system.\98\
---------------------------------------------------------------------------
\96\ See Letter from Robert H. Forney, President and Chief
Executive Officer, Chicago Stock Exchange, to Jonathan G. Katz,
Secretary, SEC, dated Oct. 3, 1997 (``CHX Letter'') at 1, 13-14 (the
integration of alternative trading systems into the NMS and the
transition to decimal trading highlights the need for Commission
action in establishing minimum trading increments for NMS
securities); Letter from Craig S. Tyle, General Counsel, Investment
Company Institute, to Jonathan G. Katz, Secretary, SEC, dated Oct.
3, 1997 (``ICI Letter'') at 2, 6 (Commission should enhance the NMS
by requiring specialists and market makers to provide access to
their limit orders in the same manner as alternative trading systems
and by establishing linkages between alternative trading systems,
market makers, and exchanges); Letter from Adam W. Gurwitz, Vice
President Legal and Secretary, Cincinnati Stock Exchange, to
Jonathan G. Katz, Secretary, SEC, dated Oct. 2, 1997 (``CSE
Letter'') at 2 (broker-dealers that operate alternative trading
systems should make all orders in those systems available to the
public quotation system); Letter from Charles J. Henry, President
and Chief Operating Officer, Chicago Board Options Exchange, to
Jonathan G. Katz, Secretary, SEC, dated Oct. 2, 1997 (``CBOE
Letter'') at 4 (development of alternative trading systems should
occur within the framework of the NMS); Letter from Daniel Parker
Odell, Assistant Secretary, NYSE, to Jonathan G. Katz, Secretary,
SEC, dated Oct. 17, 1997 (``NYSE Letter'') at 4 (the best way to
advance transparency is by enhancing the dissemination of, and
access to alternative trading systems market interest through
existing NMS facilities); Letter from Robert W. Seijas and Joel M.
Surnamer, Co-Presidents, The Specialist Association, to Jonathan G.
Katz, Secretary, SEC, dated Oct. 24, 1997 (``Specialist Assoc.
Letter'') at 2 (alternative trading systems that trade NMS
securities operate largely outside the NMS; this situation should be
corrected).
\97\ NYSE Letter at 4. See also Letter from R. Warren Langley,
President and Chief Operating Officer, Pacific Exchange, to Jonathan
G. Katz, Secretary, SEC, dated Oct. 20, 1997 (``PCX Letter'') at 18
(to achieve complete transparency, it is necessary to publicly
disseminate information regarding the size and price of all
prospective interest for each security, as well as the trade price
and volume of completed transactions from all markets trading that
security).
\98\ Letter from John C. Conley, Secretary, NASD, Nasdaq, and
NASD Regulation, to Jonathan G. Katz, Secretary, SEC, dated Oct. 10,
1997 (``NASD Letter'') at 7. See also Letter from Kenneth Pasternak,
President and CEO, and Walter Raquet, Managing Director, Knight
Securities, LP, to Jonathan G. Katz, Secretary, SEC, dated Sept. 11,
1997 (``Knight Letter'') at 3 (the continued exemption of non-market
maker information from the public quotation system is damaging to
competing over-the-counter market makers, and inconsistent with fair
and reasonable regulation).
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The Commission preliminarily believes that in light of the
significant trading volume on some alternative trading systems,
integration of these orders into the NMS may be essential to prevent
the development of a two-tiered market. In response to commenters'
concerns that a loss of trading anonymity would adversely affect the
value that alternative trading systems provide to institutions, the
Commission's proposal would allow an alternative trading system to
comply with any public display requirement by identifying itself,
rather than the subscriber that placed the order. Thus, the
Commission's proposal, much like the ECN Display Alternative, would
preserve the benefits associated with anonymity. Moreover, the
Commission preliminarily believes that the continued ability of
institutions to retain their anonymity and to use features within
alternative trading systems to shield the full size of their orders
would give institutions the ability to keep their full trading interest
private. Requiring high volume alternative trading systems to furnish
to the public quotation system the full size of the best displayed buy
and sell orders would ensure that the public quote better reflects true
trading interest in a particular security. Furthermore, the Commission
believes that institutional investors' orders entered into alternative
trading systems provide valuable liquidity, and that displaying such
trading interest may substantially strengthen the NMS.
A number of commenters recommended that the Commission not require
alternative trading systems to publicly display all orders in the
public quotation system.\99\ The Commission understands that some
commenters were concerned that a requirement to display institutional
trading interest in the public quotation system might increase its
market impact.\100\ The types of impact which concerned these
commenters included adverse effects on volatility, resulting in worse
trade executions for institutional trading interests.\101\
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\99\ See Letter from Daniel Jamieson, to Jonathan G. Katz,
Secretary, SEC, dated July 23, 1997 (``Jamieson Letter'') at 4-5;
Letter from Jonathan R. Macey, J. DuPratt White Professor of Law and
Director, John M. Olin Program in Law and Economics, Cornell Law
School and Maureen O'Hara, Robert W. Purcell Professor of Finance,
Cornell University, to Jonathan G. Katz, Secretary, SEC, dated Oct
1. 1997 (``Macey and O'Hara Letter'') at 44-45; Letter from William
A. Lupien, Chairman and Chief Executive Officer, OptiMark
Technologies, Inc., to Jonathan G. Katz, Secretary, SEC, dated Oct.
6, 1997 (``OptiMark Letter'') at 6-7; Letter from Sam Scott Miller,
Orrick, Herrington & Sutcliffe, LLP, to Jonathan G. Katz, Secretary,
SEC, dated Oct. 3, 1997 (``OHS Letter (10/3/97)'') at 14-15
(institutions and other non-market maker subscribers should not be
required to sacrifice the benefits of limiting the size of their
displayed orders because of their use of technology); Letter from
Douglas M. Atkin, Instinet, to Jonathan G. Katz, Secretary, SEC,
dated Oct. 3, 1997 (``Instinet Letter'') at 12-15 (mandating pre-
trade transparency could result in illiquid markets); Letter from
John M. Liftin, Chair, Committee on Federal Regulation of Securities
and Roger D. Blanc, Chair, Subcommittee on Market Regulation,
American Bar Association, to Jonathan G. Katz, Secretary, SEC, dated
Oct. 1, 1997 (``ABA Letter'') at 22-24; Letter from Lou Eccleston
and Kevin M. Foley, Bloomberg L.P., to Jonathan G. Katz, Secretary,
SEC, dated Oct. 3, 1997 (``Bloomberg Letter'') at 8-9; ICI Letter at
3. Cf. Letter from A.B. Krongard, Chairman, SIA Task Force on
Alternative Trading System Concept Release, Securities Industry
Association, to Jonathan G. Katz, Secretary, SEC, dated Oct. 3, 1997
(``SIA Letter (10/3/97)'') at 13 (tentatively supporting the display
of the prices of the institutional orders in alternative trading
systems, but not the size of such orders).
\100\ ABA Letter at 24. See also Macey and O'Hara Letter at 45
(commenting that requiring institutional orders to be displayed
would reduce market liquidity by reducing both trading volume and
investors' incentives to engage in searches for better priced
orders).
\101\ ABA Letter at 24.
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Moreover, some commenters have expressed concerns that requiring
the public display of institutional orders may create a disincentive
for institutions to continue to route their orders to any alternative
trading system subject to such a requirement. These commenters believe
that a public display requirement would encourage institutions to route
their orders to execution venues that do not offer any pre-trade
transparency.
In light of these concerns, the Commission requests comment on
whether it would be more appropriate to adopt an alternative to Rule
301(b)(3) that would permit, but not require, the public display of the
best-priced institutional orders displayed in a high volume alternative
trading system. Under this alternative, an alternative trading system
meeting the requirements of Rule 301(b)(3)(i) would only be required to
provide to a national securities exchange or national securities
association the best-priced
[[Page 23517]]
orders in covered securities displayed in the alternative trading
system by any broker or dealer and by any other subscriber that elects
to make its orders available for public display.
In addition, the alternative approach would contain a separate
provision requiring an alternative trading system to provide its
institutional subscribers with an ongoing opportunity to decide whether
or not to make their orders available for display to the public
quotation system. Such a provision would require an institutional
subscriber to affirmatively make the decision to opt out of displaying
its orders to the public quote. In this regard, an alternative trading
system would have to provide that any default setting offered by the
system would be set for public display, unless the institutional
subscriber affirmatively indicated otherwise. Further, the Commission
would interpret this provision to prohibit an alternative trading
system from taking any action to discourage its institutional
subscribers from choosing to display their orders to the public quote.
Except for these differences, this alternative would operate in the
same fashion as proposed Rule 301(b)(3). The Commission requests
comment on whether such an alternative would sufficiently address the
Commission's concerns with transparency and fragmentation in the
markets.
The Commission encourages commenters to address whether the
proposed transparency requirements achieve the Commission's goals of
minimizing the negative effects of fragmented markets, and to offer
suggestions for other ways to achieve this goal. The Commission also
requests comments and data regarding institutional use of alternative
trading systems and the resulting impact of this proposal on market
liquidity and pricing. In addition, the Commission requests comment on
the most efficient method of integrating an alternative trading
system's orders into the quotation system of a national securities
exchange or national securities association. Finally, the Commission
requests comment on whether institutional orders above a certain size
should not be required to be displayed. If so, commenters are requested
to specify what size order above which it would be appropriate to allow
institutions to elect not to publicly display.
(ii) Access to Publicly Displayed Orders
The Commission is also proposing that alternative trading systems
be required to provide non-subscriber broker-dealers equivalent access
to the orders alternative trading systems would be required to
disseminate in the public quotation system. The Commission agrees with
those commenters who stressed the importance of equivalent access for
non-participants and stated that requiring alternative trading systems
to display prices in the public quotation system would not go far
enough to facilitate the best execution of customer orders without a
mechanism to access orders at those prices.\102\ For example, the SIA
commented that it would be reasonable to require alternative trading
systems to provide non-participants access to orders in alternative
trading systems, provided that access is offered through an entity that
meets the general standards for system participants (e.g., credit
quality or net worth) and that access is provided through an entity
that can provide appropriate clearance and settlement (unless the
alternative trading system provides a clearance and settlement
mechanism).\103\ The NYSE noted that fostering transparency and market
coordination also requires enhanced access to alternative trading
systems through the Intermarket Trading System (``ITS'').\104\ The
Commission believes that in addition to the display of better
alternative trading system prices in the public quotation system, the
availability of such trading interest to public investors is an
essential element of the NMS. Therefore, the Commission is proposing
that alternative trading systems afford all non-subscriber broker-
dealers equivalent access to orders displayed in the public quote,
similar to the manner in which ECNs currently comply with the ECN
Display Alternative under the Quote Rule.\105\
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\102\ Specialist Assoc. Letter at 10 (recommending that
alternative trading systems be required to afford all non-
participant broker-dealers equivalent access to orders in their
systems); Letter from Jeffery T. Brown, Smith Lodge & Schneider (for
Block Trading Inc.), to Jonathan G. Katz, Secretary, SEC, dated Oct.
7, 1997 (``SLS Letter'') at 4.
\103\ SIA Letter (10/3/97) at 13. See also ABA Letter at 24
(commenting that the Commission consider whether the present
SelectNet linkage to ECN prices provides an adequate model on which
to base any future non-subscriber access to alternative trading
system orders). But see Letter from Dan Sheridan, Head of Market
Regulation, London Stock Exchange, to Richard R. Lindsey, Director,
Division of Market Regulation, SEC, dated Sept. 2, 1997 (``LSE
Letter'') at 8 (recommending that alternative trading systems be
able to restrict access to executions if a particular non-
participant is a credit risk, has a history of unresolved positions,
or outstanding fees).
\104\ NYSE Letter at 4. See also PCX Letter at 30 (noting that
non-participant broker-dealers should have ``reasonable'' access to
execute orders in an alternative trading system, but this access
does not necessarily have to be as quick or convenient as direct
participants' access to orders in the alternative trading system).
\105\ Rule 11Ac1-1 under the Exchange Act, 17 CFR 240.11Ac1-1
(``Quote Rule''). See also Order Handling Rules Adopting Release,
supra note 88.
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In particular, the Commission believes that an alternative trading
system should allow non-subscribing broker-dealers to execute against
the best priced order to the same extent as would be possible had that
price been reflected in the public quote by a national securities
exchange or national securities association. Thus, an alternative
trading system should respond to orders entered by non-participants no
slower than it responds to orders entered directly by subscribers. In
addition, the Commission believes that for an alternative trading
system to comply with this equivalent execution access requirement, the
publicly displayed alternative trading system orders would need to be
subject to automatic execution through small order execution systems
operated by the SRO to which the alternative trading system is linked.
For example, under the Integrated Order Delivery and Execution System
proposed by the NASD,\106\ alternative trading systems linked to Nasdaq
would be required to take automatic executions up to the displayed size
of orders in their systems. The Integrated Order Delivery and Execution
System would replace Nasdaq's Small Order Execution System (``SOES'')
and SelectNet (and related NASD rules), while maintaining features of
each.
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\106\ Securities Exchange Act Release No. 39718 (Mar. 4, 1998),
63 FR 12124 (Mar. 12, 1998). The Integrated Order Delivery and
Execution System would feature a voluntary central limit order file
that all market participants would be able to access either directly
or through an Integrated Order Delivery and Execution System
participant. Registered NASD members and certain customers they
sponsor would be able to deliver various sized orders through the
Integrated Order Delivery and Execution System to electronically
access displayed quotations. Orders would remain anonymous until
they are executed.
---------------------------------------------------------------------------
In its letter commenting on the Concept Release, Bloomberg
suggested that alternative trading systems should be permitted to
establish a direct connection with non-participants so that alternative
trading systems would not be affected by any delay caused by an SRO's
system to which it is linked.\107\ The Commission questions whether
this proposal is feasible, however, because such a connection would not
permit the non-participant's
[[Page 23518]]
order to interact with any orders, other than those in the alternative
trading system. In addition, a non-participant order sent through an
SRO's system would not reach an alternative trading system that had
provided a direct link for non-participants in lieu of a link to the
SRO. The Commission asks for comment on whether the proposal to require
alternative trading systems to provide equivalent access to displayed
orders is appropriate and whether there are any reasons that non-
participants of alternative trading systems should not be able to
access such orders. Is there a feasible way to allow market-wide order
interaction without linkage to SRO order execution systems? Is there a
feasible way to grant equivalent non-subscriber access to institutions
that are not broker-dealers?
---------------------------------------------------------------------------
\107\ Bloomberg Letter at 6-7 (recommending that the Commission
establish an alternative to the SelectNet linkage for non-
participant execution against displayed ECN orders which would allow
an ECN to directly connect non-participants to its system without
the three-second delay that currently accompanies access through
SelectNet).
---------------------------------------------------------------------------
(iii) Execution Access Fees
The Commission agrees with those commenters that suggested that fee
schedules should not be used to circumvent the ability of non-
participants to access a system's publicly displayed orders.\108\ The
Commission also understands that competitive forces will help determine
appropriate fees.\109\ Therefore, although reasonable fees are a
component of equal access, the Commission is not proposing to set
specific fees that alternative trading systems may charge. Rather, the
fees would be determined by the system's internal cost structure.
---------------------------------------------------------------------------
\108\ See LSE Letter at 7; Bloomberg Letter at 11. See also
Knight Letter at 8 (all fees charged by SelectNet, SOES, or an ECN
should be borne by the taker of liquidity and should be based upon
actual costs to ensure that fees are not subsidizing other
activities).
\109\ See Letter from Junius W. Peake, Mofort Distinguished
Professor of Finance, University of Northern Colorado, to Jonathan
G. Katz, Secretary, SEC, dated July 14, 1997 (``Peake Letter (7/14/
97)'') at 15; ABA Letter at 24; PCX Letter at 31.
---------------------------------------------------------------------------
The Commission, however, intends that fees charged not have the
effect of denying non-subscribers access to the alternative trading
system's publicly displayed orders. Under Regulation ATS, the
Commission proposes to prohibit alternative trading systems subject to
the display and execution access requirements under proposed Rule
301(b)(3) from charging broker-dealers for access to publicly displayed
orders in excess of the fee charged by the alternative trading system
to a substantial proportion of its existing broker-dealer subscribers.
Specifically, under proposed Rule 301(b)(4), the highest fee an
alternative trading system would be permitted to charge non-subscribers
would be the lesser of the fee charged by the alternative trading
system to a substantial portion of its existing broker-dealer
subscribers or the fee permitted under the rules of the applicable
national securities exchange or national securities association. The
Commission preliminarily believes that the national securities exchange
or national securities association to which the alternative trading
system provides the prices and sizes of its best priced orders should
be authorized to assure that fees charged by alternative trading
systems to non-subscribers are consistent with fees typically charged
by the exchange or association for access to displayed orders.
Therefore, if the exchange or association did not permit any fees for
access to the quotes on the system operated by the exchange or
association, the exchange or association could prohibit the alternative
trading system from charging fees to non-subscribers, regardless of the
fees it charged to subscribers. Alternatively, the exchange or
association could use this authority to require alternative trading
system fees to be charged in a manner consistent with the exchange's or
association's market, such as requiring the fee to be incorporated in
the displayed quote.
The Commission requests comment on whether there are any reasons
that alternative trading systems should be allowed to charge higher
fees to non-participants than would be allowed under the proposed rule.
The Commission also requests comment on whether there are alternatives
for assuring fair execution access for non-subscribers or another test
for determining whether the non-subscriber fees assure equal access.
Finally, the Commission requests comment on whether fees should be
included in the price of an order quoted to the public. The Commission
is aware that while orders are displayed in fractions this might prove
untenable, but would like commenters' views on this approach assuming
orders are quoted in decimals. If this approach is taken, how would
variations in a pricing schedule be taken into account?
The proposed rule is intended to ensure that no alternative trading
system sets fees that render its system inaccessible to the investing
public through non-participant broker-dealers. Further, the Commission
encourages SROs that accept alternative trading system quotes to work
with alternative trading systems to develop uniform standards regarding
display and execution access by SRO members to alternative trading
systems linked to the SRO.\110\ In addition, to foster equivalent
access to alternative trading systems for exchange-listed securities,
the Commission would expect ITS participants to modify ITS Plan
requirements where necessary to accommodate alternative trading system
participation in the markets of ITS participants, and access to those
alternative trading systems through ITS.
---------------------------------------------------------------------------
\110\ See, e.g., NASD Rule 4623. Securities Exchange Act Release
Nos. 38156 (Jan. 10, 1997), 62 FR 2415 (Jan. 16, 1997); 38008 (Dec.
2, 1996), 61 FR 64550 (Dec. 5, 1996).
---------------------------------------------------------------------------
(iv) Amendment to Rule 11Ac1-1 under the Exchange Act
The Commission is also proposing an amendment to Rule 11Ac1-1 under
the Exchange Act (``Quote Rule'').\111\ The Quote Rule currently
requires all market makers and specialists to make publicly available
any superior prices that it privately offers through ECNs. The ECN
Display Alternative in the Quote Rule permits an ECN to fulfill these
obligations on behalf of market makers and specialists using its system
by submitting the ECN's best market maker or specialist priced
quotation to an SRO for inclusion into the public quotation.\112\
Today's proposed amendment to the Quote Rule is intended to expand the
ECN Display Alternative to allow alternative trading systems that
display orders and provide equal execution access to those orders under
Rule 301(b)(3) of proposed Regulation ATS to fulfill market makers' and
specialists' obligations under the Quote Rule.
---------------------------------------------------------------------------
\111\ Proposed Amended Rule 11Ac1-1(c)(5)(ii) (A) and (B).
\112\ See supra notes 88-92 and accompanying text.
---------------------------------------------------------------------------
d. Fair access. The Exchange Act requires registered exchanges and
national securities associations to consider the public interest in
administering their markets and to establish rules designed to admit
members fairly.\113\ These requirements are intended to ensure that
markets treat investors fairly.\114\ Under the current regulatory
approach, however, there is no regulatory redress for unfair denials or
limitations of access by alternative trading systems. The availability
of redress for such actions may not be critical when market
participants are able to substitute the services of one alternative
trading system with those of another. However, when an alternative
trading system has a significantly large percentage of the volume of
trading,
[[Page 23519]]
unfairly discriminatory actions hurt investors lacking access to the
system.
---------------------------------------------------------------------------
\113\ Sections 6(b)(2) and 6(c) of the Exchange Act, 15 U.S.C.
78f(b)(2) and (c); section 15A(b)(8) of the Exchange Act, 15 U.S.C.
78o-3(b)(8).
\114\ ``Restraints on membership cannot be justified as
achieving a valid regulatory purpose and, therefore, constitute an
unnecessary burden on competition and an impediment to the
development of a nation market system.'' H.R. Rep. No. 123, 94th
Cong. 1st Sess. 53 (1975).
---------------------------------------------------------------------------
Fair treatment by alternative trading systems of potential and
current subscribers is particularly important when an alternative
trading system captures a large percentage of trading volume in a
security, because viable alternatives to trading on such a system are
limited. Although the Commission is proposing to require alternative
trading systems with significant trading volume to publicly display
their best bid and offer and provide equal execution access to those
orders,\115\ direct participation in alternative trading systems offers
benefits in addition to execution against the best bid and offer. For
example, participants can enter limit orders into the system, rather
than just execute against existing orders on a fill-or-kill basis.
Participants in an alternative trading system can view all orders, not
just the best bid or offer, which provides important information about
the depth of interest in a particular security. Participants also have
access to unique features of alternative trading systems, such as
``negotiation'' features, whereby one participant can send orders to
another participant proposing specific terms to a trade, without either
participant revealing its identity. Some alternative trading systems
also allow participants to enter ``reserve'' orders which hide the full
size of an order from view. Because of these advantages to
participation in an alternative trading system, access to the best bid
and offer through an SRO is an incomplete substitute. Therefore, the
Commission proposes to require alternative trading systems that are
registered as broker-dealers and that have a significant percentage of
overall trading volume in a particular security to comply with fair
access standards, as described in more detail below.\116\
---------------------------------------------------------------------------
\115\ See supra Section III.A.2.c.(ii).
\116\ Proposed Rule 301(b)(5).
---------------------------------------------------------------------------
While some commenters did not believe fair access requirements were
warranted, they based this conclusion on their belief that denials of
access have not been a problem.\117\ The Commission, however, is aware
of instances in which alternative trading systems applied access
standards inconsistently.\118\ Consequently, the Commission agrees with
commenters who recommended that alternative trading systems provide
fair access to subscribers if such systems attain a significant
proportion of trading in a security.\119\
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\117\ See NASD Letter at 7-8; ICI Letter at 3.
\118\ The Commission understands that the NASD is currently
reviewing a complaint against an alternative trading system for an
unreasonable denial of access.
\119\ See Jamieson Letter at 7; SLS Letter at 4; Letter from
Christopher J. Carroll, Concept Release Task Force, The Bond Market
Association, to Jonathan G. Katz, Secretary, SEC, dated Oct. 3, 1997
(``Bond Market Assoc. Letter'') at 10-11. See also OptMark Letter at
5-6 (commenting that unreasonable denials of access raise concerns
about anticompetitive behavior); LSE Letter at 9 (commenting that
alternative trading systems not be required to make the system
available to the public generally, but that such systems should not
discriminate unfairly and that objective access standards for
admission and acceptance should be established by alternative
trading systems, subject to oversight by the Commission or the
SROs).
---------------------------------------------------------------------------
Specifically, the Commission is proposing that an alternative
trading system subject to Regulation ATS comply with fair access
requirements if, during at least four of the preceding six months, the
alternative trading system accounted for more than twenty percent of
the average daily share volume in any equity security or category of
debt.\120\ For equity securities,\121\ the proposed volume threshold is
on a security-by-security basis. Accordingly, if an alternative trading
system accounts for greater than twenty percent of the share volume in
any equity security, it would be subject to the proposed fair access
requirements with respect to that security. The Commission requests
comment on whether the twenty percent threshold is appropriate, or
whether the volume threshold should be higher or lower than twenty
percent. The Commission also requests comment on the best method for an
alternative trading system to notify interested parties that its system
had reached the volume threshold in a given security. Should the
designated examining authority, for example, publish such information
for its members?
---------------------------------------------------------------------------
\120\ Proposed Rule 301(b)(5)(i).
\121\ Section 3(a)(11) of the Exchange Act, 15 U.S.C.
78c(a)(11); 17 CFR 240.3a11-1. Options and limited partnerships are
included within the definition of an equity security.
---------------------------------------------------------------------------
For debt securities, the Commission proposes that if an alternative
trading system accounts for more than twenty percent of the volume in
any category of debt security, the alternative trading system would be
subject to the fair access requirements with respect to that category.
The Commission requests comment on the appropriate categories of debt
securities and whether the twenty percent volume threshold is
appropriate. For example, the Commission would like comments on
categories such as mortgage and asset-backed securities (private label
issues only), municipal securities, corporate debt securities, foreign
corporate debt securities, and sovereign debt securities. The
Commission also requests comment on whether categories of debt
securities should be further divided based on an instrument's maturity,
credit rating, or other criteria. The Commission also requests comment
on the best sources of data for the volume of a particular debt
category.
For alternative trading systems that meet the proposed volume
thresholds, the Commission is proposing to require those alternative
trading systems to establish standards for granting access to trading
on its system. An alternative trading system would be required to
maintain these standards in its records,\122\ but would not be required
to provide the Commission with such standards, unless a person denied
or limited access to the alternative trading system appealed that
action to the Commission. In addition, the alternative trading system
would be prohibited from unreasonably prohibiting or limiting any
person with respect to access to its services and would be required to
provide notice to any person denied or limited access to the
alternative trading system that they have a right to appeal the
alternative trading system's action to the Commission under the
Commission's Rules of Practice.\123\
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\122\ Propose Rule 303(a)(1)(iii). The Commission would expect
an alternative trading system to maintain a record of its standards
at each point in time. If the alternative trading systems amends or
modifies its access standards, the records kept should reflect
historic standards, as well as current standards.
\123\ Proposed Rule 301(b)(5)(ii).
---------------------------------------------------------------------------
This right to appeal would be created through several amendments to
the Commission's Rules of Practice. In particular, the Commission
proposes to amend Rule 420 under the Commission's Rules of Practice
\124\ to allow a person who is aggrieved by an alternative trading
system determination that prohibits or limits that person's access to
services to file an application for review by the Commission. The
Commission also proposes to amend Rule 410 under the Commission's Rules
of Practice \125\ so that a person who is aggrieved by a limitation or
prohibition of access can move for a stay of action by the alternative
trading system pending an appeal. Finally, the Commission proposes to
amend Rules 101(a)(9),\126\ 202(a),\127\ 210(a)(1),\128\ and 421 under
the Commission's Rules of Practice \129\ to include references to
alternative trading systems so that the Commission's Rules of Practice
with
[[Page 23520]]
respect to the appeals process apply to allegations of unfair denials
of access by alternative trading systems.
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\124\ 17 CFR 201.420.
\125\ 17 CFR 201.410.
\126\ 17 CFR 201.101(a)(9).
\127\ 17 CFR 201.202(a).
\128\ 17 CFR 201.210(a)(1).
\129\ 17 CFR 201.421.
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These provisions are based on the principle that qualified market
participants should have fair access to the nation's securities
markets. Alternative trading systems would remain free to have
reasonable standards for access. Such standards should act to prohibit
unreasonably discriminatory denials of access. A denial of access would
be reasonable, for example, if it were based on objective standards.
For example, an alternative trading system could establish minimum
capital or credit requirements for subscribers. Similarly, an
alternative trading system could reasonably deny access to investors
based on an unfavorable disciplinary history. Provided that these or
other standards were applied consistently to all subscribers, an
alternative trading system would be considered to be granting and
denying access fairly. A denial of access might be unreasonable,
however, if it were based solely on the trading strategy of a potential
participant.
The Commission requests comment on its proposal to prohibit
alternative trading systems with significant volume from unfairly
discriminating against market participants in providing access. The
Commission seeks commenters views regarding appropriate reasons for
denying market participants access to an alternative trading
system.\130\ The Commission would also like commenters' views on
whether the proposed fair access requirement would achieve the
Commission's goal of promoting fair access to systems having a
significant portion of the market in a particular security. The
Commission requests comment on whether an alternative trading system
should be required to provide fair access to all securities it trades
when it reaches the twenty percent threshold in a security. Should fair
access be granted only with respect to those securities that have
reached the threshold, or with respect to all securities? Should access
be granted to all after a certain number or percentage of securities
traded have reached the twenty percent threshold? If so, what number or
percentage? In addition, the Commission would like commenters' views on
whether persons denied access to an alternative trading system should
have the right to appeal this action to the Commission, the form the
appeal should take, and the appropriate standard for Commission review.
---------------------------------------------------------------------------
\130\ For example, the Commission has reorganized that the
creditworthiness of a counterparty is a legitimate concern of market
participants. See Letter from Richard R. Lindsey, Director, Division
of Market Regulation, SEC, to Richard Grasso, Chairman and Chief
Executive Officer, NYSE, dated Nov. 22, 1996 at 17.
---------------------------------------------------------------------------
e. Capacity, integrity, and security standards. In November 1989
and May 1991, the Commission published two policy statements regarding
the use of technology in the securities markets.\131\ These policy
statements established the automation review program and called for the
SROs to establish, on a voluntary basis, comprehensive planning,
testing, and assessment programs to determine systems' capacity and
vulnerability. The Commission recommended that SROs: (1) Establish
current and future capacity estimates; (2) conduct capacity stress
tests; and (3) obtain annual independent assessments of systems to
determine whether they can perform adequately.\132\ In addition, the
Commission staff conducts oversight reviews of the SROs' systems
operations. All SROs currently participate in the Commission's
automation review program, which has been a significant force in
stimulating the SROs to upgrade their systems technology.
---------------------------------------------------------------------------
\131\ Securities Exchange Act Release No. 27445 (Nov. 16, 1989),
54 FR 48704 (``ARP I''); Securities Exchange Act Release No. 29185
(May 9, 1991), 56 FR 22489 (``ARP II''). ARP I and ARP II were
published in response to operational difficulties experienced by SRO
automated systems during the October 1987 market break. These
releases predicted future capacity requirements, emphasized the need
to maintain accurate trade and quote information, and discussed the
degree to which computer automation has become, and is likely to
increase as, an intergral part of securities trading.
\132\ ARP II, supra note 131, set forth guidance concerning the
nature of these independent reviews.
---------------------------------------------------------------------------
The automation review program was established because of ``the
impact that systems failures have on public investors, broker-dealer
risk exposure, and market efficiency.''\133\ While this program did not
directly apply to alternative trading systems, the Commission noted
that all broker-dealers should engage in systems testing and use the
policy statement as a guideline.\134\ Because some alternative trading
systems now account for a significant share of trading in the U.S.
securities markets, failures of their automated systems have as much of
a potential to disrupt the securities markets as failures of SROs'
automated systems. For this reason, the Commission is proposing to
require alternative trading systems with significant volume to meet
certain systems capacity, integrity, and security standards.\135\ These
proposed requirements would be similar to those standards SROs
currently follow under the automation review program.
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\133\ ARP I, supra note 131, 54 FR at 48705; ARP II, supra note
131, 56 FR at 22490.
\134\ See ARP I, supra note 131, 54 FR at 48706 n. 17; ARP II,
supra note 131, 56 FR at 22493 n.15.
\135\ Proposed Rule 301(b)(6).
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Under proposed Rule 301(b)(6), certain alternative trading systems
registered as broker-dealers would be required to comply with
requirements designed to ensure adequate systems capacity, integrity,
and security. These requirements would apply to an alternative trading
system if during four of the preceding six months it had more than
twenty percent of the aggregate daily share volume in any equity
security or in a specified category of debt security.\136\ For equity
securities, the proposed volume thresholds are on a security-by-
security basis. Accordingly, if any one equity security traded on an
alternative trading system accounts for more than twenty percent of the
share volume in that security, the alternative trading system would be
required to meet the proposed capacity, integrity, and security
requirements.
---------------------------------------------------------------------------
\136\ Proposed Rule 301(b)(6)(i).
---------------------------------------------------------------------------
With respect to debt securities, the proposed volume threshold
would be applied to categories of debt securities. As discussed in
regard to the fair access requirements, the Commission is preliminarily
considering categorizing debt securities as: mortgage and asset-backed
securities (private issue only), municipal securities, corporate debt
securities, foreign corporate debt securities, and sovereign debt
securities. These categories could be further broken down into
subcategories based on factors such as date of maturity and rating. As
stated above, alternative trading systems subject to proposed
Regulation ATS would be required to meet the proposed capacity,
integrity, and security requirements if the alternative trading system
accounted for more than twenty percent of the volume in a category of
debt securities.
An alternative trading system that meets these volume thresholds
would be required to: (1) Establish reasonable current and future
capacity estimates; (2) conduct periodic capacity stress tests of
critical systems to determine such system's ability to process
transactions in an accurate, timely, and efficient manner; (3) develop
and implement reasonable procedures to monitor system development and
testing methodology; (4) review the vulnerability of its systems and
data center computer operations to internal and external threats,
physical hazards, and natural disasters; and (5) establish adequate
contingency and disaster
[[Page 23521]]
recovery plans. An alternative trading system would be required to meet
these proposed standards with respect to all its systems that support
order entry, order handling, execution, order routing, transaction
reporting, and trade comparison.\137\ In addition, alternative trading
systems subject to this provision would be required to notify the
Commission staff of material systems outages and material systems
changes.\138\ This information would enable Commission staff to
maintain an understanding of the operation of alternative trading
systems generally and to identify potential problems and trends that
may require attention.
---------------------------------------------------------------------------
\137\ Proposed Rule 301(b)(6)(ii)(A)-(F)
\138\ Proposed Rule 301(b)(6)(ii)(G).
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Finally, under proposed Regulation ATS, alternative trading systems
that meet the volume levels set forth above would be required to
perform an annual independent review of the systems that support order
entry, order handling, execution, order routing, transaction reporting
and trade comparison.\139\ As discussed in greater detail in the
Commission's May 1991 Policy Statement,\140\ an independent review
should be performed by competent, independent audit personnel following
established audit procedures and standards. If internal auditors are
used by an alternative trading system to complete the review, these
auditors should comply with the standards of the Institute of Internal
Auditors and the Electronic Data Processing Auditors Association
(``EDPAA''). If external auditors are used, they should comply with the
standards of the American Institute of Certified Public Accountants and
the EDPAA.
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\139\ Proposed Rule 301(b)(6). Regulation ATS would also require
alternative trading systems to preserve documentation relating to
their efforts to meet the requirements of this rule. See Proposed
Rule 303(a)(1)(iv).
\140\ See ARP II, supra note 131.
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Some commenters suggested that the Commission need not regulate
capacity of alternative trading systems because market forces would
ensure that such systems maintain sufficient capacity.\141\ A number of
commenters, however, said that systems integrity was a concern. In
fact, several commenters recommended that the Commission develop
general minimum criteria to assure that alternative trading systems
maintain sufficient systems capacity.\142\
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\141\ See Letter from Joanne T. Medero, Barclays Global
Investors, to Jonathan G. Katz, Secretary, SEC, dated Oct. 3, 1997
(``BGI Letter'') at 3 (any alternative trading system that is
perceived by customers or potential customers as posing execution
risks will not be used); Bloomberg Letter at 4 (competition will
provide sufficient impetus for alternative trading systems to
maintain adequate capacity); Peake Letter (7/14/97) at 16 (customers
of alternative trading systems presumably need to be satisfied as to
the quality of the vendor); Jamieson Letter at 4-6 (if alternative
trading systems do not work customers will not use them); LSE Letter
8-9 (users will take their business elsewhere if an alternative
trading system fails); OptiMark Letter at 7 (capacity should not be
regulated because alternative trading systems make up a small
portion of the market resulting in a relatively little market
impact); Macey and O'Hara Letter at 47; OHS Letter (10/3/97) at 17.
See also Letter from Joseph T. McLaughlin, Managing Director and
General Counsel, Credit Suisse First Boston, to Jonathan G. Katz,
Secretary, SEC, dated Oct. 7, 1997 (``CSFB Letter'') at 18
(commenting that capacity concerns are misplaced for most systems,
but for larger alternative trading systems, the Commission could
impose heightened regulation regarding capacity to the extend that
the Commission determines that the failure of a particular system
could result in risks comparable to the failure of a national
securities exchange).
\142\ See Letter from Scott L. Fagin, LIMITrader, to Jonathan G.
Katz, Secretary, SEC, dated June 26 1997 (``Fagin Letter'') at 3;
Letter from Thomas J. Jordan, Executive Director, Financial
Information Forum, to Jonathan G. Katz, Secretary, SEC, dated Oct.
3, 1997 (``FIF Letter'') at 1; Letter from Robert C. Weaver,
Attorney, to Jonathan G. Katz, Secretary, SEC, dated Oct. 2, 1997
(``Weaver Letter'') at 7; Specialist Assoc. Letter at 12 (the
Commission should develop criteria for alternative trading systems
to safeguard the integrity and security of their trading systems);
PCX Letter at 28; NYSE Letter at 5 (although alternative trading
systems have strong incentives to ensure their systems have adequate
capacity, to the extent that market forces do not provide adequate
protection, the Commission should require alternative trading
systems to certify at specified intervals that they have adequate
capacity, subject to SRO oversight). See also ICI Letter at 4
(commenting that it could support a periodic reporting requirement,
but substantive regulation might impede innovation).
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The Commission's experience has shown that market forces have not
been a sufficient incentive for ensuring adequate capacity.\143\ For
example, during the past year, Instinet, Island, Bloomberg, and
Archipelago (operated by Terra Nova) have all experienced system
outages due to problems with their automated systems. On a number of
occasions, ECNs have had to stop disseminating market maker quotations
in order to keep from closing altogether, including during the market
decline of October 1997 when one significant ECN withdrew its quotes
from Nasdaq because of lack of capacity. Similarly, a major interdealer
broker in non-exempt securities experienced serious capacity problems
in processing the large number of transactions in October 1997 and had
to close down temporarily.
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\143\ In addition, the United States General Accounting Office
(``GAO'') has conducted several studies on the subject of computer
systems and their role in the financial markets. Generally, the GAO
has recommended that the Commission take steps to improve systems
capacity, integrity, and security. See GAO, Stronger System Controls
and Oversight Needed to Prevent NASD Computer Outages (Dec. 1994)
(regarding Nasdaq system outages); GAO, Stock Markets: Information
Vendors Need SEC Oversight to Control Automation Risks (Jan. 1992)
(regarding risk assessments of automated operations of stock market
information dissemination vendors); GAO, Computer Security Controls
at Five Stock Exchanges Need Strengthening (Aug. 1991) (regarding
systems related risks at stock markets); GAO, Active Oversight of
Market Automation by SEC and CRTC Needed (Apr. 1991) (regarding
automation risks of the securities and futures markets); GAO,
Tighter Computer Security Needed (Jan. 1990) (regarding the Common
Message Switch system and the Intermarket Trading System operated by
the Securities Industry Automation Corporation and the Nasdaq system
operated by the NASD).
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Investors and other market participants increasingly rely on
alternative trading systems to buy and sell securities. The ability of
these markets to meet the demands of market participants is directly
related to the reliability of their automated systems. For this reason,
alternative trading systems have significant business incentives to
ensure that their systems have adequate capacity so that participants'
orders do not experience unnecessary delays. The proposed systems
capacity, integrity, and security rules,144 are intended as
a back-up to ensure that alternative trading systems that have a
significant role in the market maintain sufficient systems and
procedures to avoid or minimize the effects of potential systems
problems in the secondary markets. Alternative trading systems that
have a significant role in the marketplace should be able to handle
reasonably foreseeable volume surges and be prepared for reasonably
anticipated future volume increases.
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\144\ Proposed Rule 301(b)(6)(ii).
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The Commission requests comment on whether the volume thresholds
stated above are appropriate for the imposition of these capacity,
integrity, and security standards. What volume thresholds would be most
appropriate, and what is the best method of calculating them? Are there
other capacity, integrity, and security standards that would be more
appropriate, or other ways to monitor alternative trading systems
capacity? In addition, the Commission would like commenters' views on
whether the categories and subcategories of debt discussed above are
appropriate and feasible. If commenters believe other categories or
subcategories of debt should be used, the Commission requests
suggestions. The Commission also asks for comment on whether the volume
thresholds for limited partnerships and options should be based on
categories of securities rather than on a security by security basis.
Would this method better reflect an alternative trading system's market
impact? 145
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\145\ See supra note 121.
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f. Examination, inspection, and investigations of subscribers.
Under the proposed rules, an alternative trading
[[Page 23522]]
system would be required to cooperate with the Commission's or an SRO's
inspection or examination of the alternative trading system or any of
the alternative trading system's subscribers.146 Presently,
the Commission has the authority to inspect and examine any member of
any national securities exchange or any national securities association
directly. This is because all such members are broker-dealers.
Alternative trading systems, however, also have certain other
subscribers, such as banks, to which the Commission's inspection
authority does not extend. Because alternative trading systems could be
used by subscribers to manipulate the market in a
security,147 it is imperative that alternative trading
systems cooperate in all inspections and examinations. Although neither
the Commission nor the SROs have the authority to directly inspect non-
broker-dealer subscribers of alternative trading systems, any relevant
trading information involving such subscribers would be maintained by
the alternative trading system, under its recordkeeping requirements,
and be required to be made available upon request to its SRO or the
Commission.
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\146\ Proposed Rule 301(b)(7).
\147\ The Commission is aware of several incidents involving the
manipulation of quotations through alternative trading systems. The
participants who engaged in this manipulation were able to gain a
profit as a result.
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g. Recordkeeping. Proposed Regulation ATS would require alternative
trading systems to make and keep the records necessary to create a
meaningful audit trail.148 Specifically, the Commission
proposes that alternative trading systems maintain daily summaries of
trading and time-sequenced records of order information, including the
date and time the order was received, the date, time, and price at
which the order was executed, and the identity of the parties to the
transaction. In addition, alternative trading systems would be required
to maintain a record of subscribers and any affiliations between
subscribers and the alternative trading system.149 While
some of the information that would be required by the proposed rule
will also be required under the NASD's Order Audit Trail System
(``OATS''),150 OATS is an NASD rule and does not cover all
securities traded through alternative trading systems.
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\148\ Proposed Rule 301(b)(8).
\149\ Proposed Rule 302.
\150\ Securities Exchange Act Release No. 39729 (March 6, 1998),
63 FR 12559 (March 13, 1998).
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This proposal also requires alternative trading systems to keep
records of all notices provided to subscribers, including notices
addressing hours of operation, system malfunctions, changes to system
procedures and instructions pertaining to access to the alternative
trading system. In addition, alternative trading systems would be
required to keep documents made (if any) in the course of complying
with the systems capacity, integrity, and security standards in
Proposed Rule 301(b)(6). These documents would include all reports to
an alternative trading system's senior management, and records
concerning current and future capacity estimates, the results of any
stress tests conducted, procedures used to evaluate the anticipated
impact of new systems when integrated with existing systems, and
records relating to arrangements made with a service bureau to operate
any automated systems. These records would allow the Commission to
examine whether alternative trading systems are complying with the
requirements under Proposed Rule 301(b)(6). Finally, an alternative
trading system subject to the fair access requirements discussed above
would be required to keep a record of its access
standards.151
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\151\ See supra notes 122-123 and accompanying text.
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The Commission proposes that these records be kept for at least
three years, the first two years in an easily accessible place.
Proposed Regulation ATS also would require some records, such as
partnership articles and articles of incorporation, to be kept for the
life of the alternative trading system.152 The Commission is
proposing to allow alternative trading systems to keep records in any
form broker-dealers are permitted to keep records under Rule 17a-4(f)
under the Exchange Act.153
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\152\ Proposed Rule 303.
\153\ Proposed Rule 303(b). Rule 17a-4(f) provides for the
maintenance of records on microfilm, microfiche, or electronic
storage media. The Commission recognizes that alternative trading
systems will likely generate much of the information in electronic
form and generally may wish to keep records in electronic format. 17
CFR 240.17a-4(f).
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The Commission recognizes that alternative trading systems subject
to proposed Regulation ATS would be subject to the recordkeeping
requirements for broker-dealers under Rules 17a-3 and 17a-4 of the
Exchange Act,154 which may require that some of the same
records be made and kept. Proposed Regulation ATS would not require an
alternative trading system to duplicate trading records maintained in
the course of its normal recordkeeping operations, provided that the
alternative trading system could sort and retrieve system records
separately upon request. In addition, as broker-dealers are currently
permitted to do,155 proposed Regulation ATS would permit an
alternative trading system to retain a service bureau, depository, or
other recordkeeping service to maintain required records on behalf of
the alternative trading system as long as the designated party agrees
to make the records available to the Commission upon
request.156
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\154\ 17 CFR 240.17a-3 and 17 CFR 240.17a-4.
\155\ 17 CFR 240.17a-4(i).
\156\ Proposed Rule 303(d).
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The Commission believes that the records it is proposing to require
alternative trading systems to make and keep are records that
alternative trading systems would otherwise keep as part of their
business, and that therefore these proposed requirements would not
place undue burdens upon alternative trading systems.
h. Reporting and Form ATS-R. Proposed Regulation ATS would require
alternative trading systems to file with the Commission transaction
reports within 30 calendar days of the end of each calendar quarter on
Form ATS-R.157 Specifically, proposed Form ATS-R would
require alternative trading systems to report total volume in terms of
number of units traded and dollar value for the following categories of
securities: (1) Listed equity securities, (2) Nasdaq NM securities, (3)
Nasdaq SmallCap securities, (4) equity securities that are eligible for
resale pursuant to Rule 144A under the Securities Act of
1933,158 (5) penny stocks, (6) equity securities not
included in (1)-(5), (7) rights and warrants, (8) listed options, and
(9) unlisted options. In addition, alternative trading systems would
have to report the total dollar value for: (1) Corporate debt
securities, (2) government securities, (3) municipal securities, (4)
mortgage related securities, and (5) debt securities not included in
(1)-(4). The Commission is also proposing that alternative trading
systems file after-hours trading information in listed equity, Nasdaq
NM, and Nasdaq SmallCap securities, as well as listed options. This
information would permit the Commission to monitor the trading on
alternative trading systems.
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\157\ Proposed Rule 301(b)(9).
\158\ 17 CFR 230.144A. Brokers and others who use alternative
trading systems to trade Rule 144A eligible securities and other
types of restricted securities should make sure those systems are
structured to permit the traders' compliance with their obligations
under Rule 144A and under the Securities Act of 1933.
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Because this release proposes to eliminate Rule 17a-
23,159 data filed by
[[Page 23523]]
alternative trading systems on Form ATS-R would replace the information
currently filed on Form 17A-23 by broker-dealers operating trading
systems, although proposed Form ATS-R modifies what broker-dealer
trading systems are currently required to file on Part II of Form 17a-
23. By creating a template for alternative trading systems to file
periodic reporting data, the information would be filed in a more
uniform manner and would be more useful to the Commission. For example,
this information would be used by Commission staff to develop
examination modules for the inspection of alternative trading systems.
It would also be used by the Commission staff to further understand the
effect of alternative trading systems on the securities markets. In
addition, the Commission is now proposing to ask for information about
the volume of particular types of securities that are not listed on an
exchange or traded on Nasdaq. These new reporting requirements on Form
ATS-R should improve the quality of the data that the Commission
gathers. Due to the highly automated nature of alternative trading
system operations and the experiences with Rule 17a-23, the Commission
does not anticipate that gathering and submitting the data required on
Form ATS-R would be overly burdensome.
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\159\ See infra Section IV.A. Rule 17a-23 under the Exchange Act
generally requires U.S. broker-dealers that sponsor broker-dealer
trading systems to provide a description of their systems to the
Commission and report transaction volume and other information on a
quarterly basis. This rule also requires that such broker-dealers
keep records regarding system activity and to make such records
available to the Commission. 17 CFR 240.17a-23. See also Securities
Exchange Act Release No. 35124 (Dec. 20, 1994), 59 FR 66702 (Dec.
28, 1994).
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Alternative trading systems would also be required to make reports
on Form ATS-R available to surveillance personnel of any SRO of which
they are a member.160 Alternative trading systems would not
be required to routinely provide these reports to their SRO, but would
be required to make such reports available upon request of the SRO. The
Commission, however, requests comment on whether alternative trading
systems should be required routinely to provide reports made on Form
ATS-R to their SROs.
---------------------------------------------------------------------------
\160\ Proposed Rule 301(b)(2)(vii).
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The Commission solicits comment on the transaction reporting
requirements and Form ATS-R. In particular, the Commission solicits
comment on the frequency and scope of transaction reporting
requirements proposed in Regulation ATS, as well as the appropriateness
of permitting Form ATS-R to be filed electronically.
i. Procedures to ensure confidential treatment of trading
information. The proposed rules would require alternative trading
systems to have in place safeguards and procedures to protect trading
information and to separate alternative trading system functions from
other broker-dealer functions, including proprietary and customer
trading. The Commission believes that the sensitive nature of the
trading information subscribers send to alternative trading systems
requires such systems to take certain steps to ensure the
confidentiality of such information.
In inspections of some ECNs, the Commission staff found that some
of the broker-dealers operating ECNs used the same personnel to operate
the ECN as they did for more traditional broker-dealer activities, such
as handling customer orders that were received by telephone. This
situation creates the potential for misuse of the confidential trading
information in the ECN, such as customers' orders receiving
preferential treatment, or customers receiving material confidential
information about orders in the ECN. The rules the Commission is
proposing today are designed to eliminate the potential for abuse of
the confidential trading information that subscribers send to
alternative trading systems. The Commission recognizes that some
alternative trading systems combine traditional brokerage services with
their systems. The proposed rules are not intended to preclude these
services; rather, they are designed to prevent the misuse of private
customer information in the system for the benefit of other customers,
the alternative trading system operator, or its employees.
Therefore, the Commission is proposing that: (i) Information, such
as the identity of subscribers and their orders, be available only to
those employees of the alternative trading system who operate the
system or are responsible for its compliance with the proposed rules;
(2) the alternative trading system have in place procedures to ensure
that all its employees are unable to use any confidential information
for proprietary or customer trading, unless the customer agrees; and
(3) procedures exist to ensure that employees of the alternative
trading system cannot use such information for trading in their own
accounts.161
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\161\ Proposed Rule 301(b)(10).
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The Commission expects that existing alternative trading systems
will implement procedures such as these as quickly as possible, if they
do not already have them in place. These procedures should be clear and
unambiguous and presented to all employees, regardless of whether they
have direct responsibility for the operation of the alternative trading
system. Presently, many broker-dealers employ various means to ensure
that sensitive information does not flow from one division to another.
These methods include physical separation, written procedures, separate
personnel, and restricted access. The Commission believes that
firewalls such as these could be used by broker-dealers that operate
alternative trading systems to ensure that sensitive information
regarding the alternative trading system is contained in the proper
unit of the broker-dealer.
The Commission is not proposing specific procedures because it
believes that the broker-dealers who operate the alternative trading
systems are in the best position to know what procedures would best
prevent abuses. Experience has demonstrated, however, the potential for
abuse and the Commission regards these procedures as essential.
Commenters are encouraged to comment on these requirements, including
how to prevent misuse of customer confidential information while
offering brokerage services. If commenters believe specific procedures
would be more beneficial, the Commission requests that suggestions be
included with the comments.
j. Name of alternative trading systems. Under proposed Rule
301(b)(11), the Commission proposes to prohibit an alternative trading
system registered as a broker-dealer from using the term ``exchange''
in its name. The Commission believes that use of the term ``exchange''
by a system not regulated as an exchange would be deceptive and could
mislead investors that such alternative trading system is registered as
a national securities exchange. The Commission believes that the
proposed regulatory framework provides alternative trading systems with
the flexibility to position themselves as either exchanges or broker-
dealers. The Commission does not propose to dictate which form of
regulation an alternative trading systems chooses, but it is important
that the investing public not be confused about the market role such
systems have chosen to assume. Accordingly, the Commission believes
that if an alternative trading system chooses to register as a broker-
dealer under Regulation ATS, it should not use the term ``exchange'' in
its name.
The Commission requests comment on issues raised by the proposed
prohibition on alternative trading systems registered as broker-dealers
under Regulation ATS from using the
[[Page 23524]]
term ``exchange'' in their names, and whether other terms, such as
``stock market'' are similarly misleading. The Commission also requests
comment on whether it is misleading for other types of systems, such as
bulletin board systems, to use the term ``stock market'' in their name.
B. Registration as a National Securities Exchange
1. Benefits of Registration as a National Securities Exchange
Registration as a national securities exchange provides several
attractive benefits that may make this option more suitable to the
business objectives of certain alternative trading systems. The primary
advantage of exchange registration is the relative autonomy that
exchanges enjoy in their daily operation. Exchanges are SROs, and are
thus subject to surveillance and oversight only by the Commission.
Consequently, any alternative trading system that elects exchange
registration would not be subject to oversight by a competing national
securities exchange or national securities association.\162\ Similarly,
as a national securities exchange, an alternative trading system would
be able to establish its own rules of conduct, trading rules, and fee
structures for external access. An alternative trading system
registered as a broker-dealer, on the other hand, would have to comply
with the rules of the SRO to which it belongs, including any rules
regarding the automatic execution of small orders.
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\162\ Alternative trading systems that continue to be regulated
as broker-dealers would remain subject to oversight by national
securities exchanges and the NASD, in their self-regulatory
capacities. See supra Section III.A.2.a.
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In addition, systems that elect to register as exchanges may gain
added prestige and investor confidence. As a registered exchange, an
alternative trading system would be able to establish listing
standards, which could promote investor confidence in the quality of
the securities listed on the alternative trading system. In addition,
registered exchanges can become direct participants in the NMS
mechanisms, such as the ITS, Consolidated Tape Association (``CTA''),
and the Consolidated Quotation System (``CQS''). Direct participation
in these systems may provide a higher degree of transparency and
execution opportunities for alternative trading system subscribers. As
direct participants in the NMS mechanisms, registered exchanges are
also entitled to share in the profits generated by the NMS systems,
such as revenue from CTA fees. Further, only exchanges are eligible to
be participants of the Options Clearing Corporation and thereby
determine such matters as listing, registration, clearance, issuance
and exercise of options contracts.\163\
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\163\ Options Clearing Corporation By-laws, Art. VII, Sections 1
and 4. Registered exchanges that are members of the Options Clearing
Corporation are also able to use registration and disclosure
materials tailored for standardized options.
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2. Responsibilities of Registered National Securities Exchanges
A fundamental objective of the Commission's proposal is to create
regulations that are sufficiently flexible to accommodate the chosen
business objectives of the various alternative trading systems,
including those that elect to register as exchanges. Nevertheless, the
Commission views certain exchange obligations as fundamental to the
fair and efficient operation of exchanges in the marketplace and
critical for the protection of investors. Thus, the Commission proposes
to require those alternative trading systems that choose to register as
exchanges to satisfy these fundamental exchange obligations in order to
ensure that the goals of market regulation, as set forth in the
Exchange Act, are met. The Commission requests comment on whether any
exemptions from exchange regulatory provisions would be necessary or
appropriate to enable alternative trading systems to register as
exchanges.
a. Self-regulatory responsibilities. One of the central functions
performed by exchanges under the current regulatory structure is the
self-regulatory function, which includes the implementation and
enforcement of rules for trading on the exchange, and surveillance of
members' trading and sales activities. The self-regulatory role of
exchanges is vital to the effective management of the securities
industry. Therefore, as a prerequisite for the Commission's approval of
an exchange's application for registration, an exchange would have to
organize and have the capacity to carry out the purposes of the
Exchange Act. Specifically, an exchange would have to be able to
enforce compliance by its members and persons associated with its
members with the federal securities laws and the rules of the exchange.
The exchange's rules would have to be designed to prevent fraudulent
and manipulative acts and practices, to promote just and equitable
principles of trade, and to refrain from imposing any unnecessary or
inappropriate burdens on competition, among other things.\164\ In
addition, once registered, an exchange would have to submit copies of
any proposed rule changes to the Commission for approval.\165\ As part
of its compliance activities, an exchange must maintain procedures to
surveil for violations such as insider trading and manipulation on its
facilities. While an exchange is required to have adequate measures in
place, not all exchanges must use the same procedures. Their
surveillance procedures, while fundamentally similar in effect, can be
tailored to the particular requirements of each exchange and will
depend on the nature of trading that occurs and the type of securities
that are traded on the exchange.
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\164\ Section 6(b) of the Exchange Act, 15 U.S.C. 78f(b).
\165\ Section 19(b) of the Exchange Act, 15 U.S.C. 78s(b). If
Nasdaq chose to register as an exchange, the Commission notes that
any rules governing trading on Nasdaq that have been filed by the
NASD and approved by the Commission would not constitute proposed
rules changes for purposes of Section 19(b) of the Exchange Act. See
also infra. Section V (discussing a proposed temporary rule filing
exemption).
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The Commission would consider, however, measures to reduce the
surveillance burdens for exchanges. The Commission believes that some
of the self-regulatory obligations for exchanges may be contracted to
another party. 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.\166\ The
Commission has previously permitted existing SROs to contract with each
[[Page 23525]]
other to allocate non-financial regulatory responsibilities.\167\ 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 would also be applicable
to alternative trading systems that choose to register as exchanges.
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\166\ 17 CFR 240.17d-2. Securities Exchange Act Release No.
12935 (Oct. 28, 1976), 41 FR 49093 (Nov. 8, 1976). In addition to
the regulatory responsibilities it otherwise has under the Exchange
Act, the SRO to which a firm is designated under these plans assumes
regulatory responsibilities allocated to it. Under Rule 17d-2(c),
the Commission may declare any joint plan effective if, after
providing notice and opportunity for comment, it determines that the
plan is necessary or appropriate in the public interest and for the
protection of investors, to foster cooperation and coordination
among the SROs, to remove impediments to and foster the development
of a national market system and a national clearance and settlement
system, and in conformity with the factors set forth in section
17(d) of the Exchange Act. 15 U.S.C. 78q(d). The Commission has
approved plans filed by the equity exchanges and the NASD for the
allocation of regulatory responsibilities pursuant to Rule 17d-2.
See, e.g., Securities Exchange Act Release Nos. 13326 (Mar. 3,
1977), 42 FR 13878 (Mar. 14, 1977) (NYSE/Amex); 13536 (May 12,
1977), 42 FR 26264 (May 23, 1977) (NYSE/BSE); 14152 (Nov. 9, 1977),
42 FR 59339 (Nov. 16, 1977) (NYSE/CSE); 13535 (May 12, 1977), 42 FR
26269 (May 23, 1977) (NYSE/CHX); 13531 (May 12, 1977), 42 FR 26273
(May 23, 1977) (NYSE/PSE); 14093 (Oct. 25, 1977), 42 FR 57199 (Nov.
1, 1977) (NYSE/Phlx); 15191 (Sep. 26, 1978), 43 FR 46093 (Oct. 5,
1978) (NASD/BSE, CSE, CHX and PSE); and 16858 (May 30, 1980), 45 FR
37927 (June 5, 1980) (NASD/BSE, CSE, CHX and PSE).
\167\ For example, the Commission has approved a regulatory plan
filed by the Amex, CBOE, NASD, NYSE, PCX, and the Phlx that divides
the oversight responsibilities among these SROs for common members,
by designating each participating SRO as the options examination
authority for a portion of the common members. This designated SRO
has sole regulatory responsibility for certain options-related
trading matters. See Securities Exchange Act Release No. 20158
(Sept. 8, 1983), 48 FR 41265 (Sept. 14, 1983). The SRO designated
under the plan as a broker-dealer's options examination authority is
responsible for conducting options-related sales practice
examinations and investigating options-related customer complaints
and terminations for cause of associated persons. The designated SRO
is also responsible for examining a firm's compliance with the
provisions of applicable federal securities laws and the rules and
regulations thereunder, its own rules, and the rules of any SRO of
which the firm is a member. Id.
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These plans permit an SRO to allocate its oversight obligations
with respect to certain members' compliance with various requirements,
but do not permit an SRO to allocate its oversight obligations with
respect to the activities taking place on its market. The Commission
believes that the enforcement and disciplinary actions for violations
relating to transactions executed in an SRO's market or rules unique to
that SRO should continue to be retained by that SRO. 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 certain oversight
activities while retaining ultimate responsibility for ensuring that
these activities are performed. For example, 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.
In addition, existing Commission initiatives and SRO plans that
coordinate supervision of broker-dealers that are members of more than
one SRO (``common members'') would also apply to alternative trading
systems that choose to register as exchanges.\168\ 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.\169\ 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.\170\ 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.
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\168\ 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. See 17 CFR 240.17d-2; 17 CFR 240.19g2-1.
\169\ 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).
\170\ See Securities Exchange Act Release No. 23192 (May 1,
1986) 51 FR 17426 (May 12, 1986). Moreover, section 108 of NSMIA.
supra note 3, adds a provision to section 17 of the Exchange Act
that calls for improving coordination of supervision of members and
elimination of any unnecessary and burdensome duplication in the
examination process.
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b. Fair Representation. The Commission understands that certain
obligations may be inconsistent with the proprietary nature of
alternative trading systems. For example, a major obstacle to the
regulation of proprietary alternative trading systems as exchanges has
been the concern that they would be subject to certain exchange
obligations incompatible with their structures.\171\ Specifically,
section 6(b)(3) of the Exchange Act requires that exchanges have member
controlled boards of directors and assure the ``fair representation''
of their members in the selection of their boards of directors.\172\
Without some modification, the current application of these
requirements could inappropriately dictate the corporate governance
choices of alternative trading systems that register as exchanges and
could prevent them from adopting innovative means of carrying out self-
regulatory obligations. In particular, for a proprietary system, the
``fair representation'' obligations strictly applied could require the
customers of a system to govern the system. Customer control of a
commercial enterprise could change the relationship of the system to
its subscribers, could foreseeably conflict with the profit-driven
nature of the organization, and could impose a public structure on a
private enterprise. The Commission therefore proposes to allow non-
membership, for-profit alternative trading systems that choose to
register as exchanges some flexibility in satisfying the ``fair
representation'' requirement in the Exchange Act.
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\171\ See Delta Release, supra note 10, at 1900. In Board of
Trade of the City of Chicago v. Securities and Exchange Commission,
923 F.2d 1270 (7th Cir. 1991) (Delta II), the court stated that:
The Delta system cannot register as an exchange because the
statute requires that an exchange be controlled by its participants,
who in turn must be registered brokers or individuals associated
with such brokers. So all the financial institutions that trade
through the Delta system would have to register as brokers, and [the
system sponsors] would have to turn over the ownership and control
of the system to the institutions. The system would be kaput.
Id. at 1272-73.
\172\ 15 U.S.C. 78f(b)(3).
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The Commission believes that ``fair representation'' does not
necessarily require exchanges to be owned by their members. For
example, in the past, the Commission has stated that registered
clearing agencies may employ several methods to comply with the fair
representation standard.\173\ These methods include: (1) Solicitation
of board of director 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. Other structures may also provide independent, fair
representation in the material decision making processes of an exchange
that is not owned by its subscribers. 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
[[Page 23526]]
represents the exchange's participants.\174\ As another possibility,
certain directors appointed to the board to represent the interests of
trading members or participants could be limited to considering certain
topics relating to system use and rules, while consideration of
ownership issues could be restricted to board members representing the
interests of the owners or stockholders.\175\ What constitutes fair
representation for a particular exchange would be determined in the
context of that system's application for registration under Sections
6(a) and 19(a) under the Exchange Act, subject to public notice and
comment.\176\ The Commission solicits commenters' views regarding
application of the fair representation requirement to alternative
trading systems that choose to register as exchanges.
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\173\ See Securities Exchange Act Release No. 14531 (Mar. 6,
1978), 43 FR 10288 (Mar. 10, 1978). See also Securities Exchange Act
Release No. 16900 (June 17, 1980), 45 FR 41920 (June 23, 1980).
\174\ 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.
\175\ The Commission in the past has approved exchange rules
limiting the voting rights of ``special access'' or non-equity
members as consistent with section 6(b)(3) of the Exchange Act, 15
U.S.C. 78f(b)(3). See, e.g., Securities Exchange Act Release No.
22959 (Feb. 28, 1986), 51 FR 8060 (Mar. 7, 1986) (approving rule
change by NYSE establishing ``electronic access membership'' with
restricted voting rights).
\176\ 15 U.S.C. 78f(a) and 78s(a).
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c. Membership on a national securities exchange. Section 6(c)(1) of
the Exchange Act \177\ prohibits exchanges from granting new membership
to any person not registered as a broker-dealer, or associated with a
broker-dealer. In the Concept Release, however, the Commission sought
commenters' views on whether to allow institutional membership on
national securities exchanges. Most commenters opposed institutional
membership on exchanges, voicing myriad concerns. Some commenters
thought that institutional membership would be contrary to the purposes
of the Exchange Act and would create a competitive disadvantage for
registered broker-dealers. A number of commenters opposed any
arrangement that would allow a class of members or participants to be
subject to less restrictive regulations than another class. Other
commenters feared that the practical implications would overwhelm
Commission resources as the Commission tried to decide which rules
should apply to institutions and which should not. In addition, a
number of commenters feared that institutional exchange membership
would subject institutions to unwarranted oversight by exchanges and
the Commission or to duplicative or inconsistent regulations for those
institutions that are already subject to oversight by other federal
agencies.\178\ Some commenters were concerned about the ability of
exchanges or the Commission to exercise appropriate oversight over
institutions and questioned the ability of an exchange to reject the
membership or direct access of an institution with a questionable
operating history.
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\177\ 15 U.S.C. 78f(c)(1). Section 6(c)(1), adopted in 1975,
prohibits exchanges from granting new memberships to non-broker-
dealers. At the time this Section was adopted, one non-broker-dealer
maintained membership on an exchange. This non-broker-dealer was not
affected by the prohibition and continues to maintain its
membership. 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) which requires registration of broker-
dealers with the Commission or an exemption therefrom) and rules
thereunder that regulate or prohibit any practice by a broker-
dealer.
\178\ For example, institutional investors may include
commercial banks, mutual funds, insurance companies and pension
funds. These institutions may be subject to regulatory oversight by
other federal agencies, and may be regulated for purposes that
differ from the regulatory goals of the Exchange Act.
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After reviewing commenters' concerns, as well as considering the
practical effects that institutional membership or access may have on
other exchange members and on the effective oversight of exchange
trading, the Commission is not proposing to exempt national securities
exchanges from the prohibition on membership by non-broker-
dealers.\179\ Thus, just as currently registered exchanges are required
to limit membership to broker-dealers, the Commission proposes that
alternative trading systems that choose to register as exchanges be
prohibited from including non-broker-dealer participants.
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\179\ Section 6(c)(1) of the Exchange Act, 15 U.S.C. 78f(c)(1).
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The legislative history of the Exchange Act contemplates possible
direct institutional access to exchange execution facilities.\180\ In
addition, sections 15(e) and 6(f) of the Exchange Act \181\ would
permit the Commission to subject institutional members to all exchange
rules and relevant Exchange Act provisions. The Commission, however,
believes that, in order to ensure the central goals of exchange
regulation, it would have to subject institutional members or
participants to the majority of rules and regulations to which broker-
dealers are currently subject. This would undermine most benefits an
institution would receive by not having to register as a broker-dealer.
At the same time, it would impose ad-hoc regulatory burdens on the
Commission and the exchanges as they tried to impose critical rules and
regulations on institutions. Thus, the Commission does not believe that
allowing institutional membership on exchanges is currently practical
or serves the best interests of investors or the markets generally.
---------------------------------------------------------------------------
\180\ See Concept Release, supra note 2.
\181\ 15 U.S.C. 78f(f) and 78o(e).
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The Commission is also concerned about the systemic risks that
direct institutional access may pose to the national clearance and
settlement systems. If institutional investors were granted exchange
membership or direct access to exchanges, they would need to arrange
for the clearance and settlement of their trades. This would likely be
accomplished by the direct membership of such investors in one or more
of the national clearance and settlement corporations. They would also
need to demonstrate and maintain financial creditworthiness. The
Commission could, pursuant to section 15(e) of the Exchange Act,\182\
require non-broker-dealer institutions to comply with risk management
obligations, including the requirements to maintain certain minimum
levels of net capitalization and appropriate books and records.
Insufficient net capital and incomplete books and records could
compromise financial soundness, audit trails, and other general risk
management objectives that are critical to sound markets and clearance
and settlement systems. If these important risk management measures
could not be assured for institutions, the health of the markets and
the national clearance and settlement systems could be jeopardized. As
discussed above, the Commission believes that this course would
effectively require non-broker-dealer institutions to comply with the
same requirements imposed on registered broker-dealers. Without such
requirements, institutional membership on an exchange may also conflict
with an exchange's obligation to have rules that foster the efficient
clearance and settlement of securities transactions.
---------------------------------------------------------------------------
\182\ 15 U.S.C. 78o(e).
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Accordingly, the Commission continues to believe that exchange
membership should continue to be limited to registered broker-dealers
and persons associated with registered broker-dealers in accordance
with section 6(c)(1) of the Exchange Act.\183\ Institutions, however,
would continue to be able to access alternative trading systems
registered as exchanges through
[[Page 23527]]
a registered broker-dealer member of such a trading system, similar to
the way in which institutions currently have direct access to the NYSE
through SuperDOT terminals given to them by NYSE members.\184\ For
example, the OptiMark System \185\ enables institutions to directly
enter orders in the OptiMark system through an exchange member.
Similarly, Nasdaq's proposed Integrated Order Delivery and Execution
System would provide institutional access to Nasdaq through Nasdaq
primary market makers.\186\ This form of access should not impose
significant costs or burdens on institutions or on broker-dealers
providing such access. The Commission believes that this approach would
readily serve institutional investors' needs without compromising
important regulatory objectives.
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\183\ 15 U.S.C. 78f(c)(1).
\184\ Exchange members are subject to regulatory action by the
NYSE for violations of NYSE rules by their customers entering orders
through the members' SuperDOT terminals.
\185\ See infra note 255.
\186\ See supra note 106 and accompanying text.
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The Commission, however, is soliciting comment on whether
institutions should be permitted to be members of a registered
exchange.
d. Fair access. The Commission would continue to require all
national securities exchanges to ensure the fair access of registered
broker-dealers in accordance with sections 6(b)(2) \187\ and 6(c) \188\
of the Exchange Act, which prohibit discriminatory denials of access
and discriminatory treatment of members.\189\ The obligation to ensure
fair access for members does not, however, restrict the authority of a
national securities exchange or national securities association from
maintaining reasonable standards for access.\190\ The securities
industry and the general public need access to exchanges to ensure the
best execution of orders and view exchanges as venues for trading that
are open to all qualified persons. Thus, the Commission believes that
it is consistent with the objectives of the Exchange Act to prevent any
discriminatory denial of access on an alternative trading system that
elects to register as a national securities exchange.
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\187\ 15 U.S.C. 78f(b)(2).
\188\ 15 U.S.C. 78f(c).
\189\ Section 15A(b)(8) of the Exchange Act applies similar
obligations to registered national securities associations. 15
U.S.C. 78o-3(b)(8).
\190\ A denial of access would be reasonable, for example, if it
were based on objective standards, such as capital and credit
requirements, and if these standards were applied fairly.
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In a similar vein, exchanges are prohibited from adopting any anti-
competitive rules.\191\ To further emphasize the goal of vigorous
competition, Congress required the Commission to consider the
competitive effects of exchange rules,\192\ as well as the Commission's
own rules.\193\ The fair access and fair competition requirements in
the Exchange Act are intended to ensure that national securities
exchanges and national securities associations operating markets treat
investors and their participants fairly, consistent with the
expectations of the investing public. Accordingly, the Commission
proposes to require all alternative trading systems registered as
exchanges to comply with these requirements of the Exchange Act.
---------------------------------------------------------------------------
\191\ Section 6(b)(8) of the Exchange Act, 15 U.S.C. 78f(b)(8);
section 15A(b)(9) of the Exchange Act, 15 U.S.C. 78o-3(b)(9).
\192\ Section 6(b)(6) of the Exchange Act, 15 U.S.C. 78f(b)(6).
\193\ Section 23(a) of the Exchange Act, 15 U.S.C. 78w(a).
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e. Compliance with ARP Guidelines. All national securities
exchanges are expected to maintain sufficient systems capacity to
handle foreseeable trading volume. The Commission believes that
adequate capacity is vital to the efficient operation of exchanges,
particularly during periods of high volume or volatility, such as have
been experienced in the past year. To ensure adequate systems capacity,
the Commission established the automation review program.\194\ All
exchanges and the NASD currently participate in this program. Given the
highly automated nature of most alternative trading systems, the
Commission would expect any alternative trading system that registers
as an exchange to comply with the policies and procedures outlined by
the Commission in its policy statements concerning the automation
review program, including cooperation with any reviews conducted by the
Commission.
---------------------------------------------------------------------------
\194\ See supra notes 131-134 and accompanying text.
---------------------------------------------------------------------------
f. Registration of securities. Securities traded on a national
securities exchange must be registered with the Commission and approved
for listing on the exchange.\195\ In addition, national securities
exchanges are permitted to trade securities listed on other exchanges
and Nasdaq pursuant to unlisted trading privileges, or UTP.\196\
Alternative trading systems that choose to register as exchanges would
be required to have rules for trading the class or type of securities
it seeks to trade pursuant to UTP.\197\ Moreover, to trade Nasdaq NM
securities, these systems would have to become signatories to an
existing plan governing such trading.\198\ These requirements ensure
that investors have adequate information and that all relevant trading
activity in a security is reported to, and surveilled by, the exchange
on which it is listed. Alternative trading systems that choose to
register as national securities exchanges would be subject to these
requirements. Therefore such alternative trading systems could only
trade listed securities and would have to comply with Commission
regulations governing UTP. These requirements would not apply to
alternative trading systems that choose to register as broker-dealers.
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\195\ Section 12(a) of the Exchange Act makes it unlawful for
any member, broker, or dealer to effect any transaction in any
security (other than an exempted security) on a national securities
exchange unless a registration statement has been filed with the
Commission and is in effect as to such security for such exchange in
accordance with the provisions of the Exchange Act and the rules and
regulations thereunder. 15 U.S.C. 78l(a). Section 12(b) of the
Exchange Act, 15 U.S.C. 781(b), contains procedures for the
registration of securities on a national securities exchange.
Section 12(a) does not apply to exchanges that the Commission has
exempted from registration as national securities exchanges. See,
e.g., Securities Exchange Act Release No. 28899 (Feb. 20, 1991), 56
FR 8377 (Feb. 29, 1991). See also, Securities Exchange Act Release
No. 37271 (June 3, 1996), 61 FR 29145 (June 7, 1996).
\196\ Section 12(f) of the Exchange Act, 15 U.S.C. 78l(f). Under
section 12(f) of the Exchange Act, 15 U.S.C. 78l(f), exchanges
cannot trade securities not registered on an exchange or classified
as Nasdaq NM securities (such as Nasdaq SmallCap or OTC securities)
without Commission action. Section 12(f) of the Exchange Act
authorizes the Commission to permit the extension of UTP to any
security registered otherwise than on an exchange. The OTC-UTP plan
which provides UTP for Nasdaq NM securities, is the only extension
to date approved by the Commission. See OTC-UTP plan, infra note
210. Thus, registered exchanges cannot currently trade Nasdaq
SmallCap securities or exempted securities that are not separately
listed on the exchange.
\197\ Rule 12f-5 under the Exchange Act, 17 CFR 240.12f-5.
\198\ See OTC-UTP plan, infra note 210 and accompanying text.
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The Commission is not proposing that alternative trading systems
that choose to register as broker-dealers and be regulated under
Regulation ATS be limited in the types of securities they trade. The
Commission, however, solicits comment on whether securities traded on
all alternative trading systems should be registered under section 12
of the Exchange Act. Alternatively, the Commission requests comment on
whether a securities registration requirement should apply when the
trading volume on the alternative trading system, or in any particular
security traded through an alternative trading system, reaches a
specified level. If so, the Commission requests comment on what the
appropriate volume threshold should be. Because
[[Page 23528]]
some unregistered securities traded through alternative trading systems
may be foreign securities traded on foreign markets, the Commission
requests comment on whether any volume threshold should be measured
against worldwide trading volume, similar to the test for ``average
daily trading volume'' under Rule 100 of Regulation M.\199\
---------------------------------------------------------------------------
\199\ 17 CFR 242.100.
---------------------------------------------------------------------------
The Commission also requests comment on whether there are other
ways to ensure that information about unregistered securities traded on
alternative trading systems is available to investors.\200\ The
Commission requests comment on whether the proposed amendments to Rule
15c2-11 would address this concern.\201\
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\200\ The Commission notes that any market maker in a security
that posts quotations in an alternative trading system that is a
``quotation medium'' under Rule 15c2-11 of the Exchange Act, 17 CFR
240.15c2-11, currently would have to comply with Rule 15c2-11, which
requires market makers to obtain fundamental information about an
issuer prior to initiating or resuming quotes.
\201\ The Commission has requested comment in a release
proposing changes to Rule 15c2-11 under the Exchange Act on whether
the information that would be required by such amendment should
continue to apply to quotations in alternative trading systems. See
Securities Exchange Act Release No. 39670 (Feb. 17, 1998), 63 FR
9661 (Feb. 25, 1998).
---------------------------------------------------------------------------
g. NMS participation. Any alternative trading system that elects to
register as a national securities exchange would also be expected to
become a participant in the market-wide transaction and quotation
reporting plans currently operated by registered exchanges and the
NASD. These plans comprise the CQS, the CTA, the ITS,\202\ the Options
Price Reporting Authority (``OPRA''),\203\ and the Nasdaq/National
Market System/Unlisted Trading Privileges (``OTC-UTP'').\204\ These
plans link trading, quotation, and reporting for all registered
exchanges and the NASD and are responsible for the transparent,
efficient, and fair operation of the securities markets. These plans
form the backbone of the NMS and participation in these plans by all
registered exchanges is vital to the success of the NMS.
---------------------------------------------------------------------------
\202\ 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).
\203\ See infra note 210 and accompanying text for a description
of the OPRA plan.
\204\ See infra note 210 and accompanying text for a description
of the OTC-UTP plan.
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Participation in effective quote and transaction reporting plans
and procedures would, therefore, be mandatory for any newly registered
exchange, as it is now for currently registered exchanges.\205\ The CTA
and the CQS, which make quote and transaction information in exchange-
listed securities available to the public, satisfy the requirements for
effective quote and transaction reporting plans and procedures.\206\
Both of these plans have provisions governing the entry of participants
to the plans,\207\ and allow any national securities exchange or
registered national securities association to become a
participant.\208\ New participants are required to pay certain entry
fees to the existing participants.\209\ Participants in these plans
share in the income and expenses associated with the plans'
operations.\210\ While national securities exchanges are required to
participate in an effective quote and transaction reporting plan, the
specific plans are not mandated. Accordingly, if the CTA and the CQS
plans' terms are not compatible with the structure of alternative
trading systems that register as exchanges, new plans could be formed
to satisfy this requirement. Such initiatives may prove cumbersome, and
would have to satisfy the goals of consolidation of quotes and trading
information. It may ultimately be advisable for the participants of
existing plans to work with newly registered exchanges to meet any
special needs posed by the new exchanges.
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\205\ See Rules 11 Ac1-1(b)(1) and 11Aa3-2(c) under the Exchange
Act, 17 CFR 240.11Ac1-1(b)(1) and 240.11Aa3-2(c).
\206\ Both the CTA and the CQS are presently operated by the
eight national securities exchanges and the NASD.
\207\ The CTA plan also contains a provision for entities other
than participants to report directly to the CTA as ``other reporting
parties.'' Pursuant to this provision, parties other than a national
securities exchange or association may be permitted to provide
transaction data directly to the CTA. Alternative trading systems
that do not elect to register as exchanges would be eligible for
participation in the CTA plan pursuant to this provision; however,
as non-member participants, these systems would neither be obligated
to pay the required fees and expenses to the plan, nor able to share
in the plan's profits.
\208\ See Securities Exchange Act Release No. 37191 (May 9,
1996), 61 FR 24842 (May 16, 1996).
\209\ These fees represent the ``tangible and intangible
assets'' provided by the plans to the new participant. See infra
notes 342-343 (discussing entry fees for the CTA, CQS, and ITS
plans).
\210\ Similar to the CTA and CQS plans, the OTC-UTP plan
governing trading of Nasdaq NM securities, provides for the
collection, consolidation, and dissemination of quotation and
transaction information for Nasdaq NM securities by its
participants. Any national securities exchange where Nasdaq NM
securities are traded may become a full participant of the OTC-UTP
plan. The plan also provides that new participants pay a share of
development costs, share ongoing operating costs, and are entitled
to share in the plans' profits. See Joint Self-Regulatory
Organization Plan Governing the Collection, Consolidation and
Dissemination of Quotation and Transaction Information for Exchange-
listed Nasdaq/National Market System Securities and for Nasdaq/
National Market System Securities Traded on Exchanges on an Unlisted
Trading Privilege Basis (``OTC-UTP plan''). Securities Exchange Act
Release No. 24407 (Apr. 29, 1987), 52 FR 17349 (May 7, 1987). See
also Securities Exchange Act Release No. 36985 (Mar. 18, 1996), 61
FR 12122 (Mar. 25, 1996).
The OPRA plan also provides for the collection and dissemination
of last sale and quotation information with respect to options that
are traded on the participant exchanges. Under the terms of this
plan, any national securities exchange whose rules governing the
trading of standardized options have been approved by the Commission
may become a party to the OPRA plan. The plan provides that any new
party, as a condition of becoming a party, must pay a share of
OPRA's start-up costs. It also provides for revenue sharing among
all parties. The OPRA plan was approved pursuant to section 11A of
the Exchange Act and Rule 11a3-2 thereunder. See Securities Exchange
Act Release No. 17638 (Mar. 18, 1981) (``OPRA plan'').
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In addition to requiring participation by newly registered
exchanges in some or all of the effective quote and transaction
reporting plans described above, the Commission would expect newly
registered exchanges to participate in ITS,\211\ or an equivalent
system if one were developed. ITS provides trading links between market
centers and enables a broker or dealer who participates in one market
to execute orders, as principal or agent, in an ITS security at another
market center, through the system.\212\ 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 participant market
(``trade-throughs'').\213\ Participation in the ITS
[[Page 23529]]
would give users of these new exchanges access to other ITS participant
markets. Moreover, participation in ITS would require new exchanges to
comply with other applicable ITS rules and policies on matters such as,
for example, trade-throughs, locked markets,\214\ and block
trades.\215\ As with the quote and transaction reporting plans,
alternative trading systems that register as exchanges would have to be
integrated into ITS, or another system that links markets for trading
purposes would have to be created to accomplish full integration of the
newly registered exchanges into the NMS. In either case, the linkage
system would need to accommodate certain practices important to
alternative trading system users that may be incompatible with current
ITS requirements.
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\211\ 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 202, at
section 3(c).
\212\ 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.
\213\ A trade-through occurs when an ITS participant purchases
securities at a lower price or sells at a higher price than that
available in another ITS participant market. For example, if the
NYSE is displaying a bid of 20 and an offer of 20\1/8\ for an ITS
security, the prohibition on trade-throughs would prohibit another
ITS participant market from buying that security from a customer at
19\7/8\ or selling that security to a customer at 20\1/2\. In
addition, each participant market has in place rules to implement
the ITS Trade-Through Rule. See, e.g., NASD Rule 5262. The plan also
provides a mechanism for satisfying a market aggrieved by another
market's trade-through.
\214\ 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.
\215\ The ITS block trade policy provides that the member who
represents a block size order shall, at the time of execution of the
block trade, send or cause to be sent, through ITS to each
participating ITS market center displaying a bid (or offer) superior
to the execution price a commitment to trade at the execution price
and for the number of shares displayed with that market center's
better priced bid (or offer).
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The Commission solicits comment on issues raised by integration of
new exchanges in ITS. It also requests comment on what changes would be
necessary to NMS mechanisms to accommodate the registration of
alternative trading systems as exchanges and what steps would need to
be taken to integrate alternative trading systems registered as
exchanges into the NMS mechanisms.
h. Uniform trading standards. In addition to participation in NMS
mechanisms, alternative trading systems that register as exchanges
would be required to comply with any Commission-instituted trading halt
relating to securities traded on or through its facilities.\216\ Newly
registered exchanges would be required in some instances to adopt
trading halt rules to comply with certain Commission rules.\217\ Newly
registered exchanges would also have the authority and be expected to
impose trading halts for individual securities, for classes of
securities, and for their system as a whole under the appropriate
circumstances.\218\ The Commission does not believe that this
requirement would present any undue burden for alternative trading
systems that elect to register as national securities exchanges because
most alternative trading systems are already subject to the imposition
of trading halts as members of the NASD.
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\216\ The Commission may suspend trading in any security for up
to 10 days, and all trading on any national securities exchange or
otherwise, for up to 90 days pursuant to sections 12(k)(1)(A) and
(B) of the Exchange Act. 15 U.S.C. 781(k)(1)(A) and (B).
\217\ For example, a newly registered exchange would be required
under Rule 11Ac1-1 under the Exchange Act, 17 CFR 240.11Ac1-1, to
halt trading when neither quotation nor transaction information can
be disseminated.
\218\ The Commission has found that trading halt rules
instituted by a national securities exchange or a national
securities association are consistent with the objectives of section
6(b)(5) of the Exchange Act. 15 U.S.C. 78f(b)(5). See, e.g.,
Securities Exchange Act Release Nos. 39582 (Jan. 26, 1998), 63 FR
5408 (Feb. 2, 1998); 26198 (Oct. 19, 1988), 53 FR 41637 (Oct. 24,
1988). See, e.g., Amex Rule 117, NASD Rule 4120(a)(3), and NYSE
Rules 80B and 717. There is no requirement that exchanges or
associations of securities dealers employ identical trading halt
rules, and these rules may vary according to the needs of the
individual market.
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In addition, to promote the orderly operation of the securities
markets in accordance with Section 6 of the Exchange Act,\219\ the
Commission would expect all newly registered national securities
exchanges to implement circuit breaker rules to temporarily halt
trading during periods of extraordinary market volatility or unusual
market declines. Circuit breakers have been adopted to help stabilize
the markets and allow the realignment of order imbalances due to such
extreme volatility and believes that for circuit breakers to be
effective, all markets must impose corresponding circuit breakers.\220\
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\219\ 15 U.S.C. 78f.
\220\ If circuit breakers are imposed in one market, but not in
another, overall market disruptions caused by trading imbalances can
migrate from one market to the next, and efforts to stabilize such
imbalances during periods of heavy trading and extreme volatility
would be subverted. See also Securities Exchange Act Release No.
39846 (Apr. 9, 1998) (approving proposed changes to SRO rules
regarding circuit breakers).
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3. Application for Registration as an Exchange
Rules 6a-1, 6a-2, and 6a-3 under the Exchange Act \221\ set forth
the application process for registration as a national securities
exchange, for seeking an exemption from the Commission based on limited
volume, and the ongoing filing requirements for registered or exempted
exchanges. The Commission is proposing to revise these rules to clarify
the requirements for registration as an exchange and to accommodate the
registration as exchanges of automated and proprietary trading systems.
The Commission is also proposing to revise Form 1, the application used
by exchanges to register or to apply for an exemption based on limited
volume, and to repeal Form 1-A.\222\
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\221\ 17 CFR 240.6a-1, 240.6a-2, and 240.6a-3.
\222\ 17 CFR 249.1; 17 CFR 249.1a.
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a. Revisions to Form 1. Form 1 would be revised by reorganizing and
redesignating the Statement and the Exhibits. In addition, because the
Commission expects applicants using Form 1 to be fully or partially
automated, the Commission is proposing to revise some of the
information requested in Form 1 so that it is more applicable to
automated exchanges. In particular, the Commission is proposing to add
two new exhibits asking an exchange to describe the way any of its
electronic trading system operates, and the criteria used by the
exchange in admitting members.\223\ The information requested on Form 1
would also be updated to reflect new forms of exchange organization,
including the possibility that an exchange is owned by shareholders,
rather than members. Further, if an exchange is not owned by its
members, those trading on the exchange would be considered participants
or subscribers, rather than members. The Commission is proposing to
amend Form 1 to reflect this possibility. Finally, the Commission is
proposing that exchanges use Form 1, rather than Form 1-A, to file
amendments. Therefore, the Commission is proposing to repeal Form 1-A.
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\223\ New Exhibit E would require an exchange to describe, among
other things, the means of access to the electronic trading system,
the procedures governing display of quotes and/or orders, execution,
reporting, clearance, and settlement. New Exhibit L would require an
exchange to describe its criteria for membership, conditions under
which members may be subject to suspension or termination, and
procedures that would be involved in such suspension or termination.
Proposed Amended Form 1.
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b. Amendments to Rules 6a-1, 6a-2, and 6a-3 under the Exchange Act.
The proposed amendments to Rules 6a-1, 6a-2, and 6a-3 under the
Exchange Act are designed to reduce some of the filing burdens for
exchanges and to allow exchanges to comply with the filing requirements
by posting information on an Internet web page.
[[Page 23530]]
(i) Application for Registration as an Exchange or Exemption Based on
Limited Volume of Transactions
Rule 6a-1 generally requires an applicant for registration as an
exchange, or for exemption from registration, to file an application
with the Commission on Form 1 together with accompanying exhibits.\224\
Currently, the only exemption from registration available to an
exchange is under section 5 of the Exchange Act, which permits the
Commission to grant an exemption ``by reason of the limited volume of
transactions effected on such exchange.'' \225\ Because proposed
Regulation ATS would provide another exemption from exchange
registration, under which exchanges would not use Form 1, the
Commission is proposing to amend Rule 6a-1 to clarify that Form 1
should only be used by an exchange to apply for registration or for an
exemption from registration under section 5 of the Exchange Act based
on such exchange's limited volume of transactions.\226\
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\224\ Rule 6a-1(a) under the Exchange Act, 17 CFR 240.6a-1(a).
Rule 6a-1 also requires an exchange, promptly after discovering that
any information in its statement or any exhibit or amendment thereto
was inaccurate when filed, to file with the Commission an amendment
correcting such inaccuracy. 17 CFR 240.6a-1.
\225\ Section 5 of the Exchange Act, 15 U.S.C. 78e.
\226\ Proposed Rule 6a-1(a).
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(ii) Periodic Amendments.
Once registered, or exempted from registration based on its limited
volume of transactions, current Rule 6a-3 requires an exchange to file
with the Commission written notice of actions that render inaccurate
certain information filed in its application.\227\ This notice must be
filed within 10 days after such action is taken. The Commission is
proposing to relieve exchanges from some of these requirements. Under
the proposed amendments, an exchange would no longer have to file
notices within 10 days of changes to: (1) Its constitution, articles of
incorporation or association, or by-laws; (2) written rulings or
settled practices of any governing board or committee of the exchange
that have the effect of rules or interpretations; and (3) the schedule
of securities listed on the exchange. These types of changes are
required to be filed with the Commission under section 19(b) of the
Exchange Act and must be approved by the Commission.\228\ In addition,
rather than exchanges filing these changes in the form of a notice, as
is currently required under paragraph (a) of Rule 6a-3, the Commission
is proposing a technical change that would require changes to be filed
in the form of an amendment on Form 1.\229\
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\227\ Rule 6a-3(a) under the Exchange Act, 17 CFR 240.6a-3(a).
An exchange need not file notices within 10 days of any changes to
Exhibits E, F, L, and M of Form 1 concerning the exchange's, and its
affiliates' and subsidiaries', financial statements, the securities
admitted to unlisted trading privileges on the exchange, and the
unregistered securities trading on the exchange. Id.
\228\ Section 19(b) of the Exchange Act, 15 U.S.C. 78s(b).
\229\ Proposed Amended Rule 6a-2(a).
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In addition, Rule 6a-2 currently requires each registered or
exempted exchange to file an annual amendment on Form 1-A.\230\ This
annual amendment must include: (1) Any changes since the last annual
amendment to the basic information about an exchange filed in the
Statement to Form 1;\231\ (2) consolidated financial statements of the
exchange and unconsolidated financial statements for the exchange and
each affiliate and subsidiary of the exchange; \232\ (3) information
about the exchange's affiliates and subsidiaries, including the
officers, governors, or members of standing committees of the
affiliates, and its subsidiaries; \233\ (4) a list of the officers,
governors, or members of standing committees of the exchange; (5) a
list of all member organizations of the exchange; \234\ and (6)
schedules of all securities admitted to unlisted trading privileges,
and of all unregistered securities trading, on the exchange.\235\ The
Commission is proposing to eliminate the requirement to file an annual
amendment to reflect changes in the information currently filed on the
Statement to Form 1. As discussed above, the Commission is proposing
that most of this information be filed on the Execution Page of Revised
Form 1. Changes to this information would continue to be required to be
filed with the Commission within 10 days. The Commission, however, no
longer believes it is necessary to also receive an annual amendment
summarizing all changes in the past year. The Commission is proposing
to eliminate the requirement that information about the exchange's
affiliates and subsidiaries filed on Exhibit C to Revised Form 1, and
the information about an exchange's officers, governors, or members of
standing committees filed on Exhibit J to Revised Form 1, be included
as part of an annual amendment. Because exchanges are required to
notify the Commission of changes to this information within 10 days,
the Commission believes it would be adequate if exchanges file complete
Exhibits C and J only every three years.\236\
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\230\ Rules 6a-2(a) under the Exchange Act, 17 CFR 240.6A-2(a)
\231\ Rule 6a-2(a)(1) under the Exchange Act, 17 CFR 240.6a-
2(a)(1).
\232\ Rule 6a-2(a)(2) under the Exchange Act, 17 CFR 240.6a-
2(a)(2); Form 1, Exhibits E and F, 17 CFR 249.1.
\233\ Rule 6a-2(a)(3) under the Exchange Act 17 CFR 240.6a-
2(a)(3); Form 1, Exhibits G and H, 17 CFR 249.1.
\234\ Rule 6a-2(a)(3) under the Exchange Act, 17 CFR 240.6a-
2(a)(3); Form 1, Exhibit J, 17 CFR 249.1.
\235\ Rule 6a-2(a)(3) under the Exchange Act, 17 CFR 240.6a-
2(a)(3); Form 1, Exhibits L and M, 17 CFR 249.1.
\236\ Amended Rule 6a-2(c) under the Exchange Act.
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Finally, the Commission is proposing to reduce the filing burdens
on national securities exchanges and exchanges exempt from registration
by reason of the limited volume of transactions by allowing such
exchanges to comply with certain filing requirements by maintaining the
information on an Internet web page and providing the location of such
web site to the Commission.\237\ The proposed amendments would permit
national securities exchanges to also post certain information on an
Internet web site and submit that location to the Commission in lieu of
filing the information in hard copy.\238\
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\237\ Amended Rule 6a-2(d)(3) under the Exchange Act. Currently,
in lieu of filing certain information in paper with the Commission,
an exchange is permitted to refer to materials published by, or in
cooperation with, the exchange that contain the required information
or to make the information available upon request at its office,
instead of filing that information in paper. Rules 6a-2(a)(3) and
6a-2(b) under the Exchange Act, 17 CFR 240.6a-2(a)(3) and 6a-2(b).
These alternatives would continue to be available to exchanges.
Proposed Amended Rule 6a-2(d)(1)-(2).
\238\ Proposed Amended Rule 6a-2(d)(3) under the Exchange Act.
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(iii) Supplemental Material
Paragraph (b) of Rule 6a-3 currently requires registered exchanges,
or exchanges exempt from registration based on their limited volume of
transactions, to furnish to the Commission copies of all materials
issued or made available to members.\239\ The proposed changes would
continue to require exchanges to provide the Commission with such
materials, but as an alternative to filing such information on paper,
the Commission is proposing that exchanges be permitted to make the
information available on an Internet web site and provide the
Commission with the location of the web site.\240\
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\239\ 17 CFR 240.6a-3.
\240\ Proposed Amended Rule 6a-3(a) under the Exchange Act.
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The Commission is not proposing to change the requirement in
paragraph (c) of Rule 6a-3 that registered exchanges file transaction
reports within fifteen days after the end of each calendar
[[Page 23531]]
month containing information regarding the volume of stocks, bonds,
rights, and warrants sold on the exchange.\241\ The Commission,
however, solicits comment on whether to permit such information to be
filed electronically with the Commission and whether changing the
monthly filing requirement to a quarterly filing requirement would
appropriately reduce burdens on registered exchanges.
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\241\17 CFR 240.6a-3(c).
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IV. Broker-Dealer Recordkeeping and Reporting Obligations
A. Elimination of Rule 17a-23
Under the proposals in the release, the most significant
alternative trading systems would be required to register as exchanges
or register as broker-dealers and comply with the requirements under
proposed Regulation ATS. These systems are currently subject to
recordkeeping and reporting requirements under Rule 17a-23 under the
Exchange Act.\242\ These alternative trading systems would be subject
to recordkeeping and reporting requirements relating to their
operations, either as registered exchanges or as broker-dealers under
proposed Regulation ATS. The Commission is therefore proposing to
eliminate duplicative recordkeeping and reporting obligations for these
systems by repealing Rule 17a-23 and moving its recordkeeping
requirements (as they apply to broker-dealers that are not also
alternative trading systems) to the broker-dealer recordkeeping rules.
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\242\ 17 CFR 240.17a-23.
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B. Amendments to Rules 17a-3 and 17a-4
Certain trading systems that are operated by broker-dealers would
not be affected by today's proposals, and therefore would not be
required to register as exchanges or comply with Regulation ATS. This
residual group of internal broker-dealer systems \243\ would continue
to be regulated under the traditional broker-dealer regulatory scheme.
The Commission is proposing to amend Rules 17a-3 and 17a-4 under the
Exchange Act \244\ to require broker-dealers to make and keep records
regarding the activities of internal broker-dealer systems for non-
alternative trading systems. These proposed recordkeeping requirements
are similar to the recordkeeping requirements under current Rule 17a-
23. The Commission believes that these recordkeeping requirements
continue to be valuable for the oversight and inspections of internal
broker-dealer systems by the Commission and by the SROs.
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\243\ The term ``international broker-dealer system'' would be
defined as ``any facility, other than a national securities
exchange, an exchange exempt from registration based on limited
volume, or an alternative trading system as defined in Regulation
ATS * * * that provides a mechanism, automated in full or in part,
for collecting, receiving, disseminating, or displaying system
orders and facilitating agreement to the basic terms of a purchase
or sale of a security between a customer and the sponsor, or between
two customers of the sponsor, through use of the internal broker-
dealer system or through the broker or dealer sponsor of such
system.'' Proposed Rule 17a-3(16)(ii)(A) under the Exchange Act.
\244\ 17 CFR 240.17a-3 and 240.1-7a-4.
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These amendments would require broker-dealers to keep records of
any of its customers that have access to its internal broker-dealer
system, as well as any affiliations between those customers and the
broker-dealer. Broker-dealers would also be required to keep daily
trading summaries, including information on the types of securities for
which transactions have been executed through the internal broker-
dealer system, and transaction volume information.\245\
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\245\ Proposed Rules 17a-3(16)(i)(B) and (C) under the Exchange
Act.
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To clarify the application of Rule 17a-3, the Commission also is
proposing to add definitions, for the purposes of the rule, for the
terms ``internal broker-dealer system,'' \246\ ``sponsor,'' \247\ and
``system order.'' \248\
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\246\ See supra note 243.
\247\ The term ``sponsor'' would be defined as ``any broker or
dealer that organizes, operates, administers, or otherwise directly
controls an internal broker-dealer system or, if the operator of the
internal broker-dealer system is not a registered broker or dealer,
any broker or dealer that, pursuant to contract, affiliation, or
other agreement with the system operator, is involved materially on
a regular basis with executing transactions in connection with use
of the internal broker-dealer system, other than solely for its own
account or as a customer with access to the internal broker-dealer
system.'' Proposed Rule 17a-3(16)(ii)(B).
\248\ The term ``system order'' would be defined as ``any order
or other communication or indication submitted by any customer with
access to the internal broker-dealer system for entry into a trading
system announcing an interest in purchasing or selling a security,''
but will specifically exclude ``inquiries or indications of interest
that are not entered into the internal broker-dealer system.''
Proposed Rule 17a-3(16)(ii)(C).
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The Commission is also proposing to amend Rule 17a-4 under the
Exchange Act to require that the records that would be required under
the amendments to Rule 17a-3 be preserved for three years, the first
two years in an accessible place.\249\ The proposed amendment would
also require the preservation of all notices regarding an internal
broker-dealer system provided to its participants, whether communicated
in writing, through the internal broker-dealer system, or by other
automated means. Such notices include notices concerning the internal
broker-dealer system's hours of operations, malfunctions, procedural
changes, maintenance of hardware and software, and instructions for
accessing the system.
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\249\ Proposed Rules 17a-4(b)(1) and (10) under the Exchange
Act.
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V. Temporary Exemption of Pilot Trading System Rule Filings
A. Introduction
In contrast to registered exchanges, alternative trading systems
are not required to submit rule filings for Commission approval. This
difference creates a disadvantage for registered exchanges competing
with alternative trading systems. In the Concept Release, the
Commission generally sought comment on ways to expedite the rule filing
process and specifically sought comment on whether the Commission
should exempt new SRO trading systems or mechanisms from rule filing
requirements.\250\ Several commenters pointed out that under the
current regulatory structure, registered exchanges and alternative
trading systems compete on a ``playing field that is far from level,''
\251\ and attributed it, in part, to exchanges' inability to implement
new trading systems before submitting a rule filing and receiving
Commission approval.\252\ In response to these concerns and to make
existing markets more competitive, the Commission is proposing a
temporary exemption for SROs that would defer the rule filing
requirements of section 19(b) under the Exchange Act \253\ for pilot
trading systems (``pilot trading system rule'').\254\ In formulating
the pilot trading system rule, the Commission draws on its experience
in the past several years with SROs'
[[Page 23532]]
attempts to operate new pilot trading systems for their members.\255\
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\250\ See Concept Release, supra note 2, 62 FR at 30518-19.
\251\ The Pacific Exchange stated that the ``restrictions,
procedural requirements or pricing restraints to which the exchange
is subject[,] * * * [t]he relative burdens and benefits, obligations
and opportunities, administrative requirements and entrepreneurial
incentives imposed on or available to the traditional exchange
versus the [alternative trading systems] are seriously skewed.'' PCK
Letter at 11. See also CSE Letter at 3; SIA Letter (10/3/97) at 9;
OptiMark Letter at 8.
\252\ See CSE Letter at 3; SIA Letter (10/3/97) at 9; OptiMark
Letter at 8.
\253\ 15 U.S.C. 78s(b).
\254\ Today, the Commission is also proposing to relieve SROs of
the requirement to file rule changes with the Commission when an SRO
wishes to list or trade new derivative securities products. Under
this proposal, the SRO would have to have trading rules, procedures,
and listing standards for the product class in which the new
derivative securities product is included, and have surveillance
procedures for this product class. Securities Exchange Act Release
No. 39885, Apr. 20, 1998.
\255\ For example, in November 1990, the NYSE submitted a rule
filing proposing an after-hours crossing system to automate the
execution of single stock orders and baskets of securities and
received Commission approval in May 1991. See Securities Act Release
Nos. 29237 (May 24, 1991), 56 FR 24853 (May 31, 1991); 32368 (May
25, 1993), 58 FR 31565 (June 3, 1993). In August 1993, the CHX
submitted a rule filing to operate the Chicago Match system, an
electronic matching system that crossed orders entered by the CHX's
members and non-members including institutional customers, and
obtained Commission approval in November 1994. See Securities
Exchange Act Release No. 35030 (Nov. 30, 1994), 59 FR 63141 (Dec. 7,
1994). More recently, in May 1997, the PCX submitted a rule filing
for approval of the OptiMark System and received Commission approval
in September 1997. See Securities Exchange Act Release No. 39086
(Sept. 17, 1997), 62 FR 50036 (Sept. 24, 1997).
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Currently, SROs are required to submit a rule filing to the
Commission and undergo a public notice, comment, and approval process,
before they operate a new pilot trading system.\256\ The proposed pilot
trading system rule would permit SROs that develop ``pilot trading
systems,'' \257\ to begin operation shortly after submitting new Form
PILOT to the Commission. During the operation of the pilot trading
system, the sponsoring SRO would have to submit to the Commission
quarterly reports, as well as amendments to Form PILOT concerning
material changes to the pilot trading system. Before two years have
expired, the SRO must submit a rule filing to obtain from the
Commission permanent approval of the pilot trading system or cease
operation of the trading system.\258\
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\256\ Section 19(b)(1) of the Exchange Act, 15 U.S.C. 78s(b)(1),
requires an SRO to file with the Commission any proposed rule or any
proposed rule change (``proposed rule change'') accompanied by a
concise general statement of the basis and purpose of the proposal.
Once a proposed rule change has been filed, the Commission is
required to publish notice of it and provide an opportunity for
public comment. The proposed rule change may not take effect unless
it is approved by the Commission or is otherwise permitted to become
effective under section 19(b) of the Exchange Act. Section 19(b)(2)
of the Exchange Act, 15 U.S.C. 78s(b)(2), sets forth the standards
and time periods for Commission action either to approve a proposed
rule change or to institute and conclude a proceeding to determine
whether a proposed rule change should be disapproved. The Commission
may also approve a proposed rule change on an accelerated basis if
the Commission finds good cause for so doing and publishes its
reasons for so finding. Section 19(b)(2)(B) of the Exchange Act, 15
U.S.C. 78s(b)(2)(B).
\257\ See Proposed Rule 19b-5(a) for the proposed definition of
``pilot trading system.''
\258\ A pilot trading system that exceeds certain volume limits
would have to file for permanent approval before the two-year period
expires. Proposed Rule 19b-5(d) and (e). See also infra Section V.B.
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The Commission believes its proposed pilot trading system rule
would address many of the concerns raised by commenters.\259\ One of
the consequences of SROs filing rule changes before implementation is
that the rule filing process informs SROs' competitors about the
proposed pilot trading system and provides an avenue for those
competitors to copy, delay, or obstruct implementation of a pilot
trading system before it can be tested in the marketplace.\260\
According to one commenter, the rule filing process hinders innovation
because registered exchanges do not realize the full competitive
benefits of their efforts.\261\
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\259\ Several commenters specifically supported the Commission's
suggestion that SROs be relieved of the rule filing requirement, in
some way, when operating a pilot trading system. See Peake Letter
(7/14/97) at 27-28; Jamieson Letter at 20; CSE Letter at 1-3
(stating expedited treatment of proposed pilot trading system rules
would have the added benefit of reducing the costs of uncertainty
and easing regulatory burdens on exchanges and the Commission);
Weaver Letter at 18; Letter from Leopold Korins, Chairman and Chief
Executive Officer, Philadelphia Stock Exchange, to Jonathan G. Katz,
Secretary, SEC, dated Oct. 8, 1997 (``Phlx Letter'') at 5-6; PCX
Letter at 37-38 (suggesting minimum requirements for pilot trading
systems); SIA Letter (10/3/97) at 9; ABA Letter at 33.
\260\ See Letter from James F. Duffy, Executive Vice President &
General Counsel Legal & Regulatory Policy, American Stock Exchange,
to Jonathan G. Katz, Secretary, SEC, dated Nov. 12, 1997 (``Amex
Letter'') at 5-6; CSE Letter at 3; SIA Letter (10/3/97) at 9.
\261\ Amex Letter at 5.
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Inherent in the rule filing process is public disclosure of the
SROs' business plans for trading systems prior to their operation. This
gives SROs' competitors access to their plans for proposed trading
systems. In contrast, alternative trading systems that offer similarly
innovative, start-up services do not have the same rule filing
obligations and, thus, have a significant advantage in their
flexibility to devise, implement, and modify new pilot trading systems.
The proposed pilot trading system rule is designed to allow SROs to
better compete with alternative trading systems, while continuing to
ensure that investors are protected and the pilot trading system is
operated in a manner consistent with the Exchange Act.
The Commission recognizes that domestic markets must compete with
less regulated foreign markets and broker-dealers and that such
competition spurs innovation and benefits the marketplace. The
Commission agrees with commenters that excessive regulation of
traditional exchanges, alternative trading systems, or other markets
hinders these markets' ability to compete and survive in the global
arena. The proposed pilot trading system rule responds to SROs' need
for a more balanced competitive playing field.
B. Proposed Rule 19b-5
Proposed Rule 19b-5 would provide a temporary exemption for SRO
proposed rule changes concerning the operation of pilot trading systems
to defer the rule filing requirements of Section 19(b) of the Exchange
Act.
1. Proposed Definition of a Pilot Trading System
Under paragraph (a) of proposed Rule 19b-5, a trading system
operated by an SRO would be a ``pilot trading system'' if it met one of
the definitions. First, a trading system would be a ``pilot trading
system'' if the SRO operated it for less than two years, and during at
least two of the last four consecutive calendar months, it traded no
more than one percent of the U.S. average daily share trading volume of
each security traded on the trading system. In addition, the trading
system could not have an aggregate share trading volume of more than
twenty percent of the average daily share trading volume of all trading
systems operated by the SRO.\262\ Second, a trading system operated by
an SRO for less than two years would also be considered a ``pilot
trading system'' if, during at least two of the last four consecutive
calendar months it traded no more than five percent of the U.S. average
daily share trading volume of each security traded on the trading
system, and were independent of any other trading system operated by
the same SRO. In addition, under this second definition, the trading
system would have to have aggregate share trading no more than twenty
percent of the average daily share trading volume of all trading
systems operated by the SRO.\263\
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\262\ Proposed Rule 19b-5(a)(2).
\263\ Proposed Rule 19b-5(a)(1).
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The Commission would consider a trading system to be
``independent'' if it satisfies one of the following criteria. First, a
pilot trading system would be deemed independent if it trades
securities different from securities traded on any trading system
operated by the same SRO that has been approved by the Commission.
Second, a pilot trading system would be deemed independent if it does
not operate during the same trading hours as any other trading system
operated by the same SRO that has been approved by the Commission.
Finally, a pilot trading system would be deemed independent provided no
specialist or market maker on any other trading system operated by the
same SRO trades on the pilot trading system securities in which they
are a market maker or specialist.\264\
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\264\ Proposed Rule 19b-5(b).
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[[Page 23533]]
If a trading system exceeds the volume thresholds set forth in
paragraphs (a)(1) or (a)(2) of proposed Rule 19b-5, it would be allowed
to continue to operate for 60 more days under this exemption.\265\
During this 60 day period, the Commission expects that an SRO would
file for permanent approval of the trading system. The Commission
requests comment on its proposed definition of a pilot trading system.
Specifically, the Commission would like comment on whether the proposed
two-year time period, trading volume limits, and independence criteria
are too broad or too narrow. Commenters are asked to provide specific
reasons for any concerns about the proposed definition and to suggest
alternatives.
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\265\ Proposed Rule 19b-5(a)(3). See also infra Section V.C.
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2. SROs' Continuing Obligations Regarding Pilot Trading Systems
Based upon the Commission's experience with reviewing new pilot
trading system proposals submitted by SROs, the Commission believes
that to be consistent with the Exchange Act, SROs operating pilot
trading systems should satisfy the requirements discussed below. An
SRO's failure to comply with these conditions would compromise its
ability to rely on the proposed pilot trading system rule. The
Commission seeks comment on whether there are any additional conditions
with which SROs should be required to comply in order to be temporarily
exempt from the rule filing requirements. The Commission also requests
comment on whether any of the conditions described below are
unnecessary.
a. Notice and filings to the Commission. Under proposed Rule 19b-5,
SROs would be required to provide written notice, and information about
the operation of a pilot trading system, to the Commission on new Form
PILOT. The SRO could commence operation of the pilot trading system 20
days after this filing is complete.\266\ If the SRO materially changes
its proposed pilot trading system prior to commencing operation, the
SRO would be required to file an amendment to Form PILOT and wait 20
days before commencing operation. This 20-day delayed operational date,
triggered by the filing date, provides the Commission time to review
Form PILOT for compliance by the SRO with the pilot trading system
rule. The Commission believes, for example, that an SRO proposing to
operate a pilot trading system that provides trading privileges, such
as priority of execution, preferential fees or access to trade
information to SRO members and not to non-member subscribers, would not
be in the public interest nor consistent with the protection of
investors. Such proposed rule changes for trading systems, therefore,
would not be exempt from section 19(b) of the Exchange Act.\267\ The
Commission could also determine, after notice to the SRO and
opportunity for the SRO to respond, that the operation of a particular
pilot trading system would not be necessary or appropriate in the
public interest or consistent with the protection of investors without
the SRO filing proposed rule changes under section 19(b) of the
Exchange Act.
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\266\ Although the Commission would continue to accept paper
versions of these documents, the Commission encourages SROs to
submit filings on computer diskette in an appropriate word
processing format.
\267\ Proposed Rule 19b-5(f).
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Proposed Form PILOT would require an SRO to provide, as part of the
initial operation report, general information about the pilot trading
system, including: (1) The date the SRO expects to commence operation
of the pilot trading system; (2) a list of securities to be traded; (3)
a list of anticipated subscribers to the pilot trading system; and (4)
the names of entities assisting in the operation of the pilot trading
system. An SRO would also have to file an amendment to Form PILOT at
least 20 days before it implements any material change to the operation
of the pilot trading system. The Commission would consider a material
change to the pilot trading system to include the addition of new types
of securities, or a new date for commencing operation of the pilot
trading system.
In addition, an SRO would be required to submit a quarterly report
on Form PILOT. The quarterly report would include information about the
trading volume effected on the pilot trading system during the most
recent calendar quarter. Under paragraph (c)(10) of proposed Rule 19b-
5, information reported by an SRO on Form PILOT would be deemed
confidential.\268\ The Commission seeks comment on whether the
Commission should deem all information filed on Form PILOT to be
confidential. The Commission requests comment on whether additional
information should be requested on Form PILOT. The Commission seeks
comment on whether an alternative treatment of information filed on
Form PILOT, for example, that information on Form PILOT is publicly
available unless an SRO specifically requests confidential treatment,
would better protect investors.
---------------------------------------------------------------------------
\268\ Proposed Rule 19b-5(c)(10).
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b. Trading rules and procedures. The SRO would have to adopt and
implement trading rules and procedures necessary to operate the pilot
trading system in a manner consistent with the Exchange Act. For
example, the SRO would have to have appropriate trading rules and
procedures to promote the fair and orderly trading of securities on the
pilot trading system, including: (1) Position limits and margin
requirements; (2) listing standards; (3) sales practice guidelines,
such as rules regarding communications with the public; and (4)
disclosure requirements. The trading rules and procedures should be
appropriate for, and ensure the fair and orderly trading of, each type
of security to be traded on the pilot trading system. The SRO, however,
would not be required to file these trading rules and procedures with
the Commission, provided they applied only to trading conducted on the
pilot trading system.
c. Surveillance. The SRO would also have to establish procedures
for the effective surveillance of trading activity on the pilot trading
system. It is important that the SRO be able to obtain information
necessary to detect and deter market manipulation, illegal trading, and
other trading abuses. To satisfy this requirement, an SRO would have to
develop and implement internal surveillance procedures to monitor
transactions effected on the pilot trading system, and obtain
surveillance information from other markets, both domestic and foreign.
Specifically, there should be a comprehensive information sharing
agreement (``ISA'') in place between the SRO operating a pilot trading
system and any other market trading the securities, or trading the
underlying securities of derivative securities products, traded on such
pilot trading system.\269\ Such agreements provide a
[[Page 23534]]
necessary deterrent to manipulation because they facilitate the
availability of information needed to fully investigate a potential
manipulation. An SRO operating a pilot trading system trading U.S.
securities, or new derivative securities products overlying U.S.
securities, would have to continue to ensure that all exchanges on
which the U.S. securities trade are members of the Intermarket
Surveillance Group (``ISG'').\270\ The ISG was formed to coordinate,
among other things, effective surveillance and investigative
information sharing arrangements in the stock and options markets.
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\269\ The Commission believes that a comprehensive ISA requires
that the parties provide to each other, upon request, information
about market trading, clearing activity, and the identity of the
ultimate purchasers and sellers of securities. See Securities
Exchange Act Release No. 31529 (Nov. 27, 1992), 57 FR 57248 (Dec. 3,
1992). Similarly, an SRO that operates a pilot trading system that
trades securities, or derivatives of securities that are listed or
traded on a foreign market, should have a comprehensive ISA with
such foreign markets. In addition, the SRO should ensure there are
no blocking or secrecy laws in the foreign country that would
prevent or interfere with the transfer of information under the
comprehensive ISA. If securing a comprehensive ISA is not possible,
the SRO should contact the Commission. In such instances, the
Commission may determine that it is appropriate instead to rely on a
Memorandum of Understanding (``MOU'') between the Commission and the
foreign regulator. Generally, the Commission has permitted an SRO to
rely on an MOU in the absence of a comprehensive ISA only if the SRO
receives an assurance from the Commission that such an MOU can be
relied on for surveillance purposes and includes, at a minimum, the
transaction, clearing, and customer information necessary to conduct
an investigation. See Securities Exchange Act Release No. 35184
(Dec. 30, 1994), 60 FR 2616 (Jan. 10, 1995). In addition, an SRO
should endeavor to develop comprehensive ISAs with foreign exchanges
even if the SRO receives prior Commission approval to rely on an MOU
in place of a comprehensive ISA.
\270\ See ISG Agreement, dated July 14, 1983, amended Jan. 29,
1990. The ISG members are: Amex, BSE, CBOE, CHX, NASD, NYSE, PCX,
and Phlx. The major stock index futures exchanges joined the ISG as
affiliate members in 1990.
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d. Clearance and settlement. An SRO would have to establish
reasonable clearance and settlement procedures for transactions
effected on the pilot trading system. The integrity of the trading
markets depends on the timely and coordinated clearance and settlement
of transactions. For this reason, the Commission believes that an SRO
operating a pilot trading system should ensure that the necessary
linkages to clearing agencies exist for all pilot trading system users.
For example, to ensure that adequate linkages have been formed, part of
the user agreement should, at a minimum, request information about the
name of the clearing corporation member through which the user will
clear its trades.
e. Types of securities. Because a pilot trading system would be
operated by an SRO, it would be limited to trading registered or
exempted securities.\271\ In addition, a pilot trading system would not
be eligible for the exemption if it trades derivative securities, such
as options, warrants, or hybrid products, the value of which are based,
in whole or in part, on the value of or interest in any security traded
on another trading system operated by the SRO. The converse would also
be true. A pilot trading system would not be eligible for the exemption
if it trades any security or instrument, the derivative of which is
traded on another trading system operated by the SRO.\272\ SROs
contemplating trading systems that would trade these types of
derivative securities would have to continue to submit rule filings
under section 19(b)(2) of the Exchange Act.
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\271\ Securities traded on a pilot trading system would be
limited to those securities listed on the sponsoring SRO, or traded
on the SRO pursuant to unlisted trading privileges. In general,
section 12 of the Exchange Act requires an exchange to trade only
those securities that the exchange lists, except that section 12(f)
of the Exchange Act provides UTP under certain circumstances. 15
U.S.C. 78l(f). For example, exchanges are permitted to trade certain
over-the-counter securities pursaunt to a Commission order or rule.
See Securities Exchange Act Release No. 39505 (Dec. 31, 1997), 63 FR
1515 (Jan. 9, 1998). This ensures that securities traded on the
pilot trading system have provided adequate disclosure to investors
and that all relevant trading activity in a security is reported to,
and surveilled by, the SRO on which the security is listed.
\272\ Proposed Rule 19b-5(c)(6).
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f. Procedures to ensure the confidentiality of trading. An SRO
operating a pilot trading system would also have to ensure that it has
procedures to prevent the misuse of confidential information regarding
trading on the pilot trading system. For example, to the extent that
the identity of a person trading on the pilot trading system is
confidential, the SRO should limit access to the information. In
particular, only employees of the SRO who operate the pilot trading
system, or are responsible for the SRO's compliance with applicable
law, should have access to confidential information about the identity
of persons effecting transactions on the pilot trading system and the
trading information itself. The SRO also should implement procedures
for its employees regarding trading by employees for their own
accounts. Finally, the SRO would have to adopt and implement adequate
oversight procedures to ensure that the above safeguards concerning
confidentiality are followed.
g. Inspections and examinations. The SRO would have to cooperate
with any examination or inspection by the Commission of persons
effecting transactions on the pilot trading system. The Commission
staff would review SRO compliance with the conditions in proposed Rule
19b-5 through its routine inspections. The Commission notes that if an
SRO outsources the development, operation, or maintenance of the
operation of any aspect of a pilot trading system, such vendor would be
considered to be operating a facility of an SRO and therefore would
also be subject to Commission examination or inspection.\273\
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\273\ Proposed Rule 19b-5(c)(8).
---------------------------------------------------------------------------
In order for the Commission staff to determine whether an SRO has
properly relied on the proposed exemption under Rule 19b-5, the SRO
would have to maintain at its principal place of business all relevant
records and information pertaining to the pilot trading system and the
basis for which the SRO relied on the proposed exemption from the rule
filing requirement.\274\
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\274\ Proposed Rule 19b-5(c)(9).
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C. Rule Filing Under Section 19(b)(2) of the Exchange Act Required
Within Two Years
Within two years of a pilot trading systems' commencement of
operation, an SRO would have to submit a rule filing under section
19(b)(2) of the Exchange Act to obtain approval for the pilot trading
system to operate on a permanent basis. After a formal notice and
comment period, the Commission would approve the pilot trading system
for operation on a permanent basis or institute proceedings to
determine whether to disapprove the proposed rule change. Simultaneous
with its request for Commission approval under section 19(b)(2) of the
Exchange Act, an SRO may request Commission approval pursuant to
section 19(b)(3)(A) of the Exchange Act, effective immediate upon
filing, to continue to operate the trading system for a period not to
exceed six months.\275\
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\275\ Proposed Rule 19b-5(e).
---------------------------------------------------------------------------
D. Compliance With Other Federal Securities Laws
The Commission notes that Proposed Rule 19b-5 does not relieve SROs
from any other obligation under the federal securities laws, except the
requirement to file a proposed rule change with the Commission prior to
commencing operation of a pilot trading system. For example, an SRO
that fails to provide fair access to its pilot trading system would not
be operating in a manner consistent with the Exchange Act. In addition,
the SRO would have to ensure that securities listed and traded on the
pilot trading system comply with, among other things, the registration
requirements of the Exchange Act.\276\ An SRO would also continue to be
required to enforce compliance with its own rules and the federal
securities laws, including members' compliance with the Order Handling
Rules.\277\
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\276\ See supra notes 271-272 and accompanying text.
\277\ See Section 6(b)(2) of the Exchange Act. See also Order
Handling Rules Adopting Release, supra note 88.
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[[Page 23535]]
E. Request for Comment on Proposed Rule 19b-5
The Commission seeks comments on proposed Rule 19b-5 under the
Exchange Act. Comments should address whether the proposed temporary
exemption of SRO proposed rule changes relating to the operation of
pilot trading systems provides appropriate regulation of such pilot
trading systems. The Commission also requests comment on whether this
proposed temporary exemption would help to level the competitive
playing field between SROs and alternative trading systems.
As an alternative to the temporary exemption proposed today, the
Commission requests comment on the benefits or disadvantages of
allowing SROs to file proposed rule changes relating to pilot trading
systems under the expedited approval process under section 19(b)(3)(A)
of the Exchange Act. The Commission could allow an SRO to submit, under
section 19(b)(3)(A) of the Exchange Act, the proposed rule changes
concerning pilot trading systems. An SRO could then begin operating the
pilot trading system immediately after filing. Under this alternate
framework, an SRO proposed rule change would be published for comment
and could be abrogated by the Commission. Specifically, the Commission
asks commenters whether the public disclosure required in the proposed
rules filed under section 19(b)(3)(A) of the Exchange Act would achieve
the purpose of encouraging SRO pilot trading systems.
VI. The Commission's Interpretation of the ``Exchange'' Definition
A. The Commission's Interpretation in Delta
Congress drafted the statutory language defining the term exchange
to be broad, permitting the Commission to apply the definition flexibly
as the securities markets evolve over time.\278\ Section 3(a)(1) of the
Exchange Act provides that:
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\278\ It was recognized at the time the Exchange Act was enacted
that a regulatory structure for securities exchanges would ``be of
little value tomorrow if it is not flexible enough to meet new
conditions immediately as they arise and demand attention in the
public interest.'' See SEC, Report of the Special Study of the
Securities Markets of the Securities and Exchange Commission, H.R.
Doc. No. 95, 88th Cong., 1st Sess. Pt. 1 (1963) (``Special Study''),
at 6. See also S. Rep. No. 792, 73rd Cong., 2d Sess. (1934) at 5
(noting that ``exchanges cannot be regulated efficiently under a
rigid statutory program,'' and that ``considerable latitude is
allowed for the exercise of administrative discretion in the
regulation of both exchanges and the over-the-counter market.'')
The term ``exchange'' means any organization, association, or
group of persons, whether incorporated or unincorporated, which
constitutes, maintains, or provides a market place or facilities for
bringing together purchasers and sellers of securities or for
otherwise performing with respect to securities the functions
commonly performed by a stock exchange as that term is generally
understood, and includes the market place or market facilities
maintained by such exchange.\279\
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\279\ 15 U.S.C. 78c(a)(1).
Although the Exchange Act definition of ``exchange'' is quite
broad, in the 1990 Delta Release,\280\ the Commission interpreted the
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.'' \281\ Based on the interpretation upheld by
the Seventh Circuit, the Commission staff has given operators of
trading systems that do not enhance liquidity in traditional ways
through market makers, specialists, or a single price auction
structure, assurances that it would not recommend enforcement action if
those systems operated without registering as exchanges.\282\ The Delta
Release, nonetheless, emphasized that the means employed for bringing
together buyers and sellers ``may be varied, ranging from a physical
floor or trading system * * * to other means of intermediation (such as
a formal market making system or systemic procedures such as a
consolidated limit order book or regular single price auction).'' \283\
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\280\ Delta Release, supra note 10.
\281\ See Delta Release, supra note 10, at 1900. In 1988, the
Commission granted Delta temporary registration as a clearing agency
to allow it to issue, clear, and settle options executed through a
trading system operated by RMJ Securities (``RMJ''). Concurrently,
the Commission's Division of Market Regulation issued a letter
stating that the Division would not recommend enforcement action
against RMJ if its system did not register as a national securities
exchange. Subsequently, the Board of Trade of the City of Chicago
and the Chicago Mercantile Exchange petitioned the U.S. Court of
Appeals for the Seventh Circuit for review of the Commission's
actions. Both challenges were premised on the view that RMJ's system
unlawfully failed to register as an exchange or obtain an exemption
from registration. The Seventh Circuit vacated Delta's temporary
registration as a clearing agency, pending publication of a reasoned
Commission analysis of whether or not RMJ's system was an exchange
within the meaning of the Exchange Act. Board of Trade of the City
of Chicago v. Securities and Exchange Commission, 883 F.2d 525 (7th
Cir. 1989) (``Delta I''). In 1989, the Commission solicited comment
on the issue, and in 1990 published its interpretation of the term
``exchange'' and its determination that RMJ's system did not meet
that interpretation. See Delta Release, supra note 10.
\282\ 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 8363, 8369-71 (Feb. 18, 1994). See also Letters from
the Division of Market Regulation to: Tradebook (Dec. 3, 1996); The
Institutional Real Estate Clearinghouse System (May 28, 1996);
Chicago Board Brokerage, Inc. and Clearing Corporation for Options
and Securities (Dec. 13, 1995).
\283\ See Delta Release, supra note 10, at 1899.
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In explaining why the Commission interpreted the exchange
definition relatively narrowly, in 1990 the Commission expressed the
concern that ``including (Delta) within an expansive definition of the
term `exchange' would force a non-member, for-profit, proprietary
trading system into a regulatory scheme for which it is ill-suited,
thus ignoring the Congressional and judicial mandate to apply flexibly
the definition of the term `exchange' to the economic realm.'' \284\
The Commission indicated, however, that the Exchange Act itself does
not preclude a proprietary trading system such as Delta from coming
within the exchange definition.\285\ Moreover, the Commission
recognized, however, that its interpretation of the exchange definition
in 1990 could be subject to change as the securities markets continued
to change:
\284\ Id. at 1899. As discussed below, the Commission's new
general exemptive authority has increased the Commission's
flexibility in this regard.
\285\ See Delta Release, supra note 10, at 1900.
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In order to permit the Commission to apply flexibly the
[Exchange] Act's definition of the term `exchange' to innovative
trading systems in securities, Congress imbued the (Exchange) Act's
definition of the term `exchange' with a certain `plasticity'. * *
*; ``it invites reinterpretation as the way the term * * *
`generally understood' evolves.'' \286\
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\286\ Delta Release, supra note 10, at 1895 (quoting Delta I,
supra note 281, at 535).
The United States Court of Appeals for the Seventh Circuit Court
affirmed the Commission's decision that Delta was not an exchange
within the meaning of section 3(a)(1) of the Exchange Act.
Significantly, the court thought the language of the statute broad
enough ``to embrace the Delta system,'' but concluded that the
Commission was not compelled to interpret it to do so.\287\
---------------------------------------------------------------------------
\287\ Delta II, supra note 171, at 1273. The court held that,
because the statutory provision is ambiguous, the Commission had the
discretion to interpret the definition the way it did.
---------------------------------------------------------------------------
While the Delta interpretation provided an appropriate
interpretation at the time, its emphasis on the ``expectation'' of
regular execution of
[[Page 23536]]
orders at quoted prices may no longer reflect changing market
structures. Moreover, the Delta approach has resulted in the anomaly of
small volume entities being found to raise an expectation of liquidity
and being regulated as exchanges (such as the Arizona Stock
Exchange),\288\ while larger volume entities that avoid certain design
features are found not to raise this expectation and are regulated as
broker-dealers (such as Instinet).\289\ In addition, the narrow
interpretation of the term ``exchange'' in Delta has eroded the
effectiveness of the Commission's oversight of markets. For example, as
discussed in the Concept Release, it is clear that regulatory concerns
may be raised by entities that constitute a market where buyers and
sellers interact, but do not necessarily ensure a two-sided market by
design.\290\ Moreover, the Commission's traditional approach to broker-
dealer regulation is not designed to substitute for market regulation.
Consequently, these alternative trading systems are not fully
integrated into the mechanisms that promote market fairness,
efficiency, and transparency. In addition to raising regulatory
fairness concerns, this lack of integration into the NMS has had a
negative impact on the quality and pricing efficiency of secondary
markets.\291\
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\288\ See Securities Exchange Act Release No. 28899 (Feb. 20,
1991), 56 FR 8377 (Feb. 28, 1991).
\289\ See Letter from Richard G. Ketchum to Daniel T. Brooks,
Cadwalader, Wickersham & Taft (Aug. 8, 1986) (stating the Commission
staff would not recommend Instinet for an enforcement action if it
did not register with the Commission as a national securities
exchange).
\290\ See Concept Release, supra note 2, at Section II.B.2.
\291\ For example, the evidence in the Commission's report on
the NASD and the Nasdaq market pursuant to section 21(a) of the
Exchange Act suggests that widespread use of Instinet by market
makers as a private market has had a significant impact on public
investors and the operation of the Nasdaq market. See NASD 21(a)
Report, supra note 84.
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B. The Growing Significance of Alternative Trading Systems in the
National Market System
Within the past six years, the significance of alternative trading
systems in the securities markets has increased dramatically. In 1994,
the Commission's Division of Market Regulation reported that
alternative trading systems accounted for thirteen percent of the
volume in Nasdaq securities and 1.4 percent of the trading volume in
NYSE-listed securities.\292\ In the Concept Release, the Commission
estimated that, as of the end of 1996, the trading volume on
alternative trading systems amounted to almost twenty percent of the
trades in Nasdaq stocks, and almost four percent of orders \293\ in
securities listed on the NYSE.
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\292\ See Division of Market Regulation, Market 2000: An
Examination of Current Equity Market Developments app IV (1994)
(``Market 2000 Study'').
\293\ 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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In addition to the general increase in the volume of trading
occurring on alternative trading systems, the actual number of
alternative trading systems has skyrocketed. In 1991, the Commission
was aware of only a few such systems. Today, over 40 such systems are
currently operating. The viability of this number of alternative
trading systems indicates that these systems account for an increasing
proportion of trading and that a growing number of investors use these
systems. Moreover, the arrival of trading services on the Internet
portends an increasing level of retail interest in alternative means
for trading.
The securities markets rely on centralized sources of trading
opportunities and trading information. Exchange regulation is designed
to protect this centralization function and to make the opportunity to
obtain trading information and to access trading interest accessible to
the general public. As more alternative trading systems develop and
offer varying services to diverse customer bases, the availability of
trading information and the accessibility of trading opportunities may
become increasingly fragmented.
C. The Proposed Reinterpretation of ``Exchange''
For purposes of effectively regulating the securities markets,
including alternative trading systems, the Commission believes a
revised interpretation of what constitutes an exchange is in
order.\294\ Although the Commission has considered many characteristics
of the modern exchange in revising its interpretation, it believes two
elements most accurately reflect the functions and uses of today's
exchange markets. Under the interpretation proposed in Rule 3b-12, the
first essential element of an exchange would be the consolidation of
orders of multiple parties. This reflects the statutory concept of
bringing together purchasers and sellers and also reflects the idea of
a marketplace where supply and demand originate from a variety of
sources, not simply from individual brokers and dealers. The second
essential element would be that trading on an exchange is guided by
stated non-discretionary rules or procedures. As discussed above, an
essential indication of the non-discretionary status of rules and
procedures is that those rules and procedures are communicated to the
system's users. Thus, participants have an expectation regarding the
manner of execution--that is, if an order is entered, it will be
executed in accordance with those procedures and not at the discretion
of a counterparty or intermediary.\295\
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\294\ The Exchange Act, coupled with relevant legislative
history, appears to provide the Commission with ample authority to
revise its interpretation of an exchange, See, e.g., supra Section
VI.A. Courts have also consistently upheld an agency's discretion to
revise earlier interpretations when a revision is reasonably
warranted by changed circumstances. See, e.g., Rust v. Sullivan, 500
U.S. 173, 186 (1991). In Rust, the Court stated that ``an initial
agency interpretation is not instantly carved in stone, and the
agency, to engage in informed rulemaking, must consider varying
interpretations and the wisdom of its policy on a continuing
basis.'' Id. at 186 (quoting Chevron v. Natural Resources Defense
Council, 467 U.S. 837, 844-45 (1984)). The Court also stated that
``an agency is not required to `establish rules of conduct to last
forever,' but rather `must be given ample latitude to adapt its
rules and policies to the demands of changing circumstances.' '' Id.
at 186-87 (quoting Motor Vehicles Mfrs. Ass'n of United States v.
State Farm Mut. Automobile Ins. Co., 463 U.S. 29, 42 (1983). See
also Arkansas AFL-CIO v. FCC, 11 F.3rd 1430, 1441 (8th Cir. 1993)
(deferring to Federal Communications Commission decision to alter
its interpretation of the statutory term ``operated in the public
interest'' to meet the changing realities of the broadcast
industry).
\295\ The elements of the interpretation are discussed in
greater detail in Sections II.A. and II.B., supra.
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D. Other Practical Reasons for Revising the Current Interpretation
1. Additional Flexibility Provided by the National Securities Markets
Improvement Act of 1996
One principal reason the Commission, to date, interpreted the term
exchange narrowly has been to avoid the imposition of unnecessary and
burdensome regulatory obligations on small and emerging trading
systems, which could stifle innovation.\296\ The recent enactment of
NSMIA,\297\ however, alleviates the concern that an expanded
interpretation of the term exchange would inhibit innovation.\298\
[[Page 23537]]
Specifically, NSMIA added Section 36(a)(1) to the Exchange Act, which
provides that:
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\296\ For example, at the time of the Delta Release, the
Commission sought to avoid interpreting the term ``exchange'' in a
way that could unintentionally and inappropriately subject many
broker-dealers to exchange regulation. One key factor in the
Commission's decision not to regulate the Delta system as an
exchange was the concern that doing so would subject traditional
broker-dealer activities to exchange regulation. Delta Release,
supra note 10.
\297\ Pub. L. 104-290, 110 Stat. 3416 (1996). 15 U.S.C. 78mm.
\298\ Throughout the past 60 years, the Commission has attempted
to accommodate market innovations within the existing statutory
framework to the extent possible in light of investor protection
concerns, without imposing regulation that would stifle or threaten
the commercial viability of such innovations. For example, at
various times, the Commission considered the implications of
evolving market conditions on exchange regulation. See Securities
Exchange Act Release Nos. 8661 (Aug. 4, 1969), 34 FR 12952
(initially proposing Rule 15c2-10); 11673 (Sept. 23, 1975), 40 FR
45422 (withdrawing then-proposed Rule 15c2-10 and providing for
registration of securities information processors); 26708 (Apr. 13,
1989), 54 FR 15429 (reproposing Rule 15c2-10); 33621 (Feb. 14,
1994), 59 FR 8379 (withdrawing proposed Rule 15c2-10).
the Commission, by rule, regulation, or order, may conditionally or
unconditionally exempt any person, security, or transaction, or any
class or classes of persons, securities, or transactions, from any
provision or provisions of (the Exchange Act) or of any rule or
regulation thereunder, to the extent that such exemption is
necessary or appropriate in the public interest, and is consistent
with the protection of investors.\299\
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\299\ 15 U.S.C. 78mm(a)(1).
Prior to adoption of NSMIA, the Commission's authority under the
Exchange Act to reduce or eliminate certain consequences of exchange
registration was limited.\300\ Section 36, however, allows the
Commission greater flexibility in regulating new trading systems by
giving the Commission broad authority to exempt any person from any
provision of the Exchange Act. As a result, the Commission now has
greater authority to adopt a more consistent regulatory approach to
securities markets in general, and particularly for alternative trading
systems that do not neatly fit into the existing regulatory
framework.\301\ The Commission is proposing Rule 3a1-1 under the
Exchange Act, which would exempt from the definition of ``exchange''
systems that are registered as broker-dealers and in compliance with
Regulation ATS.\302\ This exemption, together with the revised
interpretation of ``exchange,'' would provide a choice to alternative
trading systems to register as national securities exchanges or as
broker-dealers.\303\
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\300\ Prior to the addition of section 36 to the Exchange Act,
the Commission could only exempt an exchange from the registration
provisions of sections 5 and 6 on the basis of an exchange's limited
volume of transactions. See section 5 of the Exchange Act, 15 U.S.C.
78e.
\301\ See S. Rep. No. 104-293, 104th Cong. 2d Sess. 15 (1996).
\302\ Proposed Rule 3a1-1 would also exempt from the definition
of ``exchange,'' any system that is operated by a national
securities association. See supra Section II.D.
\303\ See supra Section II.D.
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2. No-Action Approach to Alternative Trading Systems is No Longer
Workable
The Commission also believes that the proliferation of new trading
systems necessitates the revision of the interpretation of the term
``exchange.'' The no-action review process that the Commission has used
to date to address hybrid systems that incorporate features of both
exchanges and broker-dealers worked well and was consistent with the
protection of investors when relatively few systems applied for no-
action treatment. The no-action process allowed the Division to review
the system's services and mechanisms and to monitor the impact of such
systems on a case-by-case basis. This is no longer practicable. Absent
a revised interpretation of ``exchange,'' the Commission would have to
continue to respond to an increasing volume of no-action requests from
developing alternative trading systems that seek to avoid the burdens
associated with registration as a national securities exchange. The
Commission's proposal would eliminate the need for this no-action
approach. By codifying a regulatory framework that does not rely on
Commission staff review of each novel system development, the
Commission believes that technological improvements and enhanced
services will become available more rapidly.
3. More Rational Treatment of Regulated Entities
The Commission believes that the proposed revised interpretation of
the term exchange, in combination with the proposal to allow
alternative trading systems to register as broker-dealers in accordance
with proposed Regulation ATS,\304\ is consistent with other goals and
provisions of the Exchange Act. The proposed revised interpretation of
``exchange'' should avoid the need for the Commission to draw arbitrary
distinctions between organizations that perform similar functions. This
should avoid classifying an alternative trading system in a manner that
does not fit the structure of the system, nor squarely addresses the
regulatory concerns raised by the system. Another significant advantage
of the proposed revised interpretation of ``exchange'' is that it will
allow exchanges to be organized as proprietary systems, thereby
accommodating recent market developments.\305\
---------------------------------------------------------------------------
\304\ See supra Section III.A.
\305\ See supra Section III.B.3.
---------------------------------------------------------------------------
Moreover, the Commission's proposal would help assure consistency
with existing broker-dealer regulations. For those alternative trading
systems that wish to participate in the markets as exchanges,
regulation as a national securities exchange would be available.
However, the Commission expects that many alternative trading systems
will not elect to register as national securities exchanges. Under the
Commission's proposal, these systems would have to maintain a structure
more akin to that of traditional broker-dealers and comply with
regulatory obligations more appropriately tailored to their chosen
business structure. These obligations would include the new
requirements for more significant alternative trading systems to
address the transparency, fair access, and systems capacity, integrity,
and security concerns raised by these particular systems.\306\
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\306\ See supra Section III.A.2.c., d., and e.
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VII. Approaches Not Proposed
A. Tiered Exchange Approach
In the Concept Release, the Commission explored the possibility of
expanding the interpretation of ``exchange'' to capture the majority of
alternative trading systems operating today, and then to adopt
differing levels of regulation for three different classes of
``exchanges.'' \307\ The classes, or ``tiers,'' would vary depending on
the size and significance of the trading systems included in each
class. The first tier would have consisted of those that have limited
volume or do not establish trading prices. This tier would include most
alternative trading systems. The Commission suggested that systems
included in this tier could be exempted from most traditional exchange
requirements.
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\307\ See Concept Release, supra note 2, at Section IV.B.
---------------------------------------------------------------------------
The second tier of exchanges under this approach would have
consisted of alternative trading systems that resemble traditional
exchanges because of their significant volume of trading and active
price discovery. The Commission discussed whether these systems should
be regulated as national securities exchanges, with some exemptions
from traditional exchange regulation to eliminate barriers that would
make it difficult for these non-traditional markets to comply with full
exchange regulation, such as the membership and access requirements.
Finally, a third tier of exchanges would have encompassed
traditional membership exchanges. The Commission suggested that these
exchanges continue to be regulated as national securities exchanges,
with some accommodations to reduce unnecessary regulatory requirements
that make it difficult for currently registered exchanges to remain
competitive in a changing business environment. The Commission
suggested, for example, further
[[Page 23538]]
accelerating rule filing and approval procedures.
While comments varied with respect to the tiered approach,
commenters generally opposed this approach, fearing that it would
weaken competition by alternative trading systems and discourage growth
and innovation. Some commenters noted that the burdens of exchange
regulation would be heavy for many alternative trading systems, and
that the tiered approach would require the Commission to draw arbitrary
lines between different systems, which could result in systems that
perform virtually identical functions being subject to different
regulatory requirements. Commenters also disagreed on how distinctions
should be drawn between the tiers. In this vein, some commenters
thought that the tiered approach would inhibit the full development of
innovative systems if such growth would cause the system to be
regulated under a more burdensome regulatory tier. A few commenters
also suggested that it would be inappropriate to relax standards for
smaller start-up trading systems because investors may need more
protection with respect to these systems than for larger more
established systems.
For these reasons, the Commission has decided not to pursue the
tiered exchange regulation approach discussed in the Concept Release.
The Commission believes that the approach it is proposing is preferable
because it will enable trading systems to elect the regulation most
appropriate for the services they provide, and takes into account size
in applying particular requirements. This approach can foster
innovation while concurrently regulating trading systems in a manner
more fitting to their respective market roles.
B. SIP Approach
The Division also considered an alternative that would require all
or some portion of alternative trading systems to register as
securities information processors (``SIPs'') under section 11A of the
Exchange Act.\308\ The 1975 Amendments create a framework for
regulating SIPs, which are defined as persons engaged in the business
of:
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\308\ 15 U.S.C. 78k-1.
(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 continuous basis,
information with respect to such transactions or quotations.\309\
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\309\ Section 3(a)(22)(A) of the Exchange Act, 15 U.S.C.
78c(a)(22)(A).
To implement this alternative, the Commission would have to adopt
rules designed to address the transparency, capacity, access, and
surveillance of the systems classified as SIPs. Like the exchange
approach, the Commission has determined that the SIP approach would not
be as workable as the approach proposed today. In many respects, the
rules the Commission would have to adopt under the SIP approach would
parallel exchange regulatory requirements, but would not be able to
address all of the concerns regarding alternative trading systems'
activities. For example, markets regulated as SIPs would not be
required to enforce participants' compliance with the securities laws.
In addition, alternative trading systems would continue to be only
partially integrated into the NMS because SIPs are not required to join
market-wide plans, such as the CQS, CTA, ITS, and OPRA. Finally,
because SIPs and exchanges are defined in the Exchange Act as mutually
exclusive categories, a market classified as a SIP could not elect to
register as an exchange, even if that market's volume exceeded that of
registered exchanges.
VIII. Request for Public Comments
The Commission seeks comments on adopting the proposals as
described in this release. In addition to the requests for comments
throughout the release, the Commission asks commenters to address
whether the proposed amendments and rules provide appropriate
regulation of alternative trading systems. Commenters should also
address whether the proposed amendments and rules provide a feasible
regulatory structure for alternative trading systems registered as
broker-dealers and national securities exchanges. Commenters may also
wish to discuss whether there are any legal or policy reasons why the
Commission should consider a different approach. In addition to
responding to the specific issues 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 proposed reforms and the
expectations of investors. The Commission also invites commenters to
provide views and data as to the costs and benefits associated with the
proposed changes discussed above in comparison to the costs and
benefits of the statutory framework. For purposes of the Small Business
Regulatory Enforcement Fairness Act of 1996, the Commission is also
requesting information regarding the potential impact of the proposed
amendments and rules on the economy on an annual basis. If possible,
commenters should provide empirical data to support their views.
Comments should be submitted by July 28, 1998.
IX. Costs and Benefits of the Proposed Rules and Amendments
The growing significance of alternative trading systems has caused
the Commission to reconsider its oversight of such systems through
existing broker-dealer regulation. Even though they perform the
functions of a market, alternative trading systems that trade a
significant volume of securities currently are not obligated to surveil
their markets for manipulative activity, to make all of their quotes
public, to treat participants fairly, or to maintain adequate systems
capacity to prevent outages. As a result, the existing regulatory
approach has resulted in inferior or denied access for investors to the
best prices, incomplete audit trails and surveillance of trading on
alternative trading systems, and market disruption due to systems
outages.
The Commission is proposing to allow alternative trading systems to
choose between broker-dealer regulation or exchange regulation. In
addition, to enable registered exchanges to better compete with
alternative trading systems regulated as broker-dealers, the Commission
is proposing that SROs be permitted to operate pilot trading systems
for a limited period of time before undergoing the full notice,
comment, and approval process required for an SRO rule change. The
Commission preliminarily believes that any costs associated with this
proposal would be offset by benefits to investors and other market
participants such as reducing market fragmentation, enhancing investor
access to the best prices, and encouraging market innovation. The
Commission has identified below certain costs \310\ and benefits
associated with its proposed changes and encourages commenters to
identify, discuss, analyze, and supply relevant data regarding any
additional costs or benefits.
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\310\ The Commission's cost estimates in Section IX are derived
from its experience with similar reporting and recordkeeping
requirements as reflected in a number of submissions made pursuant
to the paperwork Reduction Act of 1995. 44 U.S.C. 3501 et seq.
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[[Page 23539]]
A. Costs and Benefits of the Proposals Regarding Alternative Trading
Systems
1. Benefits
a. Improved surveillance on alternative trading systems. The
Commission's proposal would provide benefits to investors by improving
the surveillance of trading on alternative trading systems. Adequate
surveillance of the trading on alternative trading systems is critical
to the continued integrity of our markets. This is particularly the
case with regard to alternative trading systems that have a significant
percentage of the trading volume in one or many issues of securities.
The oversight of trading activities on alternative trading systems that
choose to register as broker-dealers would improve because the
proposals clarify the relationship between SROs and alternative trading
systems.
The proposed notice, reporting, and recordkeeping requirements
under Regulation ATS would also contribute to the Commission's and the
SROs' ability to effectively oversee alternative trading systems
regulated as broker-dealers. The Commission believes that these
enhancements to the surveillance and oversight of alternative trading
systems regulated as broker-dealers would benefit the public by helping
to prevent fraud and manipulation.
The surveillance of trading on alternative trading systems that
choose to register as exchanges under the Commission's proposal would
also be improved. All registered exchanges are SROs, which have direct
obligations to surveil the trading on their own markets. The Commission
believes that, through improved surveillance mechanisms, it would be
better able to detect fraud and manipulation that could occur on
alternative trading systems. For example, alternative trading systems
can be used to artificially narrow the national best bid and offer
(``NBBO'') spreads for the sole purpose of trading through a broker-
dealer's automatic execution system at the artificial prices.\311\ The
Commission and the SROs would be able to more readily detect such
activity through enhanced surveillance. The Commission believes that
this more direct oversight of trading activities would therefore
benefit investors and the market generally by helping to prevent fraud
and manipulation.
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\311\ See e.g. At Deadline: New Age Bandits, Traders Magazine,
February, 1997, at 6.
---------------------------------------------------------------------------
b. Improved market transparency. The Commission's proposal would
enhance transparency of trading on alternative trading systems.
Transparency of orders helps ensure that publicly available prices
fully reflect overall supply and demand and helps reduce the negative
consequences of market fragmentation (e.g., the chance that an order
for a security in one market will be executed at a price inferior to
that available at the same time in another market). The Commission has
been particularly concerned that the development of so-called ``hidden
markets,'' in which a market participant privately publishes quotations
at prices superior to the quotation information it disseminates
publicly, impedes NMS objectives. Some systems that permit this
activity have become significant markets in their own right, but are
not currently required to integrate their orders into the public quote
because they are not registered as national securities exchanges or
national securities associations.
For alternative trading systems choosing to register as broker-
dealers, the Commission is proposing to improve the transparency of
orders in systems that account for a significant portion of the trading
volume in any security. The proposed rules would help to incorporate
alternative trading system quotes into the NMS, thus reducing
fragmentation, improving liquidity, facilitating price discovery, and
narrowing the quoted spread. In particular, the Commission believes
that the current proposal would extend the transparency improvements
achieved through the implementation of the Order Handling Rules. Since
the adoption of the Order Handling Rules in January 1997, quoted
spreads have decreased by an average of 41%, ECNs were alone at the
inside quote approximately 11% of the time, and the average daily
number of quote updates attributable to ECNs was about 68% of the
number of quote updates attributable to market makers, with ECNs
accounting for 272,427 quote updates as compared to 403,233 for market
makers.\312\ The success of the Order Handling Rules indicates that the
Commission's current proposal, which would achieve similar transparency
for a greater number of orders in alternative trading systems, could
further enhance liquidity and price improvement opportunities. Because
non-market maker broker-dealers and institutions at times enter the
best priced orders in an alternative trading system, the Commission
expects that display of these orders in the public quote would improve
the NBBO. For example, of all orders by non-market maker broker-dealers
and institutions that could improve the NBBO if included in the public
quote stream, only 6% of those orders were actually entered into the
public quote stream. Consequently, about 94% of those orders that could
have improved the NBBO were not included in the public quote stream and
thus did not improve the NBBO. The Commission requests comment on how
often the display of non-market maker broker-dealer and institutional
orders could improve the NBBO.
---------------------------------------------------------------------------
\312\ See Market Quality Monitoring: Overview of 1997 Market
Changes, NASD Economic Research, at 2.
---------------------------------------------------------------------------
The transparency of trading on alternative trading systems that
choose to register as exchanges would also improve. All registered
exchanges are expected to participate in the NMS plans, such as the
CTA, CQS, and ITS. These plans form an integral part of the NMS, and
contribute greatly to the operation of linked, transparent, efficient,
and fair markets. In addition to improving transparency, alternative
trading system participation in these market-wide mechanisms would
benefit investors by reducing inefficiency and trading fragmentation.
c. Fair access. The Commission believes that its proposal to
require alternative trading systems with significant volume to notify
investors denied access of their right to appeal that denial, and to
provide regulatory redress for unfair denials of access, would help
ensure that market participants are provided a fair opportunity to
participate in alternative trading systems. Fair treatment of potential
and current subscribers by alternative trading systems is important,
especially when an alternative trading system captures a large
percentage of trading volume in a security. Although an alternative
trading system with significant volume would be required to provide
access to orders that it is required to display in the public quote
stream, there are other benefits to participation on an alternative
trading system that the Commission believes an alternative trading
system should not unfairly discriminate in granting access. In
particular, participation on an alternative trading system allows an
investor to enter its own orders, view contingent orders not publicly
displayed (such as all or none orders) and use special features of an
alternative trading system, such as a negotiation feature or reserve
size feature.
Under the current regulatory approach, there is no regulatory
redress for unfair denials or limitations of access by alternative
trading systems. The availability of redress for such actions may not
be critical when market participants are able to substitute the
services of one alternative trading
[[Page 23540]]
system with those of another. However, when an alternative trading
system has a significantly large percentage of the volume of trading,
discriminatory actions hurt investors lacking access to the system. The
proposals would prevent discriminatory denials of access and ensure
that market participants are not prevented from gaining access to
significant sources of liquidity.
d. Systems capacity, integrity, and security. The Commission
believes that its proposal regarding systems capacity, integrity, and
security of alternative trading systems would provide several benefits
to the marketplace and to investors. Marketplaces are increasingly
reliant on technology and most of their functions are becoming highly
automated. Alternative trading systems are subject only to business
incentives to avoid system breakdowns that may disrupt the market. In
the past, alternative trading system failures have affected the public
market particularly during periods of high trading volume. Some
alternative trading systems have had prolonged shut-downs during the
busiest trading sessions due to systems problems. For example, during
the past year, Instinet, Island, Bloomberg, and Archipelago (operated
by Terra Nova) have all experienced systems outages due to problems
with their automated systems. On a number of occasions, ECNs have had
to stop disseminating market maker quotations in order to keep from
closing altogether, including during the market decline of October 1997
when one significant ECN withdrew its quotes from Nasdaq because of
lack of capacity. Similarly, a major interdealer broker in non-exempt
securities experienced serious capacity problems in processing the
large number of transactions in October 1997 and had to close down
temporarily.
The Commission's proposals would require alternative trading
systems that handle a significant volume of trades to establish
reasonable capacity estimates, conduct stress tests, implement
procedures to monitor system development, review systems vulnerability,
and establish adequate contingency plans. Investors would benefit from
the proposals because significant systems would be less likely to shut
down as a result of systems failures and would be better equipped to
handle market demand and provide liquidity during periods of market
stress. The ability of alternative trading systems to provide more
reliable and consistent service in the market would benefit investors
and the public markets generally. The Commission also believes that by
ensuring that significant alternative trading systems maintain
sufficient security measures from unauthorized access, investors would
benefit from robust system security.
All currently registered exchanges participate in the Commission's
automated review program. Alternative trading systems that choose to
register as exchanges would similarly be expected to participate in
this program. Under the automation review program, exchanges are
expected to maintain sufficient systems capacity to meet current and
anticipated volume levels. The benefits to investors and the public
generally, as with significant alternative trading systems, would be
the assurance that systems are reasonably equipped to handle market
demand and provide liquidity during periods of market stress.
2. Costs
The alternative trading system proposals have been tailored to
minimize their burden on alternative trading systems and especially
small systems. Many of the provisions in the proposed rules are
triggered by a volume threshold. The Commission expects that small
alternative trading systems would not have sufficient volume to trigger
those thresholds and would therefore not have to comply with those
provisions. The recordkeeping and reporting requirements with which
smaller, lower volume alternative trading systems would have to comply
under proposed Regulation ATS are substantially similar to those with
which alternative trading systems currently comply. Consequently the
costs for smaller alternative trading systems should remain unchanged.
a. Notice, reporting, and recordkeeping. All alternative trading
systems that would be subject to notice, reporting, and recordkeeping
requirements under the Commission's proposal are currently subject to
similar requirements under Rule 17a-23. The requirements proposed today
under Regulation ATS would, however, require some additional
information that is not currently required under Rule 17a-23.
Under proposed Regulation ATS, alternative trading systems would
file an initial operation report, notices of material systems changes,
and quarterly reports. The proposals also include new Forms ATS and
ATS-R to standardize reporting of such information and make it more
useful for the Commission. The proposed rules would require information
that is not currently required under Rule 17a-23, such as greater
detail about the system operations, the volume and types of securities
traded, criteria for granting access to subscribers, procedures
governing order execution, reporting, clearance and settlement,
procedures for reviewing systems capacity and contingency procedures,
and the identity of any other entities involved in operating the
system.
Proposed Regulation ATS would require staff time to comply with the
initial notice and amendment requirements. While the Commission has
designed the requirements in an effort to balance the costs of filing
with the benefits to be gained from the information, some effort would
be necessary to gather and file this information. Most of the
information, however, already exists. Alternative trading systems would
only be required to gather this information and supply it in the
required format to the Commission. The periodic updating requirements
would also require staff time over the life of the alternative trading
system to comply with the proposed rules.
The Commission estimates that there are currently about 43
alternative trading systems that would be required to register as
exchanges or register as broker-dealers and comply with Regulation
ATS.\313\ The Commission also estimates that, over time, there would be
approximately 3 new alternative trading systems each year that choose
to register as broker-dealers and comply with Regulation ATS.\314\ The
Commission also estimates that, over time, there would be approximately
3 alternative trading systems that file cessation of operations reports
each year. Thus, the Commission anticipates that, over time, if all 43
current alternative trading systems choose to register as broker-
dealers and comply with Regulation ATS, there would be approximately 43
alternative trading systems operating each year.
---------------------------------------------------------------------------
\313\ This estimate is based on filings made with the Commission
under Rule 17a-23.
\314\ Based on the Commission's experience over the last 3 years
with Rule 17a-23, it appears that there are more than 3 new
alternative trading systems per year. However, we expect that in the
steady state over time, there would be approximately 3 new
alternative trading systems per year. The rapid growth experienced
over the last several years is unlikely to continue at such a high
rate in perpetuity.
---------------------------------------------------------------------------
The Commission estimates that the average burden per respondent to
file the initial operations report on Form ATS would be 20 hours. This
burden is computed by estimating that completing the report would
require an average of 13 hours of professional work and 7 hours of
clerical work.\315\ The
[[Page 23541]]
Commission estimates that the average cost per response would be $1,019
representing the 20 hours and cost of supplies.\316\ If all 43
alternative trading systems opted to register as broker-dealers and
comply with Regulation ATS, the total, one time cost to comply with the
proposed requirements to file initial operation reports is estimated to
be $43,817.\317\ The Commission also estimates that, over time,
approximately 3 new alternative trading systems will register as
broker-dealers per year, incurring an annual aggregate burden of 60
hours for an average total cost of $3,057 after the first year
following adoption of Regulation ATS.\318\
---------------------------------------------------------------------------
\315\ This estimate for burden hours of filing Form ATS is based
on burdens associated with filing Form 1, adjusted for differences
between Form 1 and Form ATS. The division between professional and
clerical time is based on estimates of the proportions used in the
estimates of burdens for filing Form 1.
\316\ The estimated average cost per response of $1,019 is
composed of $650 for in-house professional work (13 hours at $50 per
hour), $105 for clerical work (7 hours at $15 per hour) and $264 for
printing, supplies, copying, and postage (approximately 35% of the
total labor costs). The Commission estimates overhead based on 35%
of total labor costs based on the GSA Guide to Estimating Reporting
Costs (1973).
\317\ This estimated cost of $43,817 is derived from 43
alternative trading systems filing at a cost of $1,019 each.
\318\ This estimated cost of $3,057 is derived from 3 new
alternative trading systems filing at a cost of $1,019 each.
---------------------------------------------------------------------------
In addition, the proposed rules would require alternative trading
systems to amend their initial operations report to notify the
Commission of material systems changes and other changes to the
information contained in the initial operations report. The Commission
estimates that each respondent would file 6 such amendments per
year.\319\ The Commission estimates that each respondent would incur an
average burden of 2 hours per response and incur an average cost of
$111.50 for each amendment to the initial operation report that it
submits.\320\ If all 43 alternative trading systems opted to comply
with Regulation ATS rather than to register as exchanges, the total
aggregate cost per year to comply with the proposed requirement to file
amendments to the initial operation reports is estimated to be
$28,767.\321\
---------------------------------------------------------------------------
\319\ This estimate is based on the Commission's experience with
collection of similar information under Rule 17a-23.
\320\ The estimated average cost per response of $111.50 is
composed of $75 for in-house professional work (1.5 hours at $50 per
hour), $7.50 for clerical work (0.5 hours at $15 per hour), and $29
for printing, supplies, copying, and postage (approximately 35% of
the total labor costs). The Commission estimates overhead based on
35% of total labor costs based on the GSA Guide to Estimating
Reporting Costs (1973).
\321\ This estimated cost of $28,767 is composed of $111.50 cost
per amendment for 43 alternative trading systems filing 6 times per
year.
---------------------------------------------------------------------------
Alternative trading systems registering as broker-dealers would
also be required to file quarterly reports on Form ATS-R, reporting
participating system subscribers, the securities traded on the system,
and aggregate volume information. The Commission estimates that the
quarterly reports would cause each respondent to incur an average
burden of 4 hours per response and incur an average cost of $223 for
each Form ATS-R that it submits.\322\ The annual burden per respondent
would be $892.\323\ If all 43 alternative trading systems opted to
register as broker-dealers and comply with Regulation ATS, the total
cost per year to comply with the proposed requirement to file quarterly
reports is estimated to be $38,356.\324\
---------------------------------------------------------------------------
\322\ The estimated cost of $223 per response is composed of
$150 for in-house professional work (3 hours at $50 per hour), $15
for clerical work (1 hour at $15 per hour) and $58 for printing,
supplies, copying, and postage (approximately 35% of the total labor
costs). The Commission estimates overhead based on 35% of total
labor costs based on the GSA Guide to Estimating Reporting Costs
(1973).
\323\ The estimated annual cost of $892 to file Form ATS-R is
derived from 4 quarterly reports at an estimated annual cost of $223
per filing.
\324\ This estimated cost of $38,356 is derived from 43
alternative trading systems with an estimated annual filing cost for
each of $892.
---------------------------------------------------------------------------
Finally, alternative trading systems registered as broker-dealers
would be required to submit a notice and a report on Form ATS when they
cease operations. The Commission anticipates a total of 3 such filings
per year. The Commission estimates that individual respondents would
incur a burden of 2 hours to file the cessation notice. The Commission
estimates that individual respondents would incur a cost of $111.50 to
file the cessation of operations report on Form ATS.\325\ The annual
aggregate burden for 3 alternative trading systems to file cessation of
operations reports is estimated to be $334.50.\326\
---------------------------------------------------------------------------
\325\ The estimated cost of $111.50 per response is composed of
$75 for in-house professional work (1.5 hours at $50 per hour),
$7.50 for clerical work (0.5 hours at $15 per hour), and $29 for
printing, supplies, copying and postage (approximately 35% of the
total labor costs). The Commission estimates overhead based on 35%
of total labor costs based on the GSA Guide to Estimating Reporting
Costs (1973).
\326\ The estimated cost of $334.50 is derived from an average
of 3 alternative trading systems filing 1 cessation of operations
report per year on Form ATS at an estimated cost of $111.50 each.
---------------------------------------------------------------------------
The proposed recordkeeping requirements under Regulation ATS would
require alternative trading systems registered as broker-dealers to
keep and make available to the Commission and the appropriate SRO, upon
request, records of: (1) The identities of subscribers to the system;
(2) daily summaries of trading in the system; (3) time-sequenced
records of specified order information in the system; (4) all notices
provided to subscribers; and (5) all documents relating to the system's
compliance with the capacity, security, and integrity standards set
forth in Proposed Rule 301(b)(6) under Regulation ATS.\327\ The
Commission estimates that each alternative trading system that chooses
to register as a broker-dealer would be required to expend an average
of 40 hours per year, at an estimated average cost of $1,923.20, to
comply with these proposed recordkeeping requirements.\328\ If all 43
alternative trading systems opted to register as broker-dealers, rather
than as exchanges, the total cost for both recordkeeping and record
preservation is estimated to be $82,697.60 per year.\329\ The
Commission notes that it is soliciting comment on the feasibility of
permitting alternative trading systems to file all reports
electronically, which could ease the burdens on alternative trading
systems.
---------------------------------------------------------------------------
\327\ Proposed Rules 301(b)(8), 302, and 303(a)(1).
\328\ The estimated cost of $1,923.20 is derived from an average
of 40 hours of compliance time at $48.04 per hour. The value of
compliance time is estimated as follows: an employee of a broker-
dealer charged to ensure compliance with Commission regulations
receives estimated annual compensation of $100,000. This
compensation is the equivalent of $48.08 per hour ($100,000 divided
by 2,080 payroll hours per year). The estimate of 40 hours
encompasses an estimated 36 burden hours for recordkeeping
requirements under proposed Rule 302 and an estimated 4 burden hours
for record preservation requirements under proposed Rule 303.
\329\ This estimated cost of $82,697.60 is derived from 43
alternative trading systems incurring an annual cost of $1,923.20
each.
---------------------------------------------------------------------------
b. Public display of orders and equal execution access. Proposed
Regulation ATS would require some market participants to modify their
current quotation dissemination systems. Because alternative trading
systems would be required to display the best bid and offer regardless
of the party entering the order, additional burdens could possibly be
imposed on institutions choosing to use different order entry methods
to avoid display. Accordingly, the possibility exists that alternative
trading systems could suffer decreased liquidity if institutional
customers reduced their reliance on alternative trading systems for
trading activities. The Commission believes that its proposals reduce
the likelihood of this occurrence. Moreover, the Commission
preliminarily believes that any costs would be offset by the benefits
enjoyed by the public market as a whole in the form of less
fragmentation, increased liquidity, and the equal opportunity to obtain
the best bids and
[[Page 23542]]
offers in the market. The Commission estimates that 3 alternative
trading systems would be required to comply with the display provisions
of proposed Regulation ATS due to their significant volume.
c. Fair access. The proposal would require alternative trading
systems to provide fair access and to notify investors denied access
that they can appeal this denial to the Commission and that investors
are able to appeal denials to the Commission. These requirements would
likely impose little additional cost on most alternative trading
systems. First, only alternative trading systems with significant
volume would be subject to this requirement. Second, as long as a
significant alternative trading system establishes legitimate criteria
for participation and applies those criteria consistently, there would
be few, if any fair access complaints. Nevertheless, in the event
investors are denied access, there may be some additional costs to
alternative trading systems associated with notifying investors of
their right to appeal this action to the Commission, and potentially
from defending appeals. The Commission, however, preliminarily believes
that the benefits of fair access outweigh the potential costs. The
Commission believes that without redress for denials of access,
alternative trading systems could deny access unfairly.
Under proposed Regulation ATS, alternative trading systems with
significant volume would be required to establish and maintain
standards for granting access to their system and keep records of such
standards. The Commission estimates that each respondent obligated to
establish and maintain such records would incur a burden of 5 hours per
year to make and keep standards for granting access for a total cost of
$337.50.\330\
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\330\ The estimated cost of $337.50 to establish and maintain
standards for granting access is composed of $250 for in-house
professional work (5 hours at $50 per hour) and $87.50 for printing,
supplies, copying, and postage (approximately 35% of the total labor
costs). The Commission estimates overhead based on 35% of total
labor costs based on the GSA Guide to Estimating Reporting Costs
(1973).
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Based on the Commission's experience with denials of access to
markets, the Commission estimates that alternative trading systems
would, on average, deny or limit access 27 times annually. The
Commission estimates that respondents would incur a burden of 1 hour
for each required notice to investors for an estimated annual cost to
each respondent of $546.75.\331\ The Commission estimates that
approximately 2 alternative trading systems would be required to comply
with the fair access requirements due to their significant volume. The
estimated aggregate burden for these alternative trading systems to
comply with the fair access requirements under Regulation ATS would be
64 hours for a total average aggregate cost of $1,768.50.\332\ The
Commission requests comment on the costs described above with respect
to the fair access provision of proposed Regulation ATS.
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\331\ The estimated cost of $20.25 per response is composed of
$15 for clerical work (1 hour at $15 per hour) and $5.25 for
printing, supplies, copying, and postage (approximately 35% of the
total labor costs). The Commission estimates overhead based on 35%
of total labor costs based on the GSA Guide to Estimating Reporting
Costs (1973). The estimated annual cost of $546.75 is derived from
27 notices at $20.25 per notice.
\332\ The estimated aggregate burden of 64 hours is derived from
32 hours per respondent. The burden of 32 hours per respondent is
composed of 5 hours for recordkeeping and 27 hours for notice
requirements. The estimated aggregate cost of $1,768.50 is derived
from 2 alternative trading systems each incurring an estimated
annual burden of $884.25 ($546.75 for notice requirements and
$337.50 for recordkeeping requirements).
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d. Systems capacity, integrity, and security. The Commission does
not believe that its proposals to require alternative trading systems
to meet certain systems related standards would impose significant
costs. The standards the Commission is proposing are general standards
that are consistent with good business practices. In addition, smaller
alternative trading systems would not be subject to the proposed
requirements. For those alternative trading systems that would not, for
business reasons alone, ensure adequate capacity, integrity, and
security of their systems, there would be costs associated with
complying with the proposed requirements. The costs associated with
upgrading systems to an adequate level may include, for example,
investing in computer hardware and software. In addition, alternative
trading systems would incur costs associated with the independent
review of their systems on an annual basis. The review must be
performed by independent reviewers, but those reviewers may be
employees of the alternative trading system, or third party reviewers.
The review must be conducted according to established procedures and
standards. The costs involved may vary widely depending on the business
of the alternative trading system. Accordingly, the Commission is
requesting comment on the costs that may be associated with both
internal and external reviews. Alternative trading systems would also
be subject to recordkeeping requirements to document the steps taken to
comply with proposed Regulation ATS. These requirements would be
necessary for the Commission and the appropriate SROs to ensure
compliance with systems related requirements. In addition, keeping such
records would permit alternative trading systems to effectively analyze
systems problems that occur. While alternative trading systems are not
required to file such documentation with the Commission on a regular
basis, the Commission recognizes that generating and maintaining such
documentation would impose some additional costs.
The notification requirement for material systems outages should
impose relatively little additional costs on alternative trading
systems. Moreover, the Commission believes that this small burden is
justified by the need to keep Commission staff abreast of systems'
developments and problems.
The Commission estimates that each respondent would incur an
average annual burden of 15 hours to comply with the recordkeeping
requirements associated with the systems capacity, integrity, and
security provisions of proposed Regulation ATS. The Commission
estimates that each respondent would make an average of 5 system outage
notices per year, for an estimated average burden of 1.25 hours per
year.\333\ The Commission estimates that the total estimated average
cost of compliance for each respondent would be $85 per year.\334\ Such
alternative trading systems would also be required to keep records
relating to the steps taken to comply with systems capacity, integrity,
and security requirements under Regulation ATS. The Commission
estimates that each respondent would incur a burden of 10 hours per
year to comply with such recordkeeping requirements for a total cost of
$675 per year.\335\ The Commission estimates that 2 alternative trading
systems would be required to comply with the systems
[[Page 23543]]
capacity, integrity, and security provisions of proposed Regulation ATS
due to their significant volume. The estimated aggregate cost for these
alternative trading systems chose to comply with the systems capacity,
integrity, and security requirements would be $1,520.\336\ The
Commission requests comment on the costs and benefits associated with
systems capacity, integrity, and security.
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\333\ The Commission notes that compliance with the notice
provision can be achieved by a telephone call, so the burden for
each notice is minimal. The Commission estimates only 0.25 hours per
notice would be required.
\334\ The estimated average cost per response of $17 is composed
of $12.50 for in-house professional work (0.25 hours at $50 per
hour) and $4.50 for printing, supplies, copying, and postage
(approximately 35% of the total labor costs). The Commission
estimates overhead based on 35% of total labor costs based on the
GSA Guide to Estimating Reporting Costs (1973). The estimated annual
cost of $85 is derived from 5 notices at $17 per notice.
\335\ The total estimated cost of $675 is composed of $500 for
in-house professional work (10 hours at $50 per hour) and $175 for
printing, supplies, copying, and postage (approximately 35% of the
total labor costs). The Commission estimates overhead based on 35%
of total labor costs based on the GSA Guide to Estimating Reporting
Costs (1973).
\336\ The estimated aggregate cost of $1,520 is derived from 2
alternative trading systems incurring an estimated annual cost of
$760 each ($85 for providing systems outage notices and $675 for
recordkeeping requirements).
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e. Costs of exchange registration. The proposed framework for
alternative trading systems is designed to allow such systems the
option of registering as national securities exchanges. If an
alternative trading system chooses to register as an exchange,
corresponding regulatory obligations could impose costs on such
systems; however, these costs would be assumed voluntarily.
For example, exchange-registered alternative trading systems would
have to be organized to, and have the capacity to be able to, carry out
the purposes of the Exchange Act, including their own compliance and
the ability to enforce member compliance with the securities laws.
Consequently, any newly registered exchange would have to establish
appropriate surveillance and disciplinary mechanisms. In addition,
newly registered exchanges would incur certain start-up costs
associated with this obligation, such as writing rule manuals. This is
the same standard that currently registered exchanges meet. Because the
costs associated with these requirements may vary dramatically, the
Commission is seeking comment on the estimated costs for compliance
with these requirements.
The costs of exchange registration would also include filing a Form
1 pursuant to Rule 6a-1 under the Exchange Act \337\ and complying with
other filing obligations under Rules 6a-2 \338\ and 6a-3 under the
Exchange Act.\339\ In addition, national securities exchanges incur
costs in the preparation of proposed rule changes for submission to the
Commission for approval.\340\ Section 19(b) of the Exchange Act
requires an SRO to file with the Commission proposed amendments to its
constitution, articles of incorporation, by-laws, rules, and other
similar instruments or interpretations of these instruments. Registered
exchanges are also required to maintain certain records pursuant to
Rule 17a-1 under the Exchange Act.\341\
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\337\ Rule 6a-1 currently requires that Form 1 be filed with the
Commission upon registration with the Commission as a national
securities exchange or upon applying for an exemption from
registration. This is the only time a Form 1 is filed. The estimated
average cost per response of $3,719 is composed of $2,000 for
professional work (20 hours at $100 per hour), $500 for in-house
professional work (10 hours at $50 per hour), $255 for clerical work
(17 hours at $15 per hour) and $964 for printing, supplies, copying,
and postage (approximately 35% of the total labor costs). The
Commission estimates overhead based on 35% of total labor costs
based on the GSA Guide to Estimating Reporting Costs (1973).
\338\ As proposed to be amended, Rule 6a-2 would require that an
exchange, whether registered as a national securities exchange or
exempted from registration, file with the Commission a new Form 1 to
reflect amendments to those items contained in the previously filed
Form 1. The Commission believes that the proposed amendments to Rule
6a-2 would reduce the filing obligations for all respondents. See
supra Section III.B.3.b. The Commission estimates that the average
cost per response, as reduced by the proposed amendments to Rule 6a-
2, would be $1,215. This estimate is composed of $750 for in-house
professional work (15 hours at $50 per hour), $150 for clerical work
(10 hours at $15 per hour) and $315 for printing, supplies, copying,
and postage (approximately 35% of the total labor costs). The
Commission estimates overhead based on 35% of total labor costs
based on the GSA Guide to Estimating Reporting Costs (1973).
\339\ Rule 6a-3 currently requires that an exchange, whether
registered as a national securities exchange or exempted from
registration, file with the Commission information regarding any
material issued or made generally available to members of, or
participants or subscribers to, the exchange, and a monthly report
detailing the number of shares of stocks, bonds, rights, and
warrants traded on the exchange's facilities and the aggregate
dollar amount of such securities. The Commission is proposing to
amend Rule 6a-3, but only to simplify the language of the rule. The
proposed amendments would not change the material terms of the rule.
See supra Section III.B.3.b. The Commission receives approximately
25 filings pursuant to Rule 6a-3 per year from 9 respondents, for a
total of 225 responses. The estimated average cost per response of
$9.50 is composed of $7.50 for clerical work (0.5 hours at $15 per
hour) and $2 for printing, supplies, copying, and postage
(approximately 35% of the total labor costs). The Commission
estimates overhead based on 35% of total labor costs based on the
GSA Guide to Estimating Reporting Costs (1973). The total annual
average cost for 225 responses is estimated to be $2,137.50.
\340\ See also Rule 19b-4 under the Exchange Act and Form 19b-4.
The Commission currently receives approximately 600 rule filings per
year from approximately 25 respondents. The estimated average cost
per response of $1,890 is composed of $1,250 for in-house
professional work (25 hours at $50 per hour), $150 for clerical work
(10 hours at $15 per hour), and $490 for printing, supplies,
copying, and postage (approximately 35% of the total labor costs).
The Commission estimates overhead based on 35% of total labor costs
based on the GSA Guide to Estimating Reporting Costs (1973). Major
rule filings can cost substantially more than $1,890, but account
for less than approximately one percent of the total annual rule
filings. The Commission estimated that these rule filings can cost
up to approximately $10,000 to $15,000 per filing.
\341\ The estimated average cost per respondent is $2,500, which
is composed of 50 hours of in-house professional work per year at
$50 per hour. There are currently 8 registered national securities
exchanges and 1 national securities association that are subject to
Rule 17a-1, for an annual estimated 450 burden hours and a cost of
$22,500. Other entities, such as registered clearing agencies and
the Municipal Securities Rulemaking Board are also subject to the
rule, but have not been reflected in this estimate because the
changes proposed in this release would not affect those entities.
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As registered exchanges, alternative trading systems would also be
subject to more frequent inspection by the Commission. As broker-
dealers, alternative trading systems would be inspected on a regular
basis by any SRO of which they are a member, and by the Commission only
on an intermittent basis. As registered exchanges, these systems would
be inspected more regularly by Commission staff, but would--of course--
no longer be subject to examinations by SROs.
The Commission inspects different SRO programs on independent
review cycles. For example, separate inspections are conducted for an
SRO's surveillance, arbitration, listings, and financial soundness
programs. Where appropriate, SROs would be examined for other programs
they may operate, such as index programs. Each type of examination
would be performed at regular intervals, which are typically two to
three years. An SRO, however, may expect several examinations
throughout a particular year, each in a different program. Each
examination typically involves three to four attorneys and/or
accountants from the Commission, who spend one week at the SRO, or up
to two weeks for particularly large programs, to examine records and
interview SRO personnel. In order to comply with section 17(b) under
the Exchange Act, an SRO must expend resources to provide copies of
relevant documents to, and answer questions from, the Commission staff.
The cost to an SRO of each examination varies greatly depending on the
scope of the examination and the size or complexity of the SRO's
particular program. Therefore, the Commission is not able to quantify a
meaningful average cost to the SROs for compliance with the Commission
examination program, and requests comment on the specific costs that
may be involved.
In addition, there would also be costs associated in meeting the
obligations set forth in section 11A of the Exchange Act and the rules
thereunder. These costs would include the costs of joining, or creating
new, market-wide plans, such as the CQS, CTA, ITS, and OTC-UTP,
although some of these costs would be offset by the right to share in
the revenues generated by these plans. For example, to join the CTA
plan, applicants would be asked to pay, as a condition to entry into
the plan, an amount that reflects the value of the tangible and
intangible assets created by
[[Page 23544]]
the CTA plan that would be available to the applicant.\342\ Similarly,
new participants in ITS would have to pay a share of the development
costs, which will reflect a share of the initial development costs,
which were $721,631, and a share of costs incurred after June 30,
1978.\343\ These costs would also include the costs of complying with
Rule 11Ac1-1(b) under the Exchange Act,\344\ which requires national
securities exchanges and national securities associations to make the
best bid, best offer, and aggregate quotation size for each security
traded on its facilities available to quotation vendors for public
dissemination.\345\ These costs will vary depending on the nature and
size of the systems involved, and the Commission requests comment on
the costs involved.
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\342\ CTA Plan: Second Restatement of Plan Submitted to the
Securities and Exchange Commission Pursuant to Rule 11Aa3-1 under
the Securities Exchange Act of 1934, May, 1974 and restated March
1980 and December 1995, at 8-9. The amount to be paid to the CTA
plan will vary on a case-by-case basis and may reflect a current
independent valuation of the CTA facilities, prior valuations, an
assessment of costs contributed to the plan by existing members, the
estimated usage of the plan facilities by the applicant, costs for
anticipated system modifications to accommodate the applicant, and
other relevant factors as determined by the current participants.
The terms of the CQ Plan are substantially similar with respect to
the assessment of a payment upon entry into the system. CQ Plan:
Restatement of Plan Submitted to the Securities and Exchange
Commission Pursuant to Rule 11Ac1-1 under the Securities Exchange
Act of 1934, July 1978, as restated December 1995, at 8-9.
\343\ Plan for the Purpose of Creating and Operating an
Intermarket Communication Linkage Pursuant to section 11A(a)(3)(B)
of the Securities Exchange Act of 1934, Composite: Amendments
through May 30, 1997, at 78-79.
\344\ 17 CFR 240.11Ac1-1.
\345\ The Commission estimates that each national securities
exchange or national securities association will submit information
to vendors approximately 24,266,000 times per year, which reporting
is generally done through automated facilities that conduct the
reporting on a continuous basis. Due to the continuous nature of the
information feeds, the Commission does not believe that it is
feasible to estimate the average cost per response or annual burdens
hours involved in complying with Rule 11Ac1-1(b). 17 CFR 240.11Ac1-
1(b).
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The Commission notes that the remaining costs would at least
partially be offset because the alternative trading systems assuming
the costs of exchange registration would no longer be regulated as
broker-dealers. Consequently, they would no longer be obligated to
comply with the broker-dealer requirements, such as filing and updating
Form BD, maintaining books and records in accordance with Rules 17a-3
and 17a-4 under the Exchange Act, and paying fees for membership in an
SRO. In addition, because exchange-registered alternative trading
systems would share the responsibilities of self-regulation, the
regulatory burden carried by currently registered exchanges should be
reduced. Other benefits include the freedom from oversight by a
competing SRO, the right to establish trading and conduct rules, the
right to establish fee schedules, the ability to directly participate
in the NMS mechanisms, and the right to share in the profits and
benefits produced by the NMS mechanisms such as the CQS, CTA, ITS and
OTC-UTP plans.\346\
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\346\ See supra Section III.B.1.
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B. Proposed Amendments to Application and Related Rules for
Registration as an Exchange
The Commission is proposing amendments to Rules 6a-1, 6a-2, and 6a-
3 under the Exchange Act,\347\ which require exchanges that elect to
register to file Form 1 and comply with certain information updating
and monthly reporting requirements. The proposed amendments would
describe the filing requirements for national securities exchanges in a
more clear and concise manner.
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\347\ 17 CFR 240.6a-1; 17 CFR 240.6a-2; 17 CFR 240.6a-3.
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1. Benefits
The Commission believes that the proposed amendments would provide
benefits to organizations that are currently registered, or in the
future apply for registration, as a national securities exchange.
First, the proposed amendments to Rules 6a-1, 6a-2, and 6a-3 would ease
compliance burdens by simplifying the rule. By simplifying the rule
language itself, the Commission anticipates that parties attempting to
comply with Rules 6a-1, 6a-2 and 6a-3 would be better able to
understand the rules' requirements and comply with them. Much of the
information required on Form 1 would not change, but the revised form
would recast the questions and exhibits in a different format that
would ease compliance and make the responses more relevant to investors
and the Commission. While national securities exchanges have
traditionally been membership-owned, Form 1 would also be revised to
accommodate proprietary national securities exchanges.
Second, the proposed amendments would give national securities
exchanges the option of complying with certain ongoing filing
requirements by posting information on an Internet web site and
supplying the location to the Commission, instead of filing a complete
paper copy with the Commission. The Commission anticipates that
exchanges would choose to use the Internet to comply with Rules 6a-2
and 6a-3 rather than filing many exhibits on paper. The availability of
such information on the Internet would also provide the public with
easier and less expensive access to the information than requesting
paper copies from the Commission or the national securities exchanges
as currently required. In addition, permitting exchanges to use the
Internet as a means of compliance would reduce expenses associated with
clerical time, postage, and copying.
The proposed amended rules would also reduce the frequency of
certain ongoing filings to update the information in Form 1, directly
reducing the compliance burden on national securities exchanges while
still meeting investors' and the Commission's need for reasonably
current information. Specifically, the proposed amendments would
eliminate exchanges' requirement to submit changes to their
constitution, their rules, or the securities listed on the exchange
within 10 days. The proposed amendments would also permit exchanges to
file certain information regarding subsidiaries and affiliates every
three years rather than annually. These proposed amendments would
conserve registered exchanges' staff time to comply with the rules.
The Commission estimates that the proposals would specifically
reduce the annual burdens that each respondent would incur to comply
with Rule 6a-2 by approximately 5 hours. Thus, the Commission
anticipates that respondents would spend an average of 25 hours on an
annual basis to comply with amended Rule 6a-2.\348\ The estimated
average benefit to each individual respondent is $75 per year.\349\
These estimates represent a decrease of the estimated burden that
currently exists, so exchanges would benefit from reduced filing
burdens.
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\348\ These estimates are based on the Commission's experience
with Rule 6a-2 and Form 1-A filings. The Commission expects the
current filing burdens of 30 hours to be lessened under the proposed
rules, thus the estimated burden of hours required has been adjusted
downward. The Commission notes that the proposed rules will
eliminate Form 1-A and incorporate the updating obligations into the
revised Form 1.
\349\ The estimated average annual benefit for each respondent
of $75 is composed of the savings of 5 hours of clerical work at $15
per hour.
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2. Costs
The proposed rules are intended to simplify the filing requirements
and reduce the compliance burdens for national securities exchanges and
would likely impose few additional costs on
[[Page 23545]]
national securities exchanges. Initially, there may be some additional
personnel costs required to review the proposed rules and revised Form
1, but the Commission believes that the proposed simplified
requirements would reduce overall compliance burdens and costs over
time. Reducing the frequency of filings for some requirements may
result in some information being less current. The Commission, however,
believes that much of this type of information does not change
frequently. Moreover, the option of posting such information on an
Internet web site should encourage more frequent updating of current
information.
The Commission notes that it is soliciting comment on the
feasibility of permitting the filings required under the proposed
amendments to be filed electronically, which would further reduce the
compliance burdens and costs.
The Commission estimates that each respondent would incur an
average burden of 47 hours to comply with Rule 6a-1 and file an initial
application for registration on Form 1. This represents a 2 hour
increase from the current average burden due to the estimated
additional burden of the added exhibits. The Commission estimates that
the average additional cost per response would be approximately
$30.\350\ Because the Commission receives applications for registration
as exchanges on Form 1 from time to time, it cannot estimate the annual
aggregate costs and burden hours associated with such filings. The
Commission therefore requests comment on such costs and burden hours.
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\350\ The estimated average additional cost per response of $30
is derived from 2 additional hours of clerical work at $15 per hour.
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The Commission anticipates that the proposals would not change the
burdens associated with complying with Rule 6a-3. The Commission
estimates that the average burden for each respondent to comply with
Rule 6a-3 is one-half hour per response because compliance only
requires photocopying existing documents. The Commission also estimates
that each respondent would file supplemental information under Rule 6a-
3 approximately 25 times per year. The estimated average cost per
response for each individual respondent is $9.50, resulting in an
estimated annual average burden for each respondent of $237.50.\351\
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\351\ The estimated average cost per response of $9.50 is
composed of $7.50 for clerical work (0.5 hours at $15 per hour) and
$2 for printing, supplies, copying, and postage (approximately 35%
of the total labor costs). The Commission estimates overhead based
on 35% of total labor costs based on the GSA Guide to Estimating
Reporting Costs (1973). The estimated average annual cost of $237.50
is derived from 25 annual filings at a cost of $9.50 per filing.
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C. Costs and Benefits of the Proposed Repeal of Rule 17a-23 and the
Proposed Amendments to Rules 17a-3 and 17a-4
Rule 17a-23 currently imposes certain recordkeeping and reporting
requirements on broker-dealer trading systems. In conjunction with its
other proposals, the Commission is proposing to repeal Rule 17a-23 and
amend Rules 17a-3 and 17a-4 under the Exchange Act \352\ to eliminate
all reporting requirements under Rule 17a-23 and to transfer certain
recordkeeping requirements from Rule 17a-23 to Rules 17a-3(a)(16) and
17a-4(b)(10).
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\352\ 17 CFR 240.17a-3; 17 CFR 240.17a-4.
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The new recordkeeping requirements under Rules 17a-3(a)(16) and
17a-4(b)(10) would apply solely to a limited group of broker-dealer
systems, defined in the proposed amendment to Rule 17a-3 as ``internal
broker-dealer systems.'' These are systems that would not be
encompassed under proposed Rule 3b-12 under the Exchange Act. Systems
that would be alternative trading systems under the Commission's
proposals in this release would not be subject to the recordkeeping
requirements under amended Rules 17a-3 and 17a-4. Moreover, the
reporting obligations currently under Rule 17a-23 would be eliminated
entirely.
1. Benefits
Approximately 43 of the broker-dealer trading systems currently
filing reports under Rule 17a-23 would be alternative trading systems
under the proposals in this release. These trading systems would not
fall within the proposed definition of ``internal broker-dealer
system,'' and would, therefore, not be required to maintain records
under the new provisions of Rules 17a-3(a)(16) and 17a-4(b)(10).
Accordingly, the Commission estimates that the annual aggregate costs
and annual aggregate burden for the recordkeeping obligations under
Rule 17a-23 would be reduced by $19,350 and 1,290 hours,
respectively.\353\ In addition, all reporting requirements under Rule
17a-23 would be eliminated. The Commission estimates that the annual
aggregate costs and annual aggregate burden for the reporting
obligations under Rule 17a-23 of $15,764 and 2,252 hours, respectively,
would, therefore, be eliminated.\354\ The Commission notes, however,
that alternative trading systems would be subject to recordkeeping
requirements under proposed Regulation ATS.\355\
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\353\ The estimated average benefit for alternative trading
systems of $19,350 is composed of 43 alternative trading systems
saving 30 hours of clerical work at $15 per hour. The estimated
average benefit for alternative trading systems of 1,290 hours is
composed of 43 alternative trading systems saving 30 hours each. The
cost per hour and per filing is derived from the Commission's review
of the Form 17A-23 supplied by the broker-dealers currently subject
to Rule 17a-23.
The Commission notes, however, that alternative trading systems
would be subject to recordkeeping requirements under Proposed
Regulation ATS. See supra Section IX.A.2.a.
\354\ The estimated aggregate burden of 2,252 is composed of 528
hours for initial reports (22 initial reports at 24 hours each),
1,716 hours for quarterly reports (143 quarterly reports at 12 hours
per year--4 quarters at 3 hours each) and 8 hours for cessation
reports (4 cessation reports at 2 hours each). The estimated total
cost of $33,780 is composed of 2,252 hours of clerical work at $15
per hour. The Commission notes, however, that alternative trading
systems would be subject to reporting requirements under proposed
Regulation ATS. See supra Section IX.A.2.a.
\355\ The costs and benefits associated with these recordkeeping
requirements are discussed in Section IX.A.2.a. supra.
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2. Costs
No additional recordkeeping burdens would be imposed on internal
broker-dealer systems under the proposed amendments to Rules 17a-3 and
17a-4. The proposed amendments would apply only to systems that are
presently subject to the recordkeeping requirements of Rule 17a-23.
Because the Commission is proposing to repeal Rule 17a-23 and amend
Rules 17a-3 and 17a-4 by transferring the recordkeeping requirements
from Rule 17a-23, the Commission does not anticipate any new
recordkeeping costs or burdens for respondents.
Based on Commission experience with the burdens associated with
Rule 17a-23, the Commission has estimated the burdens that would be
associated with proposed Rule 17a-3(a)(16) and 17a-4(b)(10). The
Commission estimates that there would be approximately 94 broker-
dealers operating 123 internal broker-dealer systems that would have to
keep the records described in proposed Rules 17a-3(a)(16) and 17a-
4(b)(10). The Commission estimates that each respondent would spend
approximately 27 hours keeping the required records under Rule 17a-
3(a)(16). The Commission also estimates that each respondent would
spend approximately 3 hours to preserve the required records under Rule
17a-4(b)(10). Thus, the Commission estimates that each respondent would
incur a burden of 30 hours per year complying with Rules 17a-3(a)(16)
and
[[Page 23546]]
17a-4(b)(10) and an annual cost of $1,442.40.\356\
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\356\ The Commission estimates that an employee of a broker-
dealer charged to ensure compliance with Commission regulations
receives annual compensation of $100,000. This compensation is the
equivalent of $48.08 per hour ($100,000 divided by 2,080 payroll
hours per year). The estimated annual cost of $1,442.40 is derived
from 30 burden hours per respondent at $48.08 per hour.
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D. SRO Pilot Trading System
Under proposed Rule 19b-5, SRO rule changes to operate pilot
trading systems would be temporarily exempt from the rule filing
requirement of section 19(b) of the Exchange Act.\357\
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\357\ See also supra note 340.
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1. Benefits
By permitting SROs to begin operating eligible pilot trading
systems immediately and to continue operating for two years under a
flexible regulatory scheme, the Commission preliminarily believes that
proposed Rule 19b-5 would benefit SROs and investors. As proposed, Rule
19b-5 would enhance competition in the trading markets without imposing
significant SRO compliance burdens.\358\ Proposed Rule 19b-5 would
permit the timely implementation of pilot trading systems without the
widespread dissemination of critical business information. Therefore,
the proposal should reduce SRO costs associated with the Commission
approval process and improve the competitive balance between SROs and
alternative trading systems that are regulated as broker-dealers.\359\
Moreover, the Commission believes that proposed Rule 19b-5 would foster
innovation and create a streamlined procedure for SROs to operate pilot
trading systems and would reduce filing costs for SROs pilot trading
systems.
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\358\ The Commission estimates that the current preparation and
filing of proposed rule changes pursuant to section 19(b)(2) of the
Exchange Act to operate a pilot trading system constitute major
market impact filings requiring approximately 100 hours and $10,000
to $15,000 of SRO time and money, respectively, for each proposal.
This does not include the cost of the SRO of any delay in obtaining
Commission approval or in disclosing business information; nor does
this include the benefit to an SRO of bringing its new pilot trading
system to market in a shorter amount of time. The cost per hour and
per filing is derived from information supplied by the SROs. For the
purposes of our estimates, we have valued related overhead at 35% of
the value of legal work. See GAS Guide to Estimating Reporting Costs
(1973).
\359\ The Commission estimates that under current procedures, a
proposed rule filing for a new pilot trading system takes 90 days,
on average, from the date of the original submission to be approved.
In contrast, the proposed expedited treatment of SRO rule changes
for pilot trading systems permits SROs to operate a pilot trading
system 20 days after submitting an initial operation report on
proposed Form PILOT, so long as such product complies with proposed
Rule 19b-5 under the Exchange Act.
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2. Costs
The Commission anticipates receiving approximately 6 notices per
year regarding pilot trading systems on proposed Form PILOT.\360\ An
SRO would be required to submit a Form PILOT providing detailed
operational data and update this information quarterly. The Commission
estimates that an SRO would expend 24 hours to file an initial
operation report and 3 hours to file a quarterly report and a systems
change notice.\361\ The Commission also estimates that an SRO would
file 2 amendments per year to report changes to the system.\362\ The
Commission estimates that an SRO would expend $1,242 per initial Form
PILOT filing and $155 for each quarterly Form PILOT and system change
notice filed.\363\ Thus, the total estimated annual burden for SROs to
comply with proposed Rule 19b-5 by filing an initial notice on Form
PILOT is estimated to be 144 hours for a total average cost of
$7,452.\364\ The total estimated annual burden for SROs to file systems
change notices and quarterly reports on Form PILOT is estimated to be
108 hours for a total average cost of $5,580.\365\
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\360\ This estimate is based on a review of past SRO filings
under Section 19(b) of the Exchange Act. The Commission estimates
that approximately 6 rule filings per year in the past could have
been filed under the proposed Rule 19b-5.
\361\ The estimates for burden hours involved with filing Form
PILOT are based on the Commission's experience with similar
reporting requirements under Rule 17a-23.
\362\ This estimate is based on the Commission's experience with
collection of similar information under Rule 17a-23.
\363\ The estimated average cost of $1,242 to file an initial
Form PILOT is composed of $800 for in-house professional work (16
hours at $50 per hour), $120 for clerical work (8 hours at $15 per
hour) and $322 for printing, supplies, copying, and postage
(approximately 35% of the total labor costs). The Commission
estimates overhead based on 35% of total labor costs based on the
GSA Guide to Estimating Reporting Costs (1973).
The estimated average cost of $155 to file quarterly reports and
system change notices on Form PILOT is composed of $100 for in-house
professional work (2 hours at $50 per hour), $15 for clerical work
(1 hour at $15 per hour) and $40 for printing, supplies, copying and
postage (approximately 35% of the total labor costs). The Commission
estimates overhead based on 35% of total labor costs based on the
GSA Guide to Estimating Reporting Costs (1973).
\364\ The estimated average burden of 144 hours is derived from
6 SRO respondents incurring an average burden of 24 hours per
filing. The estimated average cost of $7,452 is derived from 6 SRO
respondents making 6 initial Form PILOT filings at $1,242 per
filing.
\365\ The estimated average burden of 108 hours is derived from
6 SRO respondents filing 4 quarterly reports and 2 systems change
notices at 3 burden hours per filing. The estimated average cost of
$5,580 is derived from 6 SRO respondents filing 4 quarterly reports
and 2 systems change notices at $155 per filing.
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E. Request for Comment
The Commission requests data to quantify the costs and the value of
the benefits described above. The Commission seeks estimates of these
costs and benefits, as well as any costs and benefits not already
defined, that may result from the adoption of these proposed amendments
and rules.
The Commission requests comment on the estimate of the number of
alternative trading systems that would be permitted to register as
broker-dealers and comply with Regulation ATS, the number of new
alternative trading systems that would choose to register as broker-
dealers and comply with Regulation ATS each year in the future, and the
number of alternative trading systems registered as broker-dealers that
file cessation of operations reports each year.
In addition, the Commission requests comment on the costs and
benefits associated with the Commission's proposals with respect to
notice, reporting, and recordkeeping for alternative trading systems
choosing to register as broker-dealers. The Commission specifically
requests comment on the costs and benefits for all market participants
associated with the filing requirements on Form ATS and ATS-R and the
feasibility of permitting such forms to be filed electronically.
The Commission also requests comment on the costs and benefits
associated with the Commission's proposals to improve surveillance on
alternative trading systems. The Commission specifically requests
comment on the benefits for all market participants associated with
preventing fraud and manipulation on alternative trading systems.
The Commission requests comment on the costs associated with the
Commission's proposals to improve market transparency and equal
execution access, and the benefits associated with improving
transparency, reducing market fragmentation, and meeting NMS goals.
The Commission requests comment on the costs associated with the
Commission's proposals to ensure fair access to alternative trading
systems registered as broker-dealers, as well as the benefits
associated with preventing discriminatory denials of access and
providing the avenue of appeal to the Commission for investors denied
access to such systems.
The Commission requests comment on the costs and benefits
associated
[[Page 23547]]
with the Commission's proposals to improve systems capacity, integrity,
and security. The Commission specifically requests comment on the costs
associated with maintaining adequate systems related procedures,
safeguards, and documentation.
The Commission requests comment on the costs and benefits
associated with exchange registration. The Commission specifically
requests comment on the costs and benefits associated with providing
alternative trading systems with the option to register as national
securities exchanges under sections 5 and 6 of the Exchange Act.
The Commission requests comment on the costs and benefits
associated with the Commission's proposed amendments to Rules 17a-3,
17a-4, and repeal of Rule 17a-23. The Commission specifically requests
comment on the costs to internal broker-dealer systems of continuing to
maintain records under Rules 17a-3(a)(16) and 17a-4(b)(10), and the
benefits of eliminating the reporting requirements.
The Commission requests comment on the costs and benefits
associated with the Commission's proposal to temporarily exempt SRO
pilot trading systems from section 19(b) rule filing requirements. The
Commission specifically requests comment on the costs and benefits for
all market participants associated with such a temporary exemption from
rule filing and the associated filing requirements on Form PILOT.
The Commission generally requests comment on the competitive
benefits or anticompetitive effects that may impact any market
participants if the proposals are adopted as proposed. The Commission
also requests comment on what impact the proposals, if adopted, would
have on efficiency and capital formation. Commenters should provide
analysis and empirical data to support their views on the costs and
benefits associated with the proposal.
X. Effects on Efficiency, Competition, and Capital Formation
Section 23(a) of the Exchange Act \366\ requires that the
Commission, when promulgating rules under the Exchange Act, to consider
the anti-competitive effects of such rules, if any, and to balance any
impact against the regulatory benefits gained in furtherance of the
purposes of the Act. Section 3(f) of the Exchange Act requires the
Commission, when engaged in rulemaking, to consider or determine
whether an action is necessary or appropriate in the public interest,
and whether the action would promote efficiency, competition, and
capital formation.\367\ The Commission has considered the proposed
rules and amendments in light of these standards and preliminarily
believes that they would not impose any significant burden on
competition not necessary or appropriate in furtherance of the purposes
of the Exchange Act.
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\366\ 15 U.S.C. 78w(a)(2).
\367\ 15 U.S.C. 78c(f).
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The rules and amendments are intended to provide a choice between
registering as a broker-dealer and registering as an exchange for
markets operated as alternative trading systems. By using volume
thresholds to trigger fair access, market transparency, and
coordination, and systems capacity, integrity, and security
requirements, the Commission's proposals would not unduly burden small,
start-up alternative trading systems, and would therefore foster
competition. The proposals would also improve surveillance and
recordkeeping for all alternative trading systems, which would improve
investor confidence in such systems and help maintain fair and orderly
markets. Moreover, the proposals offer SROs the opportunity to develop
and operate pilot trading systems with less cost and time delay. This
would help to foster innovation and create benefits for investors.
Nonetheless, the Commission solicits comments on the impact of the
proposed rules and amendments on competition. Specifically, the
Commission requests commenters to address how the proposed rules and
amendments would affect competition between and among alternative
trading systems, broker-dealers, exchanges, investors, and other market
participants. Finally, commenters should consider the proposed
amendments' and rules' effect on efficiency and capital formation.
XI. Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (``IRFA'') in accordance with the Regulatory Flexibility Act
(``RFA'') \368\ regarding proposed new Rules 3a1-1, 3b-12, 19b-5,
Regulation ATS, new Forms ATS, ATS-R and PILOT, and amended Rules 6a-1,
6a-2, 6a-3, 17a-3, 17a-4, the Commission's Rules of Practice,
amendments to Form 1 and the repeal of Rule 17a-23. The following
summarizes the IRFA.
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\368\ 5 U.S.C. 603.
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As set forth in greater detail in the IRFA, the proposed rules
create the option for an alternative trading system to register as a
national securities exchange or as a broker-dealer and comply with
additional requirements depending on their activities and trading
volume. The IRFA also states that proposed amendments will exclude
pilot trading systems operated by national securities exchanges or
national securities associations from rule filing requirements.
The IRFA sets forth the statutory authority for the proposed rules.
The IRFA also discusses the effect of the proposed rules on small
entities.\369\ The IRFA states that the proposed rules would not affect
small entities, as the Commission expects that alternative trading
systems will generally be broker-dealers with total capital of at least
$500,000. The Commission estimates that there are approximately forty-
three total alternative trading systems presently in existence, with 5
of those estimated to be small entities.
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\369\ Small entities are considered broker-dealers with total
capital (net worth plus subordinated liabilities) of less than
$500,000 on the date in the prior fiscal year as of which its
audited financial statements were prepared pursuant to Rule 17a-5(d)
under the Exchange Act, 17 CFR 240.17a-5(d) or, if not required to
file such statements, a broker or dealer that had total capital (net
worth plus subordinated liabilities) of less than $500,000 on the
last day of the preceding fiscal year (or in the time that it has
been in business, if shorter); and is not affiliated with any person
(other than a natural person) that is not a small business or small
organization. 17 CFR 240.0-10(c).
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The IRFA recognizes that, in order to provide a reasonable option
to registration as a national securities exchange, any Commission
proposals must strike a balance between fostering innovation and
providing real investor protections. In order to assure that
alternative trading systems are adequately organized and fairly
operated, the Commission believes it is necessary and reasonable to
require any alternative trading system to supply basic, descriptive
information before it starts operating and periodically to supply
aggregate transaction data to the Commission. The Commission expects
relatively few small entities to start such enterprises, but believes
that the regulatory burdens established in the proposed rules are
reasonable.
In addition, by utilizing volume thresholds to trigger additional
requirements the Commission anticipates that starting and developing
alternative trading systems would not be unduly burdened by the
proposed filing requirements. Once an alternative trading system
achieves significant market influence, it is reasonable to expect those
systems to comply with fair access, order display, and systems
[[Page 23548]]
capacity, integrity, and security requirements in order to protect
investors and assure a fair secondary market.
The proposed rules would require all alternative trading systems to
file an initial notice on Form ATS. Alternative trading systems would
have periodic reporting requirements to amend Form ATS as the
information changes over time. The IRFA further notes that alternative
trading systems would be required to make quarterly transaction reports
on Form ATS-R. The IRFA states that alternative trading systems would
also be required to maintain records relating to trading activities
and, if meeting certain volume thresholds, records relating to systems
capacity, integrity and security, fair access and order display. The
Commission believes that these filing requirements are offset by the
benefits to investors, the market as a whole and the Commission's
ability to keep up with market developments and changes.
The initial notice requirement on Form ATS is a one-time filing and
the transaction reports required on Form ATS-R are only required four
times per year. The proposed rules will require alternative trading
systems to file some information not currently required under Rule 17a-
23. This information will include quarterly reports describing the
securities traded through the system and subscribers to the system.
Additionally, the proposed rules will require alternative trading
systems to file more detailed information concerning the
characteristics of the system than is currently required. The
Commission believes that the additional burdens created by these
requirements will be offset by eliminating the filing requirements
under Rule 17a-23. Small entities are unlikely to meet the volume
thresholds that would require additional recordkeeping and filing
requirements for fair access and systems capacity, integrity and
security.
The proposed rules would exempt pilot trading systems operated by
national securities exchanges and national securities associations from
rule filing requirements. The IRFA further states that the proposed
rule changes will reduce the filing burdens associated with filing an
initial Form 1 and the required subsequent amendments. The Commission
believes that these changes reduce the filing burdens on national
securities exchanges and exchanges exempt from registration under
section 5 based on the limited volume of transactions effected on such
exchanges. All national securities exchanges are too large to be
considered small entities. For exchanges exempt from registration under
section 5 pursuant to the limited volume of transactions effected on
such exchanges, the proposed rules will help to reduce the filing
burdens by clarifying current filing requirements and supplying
additional means of compliance.
As explained further in the IRFA, the Commission has considered
other alternatives to the proposed rules. The Commission believes that
it would be inconsistent with the purposes of the Act to exempt small
entities from the proposed rules.
The IRFA includes information concerning the solicitation of
comments with respect to the IRFA generally, and in particular, the
number of small entities that would be affected by the proposed rules.
Cost-benefit information reflected in the ``Costs and Benefits of the
Proposed Rules and Amendments'' and ``Effects on Efficiency,
Competition and Capital Formation'' sections of this Release is also
reflected in the IRFA. A copy of the IRFA may be obtained by contacting
Kevin Ehrlich, Division of Market Regulation, Securities Exchange
Commission, 450 Fifth Street, NW., Washington, DC. 20549.
XII. Paperwork Reduction Act
Certain provisions of the proposed rules and rule amendments
contain ``collection of information'' requirements within the meaning
of the Paperwork Reduction Act of 1995 (44 U.S.C. 3501 et seq.), and
the Commission has submitted them to the Office of Management and
Budget (``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5
CFR 1320.11. The title for the collections of information are: ``Form
1, Rules 6a-1 and 6a-2'' ``Rule 6a-3,'' ``Rule 17a-3(a)(16),'' ``Rule
17a-4(b)(10),'' ``Rule 19b-5 and Form PILOT,'' ``Rule 301, Form ATS and
Form ATS-R,'' ``Rule 302,'' ``Rule 303,'' all under the Exchange Act.
``Form 1, Rules 6a-1 and 6a-2'' and ``Rule 6a-3,'' which the Commission
is proposing to amend, contain currently approved collections of
information under OMB control numbers 3235-0017 and 3235-0021. The
proposed rules and rule amendments are necessary to respond to the
impact of technological developments in the securities markets and
permit the Commission to more effectively oversee the growing number of
alternative trading systems. An agency may not sponsor, conduct, or
require response to an information collection unless a currently valid
OMB control number is displayed.
A. Form 1, Rules 6a-1 and 6a-2
Rule 6a-1 and Form 1 currently require any organization seeking to
operate as a national securities exchange, or as an exchange exempt
from registration based on limited volume to file a Form 1. Form 1
requires the organization to describe its operation. The amendments to
Rule 6a-1 would simplify and clarify the requirements to make them
easier to understand. The revised Form 1 introduces a fill-in-the-blank
format, reconfigures the exhibits for clarity, and updates the requests
for information to accommodate new organizational models of exchanges.
The collection of information would be necessary to permit the
Commission to determine that an exchange applying for registration
complies with the provisions of the Exchange Act governing exchange
registration and statutory requirements for registration. The
Commission requires such information to protect investors and the
public interest. There are no other means of obtaining this information
and it is not available in consolidated form in any other location. The
respondents to this information collection are those entities wishing
to become registered as an exchange. Applications for registration on
Form 1 are made on a one-time basis. The Commission receives Form 1
filings from time to time. For purposes of the Paperwork Reduction Act,
the staff assumes that a maximum of one filing per year would be made,
imposing a burden of 47 hours per response and a cost of $2,000.
The Commission also proposes to amend Rule 6a-2 which contains
requirements for exchanges to file amendments updating the information
initially filed on Form 1. Proposed Rule 6a-2 revises the filing
requirements to ease the frequency of filing certain exhibits and offer
the choice of making certain information publicly available on the
Internet in lieu of making paper filings. The collection of information
would be necessary to permit the Commission to determine whether the
exchanges are complying with the Exchange Act and keeping such
information consolidated and current. The information is also made
available to members of the public who may wish to comment on the
information provided. The likely respondents to this information
collection are those entities registered as an exchange or exempt from
registration under section 5 based on the limited volume of
transactions effected on those exchanges. Currently, eight exchanges
and one exempt exchange make such filings. The
[[Page 23549]]
Commission estimates that revised Rule 6a-2 would decrease the filing
burden for each respondent by 5 hours for an average burden for each
respondent of 25 hours per filing. The Commission estimates that each
exchange would respond 1 time per year and incur an average burden of
25 hours. The Commission estimates that the aggregate burden for all
exchanges to comply with Rule 6a-2 would be 225 hours. The Commission
bases its projections on its prior experience with exchange filings
pursuant to Rules 6a-1 and 6a-2. The total estimated burden for Form 1
would be 272 hours (47 hours for one initial filing and 225 hours for
nine amendments).
For exchanges that choose to register and operate as a national
securities exchange, the provisions of Rules 6a-1 and 6a-2 as well as
the requirements of Form 1 are mandatory. All filings made with the
Commission pursuant to Rules 6a-1 and 6a-2 on Form 1 are not
confidential and are available to the public. National securities
exchanges would still be obligated by Rule 17a-1 to preserve records
for 5 years, the first 2 years in an easily accessible place. The
Commission notes that it is imposing no additional recordkeeping
requirements under proposed Rules 6a-1 or 6a-2, but is only reiterating
currently existing obligations.
B. Rule 6a-3
Rule 6a-3 currently requires that registered exchanges file with
the Commission copies of information made available to the members,
subscribers, or participants. The collection of information is
necessary to permit the Commission to determine whether exchanges are
complying with the Exchange Act and to enable the Commission to carry
out its statutory obligations and protect investors. The proposed rule
changes would help simplify the rule language and provide registered
exchanges with the option of making the information available on the
Internet in lieu of paper filings. Further, the proposed rule also
recognizes that modern exchanges may have participants or subscribers
rather than members. The respondents are exchanges or exchanges exempt
from registration based on limited volume. Currently, eight exchanges
and one exchange exempt from registration based on limited volume are
required to comply with the rule. The Commission expects no additional
filing burdens as a result of this proposed rule change. The estimated
burden for each exchange is 0.5 hours for each submission pursuant to
Rule 6a-3. The Commission anticipates that each respondent would file
25 amendments per year for a total burden of 12.5 hours per year for
each respondent. The Commission anticipates that the total estimated
aggregate annual burden for 9 respondents would be 112.5 hours. The
Commission does not anticipate that the burdens associated with Rule
6a-3 would change in a material manner.
For exchanges that choose to register and operate as a national
securities exchange, the provisions of Rule 6a-3 are mandatory. All
filings made with the Commission pursuant to Rule 6a-3 are not
confidential and are available to the public. National securities
exchanges would still be obligated by Rule 17a-1 to preserve records
for 5 years, the first 2 in an easily accessible place.
C. Rule 17a-3(a)(16)
The proposed amendments to Rule 17a-3 would require a broker-dealer
that operates an internal broker-dealer system to make certain records
regarding the daily trading activity of that system. The collection of
information would be necessary to permit the Commission and SROs to
determine whether broker-dealers are complying with the Commission's
financial responsibility programs, antifraud and antimanipulation
rules, as well as other Commission and SRO rules. The Commission cannot
obtain such information by any other means because broker-dealers are
the only entities that produce, and have access to, such information.
Broker-dealers currently comply with substantially similar
recordkeeping requirements under current Rule 17a-23, so there would be
no net additional burden on broker-dealer respondents. The Commission
estimates that there would be 94 respondents affected. Based on the
Commission's prior experience with the burdens associated with Rule
17a-23, for the purposes of the proposed amendments to Rule 17a-3, the
Commission estimates that each respondent would incur a burden of 27
hours to comply with the recordkeeping requirements. Thus, the total
aggregate burden for broker-dealers operating internal broker-dealer
systems to comply with the proposed recordkeeping requirements under
amended Rule 17a-3 would be 2,538 hours.
For alternative trading systems that choose to register as a
broker-dealer, the proposed amendments to Rule 17a-3 are mandatory. The
records required to be made are considered confidential and are not
available to the public. All records required under the proposed
amendment to Rule 17a-3 would be preserved for not less than 3 years,
the first 2 in an easily accessible place.
D. Rule 17a-4(b)(10)
The proposed amendments to Rule 17a-4 would require a broker-dealer
that operates an internal broker-dealer system to keep records it makes
pursuant to under Rule 17a-3(a)(16). The proposed amendments would also
require broker-dealers to keep information that is supplied to
subscribers, such as system notices. The Commission estimates that
there are 94 broker-dealers that would be affected. Based on the
Commission's prior experience with the burdens associated with Rule
17a-23, for purposes of the proposed amendments to Rule 17a-4, the
Commission estimates that each respondent would incur an annual burden
of 3 hours to comply with the record preservation requirements. Thus,
the total aggregate burden for broker-dealers operating internal
broker-dealer systems to comply with the record preservation
requirements under amended Rule 17a-4(b)(10) would be 282 hours.
For alternative trading systems that choose to register as a
broker-dealer, the proposed amendments to Rule 17a-4 are mandatory. The
records required to be preserved are considered confidential and are
not available to the public. All records required under the proposed
amendments to Rule 17a-4 would be preserved for not less than 3 years,
the first 2 years in an easily accessible place.
E. Rule 19b-5 and Form PILOT
Proposed Rule 19b-5 contains a requirement that SROs file a Form
PILOT to notify the Commission of their intent to operate a pilot
trading system. Proposed Rule 19b-5 also requires that SROs keep
records containing the rules and procedures relating to each pilot
trading system. SROs would be temporarily exempt from the rule filing
requirements under section 19(b) of the Exchange Act for any rule
changes associated with the pilot trading system. Because such systems
can have an impact on the market, this collection of information would
be necessary to inform the Commission of the existence and manner of
operation of such pilot trading systems. The Commission has proposed
that the SROs also must meet certain criteria in order to operate a
pilot trading system. Notice to the Commission on Form PILOT is
necessary to determine whether the SROs are meeting those criteria.
Additionally, the recordkeeping requirement is necessary because the
Commission would need to review this
[[Page 23550]]
information during an examination to determine compliance by the SRO
with the federal securities laws. By permitting SROs to merely keep
such information on hand instead of affirmatively filing it, the
Commission believes it balances the need for access to the information
with minimizing burdens on SROs. The respondents to this information
collection would be SROs who wish to develop and introduce pilot
trading systems.
Respondents would be required to file one initial Form PILOT before
commencing operation of each pilot trading system. Respondents would
also be required to file quarterly reports and systems change notices
on Form PILOT. Based on the Commission's experience with section 19(b)
rule filings, the Commission estimates that there would be 6 such
respondents per year. Under Rule 19b-5, each respondent would file one
initial Form PILOT filing before commencing operation of the pilot
trading system and 4 quarterly reports on Form PILOT. In addition, the
Commission anticipates that each respondent would file 2 systems change
notices each year on Form PILOT. Based on the Commission's experience
with similar section 19(b) rule filings, the Commission estimates that
each respondent would incur a burden of 24 hours to file an initial
operation report and an annual burden of 12 hours to file quarterly
reports on Form PILOT. The Commission also estimates that each
respondent would incur an annual burden of 6 hours to file 2 systems
change notices on Form PILOT. Thus, the aggregate burden for
respondents to file initial reports on Form PILOT would be 144 hours
and the annual aggregate burden for respondents to file quarterly
reports and systems change notices on Form PILOT would be 108 hours.
Thus, the Commission estimates that the total aggregate burden for
respondents under proposed Rule 19b-5 would be 252 hours.
For SROs that choose to operate pilot trading systems and avail
themselves to the provisions of Rule 19b-5, compliance with Rule 19b-5
and the filings required on Form PILOT are mandatory. Proposed Rule
19b-5 reiterates SROs' existing recordkeeping obligations under Rule
17a-1, which requires that such records be kept for not less than 5
years, the first 2 years in an easily accessible place.
F. Rule 301, Form ATS and Form ATS-R
Proposed Rule 301 requires alternative trading systems that do not
register as national securities exchanges to meet certain requirements.
Specifically, alternative trading systems would be required to file an
initial notice prior to operating, supply notices of material changes
to the system operation prior to implementing those changes, file
quarterly amendments notifying the Commission of changes to the system
that have not been reflected in an earlier amendment and when it ceases
operations as an alternative trading system. Alternative trading
systems would also be required to file quarterly transaction reports on
Form ATS-R detailing the type and volume of securities traded through
the alternative trading system. An alternative trading system that
meets certain volume thresholds would be required to notify investors
denied or permitted only limited access to the system that they have a
right to appeal the alternative trading systems' action to the
Commission. In addition, the proposed rule would require alternative
trading systems that meet certain volume thresholds to notify the
Commission of systems outages and keep any records made in the process
of complying with the systems capacity, integrity and security
requirements under Rule 301.
The Commission estimates that there would be 43 alternative trading
systems that would be respondents under the proposed rule. The
Commission also estimates that, over time, approximately 3 new
alternative trading systems would choose to register as a broker-dealer
and comply with Regulation ATS each year and that 3 alternative trading
systems would file cessation of operations reports on Form ATS and
cease operating. Thus, the Commission anticipates that approximately 43
alternative trading systems will incur burdens each year under proposed
Regulation ATS. Each would file a one-time notice of initial operation
report on Form ATS. The Commission estimates that alternative trading
systems would file 2 amendments per year to reflect material changes to
information on Form ATS and 4 quarterly amendments to reflect other
changes. In addition, alternative trading systems would be required to
file 4 reports per year on Form ATS-R. The Commission also estimates
that 3 alternative trading systems would file cessation of operations
reports on Form ATS on an annual basis.
The Commission estimates that 2 alternative trading systems would
meet the volume thresholds that trigger fair access obligations and
would, therefore, be required to maintain records of its access
standards and provide notice to investors denied or limited access to
the system of their right to appear a denial or limitation of access to
the Commission. Based on the Commission's experience with denials of
access to markets, the Commission estimates that such systems would
have to send 27 denial or limitation of access notices per year. The
Commission also believes that 2 alternative trading systems would meet
the trading volume thresholds that trigger the systems capacity,
integrity and security requirements and would, therefore, be required
to maintain records relating to these requirements and notify the
Commission of system outages. Based on the Commission's experience with
systems' outages in the markets, the Commission anticipates that such
systems would provide 5 systems' outage notices per year.
The Commission's estimates for burden hours associated with filing
Form ATS are based on the Commission's experience with filings made
pursuant to Rules 6a-1, 6a-2, 6a-3 and 17a-23. While the burden
estimates have been based on prior Commission experience, they have
been adjusted to reflect the specific nature of each requirement.
The Commission estimates that each respondent filing an initial
operation report on Form ATS would incur an average burden of 20 hours.
Thus, the aggregate burden for 3 alternative trading systems to file
initial operations reports on Form ATS would be 60 hours.
The Commission estimates that each respondent filing an amendment
on Form ATS would incur an average annual burden of 12 hours. Thus, the
average annual aggregate burden for 43 alternative trading systems to
file 6 amendments each to the initial operation report on Form ATS
would be 1,032 hours.
The Commission estimates that each respondent filing quarterly
reports on Form ATS-R would incur an average annual burden of 16 hours.
Thus, the average annual aggregate burden for 43 alternative trading
systems to file quarterly reports on Form ATS-R would be 688 hours.
The Commission estimates that each respondent filing a cessation of
operation report on Form ATS would incur an average burden of 2 hours.
Thus, the average annual aggregate burden for 3 alternative trading
systems to file cessation of operations reports on Form ATS would be 6
hours.
The Commission estimates that each respondent obligated to
establish and keep standards for granting access to its system would
incur a burden of 5 hours. Thus, the average annual aggregate burden
for 2 alternative trading systems to establish and keep standards for
[[Page 23551]]
granting access to its system to comply with such standards would be 10
hours.
The Commission estimates that each respondent obligated to provide
notices to investors denied or limited access to such system would
incur a burden of 1 hour per notice, or 27 hours per year. Thus, the
annual aggregate burden for 2 alternative trading systems to provide
investors notice of a denial or limitation decision and their right of
appeal to the Commission would be 54 hours.
The Commission estimates that each respondent obligated to comply
with the systems capacity, integrity and security requirements would
incur an average burden of 10 hours. Thus, the annual aggregate burden
for 2 alternative trading systems to make records relating to steps
taken to comply with the systems capacity, integrity and security
requirements would be 20 hours.
The Commission estimates that each respondent obligated to provide
systems' outage notices to the Commission would provide 5 such notices
per year and that such systems would incur a burden of 0.25 hours per
notice, or 1.25 hours per year. Thus, the annual aggregate burden for 2
alternative trading systems to provide investors notice of a denial or
limitation decision and their right of appeal to the Commission would
be 2.5 hours.
For alternative trading systems that choose to register as a
broker-dealer, the requirements of Rule 301, Form ATS and Form ATS-R
are mandatory. All filings required under Rule 301, Form ATS and Form
ATS-R are considered confidential and are not available to the public.
All records required to be made under the proposed Rule would be
preserved for 3 years, the first 2 years in an easily accessible place.
G. Rule 302
Proposed Rule 302 would require alternative trading systems to make
certain records with respect to trading activity through the
alternative trading systems. This collection of information would
permit the Commission to detect and investigate potential market
irregularities and to ensure investor protection. Such information is
not available in any other form from any other sources. The Commission
estimates 43 alternative trading systems would be required to comply
with this proposed rule. The Commission believes that most alternative
trading systems will keep such information in the course of business,
so the additional burdens of compliance would be minimal. Based on the
Commission's experience with the burdens associated with recordkeeping
requirements under Rule 17a-23, the Commission estimates that the
annual burden for each respondent to comply with the recordkeeping
requirements under proposed Rule 302 would be 36 hours and that the
annual aggregate burden for 43 alternative trading systems to comply
with Rule 302 would be 1,548 hours.
For alternative trading systems that choose to register as a
broker-dealer, the requirements of Rule 302 are mandatory. All records
required to be made under Rule 302 are considered confidential and are
not available to the public. All records required to be made under the
proposed Rule would be preserved for 3 years, the first 2 years in an
easily accessible place.
H. Rule 303
Proposed Rule 303 requires alternative trading systems registered
as broker-dealers to preserve certain records produced under Rule 302,
as well as standards for granting access to the system and records
generated in complying with the systems capacity, integrity and
security requirements for alternative trading systems with significant
trading volume. Alternative trading systems registered as broker-
dealers would not be required to file such information, but merely
retain it in an organized manner and make it available to the
Commission upon request. The Commission believes that most alternative
trading systems will keep such information in the course of business,
so the additional burdens of compliance would be minimal. The
Commission estimates that 43 such alternative trading systems would be
required to comply with Rule 303. Based on the Commission's experience
with the burdens associated with record preservation requirements under
Rule 17a-23, the Commission estimates that the annual burden for each
respondent to comply with the recordkeeping requirements under proposed
Rule 303 would be 4 hours and that the annual aggregate cost for 43
alternative trading systems to comply with Rule 303 would be 1,172
hours.
For alternative trading systems that choose to register as a
broker-dealer, the requirements of Rule 303 are mandatory. All records
required to be made under Rule 303 are considered confidential and are
not available to the public. All records required to be made under the
proposed Rule would be preserved for 3 years, the first 2 years in an
easily accessible place.
I. Request for Comment
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments to:
(i) Evaluate whether the proposed collections of information are
necessary for the proper performance of the functions of the agency,
including whether the information will have practical utility;
(ii) Evaluate the accuracy of the agency's estimate of the burden
of the proposed collections of information;
(iii) Enhance the quality, utility, and clarity of the information
to be collected;
(iv) Minimize the burden of the collections of information on those
who are to respond, including through the use of automated collection
techniques or other forms of information technology.
Persons desiring to submit comments on the collection of
information requirements should direct them to the Office of Management
and Budget, Attention: Desk Officer for the Securities and Exchange
Commission, Office of Information and Regulatory Affairs, Washington,
DC 20503, and should also send a copy of their comments to Jonathan G.
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street,
NW., Washington, DC 20549 with reference to File No. S7-12-98. OMB is
required to make a decision concerning the collections of information
between 30 and 60 days after publication, so a comment to OMB is best
assured of having its full effect if OMB receives it within 30 days of
publication.
XIII. Statutory Authority
The proposed rules and rule amendments in this release are being
proposed pursuant to 15 U.S.C. 78a et seq., particularly sections 3(b),
5, 6, 11A, 15, 17(a), 17(b), 19(b), 23(a), and 36 of the Exchange Act,
15 U.S.C. 78c, 78e, 78f, 78k-1, 78o, 78q(a), 78q(b), 78s(b), 78w(a),
and 78mm.
List of Subjects
17 CFR Part 201
Administrative practice and procedure, Equal access to justice,
Securities.
17 CFR Part 240
Brokers-dealers, Fraud, Issuers, Reporting and recordkeeping
requirements, Securities.
17 CFR Part 242
Securities.
17 CFR Part 249
Reporting and recordkeeping requirements, Securities.
For the reasons set out in the preamble, Title 17, Chapter II of
the Code of Federal Regulations is proposed to be amended as follows.
[[Page 23552]]
PART 201--RULES OF PRACTICE
1. The authority citation for part 201 continues to read as
follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77h-1, 77j, 77s, 77u,
78c(b), 78d-1, 78d-2, 78l, 78m, 78n, 78o(d), 78o-3, 78s, 78u-2, 78u-
3, 78v, 78w, 79c, 79s, 79t, 79z-5a, 77sss, 77ttt, 80a-8, 80a-9, 80a-
37, 80a-38, 80a-39, 80a-40, 80a-41, 80a-44, 80b-3, 80b-9, 80b-11,
and 80b-12 unless otherwise noted.
2. Paragraph (a)(9) of Sec. 201.101 is revised to read as follows:
Sec. 201.101 Definitions.
(a) * * *
(9) Proceeding means any agency process initiated by an order
instituting proceedings; or by the filing, pursuant to Sec. 201.410, of
a petition for review of an initial decision by a hearing officer; or
by the filing, pursuant to Sec. 201.420, of an application for review
of a self-regulatory organization or an alternative trading system
determination; or by the filing pursuant to Sec. 201.430, of a notice
of intention to file a petition for review of a determination made
pursuant to delegated authority;
* * * * *
3. The introductory text of paragraph (a) of Sec. 201.202 is
revised to read as follows:
Sec. 201.202 Specifications of procedures by parties in certain
proceedings.
(a) Motion to specify procedures. In any proceeding other than an
enforcement or disciplinary proceeding or a proceeding to review a
determination by a self-regulatory organization or an alternative
trading system pursuant to Secs. 201.420 and 201.421, a party may, at
any time up to 20 days prior to the start of a hearing, make a motion
to specify the procedures necessary or appropriate for the proceeding,
with particular reference to:
* * * * *
4. Paragraph (a)(1) of Sec. 201.210 is revised to read as follows:
Sec. 201.210 Parties, limited participants and amici curiae.
(a) Parties in an enforcement or disciplinary proceeding or a
proceeding to review a self-regulatory organization or an alternative
trading system determination. (1) Generally. No person shall be granted
leave to become a party or a non-party participant on a limited basis
in an enforcement or disciplinary proceeding or a proceeding to review
a determination by a self-regulatory organization or an alternative
trading system pursuant to Secs. 201.420 and 201.421.
* * * * *
5. Paragraph (d)(1) of Sec. 201.401 is revised to read as follows:
Sec. 201.401 Issuance of stays.
* * * * *
(d) * * * (1) Availability. A motion for a stay of an action by a
self-regulatory organization for which the Commission is the
appropriate regulatory agency or a limitation or prohibition of access
by an alternative trading system, for which action review may be sought
pursuant to Sec. 201.420, may be made by any person aggrieved thereby.
* * * * *
6. Section 201.420 is revised to read as follows:
Sec. 201.420 Appeal of determinations by self-regulatory organizations
and alternative trading systems.
(a) Application for review; when available. (1) An application for
review by the Commission may be filed by any person who is aggrieved by
a self-regulatory organization determination as to which a notice is
required to be filed with the Commission pursuant to section 19(d)(1)
of the Exchange Act, 15 U.S.C. 78s(d)(1). Such determinations include
any:
(i) Final disciplinary sanction;
(ii) Denial or conditioning of membership or participation;
(iii) Prohibition or limitation in respect to access to services
offered by that self-regulatory organization or a member thereof; or
(iv) Bar from association.
(2) An application for review by the Commission may be filed by any
person who is aggrieved by an alternative trading system determination
as to which a notice is required to be filed with the Commission
pursuant to paragraph (a)(5) of Sec. 242.301 of this chapter
(Regulation ATS). Such determination includes any prohibition or
limitation in respect to access to services offered by the alternative
trading system.
(b) Procedure. An application for review may be filed with the
Commission pursuant to Sec. 201.151 within 30 days after notice of the
determination was filed with the Commission pursuant to sections
19(d)(1) of the Exchange Act, 15 U.S.C. 78s(d)(1) or paragraph (a)(5)
of Sec. 242.301 of this chapter (Regulation ATS), and received by the
aggrieved person applying for review. The application shall be served
by the applicant on the self-regulatory organization or the alternative
trading system, whichever is applicable. The application shall identify
the determination complained of, set forth in summary form a brief
statement of alleged errors in the determination and supporting reasons
therefor and state an address where the applicant can be served with
the record index. The application shall be accompanied by the notice of
appearance required by Sec. 201.102(d).
(c) Determination not stayed. Filing an application for review with
the Commission pursuant to paragraph (b) of this section shall not
operate as a stay of the complained of determination made by the self-
regulatory organization or the alternative trading system unless the
Commission otherwise orders either pursuant to a motion filed in
accordance with Sec. 201.401 or on its own motion.
(d) Certification of the record; service of the index. Fourteen
days after receipt of an application for review or a Commission order
for review, the self-regulatory organization or the alternative trading
system shall certify and file with the Commission one copy of the
record upon which the action complained of was taken, and shall file
with the Commission three copies of an index to such record, and shall
serve upon each party one copy of the index.
7. The section heading and paragraph (a) of Sec. 201.421 are
revised to read as follows:
Sec. 201.421 Commission consideration of determinations by self-
regulatory organizations and alternative trading systems.
(a) Commission review other than pursuant to a petition for review.
The Commission may, on its own initiative, order review of any
determination by a self-regulatory organization or an alternative
trading system that could be subject to an application for review
pursuant to Sec. 201.420(a) within 40 days after notice thereof was
filed with the Commission pursuant to Section 19(d)(1) of the Exchange
Act, 15 U.S.C. 78s(d)(1) or paragraph (a)(5) of Sec. 242.301 of this
chapter (Regulation ATS).
* * * * *
8. Paragraph (a)(2)(ii) of Sec. 201.450 is revised to read as
follows:
Sec. 201.450 Briefs filed with the Commission.
(a) * * *
(2) * * *
(ii) Receipt by the Commission of an index to the record of a
determination of a self-regulatory organization or an alternative
trading system filed pursuant to Sec. 201.420(d);
* * * * *
9. Paragraph (a)(2)(i) of Sec. 201.460 is revised to read as
follows:
Sec. 201.460 Record before the Commission.
* * * * *
(a) * * *
(2) * * *
(i) The record certified pursuant to Sec. 201.420(d) by the self-
regulatory
[[Page 23553]]
organization or the alternative trading system;
* * * * *
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
10. The authority citation for part 240 continues to read in part
as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee,
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k,
78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d),
78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and
80b-11, unless otherwise noted.
* * * * *
11. Section 240.3a1-1 is added before the undesignated center
heading ``Definition of `Equity Security' as Used in Sections 12(g) and
16'' to read as follows:
Sec. 240.3a1-1 Exemption from the definition of ``Exchange'' under
Section 3(a)(1) of the Act.
(a) An organization, association, or group of persons shall be
exempt from the definition of the term ``exchange'' under section
3(a)(1) of the Act (15 U.S.C. 78c(a)(1)), if such organization,
association, or group of persons:
(1) Is operated by a national securities association; or
(2) Is an alternative trading system and is in compliance with
Regulation ATS, 17 CFR 242.300 through 242.303.
(b) Notwithstanding paragraph (a) of this section, an organization,
association, or group of persons shall not be exempt under this section
from the definition of ``exchange,'' if:
(1) The Commission determines, after notice to the alternative
trading system and an opportunity for the alternative trading system to
respond, that such an exemption would not be necessary or appropriate
in the public interest or consistent with the protection of investors;
or
(2) The organization, association, or group of persons is
registered as an exchange under section 6 of the Act (15 U.S.C. 78f).
(c) Alternative trading system has the same meaning as under
Sec. 242.300(a) of this chapter.
12. Section 240.3b-12 is added before the undesignated center
heading ``Registration and Exemption of Exchanges'' to read as follows:
Sec. 240.3b-12 Definitions of terms used in Section 3(a)(1) of the
Act.
(a) An organization, association, or group of persons shall be
considered to constitute, maintain, or provide ``a market place or
facilities for bringing together purchasers and sellers of securities
or for otherwise performing with respect to securities the functions
commonly performed by a stock exchange,'' as those terms are used in
section 3(a)(1) of the Act (15 U.S.C. 78c(a)(1)), if such organization,
association, or group of persons:
(1) Consolidates orders of multiple parties; and
(2) Sets non-discretionary material conditions (whether by
providing a trading facility or by setting rules) under which the
parties entering such orders agree to the terms of a trade.
(b) An organization, association, or group of persons shall not be
considered to constitute, maintain, or provide ``a market place or
facilities for bringing together purchasers and sellers of securities
or for otherwise performing with respect to securities the functions
commonly performed by a stock exchange,'' solely because such
organization, association, or group of persons:
(1) Routes orders to a national securities exchange, a market
operated by a national securities association, or a broker-dealer;
(2) Displays the quotes of a single dealer and allows persons to
enter orders for execution against such dealer's quotes; or
(3) Provides the means for a single broker-dealer to internally
manage customers' orders, including crossing or matching such orders
with each other, provided however that:
(i) Customers' orders are not displayed to any person, other than
the broker-dealer and its employees; and
(ii) Customers' orders are not executed according to a
predetermined procedure that is communicated to such customers.
(c) For purposes of this section the term order means any firm
indication of a willingness to buy or sell a security, as either
principal or agent, including any bid or offer quotation, market order,
limit order, or other priced order.
13. Section 240.6a-1 is amended by revising the section heading and
paragraphs (a) and (b) to read as follows:
Sec. 240.6a-1 Application for registration as a national securities
exchange or exemption from registration based on limited volume.
(a) An application for registration as a national securities
exchange, or for exemption from such registration based on limited
volume, shall be filed on Form 1 (Sec. 249.1 of this chapter), in
accordance with the instructions contained therein.
(b) Promptly after the discovery that any information filed on Form
1 was inaccurate when filed, the exchange shall file with the
Commission an amendment correcting such inaccuracy.
* * * * *
14. Section 240.6a-2 is revised to read as follows:
Sec. 240.6a-2 Amendments to application.
(a) A national securities exchange, or an exchange exempted from
such registration based on limited volume, shall file an amendment,
which shall set forth the nature and effective date of the action taken
and shall provide any new information and correct any information
rendered inaccurate, on Form 1, 17 CFR 240.249.1, within 10 days after
any action is taken that renders inaccurate, or that causes to be
incomplete, any of the following:
(1) Information filed on the Execution Page of Form 1, or amendment
thereto; or
(2) Information filed as part of Exhibit C, F, G, I, J, K or M, or
any amendments thereto.
(b) On or before June 30 of each year, a national securities
exchange, or an exchange exempted from such registration based on
limited volume, shall file, as an amendment to Form 1, the following:
(1) Exhibits D and H, as of the end of the latest fiscal year of
the exchange; and
(2) Exhibits J, K, and M and, which shall be up to date as of the
latest date practicable within 3 months of the date the amendment is
filed.
(c) On or before June 30, 2001 and every 3 years thereafter, a
national securities exchange, or an exchange exempted from such
registration based on limited volume, shall file, as an amendment to
Form 1, complete Exhibits A, B, C and H. The information filed under
this paragraph (c) shall be current as of the latest practicable date,
but shall, at a minimum, be up to date within 3 months as of the date
the amendment is filed.
(d)(1) If an exchange, on an annual or more frequent basis,
publishes, or cooperates in the publication of, any of the information
required to be filed by paragraphs (b)(2) and (c) of this section, in
lieu of filing such information, an exchange may:
(i) Identify the publication in which such information is
available, the name, address, and telephone number of the person from
whom such publication may be obtained, and the price of such
publication; and
(ii) Certify to the accuracy of such information as of its
publication date.
(2) If an exchange keeps the information required under paragraphs
(b)(2) and (c) of this section up to date and makes it available to the
[[Page 23554]]
Commission and the public upon request, in lieu of filing such
information, an exchange may certify that the information is kept up to
date and is available to the Commission and the public upon request.
(3) If the information required to be filed under paragraphs (b)(2)
and (c) of this section is available continuously on an Internet web
site controlled by an exchange, in lieu of filing such information with
the Commission, such exchange may:
(i) Indicate the location of the Internet web site where such
information may be found; and
(ii) Certify that the information available at such location is
accurate as of its date.
(e) The Commission may exempt a national securities exchange, or an
exchange exempted from such registration based on limited volume, from
filing the amendment required by this section for any affiliate or
subsidiary listed in Exhibit C of the exchange's application for
registration, as amended, that either:
(1) Is listed in Exhibit C of the application for registration, as
amended, of one or more other national securities exchanges; or
(2) Was an inactive subsidiary throughout the subsidiary's latest
fiscal year. Any such exemption may be granted upon terms and
conditions the Commission deems necessary or appropriate in the public
interest or for the protection of investors, provided however, that at
least one national securities exchange shall be required to file the
amendments required by this section for an affiliate or subsidiary
described in paragraph (e)(1) of this section.
15. Section 240.6a-3 is revised to read as follows:
Sec. 240.6a-3 Supplemental material to be filed by exchanges.
(a)(1) A national securities exchange, or an exchange exempted from
such registration based on limited volume, shall file with the
Commission any material (including notices, circulars, bulletins,
lists, and periodicals) issued or made generally available to members
of, or participants or subscribers to, the exchange. Such material
shall be filed with the Commission within 10 days after issuing or
making such material available to members, participants or subscribers.
(2) If the information required to be filed under paragraph (a)(1)
of this section is available continuously on an Internet web site
controlled by an exchange, in lieu of filing such information with the
Commission, such exchange may:
(i) Indicate the location of the Internet web site where such
information may be found; and
(ii) Certify that the information available at such location is
accurate as of its date.
(b) Within 15 days after the end of each calendar month, a national
securities exchange or an exchange exempted from such registration
based on limited volume, shall file a report concerning the securities
sold on such exchange during the calendar month. Such report shall set
forth:
(1) The number of shares of stock sold and the aggregate dollar
amount of such stock sold;
(2) The principal amount of bonds sold and the aggregate dollar
amount of such bonds sold; and
(3) The number of rights and warrants sold and the aggregate dollar
amount of such rights and warrants sold.
16. Section 240.11Ac1-1 is amended by redesignating paragraph
(c)(5)(ii)(A) as paragraph (c)(5)(ii)(A)(1), paragraph (c)(5)(ii)(B) as
paragraph (c)(5)(ii)(A)(2), paragraph (c)(5)(ii)(B)(1) as paragraph
(c)(5)(ii)(A)(2)(i), paragraph (c)(5)(ii)(B)(2) as paragraph
(c)(5)(ii)(A)(2)(ii), in newly designated paragraph
(c)(5)(ii)(A)(2)(ii) removing the period and adding in its place ``;
or'', and adding paragraph (c)(5)(ii)(B) to read as follows:
Sec. 240.11Ac1-1 Dissemination of quotations.
* * * * *
(c) * * *
(5) * * *
(ii) * * *
(A)(1) * * *
(B) Is an alternative trading system that:
(1) Displays orders and provides the ability to effect transactions
with such orders under Sec. 242.301(b)(3) of this chapter; and
(2) Otherwise is in compliance with Regulation ATS, Sec. 242.300
through 242.303.
* * * * *
17. Section 240.17a-3 is amended by adding paragraph (a)(16) to
read as follows:
Sec. 240.17a-3 Records to be made by certain exchange members, brokers
and dealers.
(a) * * *
(16)(i) The following records regarding any internal broker-dealer
system of which such a broker or dealer is the sponsor:
(A) A record of the broker's or dealer's customers that have access
to an internal broker-dealer system sponsored by such broker or dealer
(identifying any affiliations between such customers and the broker or
dealer);
(B) Daily summaries of trading in the internal broker-dealer
system, including:
(1) Securities for which transactions have been executed through
use of such system; and
(2) Transaction volume (separately stated for trading occurring
during hours when consolidated trade reporting facilities are and are
not in operation):
(i) With respect to equity securities, in number of trades, number
of shares, and total U.S. dollar value;
(ii) With respect to debt securities, in total U.S. dollar value;
and
(iii) With respect to other securities, in number of trades, number
of units of securities, and in dollar value, or other appropriate
commonly used measure of value of such securities; and
(C) Time-sequenced records of each transaction effected through the
internal broker-dealer system, including date and time executed, price,
size, security traded, counterparty identification information, and
method of execution (if internal broker-dealer system allows
alternative means or locations for execution, such as routing to
another market, matching with limit orders, or executing against the
quotations of the broker or dealer sponsoring the system).
(ii) For purposes of this paragraph the term:
(A) Internal broker-dealer system shall mean any facility, other
than a national securities exchange, an exchange exempt from
registration based on limited volume, or an alternative trading system
as defined in Regulation ATS, Secs. 242.300 through 242.303 of this
chapter, that provides a mechanism, automated in full or in part, for
collecting, receiving, disseminating, or displaying system orders and
facilitating agreement to the basic terms of a purchase or sale of a
security between a customer and the sponsor, or between two customers
of the sponsor, through use of the internal broker-dealer system or
through the broker or dealer sponsor of such system;
(B) Sponsor shall mean any broker or dealer that organizes,
operates, administers, or otherwise directly controls an internal
broker-dealer trading system or, if the operator of the internal
broker-dealer system is not a registered broker or dealer, any broker
or dealer that, pursuant to contract, affiliation, or other agreement
with the system operator, is involved on a regular basis with executing
transactions in connection with use of the internal broker-dealer
system, other than solely
[[Page 23555]]
for its own account or as a customer with access to the internal
broker-dealer system; and
(C) System order means any order or other communication or
indication submitted by any customer with access to the internal
broker-dealer system for entry into a trading system announcing an
interest in purchasing or selling a security. The term ``system order''
does not include inquiries or indications of interest that are not
entered into the internal broker-dealer system.
18. Section 240.17a-4 is amended by revising paragraph (b)(1) and
adding paragraph (b)(10) to read as follows:
Sec. 240.17a-4 Records to be preserved by certain exchange members,
brokers and dealers.
* * * * *
(b) * * *
(1) All records required to be made pursuant to paragraphs (a) (4),
(6), (7), (8), (9), and (10) of Sec. 240.17a-3.
* * * * *
(10) All notices relating to an internal broker-dealer system
provided to the customers of the broker or dealer that sponsors such
internal broker-dealer system, as defined in paragraph (a)(16)(ii)(A)
of Sec. 240.17a-3. Notices, whether written or communicated through the
internal broker-dealer trading system or other automated means, shall
be preserved under this paragraph (b)(10) if they are provided to all
customers with access to an internal broker-dealer system, or to one or
more classes of customers. Examples of notices to be preserved under
this paragraph (b)(10) include, but are not limited to, notices
addressing hours of system operations, system malfunctions, changes to
system procedures, maintenance of hardware and software, and
instructions pertaining to access to the internal broker-dealer system.
* * * * *
Sec. 240.17a-23 [Removed and reserved]
19. Section 240.17a-23 is removed and reserved.
20. Section 240.19b-5 is added to read as follows:
Sec. 240.19b-5 Temporary exemption from the filing requirements of
Section 19(b) of the Act.
Preliminary Notes
1. The following section provides for a temporary exemption from
the rule filing requirement for self-regulatory organizations that
file proposed rule changes concerning the operation of a pilot
trading system pursuant to section 19(b) of the Act (15 U.S.C.
78s(b), as amended). All other requirements under the Act that are
applicable to self-regulatory organizations continue to apply.
2. The disclosures made pursuant to the provisions of this
section are in addition to any other applicable disclosure
requirements under the federal securities laws.
(a) For purposes of this section, the term pilot trading system
shall mean a trading system operated by a self-regulatory organization
that is not substantially similar to any pilot trading system operated
by such self-regulatory organization at any time during the preceding
year, and that:
(1)(i) Has been in operation for less than two years;
(ii) Is independent of any other trading system operated by such
self-regulatory organization that has been approved by the Commission
pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b));
(iii) With respect to each security traded on such pilot trading
system, during at least two of the last four consecutive calendar
months, has traded no more than 5% of the average daily share trading
volume of such security in the United States; and
(iv) With respect to all securities traded on such pilot trading
system, during at least two of the last four consecutive calendar
months, has traded no more than 20% of the average daily share trading
volume of all trading systems operated by such self-regulatory
organization; or
(2)(i) Has been in operation for less than two years;
(ii) With respect to each security traded on such pilot trading
system, during at least two of the last four consecutive calendar
months, has traded no more than 1% of the average daily share trading
volume of such security in the United States; and
(iii) With respect to all securities traded on such pilot trading
system, during at least two of the last four consecutive calendar
months, has traded no more than 20% of the average daily share trading
volume of all trading systems operated by such self-regulatory
organization; or
(3)(i) Has been in operation for less than two years; and
(ii)(A) Satisfied the definition of pilot trading system under
paragraph (a)(1) of this section no more than 60 days ago, and
continues to be independent of any other trading system operated by
such self-regulatory organization that has been approved by the
Commission pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b)); or
(B) Satisfied the definition of pilot trading system under
paragraph (a)(2) of this section no more than 60 days ago.
(b) A pilot trading system shall be deemed independent of any other
trading system operated by a self-regulatory organization if:
(1) Such pilot trading system trades securities other than the
issues of securities that trade on any other trading system operated by
such self-regulatory organization that has been approved by the
Commission pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b)); or
(2) Such pilot trading system does not operate during the same
trading hours as any other trading system operated by such self-
regulatory organization that has been approved by the Commission
pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b)); or
(3) No specialist or market maker on any other trading system
operated by such self-regulatory organization that has been approved by
the Commission pursuant to section 19(b) of the Act, (15 U.S.C.
78s(b)), is permitted to effect transactions on the pilot trading
system in securities in which they are a specialist or market maker.
(c) A self-regulatory organization shall be exempt temporarily from
the requirement under section 19(b) of the Act, (15 U.S.C. 78s(b)), to
submit a proposed rule change on Form 19b-4, 17 CFR 249.819, if the
self-regulatory organization complies with the requirements in this
paragraph (c).
(1) Scope of exemption. Such proposed rule change relates to the
operation of a pilot trading system.
(2) Form PILOT. The self-regulatory organization:
(i) Files Part I of Form PILOT, 17 CFR 249.821, in accordance with
the instructions therein, at least 20 days prior to commencing
operation of the pilot trading system;
(ii) Files an amendment on Part I of Form PILOT at least 20 days
prior to implementing a material change to the operation of the pilot
trading system; and
(iii) Files a quarterly report on Part II of Form PILOT within 30
calendar days after the end of each calendar quarter in which the
market has operated after the effective date of this section.
(3) Trading rules and procedures and listing standards. The self-
regulatory organization has in place trading rules and procedures and
listing standards necessary to operate the pilot trading system.
(4) Surveillance. The self-regulatory organization establishes
internal procedures for the effective surveillance of trading activity
on the self-regulatory organization's pilot trading system.
(5) Clearance and settlement. The self-regulatory organization
establishes reasonable clearance and settlement procedures for
transactions effected on
[[Page 23556]]
the self-regulatory organization's pilot trading system.
(6) Types of securities. The self-regulatory organization:
(i) Permits to trade on the pilot trading system only securities
listed on a national securities exchange or to which unlisted trading
privileges have been extended pursuant to a rule, regulation, or order
of the Commission under section 12(f) of the Act, (15 U.S.C. 78l(f));
(ii) Does not permit to trade on the pilot trading system any
security or instrument, such as an option, warrant or hybrid product,
the value of which is based, in whole or in part, upon the performance
of any security that is traded on another trading system operated by
such self-regulatory organization that has been approved by the
Commission pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b));
and
(iii) Does not permit to trade on the pilot trading system any
security or instrument, such as an equity security, the derivative of
which is traded on another trading system operated by such self-
regulatory organization that has been approved by the Commission
pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b)).
(7) Procedures to ensure the confidential treatment of trading
information. The self-regulatory organization has in place adequate
safeguards and procedures relating to the treatment of trading
information. Such safeguards and procedures shall include:
(i) Limiting access to the confidential information regarding the
identity of members, and other persons, effecting transactions on the
pilot trading system, as well as such members' and other persons'
confidential trading information, to those employees of the self-
regulatory organization who are operating the pilot trading system or
are responsible for such pilot trading system's compliance with these
or any other applicable rules;
(ii) Implementing standards controlling the self-regulatory
organization employees' trading for their own accounts; and
(iii) Adopting and implementing adequate oversight procedures to
ensure that the safeguards and procedures outlined in paragraphs
(c)(7)(i) and (ii) of this section are followed.
(8) Examinations, inspections, and investigations of subscribers.
The self-regulatory organization and its members cooperate with the
examination, inspection, or investigation by the Commission of
transactions effected on the pilot trading system.
(9) Recordkeeping. The self-regulatory organization shall retain at
its principal place of business and make available to Commission staff
for inspection, all the rules and procedures relating to each pilot
trading system operating pursuant to this section for a period of not
less than five years, the first two years in an easily accessible
place, as prescribed in Sec. 240.17a-1.
(10) Every notice or amendment filed pursuant to this paragraph (c)
shall constitute a ``report'' within the meaning of sections 11A,
17(a), 18(a), and 32(a), (15 U.S.C. 78k-1, 78q(a), 78r(a), and
78ff(a)), and any other applicable provisions of the Act. All notices
or report filed pursuant to this paragraph (c) shall be deemed to be
confidential.
(d) A self-regulatory organization shall request Commission
approval, pursuant to section 19(b)(2) of the Act, (15 U.S.C. 78s(b)),
for any rule change relating to the operation of a pilot trading system
by submitting Form 19b-4, 17 CFR 249.819, no later than two years after
the commencement of operation of such pilot trading system, or shall
cease operation of the pilot trading system.
(e) Simultaneous with a request for Commission approval pursuant to
section 19(b)(2) of the Act, (15 U.S.C. 78s(b)(2)), a self-regulatory
organization may request Commission approval pursuant to section
19(b)(3)(A) of the Act, (15 U.S.C. 78s(b)(3)(A)), for any rule change
relating to the operation of a pilot trading system by submitting Form
19b-4, 17 CFR 249.819, effective immediate upon filing, to continue
operations of such trading system for a period not to exceed six
months.
(f) Notwithstanding paragraph (c) of this section, rule changes
with respect to pilot trading systems operated by a self-regulatory
organization shall not be exempt from the rule filing requirements of
section 19(b) of the Act, (15 U.S.C. 78s(b)(2)), if the Commission
determines, after notice to the SRO and opportunity for the SRO to
respond, that exemption of such changes would not be necessary or
appropriate in the public interest or consistent with the protection of
investors.
PART 242--REGULATIONS M AND ATS
21. The authority citation for part 242 is revised to read as
follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78i(a), 78j,
78k-1(c), 78l, 78m, 78 mm, 78n, 78o(b), 78o(c), 78o(g), 78q(a),
78q(b), 78q(h), 78w(a), 78dd-1, 80a-23, 80a-29, and 80a-37.
22. The part heading for part 242 is revised as set forth above.
23. Part 242 is amended by adding Regulation ATS, Secs. 242.300
through 242.303 to read as follows:
Regulation ATS--Alternative Trading Systems
Sec.
242.300 Definitions.
242.301 Requirements for alternative trading systems that are not
national securities exchanges.
242.302 Recordkeeping requirements for alternative trading systems.
242.303 Record preservation requirements for alternative trading
systems.
Regulation ATS--Alternative Trading Systems
Preliminary Notes
1. An alternative trading system is required to comply with the
requirements in this Regulation ATS, unless such alternative trading
system:
(a) Is registered as a national securities exchange;
(b) Is exempt from registration as a national securities
exchange based on the limited volume of transactions effected on the
alternative trading system; or
(c) Trades only government securities and certain other related
instruments.
All alternative trading systems must comply with the antifraud,
antimanipulation, and other applicable provisions of the federal
securities laws.
2. The requirements imposed upon an alternative trading system
by Regulation ATS are in addition to any requirements applicable to
broker-dealers registered under Section 15 of the Act, (15 U.S.C.
78o).
3. An alternative trading system must comply with any applicable
state law relating to the offer or sale of securities or the
registration or regulation of persons or entities effecting
transactions in securities.
4. The disclosures made pursuant to the provisions of this
section are in addition to any other disclosure requirements under
the federal securities laws.
Sec. 242.300 Definitions.
For purposes of this section, the following definitions shall
apply:
(a) Alternative trading system means any organization, association,
person, group of persons, or system:
(1) That constitutes, maintains, or provides a market place or
facilities for bringing together purchasers and sellers of securities
or for otherwise performing with respect to securities the functions
commonly performed by a stock exchange within the meaning of
Sec. 240.3b-12 of this chapter; and
(2) That does not:
(i) Set rules governing the conduct of subscribers other than the
conduct of such subscribers' trading on such organization, association,
person, group of persons, or system, or
(ii) Discipline subscribers other than by exclusion from trading.
[[Page 23557]]
(b) Subscriber means any person that has entered into a contractual
agreement with an alternative trading system to access such alternative
trading system for the purpose of effecting transactions in securities
or submitting, disseminating, or displaying orders on such alternative
trading system, including a customer, member, user, or participant in
an alternative trading system. A subscriber, however, shall not include
a national securities exchange or national securities association.
(c) Affiliate of a subscriber means any person that, directly or
indirectly, controls, is under common control with, or is controlled
by, the subscriber, including any employee.
(d) Debt security shall mean any security other than an equity
security, as defined in Sec. 240.3a11-1 of this chapter, as well as
non-participatory preferred stock.
(e) Order means any firm indication of a willingness to buy or sell
a security, as either principal or agent, including any bid or offer
quotation, market order, limit order, or other priced order.
(f) Control means the power, directly or indirectly, to direct the
management or policies of an alternative trading system, whether
through ownership of securities, by contract, or otherwise. A person is
presumed to control an alternative trading system, if that person:
(1) Is a director, general partner, or officer exercising executive
responsibility (or having similar status or performing similar
functions);
(2) Directly or indirectly has the right to vote 25% or more of a
class of voting security or has the power to sell or direct the sale of
25% or more of a class of voting securities of the alternative trading
system; or
(3) In the case of a partnership, has contributed, or has the right
to receive upon dissolution, 25% or more of the capital of the
alternative trading system.
(g) Covered security shall have the meaning provided in
Sec. 240.11Ac1-1(a)(6) of this chapter, provided, however, that a debt
or convertible debt security shall not be deemed a covered security for
purposes of Regulation ATS.
(h) Effective transaction reporting plan shall have the meaning
provided in Sec. 240.11Aa3-1(a)(3) of this chapter.
(i) Exchange market maker shall have the meaning provided in
Sec. 240.11Ac1-1(a)(9) of this chapter.
(j) OTC market maker shall have the meaning provided in
Sec. 240.11Ac1-1(a)(13) of this chapter.
(k) Corporate debt security shall mean any security, other than an
exempted security, that evidences a liability of the issuer and that
has a maturity date that is at least one year following the date of
issuance.
Sec. 242.301 Requirements for alternative trading systems that are not
national securities exchanges.
(a) Scope of section. An alternative trading system shall comply
with the requirements in paragraph (b) of this section, unless such
alternative trading system is:
(1) Registered as an exchange under section 6 of the Act, (15
U.S.C. 78f);
(2) Exempt from registration as an exchange based on the limited
volume of transactions effected;
(3) Operated by a national securities association; or
(4) Registered as a broker-dealer under sections 15(b), or 15C of
the Act, (15 U.S.C. 78o(b), and 78o-5), and trades only the following
types of securities:
(i) Government securities, as defined in section 3(a)(42) of the
Act, (15 U.S.C. 78c(a)(42));
(ii) Debt securities that:
(A) Are issued pursuant to the Brady Plan debt-restructuring
program; and
(B) Have all of their principal payments guaranteed by the issuance
of government securities; and
(iii) Repurchase and reverse repurchase agreements solely involving
securities included within paragraphs (a)(4)(i) and (a)(4)(ii) of this
section.
(b) Requirements. Every alternative trading system subject to this
Regulation ATS, pursuant to paragraph (a) of this section, shall comply
with the requirements in this paragraph (b).
(1) Broker-dealer registration. The alternative trading system
shall register as a broker-dealer under section 15 of the Act, (15
U.S.C. 78o).
(2) Notice. (i) The alternative trading system shall file an
initial operation report on Form ATS, Sec. 249.637 of this chapter, in
accordance with the instructions therein, at least 20 days prior to
commencing operation as an alternative trading system, or if the
alternative trading system is operating as of (effective date of rule),
no later than (60 days following effective date).
(ii) The alternative trading system shall file an amendment on Form
ATS at least 20 calendar days prior to implementing a material change
to the operation of the alternative trading system.
(iii) If any information contained in the initial operation report
filed under paragraph (b)(2)(i) of this section becomes inaccurate for
any reason and has not been previously reported to the Commission as an
amendment on Form ATS, the alternative trading system shall file an
amendment on Form ATS correcting such information within 30 calendar
days after the end of each calendar quarter in which the alternative
trading system has operated.
(iv) The alternative trading system shall promptly file an
amendment on Form ATS correcting information previously reported on
Form ATS after discovery that any information filed under paragraphs
(b)(2)(i), (ii) or (iii) of this section was inaccurate when filed.
(v) The alternative trading system shall promptly file a cessation
of operations report on Form ATS in accordance with the instructions
therein upon ceasing to operate as an alternative trading system.
(vi) Every notice or amendment filed pursuant to this paragraph
(b)(2) shall constitute a ``report'' within the meaning of sections
11A, 17(a), 18(a), and 32(a), (15 U.S.C. 78k-1, 78q(a), 78r(a), and
78ff(a)), and any other applicable provisions of the Act.
(vii) The reports provided for in paragraph (b)(2) of this section
shall be considered filed upon receipt at the Commission's principal
office in Washington, DC. Duplicate originals of the reports provided
for in paragraphs (b)(2)(i) through (v) of this section must be filed
with surveillance personnel designated as such by any self-regulatory
organization of which the alternative trading system is a member
simultaneously with filing with the Commission. Duplicates of the
reports required by paragraph (b)(9) of this section shall be provided
to surveillance personnel of such self-regulatory authority upon
request. All reports filed pursuant to this paragraph (b)(2) and
paragraph (b)(9) of this section shall be deemed confidential when
filed.
(3) Order display and execution access. (i) An alternative trading
system shall comply with the requirements set forth in paragraph
(b)(3)(ii) of this section if, with respect to any covered security in
which the alternative trading system:
(A) Displays subscriber orders to any person (other than
alternative trading system employees); and
(B) During at least 4 of the preceding 6 calendar months, had an
average daily trading volume greater than 10% of the aggregate average
daily share volume for such covered security as reported by an
effective transaction reporting plan or disseminated through an
automated quotation system as described in section 3(a)(51)(A)(ii) of
the Act, (15 U.S.C. 78c(a)(51)(A)(ii)).
(ii) Such alternative trading system shall:
(A) Provide to a national securities exchange or national
securities association (or an exclusive processor acting on behalf of
one or more national
[[Page 23558]]
securities exchanges or national securities associations) the prices
and sizes of the orders at the highest buy price and the lowest sell
price for such covered security displayed to more than one person in
the alternative trading system and ensure that such prices and sizes
are included in the quotation data made available by the exchange,
association or exclusive processor to quotation vendors pursuant to
Sec. 240.11Ac1-1 of this chapter; and
(B) Provide to any broker-dealer that has access to a national
securities exchange or national securities association, to which the
alternative trading system provides the prices and sizes of displayed
orders pursuant to paragraph (b)(3)(ii)(A) of this section, the ability
to effect a transaction with such orders that is:
(1) Equivalent to the ability of such member to effect a
transaction with other orders displayed on the exchange or by the
association; and
(2) At the price of the highest priced buy order or lowest priced
sell order displayed for the lesser of the cumulative size of such
priced orders entered therein at such price, or the size of the
execution sought by the member.
(4) Fees. The alternative trading system shall not charge any fee
to members of a national securities exchange or national securities
association for access to the alternative trading system required by
paragraph (b)(3)(ii)(B) of this section that is:
(i) In excess of the highest fee the alternative trading system
charges a substantial proportion of its broker-dealer subscribers for
access made available to subscribers by the alternative trading system;
or
(ii) Prohibited by rules of the national securities exchange or
national securities association, to which the alternative trading
system provides the prices and sizes of orders under paragraph
(b)(3)(ii)(B) of this section, that are designed to assure consistency
with standards for access to quotations displayed on the market
operated by such national securities exchange or national securities
association.
(5) Fair access. (i) An alternative trading system shall comply
with the requirements in paragraph (b)(5)(ii) of this section, if
during at least 4 of the preceding 6 calendar months, such alternative
trading system had:
(A) With respect to any covered security, greater than 20% of the
average daily share volume in that security reported by the effective
transaction reporting plan or disseminated through an automated
quotation system as described in section 3(a)(51)(A)(ii) of the Act (15
U.S.C. 78c(a)(51)(A)(ii));
(B) With respect to an equity security that is not a covered
security and for which transactions are reported to a self-regulatory
organization, greater than 20% of the average daily share volume in
that security as calculated by the self-regulatory organization to
which such transactions are reported; or
(C) With respect to any category of debt security, including
corporate debt securities, greater than 20% of the average daily volume
traded in the United States.
(ii) An alternative trading system shall:
(A) Establish standards for granting access to trading on its
system;
(B) Not unreasonably prohibit or limit any person in respect to
access to services offered by such alternative trading system; and
(C) Within 24 hours of prohibiting or limiting, directly or
indirectly, any person's access to any services offered by an
alternative trading system, such alternative trading system shall send
notice to such person stating that such person has the right to appeal
to the Commission the action taken by such alternative trading system.
(iii) If any alternative trading system meeting the standards in
paragraph (b)(5)(i) of this section, directly or indirectly, prohibits
or limits access to the services offered, any person aggrieved thereby
may file with the Commission a written motion for a stay of such
prohibition or limitation pursuant to Sec. 201.401 of this chapter.
(iv) Applications to the Commission for review of any prohibition
or limitation of access to services offered by an alternative trading
system shall be made pursuant to Sec. 201.420 of this chapter.
(v) Every notice filed pursuant to this paragraph (b)(5) shall
constitute a ``report'' within the meaning of sections 11A, 17(a),
18(a), and 32(a) (15 U.S.C. 78q(a), 78r(a), and 78ff(a)), and any other
applicable provisions, of the Act.
(vi) All reports filed pursuant to this paragraph (b)(5) shall be
deemed confidential when filed.
(6) Capacity, integrity, and security of automated systems. (i) The
alternative trading system shall comply with the requirements in
paragraph (b)(6)(ii) of this section, if during at least 4 of the
preceding 6 calendar months, such alternative trading system had an
average daily share volume:
(A) With respect any covered security, greater than 20% of the
average daily share volume reported by the effective transaction
reporting plan or disseminated through an automated quotation system as
described in section 3(a)(51)(A)(ii) of the Act, (15 U.S.C.
78c(a)(51)(A)(ii));
(B) With respect to equity securities that are not covered
securities and for which transactions are reported to a self-regulatory
organization, greater than 20% of the average daily share volume as
calculated by the self-regulatory organization to which such
transactions are reported; or
(C) With respect to category of debt security, including corporate
debt securities, greater than 20% of the average daily volume traded in
the United States.
(ii) With respect to those systems that support order entry, order
routing, execution, transaction reporting, and trade comparison, the
alternative trading system shall:
(A) Establish reasonable current and future capacity estimates;
(B) Conduct periodic capacity stress tests of critical systems to
determine such system's ability to process transactions in an accurate,
timely, and efficient manner;
(C) Develop and implement reasonable procedures to review and keep
current its system development and testing methodology;
(D) Review vulnerability of its systems and data center computer
operations to internal and external threats, physical hazards, and
natural disasters;
(E) Establish adequate contingency and disaster recovery plans;
(F) On an annual basis, perform an independent review, in
accordance with established audit procedures and standards, of such
alternative trading system's controls for ensuring that paragraphs
(b)(6)(ii)(A) through (E) of this section are met, and conduct a review
by senior management of a report containing the recommendations and
conclusions of the independent review; and
(G) Promptly notify the Commission staff of material systems
outages and significant systems changes.
(7) Examinations, inspections, and investigations of subscribers.
The alternative trading system shall permit the examination and
inspection, of its premises, systems, and records, and cooperate with
the examination, inspection, or investigation of subscribers, whether
such examination is being conducted by the Commission or by a self-
regulatory organization of which such subscriber is a member.
(8) Recordkeeping. The alternative trading system shall:
(i) Make and keep current the records specified in Sec. 242.302;
and
(ii) Preserve the records specified in Sec. 242.303.
[[Page 23559]]
(9) Reporting. The alternative trading system shall:
(i) File the information described in Form ATS-R (Sec. 249.638 of
this chapter) within 30 calendar days after the end of each calendar
quarter in which the market has operated after the effective date of
this section; and
(ii) File the information described in Form ATS-R within 10
calendar days after an alternative trading system ceases to operate.
(10) Procedures to ensure the confidential treatment of trading
information. The alternative trading system shall have in place
adequate safeguards and procedures to protect subscribers' confidential
trading information. Such safeguards and procedures shall include:
(i) Limiting access to the confidential trading information of
subscribers to those employees of the alternative trading system who
are operating the system or responsible for its compliance with these
or any other applicable rules;
(ii) Implementing standards controlling employees of the
alternative trading system trading for their own accounts; and
(iii) Adopting and implementing adequate oversight procedures to
ensure that the safeguards and procedures outlined in paragraphs
(b)(6)(ii)(A), (B) and (C) of this section are followed.
(11) Name. The alternative trading system shall not use in its name
the word ``exchange,'' or derivations of the word ``exchange.''
Sec. 242.302 Recordkeeping requirements for alternative trading
systems.
To comply with the condition set forth in paragraph (b)(8) of
Sec. 242.301, an alternative trading system shall make and keep current
the following records:
(a) A record of subscribers to such alternative trading system
(identifying any affiliations between the alternative trading system
and subscribers to the alternative trading system);
(b) Daily summaries of trading in the alternative trading system
including:
(1) Securities for which transactions have been executed;
(2) Transaction volume, expressed with respect to equity securities
in:
(i) Number of trades;
(ii) Number of shares traded; and
(iii) Total U.S. dollar value; and
(3) Transaction volume, expressed with respect to debt securities
in:
(i) Number of trades; and
(ii) Total U.S. dollar value; and
(c) Time-sequenced records of order information in the alternative
trading system, including:
(1) Date and time (expressed in terms of hours, minutes, and
seconds) that the order was received;
(2) Identity of the security;
(3) The number of shares or bonds to which the order applies;
(4) An identification of the order related to a program trade or an
index arbitrage trade as defined in New York Stock Exchange Rule 80A;
(5) The designation of the order as a buy or sell order;
(6) The designation of the order as a short sale order;
(7) The designation of the order as a market order, limit order,
stop order, stop limit order, or other type or order;
(8) Any limit or stop price prescribed by the order;
(9) The date on which the order expires and, if the time in force
is less than one day, the time when the order expires;
(10) The time limit during which the order is in force;
(11) Any instructions to modify or cancel the order;
(12) Date and time (expressed in terms of hours, minutes, and
seconds) that the order was executed;
(13) Price at which the order was executed;
(14) Size of the order executed (expressed in number of shares or
units or principal amount);
(15) The type of account, i.e., retail, wholesale, employee,
proprietary, or any other type of account designated by the alternative
trading system, for which the order is submitted; and
(16) Identity of the parties to the transaction.
Sec. 242.303 Record preservation requirements for alternative trading
systems.
(a) To comply with the condition set forth in paragraph (b)(9) of
Sec. 242.301, an alternative trading system shall preserve the
following records:
(1) For a period of not less than three years, the first two years
in an easily accessible place, an alternative trading system shall
preserve:
(i) All records required to be made pursuant to Sec. 242.302;
(ii) All notices provided by such alternative trading system to
subscribers generally, whether written or communicated through
automated means, including, but not limited to, notices addressing
hours of system operations, system malfunctions, changes to system
procedures, maintenance of hardware and software, instructions
pertaining to access to the market and denials of, or limitations on,
access to the alternative trading system;
(iii) If subject to paragraph (b)(5)(ii) of Sec. 242.301, at least
one copy of such alternative trading system's standards for access to
trading; and
(iv) At least one copy of all documents made or received by the
alternative trading system in the course of complying with paragraph
(b)(6) of Sec. 242.301, including all correspondence, memoranda,
papers, books, notices, accounts, reports, test scripts, test results,
and other similar records.
(2) During the life of the enterprise and of any successor
enterprise, an alternative trading system shall preserve:
(i) All partnership articles or, in the case of a corporation, all
articles of incorporation or charter, minute books and stock
certificate books; and
(ii) Copies of reports filed pursuant to paragraphs (b)(2) and
(b)(5) of Sec. 242.301.
(b) The records required to be maintained and preserved pursuant to
paragraph (a) of this section must be produced, reproduced, and
maintained in paper form or in any of the forms permitted under
Sec. 240.17a-4(f) of this chapter.
(c) Alternative trading systems must comply with any other
applicable recordkeeping or reporting requirement in the Act, and the
rules and regulations thereunder. If the information in a record
required to be made pursuant to Sec. 242.303 is preserved in a record
made pursuant to Sec. 240.17a-3 or Sec. 240.17a-4 of this chapter, or
otherwise preserved by the alternative trading system (whether in
summary or some other form), Sec. 242.303 shall not require the sponsor
to maintain such information in a separate file, provided that the
sponsor can promptly sort and retrieve the information as if it had
been kept in a separate file as a record made pursuant to this section,
and preserves the information in accordance with the time periods
specified in paragraph (a)(1) of Sec. 242.303.
(d) The records required to be maintained and preserved pursuant to
Sec. 242.303 may be prepared or maintained by a service bureau,
depository, or other recordkeeping service on behalf of the alternative
trading system. An agreement with a service bureau, depository, or
other recordkeeping service shall not relieve the alternative trading
system from the responsibility to prepare and maintain records as
specified in this section. The service bureau, depository, or other
recordkeeping service shall file with the Commission a written
undertaking in a form acceptable to the Commission, signed by a duly
authorized person, to the effect that such records are the property of
the alternative trading system required to maintain and preserve such
records and will be surrendered promptly on request of the
[[Page 23560]]
alternative trading system and including the following provision:
With respect to any books and records maintained or preserved on
behalf of [name of alternative trading system], the undersigned hereby
undertakes to permit examination of such books and records at any time
or from time to time during business hours by representatives or
designees of the Securities and Exchange Commission, and to promptly
furnish to the Commission or its designee a true, correct, complete and
current hard copy of any or all or any part of such books and records.
(e) Every alternative trading system shall furnish to any
representative of the Commission promptly upon request, legible, true,
and complete copies of those records that are required to be preserved
under this section.
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
24. The authority citation for part 249 continues to read in part
as follows:
Authority: 15 U.S.C. 78a, et seq., unless otherwise noted.
* * * * *
25. Section 249.1 and Form 1 are revised to read as follows:
Sec. 249.1 Form 1, for application for, and amendments to applications
for, registration as a national securities exchange or exemption from
registration pursuant to Section 5 of the Exchange Act.
The form shall be used for application for, and amendments to
applications for, registration as a national securities exchange or
exemption from registration pursuant to section 5 of the Exchange Act,
(15 U.S.C. 78e).
BILLING CODE 8010-01-P
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Sec. 249.1a and Form 1-A [Removed]
26. Section 249.1a and Form 1-A are removed.
Sec. 249.636 and Form ATS [Removed and reserved]
27. Section 249.636 and Form 17A-23 are removed and reserved.
28. Section 249.637 and Form ATS are added to read as follows:
Sec. 249.637 Form ATS, information required of alternative trading
systems pursuant to Sec. 242.301(b)(2) of this chapter.
This form shall be used by every alternative trading system to file
required notices, reports and amendments under Sec. 242.301(b)(2) of
this chapter.
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29. Section 249.638 and Form ATS-R are added to read as follows:
Sec. 249.638 Form ATS-R, information required of alternative trading
systems pursuant to Sec. 242.301(b)(8) of this chapter.
This form shall be used by every alternative trading system to file
required reports under Sec. 242.301(b)(8) of this chapter.
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30. Section 249.821 and Form PILOT are added to read as follows:
Sec. 249.821 Form PILOT, information required of self-regulatory
organizations operating pilot trading systems pursuant to Sec. 204.19b-
5 of this chapter.
This form shall be used by all self-regulatory organizations, as
defined in Section 3(a)(26) of the Act, (15 U.S.C. 78c(a)(26)), to file
required information and reports with regard to pilot trading systems
pursuant to Sec. 240.19b-5 of this chapter.
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By the Commission.
Dated: April 21, 1998.
Margaret H. McFarland,
Deptuy Secretary.
[FR Doc. 98-10945 Filed 4-28-98; 8:45 am]
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