[Federal Register Volume 63, Number 245 (Tuesday, December 22, 1998)]
[Rules and Regulations]
[Pages 70844-70951]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-33299]



[[Page 70843]]

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Part II





Securities and Exchange Commission





_______________________________________________________________________



17 CFR Part 202 et al.



Exchanges and Alternative Trading Systems and Filing Requirements for 
Self-Regulatory Organizations Regarding New Derivative Securities 
Products; Final Rules

  Federal Register / Vol. 63, No. 245 / Tuesday, December 22, 1998 / 
Rules and Regulations  

[[Page 70844]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 202, 240, 242 and 249

[Release No. 34-40760; File No. S7-12-98]
RIN 3235-AH41


Regulation of Exchanges and Alternative Trading Systems

AGENCY: Securities and Exchange Commission.

ACTION: Final rules.

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SUMMARY: The Securities and Exchange Commission today is adopting new 
rules and rule amendments to allow alternative trading systems to 
choose whether to register as national securities exchanges, or to 
register as broker-dealers and comply with additional requirements 
under Regulation ATS, depending on their activities and trading volume. 
The Commission is also adopting amendments to rules regarding 
registration as a national securities exchange, repealing Rule 17a-23, 
and amending the books and records rules by transferring the 
recordkeeping requirements from Rule 17a-23 to Rules 17a-3 and 17a-4 as 
they apply to broker-dealer internal trading systems. Finally, the 
Commission is excluding from the rule filing requirements for self-
regulatory organizations certain pilot trading systems operated by 
national securities exchanges and national securities associations. 
These rules will more effectively integrate the growing number of 
alternative trading systems into the national market system, 
accommodate the registration of proprietary alternative trading systems 
as exchanges, and provide an opportunity for registered exchanges to 
better compete with alternative trading systems.

DATES: Effective Date: April 21, 1999, except Secs. 242.301(b)(5)(i)(D) 
and (E) and Secs. 242.301(b)(6)(i) (D) and (E), which shall become 
effective on April 1, 2000.
    Compliance Date: Prior to April 21, 1999, the Commission will 
publish a schedule of those securities with respect to which 
alternative trading systems must comply with Sec. 242.301(b)(3) on 
April 21, 1999 and those securities with respect to which alternative 
trading systems must comply with Sec. 242.301(b)(3) on August 30, 1999. 
See Section VIII of this release.

FOR FURTHER INFORMATION CONTACT: Elizabeth King, Senior Special 
Counsel, at (202) 942-0140, Marianne Duffy, Special Counsel, at (202) 
942-4163, Constance Kiggins, Special Counsel, at (202) 942-0059, Kevin 
Ehrlich, Attorney, at (202) 942-0778, Denise Landers, Attorney, at 
(202) 942-0137 and John Roeser, Attorney, at (202) 942-0762, Division 
of Market Regulation, Securities and Exchange Commission, Stop 10-1, 
450 Fifth Street, NW, Washington, DC 20549. For questions or comments 
regarding securities registration issues raised in this release, 
contact David Sirignano, Associate Director, at (202) 942-2870, 
Division of Corporation Finance, Securities and Exchange Commission, 
Stop 3-1, 450 Fifth Street, NW, Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
II. Executive Summary of Final Rules
    A. New Interpretation of ``Exchange''
    B. Exemption for Regulated Alternative Trading Systems
    C. Regulation ATS
    D. For-Profit Exchanges
    E. Temporary Exemption from Rule Filing Requirements for SROs' 
Pilot Trading Systems
III. Rule 3b-16 under the Exchange Act
    A. Brings Together the Orders of Multiple Buyers and Sellers
    1. To Bring Together
    2. Multiple Buyers and Sellers
    3. Definition of ``Order''
    B. Established, Non-Discretionary Methods
    1. Established, Non-Discretionary Methods Provided by a Trading 
Facility
    2. Established, Non-Discretionary Methods Provided by Setting 
Rules
    C. Systems Excluded From Rule 3b-16
    1. Order Routing Systems
    2. Dealer Systems
    D. Examples of Systems Illustrating Application of Rule 3b-16
    1. Examples of Systems Included Within Rule 3b-16
    2. Examples of Systems Not included Within Rule 3b-16
    E. Exemption from the Definition of ``Exchange''
    F. Commission's Authority to Require Registration as an Exchange
IV. Regulation of Alternative Trading Systems
    A. Regulation ATS
    1. Scope of Regulation ATS
    a. Definition of Alternative Trading System
    b. Exclusion of Trading Systems Registered as Exchanges or 
Operated by a National Securities Association
    c. Exclusion of Alternative Trading Systems Trading Solely 
Government and Related Securities
    (i) Discussion
    (ii) Response to Commenters
    d. Alternative Trading Systems Trading Non-Government Debt 
Securities
    (i) Discussion
    (ii) Response to Commenters
    e. Exemptions from Certain Requirements of Regulation ATS 
Pursuant to Application to the Commission
    2. Requirements for Alternative Trading Systems Subject to 
Regulation ATS
    a. Membership in an SRO
    b. Notice of Operation as an Alternative Trading System and 
Amendments
    c. Market Transparency
    (i) Importance of Market Transparency
    (ii) Integration of Orders into the Public Quotation System
    (A) New Requirements for Alternative Trading Systems
    (B) Response to Comments
    (iii) Access to Publicly Displayed Orders
    (A) Application of Access Requirements under Regulation ATS
    (B) Response to Comments
    (iv) Execution Access Fees
    (A) Limitations on Alternative Trading System Fees Charged to 
Non-Subscribers
    (B) Response to Comments
    (v) Amendment to Rule 11Ac1-1 under the Exchange Act
    d. Fair Access
    (i) Importance of Fair Access
    (ii) Fair Access Requirement
    (iii) Response to Comments
    e. Capacity, Integrity, and Security Standards
    (i) Application of Capacity, Integrity, and Security Standards
    (ii) Response to Comments
    f. Examination, Inspection, and Investigations of Subscribers
    g. Recordkeeping
    h. Reporting and Form ATS-R
    i. Procedures to Ensure Confidential Treatment of Trading 
Information
    B. Registration as a National Securities Exchange
    1. Self-Regulatory Responsibilities
    2. Fair Representation
    (i) Public Directors
    (ii) Fair Representation of Exchange Members
    3. Membership on a National Securities Exchange
    4. Fair Access
    5. Compliance with ARP Guidelines
    6. Registration of Securities
    7. National Market System Participation
    8. Uniform Trading Standards
    9. Proposed Rule Changes
    C. Application for Registration as an Exchange
    1. Revisions to and Repeal of Form 1-A
    2. Amendments to Rules 6a-1, 6a-2, and 6a-3 under the Exchange 
Act
    a. Rule 6a-1 Application for Registration as an Exchange or 
Exemption Based on Limited Volume of Transactions
    b. Rule 6a-2 Periodic Amendments
    c. Rule 6a-3 Supplemental Material
    D. National Securities Exchanges Operating Alternative Trading 
Systems
V. Broker-Dealer Recordkeeping and Reporting Obligations
    A. Elimination of Rule 17a-23
    B. Amendments to Rules 17a-3 and 17a-4
VI. Temporary Exemption of Pilot Trading System Rule Filings
    A. Introduction
    B. Rule 19b-5
    1. Types of Systems Eligible for Exemption Under Rule 19b-5
    a. Definition of Pilot Trading System
    b. Response to Comments on the Proposed Definition of Pilot 
Trading System
    c. Adopted Definition of Pilot Trading System

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    2. Scope of Pilot Trading Rule Exemption
    3. SRO's Continuing Obligations Regarding Pilot Trading Systems
    a. Notice and Filings to the Commission
    b. Fair Access
    c. Trading Rules and Procedures
    d. Surveillance
    e. Clearance and Settlement
    f. Types of Securities
    g. Activities of Specialists
    h. Inspections and Examinations
    i. Public Availability of Pilot Trading System Rules
    C. Rule Filing Under Section 19(b)(2) of the Exchange Act 
Required Within Two Years
VII. The Commission's Interpretation of the ``Exchange'' Definition
    A. The Commission's Interpretation in Delta
    B. The Growing Significance of Alternative Trading Systems in 
the National Market System
    C. The Revised Interpretation of ``Exchange''
    D. Other Practical Reasons for Revising the Current 
Interpretation
    1. Additional Flexibility Provided by the National Securities 
Markets Improvement Act of 1996
    2. No-action Approach to Alternative Trading Systems is No 
Longer Workable
    3. More Rational Treatment of Regulated Entities
VIII. Effective Dates and Compliance Dates
IX. Costs and Benefits of the Rules and Amendments
    A. Costs and Benefits of the Rules and Amendments Regarding 
Alternative Trading Systems
    1. Benefits
    a. Improved Market Transparency
    b. Improved Investor Protections
    c. Fair Access
    d. Systems Capacity, Integrity, and Security
    2. Costs
    a. Notice, Reporting, and Recordkeeping
    b. Public Display of Orders and Equal Execution Access
    c. Fair Access
    d. Systems Capacity, Integrity, and Security
    e. Costs of Exchange Registration
    B. Amendments to Application and Related Rules for Registration 
as an Exchange
    1. Benefits
    2. Costs
    C. Costs and Benefits of the Repeal of Rule 17a-23 and the 
Amendments to Rules 17a-3 and 17a-4
    D. SRO Pilot Trading System
    X. Effects on Competition, Efficiency and Capital Formation
    XI. Summary of Final Regulatory Flexibility Analysis
    XII. Paperwork Reduction Act
    A. Form 1, Rules 6a-1 and 6a-2
    B. Rule 6a-3
    C. Rule 17a-3(a)(16)
    D. Rule 17a-4(b)(10)
    E. Rule 19b-5 and Form PILOT
    F. Rule 301, Form ATS and Form ATS-R
    1. Notice, Reporting, and Recordkeeping
    2. Fair Access
    3. Systems Capacity, Integrity, and Security
    G. Rule 302
    H. Rule 303
XIII. Statutory Authority

I. Introduction

    Today the Securities and Exchange Commission (''Commission'' or 
``SEC'') is adopting a regulatory framework for alternative trading 
systems,\1\ to strengthen the public markets for securities, while 
encouraging innovative new markets. During the past three years, the 
Commission has undertaken a reevaluation of its regulatory framework 
for markets because of substantial changes in the way securities are 
traded. Market participants have incorporated technology into their 
businesses to provide investors with an increasing array of services, 
and to furnish these services more efficiently, and often at lower 
prices. The current regulatory framework, however, designed more than 
six decades ago, did not envision many of these trading and business 
functions. In particular, market participants have developed a variety 
of alternative trading systems that furnish services traditionally 
provided solely by registered exchanges.
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    \1\ The term ``alternative trading system'' is defined in Rule 
300(a), 17 CFR 242.300(a). This term encompasses some systems that 
previous Commission releases called proprietary trading systems, 
broker-dealer trading systems, and electronic communication 
networks.
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    To better understand the questions raised by technological 
developments in the U.S. markets, in May 1997, the Commission published 
a concept release exploring ways to respond to the rapid technological 
developments affecting securities markets and, in particular, the 
growing significance of alternative trading systems (``Concept 
Release'').\2\ After taking into consideration the comments submitted 
in response to the Concept Release, in April 1998, the Commission 
proposed a new regulatory framework for alternative trading systems 
(``Proposing Release'').\3\
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    \2\ Securities Exchange Act Release No. 38672 (May 23, 1997), 62 
FR 30485 (June 4, 1997). The comment letters to the Concept Release 
and a summary of these comments have been placed in Public File S7-
16-97, which is available for inspection in the Commission's Public 
Reference Room.
    \3\ Securities Exchange Act Release No. 39884 (Apr. 17, 1998), 
63 FR 23504 (Apr. 29, 1998). The comment letters to the Proposing 
Release and a summary of those comments received as of August 25, 
1998 have been placed in Public File S7-12-98, which is available 
for inspection in the Commission's Public Reference Room.
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    Alternative trading systems now handle more than twenty percent of 
the orders in securities listed on The Nasdaq Stock Market 
(``Nasdaq''), and almost four percent of orders in exchange listed 
securities. These systems operate markets similar to the registered 
exchanges and Nasdaq. Over time, an alternative trading system may 
become the primary market for some securities. Yet these markets are 
private, available only to chosen subscribers, and are regulated as 
broker-dealers, not in the way registered exchanges and Nasdaq are 
regulated. This creates disparities that affect investor protection and 
the operation of the markets as a whole.
    Our national market system, as it has evolved since 1975, has 
sought the benefits of both market centralization--deep, liquid 
markets--and competition. To achieve these benefits, the national 
market system has maintained equally regulated, individual markets, 
which are linked together to make their best prices publicly known and 
accessible. Alternative trading systems have remained largely outside 
the national market system. For example, the evidence in the 
Commission's report on the National Association of Securities Dealers, 
Inc. (``NASD'') and Nasdaq suggested that widespread use of Instinet by 
market makers as a private market had a significant impact on public 
investors and the operation of the Nasdaq market.\4\ Through Instinet, 
market makers were able to quote prices better than those made 
available to public investors. This private market developed only 
because the activity on alternative trading systems is not fully 
disclosed, or accessible, to public investors. Moreover, these trading 
systems have no obligation to provide investors a fair opportunity to 
participate in their systems or to treat their participants fairly. 
These systems may also not be adequately surveilled for market 
manipulation and fraud. In fact, market participants can manipulate the 
prices in the public securities markets through the use of alternative 
trading systems.\5\ In addition, alternative trading systems have no 
obligation to ensure that their systems are sufficient to handle rapid 
increases in trading volume as occurs in times of market volatility, 
and at times they have failed to do so. Because of the increasingly 
important role of alternative trading systems, these differences are 
inconsistent with the national market system goals set forth

[[Page 70846]]

by Congress in the 1975 amendments to the Securities Exchange Act of 
1934 (``1975 Amendments'') \6\ and call into question the fairness of 
current regulatory requirements.
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    \4\ See SEC, Report Pursuant to Section 21(a) of the Securities 
Exchange Act of 1934 Regarding the NASD and the Nasdaq Market (1996) 
(``NASD 21(a) Report'').
    \5\ See In the Matter of Ian and Lawrence Fishman, Securities 
Exchange Act Release No. 40115 (June 24, 1998) (finding that the 
Fishman brothers manipulated the national best bid and offer in 
violation of Section 10(b) and Rule 10b-5 under the Exchange Act by 
coordinating the entry of orders routed to alternative trading 
systems).
    \6\ Pub. L. 29, 89 Stat. 97 (1975). Congress granted to the 
Commission authority in 1975 to adopt rules that promote (1) 
economically efficient execution of securities transactions, (2) 
fair competition, (3) transparency, (4) investor access to the best 
markets, and (5) the opportunity for investors' orders to be 
executed without the participation of a dealer. See S. Rep. No. 75, 
94th Cong., 1st Sess. 8 (1975); H.R. Rep. No. 229, 94th Cong., 1st 
Sess 92 (1975). See also section 11A(a)(1) of the Exchange Act, 15 
U.S.C. 78k-1(a)(1).
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    In 1996, Congress provided the Commission with greater flexibility 
to regulate new trading systems by giving the Commission broad 
authority to exempt any person from any of the provisions of the 
Securities Exchange Act of 1934 (``Exchange Act'') and impose 
appropriate conditions on their operation.\7\ This new exemptive 
authority, combined with the ability to facilitate a national market 
system, provides the Commission with the tools it needs to adopt a 
regulatory framework that addresses its concerns about alternative 
trading systems without jeopardizing the commercial viability of these 
markets. In the Proposing Release, the Commission proposed ways to use 
these tools to adopt new rules and rule amendments designed to resolve 
many of the concerns raised by alternative trading systems, better 
integrate these systems into our national market system structure, and 
make the benefits of these systems available to more investors.
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    \7\ Section 36 of the Exchange Act, 15 U.S.C. 78mm, was enacted 
as part of the National Securities Markets Improvement Act of 1996, 
Pub. L. 104-290 (``NSMIA''). See infra Section VII.D.1.
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    In response to its Proposing Release,\8\ the Commission received 
seventy comment letters.\9\ Commenters generally supported the 
Commission's proposals and welcomed the regulatory flexibility these 
proposals offered.\10\ Many commenters agreed with the Commission that 
the regulatory structure needs to be modernized to better integrate 
alternative trading systems into the national market system.\11\ For 
example, several commenters expressed the view that, on balance, the 
proposed regulatory framework for alternative trading systems 
represented a preferable alternative to the current regulation of these 
systems as broker-dealers, which is not only inadequate for many 
alternative trading systems, but also results in disparate regulatory 
treatment of exchange markets and their alternative trading system 
competitors.\12\ Other commenters believed that the Commission's 
proposal was a step in the right direction, both from a competitive 
business perspective and from an investor protection and fair 
regulation perspective. While some commenters thought that the 
Commission should continue the present framework for alternative 
trading systems,\13\ most believed that the proposal provided a 
framework that could maintain a competitive balance among the markets 
offering services to investors.\14\ Other commenters were pleased by 
the Commission's determination to allow market participants to engage 
in business decisions regarding how to register with the 
Commission.\15\ Commenters also generally supported the Commission's 
proposal to allow for-profit exchanges,\16\ and generally supported the 
proposed temporary exemption for pilot trading systems.\17\
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    \8\ See supra note 3.
    \9\ This is the number of comment letters received by the 
Commission as of the close of business on December 1, 1998.
    \10\ Some commenters, however, suggested that the better 
approach would be for the Commission to retain its present 
regulatory framework for alternative trading systems. See, e.g., 
Letter from Robin Roger, Principal and Counsel, Morgan Stanley Dean 
Witter to Jonathan G. Katz, Secretary, SEC, dated Sept. 11, 1998 
(``MSDW Letter'') at 3-4; Letter from Christopher J. Carroll and W. 
Hal Hinkle, Co-Chairs, ATS Task Force, The Bond Market Association 
to Jonathan G. Katz, Secretary, SEC, dated July 28, 1998 (``TBMA 
Letter'') at 2, 8-12; Letter from Lee B. Spencer, Jr., Chairman, SIA 
Federal Regulation Committee and Perry L. Taylor, Jr., Chairman, SIA 
Alternative Trading System Subcommittee, Securities Industry 
Association to Jonathan G. Katz, Secretary, SEC, dated July 31, 1998 
(``SIA Letter'') at 2, 5. Another commenter suggested that the 
Commission solicit comment again on the broader issues discussed in 
the Concept Release. See Letter from Louis C. Magill, President, 
Corporate Capital Securities, Inc. to Jonathan G. Katz, Secretary, 
SEC, dated July 27, 1998 (``Corporate Capital Letter'') at 4.
    \11\ See, e.g., Letter from Joanne Moffic-Silver, Secretary and 
General Counsel, Chicago Board Options Exchange to Jonathan G. Katz, 
Secretary, SEC, dated July 28, 1998 (``CBOE Letter'') at 3; Letter 
from John C. Katovich, Senior Vice President and General Counsel, 
OptiMark Technologies Inc. to Jonathan G. Katz, Secretary, SEC, 
dated Aug. 13, 1998 (``OptiMark Letter'') at 1.
    \12\ See, e.g., CBOE Letter at 3.
    \13\ See, e.g., SIA Letter at 1, 5-6.
    \14\ See, e.g., Letter from Joan C. Conley, Corporate Secretary, 
National Association of Securities Dealers, Inc. to Jonathan G. 
Katz, Secretary, SEC, dated Aug. 10, 1998 (``NASD Letter'') at 1-2.
    \15\ See, e.g., Letter from Douglas M. Atkin, Chief Executive 
Officer, Instinet International to Jonathan G. Katz, Secretary, SEC, 
dated Aug. 3, 1998 (``Instinet Letter'') at 1, 7; Letter from 
Frederic W. Rittereiser, President and Chief Executive Officer and 
William W. Uchimoto, Executive Vice President and General Counsel, 
Ashton Technology Group, Inc. to Jonathan G. Katz, Secretary, SEC, 
dated July 28, 1998 (``Ashton Letter'') at 1; Letter from Mary Sue 
Fisher, Managing Director, Legal and Compliance, Chicago Board 
Brokerage, LLC to Jonathan G. Katz, Secretary, SEC, dated July 29, 
1998 (``CBB Letter'') at 1-2.
    \16\ See, e.g., TBMA Letter at 4; Letter from Larry E. Fondren, 
President, Integrated Bond Exchange, Inc. to Jonathan G. Katz, 
Secretary, SEC, dated July 27, 1998 (``IBEX Letter'') at 13.
    \17\ See, e.g., Letter from Craig S. Tyle, General Counsel, 
Investment Company Institute to Jonathan G. Katz, Secretary, SEC, 
dated July 28, 1998 (``7/28/98 ICI Letter'') at 5; Letter from James 
E. Buck, Senior Vice President and Secretary, New York Stock 
Exchange, Inc. to Jonathan G. Katz, Secretary, SEC, dated July 28, 
1998 (``NYSE Letter'') at 9; Letter from Robert H. Forney, President 
and Chief Executive Officer, Chicago Stock Exchange to Jonathan G. 
Katz, Secretary, SEC, dated July 30, 1998 (``CHX Letter'') at 11; 
Letter from T. Eric Kilcollin, President and Chief Executive 
Officer, Chicago Mercantile Exchange to Jonathan G. Katz, Secretary, 
SEC, dated Aug. 5, 1998 (``CME Letter'') at 4; Letter from James F. 
Duffy, Executive Vice President and General Counsel, Legal and 
Regulatory Policy, American Stock Exchange, Inc. to Jonathan G. 
Katz, Secretary, SEC, dated Aug. 18, 1998 (``Amex Letter'') at 1; 
Ashton Letter at 2; CBOE Letter at 3, 8-9. See infra Section VI for 
a discussion of the temporary exemption for pilot trading systems.
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    The Commission believes that its regulation of markets should both 
accommodate traditional market structures and provide sufficient 
flexibility to ensure that new markets promote fairness, efficiency, 
and transparency. In adopting a new regulatory framework for 
alternative trading systems today, the Commission has incorporated 
suggestions and responded to requests for clarification made by 
commenters. The Commission believes that this regulatory approach 
effectively addresses commenters' concerns while carefully tailoring a 
regulatory framework that is flexible enough to accommodate the 
evolving technology of, and benefits provided by, alternative trading 
systems.
    While the revised regulatory scheme implemented today is designed 
to address changes in the way securities are traded, the Commission's 
assessment of the impact that these systems may have on the trading of 
unregistered securities (i.e. of both domestic and foreign issuers), 
and of the appropriate regulatory posture to these developments, is 
still ongoing. This matter and the broader issues involving recent 
trends and initiatives that give U.S. investors greater and more 
instantaneous access to foreign securities markets create tensions 
between competing Commission goals. The Commission, for example, wishes 
to foster developments that enable U.S. investors to execute securities 
trades more efficiently, but it also desires that foreign securities 
traded in U.S. markets have full and fair disclosure. These tensions 
and issues will be addressed by the Commission in the future.

II. Executive Summary of Final Rules

    The final rules seek to establish a regulatory framework that makes 
sense both for current and future securities

[[Page 70847]]

markets. This regulatory framework should encourage market innovation 
while ensuring basic investor protections. The Commission continues to 
believe that the approach outlined in the Proposing Release will 
accomplish these goals. In general, this approach gives securities 
markets a choice to register as exchanges, or to register as broker-
dealers and comply with Regulation ATS.\18\ The Commission believes the 
framework it is adopting meets the varying needs and structures of 
market participants and is flexible enough to accommodate the business 
objectives of, and the benefits provided by, alternative trading 
systems. The principal components of this new framework are discussed 
below.
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    \18\ 17 CFR 242.300-303.
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A. New Interpretation of ``Exchange''

    A fundamental component of the new regulatory framework is new Rule 
3b-16. This rule interprets key language in the statutory definition of 
``exchange'' under section 3(a)(1) of the Exchange Act.\19\ Rule 3b-16 
reflects a more comprehensive and meaningful interpretation of what an 
exchange is in light of today's markets. Until now, the Commission's 
interpretation of the exchange definition reflected relatively rigid 
regulatory requirements and classifications for ``exchange'' and 
``broker-dealers.'' Advancing technology has increasingly blurred these 
distinctions, and alternative trading systems today are used by market 
participants as functional equivalents of exchanges. Accordingly, the 
Commission's new interpretation of exchange contained in Rule 3b-16\20\ 
encompasses these equivalent markets and the Commission's new general 
exemptive authority enables it to craft a new regulatory framework.
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    \19\ 15 U.S.C. 78c(a)(1).
    \20\ 17 CFR 240.3b-16.
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    The statutory definition of ``exchange'' includes a ``market place 
or facilities for bringing together purchasers and sellers of 
securities or for otherwise performing with respect to securities the 
functions commonly performed by a stock exchange.''\21\ In response to 
commenters' concerns and suggestions, the Commission has carefully 
revised Rule 3b-16 to define these terms to mean any organization, 
association, or group of persons that: (1) Brings together the orders 
of multiple buyers and sellers; and (2) uses established, non-
discretionary methods (whether by providing a trading facility or by 
setting rules) under which such orders interact with each other, and 
the buyers and sellers entering such orders agree to the terms of a 
trade.\22\
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    \21\ 15 U.S.C. 78c(a)(1).
    \22\ Rule 3b-16(a), 17 CFR 240.3b-16(a).
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    Rule 3b-16 explicitly excludes those systems that the Commission 
believes perform only traditional broker-dealer activities. The 
Commission modified these exclusions to address issues raised by 
commenters. Rule 3b-16 now expressly excludes the following systems 
from the revised interpretation of ``exchange'': (1) Systems that 
merely route orders to other facilities for execution; (2) systems 
operated by a single registered market maker to display its own bids 
and offers and the limit orders of its customers, and to execute trades 
against such orders; and (3) systems that allow persons to enter orders 
for execution against the bids and offers of a single dealer.\23\
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    \23\ Rule 3b-16(b), 17 CFR 240.3b-16(b).
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B. Exemption for Regulated Alternative Trading Systems

    The framework the Commission adopts today uses the Commission's new 
exemptive authority to allow most alternative trading systems to choose 
to be regulated either as exchanges or as broker-dealers. Rule 3a1-1 
exempts most alternative trading systems from the definition of 
``exchange,'' and therefore the requirement to register as an exchange, 
if they comply with Regulation ATS. However, any system exercising 
self-regulatory powers, such as regulating its members' or subscribers' 
conduct when engaged in activities outside of that trading system, must 
register as an exchange or be operated by a national securities 
association. This is because self-regulatory activities in the 
securities markets must be subject to Commission oversight under 
Section 19 of the Exchange Act.\24\ Thus any system exercising self-
regulatory powers will not be permitted the option of registering as a 
broker-dealer.
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    \24\ 15 U.S.C. 78s.
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    In addition, the Commission can determine that a dominant 
alternative trading system should be registered as an exchange. An 
alternative trading system would first have to exceed certain volume 
levels and the Commission, after notice and an opportunity for the 
alternative trading system to respond, would have to determine that an 
exemption from exchange regulation is not necessary or appropriate in 
the public interest or consistent with the protection of investors, 
taking into account the requirements of exchange registration and the 
objectives of the national market system.\25\ At this time, however, 
the Commission does not believe that it is necessary or appropriate 
under this provision that any alternative trading system register as an 
exchange.
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    \25\ Rule 3a1-1(b)(1), 17 CFR 240.3a1-1(b)(1).
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C. Regulation ATS

    The Commission is adopting new Regulation ATS, substantially in the 
form proposed, to impose essential elements of market-oriented 
regulation on alternative trading systems. This new regulation 
addresses the concerns raised by the market activities of alternative 
trading systems that choose to register as broker-dealers. To allow new 
markets to start, without disproportionate burdens, a system with less 
than five percent of the trading volume in all securities it trades is 
required only to: (1) File with the Commission a notice of operation 
and quarterly reports; (2) maintain records, including an audit trail 
of transactions; and (3) refrain from using the words ``exchange,'' 
``stock market,'' or similar terms in its name.
    If, however, an alternative trading system with five percent or 
more of the trading volume in any national market system security 
chooses to register as a broker-dealer--instead of as an exchange--the 
Commission believes it is in the public interest to integrate its 
activities into the national market system. In addition to the 
requirements for smaller alternative trading systems, Regulation ATS 
requires alternative trading systems that trade five percent or more of 
the volume in national market system securities to be linked with a 
registered market in order to disseminate the best priced orders in 
those national market system securities displayed in their systems 
(including institutional orders) into the public quote stream.\26\ Such 
alternative trading systems must also comply with the same market rules 
governing execution priorities and obligations that apply to members of 
the registered exchange or national securities association to which the 
alternative trading system is linked.\27\
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    \26\ Rule 301(b)(3), 17 CFR 240.301(b)(3). Alternative trading 
systems will only have to comply with this rule for fifty percent of 
securities on April 21, 1999. By August 30, 1999, alternative 
trading systems will have to comply with this rule for all 
securities. Prior to April 21, 1999, the Commission will publish a 
schedule of those individual securities for which alternative 
trading systems must comply with Rule 301(b)(3) on April 21, 1999. 
See infra notes 192-193-and 216-217-and accompanying text.
    \27\ This linkage requirement would not apply to alternative 
trading systems that do not display participant orders to anyone, 
including other system participants. In addition, this requirement 
would not apply to alternative trading systems to the extent that 
they trade securities other than national market system securities. 
See infra Section IV.A.2.c.(ii).

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[[Page 70848]]

    In addition, alternative trading systems with twenty percent or 
more of the trading volume in any single security, whether equity or 
debt, would be required to: (1) Grant or deny access based on objective 
standards established by the trading system and applied in a non-
discriminatory manner; and (2) establish procedures to ensure adequate 
systems capacity, integrity, and contingency planning. The Commission 
believes that these requirements will better integrate those 
significant alternative trading systems into national market system 
mechanisms. Moreover, because alternative trading systems that choose 
to register as broker-dealers are not required to surveil activities on 
their markets, the Commission intends to work with the self-regulatory 
organizations (``SROs'') to ensure that they can operate ongoing, real-
time surveillance for market manipulation and fraud and develop 
surveillance and examination procedures specifically targeted to 
alternative trading systems they oversee.

D. For-Profit Exchanges

    In this release, the Commission also expresses its view that 
registered exchanges may structure themselves as for-profit 
organizations. This will allow alternative trading systems, which are 
typically proprietary, to choose to register as exchanges without 
changing their organizational structure. In addition, currently 
registered exchanges--which are all membership organizations--could 
choose to demutualize. This release provides guidance on ways for 
proprietary markets to meet their fair representation requirements as 
non-membership national securities exchanges.\28\
---------------------------------------------------------------------------

    \28\ See infra Section IV.B.2.
---------------------------------------------------------------------------

E. Temporary Exemption From Rule Filing Requirements for SROs' Pilot 
Trading Systems

    To help reduce competitive impediments to innovation by SROs, the 
Commission is allowing them to start new trading systems without 
preapproval by the Commission. The Commission is adopting Rule 19b-5 to 
permit SROs, without filing for approval with the Commission, to 
operate new pilot trading systems for up to two years. These pilot 
trading systems will be subject to specific conditions, including 
limitations on their trading volumes.\29\
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    \29\ See infra Section VI. The purpose of this new rule is to 
provide registered exchanges and national securities associations 
with a greater opportunity to compete with alternative trading 
systems registered as broker-dealers and with foreign markets.
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III. Rule 3b-16 Under the Exchange Act

    The Commission today is adopting new Rule 3b-16 under the Exchange 
Act. This rule defines terms used in the statutory definition of 
``exchange,'' found in section 3(a)(1) of the Exchange Act.\30\ The 
statutory definition of ``exchange'' includes a ``market place or 
facilities for bringing together purchasers and sellers of securities 
or for otherwise performing with respect to securities the functions 
commonly performed by a stock exchange.'' The new rule interprets these 
terms to include any organization, association, or group of persons 
that: (1) Brings together the orders of multiple buyers and sellers; 
and (2) uses established, non-discretionary methods (whether by 
providing a trading facility or by setting rules) under which such 
orders interact with each other, and the buyers and sellers entering 
such orders agree to the terms of a trade.\31\ This rule revises the 
current interpretation of the term ``exchange,'' as set forth in the 
Delta Release.\32\
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    \30\ 15 U.S.C. 78c(a)(1).
    \31\ Rule 3b-16(a), 17 CFR 240.3b-16(a). In the Proposing 
Release, the Commission proposed to define the terms in the 
definition of ``exchange'' to be ``any organization, association, or 
group of persons that: (1) Consolidates orders of multiple parties; 
and (2) sets non-discretionary material conditions (whether by 
providing a trading facility or by setting rules) under which 
parties entering such orders agree to the terms of a trade.'' See 
Proposing Release, supra note 3.
    \32\ See Securities Exchange Act Release No. 27611 (Jan. 12, 
1990), 55 FR 1980, 1900 (Jan. 19, 1990) (``Delta Release''). See 
infra Section VII for a further discussion of the Delta Release and 
the basis and purpose of the revised interpretation.
---------------------------------------------------------------------------

    New Rule 3b-16 is an important element of the Commission's new 
regulatory framework for alternative trading systems. As discussed 
above, the rapid growth and technological advancements of alternative 
trading systems have eroded the distinctions between the roles played 
by alternative trading systems and by traditional exchanges. 
Alternative trading systems today provide services more akin to 
exchange functions than broker-dealer functions, such as matching 
counterparties' orders, executing trades, operating limit order books, 
and facilitating active price discovery. For many of these systems, 
regulation as a market more appropriately fits their economic 
functions. Rule 3b-16 defines terms in the statutory definition of 
exchange to include markets that engage in activities functionally 
equivalent to markets currently registered as national securities 
exchanges. Moreover, because in some cases exchange regulation may 
better meet these systems' business objectives, the Commission believes 
that alternative trading systems should have the option to register as 
national securities exchanges.\33\ The rule helps modernize the 
Commission's approach to these systems because it adapts the concept of 
what is ``generally understood'' to be an exchange to reflect changes 
in the markets brought about by automated trading. In addition, in 
light of recent technological developments, Rule 3b-16 more closely 
reflects the statutory concept of ``bringing together'' buying and 
selling interests.
---------------------------------------------------------------------------

    \33\ See infra Section IV.B. (discussing registration as a 
national securities exchange). Under Section 5 of the Exchange Act, 
an exemption may be granted to an exchange from registration as a 
national securities exchange on the basis of low volume, or expected 
low volume. Currently, there is only one exchange, the Arizona Stock 
Exchange (``AZX''), that is operating under a limited volume 
exemption. See Securities Exchange Act Release No. 28899 (Feb. 20, 
1991), 56 FR 8377 (Feb. 28, 1991). In addition, the Commission 
solicited comment on whether Tradepoint Financial Networks, plc 
should be granted a limited volume exemption. See Securities 
Exchange Act Release No. 40161 (July 2, 1998), 45 FR 41920 (July 9, 
1998).
    The Commission believes that the low volume exemption continues 
to be appropriate for some exchanges, such as an exchange that, for 
example, disciplines its members (other than by excluding them or 
limiting them from trading based on objective criteria, such as 
creditworthiness), or has other self-regulatory attributes that 
exclude it from the definition of alternative trading system, Rule 
300(a), and therefore preclude it from making the choice to register 
as a broker-dealer. Any exchange seeking a low volume exemption 
would, of course, have to have low volume. The Commission believes 
that the low volume exemption would be inappropriate for any 
alternative trading system that can register as a broker-dealer and 
comply with Regulation ATS, and that the conditions under Regulation 
ATS should generally be met by any alternative trading system 
falling within Rule 3b-16, including an alternative trading system 
that, for other reasons, seeks a low volume exemption.
---------------------------------------------------------------------------

    The Proposing Release sought comment on whether the proposed 
definition captures the fundamental features of an exchange as that 
term is generally understood today. The Commission received several 
comments supportive of its proposed revision to the interpretation of 
``exchange.'' For example, the NASD commented that this new definition 
``is not inappropriate, particularly with the express exclusion for 
internal broker-dealer systems.'' \34\ Other commenters also supported 
broadening the Commission's interpretation of what constitutes an 
exchange and agreed that the proposed rule accurately identified the 
fundamental features of a securities ``exchange.'' \35\ On the other 
hand, some commenters questioned the basis and need for the Commission 
to move away from its interpretation in Delta. The

[[Page 70849]]

Commission responds to these comments below in Section VII.
---------------------------------------------------------------------------

    \34\ NASD Letter at 3, n.4.
    \35\ See CME Letter at 2; IBEX Letter at 4.
---------------------------------------------------------------------------

    Finally, one commenter expressed concern that the proposed revision 
to the Commission's interpretation of ``exchange'' would encompass 
every market participant providing electronic or other technologically 
advanced trading service.\36\ The Commission does not intend for the 
distinction between exchanges and broker-dealers to turn on automation, 
and does not believe that its revised interpretation of ``exchange'' 
has this effect. In particular, the Commission notes that paragraph (a) 
of new Rule 3b-16 does not contain the word automation, but is instead 
descriptive of those activities the Commission considers to be the 
activities of a ``market'' where buyers and sellers meet and includes 
purely floor-based exchanges, as well as fully automated ones. 
Moreover, paragraph (b) clearly excludes certain systems that--even 
though automated--are not exchanges, such as automated single dealer 
systems.
---------------------------------------------------------------------------

    \36\ Instinet Letter at 7.
---------------------------------------------------------------------------

    The language of Rule 3b-16 the Commission is adopting today 
modifies the language the Commission proposed in response to 
commenters' suggestions and concerns, and their requests for 
clarification. The discussion below is intended to further explain how 
the Commission envisions that its new interpretation of ``exchange'' 
will be applied and responds to specific requests for clarification by 
commenters.

A. Brings Together the Orders of Multiple Buyers and Sellers

    In order to be covered by the definition in Rule 3b-16, a system 
must satisfy the first part of Rule 3b-16(a)--brings together the 
orders of multiple buyers and sellers. This emphasizes the concept of 
``bringing together purchasers and sellers of securities'' set forth in 
the definition of ``exchange'' in section 3(a)(1) of the Exchange Act. 
While the intent is the same, the language in Rule 3b-16(a)(1) has been 
modified from the proposal to address the concerns of some of the 
commenters who requested that the definition be clarified.
1. To Bring Together
    The Commission is adopting the language ``brings together'' in Rule 
3b-16, rather than ``consolidates'' as originally proposed. While the 
Commission believes that ``consolidates'' and ``brings together'' have 
the same meaning, the latter more closely mirrors the language in the 
statute and is a plainer use of language.
    A system brings together orders if it displays, or otherwise 
represents, trading interests entered on the system to system users. 
These systems include consolidated quote screens, such as the system 
operated by Nasdaq. A system also brings together orders if it receives 
subscribers' orders centrally for future processing and execution. For 
example, a limit order matching book that allows subscribers to display 
buy and sell orders in particular securities and to obtain execution 
against matching orders contemporaneously entered or stored in the 
system ``brings together orders.'' These activities are currently 
performed by systems that bring together orders internally for crossing 
\37\ or matching,\38\ as well as floor-based markets that impose 
trading rules. In addition, interdealer brokers (``IDBs'') \39\ bring 
together orders, regardless of their level of automation.\40\ 
Accordingly, a system ``brings together orders'' when orders entered in 
the system for a given security have the opportunity to interact with 
other orders entered into the system for the same security.
---------------------------------------------------------------------------

    \37\ A crossing system is, typically, one that allows 
participants to enter unpriced orders to buy and sell securities. 
Orders are crossed at specified times at a price derived from 
another market.
    \38\ Matching systems allow participants to enter priced limit 
orders and match those orders with other orders in the system. 
Participants are able to view unmatched limit orders in the system's 
book. The sponsor of a matching system typically acts as riskless 
principal or a dealer firm on behalf of the system acts as riskless 
principal, with respect to matched orders, or contracts with another 
broker-dealer to perform this function.
    \39\ Currently, debt markets are not centrally organized by a 
single entity, but are nonetheless informally organized around 
interdealer brokers. Interdealer brokers (also called blind brokers 
and brokers' brokers) display, on an anonymous basis, the offers to 
buy and sell securities that are placed with them by subscribers. In 
order to place a bid or offer, a subscriber typically telephones the 
interdealer broker, which enters the order into its system and 
displays it to other subscribers. Some interdealer brokers display 
all bids and offers; others display only the best bid and offer. To 
execute against an offer displayed on the computer screen, a 
subscriber telephones the interdealer broker, although sometimes 
execution may be electronic. The identities of the counterparties 
are, generally, kept confidential through clearance and settlement 
of the trade. Some interdealer brokers, however, reveal the names of 
each counterparty after execution. Traditionally interdealer brokers 
facilitated trading only between dealers. Increasingly, however, 
interdealer brokers are permitting non-dealers to participate in 
their systems.
    \40\ But see infra notes 123-130 and accompanying text 
(discussing the exclusion from Regulation ATS for alternative 
trading systems that trade exclusively government, and other 
related, securities).
---------------------------------------------------------------------------

2. Multiple Buyers and Sellers
    In addition, to satisfy paragraph (a)(1) of Rule 3b-16, a system 
must bring together orders of multiple buyers and multiple sellers. The 
Commission proposed to use the term ``multiple parties'' in paragraph 
(a)(1) of Rule 3b-16, rather than the term ``multiple buyers and 
sellers.'' The Commission believes that this modification to the 
language proposed in Rule 3b-16 addresses the concerns of those 
commenters who requested that the Commission clarify that systems in 
which there is only a single seller, such as systems that permit 
issuers to sell their own securities to investors, would not be 
included within Rule 3b-16. While such systems have multiple buyers 
(i.e., investors), they have only one seller for each security (i.e., 
issuers) and, therefore, do not meet the multiple buyers and sellers 
test. An example of this type of system is CP Direct in which an issuer 
can offer to sell its commercial paper to the customers of CS First 
Boston.\41\ Another example of systems that do not meet the multiple 
buyers and sellers criteria are systems in which securities are offered 
by a single seller at successively lower prices. In addition, systems 
designed for the purpose of executing orders against a single 
counterparty, such as the dealer operating a system, would not be 
considered to have multiple buyers and sellers. Thus a single 
counterparty that buys and sells securities through a system, where 
other parties entering orders only execute against the single 
designated counterparty, would not meet the requirements of the first 
part of Rule 3b-16.\42\ However, the mere interpositioning of a 
designated counterparty as riskless principal for settlement purposes 
after the purchasing and selling counterparties to a trade have been 
matched would not, by itself, mean that the system does not have 
multiple buyers and sellers.
---------------------------------------------------------------------------

    \41\ See Bruce Rule, PSA Panels Embrace Internet for 
Institutional Trading; and Regulators Love the Audit Trail, 
Investment Dealers' Digest, Nov. 18, 1996 (discussing CP Direct). 
The converse situation--i.e., where there is one buyer and multiple 
sellers for a given instrument--would also not meet the ``multiple 
buyers and sellers'' requirement. The Commission, however, is not 
aware of any system that currently operates this way.
    \42\ This type of system would also be expressly excluded from 
Rule 3b-16 under paragraph (b)(2). See infra Section III.C.2.
---------------------------------------------------------------------------

3. Definition of ``Order''
    Finally, the rule makes clear that, to be included within the 
definition in Rule 3b-16(a), a system must bring together participants' 
``orders.'' The term ``order'' is defined in paragraph (c) of Rule 3b-
16 to include any firm indication of a willingness to buy or sell a 
security, whether made on a principal

[[Page 70850]]

or agency basis.\43\ Firm indications of buying or selling interest 
specifically include bid or offer quotations, market orders, limit 
orders, and any other priced order.
---------------------------------------------------------------------------

    \43\ Rule 3b-16(c), 17 CFR 240.3b-16(c).
---------------------------------------------------------------------------

    Several commenters requested that the Commission clarify the 
proposed definition of ``order.'' One commenter expressed concern that 
the proposed definition of ``order'' was too broad and recommended that 
the revised interpretation of ``exchange'' be clarified to exclude 
trading systems that broadcast non-executable indicative quotations, 
and noted that IDBs frequently communicate an indicative price to a 
customer, which is merely a starting point for a negotiation of the 
final transaction price.\44\ The Commission notes that the term 
``order'' is defined as ``any firm indication of a willingness to buy 
or sell a security, * * * including any bid or offer quotation, market 
order, limit order, or other priced order.''\45\ Whether or not an 
indication of interest is ``firm'' will depend on what actually takes 
place between the buyer and seller.
---------------------------------------------------------------------------

    \44\ TBMA Letter at 15-16 (stating that the bids and offers 
associated with telephone-based IDBs are generally ``subject,'' 
i.e., the broker must check back with the dealer client before 
finalizing the transaction).
    \45\: Rule 3b-16(c), 17 CFR 240.3b-16(c).
---------------------------------------------------------------------------

    The label put on an order--``firm'' or ``not firm''--is not 
dispositive. For example, a system claiming it displays only 
``indications of interest'' that are not orders, may be covered by the 
new interpretation of ``exchange'' if those indications are, in fact, 
firm in practice. In general, the Commission intends to read the 
definition of ``order'' broadly and will not consider systems to fall 
outside the definition in Rule 3b-16 based solely on a system's 
labeling of indications of interest as ``not firm.'' Instead, what 
actually takes place between the buyers and sellers interacting in a 
particular system will determine whether indications of interest are 
``firm'' or not. At a minimum, an indication of interest will be 
considered firm if it can be executed without the further agreement of 
the person entering the indication. Even if the person must give its 
subsequent assent to an execution, however, the indication will still 
be considered firm if this subsequent agreement is always, or almost 
always, granted so that the agreement is largely a formality. For 
instance, indications of interest where there is a clear or prevailing 
presumption that a trade will take place at the indicated price, based 
on understandings or past dealings, will be viewed as orders.
    Generally, however, a system that displays bona fide, non-firm 
indications of interest--including, but not limited to, indications of 
interest to buy or sell a particular security without either prices or 
quantities associated with those indications--will not be displaying 
``orders'' and, therefore, not fall within Rule 3b-16.
    Nevertheless, the price or size of an indication of interest may be 
either explicit or may be inferred from the facts and circumstances 
accompanying the indication. For example, an indication of interest 
will be considered to include a price if the system in which the 
indication of interest is entered defaults automatically to a price 
pegged to another market, index, rate, or other variable, or if the 
person entering such indication indicates that such person is 
interested in trading at a price pegged to another market, index, rate, 
or other variable, which includes ``market'' orders.
    The same commenter expressed concern that the proposed definition 
of order could have the effect of including markets within the 
definition of ``exchange'' that quote prices over the telephone for a 
potential transaction.\46\ As discussed above, whether or not a 
particular system is an exchange does not turn solely on the level of 
automation used: ``orders'' can be given over the telephone, as well as 
electronically.
---------------------------------------------------------------------------

    \46\ TBMA Letter at 15.
---------------------------------------------------------------------------

    The Commission emphasizes that merely because a system ``brings 
together orders of multiple buyers and sellers,'' does not mean that 
the system is an exchange. In order to fall within Rule 3b-16, a system 
must also satisfy the requirements in paragraph (a)(2). Thus, whether 
or not an ``order'' is part of a system that falls within the new 
interpretation of ``exchange'' depends upon the activities of that 
system taken as a whole. For example, a system could display 
subscribers' ``orders'' to other market participants, but would not be 
encompassed by Rule 3b-16 if subscribers contacted each other and 
agreed to the terms of their trades outside of the system.\47\ Unless a 
system also establishes rules or operates a trading facility under 
which subscribers can agree to the terms of their trades, the system 
will not be included within Rule 3b-16, even if it brings together 
``orders.''
---------------------------------------------------------------------------

    \47\ These bulletin board types of systems were described in no-
action letters from the staff. See Letter dated June 24, 1996 from 
Catherine McGuire, Chief Counsel, Division of Market Regulation, 
SEC, Jack W. Murphy, Chief Counsel, Division of Investment 
Management, SEC, and Martin P. Dunn, Chief Counsel, Division of 
Corporate Finance, SEC to Barry Reder, Coblentz, Cahen, McCabe and 
Breyer, LLP (counsel to Real Goods Trading Corporation); Letter 
dated Aug. 5, 1996 from Catherine McGuire, Chief Counsel, Division 
of Market Regulation, SEC to: Bruce D. Stuart, Esq. (counsel to 
PerfectData Corporation); and Letter dated April 17, 1996 from 
Abigail Arms, Associate Director, Division of Corporate Finance, 
SEC, and Catherine McGuire, Associate Director, Division of Market 
Regulation, SEC to Andrew Klein (President and Chief Executive 
Officer of Spring Street Brewing Company).
---------------------------------------------------------------------------

    Finally, the NYSE commented that the Commission's definition of 
``order'' appeared to cover trading interest that, in the Order 
approving the Pacific Exchange (``PCX'') Application of the OptiMark 
System (``OptiMark Order''), the Commission did not consider to be an 
order. In the OptiMark Order, the Commission took the position that the 
profiles entered into OptiMark are not bids or offers under Rule 11Ac1-
1 (``Firm Quote Rule'').\48\ The Commission's definition of ``order'' 
in paragraph (c) of Rule 3b-16 is intended to be broader than the terms 
bid and offer in the Firm Quote Rule.\49\ Therefore, it is possible for 
an indication of interest to be an ``order'' under Rule 3b-16, without 
being a bid or offer under the Firm Quote Rule.
---------------------------------------------------------------------------

    \48\ See Securities Exchange Act Release No. 39086 (Sept. 17, 
1997), 62 FR 50036 (Sept. 24, 1997). In approving OptiMark, the 
Commission stated that OptiMark's unique design warrants a non-
traditional approach in determining whether to require the 
dissemination of trading interest expressed through operation of 
OptiMark.
    \49\ See Rule 11Ac1-1(c), 17 CFR 240.11Ac1-1(c).
---------------------------------------------------------------------------

B. Established, Non-Discretionary Methods

    In addition to bringing together the orders of multiple parties, to 
be included within Rule 3b-16, a system would have to use established, 
non-discretionary methods * * * under which such orders interact with 
each other and the buyers and sellers entering orders agree to the 
terms of the trade. A system uses established non-discretionary methods 
either by providing a trading facility or by setting rules governing 
trading among subscribers. The Commission intends for ``established, 
non-discretionary methods'' to include any methods that dictate the 
terms of trading among the multiple buyers and sellers entering orders 
into the system. Such methods include those that set procedures or 
priorities under which open terms of a trade may be determined. For 
example, traditional exchanges' rules of priority, parity, and 
precedence are ``established, non-discretionary methods,'' as are the 
trading algorithms of electronic systems. Similarly, systems that 
determine the trading price at some designated future date on the basis 
of pre-established

[[Page 70851]]

criteria (such as the weighted average trading price for the security 
on the specified date in a specified market or markets) are using 
established, non-discretionary methods. A requirement that the trade 
subsequently be ratified does not avoid this element. For example, a 
system that trades limited partnership units might use established, 
non-discretionary methods even though approval from the general partner 
is required prior to settlement. Rules that merely supply the means of 
communication with a system (for example, software or hardware tools 
that subscribers may use in accessing a system), however, do not 
satisfy this element of Rule 3b-16.
    In general, where customers of a broker-dealer exercise control 
over their own orders in a trading system operated by the broker-
dealer, that broker-dealer is unlikely to be viewed as using 
discretionary methods in handling the order. An example of systems that 
the Commission believes do not use established, non-discretionary 
methods are traditional block trading desks. Block trading desks 
generally retain some discretion in determining how to execute a 
customer's order, and frequently commit capital to satisfy their 
customers' needs. For example, a block positioner may ``shop'' the 
order around in an attempt to find a contra-side interest with another 
investor. In some cases, the block positioner may take the other side 
of the order, keeping the block as a proprietary position. While block 
trading desks do cross customers' orders, these crosses are not done 
according to fixed non-discretionary methods, but instead are based on 
the block trading desks' ability to find a contra-side to the order. It 
may cross two customer orders, or it may assemble a block of several 
customer orders with completion dependent on its willingness to take a 
proprietary position for part of the block. Execution prices, size of 
the proprietary position and agency compensation may all be part of a 
single negotiated deal. Consequently, the Commission would not consider 
traditional block trading desks to be using established, non-
discretionary methods and, therefore, they would not fall within Rule 
3b-16.
    In addition, systems that merely provide information to subscribers 
about other subscribers' trading interest, without facilities for 
execution, do not fall within paragraph (a) of Rule 3b-16. One 
commenter asked the Commission to clarify that such systems would not 
be viewed as exchanges.\50\ While such vendors may allow buyers and 
sellers to find each other, they do not provide a facility or set rules 
under which those orders interact with each other. Accordingly, the 
Commission agrees with this commenter that such systems are not 
exchanges.
---------------------------------------------------------------------------

    \50\ MSDW Letter at 11.
---------------------------------------------------------------------------

    In contrast, when a customer gives a broker-dealer flexibility in 
how to handle an order, it relinquishes a degree of control over that 
order. The Commission recognizes that broker-dealers exercising 
discretion or judgment over customer orders may use internal systems to 
trade and manage these orders. The mere use of these systems does not 
make a broker an exchange, unless those systems themselves predetermine 
the handling and execution practices for the order, replacing the 
broker-dealer's judgment and flexibility in working the order.
    One commenter suggested that the lack of display of customer orders 
outside the broker-dealer should be determinative of whether the system 
was an exchange.\51\ The Commission notes that it is possible for a 
system to use established, non-discretionary methods even if orders are 
not displayed. For example, the OptiMark System--by design--does not 
display participants' indications of interest. There is, however, no 
discretion exercised by the operator of the OptiMark System; the trade 
optimization calculations are established, non-discretionary methods.
---------------------------------------------------------------------------

    \51\ MSDW Letter, pp. 7-8.
---------------------------------------------------------------------------

    Finally, the Commission proposed to explicitly exclude from the 
revised interpretation of ``exchange'' trading systems that allow a 
single broker-dealer to internally manage its customers' orders.\52\ 
The Commission was concerned that such systems might technically be 
covered by paragraph (a) of Rule 3b-16 if they occasionally crossed or 
matched customer orders. Because the Commission believes that these 
systems have generally automated traditional brokerage functions, it 
proposed to clearly exclude them from the revised interpretation of 
``exchange.'' Several commenters noted their agreement with the 
Commission's proposed exclusion of these internal broker-dealer systems 
from its reinterpretation of ``exchange,'' \53\ but requested that the 
Commission clarify it. In particular, the Securities Industry 
Association (``SIA'') and The Bond Market Association (``TBMA'') 
requested that the Commission clarify the intended meaning of the terms 
``predetermined procedures'' and ``communicated to customers'' as used 
in the proposed exclusion.\54\
---------------------------------------------------------------------------

    \52\ Proposed Rule 3b-12(b)(2).
    \53\ See NASD Letter at 3, n.4; TBMA Letter at 3, 14; SIA Letter 
at 3, 10; MSDW Letter at 5-6.
    \54\ See TBMA Letter at 3, 14-15; SIA Letter at 3, 10-11.
---------------------------------------------------------------------------

    The Commission intended to exclude a number of different types of 
systems under this proposed exclusion. First, this exclusion was 
intended to cover internal systems operated by market makers to 
automate the management of their customer orders, including the display 
of customer limit orders, and to match those displayed orders with 
other customer orders. The Commission is now adopting a more specific 
exclusion to cover these types of systems.
    In addition, in large part, the Commission intended to exclude 
systems that automate the management of customer orders that require a 
broker-dealer to use its discretion. These types of systems would not 
be included within paragraph (a) of Rule 3b-16 because--like 
traditional block trading desks--they do not use established, non-
discretionary methods. The purpose of the proposed exclusion for 
internal broker-dealer systems was to exclude traditional internal 
systems created to increase efficiency rather than to provide a non-
discretionary trading system for customers. In light of the comments on 
the proposed exclusion for internal broker-dealer systems and the 
difficulty of distinguishing among internal systems on this basis, the 
Commission now believes it is better not to attempt to set specific 
requirements that internal broker-dealer systems must meet in order to 
be excluded from Rule 3b-16. Instead, the Commission is clarifying that 
trading systems that do not use established, non-discretionary methods 
fail to meet the two-part test in paragraph (a) and are, therefore, not 
included within the revised interpretation of ``exchange.''
1. Established, Non-Discretionary Methods Provided by a Trading 
Facility
    As stated previously, a trading system that uses established, non-
discretionary methods would include a traditional exchange floor where 
specialists are responsible for executing orders. It would also include 
a computer system (whether comprised of software, hardware, protocols, 
or any combination thereof) through which orders interact, or any other 
trading mechanism that provides a means or location for the bringing 
together and execution of orders. For example, the Commission considers 
the use of an algorithm by an electronic trading system that sets 
trading procedures and priorities to be a trading facility that uses 
established, non-discretionary methods.

[[Page 70852]]

    The Commission will attribute the activities of a trading facility 
to a system if that facility is offered by the system directly or 
indirectly (such as where a system arranges for a third party or 
parties to offer the trading facility). Thus, if a system that brings 
together the orders of multiple parties arranges for a third party 
vendor to distribute software that establishes non-discretionary 
methods under which orders interact, that system will fall within Rule 
3b-16. Similarly, if a bulletin board operator contracted with another 
party to provide execution facilities for the bulletin board users, the 
bulletin board will be deemed to have established a trading facility 
because it took affirmative steps to arrange for the necessary exchange 
functions for its users.\55\ In addition, if an organization arranges 
for separate entities to provide different pieces of a trading system, 
which together meet the definition contained in paragraph (a) of Rule 
3b-16, the organization responsible for arranging the collective 
efforts will be deemed to have established a trading facility. For 
example, the arrangement between the Delta Government Options 
Corporation (``Delta''), RMJ Options Trading Corporation, and Security 
Pacific National Trust Company, as described in a 1990 Commission 
release,\56\ would together meet the definition set forth in Rule 3b-
16. Moreover, a trading system that falls within the Commission's 
interpretation of ``exchange'' in Rule 3b-16 will still be considered 
an ``exchange,'' even if it matches two trades and routes them to 
another system or exchange for execution. Whether or not the actual 
execution of the order takes place on the system is not a determining 
factor of whether the system falls under Rule 3b-16.
---------------------------------------------------------------------------

    \55\ Whether or not a bulletin board will be considered an 
exchange under the rule will also depend on whether it meets the 
other elements of the definition.
    \56\ See Delta Release, supra note 32. The Commission notes that 
the arrangement between these entities no longer exists, and that 
Delta, in its current form, would not fit the new interpretation of 
the definition of exchange.
---------------------------------------------------------------------------

2. Established, Non-Discretionary Methods Provided by Setting Rules
    Alternatively, a system may use established, non-discretionary 
methods through the imposition of rules under which parties entering 
orders on the system agree to the terms of a trade. For example, if a 
system imposes affirmative quote obligations on its subscribers, such 
as obligations to post two-sided quotations or to post quotations no 
worse than the quotes subscribers post on other systems, the Commission 
will consider it to be using established, non-discretionary methods.
    In addition, rules imposing execution priorities, such as time and 
price priority rules, would be ``established, non-discretionary 
methods.'' Similarly, a system that standardizes the material terms of 
instruments traded on the system, such as the system operated by Delta 
at the time the Commission published the Delta Release,\57\ will be 
considered to use established, non-discretionary methods.
---------------------------------------------------------------------------

    \57\ See id., at 1897.
---------------------------------------------------------------------------

    Similarly, Nasdaq's use of established, non-discretionary methods 
bring it within the revised interpretation of ``exchange'' in Rule 3b-
16. The NASD imposes basic rules by which securities are traded on 
Nasdaq. Specifically, it imposes affirmative obligations on market 
makers in Nasdaq National Market (``Nasdaq NM'') and SmallCap 
securities, including obligations to post firm and two-sided quotes. It 
also operates the Small Order Execution System (``SOES'') and SelectNet 
systems, requiring market makers to accept executions or orders for 
execution in these securities. Through Nasdaq, market participants act 
in concert to centralize and disseminate trading interest and establish 
the basic rules by which securities are traded. The Commission believes 
that Nasdaq performs what today is generally understood to be the 
functions commonly performed by a stock exchange. Nasdaq, however, is 
currently registered as a securities information processor under 
section 11A of the Exchange Act \58\ and is operated by the NASD, a 
registered securities association under Section 15A of the Exchange 
Act.\59\ Because the requirements currently applicable to a registered 
securities association are virtually identical to the requirements 
applicable to registered exchanges, the Commission does not believe it 
is necessary or appropriate in the public interest to require Nasdaq to 
register as an exchange.\60\ Under the rules the Commission is adopting 
today, however, Nasdaq could choose to register under section 6 of the 
Exchange Act as a national securities exchange.\61\
---------------------------------------------------------------------------

    \58\ 15 U.S.C. 78k-1.
    \59\ 15 U.S.C. 78o-3. The NASD, parent of Nasdaq, is the self-
regulatory organization. The NASD delegates to NASD Regulation, Inc. 
(``NASDR''), the wholly owned regulatory subsidiary of the NASD, its 
SRO responsibilities to surveil trading conducted on Nasdaq and the 
OTC Bulletin Boards, and to enforce compliance by its members (and 
persons associated with its members) with applicable laws and rules. 
Nasdaq also surveils trading conducted on its market and refers 
potential violations to NASDR. See also infra note 342.
    \60\ See infra notes 93-94 and accompanying text (discussing 
Rule 3a1-1(a)(1), which explicitly exempts any system operated by a 
national securities association from the definition of the term 
``exchange'').
    \61\ 15 U.S.C. 78f. If Nasdaq registered as an exchange, it 
would have its own SRO responsibilities, but the Commission does not 
expect this to increase Nasdaq's current burden. In view of the 
NASD's SRO status the Commission could use its authority under 
Sections 17 and 19 of the Exchange Act, 15 U.S.C. 78q and 78s, to 
delegate any obligations Nasdaq would have as a registered exchange 
to enforce compliance by its members (and persons associated with 
its members) with the federal securities laws to NASDR.
---------------------------------------------------------------------------

C. Systems Excluded From Rule 3b-16

    The Proposing Release specifically excluded from the proposed, 
revised interpretation of ``exchange'' several types of activities that 
could be considered traditional brokerage activities: order routing 
systems, dealer quotation systems, and internal broker-dealer order 
management and execution systems. Commenters widely agreed that 
automated broker-dealer functions should not be encompassed in the 
meaning of ``exchange.'' \62\ The Commission agrees. Commenters did, 
however, ask for clarification about the application of the exclusions 
in paragraph (b). In particular, some commenters appeared to 
misunderstand Rule 3b-16 as requiring that a system fall within one of 
the exclusions in paragraph (b) in order to be outside of the revised 
interpretation of ``exchange.'' This was not the Commission's intent. A 
system is not included within the revised interpretation of 
``exchange'' if: (1) It fails to meet the two-part test in paragraph 
(a) of Rule 3b-16; or (2) it falls within one of the exclusions in 
paragraph (b).
---------------------------------------------------------------------------

    \62\ See SIA Letter at 3, 10-11; DBSI Letter at 3; NASD Letter 
at 4; TBMA Letter at 3, 14.
---------------------------------------------------------------------------

    The Commission has included paragraph (b) of Rule 3b-16 to 
explicitly exclude some systems that the Commission believes are not 
exchanges. Paragraph (b) of Rule 3b-16 expressly excludes: (1) Systems 
that merely route orders to other execution facilities; and (2) systems 
that allow persons to enter orders for execution against the bids and 
offers of a single dealer, and systems that automate the activities of 
registered market markers.
    Two commenters asked the Commission to exclude from the revised 
interpretation of ``exchange'' all correspondent clearing 
relationships, as well as agreements among broker-dealers to handle 
their respective order flow.\63\ The Commission has excluded routing 
systems under Rule 3b-16(b)(1). Whether or not correspondent clearing

[[Page 70853]]

relationships are excluded, however, depends on the nature of the 
systems used in that relationship. The Commission does not believe that 
systems operated by clearing firms should be excluded simply because 
their correspondents participate in them. The Commission believes that 
such an exclusion would be overly broad.
---------------------------------------------------------------------------

    \63\ See TBMA Letter at 14, n.26; SIA Letter at 10-11, n.18.
---------------------------------------------------------------------------

    One commenter questioned whether IDBs are the functional equivalent 
of internal broker-dealer systems and, therefore, should be excluded 
from Rule 3b-16.\64\ The Commission believes that most screen-based 
IDBs function by displaying, on an anonymous basis, the offers to buy 
and sell securities that are placed with them by subscribers. While 
typically a subscriber uses a telephone to place the orders and 
ordinarily use the telephone to request execution, multiple buyers and 
sellers are involved, and generally customers view some or all orders 
on screens. Thus, IDBs bring together the orders of multiple buyers and 
sellers. Where an IDB has set procedures under which it executes 
subscriber orders against displayed or retained orders in a 
predetermined fashion, the methods by which these orders are brought 
together likely would be established and non-discretionary. The 
Commission believes that IDBs that function in this fashion are covered 
by Rule 3b-16. If an IDB does not display orders or communicate them 
verbally to customers, and does not execute orders according to pre-
determined, well-understood rules, it may not be covered by the rules 
the Commission is adopting today. As a general matter, however, the 
Commission believes that most IDBs would be covered by the definition 
in Rule 3b-16(a) and not excluded by any of its exclusions.
---------------------------------------------------------------------------

    \64\ TBMA Letter at 14, n.25 (suggesting that the Commission 
expressly recognize the possibility that some IDBs may be able to 
rely on the exclusion for internal broker-dealer systems).
---------------------------------------------------------------------------

    In addition, one commenter recommended that any entity that has the 
discretion to commit capital to a trade be excluded from Rule 3b-16, 
because broker-dealers commit capital, but exchanges do not.\65\ The 
Commission generally views the willingness to predictably commit 
capital as a traditional broker-dealer activity. For this reason it is 
explicitly excluding registered market maker and single dealer systems, 
which commit capital in all--or almost all--trades. In addition, 
broker-dealers frequently commit capital as part of their block trading 
desk activities. As discussed above, the Commission does not believe 
that traditional block trading desks are covered under paragraph (a) of 
Rule 3b-16. However, the Commission does not believe that a system 
engaging in activities as a market should be excluded from the scope of 
Rule 3b-16 simply because the broker-dealer operating the system may 
participate as a dealer in that system.
---------------------------------------------------------------------------

    \65\ SIA Letter at 3-4, 6-7, 9.
---------------------------------------------------------------------------

    Finally, one commenter asserted that ``passive systems,'' such as 
POSIT,\66\ should be excluded from the Commission's revised 
interpretation of ``exchange,'' because they do not have a traditional 
price discovery mechanism.\67\ The Commission, however, does not agree 
that systems like POSIT are simply an automation of traditional 
brokerage functions, but believes they are markets. Like other markets, 
``passive'' or derivative pricing systems bring together the orders of 
multiple buyers and sellers. All subscribers enter orders,\68\ which 
interact at pre-specified times. In addition, ``passive systems'' 
establish non-discretionary methods under which subscribers agree to 
the terms of the trade. Such systems cross orders at pre-established 
times during the day according to specified priorities, such as time 
priority. While these orders are traded at a price that is not known at 
the time a subscriber enters an order, the parameters under which such 
price will be determined are established and not subject to discretion 
by the operator of the ``passive system.'' While these systems do not 
themselves have traditional price discovery mechanisms, they have the 
potential to--and frequently do--affect the markets from which their 
prices are derived.\69\ The Commission, however, agrees with this 
commenter that these systems do not raise the same concerns as 
alternative trading systems with price discovery mechanisms and, 
therefore, even if such systems have significant trading volume, if 
they choose to register as broker-dealers they are not required to meet 
the fair access and systems capacity requirements.\70\ The Commission, 
however, will monitor the activities of these passive systems and if 
concerns arise with regard to their activities will reconsider whether 
these requirements should apply.
---------------------------------------------------------------------------

    \66\ POSIT is an alternative trading system operated by ITG Inc. 
Broker-dealers and institutions enter unpriced orders to buy and 
sell exchange listed and Nasdaq securities into POSIT at any time 
prior to a pre-selected crossing time. At the crossing time, buy 
orders in the system for each security are crossed, where possible, 
with sell orders and crossed orders are executed at a price derived 
from the primary market where the security trades.
    \67\ Letter from Timothy H. Hosking, General Counsel, ITG Inc., 
to Jonathan G. Katz, Secretary, SEC dated Nov. 20, 1998 (``ITG 
Letter'') at 2-3.
    \68\ The indications of interest entered into ``passive'' or 
derivative pricing systems are ``orders,'' under Rule 3b-16(c). 
While the orders are entered without a specified price, subscribers 
agree to trade at a price based on the primary market, such as the 
mid-point of the bid and ask at the time orders are matched or at 
the primary market's opening price.
    \69\ In addition, there exists the incentive for subscribers to 
these ``passive systems'' to manipulate the price in the market from 
which the ``passive system'' derives its price in order to obtain a 
favorable execution on the passive system.
    \70\ See Rules 301(b)(5)(iii) and 301(b)(6)(iii), 17 CFR 
242.301(b)(5)(iii) and 242.301(b)(6)(iii). See infra notes 248, 278, 
241-291 and accompanying text. Further, the Commission did not 
propose, nor is it adopting, a requirement that alternative trading 
systems that register as broker-dealers publicly display any orders 
that are not displayed to that system's subscribers. Thus, 
alternative trading systems--like most ``passive'' systems--that do 
not display subscriber orders at all, are not subject to the public 
display requirement if they register as broker-dealers under 
Regulation ATS.
---------------------------------------------------------------------------

1. Order Routing Systems
    The Commission proposed to exclude from proposed Rule 3b-16 those 
trading systems that merely route orders to an exchange or broker-
dealer for execution. The only commenter to address this provision was 
the SIA, which expressed its support for this exclusion.\71\ The 
Commission is adopting the exclusion as proposed in Rule 3b-16(b)(1). 
Examples of such systems include the New York Stock Exchange's 
(``NYSE's'') and the American Stock Exchange's (``Amex's'') Common 
Message Switch \72\ and BRASS.\73\ Nasdaq, however, is not merely a 
routing system. In addition to SelectNet's routing capabilities, Nasdaq 
is a quotation facility, permits executions through its SOES system, 
and establishes rules for its members regarding the firmness of their 
bids and offers and how members deal with each other.
---------------------------------------------------------------------------

    \71\ SIA Letter at 10.
    \72\ A similar system, also operated by the Amex, is Automated 
Post Execution Reporting System, or AutoPERS.
    \73\ BRASS is an order routing system operated by Automated 
Securities Clearance, Ltd. (``ASC''). ASC provides system users with 
software and hardware that enables users to enter orders into the 
system which are then routed to an exchange or Nasdaq for execution. 
BRASS software enables a market maker to execute orders against its 
inventory at the market maker's quoted price, monitor compliance 
with the Commission's Limit Order Display Rule, infra note 76, route 
an order to another market maker or market, report executed 
transactions, and monitor, among other things, trading positions, 
and profit/loss margins. Separately, an entity affiliated with ASC, 
the BRASS Utility, LLC (``BRUT''), operates an electronic 
communications network (``ECN'') to which orders can be routed 
through the use of BRASS software. See infra note 178.
---------------------------------------------------------------------------

    The Commission does not believe that these routing systems meet the 
two-part test in paragraph (a) of Rule 3b-16 because they do not bring 
together orders of multiple buyers and sellers.

[[Page 70854]]

Instead, all orders entered into a routing system are sent to another 
execution facility. In addition, routing systems do not establish non-
discretionary methods under which parties entering orders interact with 
each other.
2. Dealer Systems
    In the Proposing Release, the Commission discussed the application 
of proposed Rule 3b-16 to single dealer systems. Such systems automate 
the order routing and execution mechanisms of a single market maker and 
guarantee that the market maker will execute orders submitted to it at 
its own posted quotation for the security or, for example, at the 
inside price quoted on Nasdaq. Because single market maker systems 
merely provide a more efficient means of executing the trading interest 
of separate customers with one dealer, the Commission stated that they 
should not be considered exchanges. Accordingly, the Commission 
proposed to explicitly exclude from proposed Rule 3b-16 those trading 
systems that display the quotations of a single dealer and allow 
persons to enter orders for execution against the dealer's proprietary 
account, usually at the dealer's quote. This exclusion was intended to 
encompass systems operated by third market makers,\74\ as well as those 
systems operated by dealers, primarily in debt securities, who display 
their own quotations to customers and other broker-dealers on 
proprietary or vendor screens.
---------------------------------------------------------------------------

    \74\ Third market firms are NASD member firms that execute 
orders for exchange-listed securities.
---------------------------------------------------------------------------

    The Commission is today adopting paragraph (b)(2) of Rule 3b-16 to 
exclude systems that display quotes of a single dealer and allow 
persons to enter orders for execution against the bids and offers of a 
single dealer. If a market maker executes a customer order at the 
National Best Bid or Offer (``NBBO''), rather than at its displayed bid 
or offer, the Commission will consider the NBBO as the market maker's 
quote for purposes of that trade. As in the proposal, paragraph (b)(2) 
is intended to exclude from Rule 3b-16 all dealers, including third 
market makers.
    The Commission received two comment letters asking the Commission 
to reconsider its proposed exclusion of third market makers.\75\ These 
commenters disagreed with the Commission's distinction between third 
market makers and exchanges, and stated that these systems compete 
directly with the regional exchanges for order flow. Consequently, 
these commenters suggested that the Commission include third market 
makers within its revised interpretation of ``exchange.'' As discussed 
in the Proposing Release, however, the Commission does not believe that 
a single dealer that automates its means of communicating trading 
interest to customers is a market. Instead, such systems automate 
functions traditionally performed by dealers.
---------------------------------------------------------------------------

    \75\ See Letter from David E. Rosedahl, Executive Vice President 
and Chief Regulatory Officer, Pacific Exchange, Inc. to Jonathan G. 
Katz, Secretary, SEC, dated Aug. 20, 1998 (``PCX Letter'') at 2-6; 
CHX Letter at 3-4.
---------------------------------------------------------------------------

    Accordingly, the exclusion the Commission is adopting today in 
paragraph (b)(2) of Rule 3b-16 is intended to cover systems operated by 
third market makers. Because of the Commission's own rules and those of 
the SROs, a third market maker's quote may not always reflect its own 
bids and offers, but may--at times--represent a customer limit order. 
The Limit Order Display Rule \76\ requires third market makers (among 
others) to display customer limit orders in a security that are at a 
price that would improve the bid or offer of such market maker in that 
security. The Commission does not believe that a market maker engaging 
principally in the business of trading for its own account should be 
included within Rule 3b-16 solely because it is complying with the 
Limit Order Display Rule. Consequently, in the Proposing Release the 
Commission stated that, for purposes of this exclusion, if a dealer 
displayed a customer order to comply with a Commission or SRO rule, 
that customer order would be considered to be the ``dealer's quote.'' 
\77\ To ensure that Rule 3b-16 clearly excludes such dealers, the 
Commission is adopting paragraph (b)(2)(ii) of Rule 3b-16. Paragraph 
(b)(2)(ii) excludes a registered market maker that displays its own 
quotes and customer limit orders, and allows its customers and other 
broker-dealers to enter orders for execution against the displayed 
orders. The exclusion also allows such a registered market maker, as an 
incidental activity resulting from its market maker status, to match or 
cross orders for securities in which it makes a market, even if those 
orders are not displayed.\78\
---------------------------------------------------------------------------

    \76\ Rule 11Ac1-4(b)(1)(i), 17 CFR 240.11Ac1-4(b)(1)(i).
    \77\ Proposing Release, supra note 3, at n.9.
    \78\ Rule 3b-16(b)(2)(ii), 17 CFR 240.3b-16(b)(2)(ii).
---------------------------------------------------------------------------

    Two other commenters expressed their support for the single dealer 
exclusion.\79\ One of these commenters, however, suggested that the 
Commission modify the exclusion so that trading systems that display 
the quotes of a dealer and its affiliates and allow persons to execute 
against those quotes be excluded from Rule 3b-16.\80\ The Commission is 
adopting the exclusion from Rule 3b-16 for single dealer systems, but 
does not agree with this commenter that a dealer's affiliates should be 
included in the exclusion.
---------------------------------------------------------------------------

    \79\ See SIA Letter at 10; DBSI Letter at 3.
    \80\ DBSI Letter at 3.
---------------------------------------------------------------------------

    In addition, one commenter requested that the Commission clarify 
whether the exclusion for dealer quotation systems would apply to 
systems that allow other broker-dealers to execute against a single 
dealer's quotations.\81\ The Commission intends for this exclusion to 
cover dealer quotation systems that permit other broker-dealers to 
execute against the dealer's quotations and realizes that its use of 
the term ``customer'' in the proposal would preclude this. Accordingly, 
the Commission is adopting the exclusion in paragraph (b)(2) so that it 
encompasses single dealer systems that allow any person to enter orders 
for execution against that dealer's quotes.\82\ A single dealer system 
could also match orders that are not displayed to any person other than 
the dealer and its employees, provided this matching is only incidental 
to its primary activity as a dealer.\83\
---------------------------------------------------------------------------

    \81\ SIA Letter at 11.
    \82\ Rule 3b-16(b)(4), 17 CFR 240.3b-16(b)(4).
    \83\ Rule 3b-16(b)(2)(i), 17 CFR 240.3b-16(b)(2)(i).
---------------------------------------------------------------------------

D. Examples of Systems Illustrating Application of Rule 3b-16

    The following examples are provided to illustrate various 
applications of Rule 3b-16.\84\ While these examples are intended to 
provide guidance, the application of Rule 3b-16 will be fact-specific.
---------------------------------------------------------------------------

    \84\ These systems may also implicate other provisions of the 
federal securities laws.
---------------------------------------------------------------------------

1. Examples of Systems Included Within Rule 3b-16
    a. System A is a trading floor that maintains a continuous two-
sided auction market under a unitary specialist system. Through the use 
of an electronic communication system, orders are transmitted from 
member firms to the floor and execution reports are transmitted from 
the floor to the member firms. System A also has an automated routing 
and small order execution system. Price discovery occurs through the 
interaction of bids and offers of market participants under the 
application of System A's rules of priority, parity, and precedence. 
The specialist's dealings are subject to compliance obligations 
established by System A. System A is included under Rule 3b-16.

[[Page 70855]]

    b. System B allows participants to enter, replace, or cancel limit 
orders prior to a pre-established auction cutoff time. Bids and offers 
(including price and size) are displayed in the System B's order book, 
which participants can view on their screens. After the cutoff time, 
the system reviews all orders with respect to each security and 
determines the price at which the volume of buying interest is closest 
to the volume of selling interest. That price is the ``auction price.'' 
Participants that have entered bids at or above, and offers at or 
below, the auction price receive an execution at the auction price on 
the basis of time priority up to the available size. Matched orders are 
executed by a registered broker-dealer. System B is included under Rule 
3b-16.
    c. System C allows participants to enter limit orders and matches 
those orders with other orders in System C based on internal 
parameters. System C displays unmatched limit orders in the system's 
book on an anonymous basis to all participants. The broker-dealer 
operating System C acts as a riskless principal in executing all 
matched orders. System C is included under Rule 3b-16.
    d. System D limits participation to institutional investors that 
trade illiquid restricted securities. To offer a security, a seller 
notifies System D as to the security, the price and the amount offered. 
After System D accepts an order, it enters it into the system where it 
is posted anonymously. Prospective purchasers may accept a posted order 
or seek to negotiate a transaction by contacting System D. System D 
facilitates the purchase and sale of securities through the system on 
an agency basis. Participants enter a bid or offer by calling a 
dedicated telephone number at System D. Once each side of the 
transaction agrees to the terms of the trade, System D obtains 
necessary documentation from the participants and reviews all the 
documentation. Once all the documentation has been processed, System D 
notifies the parties setting the transfer and settlement date, at which 
time System D will coordinate the transfer of funds and the issuer is 
notified to effect the transfer on its books. System D is included 
under Rule 3b-16.
    e. System E allows participants to enter orders for securities by 
computer, facsimile, or telephone. Those orders are not displayed to 
other participants. System E crosses orders at specified times at a 
price derived from another market such as the closing price, a volume 
weighted average price, or the midpoint between the closing bid and ask 
on the primary market. System E is included under Rule 3b-16, but would 
be exempt from the requirements of Regulation ATS under Rule 301(a)(5) 
if it is registered as a broker-dealer.
    f. System F displays, on an anonymous basis, firm offers to buy and 
sell securities from its participants. Participants typically telephone 
an employee of System F to place a bid or offer, which the employee 
enters into the system for display to other participants. To execute 
against a bid or offer displayed on the computer screen, a participant 
telephones an employee at System F. The employee is required to execute 
the participant's order against the displayed order if it matches. 
System F is included under Rule 3b-16. If System F allowed subscribers 
to execute against a displayed order by sending a message 
electronically, it would also be included under Rule 3b-16.
    g. System G permits competing market makers to post continuous two-
sided quotes in certain securities. Quotes are consolidated and 
disseminated to subscribers electronically. System G maintains and 
enforces rules setting standards for the posting of quotes and 
executions. Trades are executed by subscribers calling market makers 
outside the system and executing trades based on quotes displayed in 
the system. System G is included under Rule 3b-16.
    h. System H is owned and operated by a bank. System H permits 
registered broker-dealers to place orders to buy or sell securities at 
specified prices and sizes and have those orders displayed to all users 
on an anonymous basis. Registered broker-dealers may trade both for 
their own account or on an agency basis on behalf of their customers. 
System H automatically executes an order if it matches an existing 
order. If no match is immediately available, System H displays the 
order on the system on an anonymous basis to all users. System H is 
included under Rule 3b-16.
    i. System I permits participants to enter a range of ranked 
contingent buy and sell orders at which they are willing to trade 
securities. These orders are matched based on a mathematical algorithm 
whose priorities are designed to achieve the participants' objectives. 
System I does not display orders to any participants. System I is 
included under Rule 3b-16.
2. Examples of Systems Not Included Within Rule 3b-16
    a. System J routes orders from broker-dealers to registered 
exchanges or to other broker-dealers for execution. System J also 
routes execution reports back to the broker-dealers that entered the 
orders. System J provides no facility for execution, but rather only 
acts as a communications system for the transmission of orders and 
execution reports. System J falls within the exclusion in paragraph 
(b)(1) of Rule 3b-16.
    b. System K displays a registered market maker's quotes in 
exchange-listed securities and permits subscribers to submit orders for 
those securities to the market maker. Limit orders are displayed in the 
market maker's quote pursuant to requirements under the Commission's 
order execution rules. Market orders are executed against the market 
maker's quote or at the NBBO or at a price better than the NBBO. Limit 
orders are held until marketable. System K falls within the exclusion 
in paragraph (b)(2) of Rule 3b-16.
    c. System L allows a dealer to disseminate its proprietary 
quotations to its customers and permits customers to transmit orders to 
buy from or sell to that dealer at those quoted prices. System L is not 
included under Rule 3b-16 because it falls within the exclusion in 
paragraph (b)(2) of Rule 3b-16.
    d. System M is operated by a broker-dealer that makes markets in 
Nasdaq securities. System M permits the broker-dealer's customers, as 
well as other broker-dealers (including correspondent broker-dealers 
with whom it has a clearing arrangement) to send orders electronically 
or by telephone to the broker-dealer. An order transmitted 
electronically goes directly to the system server. An order transmitted 
by phone is received by an employee of the broker-dealer, who enters it 
into the System M. If it is a market order for a Nasdaq security in 
which the broker-dealer makes a market, System M checks to see if the 
order can be crossed against a customer limit order held by the broker-
dealer. If two customer orders cannot be crossed, System M 
automatically executes the market order against the firm's inventory if 
the order size is at or below certain parameters. If the order size 
exceeds those parameters, the market order will be routed to a trader 
for manual execution against the firm's inventory, or other handling as 
the trader determines. If the order is for a security in which the 
broker-dealer does not make a market, System M sends the order to a 
market maker in the security or to another market for execution. System 
M falls within the exclusions in paragraph (b)(1) and (b)(2) of Rule 
3b-16.
    e. System N allows participants to post the names of securities 
they wish to buy or sell. Other participants view

[[Page 70856]]

this ``bids wanted list'' or ``offers wanted list'' and place bids or 
offers for the specified securities during a defined auction period. 
The participant who posted the security on the ``bids wanted list'' or 
``offers wanted list'' may either accept or reject the best bid or 
offer at the close of the auction. System N is not included under Rule 
3b-16 because there is only one seller.
    f. System O permits correspondent firms of a broker-dealer to send 
orders electronically to that broker-dealer. The broker-dealer executes 
the orders against its own inventory. System O falls within the 
exclusion in paragraph (b)(2)(i) of Rule 3b-16.
    g. System P is an Internet web site set up by an issuer. Through 
this web site, the issuer provides information to prospective buyers 
and sellers of its common stock. Prospective buyers and sellers post 
their identities, contact information, and the number of shares offered 
or sought at a given price. The issuer makes that information, along 
with the date the information was submitted, available to prospective 
buyers and sellers. The participants contact each other outside of the 
web site to execute trades. System P is not included under Rule 3b-16 
because it does not establish non-discretionary methods under which 
buyers and sellers interact.
    h. System Q is a screen-based system on which broker-dealers post 
indications of interest to institutional customers in the securities 
the broker-dealers wish to trade and advertise trades they have 
recently conducted. System R sets no requirements and provides no 
procedures regarding whether or how posted quantities and prices of 
securities can be executed. System Q is not included under Rule 3b-16 
because it does not establish non-discretionary methods under which 
buyers and sellers interact.
    i. System R is an internal system operated by a broker-dealer to 
display only to its registered representatives the prices and sizes of 
securities offered for sale by the firm in its capacity as a dealer. A 
registered representative can enter a buy order, specifying price and 
size, on behalf of its customer. If the terms of the customer's order 
match the dealer's posted offer, System R automatically executes the 
order. If the terms are different, System R places the customer's order 
on the screen for later matching. Assuming the matches of customer 
orders are merely incidental relative to the dealer's own trades, 
System R falls within the exclusion in paragraph (b)(2)(i) of Rule 3b-
16.
    j. System S permits an issuer to post prices to sell its own 
securities to a broker-dealer's customers. The issuer is under no 
obligation to post prices on the system and may choose to do so at any 
time. If a customer accepts the posted price and size, System S routes 
the order to the issuer who retains discretion to accept or reject the 
trade. If the posted price or size is not accepted as posted, System S 
automatically alerts the issuer that further negotiation is necessary. 
System S is not included under Rule 3b-16 because it has only one 
seller and, therefore, fails to meet the ``multiple buyers and sellers 
requirement.''
    k. System T facilitates the clearance and settlement of securities 
products. Participating IDBs disseminate and match trading interest 
through their own proprietary trading screens to their own customers. 
The participating IDBs then submit matched transactions between their 
customers to System T for clearance and settlement. The IDBs' screens 
are not linked together and the IDBs interact only with those dealers 
using the system. The customers' orders interact only with the quote of 
the IDB of which they are a customer and do not interact with the other 
customer orders of that IDB. Dissemination and execution of orders by 
the IDBs is governed solely by their rules and not by System T.\85\ 
System T is not included under Rule 3b-16.
---------------------------------------------------------------------------

    \85\ In some cases, however, the systems operated by the 
interdealer brokers may fall within Rule 3b-16. See supra System F.
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E. Exemption From the Definition of ``Exchange''

    Section 36 of the Exchange Act \86\ gives the Commission broad 
authority to exempt any person, security, or transaction from 
provisions of the Exchange Act and the rules thereunder. Such an 
exemption may be subject to conditions. Using this authority, the 
Commission is adopting Rule 3a1-1.\87\ This rule exempts from the 
definition of ``exchange'': (1) Any alternative trading system that 
compies with Regulations ATS \88\ (2) any alternative trading system 
that under Rule 301(a) of Regulation ATS is not required to comply with 
regulation ATS and alternative trading system operated by a national 
securities association,\89\ and (3) any alternative trading system 
operated by a national securities association.\90\ Finally, as 
described more fully below,\91\ paragraph (b)(1) of Rule 3a1-1 also 
conditions an alternative trading system's exemption on the absence of 
a Commission determination that the exemption in a particular case is 
not ``necessary or appropriate in the public interest or consistent 
with the protection of investors.'' \92\
---------------------------------------------------------------------------

    \86\ 15 U.S.C. 78mm.
    \87\ 17 CFR 240.3a1-1.
    \88\ 17 CFR 240.3a1-1(a)(2). See infra note and accompanying 
text for the definition of an alternative trading system.
    \89\ 17 CFR 240.3a1-1(a)(3). See notes--and accompanying text.
    \90\ 17 CFR 240.3a1-1(a)(1).
    \91\ See infra Section III.F.
    \92\ Rule 3a1-1(b), 17 CFR 240.3a1-1(b).
---------------------------------------------------------------------------

    The Commission has determined that this exemption is in the public 
interest and will promote efficiency, competition, and capital 
formation because it has the effect of providing alternative trading 
systems with the option of positioning themselves in the marketplace as 
either registered exchanges or as broker-dealers. The Commission 
believes that allowing alternative trading systems to make a business 
decision about how to register with the Commission will continue to 
encourage the development of new and innovative trading facilities. The 
Commission has also determined that this exemption is consistent with 
the protection of investors because investors will benefit from 
conditions governing an alternative trading system, in particular 
Regulation ATS's enhanced transparency, market access, system 
integrity, and audit trail provisions.
    Moreover, because national securities associations are subject to 
requirements virtually identical to those applicable to national 
securities exchanges,\93\ Rule 3a1-1 also exempts from the definition 
of ``exchange'' any alternative trading system operated by a national 
securities association.\94\ The Commission believes that the regulation 
of alternative trading systems operated by a national securities 
association is adequate, and therefore, that such systems should not be 
required to register either as exchanges, or as broker-dealers and 
comply with Regulation ATS. Consequently, trading systems operated by 
national securities associations may continue to operate as they do 
now.
---------------------------------------------------------------------------

    \93\ Registration as a national securities association under 
section 15A of the Exchange Act is voluntary. 15 U.S.C. 78o-3. 
Currently the only national securities association is the NASD, 
which operates Nasdaq.
    \94\ Rule 3a1-1(a)(1). See also Rule 301(a)(3) (excluding 
alternative trading systems operated by a national securities 
association from the scope of proposed Regulation ATS).
---------------------------------------------------------------------------

    Finally, in response to a commenter's request that the Commission 
clarify that the exemption from the definition of ``exchange'' provided 
in Rule 3a1-1(a)(2) includes broker-dealers that are excluded from the 
scope of Regulation ATS by Rule 301(a),\95\ the Commission is adding 
paragraph (a)(3) to Rule 3a1-

[[Page 70857]]

1. The Commission intended for broker-dealers that perform only 
activities delineated in Rule 301(a) to be exempt from the definition 
of exchange under Rule 3a1-1, and is making this clear by adding this 
new paragraph.\96\
---------------------------------------------------------------------------

    \95\ Instinet Letter at 8, n.11.
    \96\ 17 CFR 240.3a1-1(a)(3).
---------------------------------------------------------------------------

    The Commission intends for the exemption provided by Rule 3a1-1 to 
make clear that alternative trading systems that register as broker-
dealers and comply with Regulation ATS not be regulated as national 
securities exchanges. The Commission believes that the requirements in 
Regulation ATS as adopted will address the market-like functions of 
alternative trading systems without imposing requirements applicable to 
exchanges that might not fit comfortably with certain alternative 
trading systems' structures and businesses.
    In the Proposing Release, the Commission requested comment on 
whether an exclusion from the definition in Rule 3b-16 for alternative 
trading systems that register as broker-dealers and comply with the 
provisions of Regulation ATS would be preferable to the exemption under 
Rule 3a1-1. Several commenters expressed a preference for an exclusion, 
rather than an exemption.\97\ Most of these commenters were concerned 
that foreign regulators would view these systems, currently registered 
as broker-dealers, as exchanges if they were now exempted from the 
definition of exchange rather than excluded from it. The Commission 
believes that its new framework being adopted today represents a 
carefully balanced approach to the regulation of markets that is 
grounded in the particular statutory structure of the Exchange Act. 
First, the Commission notes that its exemption for alternative trading 
systems applies to the definition of an exchange. By exempting 
alternative trading systems from this definition, the Commission is 
making clear its view that these systems should not be treated as 
exchanges under the Exchange Act or in any other context. Moreover, the 
Commission does not intend its interpretation of exchange to be used 
outside of the Exchange Act context. The Commission strongly cautions 
against applying this interpretation in other contexts where its 
effects will differ from those under the Exchange Act. The Commission 
also believes that application in another context of only one element 
of the structure adopted today would be inappropriate and would 
seriously call into question the validity of the interpretation in that 
context.
---------------------------------------------------------------------------

    \97\ See TBMA Letter at 12-13 (expressing concern that foreign 
regulators might be influenced by the Commission's categorization of 
a system as an ``exchange,'' even if that system chose to be 
regulated in the U.S. as a broker-dealer); Instinet Letter at 3, 6-
7, 13-14 and 6-7, n.9 (stating that classifying a securities firm as 
an exchange in the U.S. could significantly impair a firm's ability 
to participate in foreign markets * * * because a number of foreign 
regulators may regard all broker-dealers covered by the expanded 
`exchange' definition as `exchanges'). See also CBB Letter at 3.
---------------------------------------------------------------------------

    Another concern raised by at least one commenter was that investors 
could be influenced in how they view a trading system, if such trading 
system is included within the Commission's interpretation of 
``exchange.'' \98\ The Commission believes that investors' views of 
systems are shaped more by the functions those systems perform than by 
the way they are classified. The Commission also believes that the 
enhanced regulation of alternative trading systems that choose to 
remain registered as broker-dealers that is provided by Regulation ATS 
provides more protection for the investors who use these systems.
---------------------------------------------------------------------------

    \98\ TBMA Letter at 12.
---------------------------------------------------------------------------

    In the Proposing Release, the Commission also requested comment on 
the scope, form, and conditions of the exemption in Rule 3a1-1. 
Commenters generally approved of the Commission's proposal to allow 
alternative trading systems the choice to register as exchanges or be 
exempt from the definition of ``exchange'' by registering as broker-
dealers and complying with Regulation ATS.\99\ One commenter questioned 
whether national securities exchanges would have the choice to register 
as alternative trading systems, in effect ceasing to act as SROs and 
electing instead to be regulated as a broker-dealer under Regulation 
ATS.\100\ The Commission believes that, as a general matter, national 
securities exchanges do have this choice under the rules the Commission 
is adopting today.\101\ Any national securities exchange making this 
choice would, of course, be required to give up its SRO functions and 
privileges, and to register as a broker-dealer and become a member of a 
national securities association or other SRO.\102\ That organization 
would then act as the SRO for this alternative trading system. If a 
national securities exchange chose, as part of this restructuring, to 
allow its members to form their own national securities association to 
operate this new alternative trading system, that alternative trading 
system would be run directly by a national securities association, and, 
as stated above, would be regulated in a manner that was equivalent to 
being regulated as a national securities exchange.\103\
---------------------------------------------------------------------------

    \99\ See Letter from Mike Cormack, Manager, Equity Trading, 
American Century to Jonathan G. Katz, Secretary, SEC, dated Aug. 12, 
1998 (``American Century Letter'') at 1-2 (supporting the 
Commission's proposal to permit alternative trading systems to 
register as exchanges because it would provide an option for 
innovators, and noting alternative trading systems' objection to the 
NASD's proposed central limit order book based on the belief that an 
SRO regulating alternative trading systems should not operate a 
competing system); NASD Letter at 3 (commenting that both 
registration as an exchange and Regulation ATS ``generally appear to 
ensure that alternative trading systems operate with the appropriate 
levels of investor protection, while affording alternative trading 
systems the necessary flexibility to choose between different models 
of regulation''); CME Letter at 3 (generally supporting the 
additional requirements for alternative trading systems because they 
will improve investor protection and lessen the regulatory disparity 
that currently exists between alternative trading systems and 
traditional exchanges); Instinet Letter at 7, n.10 (stating that the 
Commission should modify the exemption in Rule 3a1-1 from exchange 
registration so that alternative trading systems that, while acting 
in good faith, fail to comply fully with each of the technical 
requirements of Regulation ATS do not violate Sections 5 and 6 of 
the Exchange Act); ICI Letter at 2; IBEX Letter at 4.
    \100\ CHX Letter at 6 (questioning why traditional exchanges 
should not have the opportunity to make the same choice as 
alternative trading systems, and commenting that SROs should be 
permitted to form subsidiaries that were alternative trading systems 
registered as broker-dealers).
    \101\ In making this significant decision, a national securities 
exchange would have to follow its constitution and by-laws 
(including provisions concerning membership votes), and any 
applicable state law requirements.
    \102\ Section 15(b)(8) of the Exchange Act requires any broker-
dealer engaging in transactions other than solely on a national 
securities exchange of which it is a member, to become a member of a 
national securities association. 15 U.S.C. 78o(b)(8).
    \103\ The Commission does not mean to imply that national 
securities exchanges cannot make this choice. The Commission is 
merely pointing out that if a national securities exchange does so, 
it cannot continue to act as its own SRO.
---------------------------------------------------------------------------

F. Commission's Authority To Require Registration as an Exchange

    Rule 3a1-1(b) contains an exception to the exemption from the 
exchange definition. Under this exception, the Commission effectively 
may require a trading system that is a substantial market (as set forth 
in the rule) to register as a national securities exchange if it finds 
in a particular case that it is necessary or appropriate in the public 
interest or consistent with the protection of investors.\104\ In 
particular, the Commission could deny or withhold exemptive status from 
a trading system that otherwise meets the exemptive conditions under 
Rule 3a1-1(a). Although the standard for denying or withholding the 
exemption is based on objective factors, the Commission has discretion 
whether to initiate any process to consider whether to revoke a

[[Page 70858]]

particular entity's exemption under the rule.
---------------------------------------------------------------------------

    \104\ Rule 3a1-1(b), 17 CFR 240.3a1-1(b)(1).
---------------------------------------------------------------------------

    Specifically, under Rule 3a1-1(b), if an organization, association, 
or group of persons meets certain, specified volume levels, the 
Commission could consider whether registration as an exchange is 
necessary. The Commission will not consider making an assessment 
whether a particular system should register as an exchange unless that 
system, during three of preceding four calendar quarters had: (1) Fifty 
percent or more of the average daily dollar trading volume in any 
security and five percent or more of the average daily dollar trading 
volume in any class of security; or (2) Forty percent or more of the 
average daily dollar trading volume in any class of securities. The 
Commission would also provide such a system with notice and an 
opportunity to respond before determining that exemption from 
registration as an exchange is not appropriate in the public interest. 
In making that determination, the Commission would take into account 
the requirements for exchange registration under section 6 of the 
Exchange Act and the objectives of the national market system under 
section 11A of the Exchange Act. For example, it may not be consistent 
with the protection of investors or in the public interest for a 
trading system that is the dominant market, in some important segment 
of the securities market, to be exempt from registration as an exchange 
if competition cannot be relied upon to ensure fair and efficient 
trading structures in that case. In that case it may be necessary for 
the Commission's greater oversight authority over registered exchanges 
to apply.\105\ As another example, if the Commission believed that an 
exemption under Rule 3a1-1 for a particular trading system that meets 
the volume thresholds would create systemic risk or lead to instability 
in the securities markets' infrastructure, it could determine that an 
exemption from registration as an exchange was not appropriate in the 
public interest or consistent with the protection of investors.
---------------------------------------------------------------------------

    \105\ The Commission does not mean to imply that the NASD will 
be required to register Nasdaq as a national securities exchange. As 
stated above, because Nasdaq is operated by a national securities 
association, it is currently subject to requirements virtually 
identical to those applicable to national securities exchanges. Any 
alternative trading system, however, currently operated by a 
national securities association could choose to register as an 
exchange.
---------------------------------------------------------------------------

    The Commission believes that there are alternative trading systems 
operating today that exceed the volume levels in paragraph (b)(1) of 
Rule 3a1-1. However, the Commission does not believe at this time that 
there are any alternative trading systems--given their current 
operations--for which the exemption from the definition of exchange in 
paragraph (a) of Rule 3a1-1 is not appropriate.
    In addition, under section 19(c)(3) of the Exchange Act,\106\ the 
Commission has the authority to promulgate rules for the de-
registration of an exchange. In order to ensure a smooth transition for 
exchanges that wish to de-register and become registered broker-dealers 
subject to Regulation ATS, the Commission will consider promulgating 
de-registration rules. Such rules would also give the Commission the 
opportunity to formally consider whether certain exchanges should be 
prohibited from de-registering, just as Rule 3a1-1(b) gives the 
Commission the opportunity to consider whether certain alternative 
trading systems registered as broker-dealers should be compelled to 
register as exchanges.
---------------------------------------------------------------------------

    \106\ 15 U.S.C. 78s(c)(3).
---------------------------------------------------------------------------

IV. Regulation of Alternative Trading Systems

    Securities markets have become increasingly interdependent. The use 
of technology permits market participants to link products, implement 
complex hedging strategies across markets and across products, and 
trade on multiple markets simultaneously. While these opportunities 
benefit many investors, they may also create misallocations of capital, 
widespread inefficiency, and trading fragmentation if markets are not 
coordinated. In addition, a lack of coordination among markets has the 
potential to increase system-wide risks. Congress adopted the 1975 
Amendments, in part, to address these negative effects of potentially 
fragmented markets.\107\ The Commission believes that it is consistent 
with Congress' goals to integrate significant alternative trading 
systems into the national market system.
---------------------------------------------------------------------------

    \107\ See S. Rep. No. 75, 94th Cong., 1st Sess. 8 (1975) at 2, 
8; H.R. Rep. No. 229, 94th Cong., 1st Sess 92 (1975).
---------------------------------------------------------------------------

    In the 1975 Amendments, Congress specifically endorsed the 
development of an national market system, and sought to clarify and 
strengthen the Commission's authority to promote the achievement of 
such a system.\108\ Because of uncertainty as to how technological and 
economic changes would affect the securities markets, Congress 
explicitly rejected mandating specific components of an national market 
system.\109\ Instead, Congress recognized that the securities markets 
dynamically change and, accordingly, granted the Commission broad 
authority to oversee the implementation, operation, and regulation of 
the national market system in accordance with Congressional goals and 
objectives.\110\
---------------------------------------------------------------------------

    \108\ See supra note 6.
    \109\ See S. Rep. No. 75. supra note 107. ``(T)he increasing 
tempo and magnitude of the changes that are occurring in our 
domestic and international economy make it clear that the securities 
markets are due to be tested as never before,'' and that it was, 
therefore, important to assure ``that the securities markets and the 
regulations of the securities industry remain strong and capable of 
fostering (the) fundamental goals (of the Exchange Act) under 
changing economic and technological conditions.'' Id. at 3.
    \110\ S. Rep. No. 75 supra note 107, at 8-9.
---------------------------------------------------------------------------

    Congress identified two paramount objectives in the development of 
an national market system: the maintenance of stable and orderly 
markets with maximum capacity, and the centralization of all buying and 
selling interest so that each investor has the opportunity for the best 
possible execution of his or her order, regardless of where the 
investor places the order.\111\ In addition, Congress directed the 
Commission to remove present and future competitive restrictions on 
access to market information and order systems, and to assure the equal 
regulation of markets, exchange members, and broker-dealers effecting 
transactions in the national market system.\112\ In particular, 
Congress found that it was in the public interest to assure ``fair 
competition * * * between exchange markets and markets other than 
exchange markets.'' \113\
---------------------------------------------------------------------------

    \111\ S. Rep. No. 75 supra note 107, at 7; see Section 
11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k-1(a)(1)(C).
    \112\ See S. Rep. No. 75 supra note 107, at 104-05.
    \113\ Section 11A(a)(1)(C)(ii) of the Exchange Act, 15 U.S.C. 
78k-1(a)(1)(C)(ii). A fundamental goal of a national market system 
was to ``achieve a market characterized by economically efficient 
executions, fair competition, (and the) broad dissemination of basic 
market information.'' S. Rep. No. 75 supra note 107, at 101.
---------------------------------------------------------------------------

    To further national market system goals, Congress granted the 
Commission broad authority to make rules, including those to: (1) 
Prevent the use and publication of deceptive trade and order 
information; (2) assure the prompt, accurate, and reliable distribution 
of quotation and transaction information; (3) enable non-discriminatory 
access to such information; and (4) assure that all broker-dealers 
transmit and direct orders for securities in a manner consistent with 
the operation of a national market system.\114\ Moreover, Congress 
recognized that in order to implement national market system goals, the 
Commission would need to classify markets, firms, and securities and 
facilitate the development of

[[Page 70859]]

``subsystems within the national market system.'' \115\
---------------------------------------------------------------------------

    \114\ See Section 11A(c)(1) of the Exchange Act, 15 U.S.C. 78k-
1(c)(1).
    \115\ S. Rep. No. 75 supra note 107, at 7.
---------------------------------------------------------------------------

    The Commission believes the rules it is adopting today advance 
national market system goals. At present, alternative trading systems 
are not fully integrated into the national market system, leaving gaps 
in market access and fairness, systems capacity, transparency, and 
surveillance. These concerns, together with the increasing significance 
of alternative trading systems, call into question the fairness of 
current regulatory requirements, the effectiveness of existing national 
market system mechanisms, and the quality of public secondary markets. 
Under the rules the Commission is adopting today, alternative trading 
systems that have the most significant effect on our markets will be 
required to integrate their trading into national market system 
mechanisms. Alternative trading systems may choose to register either 
as national securities exchanges or as broker-dealers. Systems that 
elect broker-dealer regulation will be integrated into the national 
market system under Regulation ATS if they have significant trading 
volume.\116\ Discussed in Section IV.A. below are the requirements for 
alternative trading systems that choose to register as broker-dealers 
and comply with Regulation ATS. Any alternative trading system that 
registers as a national securities exchange will be obligated--as 
currently registered exchanges are--to participate in the national 
market system mechanisms. Section IV.B. contains a discussion of the 
requirements applicable to alternative trading systems that choose to 
register as exchanges.
---------------------------------------------------------------------------

    \116\ In addition to its authority under section 11A of the 
Exchange Act, 15 U.S.C. 78k-1, the Commission is adopting Regulation 
ATS pursuant to its rulemaking power under other parts of the 
Exchange Act, including sections 3(b) (power to define terms), 
15(b)(1) (registration and regulation of broker-dealers), 15(c)(2) 
(prescribing means reasonably designed to prevent fraud), 17(a) 
(books and records requirements), 17(b) (inspection of records), 
23(a)(1) (general power to make rules and classify persons, 
securities, and other matters), and 36 (general exemptive 
authority). 15 U.S.C. 78c(b), 78o(b)(1), 78o(c)(2), 78q(a), 78q(b), 
78w(a)(1), and 78mm, respectively. For a discussion on the general 
exemptive authority in section 36 of the Exchange Act, 15 U.S.C. 
78mm, see infra Section VII.D.1.
---------------------------------------------------------------------------

A. Regulation ATS

1. Scope of Regulation ATS
a. Definition of Alternative Trading System
    The Commission proposed to define the term ``alternative trading 
system'' as any system that: (1) Constitutes, maintains, or provides a 
marketplace or facilities for bringing together purchasers and sellers 
of securities or for otherwise performing with respect to securities 
the functions commonly performed by a stock exchange under Exchange Act 
Rule 3b-16; \117\ and (2) does not set rules governing the conduct of 
subscribers other than the conduct of such subscribers' trading on such 
organization, association, person, group of persons, or system, or 
discipline subscribers other than by exclusion from trading.\118\ This 
proposed definition would have the effect of precluding any trading 
system that performs self-regulatory functions from opting to register 
as a broker-dealer, rather than as an exchange. Such a system would 
consequently be required to register as an exchange or be operated by a 
national securities association. Nothing, however, would prevent a 
registered exchange from giving up its self-regulatory functions and 
choosing instead to comply with Regulation ATS.\119\
---------------------------------------------------------------------------

    \117\ See supra Section III (discussing Rule 3b-16).
    \118\ Rule 300(a), 17 CFR 242.300(a).
    \119\ See supra note and accompanying text. The Commission has 
the authority to require significant markets to remain registered as 
exchanges. See supra Section III.F.
---------------------------------------------------------------------------

    The Commission received only one comment on this proposed 
definition. This commenter suggested that the proposed definition for 
alternative trading systems was too complex and should instead, simply 
be defined as an exchange that does not set conduct rules or discipline 
subscribers.\120\ Under the framework the Commission is adopting today, 
an alternative trading system is exempt from the definition of an 
exchange if it registers as a broker-dealer and complies with 
Regulation ATS.\121\
---------------------------------------------------------------------------

    \120\ PCX Letter at 3.
    \121\ Rule 3a1-1(a)(2), 17 CFR 240.3a1-1(a)(2).
---------------------------------------------------------------------------

    Because the Commission continues to believe that any system that 
uses its market power to regulate its participants should be regulated 
as an SRO, the Commission is adopting the definition of alternative 
trading system as proposed. The Commission would consider a trading 
system to be ``governing the conduct of subscribers'' outside the 
trading system if it imposed on subscribers, as conditions of 
participation in trading, any requirements for which the trading system 
had to examine subscribers for compliance. In addition, if a trading 
system imposed as conditions of participation, directly or indirectly, 
restrictions on subscribers' activities outside of the trading system, 
the Commission believes that such a trading system should be a 
registered exchange or operated by a national securities association. 
For example, the Commission would not consider a trading system to be 
an alternative trading system, as defined in Rule 300(a), if that 
trading system prohibited subscribers from placing orders on its system 
at prices inferior to those subscribers place on other systems. The 
Commission believes such rules should only be imposed and enforced by 
regulatory bodies because of the potential that they may be applied for 
anti-competitive purposes. The Commission does not intend for this 
limitation to preclude an alternative trading system from imposing 
credit conditions on subscribers or requiring subscribers to submit 
financial information to the alternative trading system.
b. Exclusion of Trading Systems Registered as Exchanges or Operated by 
a National Securities Association
    The Commission proposed to exclude from the scope of Regulation ATS 
certain alternative trading systems that are subject to other 
appropriate regulations. In particular, Rule 301(a) would exclude 
alternative trading systems (1) registered as exchanges, (2) exempt 
from exchange registration based on limited volume,\122\ or (3) 
operated by a national securities association. These systems are 
subject to regulation as markets under other provisions of the Exchange 
Act. The Commission is adopting these exclusions as proposed.
---------------------------------------------------------------------------

    \122\ See supra note 33.
---------------------------------------------------------------------------

c. Exclusion of Alternative Trading Systems Trading Solely Government 
and Related Securities
(i) Discussion
    In addition, the Commission proposed that any alternative trading 
system that trades only government securities,\123\ Brady Bonds, and 
repurchase and reverse repurchase agreements involving government 
securities or Brady Bonds be excluded from the scope of Regulation ATS, 
as long as the alternative trading system is registered as a broker-
dealer. The Commission believes that alternative trading systems 
trading only government securities raise several of the structural 
issues raised by alternative trading systems trading equity and other 
debt securities. Nevertheless, the Commission recognizes that 
government securities are subject to other forms of regulation that 
help to ensure that those markets are fair and orderly. In particular,

[[Page 70860]]

government securities broker-dealers are currently regulated jointly by 
the Commission, U.S. Department of the Treasury (``Treasury''), and 
federal banking regulators, under the Exchange Act (particularly the 
provisions of the Government Securities Act of 1986) and the federal 
banking laws.\124\ Unlike surveillance of trading in equities and other 
instruments traded primarily on registered exchanges,\125\ surveillance 
of trading in government securities is coordinated among the Treasury, 
the Commission, and the Board of Governors of the Federal Reserve 
System.
---------------------------------------------------------------------------

    \123\ The term ``government security'' is defined in section 
3(a)(42) of the Exchange Act, 15 U.S.C. 78c(a)(42).
    \124\ See generally Department of the Treasury, Securities and 
Exchange Commission, and Board of Governors of the Federal Reserve 
System, Joint Study of the Regulatory System for Government 
Securities (March 1998); Department of the Treasury, Report of the 
Secretary of the Treasury on Specialized Government Securities 
Brokers and Dealers (July 1995) (``1995 Treasury Report'').
    The Government Securities Act of 1986 (``GSA'') amended the 
Exchange Act to incorporate new section 15C, which, among other 
things, established registration and notice requirements for 
government securities brokers and dealers. Section 15C generally 
requires government securities brokers and dealers (i.e., 15C firms 
or specialized government securities brokers and dealers) to 
register with the Commission and to become members of an SRO 
(twenty-two firms as of March 1998). Firms that are registered with 
the Commission as general securities brokers or dealers (i.e., 
traditional broker-dealers registered under section 15(b) of the 
Exchange Act) are required to file notice with the Commission of 
their government securities business (3,023 firms as of April 1998). 
In addition, financial institutions that engage in government 
securities broker or dealer activities are required to file notice 
of such activities with their appropriate regulatory agency (120 
institutions as of March 1998).
    Under the regulatory structure established by the GSA, the 
Treasury was granted authority to adopt regulations for all 
government securities brokers and dealers concerning financial 
responsibility, protection of investors' funds and securities, 
recordkeeping, reporting, and audit requirements, and to adopt 
regulations governing the custody of government securities held by 
depository institutions. The Government Securities Act Amendments of 
1993 (``GSAA'') expanded the authority of the federal regulators and 
the SROs over government securities transactions. The GSAA, among 
other things, reauthorized the Treasury's rulemaking 
responsibilities, granted the Treasury authority to prescribe large 
position recordkeeping and reporting rules, extended the 
Commission's antifraud and antimanipulation authority to all 
government securities brokers and dealers, required government 
securities brokers and dealers to provide to the Commission on 
request records of government securities transactions to reconstruct 
trading in the course of a particular inquiry or investigation, 
removed the statutory restrictions on the authority of the NASD to 
extend sales practice rules to its members' transactions in 
government securities, and provided the bank regulatory agencies 
with the authority to issue sales practice rules for financial 
institutions engaged in government securities broker or dealer 
activities.
    The GSA also strengthened the ability of federal regulators to 
examine, and to bring enforcement actions against, government 
securities brokers and dealers. The Commission and the SROs have 
examination and enforcement authority over government securities 
brokers and dealers registered under section 15C and over the 
government securities activities of general securities brokers and 
dealers. The Commission's enforcement authority includes the power 
to censure, place limitations on the activities, functions, or 
operations of, suspend for a period not exceeding 12 months, or 
revoke the registration of the entity. For financial institutions 
that are government securities brokers or dealers, the institution's 
appropriate regulatory agency has examination and enforcement 
authority over the institution. The appropriate regulatory agency 
must notify the Commission of any sanctions imposed on such 
institutions, and the Commission must maintain a record of the 
sanctions.
    \125\ Although all marketable Treasury notes, bonds, and zero-
coupon securities are listed on the NYSE, exchange trading volume is 
a small fraction of the total over-the-counter volume in these 
instruments. See U.S. Department of the Treasury, U.S. Securities 
and Exchange Commission, and Board of Governors of the Federal 
Reserve System, Joint Report on the Government Securities Market 26 
(1992).
---------------------------------------------------------------------------

    The Commission is adopting this proposed exclusion from Regulation 
ATS with some modifications.\126\ Specifically, the Commission is 
eliminating Brady Bonds from the types of securities an alternative 
trading system can trade and fall within this exclusion. The Commission 
received no comments specifically addressing the trading of Brady Bonds 
by alternative trading systems. Based on information the Commission has 
available about trading on alternative trading systems, however, the 
Commission is not aware of any systems trading Brady Bonds that do not 
also trade other non-government securities, most typically other 
emerging market debt. Accordingly, no alternative trading systems 
trading Brady Bonds would have been exempt under the proposals. 
Further, the Commission does not treat Brady Bonds in the same manner 
as government securities in other contexts. Moreover, the significance 
of Brady Bonds in the market is diminishing.
---------------------------------------------------------------------------

    \126\ In other words, these systems are not required to register 
as either an exchange or to comply with the requirements of 
Regulation ATS. Rule 301(a)(4), 17 CFR 242.301(a)(4).
---------------------------------------------------------------------------

    In addition, the Commission is expanding the exclusion in two 
respects. First, the Commission is adding commercial paper \127\ and 
certain options on government securities \128\ to the types of 
securities alternative trading systems may trade without being subject 
to Regulation ATS. The Commission believes this expansion is 
appropriate because commercial paper does not require registration even 
as a broker-dealer, and because the term ``government securities'' 
includes certain options on government securities for purposes of 
sections 15C and 17A of the Exchange Act.\129\ Second, the Commission 
is expanding this exclusion from Regulation ATS to include alternative 
trading systems that are banks and that trade solely government 
securities, repurchase and reverse repurchase agreements on government 
securities, certain options of government securities, and commercial 
paper because of banks' traditional role in the government securities 
market.\130\
---------------------------------------------------------------------------

    \127\ Rule 301(a)(4)(ii)(E), 17 CFR 242.301(a)(4)(ii)(E). The 
term ``commercial paper'' is defined in Rule 300(m), 17 CFR 
242.300(m). This definition is based on the definition of commercial 
paper as set forth in 12 CFR 541.5, an Office of Thrift Supervision 
regulation that defines commercial paper, and section 3(a)(3) of the 
Securities Act of 1933, which uses identical language to identify 
these securities as one category of exempted securities.
    \128\ Rule 301(a)(4)(D), 17 CFR 242.301(a)(4)(D).
    \129\ Section 3(a)(42) of the Exchange Act, 15 U.S.C. 
78c(a)(42).
    \130\ Rule 301(a)(4), 17 CFR 242.301(a)(4).
---------------------------------------------------------------------------

(ii) Response to Commenters
    The Commission solicited comment on whether it was appropriate to 
exclude from the regulatory framework for alternative trading systems 
those alternative trading systems trading solely government and other 
related securities. Of those commenters who addressed this issue, most 
were in favor of excluding such systems. Most of these commenters 
agreed with the Commission that alternative trading systems trading 
government securities are subject to their own specialized oversight 
structure and, therefore, were appropriately excluded from the scope of 
the Commission's proposal.\131\ Only one commenter opposed the proposed 
exclusion of alternative trading systems that trade government 
securities.\132\
---------------------------------------------------------------------------

    \131\ See, e.g., TBMA Letter at 17-18 (also urging the 
Commission to clarify the application of proposed Regulation ATS 
where a trading system trades government securities, as well as non-
government securities); CBB Letter at 3 (but requesting guidance 
from the Commission on whether an ATS trading government securities 
and relying on such an exemption would be precluded from trading 
products other than securities); SIA Letter at 3, 11.
    \132\ IBEX Letter at 4-5.
---------------------------------------------------------------------------

    One commenter suggested that the Commission exclude alternative 
trading systems that trade government securities from the definition in 
Rule 3b-16, rather than exclude them from Regulation ATS. This 
commenter stated that if these alternative trading systems were 
classified as exchanges that fact would be cited by proponents of a 
narrow interpretation of the Treasury Amendment to the Commodity 
Exchange Act, potentially resulting in a broad definition of ``board of 
trade'' beyond its intended meaning as a traditional organized 
exchange.\133\ As stated earlier, the Commission believes that it would 
be inappropriate and

[[Page 70861]]

without a reasoned basis to transfer part or all of its determination 
regarding regulation to other statutory contexts.\134\ The Commission's 
reinterpretation of ``exchange'' is grounded on its decision to use its 
exemptive authority to allow alternative trading systems to choose to 
be regulated as broker-dealers. The Commission's reinterpretation of 
exchange should not be relied upon by other regulators to interpret 
other, potentially more restrictive statutory schemes.
---------------------------------------------------------------------------

    \133\ TBMA Letter at 13, n.21.
    \134\ See supra note 97 and accompanying text.
---------------------------------------------------------------------------

    In addition, this same commenter encouraged the Commission to 
consider the effects of the proposed rules on banks that operate 
alternative trading systems. In particular, this commenter noted that 
the exclusion for alternative trading systems that trade government 
securities applied only if the alternative trading system registered as 
a broker-dealer, not if the alternative trading system were a 
bank.\135\ The Commission did not intend to require banks trading 
government securities to register as broker-dealers and, therefore, 
Rule 301(a)(4), as adopted, excludes from Regulation ATS alternative 
trading systems that trade government securities if these systems are 
registered as broker-dealers or are banks.
---------------------------------------------------------------------------

    \135\ TBMA Letter at 17.
---------------------------------------------------------------------------

    Several commenters raised questions about the application of 
Regulation ATS to alternative trading systems that trade not only 
government securities, but also other types of securities.\136\ One 
commenter asked the Commission to extend the proposed exemption for 
alternative trading systems that trade only government securities and 
other related securities to all trading in those securities. This 
commenter stated that broker-dealers that trade government securities, 
as well as other securities and financial instruments, should not be 
required to restructure their operations to avail themselves of an 
exclusion for government securities activities.\137\
---------------------------------------------------------------------------

    \136\ See TBMA Letter at 17; Instinet Letter at 8, n.11; CBB 
Letter at 3-4.
    \137\ Instinet Letter at 8, n.11.
---------------------------------------------------------------------------

    The Commission does not believe that an alternative trading 
systems' government securities trading will be subject to more 
burdensome regulation if it is conducted in the same system as trading 
in other securities, than if it is conducted in a separate and, 
therefore, excluded system. Accordingly, the exclusion applies to 
systems that only trade government and other related securities.
    Government securities are not ``covered securities'' \138\ and, 
therefore, are not subject to the transparency requirements of 
Regulation ATS. In addition, an alternative trading system is only 
required to comply with the fair access requirements for those 
securities (or categories of securities) in which it represents twenty 
percent or more of the total volume. The fair access requirement does 
not apply to government securities regardless of whether government 
securities trading is conducted in the same alternative trading system 
as securities subject to the fair access requirements or in a separate 
alternative trading system. Finally, the capacity, integrity, and 
security requirements would never be triggered by an alternative 
trading system's government securities trading. If, however, the 
trading in other securities on that same system exceeds the twenty 
percent threshold, an alternative trading system in which government 
securities are traded would have to meet the capacity, integrity, and 
security standards. Nevertheless, it seems unlikely that an alternative 
trading system would choose to create a separate alternative trading 
system for its government securities trading solely for the privilege 
of trading government securities on a system with lesser capacity, 
integrity, and security than the system on which other securities are 
traded. Therefore, the Commission does not believe that it will be 
necessary, as a practical matter, for an alternative trading system to 
restructure its system to avail itself of the government securities 
exclusion.
---------------------------------------------------------------------------

    \138\ See infra note 180 and accompanying text for the 
definition of ``covered security.''
---------------------------------------------------------------------------

    Another commenter asked that the Commission expressly confirm that 
the exclusion from the scope of Regulation ATS for systems trading 
government and related securities does not preclude such an alternative 
trading system from offering services involving products other than 
securities.\139\ In response, the Commission has clarified that to be 
excluded from the scope of Regulation ATS an alternative trading system 
need only limit its securities activities to government securities, 
Brady Bonds, repurchase and reverse repurchase agreements on such 
instruments, and commercial paper.
---------------------------------------------------------------------------

    \139\ CBB Letter at 3.
---------------------------------------------------------------------------

    Finally, this commenter suggested that the Commission adopt rules 
to permit government securities alternative trading systems to trade 
other fixed income securities on a limited pilot basis. This commenter 
argued that, without such a limited exemption, Regulation ATS would 
have a chilling effect on the ability of government securities 
alternative trading systems to introduce technological innovation, and 
that such a provision would raise no significant investor protection 
concerns.\140\ The Commission, however, does not believe that allowing 
one category of alternative trading systems (i.e., those trading 
government securities) to trade other types of fixed income securities 
where the regulation and surveillance is different, without complying 
with Regulation ATS is appropriate. The notice and recordkeeping 
requirements under Regulation ATS are limited and should not interfere 
with market participants' ability to test new, innovative systems.
---------------------------------------------------------------------------

    \140\ CBB Letter at 3-4.
---------------------------------------------------------------------------

d. Alternative Trading Systems Trading Non-Government Debt Securities
(i) Discussion
    The Commission proposed that alternative trading systems that trade 
debt securities (other than those trading government and other related 
securities) be subject to Regulation ATS, if they choose not to 
register as exchanges. Under Regulation ATS, these systems would be 
required to file a notice with the Commission, maintain an audit trail, 
periodically report certain information to the Commission, and ensure 
that they have adequate safeguards to protect subscribers' confidential 
trading information. In addition, alternative trading systems with 
twenty percent or more of the trading volume in a particular category 
of debt would have to meet the fair access and systems capacity, 
integrity, and security standards.\141\ The Commission solicited 
comment on what categories of debt would be appropriate for this 
purpose and what sources of debt transaction volume information is 
available. Specifically, the Commission solicited comment on whether 
the following categories would be appropriate: mortgage and asset-
backed securities, municipal securities, corporate debt securities, 
foreign corporate debt securities, and sovereign debt securities.
---------------------------------------------------------------------------

    \141\ The proposal would not require an alternative trading 
system to publicly display its best orders in fixed income 
securities.
---------------------------------------------------------------------------

    The Commission is adopting the proposal to include alternative 
trading systems that trade fixed income securities within its new 
regulatory framework. With respect to the fair access and systems 
capacity, integrity and security requirement, the rules as adopted 
require alternative trading systems with twenty percent or more of the 
volume in municipal securities, investment grade corporate debt 
securities, and non-investment grade corporate debt securities to 
comply with the fair access and systems capacity,

[[Page 70862]]

integrity, and security requirements. Accordingly, the Commission is 
adopting rules to define these three categories of debt securities. The 
Commission is deferring any action on requiring alternative trading 
systems that trade foreign corporate debt or foreign sovereign debt to 
comply with the fair access and systems capacity, integrity, and 
security requirements.
    For municipals, the Commission is incorporating into Regulation ATS 
the definition of municipal securities in section 3(a)(29) of the 
Exchange Act.\142\ A debt security (other than an exempted security) 
with a fixed maturity of at least one year will be considered 
investment grade corporate debt if it is rated in one of the four 
highest ratings categories by at least one Nationally Recognized 
Statistical Ratings Organization,\143\ and will be considered non-
investment grade corporate debt if it is not so rated.\144\ The 
Commission believes that these categories are widely recognized as 
relatively distinct markets within the debt market as a whole and, 
while not encompassing all forms of debt securities, will ensure that 
alternative trading systems that provide markets for significant 
segments of the debt market take adequate measures for systems 
capacity, integrity, and security, as well as provide fair access.
---------------------------------------------------------------------------

    \142\ 15 U.S.C. 78c(a)(29).
    \143\ Rule 300(l), 17 CFR 242.300(l).
    \144\ Rule 300(m), 17 CFR 242.300(m).
---------------------------------------------------------------------------

    While the Commission is adopting rules to establish the appropriate 
categories for debt securities, the volume-based rules with respect to 
all categories, except municipal securities, will not become effective 
until volume information is available in a format that will enable 
alternative trading systems to determine their relative volume. Volume 
data for municipal securities is available and being published through 
the Municipal Securities Rulemaking Board's (``MSRB'') Daily Volume 
Price Reports. On August 24, 1998, the MSRB started producing a 
Combined Daily Report to summarize both intra-dealer and customer 
transactions of municipal securities that are traded four or more times 
per day pursuant to Rule G-14. This report is made available through 
data vendors, such as Bloomberg, by approximately 6:00 am each business 
day.\145\ Among other information, the Combined Daily Report provides 
total volume data against which alternative trading systems that trade 
municipal securities can measure their compliance obligations under 
Regulation ATS.
---------------------------------------------------------------------------

    \145\ An initiative by TBMA would also make the MSRB data 
available on TBMA's web site <http://www.investinginbonds.com>. See 
Robert Whalen, Investor Aids: TBMA's Internet-Based Price Reporting 
Aims to Increase Market Transparency, The Bond Buyer, Nov. 25, 1998, 
at 28.
---------------------------------------------------------------------------

    Volume data for the remaining two categories--investment grade and 
non-investment grade corporate debt--, however, is not currently 
compiled or published so that alternative trading systems can determine 
their obligations under Regulation ATS. In order to allow time for 
logistical arrangements to make such data available, the Commission 
will not make these fair access and systems capacity, integrity and 
security provisions of Regulation ATS effective until April 1, 
2000.\146\
---------------------------------------------------------------------------

    \146\ Due to the Commission's concerns regarding the Year 2000 
computer technology conversion process, no new Commission rules 
requiring major computer reprogramming will be made effective 
between June 1, 1999 and March 31, 2000. See Securities Exchange Act 
Release No. 40377 (Aug. 27, 1998), 63 FR 47501 (Sept. 3, 1998). 
Accordingly, because the logistical framework for investment grade 
and non-investment grade corporate debt data has not been fully 
developed, the Commission is not making Rules 301(b)(5)(D) and (E) 
and Rules 301(b)(6)(D) and (E) effective until after the moratorium 
is lifted.
---------------------------------------------------------------------------

(ii) Response to Commenters
    Some commenters thought that the Commission should exclude debt 
securities entirely from Regulation ATS.\147\ On the other hand, 
several commenters supported the Commission's proposal to include 
alternative trading systems that trade debt securities.\148\ The 
Commission believes that many of the same concerns about the trading of 
equity securities on alternative trading systems apply equally to the 
trading of fixed income securities on alternative trading systems. 
Specifically, it is important that markets with significant portions of 
the volume in particular instruments have adequate systems capacity, 
integrity, and security, regardless of whether those instruments are 
equity securities or debt securities. Similarly, as electronic systems 
for debt grow, it will become increasingly important for the fair 
operation of our markets for market participants to have fair access to 
significant market centers in debt securities. One of the consequences 
of the growing role of alternative trading systems in the securities 
markets generally is that debt securities are increasingly being traded 
on these systems, similar to the way equity securities are traded. This 
change in the market requires appropriate measures for markets for 
debt.
---------------------------------------------------------------------------

    \147\ See TBMA Letter at 3, MSDW Letter at 13; SIA Letter at 11; 
DBSI Letter at 1 (adopting TBMA Letter).
    \148\ See NYSE Letter at 6 (supporting regulation of alternative 
trading systems that trade debt securities as important for investor 
protection); IBEX Letter at 2-3 (also generally urging the 
Commission to take steps to increase transparency, access to best 
priced orders, and other investor protections in the debt markets, 
e.g., insider trading and front running rules).
---------------------------------------------------------------------------

    Two commenters suggested that the Commission exempt or exclude 
alternative trading systems trading municipal securities for the same 
reasons that it proposed to exclude alternative trading systems that 
trade government securities.\149\ For example, one commenter asserted 
that the municipal securities market is overseen not only by securities 
regulators, but also by the federal banking regulators. This commenter 
also pointed out that the Commission had proposed excluding municipal 
securities in the Concept Release and stated that the Commission should 
have maintained this approach in the Proposing Release.\150\ Although 
the Commission did solicit comment in the Concept Release on whether 
alternative trading systems trading municipal securities should be 
excluded from any proposed new regulatory framework, the Commission has 
concluded that it would not be appropriate to do so.
---------------------------------------------------------------------------

    \149\ See TBMA Letter at 18-20; SIA Letter at 3, 11.
    \150\ TBMA Letter at 19-20.
---------------------------------------------------------------------------

    There are substantial differences between the oversight of the 
government securities market and the municipal securities markets, and 
between government securities instruments and municipal securities 
instruments. For example, municipal securities are far more varied 
products than government securities. While traditional general 
obligation bonds issued by municipalities are more akin to government 
securities in that they are backed by the full faith and credit of the 
issuing taxing authority, revenue bonds, which bear greater resemblance 
to privately issued bonds due to their ties to specific revenue 
sources, are riskier products.\151\ Most municipal bonds are rarely 
traded. The market for government securities, on the other hand, is 
deep and liquid.\152\ Therefore, alternative trading systems that may 
develop for municipal securities may have widely different qualities 
than those for government securities. Moreover, regulation of the 
government

[[Page 70863]]

securities market is shared by the Federal Reserve Board, the Treasury 
Department and the Commission and other bank regulators, while 
oversight of the municipal securities market is assigned to the 
Commission and the MSRB. For these reasons, the Commission believes it 
would not be appropriate to exempt alternative trading systems that 
trade municipal securities from Regulation ATS.
---------------------------------------------------------------------------

    \151\ See Robert Zipf, How the Bond Market Works 86-87 (1997) 
(noting characteristics of general obligation and revenue bonds and 
the heightened risk of revenue bonds relative to general obligation 
bonds).
    \152\ As of June 30, 1998, there was approximately $3.4 trillion 
of U.S. Treasury debt securities outstanding with average daily 
trading volume of over $200 billion. By comparison, there was 
approximately $1.4 trillion of municipal debt securities outstanding 
with average daily trading volume of approximately $1 billion. The 
Bond Market Association, Research Quarterly (August 1998) <http://
www.bondmarkets.com/research/9808rschq.pdf>.
---------------------------------------------------------------------------

    Only one commenter directly addressed the Commission's request for 
comment on possible categories of debt. Although TBMA encouraged the 
Commission to exclude alternative trading systems trading debt 
securities from Rule 3b-16,\153\ it stated that, if the Commission 
chose to go forward with the proposal, it ``believes that the proposed 
categories reflect a reasonable indication of how market participants 
view and trade debt securities.'' \154\
---------------------------------------------------------------------------

    \153\ TBMA Letter at 6-7, 21.
    \154\ TBMA Letter at 24.
---------------------------------------------------------------------------

    Several commenters recommended that the Commission consider the 
clearing agencies as a source of information on the trading volume in 
the debt market.\155\ One commenter also noted that for municipal 
securities, the MSRB's transaction reporting requirements could be a 
good source for volume information.\156\ As discussed above, the 
Commission plans to use the MSRB's transaction reporting program as a 
basis for volume in the municipal securities market.
---------------------------------------------------------------------------

    \155\ See TBMA Letter at 23-25; IBEX Letter at 12. IBEX also 
suggested reactivating the SIA practice of publishing the average 
daily trading volume of corporate and other bonds on a monthly basis 
which was discontinued in 1994. IBEX Letter at 12.
    \156\ TBMA Letter at 23-25.
---------------------------------------------------------------------------

e. Exemptions From Certain Requirements of Regulation ATS Pursuant to 
Application to the Commission
    The Commission today is also adopting a provision to allow the 
Commission, upon application by an alternative trading system, to 
exempt by order such alternative trading system from one or more of the 
requirements of Regulation ATS.\157\ The Commission expects to issue 
such an order only under unusual circumstances, and only after 
determining that such an order is consistent with the public interest, 
the protection of investors and the removal of impediments to, and the 
perfection of the mechanisms of, a national market system.
---------------------------------------------------------------------------

    \157\ Rule 301(a)(5), 17 CFR 242.301(a)(5).
---------------------------------------------------------------------------

    While the Commission believes that the requirements it is adopting 
under Regulation ATS are appropriate for all alternative trading 
systems operating today, the Commission is aware that a system may 
develop in the future to which these requirements may not be 
appropriate, and they could hinder the development of specialized 
trading systems. For example, the Commission could consider exempting 
an alternative trading system that limited participation only to 
investment companies with similar investment strategies, such as index 
funds, from the transparency requirements.\158\
---------------------------------------------------------------------------

    \158\ The transparency requirements are discussed infra Section 
IV.A.2.c.
---------------------------------------------------------------------------

2. Requirements for Alternative Trading Systems Subject to Regulation 
ATS
    Discussed below are the requirements for alternative trading 
systems subject to Regulation ATS.
a. Membership in an SRO
    Because alternative trading systems that choose to register as 
broker-dealers will not themselves have self-regulatory 
responsibilities, the Commission believes it is important for such 
systems to be members of an SRO. For this reason, the Commission 
proposed to require alternative trading systems subject to Regulation 
ATS to be members of an SRO.
    Most alternative trading systems are currently registered as 
broker-dealers and, therefore, are also members of an SRO.\159\ The 
Commission understands some alternative trading systems may have 
concerns about SROs abusing their regulatory authority for competitive 
reasons. While the Commission understands that SROs operate competing 
markets and, therefore, have potential conflicts of interest in 
overseeing alternative trading systems, the Commission believes these 
conflicts can be minimized using the Commission's oversight.\160\ The 
Commission considers it part of its own oversight responsibility over 
SROs to prevent and take the necessary steps to address any such 
actions by SROs.\161\ Further, an alternative trading system that 
wishes to avoid potential conflicts of interest altogether may choose 
to register as an exchange. The Commission also notes that section 15A 
of the Exchange Act would permit an association of brokers and dealers 
to establish an SRO that does not operate a market.\162\ Such a 
national securities association could be established solely for 
purposes of overseeing the activities of alternative trading systems. 
Of course, this association must be able to effectively conduct its SRO 
responsibilities.
---------------------------------------------------------------------------

    \159\ Section 15(b)(8) of the Exchange Act, 15 U.S.C. 78o(b)(8).
    \160\ For example, the structural reforms undertaken by the NASD 
since August 1996 should aid in ensuring the independence of NASDR 
and insulating its staff from the commercial interests of Nasdaq.
    \161\ See supra note 4.
    \162\ Section 15A of the Exchange Act, 15 U.S.C. 78o-3.
---------------------------------------------------------------------------

    The Commission expects SROs to effectively surveil trading that 
occurs on alternative trading systems by integrating alternative 
trading system trading data into the SRO's existing surveillance 
systems. SROs should also incorporate relevant information regarding 
the entities trading on such systems into their existing surveillance 
programs. The enhanced recordkeeping requirements for alternative 
trading systems will aid SRO oversight considerably in this 
regard.\163\
---------------------------------------------------------------------------

    \163\ See Rule 301(b)(8), 17 CFR 242.301(b)(8).
---------------------------------------------------------------------------

    The Commission believes it is appropriate to continue to require 
alternative trading systems that register as broker-dealers to be SRO 
members and is, therefore, adopting this requirement as proposed.\164\
---------------------------------------------------------------------------

    \164\ Rule 301(b)(1), 17 CFR 242.301(b)(1).
---------------------------------------------------------------------------

b. Notice of Operation as an Alternative Trading System and Amendments
    The Commission proposed to require an alternative trading system 
registered as a broker-dealer to file a notice with the Commission 
before commencing operation, amendments to this notice in the event of 
material changes, and a notice when an alternative trading system 
ceases operation. The Commission is adopting these requirements as 
proposed.
    More specifically, under Regulation ATS, alternative trading 
systems are required to file an initial operation report with the 
Commission on Form ATS at least twenty days prior to commencing 
operation.\165\ Alternative trading systems operating currently must 
file Form ATS within twenty days of the effective date of these final 
rules.\166\ Form ATS requests information about the alternative trading 
system, including a detailed description of how it will operate, its 
prospective subscribers, and the securities it intends to trade. In 
addition, the alternative trading system is required to describe its 
existing procedures for reviewing systems capacity, security, and 
contingency planning. Alternative trading systems are currently 
required to

[[Page 70864]]

report most of this information on Part I of Form 17A-23, which the 
Commission proposed to repeal.\167\ Form ATS is not an application and 
the Commission would not ``approve'' an alternative trading system 
before it began to operate. Form ATS is, instead, a notice to the 
Commission.
---------------------------------------------------------------------------

    \165\ Rule 301(b)(2)(i) and Form ATS, 17 CFR 242.301(b)(2)(i) 
and 17 CFR 249.637.
    \166\ Most currently operating alternative trading systems have 
filed Part 1 of Form 17A-23. To avail themselves of the exemption in 
Rule 3a1-1(a)(2), these systems must file Form ATS within 20 days of 
the effective date of these rules. Internal broker-dealer systems, 
17 CFR 240.17a-3(a)(16)(ii)(A), which may also have previously filed 
Part I of Form 17A-23, do not have to file Form ATS.
    \167\ 17 CFR 240.17a-23. See infra Section V.
---------------------------------------------------------------------------

    An alternative trading system is also required to notify the 
Commission of material changes to its operation by filing an amendment 
to Form ATS at least twenty calendar days prior to implementing such 
changes.\168\ One commenter requested that the Commission provide more 
specific guidance as to what would be considered a ``material change.'' 
\169\ As discussed in the Proposing Release, material changes to an 
alternative trading system include any change to: the operating 
platform, the types of securities traded, or the types of subscribers. 
The Commission notes that currently all alternative trading systems 
implicitly make materiality decisions in determining when to notify 
their subscribers of changes.
---------------------------------------------------------------------------

    \168\ Rule 301(b)(2)(ii), 17 CFR 242.301(b)(2)(ii).
    \169\ SIA Letter at 17-18.
---------------------------------------------------------------------------

    In addition to reporting material changes at least twenty days 
before implementation, alternative trading systems are required to 
notify the Commission in quarterly amendments of any changes to the 
information in the initial operation report that have not been reported 
in a previous amendment.\170\ Finally, if an alternative trading system 
ceases operations, it is required to promptly file a notice with the 
Commission.\171\ Under Regulation ATS, the initial operation report, 
any amendments, and the report filed when an alternative trading system 
ceases operation will be kept confidential.
---------------------------------------------------------------------------

    \170\ Rule 301(b)(2)(iii), 17 CFR 242.301(b)(2)(iii). 
Alternative trading systems would also be required to file an 
amendment to Form ATS to correct any previously filed information 
that has been discovered to have been inaccurate when filed. Rule 
301(b)(2)(iv), 17 CFR 242.301(b)(2)(iv).
    \171\ Rule 301(b)(2)(v), 17 CFR 301(b)(2)(v). An alternative 
trading system is required to provide a duplicate of each of these 
filings to surveillance personnel designated by the SRO of which it 
is a member. Rule 301(b)(2)(vii), 17 CFR 301(b)(2)(vii).
---------------------------------------------------------------------------

    In the Proposing Release,\172\ the Commission requested comment on 
the notice requirements and Form ATS. The Commission specifically 
requested comment on whether such requirements would be burdensome for 
alternative trading systems, and if so, whether the burden is 
inappropriate. The Commission also sought comment on the frequency of 
filings and whether more or less frequent filings would be preferable. 
Finally, the Commission sought comment on whether it would be 
appropriate to permit or to require electronic filing of Form ATS and 
all subsequent amendments.
---------------------------------------------------------------------------

    \172\ See supra note 3.
---------------------------------------------------------------------------

    Most of the commenters did not comment directly on the notice 
requirements or Form ATS. One commenter recommended that the Commission 
allow for filing of the initial operation report on Form ATS within 
twenty days after commencing operation, rather than twenty days before 
commencing operation as proposed.\173\ This commenter stated that such 
a change would ease the regulatory burden on new systems that often 
have uncertain timelines and would avoid the possibility that a new 
trading system would be prevented from operating solely because of the 
need to wait for a twenty-day regulatory time period to run.
---------------------------------------------------------------------------

    \173\ SIA Letter at 17-18.
---------------------------------------------------------------------------

    The Commission, however, believes that twenty days is a short 
enough period of time that alternative trading systems would not be 
inconvenienced by the requirement. If a system were only required to 
provide notice after it commenced operations, the Commission would have 
no notice of potential problems that might impact investors before the 
system begins to operate. The Commission also notes that currently 
broker-dealer trading systems have an identical requirement to file 
Form 17A-23 with the Commission twenty days prior to commencing 
operation. The Commission knows of no broker-dealer trading system that 
was unable to start operating because of the twenty day period. 
Consequently, the Commission believes the Rule, as adopted, is a 
reasonable means for the Commission to carry out its functions and 
imposes no unnecessary burdens on respondents.
    The Commission also requested comment on whether the information in 
Form ATS should remain confidential. Two commenters supported the 
Commission's proposal to keep confidential the information contained in 
Form ATS,\174\ and one commenter encouraged the public availability of 
filed information.\175\ The Commission continues to believe that notice 
reports filed with the Commission and the alternative trading system's 
SRO pursuant to Regulation ATS should be kept confidential. Information 
required on Form ATS may be proprietary and disclosure of such 
information could place alternative trading systems in a 
disadvantageous competitive position. Further, because the Commission 
wishes to encourage candid and complete filings in order to make 
informed decisions and track market changes, preserving confidentiality 
provides respondents with the necessary comfort to make full and 
complete filings. Finally, based on the Commission's experience with 
Rule 17a-23 filings, the Commission believes that confidentiality is 
appropriate.
---------------------------------------------------------------------------

    \174\ See SIA Letter at 17-18; American Century Letter at 6.
    \175\ IBEX Letter at 5.
---------------------------------------------------------------------------

    Finally, the Commission solicited comment on the possibility of 
permitting Form ATS to be filed electronically. Several commenters 
supported the acceptance of electronic filings by the Commission as a 
way to reduce the regulatory burden of filing Form ATS and in light of 
the technological nature of alternative trading systems.\176\ The 
Commission agrees that electronic filing is an important goal and plans 
to work toward it. Currently, however, legal and technological 
limitations--primarily relating to security and authentication--make an 
electronic filing system infeasible. At this time, the Commission is 
capable of, and plans to, provide alternative trading systems with the 
ability to access Form ATS and Form ATS-R on-line, through the 
Commission's web site, so that the form can be downloaded. Alternative 
trading systems would then have to submit these forms to the Commission 
by mail or facsimile. Ultimately, the Commission anticipates that 
current technological barriers will be overcome, and a system able to 
electronically accept Forms ATS and ATS-R will be available.
---------------------------------------------------------------------------

    \176\ See IBEX Letter at 5; SIA Letter at 18; American Century 
Letter at 6.
---------------------------------------------------------------------------

c. Market Transparency
(i) Importance of Market Transparency
    In 1997, the Commission implemented rules that require a market 
maker or specialist to make publicly available any superior prices that 
it privately offers through certain types of alternative trading 
systems known as ECNs.\177\ The rules permit an ECN to fulfill these 
obligations on behalf of market makers or specialists using its system, 
by submitting the ECN's best priced market maker or specialist 
quotations to an SRO for inclusion into

[[Page 70865]]

public quotation displays (``ECN Display Alternative'').\178\
---------------------------------------------------------------------------

    \177\ ECNs include any automated trading mechanism that widely 
disseminates market maker orders to third parties and permits such 
orders to be executed through the system, other than crossing 
systems. Rule 11Ac-1-1, 17 CFR 240.11Ac1-1. See also Securities 
Exchange Act Release No. 37619A (Sept. 6, 1996), 61 FR 48290 (Sept. 
12, 1996) (``Order Handling Rules Adopting Release'').
    \178\ Presently, nine alternative trading systems have elected 
to display quotes under the ECN Display Alternative. See Letters 
dated Jan. 17, 1997 from Richard R. Lindsey, Director, Division of 
Market Regulation, SEC to: Charles R. Hood, Senior V.P. and General 
Counsel, Instinet Corporation (recognizing Instinet as an ECN); 
Joshua Levine and Jeffrey Citron, Smith Wall Associates (recognizing 
the Island System as an ECN); Gerald D. Putnam, President, Terra 
Nova Trading, LLC (recognizing the TONTO System, now known as 
Archipelago, as an ECN); and Roger D. Blanc, Wilkie Farr & Gallagher 
(counsel to Bloomberg) (recognizing Bloomberg Tradebook as an ECN). 
See also Letter dated October 6, 1997 from Richard R. Lindsey, 
Director, Division of Market Regulation, SEC to Matthew G. Maloney, 
Dickstein Shapiro Morin & Oshinsky LLP (counsel to Spear, Leeds & 
Kellogg) (recognizing the REDI System as an ECN); Letter dated 
February 4, 1998 from Robert L.D. Colby, Deputy Director, Division 
of Market Regulation, SEC, to Linda Lerner, General Counsel, All-
Tech Investment Group, Inc. (recognizing the Attain System as an 
ECN); Letter dated April 21, 1998 from Richard R. Lindsey, Director, 
Division of Market Regulation, SEC to Mark Dorsey, Fried, Frank, 
Harris, Shriver & Jacobsen (counsel to The Brass Utility, LLC) 
(recognizing BRUT as an ECN); and Letters dated Nov. 13, 1998 from 
Robert L.D. Colby, Deputy Director, Division of Market Regulation, 
SEC to: Lloyd H. Feller, Morgan, Lewis & Bockius LLP (counsel to 
Strike Technologies LLC) (recognizing the Strike System as an ECN); 
John M. Schaible, PIM Global Equities, Inc. (recognizing the Trading 
System as an ECN).
---------------------------------------------------------------------------

    Since the Order Handling Rules were implemented, the spread between 
bids and offers in covered securities has narrowed dramatically.\179\ 
This has benefited investors, including retail investors, who have 
enjoyed significant cost savings when trading covered securities.\180\
---------------------------------------------------------------------------

    \179\ Quoted spreads, which measure the difference between the 
inside ask and the inside bid, have declined by forty-one percent. 
The effective spread, which takes into account that trades may occur 
inside or outside the quoted spread, declined by twenty-four 
percent. The lower decline in the effective spread is due to a 
decline in trading inside the spread. See NASD Economic Research, 
Market Quality Monitoring: Overview of 1997 Market Changes (Mar. 17, 
1998).
    \180\ A covered security is defined in the same way as it is 
under Rule 11Ac1-1(a)(6), 17 CFR 240.11Ac1-1. Specifically, a 
``covered security'' is any security reported by an effective 
transaction reporting plan and any other security for which a 
transaction report, last sale data, or quotation information is 
disseminated through an automated quotation system as described in 
section 3(a)(51)(A)(ii) of the Exchange Act, 15 U.S.C. 
78c(a)(51)(A)(ii). See Rule 300(g). Accordingly, a covered security 
includes all exchange-listed securities, Nasdaq NM securities, and 
Nasdaq SmallCap securities.
---------------------------------------------------------------------------

    These rules, however, were not intended to fully coordinate trading 
on alternative trading systems with public market trading.\181\ While 
these rules have helped integrate orders on certain alternative trading 
systems into the public quotation system, they only disclose the orders 
market makers and specialists enter into ECNs, unless the system 
voluntarily undertakes to disclose institutional prices.\182\ In many 
cases, institutional orders, as well as other non-market maker orders, 
remain undisclosed to the public.\183\ Moreover, it is voluntary for an 
ECN to reflect the best priced quotations in the public quotation 
system on behalf of market makers and specialists that participate in 
its system.
---------------------------------------------------------------------------

    \181\ See Order Handling Rules Adopting Release, supra note 177, 
at 87-96.
    \182\ There is divergence among ECNs in the extent to which they 
have chosen to integrate non-market maker orders into the prices 
they display to the public. Several of the nine ECNs that are 
currently linked to Nasdaq display to the public the best prices of 
any orders entered into their systems (including both market makers 
and institutions).
    \183\ Because such trading interest frequently remains 
undisclosed, within certain alternative trading systems non-market 
maker participants are able to display prices that lock and cross 
the public quotations. If the quotes of such participants were 
disclosed to the public, the Commission believes it would result in 
improved price opportunities for public investors.
---------------------------------------------------------------------------

    Because certain trading interest on alternative trading systems is 
not integrated into the national market system, price transparency is 
impaired and dissemination of quotation information is incomplete. 
These developments are contrary to the goals the Commission enunciated 
over twenty-five years ago when it noted that an essential purpose of a 
national market system:

    [I]s to make information on prices, volume, and quotes for 
securities in all markets available to all investors, so that buyers 
and sellers of securities, wherever located, can make informed 
investment decisions and not pay more than the lowest price at which 
someone is willing to sell, and not sell for less than the highest 
price a buyer is prepared to offer.\184\
---------------------------------------------------------------------------

    \184\ See SEC, Statement of the Securities and Exchange 
Commission on the Future Structure of the Securities Markets (Feb. 
2, 1972), 37 FR 5286 (Feb. 4, 1972) (emphasis added).
---------------------------------------------------------------------------

(ii) Integration of Orders Into the Public Quotation System
    Alternative trading systems are becoming increasingly popular 
venues for trading securities. Because these systems are not registered 
exchanges and do not participate in the national market system, there 
is a possibility that our securities markets could become less 
transparent over time.\185\ The Commission believes that it is 
inconsistent with congressional goals for a national market system if 
the best trading opportunities are made accessible only to those market 
participants who, due to their size or sophistication, can avail 
themselves of prices in alternative trading systems. The vast majority 
of investors may not be aware that better prices are disseminated to 
alternative trading system subscribers and many do not qualify for 
direct access to these systems and do not have the ability to route 
their orders, directly or indirectly, to such systems. As a result, 
many customers, both institutional and retail, do not always obtain the 
benefit of the better prices entered into an alternative trading 
system. As the American Association of Individual Investors pointed 
out, ``(s)imply stated, investors benefit, as do markets, from knowing 
the full array of best-priced orders from all sources * * * It is in 
the best interests of individual investors that alternative trading 
systems disseminate best-priced orders into quotation systems that are 
available to the public.'' \186\
---------------------------------------------------------------------------

    \185\ In the Concept Release, supra note 2, the Commission 
considered whether to require certain alternative trading systems to 
register as exchanges. This approach would have addressed the 
Commission's concerns about lack of transparency by requiring 
certain significant alternative trading systems to participate 
directly in the national market system plans. Commenters to the 
Concept Release, however, expressed concerns about requiring 
alternative trading systems to register as exchanges, and that a 
much more workable and realistic approach would be to enhance the 
system of broker-dealer regulation under which alternative trading 
systems are currently regulated. For example, in recommending that 
the Commission consider allowing alternative trading systems to 
continue to be regulated as broker-dealers, the SIA commented that 
``additional steps to integrate aggregate trading interest on 
alternative trading systems to public view would be a sensible way 
of addressing concerns that may exist in the aftermath of the Order 
Handling Rules.'' See letter from A. B. Krongard, Chairman, 
Securities Industry Association Task Force on Alternative Trading 
System Concept Release to Jonathan G. Katz, Secretary, SEC, received 
Oct. 6, 1997.
    \186\ Letter from John Markese, President, American Association 
of Individual Investors, to Jonathan G. Katz, Secretary, SEC, dated 
Nov. 24, 1998 (``AAII Letter'') at 1.
---------------------------------------------------------------------------

(A) New Requirements for Alternative Trading Systems
    The Commission is adopting Exchange Act Rule 301(b)(3) to further 
enhance transparency of orders displayed on alternative trading 
systems, and to ensure that publicly displayed prices better reflect 
market-wide supply and demand. Specifically, this rule requires 
alternative trading systems with five percent or more of the trading 
volume in any ``covered security'' \187\ to publicly disseminate their 
best priced orders in those securities. These orders will then be 
included in the quotation data made available to quotation vendors by 
national securities exchanges and national securities 
associations.\188\ Only those orders that are displayed to more than 
one alternative trading system subscriber would be subject to the

[[Page 70866]]

public display requirement. As discussed in Section IV.A.2.c.iii. 
below, alternative trading systems are also required to provide all 
registered broker-dealers with access to these displayed orders.
---------------------------------------------------------------------------

    \187\ See supra note 180.
    \188\ 17 CFR 240.11Ac1-1.
---------------------------------------------------------------------------

    Importantly, the public display requirement in Rule 301(b)(3) 
applies only to orders in ``covered securities.'' The term ``covered 
securities'' includes only exchange-listed, Nasdaq NM, and Nasdaq 
SmallCap securities. Accordingly, alternative trading systems trading 
equity securities not included within the definition of ``covered 
security,'' or debt securities, would not be subject to the public 
display requirement under Regulation ATS.
    In the Proposing Release, the Commission proposed a public display 
requirement substantially similar to the one it is adopting today. The 
proposal, however, would have only required alternative trading systems 
to publicly display their best priced orders in a covered security when 
the system represents ten percent of the trading volume in that 
security. The Commission decided instead to adopt a five percent 
threshold in light of the comment letters, many of which supported the 
public display requirement and recommended that the volume threshold be 
lower than ten percent.
    In the Proposing Release, the Commission proposed that the display 
requirement be applied on a security-by-security basis and would not 
have required an alternative trading system to publicly display orders 
for any securities in which its trading volume accounted for less than 
ten percent of the total volume for such security. The Commission, 
however, requested comment on whether an alternative trading system 
should be required to display the best priced orders in all securities 
traded in its system, if it reaches the volume threshold in a specified 
number or percentage of the securities it trades.
    After considering the comments on the issue, the Commission is 
adopting the security-by-security approach as proposed. Although a 
system that trades more than the volume threshold in a substantial 
number of securities could be considered a significant market whose 
best prices in all securities should be transparent, for now the 
Commission has decided to take the security-by-security approach with a 
lower volume threshold (five percent) than proposed. The security-by-
security approach, among other things, will more readily enable the 
phase-in of securities subject to the transparency requirements as 
discussed below.
    The Commission emphasizes that, as proposed, Rule 301(b)(3) only 
requires alternative trading systems to publicly display subscribers' 
orders that are displayed to more than one other system subscriber. 
Thus, if an alternative trading system, like some crossing systems, by 
its design does not display orders to other subscribers, the rules do 
not require those orders to be integrated into the public quote 
stream.\189\ Similarly, if a portion of a subscriber's order is not 
displayed to other alternative trading system subscribers, that hidden 
portion is not subject to the public display requirement in Rule 
301(b)(3). Thus, the Commission's rules allow institutions and non-
market makers to guard the full size of their orders by using the 
``reserve size'' features offered by some alternative trading systems, 
which allow subscribers to display orders incrementally. For example, a 
subscriber that wishes to sell 100,000 shares of a given security could 
place its order in an alternative trading system and specify that only 
10,000 shares are to be displayed to other alternative trading system 
subscribers at a time. In this instance, Rule 301(b)(3) requires that 
only 10,000 shares be reflected in the public quote. The ability to 
continue to control how much of their own orders to reveal was a 
concern of several institutions who commented.\190\ Finally, 
alternative trading systems are not required to provide to the public 
quote stream orders displayed to only one other alternative trading 
system subscriber, such as through use of a negotiation feature.
---------------------------------------------------------------------------

    \189\ One commenter (who does not internally display orders) 
expressed its support for this aspect of the proposed transparency 
requirement, stating that, while exchanges and broker-dealers should 
be subject to the same public display requirement, if an alternative 
trading system did not display any orders to subscribers, it should 
not be required to publicly display those orders to non-subscribers 
through the public quotation stream. See OptiMark Letter at 4.
    \190\ See infra notes 206-207 and accompanying text.
---------------------------------------------------------------------------

    The Commission believes that in light of the significant trading 
volume on some alternative trading systems, integration of 
institutional and non-market maker broker-dealer orders into the 
national market system is essential to prevent the development of a 
two-tiered market. Trading anonymity will be preserved because an 
alternative trading system will comply with any public display 
requirement by identifying itself, rather than the subscriber that 
placed the order. Thus, the Commission's proposal, much like the ECN 
Display Alternative, is designed to preserve the benefits associated 
with anonymity. Moreover, the Commission believes that the continued 
ability of institutions to retain their anonymity and to use features 
within alternative trading systems to shield the full size of their 
orders gives institutions the ability to keep their full trading 
interest private. The Commission recognizes that anonymity is often 
important to institutional investors so that when they are unwinding or 
building security holdings they do not signal their trading strategy 
and negatively impact their own market position.\191\
---------------------------------------------------------------------------

    \191\ The Commission plans to monitor the effects of the reserve 
function on market liquidity and transparency.
---------------------------------------------------------------------------

    Requiring alternative trading systems to furnish to the public 
quotation system the full size of the best displayed buy and sell 
orders will ensure that the public quote better reflects true trading 
interest in a particular security. Furthermore, the Commission believes 
that institutional investors' orders entered into alternative trading 
systems provide valuable liquidity, and that displaying such trading 
interest will substantially strengthen the national market system. 
Moreover, this public display requirement levels the playing field 
between market makers--who, when they send customer limit orders to 
ECNs, the ECN must publicly display that order--and those ECNs, who do 
not have to display customer limit orders sent directly to the ECN.
    In order to monitor the effects of the public display requirement, 
however, the rules will permit affected alternative trading systems to 
phase-in institutional orders in covered securities.\192\ Before April 
21, 1999, the Commission will publish a schedule for the phase-in of 
individual securities. Fifty percent of the securities subject to the 
transparency requirement will be phased-in on April 21, 1999 and the 
remainder of the securities will be phased-in on August 30, 1999.\193\
---------------------------------------------------------------------------

    \192\ In addition to phasing in the transparency requirements 
for institutional orders, affected alternative trading systems may 
also choose to phase-in the access requirements for the covered 
securities. See infra notes 216-217 and accompanying text.
    \193\ The Commission notes that the later date will fall within 
the moratorium to facilitate Year 2000 conversion. Securities 
Exchange Act Release No. 40377 (Aug. 27, 1998), 63 FR 47051 (Sept. 
3, 1998). The Commission believes that the phase-in will not require 
major reprogramming, however, and consequently is not subject to the 
moratorium. In addition, alternative trading systems may voluntarily 
publicly display all non-market maker broker-dealer and 
institutional orders covered by the requirement on or before April 
21, 1999.
---------------------------------------------------------------------------

(B) Response to Comments
    The Commission requested comment on whether a ten percent volume

[[Page 70867]]

threshold would effectively ensure that alternative trading systems 
comprising a significant percentage of the market are subject to basic 
market transparency requirements. The commenters that responded to this 
issue were split on whether a ten percent volume threshold was too high 
or too low, although most felt it was too high and should be 
lowered.\194\ A few commenters, however, stated that they believed the 
volume thresholds were too low.\195\
---------------------------------------------------------------------------

    \194\ See AAII Letter at 1 (suggesting that the volume threshold 
be much lower than ten percent), NYSE Letter at 5 (stating that it 
believed a more appropriate level would be five percent of the 
aggregate daily volume in a security in any two of the three most 
recent months, because very few registered markets (exchanges and 
associations) accounted for more than ten percent of the volume in 
any security); CHX Letter at 8 (suggesting that the Commission 
require all alternative trading systems to display their best orders 
regardless of trading volume); NASD Letter at 1 (suggesting a volume 
threshold of one percent); American Century Letter at 5 (stating 
opposition to any volume threshold, as volume in any alternative 
trading system may be sporadic over time). See also ICI Letter at 3; 
IBEX Letter at 7-8; Ashton Letter at 4; TBMA Letter pp. 21-22 
(stating that it concurred that display of equity securities trading 
on alternative trading systems was beneficial to the market as a 
whole).
    \195\ See SIA Letter at 12 (stating that a volume level of ten 
percent had the potential to capture insignificant market players 
and therefore recommending that the Commission consider a level of 
twenty percent).
---------------------------------------------------------------------------

    As discussed above, the transparency requirement the Commission is 
adopting in Rule 301(b)(3) obligates an alternative trading system to 
disseminate into the public quote the best priced orders in each 
covered security in which the trading on such system represents more 
than five percent of total trading volume. The Commission is persuaded 
by commenters that stated that a ten percent threshold would exclude 
trading on too many alternative trading systems. The Commission 
believes that lowering the threshold to five percent will provide more 
benefits to investors, promote additional market integration, and 
further discourage two-tier markets. At the same time, the Commission 
believes that those alternative trading systems with less than five 
percent of the volume would not add sufficiently to transparency to 
justify the costs associated with linking to a market.
    The Commission requested comment on whether an alternative trading 
system should be required to display the best priced orders in all 
securities traded in its system, if it reaches the volume threshold in 
a specified number or percentage of the securities it trades. Of those 
commenters addressing this issue, most were in favor of display of the 
best priced orders in all securities traded on an alternative trading 
system once that alternative trading system exceeded the volume 
threshold in some fixed number of securities.\196\ The NYSE stated that 
if an alternative trading system developed a ``general presence'' in 
the market, for example by reaching the volume threshold in ten or more 
securities, that alternative trading system should display the best 
priced orders in all securities it trades. One commenter, however, 
specifically opposed the display of all securities traded on an 
alternative trading system rather than mandating display on a security-
by-security basis.\197\ This commenter also noted that even display on 
a security-by-security basis may capture a system that trades a 
significant amount of one security, despite the fact that that security 
was a minor part of the overall trading in the system. As discussed 
above, however, the Commission is adopting the rule as proposed.
---------------------------------------------------------------------------

    \196\ See ICI Letter at 2, n.5 (stating that the display 
requirement should apply to all securities and to all alternative 
trading systems, regardless of volume. The ICI stated that this 
would avoid the practice of routing to a particular system simply to 
avoid display); NYSE Letter at 5 (stating that if an alternative 
trading system developed a ``general presence'' in the market, for 
example by reaching the volume threshold in ten or more securities, 
that alternative trading system should display the best priced 
orders in all securities it traded); Ashton Letter at 4 (stating 
that once an alternative trading system achieved one percent in a 
given ``category'' of securities over a six month period, the system 
should be required to display its best orders in all the securities 
in that category); CHX Letter at 8 (stating that any volume 
threshold should be applied on an alternative trading system as a 
whole, not on a security-by-security basis, because of the burden of 
tracking security-by-security); American Century Letter at 5 
(commenting that a rule requiring public display of all orders 
displayed in an alternative trading system was preferable). See also 
IBEX Letter at 8; NASD Letter at 11. But see SIA Letter at 12.
    \197\ See SIA Letter at 13-14 (supporting display of orders on a 
security-by-security basis and recommending that the volume 
threshold be raised to twenty percent of the trading volume in that 
security nationwide; also stating that no orders should be required 
to be displayed in the public quotation stream unless the trading 
volume in that security on the alternative trading system exceeded 
twenty percent of the alternative trading system's overall trading 
activity). Of course, the Commission assumes that those commenters 
who opposed display of non-market maker orders generally would also 
oppose the display of all securities as well, rather than only those 
above a certain volume threshold. See infra notes 204-205.
---------------------------------------------------------------------------

    The Commission also requested comment on whether alternative 
trading systems should be required to display the full size of the best 
priced order, even if the full size is hidden from alternative trading 
system subscribers through use of a ``reserve size'' or similar 
feature. All commenters directly addressing this issue \198\ stated 
that the reserve feature should be maintained, especially if the 
Commission's rules as adopted required displayed institutional orders 
to be integrated into the public quotation stream. The Commission 
agrees that the reserve features are critical to institutions' ability 
to minimize the market impact of their orders. Further, when orders are 
not displayed to anyone, the Commission's concerns about a two-tiered 
market--where some market participants have information others do not--
are absent. Accordingly, Rule 301(b)(3) only requires alternative 
trading systems to publicly disseminate the best priced orders that are 
displayed to other alternative trading system subscribers.
---------------------------------------------------------------------------

    \198\ See ICI Letter at 3 (stating that the ICI supports display 
of institutional orders provided that the reserve size feature is 
retained, and provided that orders are displayed in the public 
quotation system under the name of the alternative trading system, 
and not the name of the subscriber placing the order, thereby 
preserving anonymity); IBEX Letter at 8-9 (stating that the 
``reserve size'' feature permitted alternative trading system 
subscribers to avoid adverse market impact and negotiate a larger 
transaction with a single counter-party, two features IBEX believes 
to be of considerable value. IBEX stated, however, that reserve size 
availability to subscribers to an alternative trading system should 
be contingent on an initial increment being publicly displayed; non-
subscribers being able to execute against the reserve size; and the 
full size and price of each increment being immediately reported, as 
executed, to the public quotation system); Ashton Letter at 6 
(stating that all orders up to 10,000 shares should be displayed, 
and that orders in excess of 10,000 shares, should have a minimum of 
10,000 shares publicly displayed; also stating that negotiation and 
reserve size features should be available to non-subscribers, as 
well as subscribers); American Century Letter at 5 (stating that it 
was ``imperative'' that the reserve feature be maintained, because 
it provided depth of supply and demand at a price, while protecting 
the order from being used as a ``free option'' by other participants 
in the market). See also Instinet Letter at 11-13 (arguing against 
total pre-trade transparency); Bloomberg Letter at 19 n.32 (noting 
reserve feature in the Tradebook System); Letter from Daniel G. 
Weaver, Associate Professor of Finance, Zicklin School of Business, 
Barauch College to Jonathan G. Katz, Secretary, SEC, dated Nov. 23, 
1998 (``Weaver Letter'') (stating that institutions will move their 
trading upstairs even if the full size of their orders is hidden 
from alternative trading system subscribers through their use of a 
``reserve size'' feature).
---------------------------------------------------------------------------

    The Commission requested comment on whether it would be more 
appropriate to adopt an alternative to Rule 301(b)(3) that would 
permit, but not require, the public display of the best-priced 
institutional orders displayed in a high volume alternative trading 
system. Under this alternative, an alternative trading system meeting 
the requirements of Rule 301(b)(3)(i) would only be required to provide 
to a national securities exchange or national securities association 
the best-priced orders in covered securities displayed in the 
alternative trading system by any broker or dealer and by any other 
subscriber that elects to make its orders available for public display. 
The

[[Page 70868]]

Commission requested comment on whether such an alternative would 
sufficiently address the Commission's concerns with transparency and 
fragmentation in the markets. The Commission is concerned, however, 
that this alternative could exacerbate the competitive disparities 
between broker-dealers and ECNs. Under the Order Handling Rules, 
different order display requirements are imposed on limit orders 
received by a market maker and forwarded to an ECN, than are imposed on 
orders entered directly into an ECN. One commenter expressed concern 
that this differential treatment could serve as a disincentive for 
customers to place orders with a broker-dealer that acts as a market 
maker in a security.\199\
---------------------------------------------------------------------------

    \199\ See Letter from Wessels, Arnold & Henderson, LLC to 
Jonathan G. Katz, Secretary, SEC, dated Nov. 12, 1997 (commenting on 
the Concept Release).
---------------------------------------------------------------------------

    Most commenters that expressed support for the display of 
institutional and non-market maker broker-dealer orders did so because 
the display of these orders would increase transparency and liquidity 
in the market. The Investment Company Institute (``ICI'') stated that 
it would support the display of institutional orders because it 
believed display of those orders would improve the overall transparency 
and liquidity of the market. This support, however, was contingent upon 
the continued availability of the ``reserve'' feature offered by some 
alternative trading systems.\200\ Another commenter, similarly, 
supported disclosure of institutional orders because displayed orders 
``are good for markets,'' and stated that there was no cause for 
concern that requiring institutions to display in the public quotation 
stream would lead to a decrease in orders displayed through alternative 
trading systems. In fact, this commenter stated its belief that the 
opposite would occur, and pointed to the proliferation of ECNs as 
evidence.\201\ The NYSE also commented that requiring display of 
institutional orders in the market would add transparency and 
liquidity. The NYSE added that it strongly believes all orders of high 
volume alternative trading systems, including orders of 10,000 shares 
or more, should be required to be publicly displayed.\202\ Ashton 
suggested that orders of up to 10,000 shares on all alternative trading 
systems should be fully displayed, and orders exceeding 10,000 shares 
should have at least 10,000 shares publicly displayed. Ashton stated 
that it believed this would strike the appropriate balance between 
displaying such orders and minimizing their market impact.\203\
---------------------------------------------------------------------------

    \200\ 7/28/98 ICI Letter at 2-3. In a later letter, the ICI 
requested clarification of whether certain orders the ICI described 
as ``non-firm'' would be subject to display under the Commission's 
rules. See Letter from Craig S. Tyle, General Counsel, ICI, to 
Jonathan G. Katz, dated November 13, 1998 (``11/13/98 ICI Letter''). 
See also the discussion supra at Section III.A.3.
    \201\ American Century Letter at 4-5.
    \202\ NYSE Letter at 6.
    \203\ Ashton Letter at 6.
---------------------------------------------------------------------------

    The commenters who opposed display of non-market maker broker-
dealer and institutional orders did so because of the market impact 
they felt such orders would have if displayed. Instinet stated that 
requiring the display of institutional orders would have several 
negative effects on the market. In particular, Instinet claimed that 
public display of institutional orders could have a ``significant 
negative impact'' on the price and volatility of a security, would 
divert this order flow to entities not subject to Regulation ATS or to 
offshore markets, and would curtail the ability of institutions to 
manage the securities transactions of the individual investors for whom 
they act as proxy.\204\ Instinet also stated that institutional and 
other non-market maker investors do not perform specialized market 
functions, and therefore should not be subject to mandatory display in 
the public quotation system. Finally, Instinet stated it believed that 
customers should be able to determine the transparency of their orders 
whether they were placed with a ``traditional brokerage firm'' or a 
firm ``that offers both traditional and electronic execution 
opportunities.'' \205\
---------------------------------------------------------------------------

    \204\ Instinet Letter at 3, 12, and 14.
    \205\ Id. at n.18 and n.23. See also Letter from David K. 
Whitcomb, Professor of Finance and Economics, Rutgers University to 
Jonathan G. Katz, Secretary, SEC, dated July 27, 1998 (``Whitcomb 
Letter'') at 2-3 (stating that institutions may, in some instances, 
feel strongly that displaying their orders more widely than to other 
participants in the alternative trading system is undesirable, and 
that, as a result, institutions may be induced to spread their 
business among firms on the basis of whether the alternative trading 
system has reached the volume threshold for public display of 
orders, rather than on the basis of quality of service.); Letter 
from Ruben Lee, Oxford Finance Group to Jonathan G. Katz, Secretary, 
SEC, dated July 28, 1998 (``Lee Letter'') at 2-3 (stating that while 
mandatory transparency might help retail investors monitor the 
quality of their executions and reduce the inequality in access to 
information that retail investors face, it could compromise 
efficiency and liquidity).
---------------------------------------------------------------------------

    The Commission is not persuaded by commenters that suggest that 
institutions currently willing to use alternative trading systems to 
display their orders to other alternative trading system subscribers, 
including other institutions, market-makers, and broker-dealers, will 
be less willing to use alternative trading systems that must display 
those orders to the public market. Our reasons are as follows. The 
primary group of market participants that will benefit from the public 
display of institutional orders is retail investors. Retail investors 
are not currently alternative trading system subscribers. To avoid 
market impact, institutions try to avoid signaling other institutions 
and market professionals, not retail investors. Almost all market 
professionals and a significant number of institutions already 
subscribe to alternative trading systems. Thus, the Commission believes 
that the additional exposure to the market should not affect 
institutions' behavior in their use of alternative trading systems. 
Moreover, to the extent that institutions want to display small sized 
orders in the public market, rather than their entire order, they will 
still be able to make use of an alternative trading system's ``reserve 
size'' feature. This will enable institutions to avoid exposing the 
total size of their order to the public market.
    The Commission also received numerous comment letters from 
institutions who expressed similar concerns. Some of these commenters 
appeared to be concerned that they might be forced to display all 
orders sent to alternative trading systems, even those orders, or those 
portions of orders, that are not displayed to any other alternative 
trading system subscribers.\206\ To the extent that these letters are 
concerned with ``full disclosure,'' that concern is misplaced. Instead, 
the Commission proposed, and is adopting, a public display requirement 
that applies only to those orders (or those portions of orders) that 
alternative trading system subscribers

[[Page 70869]]

have already decided to display to the large number of other 
alternative trading system subscribers. Institutions will remain free 
to use a reserve feature, if an alternative trading system has one, to 
not display full size of their orders to other alternative trading 
system subscribers. That non-display of total order size will also 
apply if that order is displayed in the public quote.
---------------------------------------------------------------------------

    \206\ See 7/28/98 ICI Letter; 11/13/98 ICI Letter; Letter from 
Rick Dahl, Chief Investment Officer, Missouri State Employees' 
Retirement System to Jonathan G. Katz, Secretary, SEC, dated Nov. 
12, 1998 (``Mosers Letter''); Letter from Russell Rhoads, Director 
of Equity Trading, and Michael B. Orkin, Chairman and CEO, Caldwell 
& Orkin, Inc. to Jonathan G. Katz, Secretary, SEC, dated Nov. 20, 
1998 (``Caldwell Letter''); Letter from Todd M. Sheridan, Senior 
Portfolio Manager, Caterpillar Investment Management Ltd. to 
Jonathan G. Katz, Secretary, SEC, dated Nov. 19, 1998; Letter from 
Praveen K. Gottipalli, Director of Investments, Symphony Asset 
Management to Jonathan G. Katz, Secretary, SEC, dated Nov. 20, 1998 
(``Symphony Letter''); Letter from Cinda A. Carmer, Senior 
Securities Trader, Heartland Capital Management, Inc. to Jonathan G. 
Katz, Secretary, SEC, dated Nov. 17, 1998; Letter from Patrick J. 
McCloskey, Senior Vice President, Wellington Management Company, LLP 
to Jonathan G. Katz, Secretary, SEC, dated Nov. 23, 1998 
(``Wellington Letter''); Letter from Carrie Canter, Principal, 
Equity Trading, Barrow, Hanley, Mewhinney & Strauss, Inc. to 
Jonathan G. Katz, Secretary, SEC, dated Nov. 12, 1998 (``Barrow 
Letter''). See also Weaver Letter (stating that if the Commission 
required institutions to display the full size of their orders, even 
if the full size is hidden from alternative trading system 
subscribers through their use of a ``reserve size'' feature, 
institutions will move their trading upstairs).
---------------------------------------------------------------------------

    Other commenters generally expressed concerns similar to those 
expressed by Instinet, emphasizing concerns about best execution for 
institutional orders, and expressing concern about increased market 
volatility.\207\ The Commission believes that display of institutional 
orders in the public quote stream will not harm best execution--if 
anything--best execution will be enhanced as all market participants 
will have an opportunity to execute against these orders. The 
Commission also believes that the experience with display of market 
maker orders under the Order Handling Rules suggests that display of 
institutional orders will not lead to increased market volatility. Many 
of the largest market participants already have access to alternative 
trading system institutional orders; therefore, their display in the 
public quote stream should not necessarily lead to increased market 
volatility. It will, however, allow those market participants who do 
not have access to these alternative trading systems to have the 
opportunity to execute against these orders.
---------------------------------------------------------------------------

    \207\ See Letter from Gary E. Shugrue, General Partner, Argos 
Partners Ltd., to Jonathan G. Katz, Secretary, SEC, dated Nov. 11, 
1998 (``Argos Letter''); Letter from Stacey Matthews, Chelsey 
Capital, to Jonathan G. Katz, Secretary, SEC, dated Nov. 16, 1998, 
(``Chelsey Letter''); Letter from John D. Race, Partner, DePrince, 
Race & Zollo, Inc., to Jonathan G. Katz, Secretary, SEC, dated Nov. 
16, 1998, (``DePrince Letter''); Letter from Michael W. Masters, 
Portfolio Manager, Masters Capital Investments, LLC, to Jonathan G. 
Katz, Secretary, SEC, dated Nov. 16, 1998, (``Masters Letter''); 
Letter from Denise O'Brien, Head of Equity Trading, Wanger Asset 
Management, LP, to Jonathan G. Katz, Secretary, SEC, received Nov. 
19, 1998, (``Wanger Letter''); Letter from Gerald N. Brown, Becker 
Capital Management, to Jonathan G. Katz, Secretary, SEC, received 
Nov. 19, 1998 (``Becker Letter''); Letter from Della L. Hood-Laster, 
V.P. Equity Trading, Loomis Sayles & Company, LP, to Jonathan G. 
Katz, Secretary SEC, dated Nov. 12, 1998, (``Loomis Letter''). See 
also Barrow Letter and Mosers Letter.
---------------------------------------------------------------------------

    Some of the letters the Commission has received since the beginning 
of November also express a concern that if institutional orders were 
publicly displayed, institutions would lose their anonymity.\208\ The 
Commission did not propose, nor is it adopting, any requirement that 
would jeopardize an institution's anonymity. Similar to the way in 
which ECNs currently display orders in the public quote, alternative 
trading systems would display their best priced orders in the public 
quote, but would not indicate which of their subscribers had entered 
the order.
---------------------------------------------------------------------------

    \208\ See Letter from Susan Ellis, Vice President, Trading, 
Granahan Investment Management, Inc. to Jonathan G. Katz, Secretary, 
SEC dated Nov. 16, 1998; Letter from Genrald N. Brown, Becker 
Capital Management to Jonathan G. Katz, Secretary, SEC received Nov. 
19, 1998; Letter from Teresa M. Brandt, Head Equity Trader, Advantus 
Capital Management, Inc. to Jonathan G. Katz, Secretary, SEC dated 
Nov. 19, 1998; Letter from Kristen Straubel, Head Trader and Robert 
T. Lutts, President, Cabot Money Management, Inc. to Jonathan G. 
Katz dated Nov. 20, 1998; Letter from Tracy Altebrando, Senior 
Equity Trader, Metropolitan Capital Advisors, Inc. to Jonathan G. 
Katz, Secretary, SEC, dated Nov. 25, 1998. See also Wanger Letter, 
Caldwell Letter, Symphony Letter, Wellington Letter.
---------------------------------------------------------------------------

    In addition, a number of institutional commenters suggested if 
Nasdaq had implemented its proposed limit order file, they would not 
oppose a requirement that alternative trading systems publicly display 
institutional orders, if those orders represent the best priced order 
in the alternative trading system they use.\209\ Unfortunately, none of 
these commenters explained why they would be willing to publicly 
display their orders through a Nasdaq sponsored central limit order 
file, but not publicly display orders they have chosen to display to 
other alternative trading system subscribers.
---------------------------------------------------------------------------

    \209\ See, e.g., Loomis Letter, Chelsey Letter.
---------------------------------------------------------------------------

    Finally, one commenter expressed concern that the order display 
rule would mean that retail investors would increasingly observe trades 
taking place below the bid and above the ask, and would be frustrated 
by their lack of access to these trades.\210\ Because certain 
institutions' orders will now be displayed in the public quote, 
however, retail investors will have access to them. The lack of access 
retail investors currently have to alternative trading systems is one 
of the reasons the Commission believes that the display of 
institutional orders in the public quote stream is particularly 
important. In addition, this commenter stated that requiring public 
display of institutional orders would tilt the playing field in favor 
of dealers who do not have to display institutional orders.\211\ Under 
the Order Handling Rules, however market makers are required to display 
all customer limit orders that improve their quote.
---------------------------------------------------------------------------

    \210\ Letter from Ed Restrepo, Head Trader, VanWagoner Capital 
Management to Jonathan G. Katz, Secretary, SEC, dated Nov. 16, 1998 
(``VanWagoner Letter'').
    \211\ See VanWagoner Letter. See also Letter from Stacey Carter 
Fleece, Chief Financial Officer, Brookhaven Capital Management to 
Jonathan G. Katz, Secretary, SEC dated Nov. 18, 1998 (stating that 
institutional orders submitted to dealers do not have to be 
published); Letter from John D. Robinson, Head Trader, Longwood 
Asset Management to Jonathan G. Katz, Secretary, SEC, dated Nov. 25, 
1998.
---------------------------------------------------------------------------

    For these reasons, the Commission agrees with those commenters who 
believe that institutional orders that are displayed to subscribers of 
an alternative trading system should be integrated into the public 
quotation system if they represent the top of the book in the 
alternative trading system.\212\ The Commission believes that any 
market impact that results from such display will be vitiated by the 
retention of the reserve feature, as discussed above. The Commission 
notes that such institutional orders are currently displayed to the 
subscribers of alternative trading systems, who may number in the 
thousands. These subscribers are often the market makers and other 
active traders in the security. As a result, prices displayed only on 
alternative trading systems are immediately known to key market players 
who can adjust their trading to take advantage of their information 
advantage. Moreover, the Commission believes that these orders will 
provide enhanced transparency and liquidity when integrated into the 
public quotation stream, and will further curtail the development of a 
two-tiered market.
---------------------------------------------------------------------------

    \212\ Under Rule 301(b)(3), non-market maker broker-dealer 
orders entered into alternative trading systems must also be 
displayed. 17 CFR 242.302(b)(3).
---------------------------------------------------------------------------

    Nonetheless, the Commission is concerned about commenters' 
statements that institutions may react to the transparency requirement 
by shipping more orders upstairs or overseas. The Commission intends to 
closely monitor the impact of this requirement, and will modify it if 
harm appears to result.
(iii) Access to Publicly Displayed Orders
(A) Application of Access Requirements Under Regulation ATS
    The Commission believes that in addition to the display of better 
alternative trading system prices in the public quotation system, the 
availability of such trading interest to public investors is an 
essential element of the national market system. Therefore, the 
Commission proposed that alternative trading systems afford all non-
subscriber broker-dealers equivalent access to the alternative trading 
system orders displayed in the public quote, similar to the manner in 
which ECNs currently comply with the ECN Display

[[Page 70870]]

Alternative under the Quote Rule.\213\ The Commission agrees with those 
commenters who stressed the importance of equivalent access for non-
participants and who stated that simply requiring alternative trading 
systems to display prices in the public quotation system does not go 
far enough to facilitate the best execution of customer orders without 
a mechanism to access orders at those prices.\214\ Accordingly, the 
Commission is adopting the requirement as proposed.\215\ Specifically, 
with respect to any security in which an alternative trading system is 
required to publicly display its best priced orders because it has five 
percent or more of all trading in that security, such alternative 
trading system must provide for members of the SRO with which it is 
linked the ability to effect a transaction with those orders. As 
discussed above, the Commission is phasing in the public display 
requirement.\216\ In addition, alternative trading systems are not 
required to provide access to a security until the public display 
requirement is effective for that security.\217\
---------------------------------------------------------------------------

    \213\ Rule 11Ac1-1(c)(5)(ii), 17 CFR 240.11Ac1-1(c)(5)(ii) 
(``Quote Rule''). See also Order Handling Rules Adopting Release, 
supra note 177.
    \214\ See infra note 218 and accompanying text.
    \215\ Rule 301(b)(5), 17 CFR 242.301(b)(5).
    \216\ See supra notes 192-193 and accompanying text.
    \217\ The Commission emphasizes that, as with the transparency 
phase-in, alternative trading systems may voluntarily provide access 
to non-subscribers on or before April 21, 1999 in all securities 
covered by the rule.
---------------------------------------------------------------------------

    The Commission believes that non-subscribing broker-dealers should 
be able to execute against those alternative trading system orders that 
are publicly displayed to the same extent as if that price had been 
reflected in the public quote by a national securities exchange or 
national securities association. Thus, an alternative trading system 
should respond to orders entered by non-participants no slower than it 
responds to orders entered directly by subscribers. The Commission 
believes that, under current NASD rules, any alternative trading system 
that allows non-subscribing broker-dealers to execute against publicly 
displayed alternative trading system orders in the same manner as ECNs 
linked to the Nasdaq market currently do would comply with this 
requirement. The NASD does not currently require ECNs to automatically 
execute orders sent to the ECN through the NASD's SelectNet linkage 
with the ECN. Any SRO to which alternative trading systems may be 
linked, may determine that it is necessary for the fair and orderly 
operation of its market to require that publicly displayed alternative 
trading system orders be subject to automatic execution. Any such 
proposed rule change, of course, would have to be filed with the 
Commission by the SRO, published for comment, and approved by the 
Commission. The Commission would not approve any such SRO rule unless 
it finds that such rule is consistent with the Exchange Act.
(B) Response to Comments
    The Commission asked for comment on whether alternative trading 
systems should be required to provide non-subscribers with equivalent 
access to displayed orders. Several commenters responded to this issue. 
Most of these commenters stated that non-subscribers should be given 
equivalent access.\218\ Only one commenter cautioned against granting 
such access. This commenter argued that alternative trading systems and 
traditional broker-dealers engage in the same business and, therefore, 
it would impede innovation as well as be unfair to require fair access 
to trading opportunities on alternative trading systems when the 
Commission is not proposing to require such access to more traditional 
broker-dealers.\219\ The Commission does not believe that alternative 
trading systems and traditional broker-dealers engage in the same 
business.\220\ As discussed above, the Commission believes that the 
public display of orders on alternative trading systems that are 
currently displayed only to the subscribers of those alternative 
trading systems will improve the public securities markets. Without a 
mechanism to access these orders, any public display requirement is 
insufficient. Accordingly, the Commission is adopting the fair access 
requirement.
---------------------------------------------------------------------------

    \218\ See ICI Letter at 3; IBEX Letter at 9-10; Ashton Letter at 
6; American Century Letter at 2; OptiMark Letter at 4.
    \219\ Instinet Letter at 10.
    \220\ See supra notes 205-212 and accompanying text.
---------------------------------------------------------------------------

    In the Proposing Release, the Commission also stated that it 
believes that for an alternative trading system to comply with this 
equivalent execution access requirement, the publicly displayed 
alternative trading system orders would need to be subject to automatic 
execution through small order execution systems operated by the SRO to 
which the alternative trading system is linked. One commenter strongly 
urged the Commission to eliminate the automatic execution access 
requirements from its proposal. This commenter was opposed to such a 
linkage, because it believed it would effectively eliminate pure agency 
brokers from markets in covered securities, because brokers would be 
required to commit capital if automatic execution resulted in multiple 
executions against client orders. This commenter also noted that the 
Commission's Order Handling Rules do not require automatic execution, 
but require only that response times for non-subscriber trade requests 
are no slower than response times for subscribers, and believed this to 
be a more balanced approach to execution access issues. \221\ 
Similarly, American Century, while supporting equivalent access to non-
subscribers, stated that automatic execution access requirements were 
risky as well, because of the possibility of double execution.\222\ The 
Commission does not expect--by operation of its rules alone--that 
alternative trading systems will be subject to automatic execution 
through SROs' small order execution systems. Nevertheless, the 
Commission believes that an SRO to which an alternative trading system 
is linked should be able to establish rules regarding how that 
alternative trading system is integrated into its market. The 
Commission notes that any change to SRO rules regarding automatic 
execution would have to be approved by the Commission after notice and 
the opportunity for the public to comment, and subject to Commission 
review for competitive fairness and consistency with the Exchange Act.
---------------------------------------------------------------------------

    \221\ Instinet Letter at 16-17.
    \222\ American Century Letter at 2.
---------------------------------------------------------------------------

    In addition, the Commission asked if there was a feasible way to 
allow market-wide interaction without linkage to SRO order execution 
systems, and whether there was a feasible way to grant equivalent non-
subscriber access to institutions that are not broker-dealers.
(iv) Execution Access Fees
(A) Limitations on Alternative Trading System Fees Charged to Non-
Subscribers
    In the Proposing Release, the Commission stated that an alternative 
trading system's fee schedules should not be used to circumvent the 
ability of non-participants to access a system's publicly displayed 
orders.\223\ Because reasonable fees are a component of equal access, 
the rules the Commission is adopting today prohibit an alternative 
trading system from setting fees that are inconsistent with the 
principle of equivalent access to the alternative trading system quotes 
by members of the SRO to which the alternative trading

[[Page 70871]]

system is linked. The rules also require an alternative trading system 
to comply with the rules or standards governing fees established by the 
national securities exchange or national securities association through 
which non-subscribers have access.\224\
---------------------------------------------------------------------------

    \223\ See Proposing Release, supra note 3, at n. 108.
    \224\ Rule 301(b)(4), 17 CFR 242.301(b)(4).
---------------------------------------------------------------------------

    The Commission believes that fees charged by an alternative trading 
system would be inconsistent with equivalent access if they have the 
effect of creating barriers to access for non-subscribers. As the 
Commission stated in adopting the Order Handling Rules, any ECN fees 
should be similar to the communications or systems charges imposed by 
various markets.\225\ In addition, the Commission believes that the 
national securities exchange or national securities association to 
which the alternative trading system provides the prices and sizes of 
its best priced orders should have further authority to assure that 
fees charged by alternative trading systems to non-subscribers are 
disclosed or otherwise consistent with fees typically charged by the 
members of the exchange or association for access to displayed orders. 
There are a number of ways the exchange or association could address 
the issue of fees charged by alternative trading systems. For example, 
subject to Commission review and approval, an exchange or association 
could establish a standard for what constitutes a fair and reasonable 
fee for non-subscriber access to an alternative trading system, 
consistent with the effective operation of the self regulatory 
organization's market and the Commission's equivalent access 
requirement. The exchange or association may also require alternative 
trading system fees to be charged in a manner consistent with the 
exchange's or association's market, such as requiring the fee to be 
incorporated in the displayed quote.
---------------------------------------------------------------------------

    \225\ See Order Handling Rules Adopting Release, supra note 177, 
at n.272.
---------------------------------------------------------------------------

    At such time as quotations in the national market system are 
reflected in decimals rather than in fractions, the Commission will 
reconsider the rule's limitation on alternative trading systems 
charging fees only as permitted by the national securities exchange or 
national securities association to which they are linked. At that time, 
the Commission will also consider whether alternative trading systems 
should be permitted or required to reflect any fee charged in their 
quotations.
    Any rules the exchange or association develops will of course need 
to be consistent with the goals of promoting competition and protecting 
investors. The Commission encourages SROs that accept alternative 
trading system quotes to work with alternative trading systems to 
develop uniform standards regarding display and execution access by SRO 
members to alternative trading systems linked to the SRO.\226\ In 
addition, to foster equivalent access to alternative trading systems 
for exchange-listed securities, the Commission expects Intermarket 
Trading System (``ITS'') participants to modify ITS Plan requirements 
where necessary to accommodate alternative trading system participation 
in the markets of ITS participants, and access to those alternative 
trading systems through ITS. If the SROs and ITS participants cannot 
come to terms with affected alternative trading systems within a 
reasonable time, the Commission will consider exercising its authority 
to mandate the necessary linkages.
---------------------------------------------------------------------------

    \226\ See, e.g., NASD Rule 4623. Securities Exchange Act Release 
Nos. 38156 (Jan. 10, 1997), 62 FR 2415 (Jan. 16, 1997); 38008 (Dec. 
2, 1996), 61 FR 64550 (Dec. 5, 1996).
---------------------------------------------------------------------------

(B) Response to Comments
    The Commission requested comment on the fees that alternative 
trading systems should be permitted to charge non-subscribers under the 
proposed rules. In addition, the Commission requested comment on 
whether there were alternatives for assuring fair execution access for 
non-subscribers other than limiting fees, or another test for 
determining whether non-subscriber fees assure equal access.
    Ten comment letters addressed the issue of fees charged by 
alternative trading systems for access by non-subscribers. Of these, 
seven were generally in favor of permitting alternative trading systems 
to charge some fee to non-subscribers,\227\ two were opposed,\228\ and 
one felt the issue needed to be addressed in a separate release by the 
Commission.\229\
---------------------------------------------------------------------------

    \227\ See ICI Letter at 3; Instinet Letter at 17-18; NASD Letter 
at 12; American Century Letter at 2; OptiMark Letter at 5. See also 
IBEX Letter at 11 (opposing allowing SROs to dictate a fee schedule 
for alternative trading systems, in which fees charged non-
subscribers are lower than those charged subscribers), Ashton Letter 
at 6, n.7 (opposed to the idea that non-subscribers be linked 
through an SRO execution system only).
    \228\ See NYSE Letter at 7; CHX Letter at 8-10.
    \229\ SIA Letter at 17 (stating that fees imposed by alternative 
trading systems raised a number of procedural, structural and policy 
issues, and recommending that the Commission make these the subject 
of a separate release).
---------------------------------------------------------------------------

    Most of the commenters who were in favor of allowing fees stated 
that fees should be ``reasonable,'' or should not exceed the fees 
typically charged to subscriber broker-dealers. The NASD, while not 
opposing such fees, stated that the Commission should reconsider the 
benchmark for an alternative trading system's fees, because it believed 
that for many alternative trading systems, non-subscriber orders were 
of primary importance. Because of this, the NASD stated that any fees 
should be set at the low end of the threshold, rather than at the level 
that a ``substantial proportion'' of an alternative trading system's 
broker-dealer customers were paying. The NASD supported permitting SROs 
to regulate fees, so that such issues could be discussed at the SRO 
level. The NASD also recommended that the Commission discuss ``the 
practical issues related to billing disputes and refusals to trade,'' 
because billing disputes have led to locked and crossed markets.\230\ 
Finally, the NASD asked the Commission to address the best execution 
obligations of market participants when a fee is not included in the 
publicly displayed price of an order. A broker-dealer's duty of best 
execution requires it to seek the most favorable terms reasonably 
available under the circumstances for a customer's transaction. While 
price is the predominant element of best execution, the traditional 
non-price factors of executions should also be considered.\231\
---------------------------------------------------------------------------

    \230\ NASD Letter at 12. See also ICI Letter at 3 (recommending 
that alternative trading systems be required to comply with any SRO 
rules limiting fees).
    \231\ See Order Handling Rules Adopting Release, supra note 177, 
at nn.347-65 and accompanying text; Division of Market Regulation, 
Division of Market Regulation, Market 2000: An Examination of 
Current Equity Market Developments App V (1994) (``Market 2000 
Study'').
---------------------------------------------------------------------------

    Instinet commented that market forces should determine the 
appropriate fees that broker-dealers can charge for their services. 
Consequently, Instinet opposed any proposal to limit (or eliminate 
entirely) access fees charged by a broker-dealer subject to Regulation 
ATS if the rules of the national securities exchange or association to 
which the broker-dealer is linked limits (or prohibits) such fees. The 
Commission will, of course, review any proposed SRO rules relating to 
access fees. To be approved by the Commission, any such rules must be 
necessary to maintain consistency within the SRO's market, as well as 
being designed to promote just and equitable principles of trade, to 
promote fair competition, to facilitate transactions in securities, 
and, in general, to protect investors and the public interest.\232\ 
Instinet also stated,

[[Page 70872]]

however, that it would urge the Commission to ensure that all public 
execution access fee requirements were handled in such a way that all 
orders integrated into the public quote stream were treated 
consistently, and so that all broker-dealers were able to set 
appropriate fees for the services they performed, subject to SRO 
rules.\233\
---------------------------------------------------------------------------

    \232\ While SRO proposed rule changes relating to fees imposed 
by the SRO are eligible to become effective upon filing under 
section 19(b)(3)(A)(ii) of the Exchange Act, and Rule 19b-4(e)(2) of 
the Exchange Act, the Commission continues to require SROs to file 
proposed rule changes regarding fees applicable to non-members or 
non-participants under section 19(b)(2) for full notice and comment. 
See Securities Exchange Act Release No. 35123 (Dec. 20, 1994), 59 FR 
66692 (Dec. 28, 1994). Thus, a proposed SRO rule relating to fees 
that alternative trading systems charge would not be eligible to 
become effective upon filing.
    \233\ Instinet Letter at 17-18 (also stating that the SRO to 
which an alternative trading system belonged should not be 
authorized to set fees).
---------------------------------------------------------------------------

    American Century stated that all market participants who posted 
bids and offers, not just alternative trading systems, should be 
permitted to charge fees. American Century recommended that 
participants who provide liquidity be permitted to charge a fee for 
that liquidity, and that those who took liquidity should pay fees.\234\ 
OptiMark stated that the Commission should consider what economic 
incentive it would be creating by permitting alternative trading 
systems that register as broker-dealers to charge fees, but not 
permitting those that register as exchanges to do so.\235\
---------------------------------------------------------------------------

    \234\ American Century Letter at 2 (also agreeing that 
decimalization will provide a more valid framework for this pricing 
structure). See also ICI Letter at 3, n.8 (stating that market 
makers should be able to assess liquidity fees when their quotes are 
``hit'').
    \235\ OptiMark Letter at 4-5.
---------------------------------------------------------------------------

    The Commission also requested comment on whether fees should be 
included in the price of an order quoted to the public, particularly 
once orders are quoted in decimals. In this regard, the NYSE and the 
Chicago Stock Exchange (``CHX'') stated that fees made it difficult to 
determine the true cost of executing an order and indicated that this 
would change if fees could be included in the quote.\236\ As discussed 
above, when quotations in the national market system are reflected in 
decimals rather than fractions, the Commission will reconsider whether 
alternative trading systems should reflect any fees charged in their 
quote, and if so, whether they should be subject to SRO requirements.
---------------------------------------------------------------------------

    \236\ NYSE Letter at 7 (stating that such fees could make it 
impossible for market participants to determine the true cost of 
executing orders, but indicating that if fees were included in the 
disseminated quotation that would be acceptable); CHX Letter at 8-10 
(alternatively, CHX suggested the Commission allow firms to ignore 
alternative trading system quotes at the NBBO if the next price 
available after payment of the access fee is worse than the next 
best available execution). But see IBEX Letter at 11 (opposing 
including fees in the public quote).
---------------------------------------------------------------------------

(v) Amendment to Rule 11Ac1-1 Under the Exchange Act
    The Commission also proposed an amendment to Rule 11Ac1-1 under the 
Exchange Act.\237\ The amendment would expand the ECN Display 
Alternative to allow alternative trading systems that display orders 
and provide equal execution access to those orders under Rule 301(b)(3) 
of Regulation ATS to fulfill market makers' and specialists' 
obligations under the Quote Rule. Only two comment letters addressed 
the proposed amendment to the Quote Rule, both of which supported 
it.\238\
---------------------------------------------------------------------------

    \237\ See supra note 213.
    \238\ See Ashton Letter at 6 (suggesting that the Commission 
consider amending the Quote Rule to require all exchanges, over-the-
counter dealers, and alternative trading systems to disseminate to 
the public quote the actual size behind the best bid and offer 
quotations). See also IBEX Letter at 11.
---------------------------------------------------------------------------

    The Commission is adopting the amendment to the Quote Rule as 
proposed.\239\ The Quote Rule currently requires all market makers and 
specialists to make publicly available any superior prices that it 
privately offers through ECNs. The ECN Display Alternative in the Quote 
Rule permits an ECN to fulfill these obligations on behalf of market 
makers and specialists using its system by submitting the ECN's best 
market maker or specialist priced quotation to an SRO for inclusion 
into the public quotation.\240\ Today's amendment to the Quote Rule is 
intended to expand the ECN Display Alternative to allow alternative 
trading systems that display orders and provide equal execution access 
to those orders under Rule 301(b)(3) of proposed Regulation ATS to 
fulfill market makers' and specialists' obligations under the Quote 
Rule.
---------------------------------------------------------------------------

    \239\ Rule 11Ac1-1(c)(5)(ii)(A) and (B), 17 CFR 11Ac1-
1(c)(5)(ii)(A) and (B).
    \240\ See supra notes 177-183 and accompanying text.
---------------------------------------------------------------------------

d. Fair Access
(i) Importance of Fair Access
    The Exchange Act requires registered exchanges and national 
securities associations to consider the public interest in 
administering their markets and to establish rules designed to admit 
members fairly.\241\ These requirements are intended to ensure that 
markets treat investors and other market participants fairly.\242\ 
Alternative trading systems that choose to register as exchanges will 
be subject to these requirements. Under the current regulatory 
approach, however, there is no mechanism to prevent unfair denials or 
limitations of access by alternative trading systems or regulatory 
oversight of such denials or limitations of access. Access to 
alternative trading systems may not be critical when market 
participants are able to substitute the services of one alternative 
trading system with those of another. However, when an alternative 
trading system has a significantly large percentage of the volume of 
trading, unfairly discriminatory actions hurt investors lacking access 
to the system.
---------------------------------------------------------------------------

    \241\ Sections 6(b)(2) and 6(c) of the Exchange Act, 15 U.S.C. 
78f(b)(2) and (c); section 15A(b)(8) of the Exchange Act, 15 U.S.C. 
78o-3(b)(8).
    \242\ ``Restraints on membership cannot be justified as 
achieving a valid regulatory purpose and, therefore, constitute an 
unnecessary burden on competition and an impediment to the 
development of a national market system.'' H.R. Rep. No. 123, 94th 
Cong., 1st Sess. 53 (1975).
---------------------------------------------------------------------------

    Fair treatment by alternative trading systems of potential and 
current subscribers is particularly important when an alternative 
trading system captures a large percentage of trading volume in a 
security, because viable alternatives to trading on such a system are 
limited. Although the Commission is adopting rules to require 
alternative trading systems with significant trading volume to publicly 
display their best bid and offer and provide equal access to those 
orders,\243\ direct participation in alternative trading systems offers 
benefits in addition to execution against the best bid and offer. For 
example, participants can enter limit orders into the system, rather 
than just execute against existing orders on a fill-or-kill basis. 
Participants in an alternative trading system can view all orders, not 
just the best bid or offer, which provides important information about 
the depth of interest in a particular security. Participants also have 
access to unique features of alternative trading systems, such as 
``negotiation'' features, whereby one participant can send orders to 
another participant proposing specific terms to a trade, without either 
participant revealing its identity. Some alternative trading systems 
also allow participants to enter ``reserve'' orders which hide the full 
size of an order from view. Because of these advantages to participants 
in an alternative trading system, access to the best bid and offer 
through an SRO is an incomplete substitute. Therefore, the rules the 
Commission is adopting today require most alternative trading systems 
that are registered as broker-dealers and that have a significant 
percentage of overall trading volume in a particular security to comply 
with fair access standards, as described in more detail below.\244\
---------------------------------------------------------------------------

    \243\ See supra Section IV.A.2.c.(ii).
    \244\ Rule 301(b)(5), 17 CFR 242.301(b)(5). Alternative trading 
systems that derive their prices for securities from prices for 
those same securities on another market are not subject to this 
requirement.

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

[[Page 70873]]

(ii) Fair Access Requirement
    The Commission is adopting Exchange Act Rule 301(b)(5) to ensure 
that qualified market participants have fair access to the nation's 
securities markets. As the Commission proposed, an alternative trading 
system registered as a broker-dealer and subject to Regulation ATS will 
be required to establish standards for access to its system and apply 
those standards fairly to all prospective subscribers, if the 
alternative trading system, during four of the preceding six months, 
accounts for twenty percent or more of the trading volume.\245\ This 
twenty percent volume threshold will be applied on a security-by-
security basis for equity securities.\246\ Accordingly, if an 
alternative trading system accounted for twenty percent or more of the 
share volume in any equity security, it must comply with the fair 
access requirements in granting access to trading in that security.
---------------------------------------------------------------------------

    \245\ The Commission notes that this twenty percent volume 
threshold is based on current market conditions. If there is a 
change in these market conditions, or if the Commission believes 
that alternative trading systems with less than twenty percent of 
the trading volume are engaging in inappropriate exclusionary 
practices or in anticompetitive conduct, the Commission may revisit 
these fair access thresholds. The Commission intends to monitor the 
impact and effect of these fair access rules, as well as the 
practices of alternative trading systems, and will consider changing 
these rules if necessary to prevent anticompetitive behavior and 
ensure that qualified investors have access to significant sources 
of liquidity in the securities markets.
    \246\ The term ``equity security'' is defined in section 
3(a)(11) of the Exchange Act, 15 U.S.C. 78c(a)(11) and Rule 3a1-1, 
17 CFR 240.3a1-1. Options and limited partnerships are included 
within the definition of an equity security.
---------------------------------------------------------------------------

    For debt securities, the Commission proposed that if an alternative 
trading system accounted for twenty percent or more of the volume in 
any category of debt security, the alternative trading system would be 
subject to the fair access requirements in granting access to trading 
in securities in that category. The Commission solicited comment on the 
appropriate categories of debt securities. Specifically, the Commission 
asked whether categories such as mortgage and asset-backed securities, 
municipal securities, corporate debt securities, foreign corporate debt 
securities, and foreign sovereign debt securities would be appropriate. 
After considering the comments, the Commission is adopting rules that 
require alternative trading systems with twenty percent or more of the 
volume in municipal securities, investment grade corporate debt 
securities, and non-investment grade corporate debt securities to meet 
the fair access requirements with respect to that category. The 
Municipal Securities Rulemaking Board's transaction reporting plan now 
provides information on the aggregate trading in municipal 
securities.\247\ The fair access requirement will be effective for 
alternative trading systems with twenty percent or more of the volume 
in municipal securities on April 21, 1999.
---------------------------------------------------------------------------

    \247\ See supra Section IV.A.1.d.
---------------------------------------------------------------------------

    Because similar information for investment grade and non-investment 
grade corporate debt, however, is not currently available, the fair 
access requirements in Rule 301(b)(5)(D) and (E) will not be made 
effective until April 1, 2000 with the expectation that further 
information will be available at that time.\248\ The Commission is 
deferring action on the fair access standards for alternative trading 
systems trading a substantial portion of the market in foreign 
corporate debt and foreign sovereign debt until such time as reliable 
data is available by which alternative trading systems may determine 
their relative portion of the market.
---------------------------------------------------------------------------

    \248\ See supra note 146 (discussing the April 1, 2000 effective 
date).
---------------------------------------------------------------------------

    The Commission is excluding from the fair access requirement those 
alternative trading systems that match customer orders for securities 
with other customer orders, at prices for those same securities 
established outside such system.\249\ Thus, regardless of their trading 
volume, systems that, for example, match customer orders prior to the 
market opening and then execute those orders at the opening price for 
the securities are not required to comply with the fair access 
requirement. In addition, systems that match unpriced orders at the 
mid-point of the bid and ask, or at a value weighted average or prices 
on another market are not subject to the fair access requirements. The 
Commission, however, would not consider an alternative trading system 
to be excluded from the fair access requirements in paragraph (b)(5) of 
Rule 301 if that system priced any security traded on that system using 
prices established outside such system for instruments other than the 
particular security being executed. Therefore, a system would not be 
excluded if it traded options or other derivatives based on prices 
established on the primary market for the underlying security.
---------------------------------------------------------------------------

    \249\ Rule 301(b)(5)(iii), 17 CFR 242.301(b)(5)(iii).
---------------------------------------------------------------------------

    Alternative trading systems subject to this fair access requirement 
must comply with the requirements in paragraph (b)(5)(ii) of Rule 302. 
Specifically, these alternative trading systems must establish 
standards for granting access to trading on their systems,\250\ and 
maintain these standards in their records.\251\ An alternative trading 
system must apply these standards fairly and is prohibited from 
unreasonably prohibiting or limiting any person with respect to trading 
in any equity securities, or in certain categories of debt securities, 
when that trading exceeds the twenty percent volume threshold. For 
example, the Commission will consider it a denial of access by an 
alternative trading system if the alternative trading system refuses to 
open an account for a customer, thereby denying that customer the use 
of its trading facilities.\252\ In addition, if an alternative trading 
system grants, denies or limits access to trading to any person, the 
alternative trading system is required to keep records of each action, 
including the reasons for such action.\253\ Each alternative trading 
system will also be required to provide a list of all grants, denials 
or limitations of access to the Commission on Form ATS-R each quarter. 
For each grant, denial or limitation of access, alternative trading 
systems must provide the name of the person, nature and effective date 
of the decision, and any other information that the alternative trading 
system deems relevant. For denials or limitations of access, 
alternative trading systems must provide information describing the 
reasons for the decision.\254\ For example, if an applicant has a 
relevant disciplinary history, has insufficient financial resources, or 
refuses to agree to abide by the rules of the alternative trading 
system, an alternative trading

[[Page 70874]]

system should include such reasons in its filing with the Commission. 
The Commission intends to enforce the fair access rules by reviewing 
these reports and investigating any possible violations of the 
rule.\255\
---------------------------------------------------------------------------

    \250\ Several commenters agreed with the Commission that an 
alternative trading system should be required to establish standards 
for granting access to trading in its system. See IBEX Letter at 12; 
Ashton Letter at 6; SIA Letter at 4, 14.
    \251\ Rule 303(a)(1)(iii), 17 CFR 242.303(a)(1)(iii). The 
Commission expects an alternative trading system to maintain a 
record of its standards at each point in time. If the alternative 
trading system amends or modifies its access standards, the records 
kept should reflect historic standards, as well as current 
standards.
    \252\ Moreover, if an alternative trading system requires 
subscribers to open an account with another broker-dealer with which 
the alternative trading system has a clearing arrangement, the 
alternative trading system is responsible for ensuring that the 
clearing broker-dealer does not unfairly deny access to any person. 
Thus, the alternative trading system--as part of its agreement with 
the clearing firm--must ensure that the clearing firm establishes 
standards for customers opening an account and that notices are sent 
to any prospective customer denied an account.
    \253\ Rule 301(b)(5)(ii), 17 CFR 242.301(b)(5)(ii).
    \254\ Rule 301(b)(5)(ii)(D), 17 CFR 242.301(b)(5)(ii)(D).
    \255\ Rule 301(b)(9), 17 CFR 242.301(b)(9); Form ATS-R, 17 CFR 
249.638.
---------------------------------------------------------------------------

    The fair access requirements the Commission is adopting today are 
based on the principle that qualified market participants should have 
fair access to the nation's securities markets. Alternative trading 
systems remain free to have reasonable standards for access. Such 
standards should act to prohibit unreasonably discriminatory denials of 
access. A denial of access is reasonable if it is based on objective 
standards. For example, an alternative trading system may establish 
minimum capital or credit requirements for subscribers.\256\ Similarly, 
an alternative trading system may reasonably deny access to investors 
based on a relevant, unfavorable disciplinary history. In addition, an 
alternative trading system could allow institutional subscribers the 
option of refusing to trade with broker-dealer subscribers, as long as 
the alternative trading system grants this option to subscribers based 
on objective and fairly applied standards. Provided that these or other 
standards were applied consistently to all subscribers, an alternative 
trading system would be considered to be granting and denying access 
fairly. A denial of access might be unreasonable, however, if it were 
discriminatorily applied among similar subscribers or if it were based 
solely on the trading strategy of a potential participant.
---------------------------------------------------------------------------

    \256\ For example, the Commission has recognized that the 
creditworthiness of a counterparty is a legitimate concern of market 
participants. See Letter from Richard R. Lindsey, Director, Division 
of Market Regulation, SEC, to Richard Grasso, Chairman and Chief 
Executive Officer, NYSE, dated Nov. 22, 1996 at 17. The Commission 
also requested comment on what might be appropriate reasons for an 
alternative trading system to deny market participants access. Most 
commenters also stated that objective standards, such as 
creditworthiness, would be appropriate, provided that these 
standards were applied in a non-discriminatory manner. See IBEX 
Letter at 12 (stating that credit-worthiness would be the most 
significant standard); ICI Letter at 4 (requesting that the 
Commission clarify that the standards for access can take into 
account factors that are relevant to credit or other forms of 
counterparty risk); SIA Letter at 14 (recommending that the 
Commission allow alternative trading systems to limit access to any 
category of its choosing, provided that the standands are not 
applied in a discriminatory manner, and stating that an alternative 
trading system should be permitted to select its standards, publish 
them, and apply them as stated in a non-discriminatory manner); TBMA 
Letter at 26 (requesting that the Commission clarify that an 
alternative trading system would still be allowed to set standards 
describing the customers with whom it wishes to do business, 
provided its standards are applied in a non-discriminatory manner). 
See also OptiMark Letter at 4, n.8 (stating that non-subscribers who 
wished to become subscribers should not be ``unreasonably denied'').
---------------------------------------------------------------------------

    The proposed rules included a right of appeal to the Commission of 
any denial or limitation of access, as well as a requirement that an 
alternative trading system notify a person denied or limited access of 
their right of appeal. The Commission has decided not to adopt these 
provisions. The Commission is concerned that such a right of appeal 
would prove burdensome to the alternative trading system, the party 
denied or limited access, and Commission staff. In addition, commenters 
generally approved of the goals of fair access, but were not supportive 
of providing a right of appeal to the Commission.
(iii) Response to Comments
    Commenters who addressed the proposed fair access requirement 
generally agreed with the Commission's goal of ensuring that 
alternative trading systems with significant volume establish criteria 
for fairly determining access.\257\ Two commenters, for various 
reasons, did not believe that a requirement ensuring fair access by 
alternative trading systems was necessary.\258\ Another commenter 
argued that alternative trading systems that do not display to 
subscribers should not be required to grant access to non-
subscribers.\259\
---------------------------------------------------------------------------

    \257\ See, e.g., IBEX Letter at 12 (stating that reasonable 
credit or capital requirements or past bad faith dealings should be 
the only basis for denying access); Ashton Letter at 6 (arguing that 
alternative trading systems should be required to provide equivalent 
access through nondiscriminatory system fees).
    \258\ See TBMA Letter at 26 (stating that it would support a 
fair access requirement for exchanges, but not for alternative 
trading systems); ICI Letter at 4 (stating that it was not aware of 
any material barriers to entry to the existing ECNs, and so did not 
believe that the fair access requirement was necessary).
    \259\ OptiMark Letter at 4.
---------------------------------------------------------------------------

    The Commission solicited comment on the level of volume at which 
fair access requirements should be applied. Of those commenters who 
addressed the Commission's proposed threshold of twenty percent, three 
believed that the level should be raised,\260\ two believed it should 
be lowered,\261\ and one believed twenty percent was appropriate.\262\ 
One of the commenters that recommended the Commission lower the 
threshold from twenty percent stated that fair access should be ensured 
regardless of volume, because volume levels are subject to variation 
over time, and because unfair denials of access by even small systems 
could make access to quotes in illiquid securities particularly 
difficult.\263\
---------------------------------------------------------------------------

    \260\ See TBMA Letter at 22-23 (recommending that the threshold 
level be raised to thirty-five percent to avoid capturing 
insignificant market participants, particularly in regard to the 
bond market); SIA Letter at 3-4 (recommending that the threshold 
level be raised to forty percent); ICI Letter at 4 (recommending 
raising the threshold level to fifty percent).
    \261\ See IBEX Letter at 12 (recommending that the threshold 
level be lowered to ten percent); American Century Letter at 3.
    \262\ NASD Letter at 12 (stating that twenty percent is an 
appropriate level).
    \263\ American Century Letter at 3.
---------------------------------------------------------------------------

    The Commission agrees with this commenter that fair access is an 
important element of fair markets. Nevertheless, in balancing the need 
for fair access with the costs that may be associated with such a 
requirement, the Commission believes that a twenty percent threshold 
strikes the right balance. As discussed above, the rules the Commission 
is adopting today require that an alternative trading system subject to 
Regulation ATS comply with fair access requirements if, during at least 
four of the preceding six months, the alternative trading system 
accounted for twenty percent or more of the average daily share volume 
in any equity security or certain categories of debt.\264\
---------------------------------------------------------------------------

    \264\ Rule 301(b)(5)(i), 17 CFR 242.301(b)(5)(i).
---------------------------------------------------------------------------

    The Commission also requested comment on whether persons denied 
access to an alternative trading system should have the right to appeal 
this action to the Commission, what form the appeal should take, and 
what the appropriate standard for Commission review should be. Five 
comment letters directly addressed the issue of appeal to the 
Commission of denials of access.
    One commenter favored a right to appeal a denial of access, but 
stated that the appeal process should begin at the SRO level.\265\ This 
commenter stated that appeal to the Commission should occur only if the 
SRO fails to resolve the dispute. Another commenter, similarly, stated 
that it believes denials or limitations of access should be handled 
through current SRO complaint and disciplinary procedures, rather than 
through procedures used to appeal SRO determinations to the Commission. 
This commenter stated that it believes formal Commission procedures 
could blur the allocation of supervisory authority over broker-dealers 
and could lead to duplicative or inconsistent review proceedings in 
some cases. Moreover, this commenter was concerned that a

[[Page 70875]]

right to appeal to the Commission could lead to the frequent filing of 
frivolous or vexatious complaints against the broker-dealer, thereby 
impeding its ability to screen out potentially unqualified 
customers.\266\ As discussed above, the Commission has decided not to 
adopt the proposed right of appeal to the Commission.
---------------------------------------------------------------------------

    \265\ IBEX Letter at 13. See also ICI Letter at 4 (stating that 
the Commission should not provide a right to appeal denial of 
access, but that complaints should be handled as any other complaint 
against broker-dealers were handled: through the appropriate SRO or 
the Commission).
    \266\ Instinet Letter at 19.
---------------------------------------------------------------------------

    One commenter opposed a right to appeal denial of access, on the 
basis that there was no need for it. If, however, the Commission did 
implement its proposal to provide those denied access with the right to 
appeal to the Commission, this commenter recommended that the 
Commission ensure that this process did not become a means to dictate 
with whom a proprietary system may contract and that the allowable 
relief not be so expansive as to allow the Commission to alter the 
alternative trading system's published access standards.\267\
---------------------------------------------------------------------------

    \267\ SIA Letter at 14-15. See also TBMA Letter at 26.
---------------------------------------------------------------------------

e. Capacity, Integrity, and Security Standards
    As discussed in the Proposing Release,\268\ in November 1989 and 
May 1991, the Commission published two policy statements regarding the 
use of technology in the securities markets.\269\ These policy 
statements established the automation review program and called for the 
SROs to establish, on a voluntary basis, comprehensive planning, 
testing, and assessment programs to determine systems' capacity and 
vulnerability. The Commission recommended that SROs: (1) establish 
current and future capacity estimates; (2) conduct capacity stress 
tests; and (3) obtain annual independent assessments of systems to 
determine whether they can perform adequately.\270\ In addition, the 
Commission staff conducts oversight reviews of the SROs' systems 
operations. All SROs currently participate in the Commission's 
automation review program, which has been a significant force in 
stimulating the SROs to upgrade their systems technology.\271\
---------------------------------------------------------------------------

    \268\ See Proposing Release, supra note 3, at Section III.A.2.e.
    \269\ Securities Exchange Act Release No. 27445 (Nov. 16, 1989), 
54 FR 48704 (``ARP I''); Securities Exchange Act Release No. 29185 
(May 9, 1991), 56 FR 22489 (``ARP II''). ARP I and ARP II were 
published in response to operational difficulties experienced by SRO 
automated systems during the October 1987 market break. These 
releases predicted future capacity requirements, emphasized the need 
to maintain accurate trade and quote information, and discussed the 
degree to which computer automation has become, and is likely to 
increase as, an integral part of securities trading.
    \270\ ARP II, supra note 269, set forth guidance concerning the 
nature of these independent reviews.
    \271\ The Commission notes that the United States General 
Accounting Office (``GAO'') has conducted several studies on the 
subject of computer systems and their role in the financial markets. 
Generally, the GAO has recommended that the Commission take steps to 
improve systems capacity, integrity, and security, See GAO, Stronger 
System Controls and Oversight Needed to Prevent NASD Computer Outage 
(Dec. 1994) (regarding Nasdaq system outages); GAO, Stock Markets: 
Information Vendors Need SEC Oversight to Control Automation Risks 
(Jan. 1992) (regarding risk assessments of automated operations of 
stock market information dissemination vendors); GAO, Computer 
Security Controls at Five Stock Exchanges Ned Strengthening (Aug. 
1991) (regarding systems related risks at stock markets); GAO, 
Active Oversight of Market Automation by SEC and CFTC Needed (Apr. 
1991) (regarding automation risks of the securities and futures 
markets); GAO, Tighter Computer Security Needed (Jan. 1990) 
(regarding the Common Message Switch System and the Intermarket 
Trading System operated by the Securities Industry Automation 
Corporation and the Nasdaq system operated by the NASD).
---------------------------------------------------------------------------

    The automation review program was established because of ``the 
impact that systems failures have on public investors, broker-dealer 
risk exposure, and market efficiency.'' \272\ While this program did 
not directly apply to alternative trading systems, the Commission noted 
that all broker-dealers should engage in systems testing and use the 
policy statement as a guideline.\273\ Because some alternative trading 
systems now account for a significant share of trading in the U.S. 
securities markets, failures of their automated systems have as much of 
a potential to disrupt the securities markets as failures of SROs' 
automated systems. For this reason, the Commission proposed to require 
alternative trading systems with significant volume to meet certain 
systems capacity, integrity, and security standards.\274\ The proposed 
requirements were similar to those standards SROs currently follow 
under the automation review program.
---------------------------------------------------------------------------

    \272\ ARP I, supra note 269, 54 FR at 48705; ARP II, supra note 
269, 56 FR at 22490.
    \273\ See ARP I, supra note 269, 54 FR at 48706, at n.17; ARP 
II, supra note 269, 56 FR at 22493, at n.15.
    \274\ With regards to system capacity, integrity, and security 
standards, the Commission notes that during the past year, Instinet, 
Island, Bloomberg, and Archipelago (operated by Terra Nova) have all 
experienced system outages due to problems with their automated 
systems. On a number of occasions, ECNs have had to stop 
disseminating market maker quotations in order to keep from closing 
altogether, including during the market decline of October 1997 when 
one significant ECN withdrew its quotes from Nasdaq because of lack 
of capacity. Similarly, a major interdealer broker in non-exempt 
securities experienced serious capacity problems in processing the 
large number of transactions in October 1997 and had to close down 
temporarily. As a result, the Commission believes that the volume 
thresholds discussed above are necessary to ensure that trading 
systems have developed systems capacity, integrity, and security 
standards that are adequate to prevent such system outages.
---------------------------------------------------------------------------

(i) Application of Capacity, Integrity, and Security Standards
    The Commission is adopting Exchange Act Rule 301(b)(6) to reduce 
the likelihood that alternative trading systems that play a significant 
role in our national market system will disrupt the securities markets 
due to failures of their automated systems. This rule requires 
alternative trading systems trading twenty percent or more of the 
volume in any equity security or in certain categories of debt 
securities \275\ to comply with standards regarding the capacity, 
integrity, and security of their automated systems. As for the fair 
access requirements discussed above, the volume thresholds are on a 
security-by-security basis for equity securities. Accordingly, if any 
one equity security traded on an alternative trading system accounts 
for more than twenty percent of the total share volume in that security 
during four of the preceding six months, the alternative trading system 
is required to meet the capacity, integrity, and security requirements 
for that security, although in practice this may cause compliance with 
the standards for all securities traded in that system. With respect to 
debt securities, an alternative trading system is required to meet the 
systems capacity, integrity, and security standards if it trades twenty 
percent or more of the volume during four of the preceding six months 
in any of the following categories: municipal securities, non-
investment grade corporate debt, and investment grade corporate 
debt.\276\
---------------------------------------------------------------------------

    \275\ Rule 301(b)(6) applies to the same categories of debt 
securities as Rule 301(b)(5), discussed supra note 248 and 
accompanying text. Specifically, the categories are investment grade 
corporate debt securities, non-investment grade corporate debt 
securities, and municipal securities. 17 CFR 242.301(b)(6).
    \276\ See supra Section IV.A.2.d.
---------------------------------------------------------------------------

    The Municipal Securities Rulemaking Board's transaction reporting 
plan now provides information on the aggregate trading in municipal 
securities.\277\ Because similar information for investment grade and 
non-investment grade corporate debt, however, is not currently 
available, the system capacity, integrity, and security requirements in 
Rule 301(b)(6)(D) and (E) will not be made effective until April 1, 
2000.\278\ The Commission is deferring action on the system reliability 
standards for alternative trading systems trading a substantial portion 
of the market in foreign corporate debt and foreign

[[Page 70876]]

sovereign debt until such time as reliable data is available by which 
alternative trading systems may determine their relative portion of the 
market.
---------------------------------------------------------------------------

    \277\ See supra Section IV.A.1.e.
    \278\ See supra note 146 (discussing the April 1, 2000 effective 
date).
---------------------------------------------------------------------------

    As for the fair access requirement, the Commission is excluding 
from the systems capacity, integrity, and security requirement those 
alternative trading systems that match customer orders for securities 
with other customer orders, at prices for those same securities 
established outside such system.\279\ Thus, regardless of their trading 
volume, systems that, for example, match customer orders prior to the 
market opening and then execute those orders at the opening price for 
the securities are not required to comply with these systems 
reliability requirements. In addition, systems that match unpriced 
orders at the mid-point of the bid and ask, or at a value weighted 
average or prices on another market are not subject to the fair access 
requirements. The Commission, however, would not consider an 
alternative trading system to be excluded from the requirements in 
paragraph (b)(6) of Rule 301 if that system priced any security traded 
on that system using prices established outside such system for 
instruments other than the particular security being executed. 
Therefore, a system would not be excluded if it traded options or other 
derivatives based on prices established on the primary market for the 
underlying security.
---------------------------------------------------------------------------

    \279\ Rule 301(b)(6)(iii), 17 CFR 242.301(b)(6)(iii).
---------------------------------------------------------------------------

    An alternative trading system that meets these volume thresholds 
will be required to: (1) Establish reasonable current and future 
capacity estimates; (2) conduct periodic capacity stress tests of 
critical systems to determine such system's ability to process 
transactions in an accurate, timely, and efficient manner; (3) develop 
and implement reasonable procedures to monitor system development and 
testing methodology; (4) review the vulnerability of its systems and 
data center computer operations to internal and external threats, 
physical hazards, and natural disasters; and (5) establish adequate 
contingency and disaster recovery plans. An alternative trading system 
is required to meet these proposed standards with respect to all its 
systems that support order entry, order handling, execution, order 
routing, transaction reporting, and trade comparison in the particular 
security.\280\ In addition, alternative trading systems subject to this 
provision are required to notify the Commission staff of material 
systems outages and material systems changes.\281\ This information 
will enable Commission staff to better understand the operation of the 
alternative trading system and to identify potential problems and 
trends that may require attention.
---------------------------------------------------------------------------

    \280\ Rule 301(b)(6)(ii)(A)-(F), 17 CFR 242.301(b)(6)(ii)(A)-
(F).
    \281\ Rule 301(b)(6)(ii)(G), 17 CFR 242.301(b)(6)(ii)(G).
---------------------------------------------------------------------------

    Finally, under Regulation ATS, alternative trading systems that 
meet the volume levels set forth above are required to perform an 
annual independent review of the systems that support order entry, 
order handling, execution, order routing, transaction reporting and 
trade comparison.\282\ As discussed in greater detail in the 
Commission's May 1991 Policy Statement,\283\ an independent review 
should be performed by competent, independent audit personnel following 
established audit procedures and standards. If internal auditors are 
used by an alternative trading system to complete the review, these 
auditors should comply with the standards of the Institute of Internal 
Auditors and the Electronic Data Processing Auditors Association 
(``EDPAA''). If external auditors are used, they should comply with the 
standards of the American Institute of Certified Public Accountants 
(``AICPA'') and the EDPAA.
---------------------------------------------------------------------------

    \282\ Rule 301(b)(6), 17 CFR 242.301(b)(6). Regulation ATS also 
requires alternative trading systems to preserve documentation 
relating to their efforts to meet the requirements of this rule. See 
Rule 303(a)(1)(iv), 17 CFR 242.303(a)(iv).
    \283\ See ARP II, supra note 269.
---------------------------------------------------------------------------

(ii) Response to Comments
    In the Proposing Release,\284\ the Commission requested comment on 
its proposal to require significant alternative trading systems to 
satisfy systems capacity, integrity, and security standards. While most 
commenters did not specifically address this proposed requirement, 
those that did comment generally supported it.\285\
---------------------------------------------------------------------------

    \284\ See Proposing Release, supra note 3, at Section III.A.2.e.
    \285\ See Ashton Letter at 5; NASD Letter at 11; TBMA Letter at 
27 (but only if a system plays some role in price discovery such as 
a traditional exchange does).
---------------------------------------------------------------------------

    The Commission asked whether the twenty percent volume threshold 
proposed was appropriate. In this regard, the NASD supported the twenty 
percent proposed volume threshold.\286\ Two other commenters, however, 
suggested that the Commission's proposed threshold was too low.\287\ 
Specifically, one of these commenters argued that the Commission should 
raise the volume threshold from twenty percent to thirty-five percent 
to avoid including debt market participants with no significant role in 
price discovery. This commenter stated that, given the decentralized 
and fungible nature of the debt markets, an alternative trading system 
trading debt securities would need twenty percent or more of the 
relevant market to materially affect the markets in the manner in which 
the Commission is concerned.\288\ Another commenter, similarly, 
suggested that these requirements not be imposed until an alternative 
trading system had forty percent of the market in any security. In 
addition, before the capacity, integrity, and security requirements are 
triggered, this commenter recommended that any security (or category of 
debt) in which the alternative trading system reached forty percent of 
aggregate daily volume also represent twenty percent or more of the 
alternative trading system's overall trading activity.\289\ One 
commenter, however, argued that the Commission's proposed threshold was 
too high, and that it should instead be applicable to alternative 
trading systems with one percent of the consolidated volume in a 
category of equity securities, such as listed or Nasdaq 
securities.\290\
---------------------------------------------------------------------------

    \286\ NASD Letter at 11.
    \287\ See TBMA Letter at 22-23; SIA Letter at 13.
    \288\ See TBMA Letter at 22-23.
    \289\ SIA Letter at 13.
    \290\ Ashton Letter at 5.
---------------------------------------------------------------------------

    In addition, while the ICI stated its belief that competitive 
pressures will generally suffice to ensure that alternative trading 
systems have the capacity to execute trades in a timely manner, the ICI 
also stated that it would not oppose such requirements as long as the 
Commission applied them in a flexible manner and did not dictate how 
alternative trading systems structure their operations.\291\
---------------------------------------------------------------------------

    \291\ ICI Letter at 4.
---------------------------------------------------------------------------

    The Commission believes that alternative trading systems that have 
a significant role in the marketplace should be able to handle 
reasonably foreseeable volume surges and be prepared for reasonably 
anticipated future volume increases. As a result, the Commission 
continues to believe that the volume thresholds above are appropriate. 
Investors and other market participants increasingly rely on 
alternative trading systems to buy and sell securities. The ability of 
these markets to meet the demands of market participants is directly 
related to the reliability of their automated systems. The Commission 
realizes that alternative trading systems have significant business 
incentives to ensure that their systems have adequate capacity so that 
participants' orders do not experience unnecessary delays. The

[[Page 70877]]

systems capacity, integrity, and security rules are intended as a back-
up to ensure that alternative trading systems that have a significant 
role in the market maintain sufficient systems and procedures to 
minimize the effects of potential systems problems in the secondary 
markets.
f. Examination, Inspection, and Investigations of Subscribers
    The Commission proposed that an alternative trading system be 
required to cooperate with the Commission's or an SRO's inspection, 
examination, or investigation of the alternative trading system or any 
of the alternative trading system's subscribers. Presently, the 
Commission has the authority to inspect and examine any member of any 
national securities exchange or any national securities association 
directly. This is because all such members are broker-dealers. 
Alternative trading systems, however, also could have certain other 
subscribers, such as institutions or individuals, to which the 
Commission's inspection authority does not extend. Because alternative 
trading systems could be used by subscribers to manipulate the market 
in a security,\292\ it is imperative that alternative trading systems 
cooperate in all inspections, examinations, and investigations. 
Although neither the Commission nor the SROs has the authority to 
directly inspect non-broker-dealer subscribers of alternative trading 
systems, any relevant trading information involving such subscribers 
would be maintained by the alternative trading system under its 
recordkeeping requirements, and would be required to be made available 
upon request to its SRO or the Commission. Under the rules the 
Commission is adopting today, an alternative trading system's exemption 
from exchange registration is conditioned on it cooperating with the 
Commission's or an SRO's inspection, examination, or investigation of 
the alternative trading system or any of its subscribers.\293\
---------------------------------------------------------------------------

    \292\ The Commission is aware of several incidents involving the 
manipulation of quotations through alternative trading systems. The 
participants who engaged in the manipulation were able to profit as 
a result. See supra note 5.
    \293\ Rule 301(b)(7), 17 CFR 242.301(b)(7).
---------------------------------------------------------------------------

g. Recordkeeping
    The Commission proposed that alternative trading systems be 
required to keep certain records. The Commission is adopting these 
recordkeeping requirements as proposed. As adopted, Regulation ATS 
requires alternative trading systems to make and keep the records 
necessary to create a meaningful audit trail.\294\ Specifically, 
alternative trading systems are required to maintain daily summaries of 
trading and time-sequenced records of order information, including the 
date and time the order was received, the date, time, and price at 
which the order was executed, and the identity of the parties to the 
transaction. In addition, alternative trading systems are required to 
maintain a record of subscribers and any affiliations between 
subscribers and the alternative trading system.\295\ While some of the 
information that is required by the Regulation ATS will also be 
required under the NASD's Order Audit Trail System (``OATS''),\296\ 
OATS is an NASD rule and does not cover all securities traded through 
alternative trading systems.
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    \294\ Rule 301(b)(8), 17 CFR 242.301(b)(8).
    \295\ Rule 302(a), 17 CFR 242.302(a).
    \296\ Securities Exchange Act Release No. 39729 (Mar. 6, 1998), 
63 FR 12559 (Mar. 13, 1998).
---------------------------------------------------------------------------

    These recordkeeping requirements also require alternative trading 
systems to keep records of all notices provided to subscribers, 
including notices addressing hours of operation, system malfunctions, 
changes to system procedures, and instructions pertaining to access to 
the alternative trading system.\297\ In addition, alternative trading 
systems are required to keep documents made (if any) in the course of 
complying with the systems capacity, integrity, and security standards 
in Rule 301(b)(6). These documents include all reports to an 
alternative trading system's senior management, and records concerning 
current and future capacity estimates, the results of any stress tests 
conducted, procedures used to evaluate the anticipated impact of new 
systems when integrated with existing systems, and records relating to 
arrangements made with a service bureau to operate any automated 
systems. These records will allow the Commission to examine whether 
alternative trading systems are complying with the requirements under 
Proposed Rule 301(b)(6). Finally, an alternative trading system subject 
to the fair access requirements discussed above is required to keep a 
record of its access standards.\298\
---------------------------------------------------------------------------

    \297\ Rule 303(a)(1)(ii), 17 CFR 242.303(a)(1)(ii).
    \298\ See supra Section IV.A.2.d.
---------------------------------------------------------------------------

    Regulation ATS requires that these records be kept for at least 
three years, the first two years in an easily accessible place. Some 
records, such as partnership articles and articles of incorporation, 
must be kept for the life of the alternative trading system.\299\ 
Alternative trading systems are permitted to keep records in any form 
broker-dealers are permitted to keep records under Rule 17a-4(f) under 
the Exchange Act.\300\
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    \299\ Rule 303(a)(2), 17 CFR 242.303(a)(2).
    \300\ Rule 303(b), 17 CFR 242.303(b). Rule 17a-4(f) provides for 
the maintenance of records on microfilm, microfiche, or electronic 
storage media. The Commission recognizes that alternative trading 
systems may generate much of the information in electronic form and 
generally may wish to keep records in electronic format. 17 CFR 
240.17a-4(f).
---------------------------------------------------------------------------

    The Commission recognizes that alternative trading systems subject 
to Regulation ATS are subject to the recordkeeping requirements for 
broker-dealers under Rules 17a-3 and 17a-4 of the Exchange Act,\301\ 
which may require that some of the same records be made and kept. 
Regulation ATS does not require an alternative trading system to 
duplicate trading records maintained in the course of its normal 
recordkeeping operations, provided that the alternative trading system 
can sort and retrieve system records separately upon request. In 
addition, as broker-dealers are currently permitted to do,\302\ 
Regulation ATS permits an alternative trading system to retain a 
service bureau, depository, or other recordkeeping service to maintain 
required records on behalf of the alternative trading system as long as 
the designated party agrees to make the records available to the 
Commission upon request.\303\
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    \301\ 17 CFR 240.17a-3 and 17 CFR 240.17a-4.
    \302\ 17 CFR 240.17a-4(i).
    \303\ Rule 303(d), 17 CFR 242.303(d).
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    The Commission solicited comment on these recordkeeping 
requirements. In general, the comments received on this provision were 
mixed. Two commenters supported requiring alternative trading systems 
to keep the records necessary to create a meaningful audit trail.\304\ 
On the other hand, one commenter expressed concern that the 
Commission's proposal would impose the same recordkeeping requirements 
on both small and large alternative trading systems. Instead, this 
commenter argued that smaller systems should be subject to none or only 
minimal regulation generally, and that even the recordkeeping 
requirements may serve as a significant barrier to market entry and 
innovation.\305\
---------------------------------------------------------------------------

    \304\ See ICI Letter at 4; Ashton Letter p. 5.
    \305\ TBMA Letter at 16. TBMA suggested exempting alternative 
trading systems that do not exceed fifteen percent of the relevant 
market from Regulation ATS and, thus, from the recordkeeping 
requirements. TBMA stated that the additional recordkeeping 
requirements would not provide the Commission significant new 
information beyond what is currently included within broker-dealer 
recordkeeping requirements. Id.
---------------------------------------------------------------------------

    The Commission believes that, for the most part, the records it is 
requiring alternative trading systems to make and keep are records that 
alternative trading

[[Page 70878]]

systems would otherwise keep as part of their business, and that 
therefore these requirements will not place undue burdens upon 
alternative trading systems. In addition, the Commission believes that 
the highly automated nature of alternative trading systems will help 
facilitate the construction and maintenance of an audit trail. The 
Commission also believes that these recordkeeping requirements are 
necessary to permit surveillance and examination to help assure fair 
and orderly markets.
    One commenter recommended that an alternative trading system's 
records and reports only be available to an alternative trading 
system's SRO on a confidential, need-to-know basis.\306\ Regulation ATS 
provides that alternative trading systems are required to permit 
inspections and examinations of their records by the Commission or the 
SRO of which they are a member.\307\ The Commission noted in the 
Proposing Release that, while potential conflicts of interest in 
overseeing alternative trading systems may arise, the Commission 
believes these conflicts can be managed using the Commission's 
oversight authority. The Commission also recognized that some market 
participants might be concerned that SROs could abuse their regulatory 
authority, but noted that the Commission has oversight responsibility 
over SROs to prevent such activity. In this regard, the Commission 
expects SROs to carefully assess, and revise where necessary, their 
internal policies and procedures for protecting the confidentiality of 
sensitive information obtained in the course of fulfilling their SRO 
regulatory responsibilities.\308\
---------------------------------------------------------------------------

    \306\ Ashton Letter at 5. Ashton pointed out that, because SRO-
sponsored systems compete directly with alternative trading systems, 
SROs should not be able to gain confidential information through the 
regulatory reporting process. Id.
    \307\ Rule 301(b)(7), 17 CFR 242.301(b)(7).
    \308\ See also Securities Exchange Act Release No. 35124 (Dec. 
20, 1994), 59 FR 66702 (Dec. 28, 1994) (addressing similar concerns 
in the context of Rule 17a-23).
---------------------------------------------------------------------------

    Finally, one commenter asked that the Commission consider the 
relationship of any new recordkeeping requirements with applicable SRO 
recordkeeping rules, such as the NASD's recently-adopted OATS.\309\ The 
Commission notes that, while some of the information required by 
Regulation ATS will also be required by SRO rules, such rules do not 
have the same scope and are not designed to meet the same goals. 
Moreover, SRO rules may not apply to all alternative trading system 
activities. In addition, the Commission is only requiring that records 
of certain information be made and kept, but is not dictating in what 
form those records are maintained. This means that alternative trading 
systems have flexibility in how they comply with SRO and Commission 
rules. Further, if duplicative rules exist, the same alternative 
trading system practices should serve to satisfy both sets of rules.
---------------------------------------------------------------------------

    \309\ Instinet Letter at 20-21. Instinet stated that the 
Commission should work with SROs to establish recordkeeping 
requirements that minimize duplication and inconsistency as well as 
providing alternative trading systems substantial flexibility in 
structuring their recordkeeping operations. Id.
---------------------------------------------------------------------------

h. Reporting and Form ATS-R
    The Commission proposed that alternative trading systems be 
required to periodically report certain information about their 
activities. The Commission is adopting these requirements as proposed. 
Regulation ATS, as adopted, requires alternative trading systems to 
file with the Commission transaction reports within 30 calendar days of 
the end of each calendar quarter on Form ATS-R.\310\ Specifically, Form 
ATS-R requires alternative trading systems to report total volume in 
terms of number of units traded and dollar value for the following 
categories of securities: (1) Listed equity securities, (2) Nasdaq NM 
securities, (3) Nasdaq SmallCap securities, (4) equity securities that 
are eligible for resale pursuant to Rule 144A under the Securities Act 
of 1933,\311\ (5) penny stocks, (6) equity securities not included in 
(1)-(5), (7) rights and warrants, (8) listed options, and (9) unlisted 
options. In addition, alternative trading systems are required to 
report the total settlement value in U.S. dollars for: (1) Corporate 
debt securities (separately for investment grade and non-investment 
grade), (2) government securities, (3) municipal securities, (4) 
mortgage related securities, and (5) debt securities not included in 
(1)-(4). Alternative trading systems are required to file after-hours 
trading information in listed equity, Nasdaq NM, and Nasdaq Small Cap 
securities, as well as listed options. This information will permit the 
Commission to monitor the trading on alternative trading systems. In 
addition, alternative trading systems subject to the fair access 
requirements in Rule 301(b)(5), as discussed above,\312\ must report 
quarterly on Form ATS-R the persons to whom they grant, deny or limit 
access to the alternative trading systems, as well as the date of the 
action, the effective date of the action, and the nature of the denials 
or limitations of access.
---------------------------------------------------------------------------

    \310\ Rule 301(b)(9), 17 CFR 242.301(b)(9).
    \311\ 17 CFR 230.144A. Brokers and others who use alternative 
trading systems to trade Rule 144A eligible securities and other 
types of restricted securities should ensure those systems are 
structured to permit the traders' compliance with their obligations 
under Rule 144A and under the Securities Act of 1933.
    \312\ See supra notes 253-255 and accompanying text.
---------------------------------------------------------------------------

    Because Rule 17a-23 \313\ will be eliminated, data filed by 
alternative trading systems on Form ATS-R will replace the information 
currently filed on Form 17A-23 by broker-dealers operating trading 
systems. Unlike Part II of Form 17A-23, Form ATS provides a template on 
which alternative trading systems are required to file the requested 
information with the Commission. This template should allow alternative 
trading systems to file the required information in a more uniform 
format that will be more useful to the Commission. For example, the 
Commission anticipates using this information to develop examination 
modules for the inspection of alternative trading systems. The 
Commission also expects to use the information to further understand 
the effect of alternative trading systems on the securities markets.
---------------------------------------------------------------------------

    \313\ See infra Section V. Rule 17a-23 under the Exchange Act 
generally requires U.S. broker-dealers that sponsor broker-dealer 
trading systems to provide a description of their systems to the 
Commission and report transaction volume and other information on a 
quarterly basis. This rule also requires that such broker-dealers 
keep records regarding system activity and to make such records 
available to the Commission. 17 CFR 240.17a-23. See also Securities 
Exchange Act Release No. 35124 (Dec. 20, 1994), 59 FR 66702 (Dec. 
28, 1994).
---------------------------------------------------------------------------

    Another difference between Part II of Form 17A-23 and Form ATS is 
that Form ATS requires alternative trading systems to provide 
information about the volume of particular types of securities that are 
not listed on an exchange or traded on Nasdaq. These new reporting 
requirements on Form ATS-R will improve the quality of the data that 
the Commission has available to consider the effectiveness of its 
regulatory program. Due to the highly automated nature of alternative 
trading system operations and the experiences with Rule 17a-23, the 
Commission does not anticipate that gathering and submitting the data 
required on Form ATS-R will be overly burdensome. Alternative trading 
systems are also required to make reports on Form ATS-R available to 
surveillance personnel of any SRO of which they are a member.\314\
---------------------------------------------------------------------------

    \314\ Rule 301(b)(2)(vii), 17 CFR 242.301(b)(2).
---------------------------------------------------------------------------

    The Commission solicited comment on the transaction reporting 
requirements and Form ATS-R. In particular, the Commission solicited 
comment on the frequency and scope of transaction reporting 
requirements

[[Page 70879]]

proposed in Regulation ATS. No commenters responded to the Commission's 
request for comments on the information requested on Form ATS-R.
    The Commission received no comments opposing the proposed reporting 
requirements. Several commenters generally supported the Commission's 
proposal to require alternative trading systems to report their trading 
volume.\315\ One commenter, however, commented that the Commission 
should require monthly reporting instead of the proposed quarterly 
reporting requirement.\316\ The Commission believes that quarterly 
reporting under Regulation ATS, as adopted, will provide sufficiently 
frequent reporting to the Commission. In view of the Commission's 
desire to minimize respondent reporting burdens, the Commission 
believes that more frequent reporting would not provide materially 
improved investor protections. Based on the Commission's experience 
with reporting requirements under Rule 17a-23, the Commission believes 
that a quarterly filing requirement of Form ATS-R is appropriate.
---------------------------------------------------------------------------

    \315\ See ICI Letter at 4 (supporting the proposal to require 
reports quarterly); Ashton Letter at 5; IBEX Letter at 5.
    \316\ Ashton Letter at 5.
---------------------------------------------------------------------------

    The Commission also requested comment on the appropriateness of 
permitting Form ATS-R to be filed electronically. Two commenters 
thought that if the Commission were to accept filings electronically it 
would be faster and less expensive.\317\
---------------------------------------------------------------------------

    \317\ See IBEX Letter at 5; American Century Letter at 6.
---------------------------------------------------------------------------

    Finally, one commenter recommended that an alternative trading 
system's records and reports only be available to an alternative 
trading system's SRO on a confidential, need-to-know basis.\318\ As 
described above with respect to the recordkeeping requirements,\319\ 
the Commission believes that the separation between the market and 
regulatory functions of an SRO and the Commission's oversight of SROs 
are sufficient to maintain an appropriate level of confidentiality of, 
and access to, alternative trading system information. The Commission 
believes that SROs need to have access to relevant information in order 
to carry out their oversight responsibilities. The Commission expects 
that SROs will maintain and enforce appropriate internal policies and 
procedures to protect against misuse of such information.
---------------------------------------------------------------------------

    \318\ Ashton Letter at 5. Ashton pointed out that, because SRO-
sponsored systems compete directly with alternative trading systems, 
SROs should not be able to gain confidential information through the 
regulatory reporting process. Id.
    \319\ See supra Section IV.A.2.g.
---------------------------------------------------------------------------

i. Procedures To Ensure Confidential Treatment of Trading Information
    The Commission requested comment on proposed Rule 301(b)(10) 
requiring alternative trading systems to have in place safeguards and 
procedures to protect trading information and to separate alternative 
trading system functions from other broker-dealer functions, including 
proprietary and customer trading. The Commission did not propose 
specific procedures, but encouraged commenters to express their views 
on the requirements, including how to prevent the misuse by alternative 
trading systems of confidential customer information. The Commission 
received only three comment letters which directly addressed this 
issue. All supported the Commission's proposal, although one also 
requested clarification on what the confidentiality provisions 
covered.\320\
---------------------------------------------------------------------------

    \320\ See ICI Letter at 4-5 (stating that it agreed that the 
failure to keep trading information confidential created the 
potential for abuse); Instinet Letter at 21 (requesting that the 
Commission clarify whether or not the proposed confidentiality 
provisions would prohibit registered representatives from providing 
customers with information (other than confidential customer 
information) regarding the trading activity of the alternative 
trading system); American Century Letter at 1-2 (stating that agency 
broker-dealer functions should be separate from intermediated 
broker-dealer functions that allow an alternative trading system 
employee to ``work'' an order on behalf of customers, and that these 
employees should not have access to the orders of customers who 
choose to work their orders without the assistance of employees of 
the alternative trading system).
---------------------------------------------------------------------------

    The rules the Commission is adopting today require alternative 
trading systems to have in place safeguards and procedures to protect 
trading information and to separate alternative trading system 
functions from other broker-dealer functions, including proprietary and 
customer trading. The Commission believes that the sensitive nature of 
the trading information subscribers send to alternative trading systems 
requires such systems to take certain steps to ensure the 
confidentiality of such information. For example, unless subscribers 
consent, registered representatives of alternative trading systems 
should not disclose information regarding trading activities of such 
subscribers to other subscribers that could not be ascertained from 
viewing the alternative trading system's screens directly at the time 
the information is conveyed.
    The Commission's concern regarding confidentiality grew out of its 
inspections of some ECNs, during which the Commission staff found that 
some of the broker-dealers operating ECNs used the same personnel to 
operate the ECN as they did for more traditional broker-dealer 
activities, such as handling customer orders that were received by 
telephone. These types of situations create the potential for misuse of 
the confidential trading information in the ECN, such as customers' 
orders receiving preferential treatment, or customers receiving 
material confidential information about orders in the ECN. The rules 
concerning confidentiality that the Commission is adopting today are 
designed to eliminate the potential for abuse of the confidential 
trading information that subscribers send to alternative trading 
systems. The Commission recognizes that some alternative trading 
systems provide traditional brokerage services as well as access to 
their alternative trading systems. The proposed rules are not intended 
to preclude these services; rather, they are designed to prevent the 
misuse of private customer information in the system for the benefit of 
other customers, the alternative trading system operator, or its 
employees.
    Therefore, the Commission is adopting rules which require that: (1) 
Information, such as the identity of subscribers and their orders, be 
available only to those employees of the alternative trading system who 
operate the system or are responsible for its compliance with the 
proposed rules; (2) the alternative trading system has in place 
procedures to ensure that all its employees are unable to use any 
confidential information for proprietary or customer trading, unless 
the customer agrees; and (3) procedures exist to ensure that employees 
of the alternative trading system cannot use such information for 
trading in their own accounts.\321\
---------------------------------------------------------------------------

    \321\ Rule 301(b)(10), 17 CFR 242.301(b)(10).
---------------------------------------------------------------------------

    The Commission intends the rules to prevent the disclosure or the 
use of information about a customer's trading orders. Many of the 
alternative trading systems operating today are anonymous; one of the 
reasons ECNs are popular with investors is that they permit wide 
dissemination of orders but provide anonymity. The broker-dealers 
operating these systems, under the rules the Commission is adopting 
today, cannot disclose any confidential customer information (including 
the identity of the subscriber entering an order) to other customers, 
or use that information for proprietary or agency trades.
    The Commission expects that existing alternative trading systems 
will

[[Page 70880]]

implement procedures such as these as quickly as possible, if they do 
not already have them in place. These procedures should be clear and 
unambiguous and presented to all employees, regardless of whether they 
have direct responsibility for the operation of the alternative trading 
system. Presently, many broker-dealers employ various means to ensure 
that sensitive information does not flow from one division to another. 
These methods include physical separation, written procedures, separate 
personnel, and restricted access. The Commission believes that 
firewalls such as these could be used by broker-dealers that operate 
alternative trading systems to ensure that sensitive information 
regarding the alternative trading system is contained in the proper 
unit of the broker-dealer.
    The Commission is not adopting specific procedures because it 
believes that the broker-dealers who operate the alternative trading 
systems are in the best position to know what procedures would best 
prevent abuses. Experience has demonstrated, however, potential for 
abuse and the Commission regards these procedures as important.

B. Registration as a National Securities Exchange

    Trading systems that fall within Rule 3b-16 are only required to 
comply with Regulation ATS if they wish to be exempt from the 
definition of ``exchange.'' Such systems may choose instead to register 
as national securities exchanges. The Commission expects that some 
trading systems will find that registration as a national securities 
exchange provides attractive benefits that make this option more 
suitable to their business objectives. In particular, registered 
exchanges enjoy more autonomy in their daily operations than do broker-
dealers that are members of SROs. Because any trading system that 
registers as an exchange would be an SRO, it would not be subject to 
oversight by a competing national securities exchange or national 
securities association.\322\ Similarly, as a national securities 
exchange, a trading system would be able to establish its own rules of 
conduct, trading rules, and fee structures for access. An alternative 
trading system registered as a broker-dealer, on the other hand, would 
have to comply with the rules of the SRO to which it belongs, including 
any rules regarding fees or the automatic execution of orders.
---------------------------------------------------------------------------

    \322\ Alternative trading systems that continue to be regulated 
as broker-dealers would remain subject to oversight by national 
securities exchanges and the NASD, in their self-regulatory 
capacities. See supra Section IV.A.2.a.
---------------------------------------------------------------------------

    In addition, systems that elect to register as exchanges may 
benefit from the added prestige and investor confidence associated with 
status as a registered exchange. Registered exchanges are also able to 
establish listing standards, which may promote investor confidence in 
the quality of the securities traded on the exchange. Registered 
exchanges may also become direct participants in the national market 
system mechanisms, such as the ITS, Consolidated Tape Association 
(``CTA''), and the Consolidated Quotation System (``CQS''). Direct 
participation in these systems may provide a higher degree of 
transparency and execution opportunities for subscribers to a trading 
system. As direct participants in the national market system 
mechanisms, registered exchanges are also entitled to share in the 
revenues generated by the national market system systems, such as 
revenue from CTA fees. Moreover, as the Commission noted in the 
Proposing Release, only registered exchanges are eligible to be 
participants of the Options Clearing Corporation (``OCC'').\323\ 
Consequently, any trading system that wants to trade standardized 
options issued by the OCC would have to register as an exchange and 
become a member of the OCC.
---------------------------------------------------------------------------

    \323\ Options Clearing Corporation By-laws, Art. VII, Sections 1 
and 4. Registered exchanges that are members of the OCC determine 
such matters as listing, registration, clearance, issuance and 
exercise of options contracts. Exchange members of the OCC are also 
able to use registration and disclosure materials tailored for 
standardized options.
---------------------------------------------------------------------------

    Finally, if a trading system chooses to register as an exchange, it 
could allow broker-dealers that are members of exchanges with off-board 
trading restrictions to trade certain securities on the trading system 
pursuant to unlisted trading privileges. The Commission believes that 
if a trading system is registered and regulated as an exchange, it 
should be considered to be an exchange, rather than an over-the-counter 
market, for purposes of exchange off-board trading.\324\
---------------------------------------------------------------------------

    \324\ The Commission has the authority to review final 
disciplinary sanctions imposed by SROs on members or associated 
persons of members, including sanctions imposed for violations of 
SRO rules. The Commission may only affirm a sanction imposed by an 
SRO on one of its members, participants or associated persons of its 
members for a violation an SRO's rules, if the Commission finds 
that: (1) The member, participant, or associated person of the 
member engaged in the acts or practices that the SRO found were 
engaged in; (2) such acts or practices are in violation of the SRO's 
rules; and (3) the SRO's rules, and the application by the SRO of 
its rules, are consistent with the purposes of the Exchange Act. 
Sections 19(d)(2) and 19(e) of the Exchange Act, 15 U.S.C. 78s(d)(2) 
and 78s(e).
---------------------------------------------------------------------------

    As discussed in the Proposing Release, the Commission views certain 
obligations of exchanges as fundamental to fair and efficient operation 
in the marketplace and critical for the protection of investors. The 
Commission did not propose any relief from the current obligations of 
registered exchanges under the Exchange Act. Nevertheless, the 
Commission requested comment on whether any exemptions from exchange 
regulatory provisions would be necessary or appropriate to enable 
alternative trading systems to register as exchanges. Commenters, 
however, generally thought that any trading system that chooses to 
register as an exchange should be subject to the same requirements as 
currently registered exchanges and cautioned the Commission against 
relieving registered exchanges from any requirements because of their 
for-profit structure. Consequently, at this time the Commission has 
determined that those trading systems choosing to register as exchanges 
should satisfy all requirements that apply to national securities 
exchanges under the Exchange Act.\325\
---------------------------------------------------------------------------

    \325\ 15 U.S.C. 78f.
---------------------------------------------------------------------------

    Many, if not all, alternative trading systems currently operating 
are proprietary, rather than not-for-profit entities. The Commission 
does not believe that there is any overriding regulatory reason to 
require exchanges to be not-for-profit membership organizations, and 
believes that alternative trading systems may retain their proprietary 
structure even if they choose to register as exchanges. The Exchange 
Act does not require national securities exchanges to be not-for-profit 
organizations. As the Commission stated in the Proposing Release, it 
believes that Congress clearly intended the 1975 Amendments to 
encourage innovation by exchanges and recognized that future exchanges 
may adopt diverse structures.\326\ The Commission believes that it is 
possible for a for-profit exchange to meet the standards set forth in 
section 6(b) of the Exchange Act.
---------------------------------------------------------------------------

    \326\ See S. Rep. No. 75, supra note 107.
---------------------------------------------------------------------------

    Any system meeting the definition set forth in Rule 3b-16 may apply 
for registration as a national securities exchange by filing an 
application with the Commission on Form 1.\327\ The Commission, in Rule 
6a-1, set forth the procedure for filing such an application.\328\ All 
Exhibits must accompany Form 1, including audited

[[Page 70881]]

financial statements prepared in accordance with United States 
Generally Accepted Accounting Principles.
---------------------------------------------------------------------------

    \327\ Section 6(a) of the Exchange Act, 15 U.S.C. 78f(a).
    \328\ 17 CFR 240.6a-1.
---------------------------------------------------------------------------

    The Commission has adopted an amendment to its rules of practice 
regarding the processing of filings. Applications for registration as a 
national securities exchange, as well as applications for exemption 
from registration due to the limited volume of transactions, will not 
be considered filed until all necessary information, including 
financial statements and other required documents, have been furnished 
in the proper form.\329\ Further, under section 6(b) of the Exchange 
Act, the Commission must make certain determinations before registering 
an exchange.\330\ In reviewing applications for registration as a 
national securities exchange, the Commission will not register an 
exchange unless it is satisfied that the exchange meets the 
requirements discussed below.
---------------------------------------------------------------------------

    \329\ 17 CFR 202.3(b)(2). The Commission is not required to 
propose changes to its Rules of Practice prior to adoption. See 5 
U.S.C. 553(b)(3)(A).
    \330\ Section 6(b) of the Exchange Act, 15 U.S.C. 78f(b).
---------------------------------------------------------------------------

1. Self-Regulatory Responsibilities
    As a prerequisite for the Commission's approval of an exchange's 
application for registration, the exchange must be organized and have 
the capacity to carry out the purposes of the Exchange Act. 
Specifically, an exchange must be able to enforce compliance by its 
members, and persons associated with its members, with the federal 
securities laws and the rules of the exchange.\331\ The Commission 
believes that the self-regulatory role of registered exchanges is 
fundamental to the enforcement of the federal securities laws. Congress 
has delegated to the SROs certain quasi-governmental functions and 
responsibilities, and has charged the Commission with overseeing the 
SROs to make sure they have the ability and resources to comply with 
those obligations. In this regard, the Commission believes that persons 
responsible for operating an SRO should not have a disciplinary 
history, and will seriously question the ability of an exchange to 
carry out its SRO functions if the founders or prospective managers of 
an applicant for registration as a national securities exchange are 
subject to a statutory disqualification, as that term is defined in 
section 3(a)(39) of the Exchange Act.\332\ The Commission believes that 
persons who, for example, have willfully violated the federal 
securities laws or have been convicted within the past ten years of a 
felony or misdemeanor involving misappropriation of funds, or 
securities fraud, larceny, theft, robbery, extortion, or other related 
crimes would be inappropriate selections to fill the role of director, 
officer, or manager of an exchange.
---------------------------------------------------------------------------

    \331\ Section 6(b)(1) of the Exchange Act, 15 U.S.C. 78f(b)(1).
    \332\ 15 U.S.C. 78c(a)(39). See also 15 U.S.C. 78o(b).
---------------------------------------------------------------------------

    An alternative trading system wishing to register as a national 
securities exchange may choose to set listing standards for its system. 
If an applicant chooses to set listing standards, it must have written 
listing and maintenance standards, as well as an adequate regulatory 
staff to apply those standards.\333\ The applicant must also have rules 
restricting the listing of securities issued in a limited partnership 
rollup transaction.\334\ The ability to carry out these functions must 
be adequately represented on an exchange's application for registration 
before the Commission will register the exchange.
---------------------------------------------------------------------------

    \333\ See Section 12(d) of the Exchange Act, 15 U.S.C. 78l(d); 
Rule 12d2-2, 17 CFR 240.12d2-2 (requiring national securities 
exchanges to file an application with the Commission to strike a 
security from listing and registration).
    \334\ See 15 U.S.C. 78f(b)(9).
---------------------------------------------------------------------------

    An applicant for registration as an exchange must also have rules 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, and to refrain from 
imposing any unnecessary or inappropriate burdens on competition, among 
other things.\335\ For example, an exchange must maintain procedures to 
surveil for securities law violations, such as insider trading and 
manipulation on the exchange. The Commission understands that 
surveillance procedures can vary and will depend on the nature of, and 
types of securities traded, on a particular exchange. Thus, while the 
Commission will require all applicants for registration as an exchange 
to have adequate measures in place, they will not have to use the same 
procedures. The Commission will also require an applicant for 
registration as a national securities exchange to show that it has 
sufficient resources, including both staff expertise and capital, to 
support its surveillance function.\336\ Consistent with these 
requirements, an applicant should, at a minimum, demonstrate that the 
officers charged with day-to-day management of the exchange are 
familiar with the federal securities laws and the role of a registered 
exchange as an SRO. In addition, an applicant for registration as a 
national securities exchange must demonstrate that it has the 
capability to maintain an audit trail of the transactions on its 
system. Furthermore, an applicant must establish rules providing for 
the allocation of fees for the use of its system.\337\
---------------------------------------------------------------------------

    \335\ Section 6(b)(5) of the Exchange Act, 15 U.S.C. 78f(b)(5). 
See also Section 6(b)(8) of the Exchange Act, 15 U.S.C. 78f(b)(6).
    \336\ The Commission notes that, according to the audited 
financial statements for 1997, the NYSE had total assets of 
$1,174,887,000 and total expenses of $488,811,000; the Amex had 
total assets of $195,547,000 and total expenses of $173,742,000; the 
PCX had total assets of $67,622,000 and total expenses of 
$60,636,000; the CSE had total assets of $13,124,585 and total 
expenses of $5,343,403; and the Boston Stock Exchange (``BSE'') had 
total assets of $33,339,961 and total expenses of $16,106,837.
    \337\ Section 6(b)(4) of the Exchange Act, 15 U.S.C. 78f(b)(4).
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    An exchange must also have general conflict of interest rules 
regarding, for example, trading on the exchange by its employees, 
owners, or exchange officials. Moreover, an exchange must have rules 
that ensure that no member's order is unfairly disadvantaged. For 
example, if an exchange has priority rules, those rules need to treat 
all exchange members fairly. Finally, an exchange must have rules 
establishing procedures for the clearance and settlement of trades 
effected on the exchange. Alternatively, an exchange must have rules 
requiring members to make their own arrangements for clearance and 
settlement of trades.
    While exchanges are required to enforce compliance by their 
members, and persons associated with their members, with applicable 
laws and rules, the Commission has used its authority under sections 17 
and 19 of the Exchange Act to allocate to particular SROs oversight of 
broker-dealers that are members of more than one SRO (``common 
members'').\338\ For example, in order to avoid unnecessary regulatory 
duplication, the Commission appoints a single SRO as the designated 
examining authority (``DEA'') to examine common members for compliance 
with the financial responsibility requirements.\339\ When an SRO has 
been named as a common member's DEA, all other SROs to which the common 
member belongs are relieved of the responsibility to examine the firm 
for compliance with applicable

[[Page 70882]]

financial responsibility rules.\340\ Consistent with past Commission 
action, the Commission may continue to designate one SRO, such as the 
NASD or the NYSE, as the primary DEA for common members of exchanges.
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    \338\ 15 U.S.C. 78q and 78s. See also 17 CFR 240.17d-2; 17 CFR 
240.19g2-1.
    \339\ With respect to a common member, section 17(d)(1) of the 
Exchange Act authorizes the Commission, by rule or order, to relieve 
an SRO of the responsibility to receive regulatory reports, to 
examine for and enforce compliance with applicable statutes, rules, 
and regulations, or to perform other specified regulatory functions. 
15 U.S.C. 78q(d)(1).
    \340\ See Securities Exchange Act Release No. 23192 (May 1, 
1986) 51 FR 17426 (May 12, 1986). Moreover, section 108 of NSMIA, 
supra note 7, adds a provision to section 17 of the Exchange Act 
that calls for improving coordination of supervision of members and 
elimination of any unnecessary and burdensome duplication in the 
examination process.
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    In addition, the Commission has previously permitted existing SROs 
to contract with each other to allocate non-financial regulatory 
responsibilities.\341\ Rule 17d-2 under the Exchange Act permits SROs 
to establish joint plans for allocating the regulatory responsibilities 
imposed by the Exchange Act with respect to common members.\342\ An SRO 
participating in a regulatory plan is relieved of regulatory 
responsibilities with respect to a broker-dealer member of such SRO, if 
those regulatory responsibilities have been designated to another SRO 
under the regulatory plan. Alternative trading systems registered as 
exchanges would also be able to establish joint plans with respect to 
common members.
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    \341\ For example, the Commission has approved a regulatory plan 
filed by the Amex, CBOE, NASD, NYSE, PCX, and the Philadelphia Stock 
Exchange (``Phlx'') that divides the oversight responsibilities 
among these SROs for common members, by designating each 
participating SRO as the options examination authority for a portion 
of the common members. This designated SRO has sole regulatory 
responsibility for certain options-related trading matters. See 
Securities Exchange Act Release No. 20158 (Sept. 8, 1983), 48 FR 
41265 (Sept. 14, 1983). The SRO designated under the plan as a 
broker-dealer's options examination authority is responsible for 
conducting options-related sales practice examinations and 
investigating options-related customer complaints and terminations 
for cause of associated persons. The designated SRO is also 
responsible for examining a firm's compliance with the provisions of 
applicable federal securities laws and the rules and regulations 
thereunder, its own rules, and the rules of any SRO of which the 
firm is a member. Id.
    \342\ 17 CFR 240.17d-2. Securities Exchange Act Release No. 
12935 (Oct. 28, 1976), 41 FR 49093 (Nov. 8, 1976). In addition to 
the regulatory responsibilities it otherwise has under the Exchange 
Act, the SRO to which a firm is designated under these plans assumes 
regulatory responsibilities allocated to it. Under Rule 17d-2(c), 
the Commission may declare any joint plan effective if, after 
providing notice and opportunity for comment, it determines that the 
plan is necessary or appropriate in the public interest and for the 
protection of investors, to foster cooperation and coordination 
among the SROs, to remove impediments to, and foster the development 
of, a national market system and a national clearance and settlement 
system, and in conformity with the factors set forth in Exchange Act 
section 17(d). 15 U.S.C. 78q(d). The Commission has approved plans 
filed by the equity exchanges and the NASD for the allocation of 
regulatory responsibilities pursuant to Rule 17d-2. See, e.g., 
Securities Exchange Act Release Nos. 13326 (Mar. 3, 1977), 42 FR 
13878 (Mar. 14, 1977) (NYSE/Amex); 13536 (May 12, 1977), 42 FR 26264 
(May 23, 1977) (NYSE/BSE); 14152 (Nov. 9, 1977), 42 FR 59339 (Nov. 
16, 1977) (NYSE/CSE); 13535 (May 12, 1977), 42 FR 26269 (May 23, 
1977) (NYSE/CHX); 13531 (May 12, 1977), 42 FR 26273 (May 23, 1977) 
(NYSE/PSE); 14093 (Oct. 25, 1977), 42 FR 57199 (Nov. 1, 1977) (NYSE/
Phlx); 15191 (Sept. 26, 1978), 43 FR 46093 (Oct. 5, 1978) (NASD/BSE, 
CSE, CHX and PSE); and 16858 (May 30, 1980), 45 FR 37927 (June 5, 
1980) (NASD/BSE, CSE, CHX and PSE).
---------------------------------------------------------------------------

    A registered exchange would also be expected to maintain an audit 
trail of trading. A fully automated exchange, however, can produce 
comprehensive, instantaneous automated records that can be monitored 
remotely. Therefore, fully automated exchanges might be able to 
contract with other SROs to perform certain oversight activities, while 
retaining ultimate responsibility for ensuring that these activities 
are performed.
    Further, the Commission also believes that the ultimate 
responsibility for enforcement and disciplinary actions for violations 
relating to transactions executed in an SRO's market or rules unique to 
that SRO should continue to be retained by that SRO. In addition, these 
exchanges must establish a disciplinary process including appropriate 
sanctions for violations of the rules and a fair procedure for 
administering the disciplinary process.\343\ Existing exchanges 
generally employ personnel and establish extensive programs to fulfill 
this responsibility. However, it may be possible for an exchange to 
contract with another SRO to perform its day-to-day enforcement and 
disciplinary activities. Nevertheless, a registered exchange would 
retain ultimate responsibility for this function.\344\ In considering 
an exchange's application for registration the Commission will consider 
whether allowing the exchange to contract with another SRO to perform 
its day-to-day enforcement and disciplinary activities would be 
consistent with the public interest.
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    \343\ See section 6(b)(6) of the Exchange Act, 15 U.S.C. 
78f(b)(6). See also section 6(b)(7) of the Exchange Act, 15 U.S.C. 
78f(b)(7).
    \344\ See, e.g. section 19 of the Exchange Act, 15 U.S.C. 78s
---------------------------------------------------------------------------

2. Fair Representation
    Section 6(b)(3) of the Exchange Act requires that registered 
exchanges have rules that: (1) Provide that one or more directors is 
representative of issuers and investors, and not associated with a 
member of the exchange, or with any broker-dealer; and (2) ``assure a 
fair representation of its members in the selection of its directors 
and administration of its affairs.'' \345\
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    \345\ Section 6(b)(3) of the Exchange Act, 15 U.S.C. 78f(b)(3).
---------------------------------------------------------------------------

(i) Public Directors
    Congress adopted the requirement that at least one director be 
representative of issuers and investors because of the public's 
interest in ensuring the fairness and stability of significant 
markets.\346\ Public representation on an exchange's board of directors 
helps to achieve this goal. The Commission believes that, under this 
structure, representation of the public on an oversight body that has 
substantive authority and decision making ability is critical to ensure 
that an exchange actively works to protect the public interest and that 
no single group of investors has the ability to systematically 
disadvantage other market participants through use of the exchange 
governance process.\347\ Therefore, the Commission would expect 
alternative trading systems that apply for registration as exchanges to 
have public representation on their boards of directors.
---------------------------------------------------------------------------

    \346\ Id.
    \347\ See NASD 21(a) Report, supra note 4.
---------------------------------------------------------------------------

(ii) Fair Representation of Exchange Members
    The second requirement, that of fair representation of an 
exchange's members, also serves to ensure that an exchange is 
administered in a way that is equitable to all market members and 
participants. Because a registered exchange is not solely a commercial 
enterprise, but also has significant regulatory powers with respect to 
its members, competition between exchanges may not be sufficient to 
ensure that an exchange carries out its regulatory responsibilities in 
an equitable manner. The fair application of an exchange's authority to 
bring and adjudicate disciplinary procedures may be particularly 
important, because these actions can have significant and far-reaching 
ramifications for broker-dealers.
    Historically, the fair representation requirement was one of the 
major obstacles to the regulation of alternative trading systems as 
exchanges because of the concern that it would be incompatible with 
their proprietary structures.\348\ In the Proposing Release,

[[Page 70883]]

however, the Commission proposed to allow non-membership, for-profit 
alternative trading systems that choose to register as exchanges some 
flexibility in satisfying this ``fair representation'' requirement.
---------------------------------------------------------------------------

    \348\ See Delta Release, supra note 32, at 1900. In Board of 
Trade of the City of Chicago v. Securities and Exchange Commission, 
923 F.2d 1270 (7th Cir. 1991) (``Delta II''), the court stated that:
    The Delta system cannot register as an exchange because the 
statute requires that an exchange be controlled by its participants, 
who in turn must be registered brokers or individuals associated 
with such brokers. So all the financial institutions that trade 
through the Delta system would have to register as brokers, and (the 
system sponsors) would have to turn over the ownership and control 
of the system to the institutions. The system would be kaput.
    Id. at 1272-73.
---------------------------------------------------------------------------

    The Commission notes that it has not, in the past, interpreted an 
exchange's obligation to provide fair representation of its members to 
mean that all members must have equal rights. Instead, the Commission 
has allowed registered SROs a degree of flexibility in complying with 
this requirement. For example, PCX ``electronic access members'' 
(``ASAP Members'') do not have voting rights, and therefore are not 
represented on the board of that exchange.\349\
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    \349\ See Securities Exchange Act Release No. 28335 (Aug. 13, 
1990), 55 FR 34106 (Aug. 21, 1990) (order approving rule change 
establishing electronic access memberships on the PCX).
---------------------------------------------------------------------------

    More recently, the Commission approved the merger between the Amex 
and the NASD. As a result of the merger, Amex, reorganized as New Amex 
LLC (``New Amex''), is now a subsidiary of the NASD. In reviewing the 
merger, the Commission considered several fair representation issues. 
Specifically, the Commission considered, among other things, Amex 
member representation on the Board of Governors of New Amex, Amex 
member representation on the Board of the NASD, the voting rights of 
the Amex membership, and representation of the Amex membership in the 
disciplinary process.
    The Commission found that the composition of the New Amex Board 
satisfied the fair representation requirement by providing the Amex 
membership with the opportunity to nominate four Amex floor governors 
to the New Amex Board.\350\ Further, the Commission found that the 
inclusion of one New Amex floor governor on the NASD Board \351\ helped 
to fulfill the fair representation requirement by providing for New 
Amex input on the parent Board.\352\ In addition, the Commission 
believes that the fair representation requirement was furthered by the 
corporate governance provisions of New Amex's constitution that require 
the consent of either Amex (through a Membership vote), the Amex 
Committee (a committee designed specifically to represent the interests 
of the Amex membership), or both, in situations impacting certain 
membership interests or material market changes to New Amex. Lastly, 
the Commission found that the disciplinary procedures of New Amex met 
the fair representation requirement by providing for review of all 
disciplinary matters by a committee composed of both Amex members and 
public representatives. Specifically, the Amex Adjudicatory Council, 
which is empowered to act for the full New Amex Board in reviewing 
appeals from disciplinary proceedings, is composed of three Public 
Members and three Floor Governors, all of whom are nominated by the 
Amex Nominating Committee (or by petition signed by twenty-five 
Members) and elected by a full Amex Membership vote.\353\
---------------------------------------------------------------------------

    \350\ The New Amex Board consists of eighteen total governors. 
Floor governor nominees will be proposed by either the Amex 
Nominating Committee (consisting of three floor members and two 
public members) or a petition signed by twenty five members and will 
be selected by a plurality of the Amex Regular and Options Principal 
members voting together as a single class. The Amex membership 
elects the members of the Amex Nominating Committee.
    \351\ The Chief Executive Officer of New Amex will also be a 
governor on the NASD Board.
    \352\ The New Amex Floor Governor is nominated by the Amex 
Membership and will be able to directly express the Amex members' 
viewpoint and concerns within the NASD Board forum. In addition, the 
Chief Executive Officer of New Amex will be able to provide 
information about, and communicate the needs of, New Amex to the 
NASD Board.
    \353\ See Securities Exchange Act Release No. 40622 (Oct. 30, 
1998), 63 FR 59819 (Nov. 5, 1998).
---------------------------------------------------------------------------

    In addition, with respect to clearing agencies, the Commission has 
stated that registered clearing agencies may employ several methods to 
comply with the fair representation standard.\354\ The Commission 
believes that other structures may also provide independent, fair 
representation for an exchange's constituencies in its material 
decision making processes if the exchange is not owned by its 
participants. For example, a proprietary alternative trading system 
that registers as an exchange might be able to fulfill this requirement 
by establishing an independent subsidiary that has final, binding 
responsibility for bringing and adjudicating disciplinary proceedings 
and making rules for the exchange, and ensuring that the governance of 
such subsidiary equitably represents the exchange's participants.\355\ 
As another possibility, certain directors appointed to the board to 
represent the interests of trading members or participants could be 
limited to considering certain topics relating to system use and rules, 
while consideration of ownership issues could be restricted to board 
members representing the interests of the owners or stockholders.\356\
---------------------------------------------------------------------------

    \354\ 15 U.S.C. 78q-1(b)(3)(c). These methods include: (1) 
Solicitation of board of directors nominations from all 
participants; (2) selection of candidates for election to the board 
of directors by a nominating committee which would be composed of, 
and selected by, the participants or representatives chosen by 
participants; (3) direct participation by participants in the 
election of directors through the allocation of voting stock to all 
participants based on their usage of the clearing agency; or (4) 
selection by participants of a slate of nominees for which 
stockholders of the clearing agency would be required to vote their 
share. See Securities Exchange Act Release No. 14531 at 24 (Mar. 6, 
1978), 43 FR 10288 (Mar. 10, 1978). See also Securities Exchange Act 
Release No. 16900 (June 17, 1980), 45 FR 41920 (June 23, 1980).
    \355\ The proprietary foreign exchange Easdaq, a recognized 
secondary market in Belgium, has established a ``regulatory 
authority'' that has a degree of independence from Easdaq's board of 
directors.
    \356\ The Commission in the past has approved exchange rules 
limiting the voting rights of ``special access'' or non-equity 
members as consistent with section 6(b)(3) of the Exchange Act, 15 
U.S.C. 78f(b)(3). See, e.g., Securities Exchange Act Release No. 
22959 (Feb. 28, 1986), 51 FR 8060 (Mar. 7, 1986) (approving rule 
change by NYSE establishing ``electronic access membership'' with 
restricted voting rights).
---------------------------------------------------------------------------

    Some commenters expressed concern that the flexibility afforded 
alternative trading systems in complying with their ``fair 
representation'' requirement not extend so far as to result in unequal 
regulation of alternative trading systems registered as exchanges and 
traditional exchanges. In addition, these commenters expressed concern 
that the efficiency of the markets not be compromised.\357\ American 
Century also expressed its support for structures in which an 
alternative trading system's board included both owners and 
participants.\358\ On the other hand, several commenters stated that 
members (or participants) of a proprietary exchange should not have any 
right to participate in the governance of the exchange and that 
imposing constraints on the manner in which alternative trading systems 
are governed may undermine the factors that lead to their efficiency 
and innovativeness.\359\
---------------------------------------------------------------------------

    \357\ See CBOE Letter at 5-6; NASD Letter at 4-5.
    \358\ American Century Letter at 6.
    \359\ See Ashton Letter at 4 (for-profit exchanges should be 
afforded considerable flexibility in their formative business stages 
in meeting fair representation obligations); OptiMark Letter at 3-4 
(users of alternative trading systems should be treated fairly, but 
are not entitled to exercise any formal rights in regard to the 
management of the system, and are adequately protected through a 
combination of regulatory safeguards and market forces); Lee Letter 
at 1-2 (owners of exchanges already have incentives to create 
suitable governance structures).
---------------------------------------------------------------------------

    The Commission believes alternative trading systems should be 
required to assure fair representation of their members if they choose 
to register as exchanges. As discussed above, registered exchanges have 
special responsibilities under the Exchange Act, regardless of whether 
they are not-for-profit or for-profit. Accordingly, the Commission 
continues to believe that exchange participants--including

[[Page 70884]]

participants in a for-profit exchange--need to have substantive input 
into disciplinary and other key processes to prevent these processes 
from being conducted in an inequitable, discriminatory, or otherwise 
inappropriate fashion.
    The NASD asked the Commission to provide more specific guidance on 
the details of the flexibility the Commission proposes to allow 
alternative trading systems applying for registration as 
exchanges.\360\ The Commission has provided several examples of ways in 
which fair representation requirements can be met in non-traditional 
ways and believes that there may be other acceptable ways. The 
Commission, however, does not believe it is necessary to specify in 
greater detail what types of structures would be acceptable to it. What 
constitutes fair representation for a particular exchange will be 
determined in the context of that system's application for registration 
under sections 6(a) and 19(a) of the Exchange Act. Under section 19(a) 
of the Exchange Act, notice of an application for registration as an 
exchange is published for comment before approval.\361\ This will 
provide interested persons with notice of, and an opportunity to 
comment on, the manner in which a particular exchange proposes to meet 
its fair representation obligations.\362\
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    \360\ NASD Letter at 4-5.
    \361\ 15 U.S.C. 78s(a).
    \362\ 15 U.S.C. 78f(a) and 78s(a). See NASD Letter at 4-5 
(commenting that the public should have an opportunity to comment on 
the proposed governance structure of an exchange before the 
Commission approves its application for registration).
---------------------------------------------------------------------------

3. Membership on a National Securities Exchange
    An applicant for registration as a national securities exchange 
must have rules to admit members and persons associated with those 
members.\363\ Section 6(c)(1) of the Exchange Act \364\ prohibits 
exchanges from granting new membership to any person not registered as 
a broker-dealer, or associated with a broker-dealer. In the Concept 
Release, the Commission solicited commenters' views on whether to allow 
institutional membership on national securities exchanges. Because most 
commenters were opposed to institutional membership on exchanges, the 
Commission did not propose to exempt registered exchanges from the 
limitations in section 6(c)(1). Nevertheless, in the Proposing Release, 
the Commission asked for comment on whether institutions should be 
permitted to be members of national securities exchanges.
---------------------------------------------------------------------------

    \363\ 15 U.S.C. 78f(b)(3)-(4) and 78f(c).
    \364\ 15 U.S.C. 78f(c)(1). Section 6(c)(1), adopted in 1975, 
prohibits exchanges from granting new memberships to non-broker-
dealers. At the time this Section was adopted, one non-broker-dealer 
maintained membership on an exchange. This non-broker-dealer was not 
affected by the prohibition and continues to maintain its 
membership.
---------------------------------------------------------------------------

    Most commenters expressing a view on institutional membership on 
registered exchanges agreed that such exchanges should be prohibited 
from having non-broker-dealer members.\365\ One commenter, however, 
believed that direct institutional access to exchanges is a choice that 
would benefit market participants by providing lower execution costs 
for the shareholders of institutional funds. Although this commenter 
noted the Commission's concerns about the regulatory burden an 
institution might face if it chose to be a direct member of an 
exchange, it thought that membership should be a choice available to 
those institutions that feel they have the economies of scale to 
warrant direct access or believe that anonymity is worth the regulatory 
cost of membership.\366\
---------------------------------------------------------------------------

    \365\ CBOE Letter at 6 (``it would be difficult, if not 
impossible, for the Commission to adequately regulate or oversee the 
array of non-broker-dealer institutions that currently are, or may 
become, participants on (alternative trading systems)''); NASD 
Letter at 8 (institutions should not be members of alternative 
trading systems that register as exchanges); IBEX Letter at 13 
(institutional and individual investors should be granted exchange 
access through the sponsorship of discount or full-service broker-
dealers).
    \366\ American Century Letter at 4.
---------------------------------------------------------------------------

    As discussed in the Proposing Release, the Commission believes 
that, in order to ensure the central goals of exchange regulation, 
direct institutional members or participants in exchanges would have to 
be subject to the majority of rules and regulations to which broker-
dealers are currently subject.\367\ Moreover, because institutions that 
were granted exchange membership or direct access to exchanges would 
likely need to become members in one or more of the national clearance 
and settlement corporations in order to clear and settle their trades, 
these institutions would need to demonstrate and maintain financial 
creditworthiness. Insufficient net capital and incomplete books and 
records could compromise financial soundness, audit trails, and other 
general risk management objectives that are critical to sound markets 
and clearance and settlement systems. Consequently, the Commission 
would need to require non-broker-dealer institutions to comply with 
financial responsibility obligations, including the requirements to 
maintain certain minimum levels of net capital and appropriate books 
and records.\368\ Without such requirements, institutional membership 
on an exchange may also conflict with an exchange's obligation to have 
rules that foster the efficient clearance and settlement of securities 
transactions.
---------------------------------------------------------------------------

    \367\ Sections 6(f) and 15(e) of the Exchange Act, 15 U.S.C. 
78f(f) and 78o(e), would permit the Commission to subject 
institutional members to all exchange rules and relevant Exchange 
Act provisions.
    \368\ The Commission could adopt such requirements pursuant to 
its authority under Section 15(c) of the Exchange Act, 15 U.S.C. 
78o(e).
---------------------------------------------------------------------------

    The Commission believes that non-broker-dealer institutions 
essentially would be required to comply with the same requirements 
imposed on registered broker-dealers and, therefore, undermine most 
benefits an institution receives by virtue of not registering as a 
broker-dealer.\369\ Thus, the Commission does not believe that allowing 
institutional membership on exchanges would be any less costly to an 
institution than establishing a broker-dealer affiliate, which can 
become a member in a registered exchange. At the same time, it would 
impose ad-hoc regulatory burdens on the Commission and the exchanges as 
they tried to impose critical rules and regulations on institutions. 
Further, the Commission does not believe that it is currently practical 
or serves the best interests of investors or the markets generally to 
allow non-broker-dealers to be members of national securities 
exchanges, because of the potential lack of regulatory oversight the 
Commission would have over these entities. Therefore, just as currently 
registered exchanges are required to limit membership to broker-
dealers, alternative trading systems that choose to register as 
exchanges would be prohibited from extending membership to non-broker-
dealers.
---------------------------------------------------------------------------

    \369\ The Commission notes that institutions currently have the 
option to establish a broker-dealer affiliate, which can become a 
member in an exchange. The institution can then direct its order 
flow through its affiliated entity. Many investment companies 
already have affiliated broker-dealers.
---------------------------------------------------------------------------

    Accordingly, the Commission believes that exchange membership 
should continue to be limited to registered broker-dealers and persons 
associated with registered broker-dealers in accordance with section 
6(c)(1) of the Exchange Act.\370\ Institutions, however, would be able 
to access alternative trading systems registered as exchanges through a 
registered broker-dealer member of such a trading system, including an 
affiliate of the institution. Institutions currently have efficient 
access to the NYSE through SuperDOT

[[Page 70885]]

terminals given to them by NYSE members,\371\ and the OptiMark System 
\372\ will enable institutions to directly enter orders in the OptiMark 
System through use of an exchange member give-up. Access of this nature 
should not impose significant costs or burdens on institutions or on 
broker-dealers providing the access. The Commission believes if 
institutions continue to have indirect access to exchanges, their needs 
can be met without compromising important regulatory objectives.
---------------------------------------------------------------------------

    \370\ 15 U.S.C. 78f(c)(1).
    \371\ Exchange members are subject to regulatory action by the 
NYSE for violations of NYSE rules by their customers entering orders 
through the members' SuperDOT terminals.
    \372\ See infra note 452.
---------------------------------------------------------------------------

    Finally, while the NASD agreed with the Commission's views that 
institutions should not be ``members'' of registered exchanges, it 
asked the Commission to provide guidance on whether a registered 
exchange may set up a broker-dealer subsidiary to provide sponsored 
access to retail and institutional customers. Further, the NASD asked 
whether the registered exchange could be the SRO for its broker-dealer 
subsidiary. The NASD believes that there is an inherent conflict of 
interest in such an arrangement and that the Commission should explain 
its views and provide SROs with guidance on the responsibilities for 
oversight of the broker-dealer in such circumstances.\373\
---------------------------------------------------------------------------

    \373\:NASD Letter at 8.
---------------------------------------------------------------------------

    In this regard, a registered exchange is not explicitly prohibited 
from establishing a broker-dealer subsidiary through which it can 
provide sponsored access to its non-broker-dealer customers. 
Nonetheless, the Commission recognizes concerns about the potential 
conflict of interest if a registered exchange were the SRO for its 
subsidiary, and believes that it may be difficult for an exchange to 
fulfill its obligations under sections 6(b)(6), 6(b)(7), and 19(g) with 
respect to such a subsidiary.\374\
---------------------------------------------------------------------------

    \374\ 15 U.S.C. 78f(b)(6)-(7) and 15 U.S.C. 78s(g). These 
provisions require that a registered exchange be able to enforce 
compliance by its members with the federal securities laws, 
appropriately discipline its members for violations of such laws, 
and provide a fair disciplinary procedure. The Commission notes, 
however, that unless a broker-dealer effects transactions in 
securities solely on a national securities exchange of which it is a 
member, it must become a member of a national securities association 
or another national securities exchange. Section 15(b)(8) of the 
Exchange Act, 15 U.S.C. 78o(b)(8).
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4. Fair Access
    Sections 6(b)(2) \375\ and 6(c) \376\ of the Exchange Act prohibit 
registered exchanges from denying access to, or discriminating against, 
members. The obligation to ensure fair access for members does not, 
however, restrict the authority of a national securities exchange to 
maintain reasonable standards for access.\377\ The securities industry 
and the general public need access to exchanges to ensure the best 
execution of orders. Exchanges are venues for trading that should be 
open to all qualified persons. The Commission stated in the Proposing 
Release that alternative trading systems that register as exchanges 
would be required to comply with section 6(b)(2) and section 6(c) of 
the Exchange Act. IBEX was the only commenter to express a view on this 
requirement and its comment was favorable.\378\ Thus, the Commission 
would require any alternative trading system registered as an exchange 
to ensure the fair access of registered broker-dealers.
---------------------------------------------------------------------------

    \375\ 15 U.S.C. 78f(b)(2).
    \376\ 15 U.S.C. 78f(c).
    \377\ A denial of access would be reasonable, for example, if it 
were based on objective standards, such as capital and credit 
requirements, and if these standards were applied fairly.
    \378\ IBEX Letter at 13-14.
---------------------------------------------------------------------------

    In a similar vein, exchanges are prohibited from adopting any anti-
competitive rules.\379\ To further emphasize the goal of vigorous 
competition, Congress requires the Commission to consider the 
competitive effects of exchange rules,\380\ as well as the Commission's 
own rules.\381\ The fair access and fair competition requirements in 
the Exchange Act are intended to ensure that national securities 
exchanges treat investors and their participants fairly, consistent 
with the expectations of the investing public. For example, as 
discussed above, an exchange's rules, including its rules of priority, 
must treat all members fairly. Accordingly, before granting an 
application for registration as an exchange, the Commission would 
review the exchange's rules for compliance with these requirements.
---------------------------------------------------------------------------

    \379\ Section 6(b)(8) of the Exchange Act, 15 U.S.C. 78f(b)(8); 
section 15A(b)(9) of the Exchange Act, 15 U.S.C. 78o-3(b)(9).
    \380\ Section 6(b)(6) of the Exchange Act, 15 U.S.C. 78f(b)(6).
    \381\ Section 23(a) of the Exchange Act, 15 U.S.C. 78w(a).
---------------------------------------------------------------------------

5. Compliance With ARP Guidelines
    All national securities exchanges are expected to maintain 
sufficient systems capacity to handle foreseeable trading volume. 
Applicants for registration as a national securities exchange must have 
adequate computer system capacity, integrity and security to support 
the operation of an exchange. The Commission believes that adequate 
capacity is vital to the efficient operation of exchanges, particularly 
during periods of high volume or volatility, such as have been 
experienced in the past year. To this end, all exchanges and the NASD 
currently participate in the Commission's automation review program 
(``ARP'').\382\ Given the highly automated nature of most alternative 
trading systems, the Commission stated in the Proposing Release that it 
would expect any exchange applying for registration as a national 
securities exchange to comply with the policies and procedures outlined 
by the Commission in its policy statements concerning the automation 
review program, including cooperation with any reviews conducted by the 
Commission. In this regard, the Commission would consider the resources 
and ability of an applicant for registration as an exchange to meet the 
standards set forth in the automation review program. In particular, 
the Commission would consider whether the applicant had sufficient 
capital to maintain its automated systems, and staff with technical 
expertise.
---------------------------------------------------------------------------

    \382\ See supra notes 269-273 and accompanying text.
---------------------------------------------------------------------------

    The Commission received one comment letter addressing this issue. 
The PCX commented that registered exchanges should only have to comply 
with the ARP guidelines if they reach the threshold level that triggers 
these requirements for alternative trading systems registered as 
broker-dealers. The PCX noted that, although many exchanges do not 
account for twenty percent, or even ten percent, of the trading in ITS 
eligible equity securities, all exchanges are required to comply with 
the ARP guidelines. The PCX commented that these regulatory 
requirements impose substantial costs on exchanges and that there is no 
basis for imposing these types of requirements on exchanges when such 
requirements are not imposed on alternative trading systems registered 
as broker-dealers that have substantially greater trading volume.\383\
---------------------------------------------------------------------------

    \383\ PCX Letter at 7-8.
---------------------------------------------------------------------------

    The Commission notes that today it is adopting a requirement that 
alternative trading systems with twenty percent or more of the volume 
in any equity security, or certain categories of debt, comply with 
certain systems capacity, integrity, and security requirements. While 
some registered exchanges may have less than twenty percent of the 
volume in similar securities, the Commission nevertheless believes that 
these exchanges' direct participation in the national market system 
necessitates

[[Page 70886]]

participation in the automation review program. Moreover, while there 
are costs associated with capacity planning and testing, contingency 
planning, stress testing, and independent reviews, as well as ensuring 
that automated systems have sufficient capacity, these are costs that 
all highly automated business must bear and not merely regulatory 
costs.\384\ The Commission's ARP guidelines are intended only to ensure 
that short-term cost cutting by registered exchanges does not 
jeopardize the operation of the securities markets.
---------------------------------------------------------------------------

    \384\ In this regard, those exchanges applying for registration 
in 1999 should also be prepared to demonstrate that their systems 
are year 2000 compliant.
---------------------------------------------------------------------------

6. Registration of Securities
    Under the Exchange Act, securities traded on a national securities 
exchange must be registered with the Commission and approved for 
listing on the exchange.\385\ In addition, national securities 
exchanges are permitted to trade securities listed on other exchanges 
and Nasdaq pursuant to unlisted trading privileges (``UTP'').\386\ 
These requirements ensure that investors have adequate information and 
that all relevant trading activity in a security is reported to, and 
surveilled by, the exchange on which it is listed. The Commission 
discussed in the Proposing Release that an alternative trading system 
choosing to register as an exchange would be subject to these 
requirements and would be required to have rules for trading the class 
or type of securities it seeks to trade pursuant to UTP.\387\ Moreover, 
to trade Nasdaq NM securities, such a system would have to become a 
signatory to an existing plan governing such trading.\388\
---------------------------------------------------------------------------

    \385\ Section 12(a) of the Exchange Act makes it unlawful for 
any member, broker, or dealer to effect any transaction in any 
security (other than an exempted security) on a national securities 
exchange unless a registration statement has been filed with the 
Commission and is in effect as to such security for such exchange in 
accordance with the provisions of the Exchange Act and the rules and 
regulations thereunder. 15 U.S.C. 78l(a). Section 12(b) of the 
Exchange Act, 15 U.S.C. 78l(b), contains procedures for the 
registration of securities on a national securities exchange. 
Section 12(a) does not apply to an exchange that the Commission has 
exempted from registration as a national securities exchange. See, 
e.g., Securities Exchange Act Release No. 28899 (Feb. 20, 1991), 56 
FR 8377 (Feb. 29, 1991). See also Securities Exchange Act Release 
No. 37271 (June 3, 1996), 61 FR 29145 (June 7, 1996).
    \386\ Section 12(f) of the Exchange Act, 15 U.S.C. 78l(f). Under 
section 12(f) of the Exchange Act, 15 U.S.C. 78l(f), exchanges 
cannot trade securities not listed on an exchange or classified as 
Nasdaq NM securities (such as Nasdaq SmallCap or OTC securities) 
without Commission action. Section 12(f) of the Exchange Act 
authorizes the Commission to permit the extension of UTP to any 
security listed otherwise than on an exchange. The OTC-UTP plan 
which provides UTP for Nasdaq NM securities, is the only extension 
to date approved by the Commission. See OTC-UTP plan, infra note 
401. Thus, registered exchanges cannot currently trade Nasdaq 
SmallCap securities or exempted securities that are not separately 
listed on the exchange.
    \387\ Rule 12f-5, 17 CFR 240.12f-5.
    \388\ See OTC-UTP plan, infra note 401 and accompanying text.
---------------------------------------------------------------------------

    With regard to these securities registration requirements, OptiMark 
commented that they would preclude, as a practical matter, those 
alternative trading systems that trade privately placed securities or 
unregistered foreign securities from choosing to register as exchanges. 
In addition, the various conditions and limited scope of the Nasdaq/
National Market System/Unlisted Trading Privileges (``OTC-UTP'') plan 
\389\ would impair the ability of alternative trading systems that 
offer competing facilities for securities listed on existing exchanges 
to register as exchanges. For example, UTP may be extended for Nasdaq 
NM securities, but this does not include Nasdaq SmallCap securities or 
other over-the-counter securities. Moreover, formally amending the OTC-
UTP plan to admit any new member and to allocate expenses and revenues 
among competing market centers is a time-consuming process.
---------------------------------------------------------------------------

    \389\ The OTC-UTP plan provides for the collection, 
consolidation, and dissemination of quotation and transaction 
information for Nasdaq NM securities by its participants. Any 
registered Exchange where Nasdaq NM securities are traded may become 
a full participant in the OTC-UTP plan. See infra note 401. See also 
Securities Exchange Act Release Nos. 24407 (Apr. 27, 1987), 52 FR 
17349 (May 7, 1987); 36985 (Mar. 18, 1996), 61 FR 12122 (Mar. 25, 
1996).
---------------------------------------------------------------------------

    Consequently, OptiMark recommended that the Commission exercise its 
exemptive authority to reduce the differences in regulatory treatment 
between alternative trading systems registered as exchanges and those 
registered as broker-dealers. In particular, OptiMark suggested that, 
regardless of whether they are registered exchanges or broker-dealers, 
alternative trading systems that limit their screen availability to 
certain qualified persons be permitted to trade unregistered 
securities, including private placements and foreign securities. 
Similarly, OptiMark believed that alternative trading systems that seek 
to compete for order flow with existing exchanges should be able to do 
so in all securities listed on those exchanges, regardless of the 
alternative trading system's registration status.\390\
---------------------------------------------------------------------------

    \390\ OptiMark Letter at 3.
---------------------------------------------------------------------------

    The issue of trading unregistered securities, and in particular 
unregistered foreign securities, on exchanges raises many difficult 
issues. Registration of securities provides public information for 
investors that is prepared in accordance with U.S. accounting and 
auditing standards. This assures that the issuer's disclosures are 
consistently presented and can be easily compared to the information 
provided by other issuers. For this reason, the Exchange Act requires 
securities to be registered if they trade on national securities 
exchanges.
    The Commission has maintained the current structure in the final 
rules: continuing to require registered exchanges to trade only 
registered securities, but not extending this requirement to 
alternative trading systems not registered as exchanges. The Commission 
is continuing to review on a broader basis the issuing and trading of 
unregistered foreign securities in the U.S. and, as part of that 
review, will specifically consider whether unregistered foreign 
securities should continue to be freely traded on alternative trading 
systems that are not registered as exchanges.
7. National Market System Participation
    As discussed in the Proposing Release, any alternative trading 
system that elects to register as a national securities exchange would 
also be expected to become a participant in the market-wide transaction 
and quotation reporting plans currently operated by registered 
exchanges and the NASD. These plans--the CQS,\391\ the CTA,\392\ the 
ITS,\393\ the Options Price Reporting Authority (``OPRA''),\394\ and 
OTC-

[[Page 70887]]

UTP \395\--link trading, quotation, and reporting for all registered 
exchanges and the NASD and are responsible for the transparent, 
efficient, and fair operation of the securities markets. These plans 
form the backbone of the national market system and participation in 
these plans by all registered exchanges is vital to the success of the 
national market system.
---------------------------------------------------------------------------

    \391\ The CTA provides vendors and other subscribers (including 
alternative trading systems) with consolidated last sale information 
for stocks admitted to dealings on any exchange pursuant to a plan 
approved by the Commission (``CTA plan''). See, e.g., Securities 
Exchange Act Release Nos. 10787 (May 10, 1974), 39 FR 17799 (final 
rules approving CTA plan); 16983 (July 16, 1980), 45 FR 49414 (July 
24, 1980); 37191 (May 9, 1996), 61 FR 24842 (May 16, 1996).
    \392\ The CQS gathers quotations from all market makers in 
exchange-listed securities and disseminates them to vendors and 
other subscribers pursuant to a plan approved by the Commission 
(``CQ plan''). Securities Exchange Act Release No. 16518 (Jan. 22, 
1980), 45 FR 6521 (final rules approving CQ plan); 37191 (May 9, 
1996), 61 FR 24842 (May 16, 1996).
    \393\ The ITS is a communications system designed to facilitate 
trading among competing markets by providing each market 
participating in the ITS pursuant to a plan approved by the 
Commission (``ITS plan'') with order routing capabilities based on 
current quotation information. See, e.g. Securities Exchange Act 
Release Nos. 37191 (May 9, 1996), 61 FR 24842 (May 16, 1996); 17532 
(Feb. 10, 1981), 46 FR 12919 (Feb. 18, 1981); 23365 (June 23, 1986), 
51 FR 23865 (July 1, 1986) (CSE/ITS linkage); 18713 (May 6, 1982) 47 
FR 20413 (May 12, 1982) (NASD's CAES/ITS linkage); 28874 (Feb. 12, 
1991), 56 FR 6889 (Feb. 20, 1991) (CBOE/ITS linkage).
    \394\ See infra note 401 and accompanying text for a description 
of the OPRA plan.
    \395\ See infra note and accompanying text for a description of 
the OTC-UTP plan.
---------------------------------------------------------------------------

    Participation in effective quote and transaction reporting plans 
and procedures would, therefore, be mandatory for any newly registered 
exchange, as it is now for currently registered exchanges.\396\ The CTA 
and the CQS, which make quote and transaction information in exchange-
listed securities available to the public,\397\ both have provisions 
governing the entry of participants to the plans,\398\ and allow any 
national securities exchange or registered national securities 
association to become a participant.\399\ New participants are required 
to pay certain entry fees to the existing participants.\400\ 
Participants in these plans share in the income and expenses associated 
with the plans' operations.\401\ Because national securities exchanges 
are required to participate in an effective quote and transaction 
reporting plan, the Commission expects the participants of existing 
plans to include them in the plans under reasonable conditions adapted 
to the situations of the new exchanges.
---------------------------------------------------------------------------

    \396\ See Rules 11Ac1-1(b)(1) and 11Aa3-2(c), 17 CFR 240.11Ac1-
1(b)(1) and 240.11Aa3-2(c).
    \397\ Both the CTA and the CQS are presently operated by the 
eight national securities exchanges and the NASD.
    \398\ The CTA plan also contains a provision for entities other 
than participants to report directly to the CTA as ``other reporting 
parties.'' Pursuant to this provision, parties other than a national 
securities exchange or association may be permitted to provide 
transaction data directly to the CTA. Alternative trading systems 
that do not elect to register as exchanges would be eligible for 
participation in the CTA plan pursuant to this provision; however, 
as non-member participants, these systems would neither be obligated 
to pay the required fees and expenses to the plan, nor able to share 
in the plan's profits.
    \399\ See Securities Exchange Act Release No. 37191 (May 9, 
1996), 61 FR 24842 (May 16, 1996).
    \400\ These fees represent the ``tangible and intangible 
assets'' provided by the plans to the new participant. See Proposing 
Release, supra note 3 at nn.342-43 (discussing entry fees for the 
CTA, CQS, and ITS plans).
    \401\ Similar to the CTA and CQ plans, the OTC-UTP plan 
governing trading of Nasdaq NM securities provides for the 
collection, consolidation, and dissemination of quotation and 
transaction information for Nasdaq NM securities by its 
participants. Any national securities exchange where Nasdaq NM 
securities are traded may become a full participant of the OTC-UTP 
plan. The plan also provides that new participants pay a share of 
development costs, share ongoing operating costs, and are entitled 
to share in the plan's profits. See Joint Self-Regulatory 
Organization Plan Governing the Collection, Consolidation and 
Dissemination of Quotation and Transaction Information for Exchange-
listed Nasdaq/National Market System Securities and for Nasdaq/
National Market System Securities Traded on Exchanges on an Unlisted 
Trading Privilege Basis (``OTC-UTP plan''). Securities Exchange Act 
Release No. 24407 (Apr. 29, 1987), 52 FR 17349 (May 7, 1987). See 
also Securities Exchange Act Release No. 36985 (Mar. 18, 1996), 61 
FR 12122 (Mar. 25, 1996).
    The OPRA plan also provides for the collection and dissemination 
of last sale and quotation information with respect to options that 
are traded on the participant exchanges. Under the terms of this 
plan, any national securities exchange whose rules governing the 
trading of standardized options have been approved by the Commission 
may become a party to the OPRA plan. The plan provides that any new 
party, as a condition of becoming a party, must pay a share of 
OPRA's start-up costs. It also provides for revenue sharing among 
all parties. The OPRA plan was approved pursuant to Section 11A of 
the Exchange Act and Rule 11a3-2 thereunder. See Securities Exchange 
Act Release No. 17638 (Mar. 18, 1981) (``OPRA plan'').
---------------------------------------------------------------------------

    In addition to requiring participation by newly registered 
exchanges in quote and transaction reporting plans, the Commission 
would expect newly registered exchanges to participate in ITS,\402\ or 
an equivalent system if one were developed. ITS provides trading links 
between market centers and enables a broker or dealer who participates 
in one market to execute orders, as principal or agent, in an ITS 
security at another market center, through the system.\403\ The ITS 
plan requires that the members of participant markets avoid initiating 
a purchase or sale at a worse price than that available on another ITS 
participant market (``trade-throughs'').\404\ Participation in ITS 
would give users of these new exchanges access to other ITS participant 
markets. Moreover, participation in ITS would require new exchanges to 
adopt rules to comply with other applicable ITS plan provisions and 
policies on matters such as, for example, trade-throughs, locked 
markets,\405\ and block trades.\406\ As with the quote and transaction 
reporting plans, alternative trading systems that register as exchanges 
would have to be integrated into ITS, or another system that links 
markets for trading purposes would have to be created to accomplish 
full integration of the newly registered exchanges into the national 
market system.
---------------------------------------------------------------------------

    \402\ To become a participant in ITS, an exchange or association 
must subscribe to, and agree to comply and to enforce compliance 
with, the provisions of the plan. See ITS plan, supra note 393, at 
section 3(c).
    \403\ ITS also establishes a procedure that allows specialists 
to solicit pre-opening interest in a security from specialists and 
market makers in other markets, thereby allowing these specialists 
and market makers to participate in the opening transaction. 
Participation in an opening transaction can be especially important 
when the price of a security has changed since the previous close.
    \404\ A trade-through occurs when an ITS participant purchases 
securities at a lower price or sells at a higher price than that 
available in another ITS participant market. For example, if the 
NYSE is displaying a bid of 20 and an offer of 20\1/8\ for an ITS 
security, the prohibition on trade-throughs would prohibit another 
ITS participant market from buying that security from a customer at 
19\7/8\ or selling that security to a customer at 20 \1/2\. In 
addition, each participant market has in place rules to implement 
the ITS Trade-Through Rule. See, e.g. NASD Rule 5262. The plan also 
provides a mechanism for satisfying a market aggrieved by another 
market's trade-through.
    \405\ A locked market occurs when an ITS participant 
disseminates a bid for an ITS security at a price that equals or 
exceeds the price of the offer for the security from another ITS 
participant or disseminates an offer for an ITS security at a price 
that equals or is less than the price of the bid for the security 
from another ITS participant. The plan provides a mechanism for 
resolving locked markets.
    \406\ The ITS block trade policy provides that the member who 
represents a block size order shall, at the time of execution of the 
block trade, send or cause to be sent, through ITS to each 
participating ITS market center displaying a bid (or offer) superior 
to the execution price a commitment to trade at the execution price 
and for the number of shares displayed with that market center's 
better priced bid (or offer).
---------------------------------------------------------------------------

    The Commission solicited comment on what issues were raised by the 
possible integration of new exchanges into ITS. One commenter strongly 
believed that the current voting structure of ITS establishes barriers 
to entry, which leads to barriers to innovation. This commenter was 
concerned that the network supporting ITS may not be strong enough to 
handle sharply higher volumes of securities transactions and that, in 
an environment with multiple exchanges, the failure of these linkages 
would impede market participants' quest for best prices.\407\ Another 
commenter, similarly, expressed concern that the means of access to, 
and participation in, the national market system plans more generally 
was not clearly defined and, therefore, provided the current 
participants in these plans an opportunity to delay and to set 
unreasonable terms and conditions for entry of new participants.\408\ 
The Commission realizes that integrating new exchanges into the 
national market system plans may require amendments to these plans and 
notes that national market system plans may be amended

[[Page 70888]]

either by vote of the participants, or by Commission action.\409\
---------------------------------------------------------------------------

    \407\ American Century Letter at 3 (citing instances of downtime 
on alternative trading systems that are attributable to SelectNet, 
rather than the alternative trading system).
    \408\ Ashton Letter at 4 (also stating that the Commission 
should be sensitive to the ``veiled anti-competitive motives'' of 
the existing plan participants and be prepared to direct any new 
qualified exchanges to be accepted into all national market system 
plans).
    \409\ Securities Exchange Act Release No. 40204 (July 15, 1998), 
63 FR 390306 (July 22, 1998) (proposal providing for the linkage of 
the PCX application of the OptiMark system to the ITS system); 
Securities Exchange Act Release No. 40260 (July 24, 1998), 63 FR 
40748 (July 30, 1998) (proposal expanding the ITS/CAES linkage to 
all listed securities, including non-Rule 19c-3 securities).
---------------------------------------------------------------------------

    The Commission also requested comment on whether any changes were 
necessary to incorporate alternative trading systems registered as 
exchanges into the national market system plans. In this regard, the 
Chicago Board Options Exchange (``CBOE'') and the NYSE stated that they 
did not believe that there would need to be significant changes to 
these plans, and that any changes that would be necessary to 
accommodate alternative trading systems registered as exchanges into 
ITS would be relatively easy to resolve.\410\ The CBOE, however, did 
state that alternative trading systems registered as exchanges should 
be subject to the same requirements regarding access to the national 
market system plans as are applicable to traditional exchanges, 
including payment of participation entry fees.\411\
---------------------------------------------------------------------------

    \410\ See CBOE Letter at 4-5; NYSE Letter at 8-9. The NYSE also 
stated that consideration of this issue can be better evaluated at 
the time an alternative trading system registers as an exchange and 
seeks to become a member of ITS. Id. But see CHX Letter at 7 
(expressing concern about a for-profit exchange becoming a full 
participant in the national market system plans because such 
exchanges would be subject to pressures not to expend significant 
resources on maintaining surveillance and enforcement capability and 
would not have the same commitment to the public interest and the 
investing public as traditional not-for-profit exchanges).
    \411\ CBOE Letter at 4-5.
---------------------------------------------------------------------------

    The NASD suggested that, before the Commission approves an 
alternative trading system's application for registration as an 
exchange, the Commission address more completely the manner in which 
such an alternative trading system registered as an exchange may 
participate in national market system plans. The NASD noted three areas 
in which the Proposing Release was silent. First, the Commission did 
not address what mechanism would be used for access among any new 
exchange and other exchanges or markets. For example, in the context of 
Nasdaq securities, the NASD thought it was unclear whether the existing 
approach to linkage and execution should continue to occur through 
Nasdaq's SelectNet system or its successor, or whether there should be 
a new ITS-like entity formed with a completely new approach to access. 
The NASD expressed a preference for using the current approach to 
linkages. Second, the NASD noted that the Commission did not address 
whether alternative trading systems registered as exchanges could 
continue to charge an access fee, and believed strongly that such 
alternative trading systems should not be allowed to charge for another 
market accessing displayed interest. Third, the Commission did not 
address the intermarket linkage issues raised by access to traditional 
exchanges by non-broker-dealers that have indirect access to 
alternative trading systems registered as exchanges.\412\
---------------------------------------------------------------------------

    \412\ NASD Letter at 7.
---------------------------------------------------------------------------

    OptiMark asked the Commission to consider the effect of an 
alternative trading system's ability to charge an execution fee on its 
choice to register as an exchange or as a broker-dealer. OptiMark noted 
that the Proposing Release only contemplated that alternative trading 
systems operating as broker-dealers would be able to charge a fee to 
non-subscribers; alternative trading systems registered as exchanges 
and participating in ITS would not.\413\
---------------------------------------------------------------------------

    \413\ OptiMark Letter at 4-5 (also asking that the Commission 
consider how members of exchanges, other than the exchange through 
which an alternative trading system registered as a broker-dealer 
disseminates its quotations, could access such alternative trading 
system's quotes).
---------------------------------------------------------------------------

    Susquehanna Investment Group (``Susquehanna'') expressed concern 
about potentially integrating many alternative trading systems 
registered as exchanges into the national market system mechanisms. 
Susquehanna commented that integrating new exchanges' quotations into 
the national market system should be done only with careful 
consideration for the preservation of the ITS trade-through rule.\414\ 
Instinet also stated that in order for an alternative trading system to 
make a determination about the feasibility of registering as an 
exchange, the Commission needs to address those unresolved issues 
relating to ITS, including the rules governing time/price priority 
within a multiple exchange structure. In addition, Instinet stated that 
inter-exchange rules need to be set forth for both the listed and over-
the-counter securities markets.\415\
---------------------------------------------------------------------------

    \414\ Letter from Gerald D. O'Connell, Susquenhanna Investment 
Group to Jonathan G. Katz, Secretary, SEC, dated July 23, 1998 
(``Susquehanna Letter'') at 1-2. See also OptiMark Letter at 4 
(asking the Commission to clarify that participation in national 
market system plans is not conditioned on any universal public 
display requirement).
    \415\ Instinet Letter at 1-2, 3, 6.
---------------------------------------------------------------------------

    The Commission agrees that access to national market system systems 
is of key importance. It currently has outstanding proposals for 
incorporation of one linkage into ITS of an alternative trading 
system--OptiMark--and a traditional exchange--PCX--and has sought 
comment on organizational and other changes to ITS to make it more 
responsive to changing conditions.\416\ The precise arrangements for 
inclusion of new exchanges into these plans depends on the structure of 
these exchanges, and will be addressed when an applicant seeks 
registration as an exchange.
---------------------------------------------------------------------------

    \416\ See supra note 409.
---------------------------------------------------------------------------

8. Uniform Trading Standards
    In addition to participation in national market system mechanisms, 
an alternative trading system that registers as an exchange would be 
required to comply with any Commission-instituted trading halt relating 
to securities traded on or through its facilities.\417\ Newly 
registered exchanges would be required in some instances to adopt 
trading halt rules to comply with certain Commission rules.\418\ A 
newly registered exchange would also have the authority and be expected 
to impose trading halts for individual securities, for classes of 
securities, and for its system as a whole under the appropriate 
circumstances.\419\ The Commission does not believe that this 
requirement would present any undue burden for alternative trading 
systems that elect to register as national securities exchanges because 
most alternative trading systems are already subject to the imposition 
of trading halts as members of the NASD.
---------------------------------------------------------------------------

    \417\ The Commission may suspend trading in any security for up 
to 10 days, and all trading on any national securities exchange or 
otherwise, for up to 90 days pursuant to sections 12(k)(1)(A) and 
(B) of the Exchange Act, 15 U.S.C. 78l(k)(1)(A) and (B).
    \418\ For example, a newly registered exchange would be required 
under Rule 11Ac1-1, 17 CFR 240.11Ac1-1, to halt trading when neither 
quotation nor transaction information can be disseminated.
    \419\ The Commission has found that trading halt rules 
instituted by a national securities exchange or a national 
securities association are consistent with the objectives of Section 
6(b)(5) of the Exchange Act, 15 U.S.C. 78f(b)(5). See, e.g., 
Securities Exchange Act Release Nos. 39582 (Jan. 26, 1998), 63 FR 
5408 (Feb. 2, 1998); 26198 (Oct. 19, 1988), 53 FR 41637 (Oct. 24, 
1988). See, e.g., Amex Rule 117, NASD Rule 4120(a)(3), and NYSE 
Rules 80B and 717. There is no requirement that exchanges or 
associations of securities dealers employ identical trading halt 
rules, and these rules may vary according to the needs of the 
individual market.
---------------------------------------------------------------------------

    In addition, to promote the orderly operation of the securities 
markets in accordance with Section 6 of the Exchange Act,\420\ the 
Commission would expect all newly registered national securities 
exchanges to implement circuit breaker rules to temporarily halt 
trading during periods

[[Page 70889]]

of extraordinary market volatility or unusual market declines. The 
Commission believes that for circuit breakers to be effective, all 
markets must impose corresponding circuit breakers.\421\
---------------------------------------------------------------------------

    \420\ 15 U.S.C. 78f.
    \421\ If circuit breakers are imposed in one market, but not in 
another, overall market disruptions caused by trading imbalances can 
migrate from one market to the next, and efforts to stabilize such 
imbalances during periods of heavy trading and extreme volatility 
would be subverted. See also Securities Exchange Act Release No. 
39846 (Apr. 9, 1998), 63 FR 18477 (Apr. 15, 1998) (approving 
proposed changes to SRO rules regarding circuit breakers).
---------------------------------------------------------------------------

9. Proposed Rule Changes
    Under Section 19(b)(1) of the Exchange Act, SROs are required to 
file all proposed rule changes with the Commission.\422\ Thus, once 
registered as an exchange, an alternative trading system would have to 
submit copies of any proposed rule changes to the Commission for 
approval.
---------------------------------------------------------------------------

    \422\ Section 19(b) of the Exchange Act, 15 U.S.C. 78s(b).
---------------------------------------------------------------------------

C. Application for Registration as an Exchange

    The Commission proposed to revise Rules 6a-1, 6a-2 and 6a-3 under 
the Exchange Act \423\ to clarify the requirements for registration as 
an exchange and to accommodate the registration as exchanges of 
automated and proprietary trading systems. Additionally, the Commission 
proposed to revise Form 1, the application used by exchanges to 
register or to apply for an exemption based on limited volume, and to 
repeal Form 1-A. After considering the comments, the Commission is 
adopting the amendments to Rule 6a-1, Rule 6a-2, Rule 6a-3 and Form 1 
as proposed.
---------------------------------------------------------------------------

    \423\ 17 CFR 240.6a-1, 240.6a-2 and 240.6a-3.
---------------------------------------------------------------------------

1. Revisions to and Repeal of Form 1-A
    The Commission is adopting the revisions to Form 1 and repealing 
Form 1-A as proposed. Form 1 is revised by reorganizing and 
redesignating the Statements and the exhibits. Because the Commission 
expects most future applicants for registration as an exchange to be 
fully or partially automated, the Commission revised some of the 
information requested in Form 1 to be more applicable to automated 
exchanges. Specifically, the Commission is adding two new exhibits 
requiring an applicant for registration as an exchange to describe the 
way any of its electronic trading systems operate, and the criteria 
used by the exchange in admitting members.\424\ In addition, the 
Commission is adding a new exhibit to Form 1 to reflect the possibility 
that an exchange is owned by shareholders, rather than members.\425\ 
The Commission is also adopting other changes to the information 
requested on Form 1 to reflect the fact that a for-profit exchange 
would have participants or subscribers trading, rather than members.
---------------------------------------------------------------------------

    \424\ Exhibit E requires an exchange to describe, among other 
things, the means of access to the electronic trading system, the 
procedures governing display of quotes and/or orders, execution, 
reporting, clearance, and settlement. Exhibit L requires an exchange 
to describe its criteria for membership, conditions under which 
members may be subject to suspension or termination, and procedures 
that would be involved in such suspension or termination.
    \425\ Exhibit K requires non-member owned exchanges to provide a 
list of direct owners and control persons.
---------------------------------------------------------------------------

    Both the NYSE and the Amex expressed concern that these new 
Exhibits would require new and additional information.\426\ Exhibits E 
and L, however, need only accompany the application for registration as 
an exchange and, therefore, are inapplicable to currently registered 
exchanges. In addition, Exhibit K applies only to non-member owned 
exchanges. Therefore, because all currently registered exchanges are 
member-owned, new Exhibit K does not apply to them. The Commission has 
clarified that Exhibit K exclusively applies to non-member owned 
exchanges. If, however, a currently registered, member-owned exchange 
were to convert to a for-profit structure, it would have to comply with 
the requirement to update Exhibit K.
---------------------------------------------------------------------------

    \426\ See NYSE Letter at 11; Amex Letter at 6.
---------------------------------------------------------------------------

    Exchanges currently registered with the Commission are required to 
use amended Form 1 in complying with Rules 6a-2 and 6a-3. The 
information registered exchanges are required to update under Rules 6a-
2 and 6a-3 is not substantially different from what registered 
exchanges are required to update today. The Commission has provided the 
chart below to assist currently registered exchanges in complying with 
the filing obligations under amended Rules 6a-2 and 6a-3.

----------------------------------------------------------------------------------------------------------------
                                                                               Corresponding part of former Form
           Amended form 1                Filing requirements under amended        1 on which information was
                                                rules 6a-2 and 6a-3                        requested
----------------------------------------------------------------------------------------------------------------
Questions 1-7 of the Execution Page.  File an amendment within 10 days after  Questions 1-6 of the Statement.
                                       any action is taken that renders the
                                       information previously filed
                                       inaccurate (Rule 6a-2((a)(1)).
Exhibit A...........................  File an amendment every three years     Exhibit A(1).
                                       (Rule 6a-2(c)) or make information
                                       available by publication, upon
                                       request, or via an Internet Web site
                                       (Rule 6a-2(d)).
Exhibit B...........................  File an amendment every three years     Exhibit A(2).
                                       (Rule 6a-2(c)) or make information
                                       available by publication, upon
                                       request, or via an Internet Web site
                                       (Rule 6a-2(d)).
Exhibit C...........................  File an amendment every three years     Question 7 of the Statement.
                                       (Rule 6a-2(c)) or make information
                                       available by publication, upon
                                       request, or via an Internet Web site
                                       (Rule 6a-2(d)).
                                      File an amendment within 10 days after  Exhibit A(3) Exhibit H.
                                       any action is taken that renders the
                                       information previously filed
                                       inaccurate (Rule 6a-2(a)(2)).
Exhibit D...........................  File an annual amendment (Rule 6a-      Exhibit F.
                                       2(b)(1)).
Exhibit E...........................  No requirement to update; only
                                       required on application for
                                       registration.
Exhibit F...........................  File an amendment within 10 days after  Exhibit B.
                                       any action is taken that renders the
                                       information previously filed
                                       inaccurate (Rule 6a-2(a)(2)).
Exhibit G...........................  File an amendment within 10 days after  Exhibit C.
                                       any action is taken that renders the
                                       information previously filed
                                       inaccurate (Rule 6a-2(a)(2)).
Exhibit H...........................  File an amendment within 10 days after  Exhibit D.
                                       any action is taken that renders the
                                       information previously filed
                                       inaccurate (Rule 6a-2(a)(2)).
Exhibit I...........................  File an annual amendment (Rule 6a-      Exhibit E.
                                       2(b)(1)).

[[Page 70890]]

 
Exhibit J...........................  File an amendment every three years     Exhibit G.
                                       (Rule 6a-2(c)) or make information
                                       available by publication, upon
                                       request, or via an Internet Web site
                                       (Rule 6a-2(d)). File an amendment
                                       within 10 days after any action is
                                       taken that renders the information
                                       previously filed inaccurate (Rule 6a-
                                       2(a)(2)).
Exhibit K...........................  Only for-profit exchanges are required
                                       to file an annual amendment (Rule 6a-
                                       2(b)(2)) or make information
                                       available by publication, upon
                                       request, or via an Internet Web site
                                       (Rule 6a-2(d)), and to file an
                                       amendment within 10 days after any
                                       action is taken that renders the
                                       information previously filed
                                       inaccurate (Rule 6a-2(a)(2)).
Exhibit L...........................  No requirement to update; only
                                       required on application for
                                       registration as an exchange.
Exhibit M...........................  File an amendment (Rule 6a-2(b)(2)) or  Question 8 of the Statement.
                                       make information available by
                                       publication, upon request, or via an
                                       Internet Web site (Rule 6a-2(d)).
                                      File an amendment within 10 days after  Question 9(a) of the Statement.
                                       any action is taken that renders the   Exhibit I.
                                       information previously filed           Exhibit J.
                                       inaccurate (Rule 6a-2(a)(2)).
Exhibit N...........................  File an amendment (Rule 6a-2(b)(2)) or  Exhibit K.
                                       make information available by          Exhibit L.
                                       publication, upon request, or via an   Exhibit M.
                                       Internet Web site (Rule 6a-2(d)).
Deleted.............................  ......................................  Question 9(b) of the Statement.
----------------------------------------------------------------------------------------------------------------

2. Amendments to Rules 6a-1, 6a-2, and 6a-3 Under the Exchange Act
    In order to reduce some of the filing burdens for exchanges and to 
allow exchanges to comply with the filing requirements by posting 
information on an Internet web page, the Commission is amending Rules 
6a-1, 6a-2, and 6a-3 under the Exchange Act.
a. Rule 6a-1 Application for Registration as an Exchange or Exemption 
Based on Limited Volume of Transactions
    The Commission proposed to amend Rule 6a-1 to clarify that Form 1 
should only be used by an exchange to apply for registration as a 
national securities exchange or for an exemption from registration 
under section 5 of the Exchange Act based on such exchange's limited 
volume of transactions. The Commission received no comments on these 
proposed changes and is adopting them as proposed.
b. Rule 6a-2 Periodic Amendments
    Paragraph (a) of amended Rule 6a-2 requires an exchange to file an 
amendment to Form 1 within 10 days of changes to: (1) Information filed 
on the Execution Page of Form 1, or amendment thereto; (2) information 
regarding all affiliates and subsidiaries (Exhibit C); (3) application 
for membership, participation or subscription to the exchange or for a 
person associated with a member, participant, or subscriber of the 
exchange (Exhibit F); (4) financial statements, reports or 
questionnaires required of members, participants or subscribers 
(Exhibit G); (5) listing applications, any agreements required to be 
executed in connection with listing and a schedule of listing fees 
(Exhibit H); \427\ (6) officers, governors, members of all standing 
committees, or persons performing similar functions, who presently hold 
or have held their offices or positions during the previous year 
(Exhibit J); (7) persons with direct ownership and control for non-
member owned exchanges (Exhibit K); and (8) any members, participants, 
subscribers or other users and the information pertaining thereto 
(Exhibit M).\428\ Additionally, rather than exchanges filing these 
changes in the form of a notice, as is currently required under 
paragraph (a) of Rule 6a-3, the changes will be filed in the form of an 
amendment on Form 1.
---------------------------------------------------------------------------

    \427\ A technical modification was made to the amendments as 
proposed to include Exhibit H in Rule 6a-2(a)(2).
    \428\ Rule 6a-2(a), 17 CFR 240.6a-2(a).
---------------------------------------------------------------------------

    These amendments to Rule 6a-2 relieve exchanges from some of the 
filing requirements to which exchanges are currently subject. 
Specifically, a registered exchange no longer has to file notice within 
10 days of changes to: (1) Its constitution, articles of incorporation 
or association, or by-laws (Exhibit A); (2) written rulings or settled 
practices of any governing board or committee of the exchange that have 
the effect of rules or interpretations (Exhibit B); and (3) the 
schedule of securities listed on the exchange (Exhibit N).
    Paragraph (b) of amended Rule 6a-2 requires an exchange to file 
annually an amendment to Form 1 with the following information: (1) 
Unconsolidated financial statements for each subsidiary or affiliate or 
the exchange for latest fiscal year (Exhibit D); (2) audited 
consolidated financial statements for last fiscal year of the exchange 
prepared in accordance with, or reconciled to, United States generally 
accepted accounting principals (Exhibit I); \429\ (3) a list of persons 
with direct ownership and control for non-member exchanges (Exhibit K); 
(4) a list of all members, participants, subscribers or other users and 
the information pertaining thereto (Exhibit M); and (5) a schedule of 
securities listed on the exchange, securities admitted to unlisted 
trading privileges and securities admitted to trading on the exchange 
which are exempt from registration under Section 12(a) of the Act 
(Exhibit N).\430\ These amendments remove exchanges' obligations to 
include the following as part of the annual amendment: (1) The 
exchange's affiliates and subsidiaries (Exhibit C) and (2) a list of 
officers, governors, and members of standing committees be

[[Page 70891]]

included as part of an annual amendment (Exhibit J).
---------------------------------------------------------------------------

    \429\ A technical modification was made to the amendments as 
proposed to remove Exhibit I from Rule 6a-2(a)(2) and to include 
Exhibit I in Rule 6a-2(b)(1).
    \430\ A technical modification was made to the amendments to 
include Exhibit N in Rule 6a-2(b)(2).
---------------------------------------------------------------------------

    Paragraph (c) of amended Rule 6a-2 requires an exchange to file an 
amendment to Form 1 every three years with the following information: 
(1) A copy of the constitution, articles or incorporation or 
association and by-laws (Exhibit A); (2) a copy all written rulings, 
settled practices having effect of rules and interpretations of any 
governing board or committee of the exchange (Exhibit B); (3) 
information regarding all affiliates and subsidiaries (Exhibit C); and 
(4) a list of officers, governors, members of all standing committees, 
or persons performing similar functions, who presently hold or have 
held their offices or positions during the previous year (Exhibit 
J).\431\
---------------------------------------------------------------------------

    \431\ A technical modification was made to the amendments to 
include Exhibit J in Rule 6a-2(c).
---------------------------------------------------------------------------

    Paragraph (d) of amended Rule 6a-2 provides exchanges with 
alternatives to the annual filing requirement for Exhibits K, M, and N, 
and to the three year filing requirement for Exhibits A, B, C, and J. 
Pursuant to Rule 6a-2(d) exchanges have the following options, in lieu 
of paper filing: (1) To publish or cooperate in the publication of this 
information on an annual or more frequent basis, and to certify to the 
accuracy of the information; (2) to keep the information up to date, 
and certify that the information is up to date and available to the 
Commission and the public upon request; or (3) to make the information 
available continuously on an Internet web site controlled by an 
exchange, indicate the location of the Internet Web site where such 
information may be found, and to certify that the information available 
at such location is accurate as of its date.\432\
---------------------------------------------------------------------------

    \432\ Rule 6a-2(d), 17 CFR 240.6a-2(d).
---------------------------------------------------------------------------

    Comments from the NYSE and the Amex suggested that the amendments 
to Rule 6a-2 and Form 1, as adopted, reimpose some of the annual filing 
requirements previously eliminated.\433\ As discussed above, Rule 6a-2 
and Form 1, as adopted, relax the current filing burdens without 
reimposing any filing requirements. The technical modifications to the 
amendments to Rule 6a-2 clarify the operation of the rule, as adopted.
---------------------------------------------------------------------------

    \433\ Securities Exchange Act Release No. 35123 (Dec. 20, 1994), 
59 FR 66692 (Dec. 28 1994).
---------------------------------------------------------------------------

c. Rule 6a-3 Supplemental Material
    Paragraph (b) of Rule 6a-3 currently requires registered exchanges, 
or exchanges exempt from registration based on their limited volume of 
transactions, to furnish to the Commission copies of all materials 
issued or made available to members. The Commission proposed to 
continue to require exchanges to provide the Commission with the 
information currently required under the rule. However, as an 
alternative to filing such information on paper, the Commission 
proposed to permit exchanges to make the information available on an 
Internet web site and provide the Commission with the location of the 
web site. The Commission did not receive comments addressing these 
proposed changes, and is adopting the amendments to Rules 6a-3(b) as 
proposed.\434\
---------------------------------------------------------------------------

    \434\ 17 CFR 240.6a-3. This rule is now found at paragraph (c) 
of Rule 6a-3.
---------------------------------------------------------------------------

D. National Securities Exchanges Operating Alternative Trading Systems

    National securities exchanges could, under the rules the Commission 
is adopting today, form subsidiaries or affiliates that operate 
alternative trading systems registered as broker-dealers.\435\ If a 
national securities exchange chose to form such a subsidiary or 
affiliate, the exchange itself could remain registered as a national 
securities exchange, while the subsidiary or affiliate operated as a 
broker-dealer. Such subsidiaries or affiliates would of course be 
required to become members of a national securities association or 
another national securities exchange.\436\ In addition, any subsidiary 
or affiliate of a registered exchange could not integrate, or otherwise 
link the alternative trading system with the exchange, including using 
the premises or property of such exchange for effecting or reporting a 
transaction, without being considered a ``facility of the exchange.'' 
\437\
---------------------------------------------------------------------------

    \435\ In addition, the owner of the alternative trading system 
would continue to be liable for securities law violations.
    \436\ But see supra note 374.
    \437\ Section 3(a)(2) of the Exchange Act, 15 U.S.C. 78c(a)(2). 
See also supra note 48 (discussing the OptiMark System as a facility 
of the PCX); 35030 (Nov. 30, 1994), 59 FR 63141 (Dec. 7, 1994) 
(discussing the Chicago Match system as a facility of the CHX); 
29237 (May 24, 1991), 56 FR 24853 (May 31, 1991) (discussing the 
Off-Hours Trading system as a facility of the NYSE).
---------------------------------------------------------------------------

V. Broker-Dealer Recordkeeping and Reporting Obligations

A. Elimination of Rule 17a-23

    Under the regulatory framework adopted in this release, alternative 
trading systems are required to register as exchanges or broker-
dealers, and comply with the requirements under Regulation ATS. These 
systems are currently subject to recordkeeping and reporting 
requirements under Rule 17a-23 of the Exchange Act.\438\ Because these 
alternative trading systems are now subject to recordkeeping and 
reporting requirements relating to their operations, either as 
registered exchanges or as broker-dealers under proposed Regulation 
ATS, the Commission is eliminating duplicative recordkeeping and 
reporting obligations for these systems by repealing Rule 17a-23. Only 
the recordkeeping requirements in Rule 17a-23 as they apply to broker-
dealers that are not also alternative trading systems, are being moved 
to the broker-dealer recordkeeping rules, Rules 17a-3 and 17a-4 under 
the Exchange Act.
---------------------------------------------------------------------------

    \438\ 17 CFR 240.17a-23.
---------------------------------------------------------------------------

B. Amendments to Rules 17a-3 and 17a-4

    Certain trading systems operated by broker-dealers are not 
alternative trading systems, and therefore are not required to register 
as exchanges or comply with Regulation ATS under the framework the 
Commission is adopting today. This group of internal broker-dealer 
systems \439\ will continue to be regulated under the traditional 
broker-dealer regulatory scheme. The Commission is amending Rules 17a-3 
and 17a-4 under the Exchange Act \440\ to require broker-dealers to 
continually make and keep records regarding the activities of internal 
broker-dealer systems for non-alternative trading systems. These 
recordkeeping requirements are similar to the recordkeeping 
requirements under Rule 17a-23, which the Commission today is 
repealing.\441\ The Commission believes that these recordkeeping 
requirements continue to be valuable to the oversight and inspections 
of internal broker-dealer systems by the Commission and the SROs.
---------------------------------------------------------------------------

    \439\ The term ``internal broker-dealer system'' is defined as 
``any facility, other than a national securities exchange, an 
exchange exempt from registration based on limited volume, or an 
alternative trading system as defined in Regulation ATS * * * that 
provides a mechanism, automated in full or in part, for collecting, 
receiving, disseminating, or displaying system orders and 
facilitating agreement to the basic terms of a purchase or sale of a 
security between a customer and the sponsor, or between two 
customers of the sponsor, through use of the internal broker-dealer 
system or through the broker or dealer sponsor of such system.'' 
Rule 17a-3(a)(16)(ii)(A), 17 CFR 240.17a-3(a)(16)(ii)(A).
    \440\ 17 CFR 240.17a-3 and 240.17a-4.
    \441\ Only one commenter addressed the Commission's proposal to 
repeal Rule 17a-23 and amend Rules 17a-3 and 17a-4. This commenter 
agreed that amended Rules 17a-3 and 17a-4 would impose similar 
obligations as current Rule 17a-23. TBMA Letter at 25-26.
---------------------------------------------------------------------------

    These amendments ensure that broker-dealers continue to keep 
records of any of their customers that have access to their internal 
broker-dealer system, as well as any affiliations between those 
customers and the

[[Page 70892]]

broker-dealer. Broker-dealers are also required to keep daily trading 
summaries, including information on the types of securities for which 
transactions have been executed through the internal broker-dealer 
system, and transaction volume information.\442\ In addition, to 
clarify the application of Rule 17a-3, the Commission is defining, for 
the purposes of the rule, the terms ``internal broker-dealer system,'' 
\443\ ``sponsor,'' \444\ and ``system order.'' \445\
---------------------------------------------------------------------------

    \442\ Rules 17a-3(a)(16)(i)(B) and (C), 17 CFR 240.17a-
3(a)(16)(i)(B) and (C).
    \443\ See supra note 439.
    \444\ The term ``sponsor'' is defined as ``any broker or dealer 
that organizes, operates, administers, or otherwise directly 
controls an internal broker-dealer system or, if the operator of the 
internal broker-dealer system is not a registered broker or dealer, 
any broker or dealer that, pursuant to contract, affiliation, or 
other agreement with the system operator, is involved materially on 
a regular basis with executing transactions in connection with use 
of the internal broker-dealer system, other than solely for its own 
account or as a customer with access to the internal broker-dealer 
system.'' Rule 17a-3(a)(16)(ii)(B), 17 CFR 240.17a-3(a)(16)(ii)(B).
    \445\ The term ``system order'' is defined as ``any order or 
other communication or indication submitted by any customer with 
access to the internal broker-dealer system for entry into a trading 
system announcing an interest in purchasing or selling a security,'' 
but specifically excludes ``inquiries or indications of interest 
that are not entered into the internal broker-dealer system.'' Rule 
17a-3(a)(16)(ii)(C), 17 CFR 240.17a-3(a)(16)(ii)(C).
---------------------------------------------------------------------------

    The Commission is also amending Rule 17a-4 under the Exchange Act 
to require that the records required under the amendments to Rule 17a-3 
be preserved for three years, the first two years in an accessible 
place.\446\ This amendment also requires the preservation of all 
notices regarding an internal broker-dealer system provided to its 
participants, whether communicated in writing, through the internal 
broker-dealer system, or by other automated means. Such notices include 
notices concerning the internal broker-dealer system's hours of 
operations, malfunctions, procedural changes, maintenance of hardware 
and software, and instructions for accessing the system.
---------------------------------------------------------------------------

    \446\ Rules 17a-4(b)(1) and (10), 17 CFR 240.17a-4(b)(1) and 
(10).
---------------------------------------------------------------------------

VI. Temporary Exemption of Pilot Trading System Rule Filings

A. Introduction

    The Commission recognizes that registered exchanges, unlike 
alternative trading systems registered as broker-dealers, must submit 
rule filings for Commission approval. In the Concept Release, the 
Commission generally sought comment on ways to expedite the rule filing 
process and specifically sought comment on whether the Commission 
should exempt new SRO trading systems or mechanisms from rule filing 
requirements.\447\ Commenters pointed out that, under the current 
regulatory structure, registered exchanges and alternative trading 
systems compete on a ``playing field that is far from level,'' \448\ 
and attributed this, in part, to exchanges' inability to implement new 
trading systems before submitting a rule filing and receiving 
Commission approval.\449\ In response to commenters' concerns and to 
make existing markets more competitive, the Commission proposed Rule 
19b-5, a temporary exemption for SROs that would defer the rule filing 
requirements of Section 19(b) under the Exchange Act \450\ for pilot 
trading systems (``pilot trading system rule'').\451\
---------------------------------------------------------------------------

    \447\ See Concept Release, supra note 2, 62 FR at 30518-19.
    \448\ See Proposing Release, supra note 3 (discussing comments 
responding to the Concept Release).
    \449\ Id. at n.252.
    \450\ 15 U.S.C. 78s(b).
    \451\ The Commission is also adopting measures to relieve SROs 
of the requirement to file rule changes with the Commission when an 
SRO wishes to list or trade new derivative securities products. 
Securities Exchange Act Release No. 40761 (Dec. 8, 1998).
---------------------------------------------------------------------------

    In formulating the pilot trading system rule, the Commission drew 
on its prior experience with SROs' attempts to operate new pilot 
trading systems for their members.\452\ In the Proposing Release, the 
Commission sought comment on whether the proposed pilot trading system 
rule would provide appropriate regulation and would level the 
competitive playing field between SROs and alternative trading systems. 
As an alternative, the Commission sought comment on the benefits and 
disadvantages of allowing SROs to file proposed rule changes relating 
to pilot trading systems under an expedited approval process pursuant 
to section 19(b)(3)(A) of the Exchange Act. Overall, comments on the 
proposed pilot trading system rule were supportive of it as a way to 
ease the regulatory disparity between registered exchanges and 
alternative trading systems.
---------------------------------------------------------------------------

    \452\ For example, in November 1990, the NYSE submitted a rule 
filing proposing an after-hours crossing system to automate the 
execution of single stock orders and baskets of securities and 
received Commission approval in May 1991. See Securities Exchange 
Act Release Nos. 29237 (May 24, 1991), 56 FR 24853 (May 31, 1991); 
32368 (May 25, 1993), 58 FR 31565 (June 3, 1993). In August 1993, 
the CHX submitted a rule filing to operate the Chicago Match system, 
an electronic matching system that crossed orders entered by the 
CHX's members and non-members including institutional customers, and 
obtained Commission approval in November 1994. See Securities 
Exchange Act Release No. 35030 (Nov. 30, 1994), 59 FR 63141 (Dec. 7, 
1994). More recently, in May 1997, the PCX submitted a rule filing 
for approval of the OptiMark System and received Commission approval 
in September 1997. See Securities Exchange Act Release No. 39086 
(Sept. 17, 1997), 62 FR 50036 (Sept. 24, 1997).
---------------------------------------------------------------------------

    The Commission received no comments opposing proposed Rule 19b-5. 
In general, commenters supported the proposal, stating that it would 
encourage further innovation and reduce some of the regulatory burdens 
that make it difficult for SROs to compete with broker-dealer operated 
trading systems. Some commenters, while generally supporting the 
temporary exemption, suggested modifying proposed Rule 19b-5. These 
comments focused on the proposed definition of a pilot trading system, 
the types of securities the Commission proposed to allow SROs to trade 
on pilot trading systems, and the confidential treatment of information 
filed by SROs regarding their pilot trading systems.\453\ After 
considering the comments, the Commission is adopting Rule 19b-5 
substantially as proposed.
---------------------------------------------------------------------------

    \453\ See ICI Letter at 5; Corporate Capital Letter at 2; CBOE 
Letter at 8; CHX Letter at 11; NASD Letter at 13; Amex Letter at 1-
2; NYSE Letter at 9; American Century Letter at 6. See also Ashton 
Letter at 2; CME Letter at 4; SIA Letter at 15; PCX Letter at 8.
---------------------------------------------------------------------------

    Currently, SROs are required to submit a rule filing to the 
Commission and undergo a public notice, comment, and approval process 
before they operate any new trading system.\454\ As adopted, the pilot 
trading system rule permits SROs that develop separate, new systems 
that qualify as ``pilot trading systems,'' \455\ to begin their 
operation shortly after submitting new Form PILOT to the Commission is 
merely an informational filing and an SRO does not need to await 
Commission approval to begin operating its pilot trading system.\456\ 
During the operation of the pilot trading system, the

[[Page 70893]]

sponsoring SRO must submit to the Commission quarterly reports, as well 
as amendments to Form PILOT concerning any material changes to the 
pilot trading system. Rule 19b-5 exempts an SRO from the requirement to 
file rule changes for the pilot trading system with the Commission for 
two years. Before two years expire, the SRO must submit a rule filing 
to obtain from the Commission permanent approval of the pilot trading 
system or must cease operation of the trading system.\457\ In addition, 
the temporary exemption under Rule 19b-5 expires sixty days after a 
pilot trading system exceeds certain volume levels. A pilot trading 
system that exceeds these volume levels must file for permanent 
approval before the two-year period expires.\458\
---------------------------------------------------------------------------

    \454\ Section 19(b)(1) of the Exchange Act, 15 U.S.C. 78s(b)(1), 
requires an SRO to file with the Commission any proposed rule or any 
proposed rule change (``proposed rule change'') accompanied by a 
concise general statement of the basis and purpose of the proposal. 
Once a proposed rule change has been filed, the Commission is 
required to publish notice of it and provide an opportunity for 
public comment. The proposed rule change may not take effect unless 
it is approved by the Commission or is otherwise permitted to become 
effective under Section 19(b) of the Exchange Act. Section 19(b)(2) 
of the Exchange Act, 15 U.S.C. 78s(b)(2), sets forth the standards 
and time periods for Commission action either to approve a proposed 
rule change or to institute and conclude a proceeding to determine 
whether a proposed rule change should be disapproved. The Commission 
may also approve a proposed rule change on an accelerated basis if 
the Commission finds good cause for so doing and publishes its 
reasons for so finding. Section 19(b)(2) of the Exchange Act, 15 
U.S.C. 78s(b)(2)(B).
    \455\ See paragraph (c) of Rule 19b-5, 17 CFR 240.19b-5(c), for 
the definition of ``pilot trading system.''
    \456\ 17 CFR 249.821.
    \457\ Rule 19b-5(f)(1) and (f)(2), 17 CFR 240.19b-5(f)(1) and 
(f)(2). See also infra Section VI.C.
    \458\ Rule 19b-5(c)(3), 17 CFR 240.19b-5(c)(3).
---------------------------------------------------------------------------

    The Commission believes the pilot trading system rule addresses 
many of the concerns raised by commenters.\459\ Inherent in the rule 
filing process is public disclosure of SROs' business plans for trading 
systems prior to their operation. Consequently, SROs' competitors are 
informed about the proposed pilot trading system and have an avenue to 
copy, delay, or obstruct implementation of the trading system before it 
can be tested in the marketplace.\460\ The rule filing process also 
hinders innovation because registered exchanges do not realize the full 
competitive benefits of their efforts.\461\ In contrast, alternative 
trading systems that offer similarly innovative, start-up services do 
not have the same rule filing obligations and, thus, have a significant 
advantage in their flexibility to devise, implement, and modify new 
pilot trading systems. Comments to the Proposing Release echo these 
concerns.\462\ By deferring the rule filing process, the pilot trading 
system rule allows SROs to better compete with alternative trading 
systems, while continuing to ensure that investors are protected and 
the pilot trading system is operated in a manner consistent with the 
Exchange Act.
---------------------------------------------------------------------------

    \459\ See infra Section VI.B.
    \460\ See Proposing Release, supra note 3, at ns.256-61 and 
accompanying text.
    \461\ See Proposing Release, supra note 3, at n.261.
    \462\ See Ashton Letter at 2; SIA Letter at 15; CME Letter at 3; 
Amex Letter at 1; Bloomberg Letter at 6.
---------------------------------------------------------------------------

    Finally, the Commission recognizes that domestic markets must 
compete with less regulated foreign markets and broker-dealers. The 
Commission agrees with commenters that excessive regulation of 
traditional exchanges, alternative trading systems, or other markets 
hinders these exchanges' ability to compete and survive in the global 
arena. The pilot trading system rule responds to SROs' need for a more 
balanced competitive playing field.

B. Rule 19b-5

    The Commission is adopting Rule 19b-5 to provide a temporary 
exemption from Section 19(b) of the Exchange Act for SRO proposed rule 
changes concerning the operation of pilot trading systems.
1. Types of Systems Eligible for Exemption Under Rule 19b-5
    a. Definition of Pilot Trading System. The Commission is adopting 
the definition of pilot trading system substantially as proposed. Under 
paragraph (c) of Rule 19b-5, a trading system operated by an SRO would 
be a ``pilot trading system'' if it met one of two definitions. First, 
a trading system would be a ``pilot trading system,'' even if it traded 
the same securities or operated during the same hours as an SRO's 
existing trading system, if the SRO operated it for less than two 
years, and during at least two of the last four consecutive calendar 
months, it traded no more than one percent of the U.S. average daily 
trading volume of each security traded on the trading system. In 
addition, the trading system could not have an aggregate share trading 
volume of more than twenty percent of the average daily trading volume 
of all trading systems operated by the SRO.\463\ Second, a trading 
system would also be considered a ``pilot trading system'' if it were 
independent \464\ of any other trading system operated by the SRO, the 
SRO operated it for less than two years, and, during at least two of 
the last four consecutive calendar months, it traded no more than five 
percent of the U.S. average daily trading volume of each security 
traded on the trading system. In addition, under this second 
definition, the trading system would have to have aggregate share 
trading no more than twenty percent of the average daily trading volume 
of all trading systems operated by the SRO.\465\
---------------------------------------------------------------------------

    \463\ Rule 19b-5(c)(2), 17 CFR 240.19b-5(c)(2).
    \464\ A pilot trading system is ``independent'' of other trading 
systems if it meets one of the standards set forth in paragraph (d) 
of Rule 19b-5.
    \465\ Rule 19b-5(c)(1), 17 CFR 240.19b-5(c)(1).
---------------------------------------------------------------------------

    If at any time within the two-year period a pilot trading system 
exceeds the volume thresholds, it would be allowed to continue to 
operate for 60 more days under this exemption.\466\ During this 60 day 
period, if the SRO intended to continue operating the trading system, 
it would have to file for permanent approval under Section 19(b) of the 
Exchange Act of the rules related to the trading system.
---------------------------------------------------------------------------

    \466\ Rule 19b-5(c)(3), 17 CFR 240.19b-5(c)(3). See also infra 
Section VI.C.
---------------------------------------------------------------------------

    The Commission received several comments asking the Commission to 
relax or eliminate the proposed requirement that, to be a pilot trading 
system with five percent of the trading volume in a security, the pilot 
trading system would have to be ``independent.'' As proposed, a pilot 
trading system would be independent if it trades securities different 
from the issues of securities traded on any other trading system that 
is operated by the same SRO and that has been approved by the 
Commission. A pilot trading system would also be deemed independent if 
it does not operate during the same trading hours as any other trading 
system that is operated by the same SRO and that has been approved by 
the Commission. Finally, a pilot trading system would be deemed 
independent if no market maker or specialist on any other trading 
system operated by the SRO trades on the pilot trading system the same 
securities in which they act as a market maker or specialist.\467\ The 
Commission emphasized that a pilot trading system need only satisfy one 
of the three criteria to qualify the pilot trading system as 
independent. After considering the comments, the Commission continues 
to believe such criteria are not unduly restrictive and are necessary 
for the protection of investors, and is adopting it as proposed.
---------------------------------------------------------------------------

    \467\ Rule 19b-5(d), 17 CFR 240.19b-5(d). For purposes of the 
pilot trading system rule, a specialist means any member subject to 
a requirement of an SRO that such member regularly maintain a market 
in a particular security. Rule 19b-5(a), 17 CFR 240.19b-5(a).
---------------------------------------------------------------------------

    b. Response to Comments on the Proposed Definition of Pilot Trading 
System. In its proposed definition of a pilot trading system, the 
Commission sought to impose limits that were in the public interest and 
for the protection of investors, while still providing SROs with the 
flexibility to innovate. The Commission requested comment on this 
proposed definition, and specifically asked whether the proposed two-
year time period, trading volume limits, and independence criteria were 
appropriate. Commenters were asked to provide specific reasons for any 
concerns about the proposed definition and to suggest alternatives. 
Several commenters focused on particular aspects of the proposed pilot 
trading system definition.
    The NYSE commented that the specific provisions of proposed Rule

[[Page 70894]]

19b-5 were carefully crafted. In addition, the NYSE agreed with the 
Commission's proposal to distinguish between systems that are 
``independent'' of other SRO trading systems and systems that work 
together with existing SRO trading systems.\468\ The ICI supported the 
proposed limited exemption for pilot trading systems. The ICI, however, 
discouraged any further expansion of the criteria that would constitute 
a pilot trading system and encouraged the Commission to carefully 
monitor pilot trading systems as they operate under the exemption.\469\
---------------------------------------------------------------------------

    \468\ NYSE Letter at 9.
    \469\ ICI Letter at 5.
---------------------------------------------------------------------------

    On the other hand, several commenters stated that Rule 19b-5 should 
be liberalized to provide SROs with a meaningful opportunity to develop 
pilot trading systems on a comparable basis to alternative trading 
systems.\470\ For example, the CME generally asserted that the numerous 
proposed restrictions on what would qualify as a pilot trading system 
would render the proposal of little practical value to exchanges.\471\ 
With regard to the volume thresholds proposed by the Commission, the 
NASD and the PCX stated that the volume thresholds were too low. \472\ 
The PCX stated that the volume restrictions did not make sense because 
they limited the ability of registered exchanges to introduce new 
trading systems--particularly when neither alternative trading systems 
nor third market makers are subject to similar volume limitations. 
Instead, the PCX stated that Rule 19b-5 should treat exchange pilot 
trading systems as though they were alternative trading systems for two 
years, provided the trading systems did not exceed a fairly high 
percentage (perhaps ten percent) of total trading volume in any 
security.\473\ Moreover, the Amex said the volume thresholds for 
individual securities would limit the utility of the exemption for 
primary markets. In particular, the Amex suggested that the Commission 
apply only an aggregate volume threshold whereby volume in an SRO pilot 
trading system could not exceed a specified percentage of total volume 
in all such SRO's trading systems. This approach, the Amex believed, 
would eliminate the administrative burden on SROs monitoring the one 
percent or five percent thresholds and would avoid the potentially 
adverse impact on the operation and success of a pilot trading system 
that could occur by removing securities from the system that exceeded a 
specified threshold.\474\
---------------------------------------------------------------------------

    \470\ See CBOE Letter at 2, 9; CHX Letter at 11; CME Letter at 
4; PCX Letter at 8-10.
    \471\ See CME Letter at 4; PCX Letter at 9-10.
    \472\ See NASD Letter at 13; PCX Letter at 9-10.
    \473\ PCX Letter at 9-10.
    \474\ Amex Letter at 1, 3.
---------------------------------------------------------------------------

    Other commenters thought the criteria establishing the independence 
of a pilot trading system from other trading systems operated by the 
same SRO were too restrictive.\475\ In particular, the CBOE and NASD 
asserted that the independence criteria unnecessarily precluded 
exchange specialists and market makers from participating in pilot 
trading systems.\476\ Similarly, the CHX stated that it was too 
limiting to require a pilot trading system to trade different 
securities or operate during different hours than the sponsoring SRO's 
other trading systems in order to be ``independent.'' \477\
---------------------------------------------------------------------------

    \475\ See CBOE Letter at 9; CHX Letter at 11.
    \476\ See CBOE Letter at 9; NASD Letter at 2, 14.
    \477\ CHX Letter at 11.
---------------------------------------------------------------------------

    c. Adopted Definition of Pilot Trading System. The Commission has 
considered these comments. As discussed above, it believes that, 
because the proposed definition of a pilot trading system, including 
the proposed volume thresholds and independence criteria is novel and 
untried, the criteria are appropriate. The Commission notes that, 
pursuant to paragraph (b)(5) under section 6 of the Exchange Act, rules 
of a registered exchange should be designed, among other things, to 
prevent fraudulent and manipulative acts and practices, to promote just 
and equitable principles of trade and, in general, to protect investors 
and the public interest.\478\ The Commission believes that the desire 
of the registered exchanges to innovate and compete with alternative 
trading systems must be balanced with their statutory obligations under 
section 6 of the Exchange Act. Therefore, the volume thresholds and 
other standards are designed to ensure that once a pilot trading 
system's activities reach a significant level, the pilot trading system 
will be subject to the public notice and comment process under section 
19(b) of the Exchange Act. The Commission recognizes that the 
definition of ``pilot trading system'' is more narrow than some SROs 
would prefer, but notes that this does not prevent registered exchanges 
from developing trading systems that do not meet the definition of 
``pilot trading system'' and filing proposed rule changes relating to 
those systems under section 19(b) of the Exchange Act.
---------------------------------------------------------------------------

    \478\ 15 U.S.C. 78f(b)(5).
---------------------------------------------------------------------------

    Similarly, through the independence criteria, the Commission 
identified characteristics that render pilot trading systems 
sufficiently distinct from the sponsoring SRO's other trading systems 
so that a five percent, rather than one percent volume level, is 
acceptable. ``Independent'' pilot trading systems pose less risk of 
substantially changing the existing markets in a manner detrimental to 
investors and, therefore, the Commission believes should be able to 
operate under the exemption at higher volume thresholds than their 
``non-independent'' counterparts before having to submit proposed rule 
filings under section 19(b) of the Exchange Act.\479\ The Commission 
will monitor use of the pilot trading system exemption, and will 
consider modifying these criteria in the future based on its experience 
with SRO's use of the exemption.
---------------------------------------------------------------------------

    \479\ See supra note 467 and accompanying text.
---------------------------------------------------------------------------

2. Scope of Pilot Trading Rule Exemption
    The Commission is adopting Rule 19b-5 to provide a temporary 
exemption from Section 19(b) of the Exchange Act for SRO proposed rule 
changes concerning the operation of pilot trading systems. This 
temporary exemption includes all rules related to the operation of 
pilot trading systems. The Commission defines trading system in 
paragraph (b) of Rule 19b-5 to include the rules of a self-regulatory 
organization that: (i) Determine how the orders of multiple buyers and 
sellers are brought together; and (ii) establish non-discretionary 
methods under which such orders interact with each other and under 
which the buyers and sellers entering such orders agree to the terms of 
trade.\480\ The Commission intends this exemption to provide SROs with 
flexibility to establish and modify the pilot trading system without 
obtaining prior approval from the Commission. However, this exemption 
does not include any SRO rules that would fundamentally affect the 
relationship between an SRO's members and those members' customers, or 
an SRO's oversight of its members.
---------------------------------------------------------------------------

    \480\ Rule 19b-5(b), 17 CFR 240.19b-5(b).
---------------------------------------------------------------------------

    The Commission notes that Rule 19b-5 does not relieve SROs from any 
obligation under the federal securities laws, other than the 
requirement to file proposed rule changes relating to the operation of 
a pilot trading system. Rule 19b-5, therefore, does not provide an 
exemption for SRO rules relating to other requirements imposed under 
other provisions of the Exchange Act, such as sections 11(a) and 10(a), 
and Rule 10a-1 thereunder. In addition, an SRO must ensure that 
securities listed and traded on any pilot trading system comply

[[Page 70895]]

with, among other things, the registration requirements of the Exchange 
Act.\481\ An SRO also continues to be required to enforce compliance 
with its own rules and the federal securities laws, including members' 
compliance with the Order Handling Rules.\482\ SROs, similarly, are 
expected to operate the pilot trading systems in compliance with rules 
governing market-wide trading halts.
---------------------------------------------------------------------------

    \481\ See supra notes 504-505 and accompanying text.
    \482\ See Section 6(b)(2) of the Exchange Act, 15 U.S.C. 78f(2). 
See also Order Handling Rules Adopting Release, supra note.
---------------------------------------------------------------------------

3. SROs' Continuing Obligations Regarding Pilot Trading Systems
    In order to ensure that pilot trading systems are operated in a 
manner consistent with the Exchange Act, the Commission proposed 
requiring SROs to comply with certain conditions before a pilot trading 
system would be eligible for the temporary exemption. In particular, 
the Commission proposed that SROs comply with the following with regard 
to pilot trading systems: (1) Notify and periodically file information 
about the pilot trading system with the Commission, (2) implement 
trading rules and procedures, (3) establish effective surveillance, (4) 
establish reasonable clearance and settlement procedures, (5) limit the 
types of securities traded, (6) cooperate with inspections and 
examinations by the Commission, and (7) have procedures to ensure the 
confidential treatment of trading information.\483\
---------------------------------------------------------------------------

    \483\ The Commission is not adopting the requirement concerning 
the procedures to ensure the confidential treatment of trading 
information because SROs are not currently required to do this with 
regard to their other trading systems.
---------------------------------------------------------------------------

    The Commission sought comment on whether there were any additional 
conditions with which SROs should be required to comply in order to be 
temporarily exempt from the rule filing requirements under Rule 19b-5. 
Commenters did not recommend any additional conditions. The Commission 
notes, however, that, as discussed below, it is adding a requirement 
that SROs make publicly available the rules relating to the operation 
of the pilot trading system.\484\
---------------------------------------------------------------------------

    \484\ See discussion infra VI.B.3.i.
---------------------------------------------------------------------------

    In the Proposing Release, the Commission stated that SROs would 
have to ``ensure'' that these conditions were satisfied in order to 
rely on the temporary exemption under proposed Rule 19b-5. One 
commenter raised concerns regarding the requirement that SROs 
``ensure'' that the conditions were met in order to rely on the 
proposed pilot trading system rule. Specifically the CBOE requested 
that an SRO be allowed to rely on proposed Rule 19b-5 if the SRO acts 
in good faith in determining that the requirements of the pilot trading 
system rule have been met.\485\ Based upon the Commission's experience 
with reviewing new pilot trading system proposals submitted by SROs, 
the Commission continues to believe that SROs operating pilot trading 
systems should satisfy the proposed requirements in order to operate 
such systems in a manner consistent with the Exchange Act. Nonetheless, 
the Commission recognizes that full compliance with some of the 
conditions may be beyond the SROs' control. The Commission agrees it is 
not practical to hold SROs strictly liable for the failure of 
unaffiliated entities to satisfy certain requirements of the proposed 
pilot trading system rule. Therefore, the Commission will consider an 
SRO exempt from rule filing requirements under Rule 19b-5 if the SRO 
acts in good faith in determining that the operation of the pilot 
trading system meets the conditions set out in paragraph (e) of that 
rule, and in operating the pilot trading system.
---------------------------------------------------------------------------

    \485\ CBOE Letter at 10.
---------------------------------------------------------------------------

    a. Notice and Filings to the Commission. The Commission proposed 
that SROs be required to provide written notice of, and information 
about, the operation of a pilot trading system to the Commission on new 
Form PILOT. On Form PILOT, an SRO would have to provide general 
information about the pilot trading system, including: (1) The date the 
SRO expects to commence operation of the pilot trading system; (2) a 
list of securities to be traded; (3) a list of anticipated members to 
the pilot trading system; and (4) the names of entities assisting in 
the operation of the pilot trading system.\486\ The SRO could start 
operation of the pilot trading system twenty days after this filing is 
complete. If the SRO materially changes its proposed pilot trading 
system prior to commencing operation, the SRO would be required to file 
an amendment to Form PILOT and wait twenty days before commencing 
operation. The Commission is adopting the notice requirement and Form 
PILOT as proposed.\487\
---------------------------------------------------------------------------

    \486\ Examples include computer companies that design and 
maintain systems and clearing agencies.
    \487\ Rule 19b-5(e)(1), 17 CFR 240.19b-5(e)(1).
---------------------------------------------------------------------------

    The twenty day period following an SRO's filing of Form PILOT is 
intended to provide the Commission with time to review the form for 
compliance by the SRO with the pilot trading system rule. In addition, 
after reviewing Form PILOT the Commission may determine, after notice 
to the SRO and an opportunity for the SRO to respond, that the 
operation of a particular pilot trading system would not be necessary 
or appropriate in the public interest or consistent with the protection 
of investors without the SRO filing proposed rule changes under section 
19(b) of the Exchange Act.\488\
---------------------------------------------------------------------------

    \488\ Rule 19b-5(g), 17 CFR 240.19b-5(g).
---------------------------------------------------------------------------

    The Commission also proposed to require an SRO to file an amendment 
to Form PILOT at least twenty days before it implements any material 
change to the operation of the pilot trading system. The Commission 
would consider a material change to the pilot trading system to include 
the addition of new types of securities, or a new date for commencing 
operation of the pilot trading system. The Commission proposed that an 
SRO also submit quarterly reports on Form PILOT that would include 
information about the trading volume effected on the pilot trading 
system during the most recent calendar quarter. The Commission received 
no comments on these requirements and is adopting them as 
proposed.\489\
---------------------------------------------------------------------------

    \489\ Rule 19b-5(e)(1), 17 CFR 240.19b-5(e)(1). The Commission 
requires that SROs identify filings made pursuant to Rule 19b-5 by 
including a file number on Form PILOT that appears as follows: 
PILOT--name of SRO--year--file number.
---------------------------------------------------------------------------

    The Commission proposed that all notices and reports filed on Form 
PILOT be kept confidential. The Commission, however, requested comment 
on whether all information on Form PILOT should be publicly available 
or whether, as an alternative, information on Form PILOT should be 
publicly available, unless an SRO specifically requests confidential 
treatment. The Commission received several comments on the confidential 
treatment of information on Form PILOT. The CBOE recommended that all 
information about a pilot trading system filed quarterly on Form PILOT 
be deemed confidential.\490\ The NYSE suggested only limited 
confidentiality for filings on Form PILOT, that is, pilot trading 
system information should be publicly available shortly prior to, or on 
the date of, launch of a new system.\491\ Another commenter offered 
that the Commission make public only certain information on Form 
PILOT.\492\ One commenter suggested that the confidential treatment of 
Form PILOT information be at the filer's discretion.\493\
---------------------------------------------------------------------------

    \490\ CBOE Letter at 9.
    \491\ NYSE Letter at 9.
    \492\ Amex Letter, p. 2.
    \493\ American Century Letter, p. 6.

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

[[Page 70896]]

    After considering commenters' suggestions, the Commission has 
determined that the confidential treatment of Form PILOT information is 
an important element in reducing the disparate regulatory treatment of 
SROs and alternative trading systems and that such confidentiality is 
critical in the period prior to a pilot trading system commencing 
operations. However, the Commission also considers important the 
public's interest in having access to accurate information about the 
pilot trading system. Accordingly, the Commission is modifying proposed 
Rule 19b-5, so that information reported by an SRO on Form PILOT is 
confidential until the pilot trading system commences operation.\494\ 
Thereafter, Form PILOT information will be made available to the 
public. b. Fair Access
---------------------------------------------------------------------------

    \494\ Rule 19b-5(e)(11), 17 CFR 240.19b-5(e)(11).
---------------------------------------------------------------------------

    b. Fair Access. Because information and access advantages of 
certain SRO members could subvert the fair and orderly trading of 
securities on a pilot trading system or the primary market, the 
Commission is adding a specific condition to the pilot trading system 
rule requiring that the SRO provide fair access to the pilot trading 
system to all members of the SRO. The Commission is adding this fair 
access requirement in order to ensure that markets treat their members 
fairly.\495\ In particular, the SRO shall establish written standards 
for granting access to the pilot trading system and apply those 
standards fairly to all members. Fair access does not require an SRO to 
allow every member to trade on a pilot trading system or to give each 
member trading on the pilot trading system the same privileges. 
However, this requirement does prohibit an SRO from unfairly 
discriminating in the access it does give its members to the pilot 
trading system. In addition, the SRO must ensure that information 
regarding orders on the pilot trading system is equally available to 
all members of the SRO with access to the pilot trading system.\496\ 
However, a specialist may have preferred access to information 
regarding orders it represents in its capacity as specialist on the 
pilot trading system.\497\ This means that such SRO rules need not 
require a member acting as a specialist on the pilot trading system to 
expose its orders to all members, that is maintain an ``open book.'' 
Such rules established by the SRO will be considered part of the pilot 
trading system for purposes of the temporary exemption.\498\
---------------------------------------------------------------------------

    \495\ The Commission notes that registered exchanges and 
national securities associations already have obligations to ensure 
that their markets treat investors and other market participants 
fairly. The Exchange Act requires registered exchanges and national 
securities associations to consider the public interest in 
administering their markets and to establish rules designed to admit 
members fairly. Sections 6(b)(2) and 6(c) of the Exchange Act, 15 
U.S.C. 78f(b)(2) and (c); section 15A(b)(8) of the Exchange Act, 15 
U.S.C. 78o-3(b)(8). See also supra notes 241-244 and accompanying 
text.
    \496\ Rule 19b-5(e)(2)(i), 17 CFR 240.19b-5(e)(2)(i).
    \497\ Rule 19b-5(e)(2)(ii), 17 CFR 240.19b-5(e)(2)(ii).
    \498\ Rule 19b-5(e)(2)(iii), 17 CFR 240.19b-5(e)(2)(iii).
---------------------------------------------------------------------------

    c. Trading Rules and Procedures. The Commission proposed to require 
SROs operating pilot trading systems under Rule 19b-5 to adopt and 
implement trading rules and procedures necessary to operate the pilot 
trading system in a manner consistent with the Exchange Act. The 
Commission received no comments specifically addressing this condition 
and is adopting it substantially as proposed. As adopted, an SRO must 
have appropriate trading rules and procedures to promote the fair and 
orderly trading of securities on the pilot trading system, including: 
(1) Margin requirements; (2) listing standards; (3) sales practice 
guidelines, such as rules regarding communications with the public; and 
(4) disclosure requirements. The trading rules and procedures should be 
appropriate for, and ensure the fair and orderly trading of, each type 
of security to be traded on the pilot trading system.\499\
---------------------------------------------------------------------------

    \499\ Rule 19b-5(e)(3), 17 CFR 240.19b-5(e)(3).
---------------------------------------------------------------------------

    d. Surveillance. Under the proposal, an SRO would have to establish 
procedures for the effective surveillance of trading activity on a 
pilot trading system. In the Proposing Release, the Commission noted 
the importance of an SRO being able to obtain information necessary to 
detect and deter market manipulation, illegal trading, and other 
trading abuses. To satisfy this requirement, the Commission proposed 
that an SRO have to develop and implement internal surveillance 
procedures to monitor transactions effected on the pilot trading 
system, and obtain surveillance information from other markets, both 
domestic and foreign.
    Specifically, in the Proposing Release, the Commission discussed 
its expectation that there be a comprehensive information sharing 
agreement (``ISA'') in place between the SRO operating a pilot trading 
system and any other market trading the securities, or trading the 
underlying securities of derivative securities products, traded on such 
pilot trading system.\500\ Such agreements provide a necessary 
deterrent to manipulation because they facilitate the availability of 
information needed to fully investigate a potential manipulation. An 
SRO operating a pilot trading system trading U.S. securities, or new 
derivative securities products overlying U.S. securities, would have to 
continue to ensure that all exchanges on which the U.S. securities 
trade are members of the Intermarket Surveillance Group (``ISG'').\501\ 
The ISG was formed to coordinate, among other things, effective 
surveillance and investigative information sharing arrangements in the 
stock and options markets.
---------------------------------------------------------------------------

    \500\ The Commission believes that a comprehensive ISA requires 
that the parties provide to each other, upon request, information 
about market trading, clearing activity, and the identity of the 
ultimate purchasers and sellers of securities. See Securities 
Exchange Act Release No. 31529 (Nov. 27, 1992), 57 FR 57248 (Dec. 3, 
1992). Similarly, an SRO that operates a pilot trading system that 
trades securities, or derivatives of securities that are listed or 
traded on a foreign market, should have a comprehensive ISA with 
such foreign markets. In addition, the SRO should ensure there are 
no blocking or secrecy laws in the foreign country that would 
prevent or interfere with the transfer of information under the 
comprehensive ISA. If securing a comprehensive ISA is not possible, 
the SRO should contact the Commission. In such instances, the 
Commission may determine that it is appropriate instead to rely on a 
Memorandum of Understanding (``MOU'') between the Commission and the 
foreign regulator. Generally, the Commission has permitted an SRO to 
rely on an MOU in the absence of a comprehensive ISA only if the SRO 
receives an assurance from the Commission that such an MOU can be 
relied on for surveillance purposes and includes, at a minimum, the 
transaction, clearing, and customer information necessary to conduct 
an investigation. See Securities Exchange Act Release No. 35184 
(Dec. 30, 1994), 60 FR 2616 (Jan. 10, 1995). In addition, an SRO 
should endeavor to develop comprehensive ISAs with foreign exchanges 
even if the SRO receives prior Commission approval to rely on an MOU 
in place of a comprehensive ISA.
    \501\See ISG Agreement, dated July 14, 1983, amended Jan. 29, 
1990. The ISG members are: Amex, BSE, CBOE, CHX, NASD, NYSE, PCX, 
and Phlx. The major stock index futures exchanges joined the ISG as 
affiliate members in 1990.
---------------------------------------------------------------------------

    The Commission received no comments specifically addressing the 
surveillance requirement under the proposed pilot trading system rule. 
The Commission continues to believe that in order for an SRO to operate 
a pilot trading system in a manner consistent with the Exchange Act, 
the SRO must be able to obtain information necessary to detect and 
deter market manipulation, illegal trading, and other trading abuses. 
Therefore, the Commission is adopting, as proposed, the requirement 
that an SRO develop and implement internal surveillance procedures to 
monitor transactions effected on the pilot trading system, and obtain 
surveillance information from other markets, both

[[Page 70897]]

domestic and foreign by means of an ISA.\502\
---------------------------------------------------------------------------

    \502\ Rule 19b--5(e)(4), 17 CFR 240.19b-5(e)(4).
---------------------------------------------------------------------------

    e. Clearance and Settlement. In the Proposing Release, the 
Commission observed that the integrity of the trading markets depends 
on the prompt and accurate clearance and settlement of securities 
transactions. For this reason, the Commission proposed that, as a 
condition of the exemption under Rule 19b-5, an SRO establish 
reasonable clearance and settlement procedures for transactions 
effected on the pilot trading system. For example, to ensure that 
adequate linkages have been formed, part of the user agreement should, 
at a minimum, request information about the name of the clearing agency 
member through which the user will clear its trades. The Commission 
received no comments specifically addressing the clearance and 
settlement requirement under the proposed pilot trading system rule. 
Therefore, the Commission is adopting as proposed, the requirement that 
an SRO operating a pilot trading system ensure that the necessary 
linkages to clearing agencies exist for all pilot trading system 
users.\503\
---------------------------------------------------------------------------

    \503\ Rule 19b-5(e)(5), 17 CFR 240.19b-5(e)(5).
---------------------------------------------------------------------------

    f. Types of Securities. The Commission proposed to limit the types 
of securities an SRO could trade on a pilot trading system. Two 
separate limitations were proposed. First, under the proposal a pilot 
trading system would only be permitted to trade securities listed on a 
national securities exchange or to which unlisted trading privileges 
was extended pursuant to a rule, regulation, or order of the Commission 
under section 12(f) of the Exchange Act. In general, section 12 of the 
Exchange Act requires an exchange to trade only those securities that 
the exchange lists, except that section 12(f) of the Exchange Act 
provides UTP under certain circumstances.\504\ For example, under the 
OTC-UTP plan, exchanges are permitted to trade certain over-the-counter 
securities pursuant to a Commission order.\505\ As proposed, a pilot 
trading system operated by a registered exchange or a national 
securities association would be limited to trading listed securities or 
securities to which UTP has been extended under section 12(f) of the 
Exchange Act. Because national securities associations currently trade 
securities that are neither exchange listed or subject to UTP, this 
provision was unnecessarily restrictive. Consequently, the Commission 
is modifying the limitation on the types of securities a pilot trading 
system may trade from that proposed. In particular, Rule 19b-5(e)(6), 
as adopted, only restricts pilot trading systems by requiring that 
securities traded be registered under section 12 of the Exchange 
Act.\506\ Registered exchanges will still be required to comply with 
sections 12(a) and 12(f) of the Exchange Act, and therefore, can only 
trade securities listed on that exchange, or securities it is permitted 
to trade under the OTC-UTP Plan.
---------------------------------------------------------------------------

    \504\ 15 U.S.C. 78l(f).
    \505\ See Securities Exchange Act Release No. 39505 (Dec. 31, 
1997), 63 FR 1515 (Jan. 9, 1998 ).
    \506\ Rule 19b-5(e)(6), 17 CFR 240.19b-5(e)(6).
---------------------------------------------------------------------------

    g. Activities of Specialists. As proposed, an SRO's pilot trading 
system would not be eligible for the exemption in Rule 19b-5 if it 
traded derivative securities, such as options, warrants, or hybrid 
products, the value of which were based, in whole or in part, upon the 
performance of any security traded on another trading system operated 
by that SRO. Similarly, the proposed exemption excluded SRO pilot 
trading systems that traded any security or instrument, such as an 
equity security, the derivative of which traded on another trading 
system operated by that SRO. The Commission, in proposing these 
limitations, intended to preclude an SRO from relying on the temporary 
exemption if a pilot trading system simultaneously traded a security 
overlying or underlying a security traded on that SRO's primary market. 
The Commission has always considered this type of trading to raise 
special concerns that should be resolved through the normal rule filing 
process.\507\
---------------------------------------------------------------------------

    \507\ See, e.g., Securities Exchange Act Release Nos. 21759 
(Feb. 14, 1985), 50 FR 7250 (Feb. 21, 1985) (order approving NYSE 
proposal to trade options on NYSE-listed stocks in a separate 
physical location from the equity trading floor); 26147 (Oct. 3, 
1988), 53 FR 39556 (Oct. 7, 1988) (order approving the trading on 
the Amex of options on Amex-listed stocks, concluding that side-by-
side trading or integrated market-making issues did not arise 
because the Amex proposed to trade stocks and related options in 
physically separate locations); and 28556 (Oct. 19, 1990), 55 FR 
43233 (Oct. 26, 1990) (order approving rule changes to establish 
rules governing the trading of stocks, warrants, and other 
securities instruments and contracts on the CBOE conditioned on the 
fact that trading in securities other than options will take place 
on a trading floor separate from the location where options are 
traded).
---------------------------------------------------------------------------

    In commenting on proposed Rule 19b-5, the CBOE and the Amex 
considered these limitations overly restrictive. The Amex suggested 
removing this limitation and instead requiring SROs to specify on Form 
PILOT their rules and procedures for trading such securities on the 
pilot trading system.\508\ The CBOE suggested an alternative to the 
limitation that pilot trading systems may not trade securities that 
overlie or underlie securities traded on another trading system 
operated by the same SRO. In particular, the CBOE suggested requiring 
the SRO to create firewalls or other safeguards between persons trading 
the derivative and the underlying or overlying securities, rather than 
flatly prohibiting it.\509\
---------------------------------------------------------------------------

    \508\ Amex Letter at 4.
    \509\ CBOE Letter at 10.
---------------------------------------------------------------------------

    After considering the commenters' recommendations, the Commission 
has determined that SROs may operate pilot trading systems under Rule 
19b-5 that simultaneously trade a security that is overlying or 
underlying a security traded on another trading system operated by that 
market, provided that such trading remains separate. This means that, 
as part of the SRO's general requirement to have written trading rules 
and procedures to operate the pilot trading system,\510\ an SRO must 
have adequate rules and procedures to trade related securities 
simultaneously. In addition, the Commission is adopting a more narrow 
prohibition than it proposed, which prohibits a member firm that is a 
specialist in a security from acting as a specialist on a pilot trading 
system operating during the same hours in a related security.\511\ For 
example, a member firm may not be a specialist in a security, such as 
an equity security, on the pilot trading system when it is also a 
specialist in a derivative of that security, such as an option or 
equity-linked note, whose value, in whole or significant part, is based 
on the performance of that security.\512\ The Commission would not 
consider listed options in a single underlying instrument to be related 
securities, for purposes of the pilot trading system exemption. The

[[Page 70898]]

limitation under Rule 19b-5(e)(7)(ii) does not preclude any member firm 
from being a specialist on a pilot trading system in a security related 
to a security in which the member firm is a specialist on the SRO's 
other trading systems, when such related securities trade at different 
times.\513\ Also, a member may be a specialist in related securities 
that, the Commission, upon application by the SRO, later determines is 
necessary or appropriate in the public interest and consistent with the 
protection of investors.\514\
---------------------------------------------------------------------------

    \510\ Rule 19b-5(e)(3), 17 CFR 240.19b-5(e)(3).
    \511\ Rule 19b-5(e)(7)(iii), 17 CFR 240.19b-5(e)(7)(iii), 
defines related securities to mean any two securities in which the 
value of one security is determined, in whole or significant part, 
by the performance of the other security; or the value of both 
securities is determined, in whole or significant part, by the 
performance of a third security, combination of securities, index, 
indicator, interest rate or other common factor.
    \512\ A specialist, for purposes of the pilot trading system 
rule, means any member that is subject to an SRO requirement to 
regularly maintain a market in a particular security. Rule 19b-5(a), 
17 CFR 240.19b-5(a). The definition of specialist is meant to 
preclude member firms with exclusive information about buy and sell 
orders from using unfairly such non-public material market 
information to their competitive advantage. For instance, a member 
acting as a specialist on the NYSE also could not simultaneously act 
as a specialist in related securities on a pilot trading system 
sponsored by the NYSE. Similarly, a member acting as a designated 
primary market maker on the CBOE also could not simultaneously act 
as a designated primary market maker in related securities on a 
pilot trading system sponsored by the CBOE.
    \513\ An SRO also may request an exemption from the limitation 
under Rule 19b-5(e)(7)(i) by filing an application for an order for 
exemptive relief under section 36. See 17 CFR 240.0-12.
    \514\ Rule 19b-5(e)(7), 17 CFR 240.19b-5(e)(7).
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    The Commission notes that Rule 19b-5 does not prohibit an SRO from 
developing a trading system that permits a member firm to be a 
specialist in related securities that trade simultaneously on trading 
systems operated by the same SRO. However, the SRO could not avail 
itself of the Rule 19b-5 temporary exemption, and instead would have to 
file proposed rule changes with the Commission under Section 19(b) of 
the Exchange Act for public notice and comment and obtain Commission 
approval prior to operating such trading system.
    h. Inspections and Examinations. As a condition to the exemption, 
the Commission proposed that an SRO cooperate with any examination or 
inspection by the Commission of persons effecting transactions on the 
pilot trading system. The Commission received no comments on this 
requirement and is adopting it as proposed.\515\ As adopted, the SRO 
shall cooperate with the examination, inspection, or investigation by 
the Commission of transactions effected on the pilot trading system. 
The Commission staff will review SRO compliance with the conditions in 
Rule 19b-5 through its routine inspections. In order for the Commission 
staff to determine whether an SRO has properly relied on the exemption 
under Rule 19b-5, the SRO must maintain at its principal place of 
business all relevant records and information pertaining to the pilot 
trading system and the basis for which the SRO relied on the exemption 
from the rule filing requirement.\516\ The Commission notes that if an 
SRO outsources the operation or maintenance of any aspect of a pilot 
trading system, such vendor would be considered to be operating a 
facility of an SRO and therefore would also be subject to Commission 
examination or inspection.
---------------------------------------------------------------------------

    \515\ Rule 19b-5(e)(8), 17 CFR 240.19b-5(e)(8).
    \516\ Rule 19b-5(e)(9), 17 CFR 240.19b-5(e)(9).
---------------------------------------------------------------------------

    i. Public Availability of Pilot Trading System Rules. Although 
pilot trading system rules do not need to be approved by the 
Commission, the Commission believes the current trading rules and 
procedures of the pilot trading system should be publicly available. 
Accordingly, the Commission is adopting a requirement that the SRO make 
its trading rules and procedures of the pilot trading system publicly 
available.\517\
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    \517\ Rule 19b-5(e)(10), 17 CFR 240.19b-5(e)(10). This specific 
requirement is necessary because Rule 6a-2, as amended, requires 
exchanges to file its trading rules and procedures only once every 
three years, while national securities associations have no such 
publication requirement except through the rule filing process under 
section 19(b) of the Exchange Act.
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C. Rule Filing Under Section 19(b)(2) of the Exchange Act Required 
Within Two Years

    Within two years of a pilot trading system commencing operation, an 
SRO must submit a rule filing under section 19(b)(2) of the Exchange 
Act to obtain approval for the pilot trading system to operate on a 
permanent basis.\518\ In accordance with section 19(b) of the Exchange 
Act, after a formal notice and comment period, the Commission will 
decide whether to approve the proposed rule changes relating to a pilot 
trading system on a permanent basis or whether to institute proceedings 
to disapprove the proposed rule changes. Simultaneous with its request 
for Commission approval under to section 19(b)(2) of the Exchange Act, 
an SRO may request Commission approval pursuant to Section 19(b)(3)(A) 
of the Exchange Act, effective immediate upon filing, to continue to 
operate the trading system for a period not to exceed six months.\519\
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    \518\ Rule 19b-5(f)(1), 17 CFR 240.19b-5(f)(1).
    \519\ Rule 19b-5(f)(1) and (f)(2), 17 CFR 240.19b-5(f)(1) and 
(f)(2).
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VII. The Commission's Interpretation of the ``Exchange'' Definition

A. The Commission's Interpretation in Delta

    In the Exchange Act, Congress provided a broad definition of the 
term ``exchange,'' permitting the Commission to apply the definition 
flexibly as the securities markets evolve over time.\520\ Section 
3(a)(1) of the Exchange Act provides that:

    \520\ It was recognized at the time the Exchange Act was enacted 
that a regulatory structure for securities exchanges would ``be of 
little value tomorrow if it is not flexible enough to meet new 
conditions immediately as they arise and demand attention in the 
public interest.'' See SEC, Report of the Special Study of the 
Securities Markets of the Securities and Exchange Commission, H.R. 
Doc. No. 95, 88th Cong., 1st Sess. Pt. 1 (1963) (``Special Study''), 
at 6. See also S. Rep. No. 792, 73rd Cong., 2d Sess. (1934) at 5 
(noting that ``exchanges cannot be regulated efficiently under a 
rigid statutory program,'' and that ``considerable latitude is 
allowed for the exercise of administrative discretion in the 
regulation of both exchanges and the over-the-counter market.'')
---------------------------------------------------------------------------

    The term ``exchange'' means any organization, association, or 
group of persons, whether incorporated or unincorporated, which 
constitutes, maintains, or provides a market place or facilities for 
bringing together purchasers and sellers of securities or for 
otherwise performing with respect to securities the functions 
commonly performed by a stock exchange as that term is generally 
understood, and includes the market place or market facilities 
maintained by such exchange.\521\
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    \521\ 15 U.S.C. 78c(a)(1).

    Although the statutory definition of ``exchange'' is quite broad, 
in the 1990 Delta Release,\522\ the Commission interpreted the 
definition narrowly to include only those organizations that are 
``designed, whether through trading rules, operational procedures or 
business incentives, to centralize trading and provide buy and sell 
quotations on a regular or continuous basis so that purchasers and 
sellers have a reasonable expectation that they can regularly execute 
their orders at those price quotations.'' \523\ Based on this

[[Page 70899]]

interpretation, which was upheld by the Seventh Circuit on review,\524\ 
the Commission staff has given operators of trading systems that do not 
enhance liquidity in traditional ways through market makers, 
specialists, or a single price auction structure, assurances that it 
would not recommend enforcement action if those systems operated 
without registering as exchanges.\525\
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    \522\ Delta Release, supra note 32. In 1988, the Commission 
granted Delta temporary registration as a clearing agency to allow 
it to issue, clear, and settle options executed through a trading 
system operated by RMJ Securities (``RMJ''). Concurrently, the 
Commission's Division of Market Regulation issued a letter stating 
that the Division would not recommend enforcement action against RMJ 
if its system did not register as a national securities exchange. 
Subsequently, the Board of Trade of the City of Chicago and the 
Chicago Mercantile Exchange petitioned the U.S. Court of Appeals for 
the Seventh Circuit for review of the Commission's actions. Both 
challenges were premised on the view that RMJ's system unlawfully 
failed to register as an exchange or obtain an exemption from 
registration. The Seventh Circuit vacated Delta's temporary 
registration as a clearing agency, pending publication of a reasoned 
Commission analysis of whether or not RMJ's system was an exchange 
within the meaning of the Exchange Act. Board of Trade of the City 
of Chicago v. Securities and Exchange Commission, 883 F.2d 525 (7th 
Cir. 1989) (``Delta I''). In 1989, the Commission solicited comment 
on the issue, and in 1990 published its interpretation of the term 
``exchange'' and its determination that RMJ's system did not meet 
that interpretation.
    \523\ See Delta Release, supra note 32. The Commission also 
identified the following factors as supporting the conclusion that 
the system in Delta should not be classified as an exchange. Unlike 
a traditional exchange, the system (1) was not open to the 
participation of retail investors on an agency basis; (2) did not 
offer limit order protection; and (3) provided a forum for trading 
instruments that lacked certain indicia of standardization. These 
factors were admittedly outside the Commission's ``central focus'' 
in Delta. Id. Moreover, most alternative trading systems that will 
fall now under the Commission's new interpretation in Rule 3b-16 
allow broker-dealer subscribers to act on behalf of retail customers 
in placing and executing orders on the system; function as limit 
order books where orders are executed according to time, price, and 
size priority; and trade standard securities.
    \524\ Board of Trade of the City of Chicago v. SEC, 923 F.2d 
1270 (7th Cir. 1991).
    \525\ For a list of no-action letters issued to system sponsors 
until the end of 1993 and a short history of the Commission's 
oversight of such systems, see Securities Exchange Act Release No. 
33605, 59 FR 8368, 8369-71 (Feb. 18, 1994). See also Letters from 
the Division of Market Regulation to: Tradebook (Dec. 3, 1996); The 
Institutional Real Estate Clearinghouse System (May 28, 1996); 
Chicago Board Brokerage, Inc. and Clearing Corporation for Options 
and Securities (Dec. 13, 1995).
---------------------------------------------------------------------------

    Several concerns compelled the Commission in 1990 to narrowly 
interpret the definition of the term ``exchange.'' First, the 
Commission was concerned that a broad interpretation would place 
``evolving (alternative) trading systems within the `strait jacket' of 
exchange regulation,'' thus stifling innovation.\526\ Second, the 
Commission was concerned that a broad definition would subject brokers, 
dealers, and other statutorily defined entities to the regulatory 
scheme prescribed for exchanges.\527\ Third, the Commission was 
concerned that ``an expansive definition of the term `exchange' would 
force a non-member, for-profit, proprietary trading system into a 
regulatory scheme for which it is ill-suited, thus ignoring the 
Congressional and judicial mandate to apply flexibly the definition of 
the term `exchange' to the economic realm.'' \528\ These concerns, 
however, are largely eliminated by Congress' broad grant of exemptive 
authority in 1996,\529\ which has permitted the Commission to craft a 
regulatory framework for markets which excludes other statutorily 
defined entities (e.g., broker-dealers operating internal matching 
systems) and flexibly regulate markets to accommodate their diverse 
business structures. In addition, while the Delta interpretation was 
appropriate at the time, its emphasis on the ``expectation'' of regular 
execution of orders at quoted prices no longer reflects today's markets 
where alternative trading systems compete directly with registered 
exchanges and Nasdaq. The Delta approach has resulted in the anomaly of 
regulating as exchanges small volume entities that raise an expectation 
of liquidity within their system (such as AZX), while regulating as 
broker-dealers higher volume entities (such as Instinet).
---------------------------------------------------------------------------

    \526\ Delta Release, supra note 32, at 1899.
    \527\ Id.
    \528\ Id.
    \529\ See supra note 7.
---------------------------------------------------------------------------

    More fundamentally, although traditional exchanges still provide 
liquidity through two-sided quotations and, hence, raise an expectation 
of execution at the quoted price, this is no longer the essential 
characteristic of a securities market where stock and other securities 
exchange hands. Today's technology enables market participants and 
investors to tap simultaneous and multiple sources of liquidity from 
remote locations. Market makers and specialists may be important 
liquidity providers on a particular exchange, but liquidity now comes 
from many sources across multiple markets.\530\ For example, the public 
exposure of investor limit orders means that it is now easier to access 
liquidity in trading venues that do not have market makers or 
specialists.\531\ Today, through their computer terminals and other 
communication links, brokers acting on behalf of their customers or 
institutions trading for themselves can see what the quoted price is on 
an exchange or Nasdaq and check it against the price available for the 
same security on one or more alternative trading systems.\532\
---------------------------------------------------------------------------

    \530\ The rules adopted today reflect and facilitate multiple 
sources of liquidity. Increasing the linkages among markets where 
significant trading activity occurs--both exchanges and alternative 
trading systems--will make the overall market for securities more 
transparent and liquid.
    \531\ See Order Handling Rules Adopting Release, supra note 177 
at Section III.
    \532\ In fact, an alternative trading system that posts firm 
orders to buy or sell a security does raise a certain expectation of 
execution at those quoted prices. The expectation is based on the 
life of the outstanding orders in the system, rather than on 
continuous two-sided quotations published by specialists or market 
makers.
---------------------------------------------------------------------------

    Notably, in Delta, the Commission indicated that the Exchange Act 
does not preclude an alternative trading system from coming within the 
``exchange definition.'' \533\ The Commission recognized that its 
interpretation of the term ``exchange'' could be subject to change as 
the securities markets continued to change:

    \533\ See Delta Release, supra note 32, at 1900.
---------------------------------------------------------------------------

    In order to permit the Commission to apply flexibly the 
(Exchange) Act's definition of the term ``exchange'' to innovative 
trading systems in securities, Congress imbued the (Exchange) Act's 
definition of the term ``exchange'' with a certain ``plasticity'' * 
* *; ``it invites reinterpretation as the way the term * * * 
`generally understood' evolves.'' \534\

    \534\ Delta Release, supra note 32, at 1895 (quoting Delta I, 
supra note 522, at 535).
---------------------------------------------------------------------------

    Moreover, on review, although the United States Court of Appeals 
for the Seventh Circuit Court accepted the Commission's interpretation 
of the term ``exchange'' and affirmed the Commission's determination 
that Delta was not an ``exchange,'' the court nevertheless stated that 
the ``Commission could have interpreted the section to embrace the 
Delta System'' but that it was not compelled to do so.\535\
---------------------------------------------------------------------------

    \535\ Delta II, supra note 348, at 1273. The court held that, 
because the statutory provision is ambiguous, the Commission had the 
discretion to interpret the definition the way it did.
---------------------------------------------------------------------------

B. The Growing Significance of Alternative Trading Systems in the 
National Market System

    Within the past six years, the significance of alternative trading 
systems in the securities markets has increased dramatically. In 1994, 
the Commission's Division of Market Regulation reported that 
alternative trading systems accounted for thirteen percent of the 
volume in Nasdaq securities and 1.4 percent of the trading volume in 
NYSE-listed securities.\536\ In the Proposing Release, the Commission 
estimated that, as of the end of 1996, the trading volume on 
alternative trading systems amounted to almost twenty percent of the 
trades in Nasdaq stocks, and almost four percent of orders in 
securities listed on the NYSE.
---------------------------------------------------------------------------

    \536\ See Division of Market Regulation, Market 2000: An 
Examination of Current Equity Market Developments app IV (1994) 
(``Market 2000 Study'').
---------------------------------------------------------------------------

    In addition to the general increase in the volume of trading 
occurring on alternative trading systems, the actual number of 
alternative trading systems has skyrocketed. In 1991, the Commission 
was aware of only a few such systems. Today, over forty such systems 
are currently operating. The viability of this number of alternative 
trading systems indicates that these systems account for an increasing 
proportion of trading and that a growing number of investors use these 
systems. Moreover, the arrival of trading services on the Internet 
portends an increasing level of retail interest in alternative means 
for trading.
    As more alternative trading systems have developed to offer varying 
services to diverse customer bases, the availability of trading 
information and the accessibility of trading opportunities have become 
increasingly fragmented. The national market system relies on 
centralized sources of trading

[[Page 70900]]

opportunities and trading information. Exchange regulation is designed 
to facilitate centralization and enhance the general public's 
opportunities to obtain trading information and to access trading 
interest.
    The narrow interpretation of the term ``exchange'' in Delta has 
eroded the effectiveness of the Commission's oversight of markets. For 
example, as discussed in the Concept Release, it is clear that 
regulatory concerns may be raised by entities that constitute a market 
where buyers and sellers interact, but do not necessarily ensure a two-
sided market by design.\537\ Moreover, the Commission's traditional 
approach to broker-dealer regulation is not designed to substitute for 
market regulation. Consequently, these alternative trading systems are 
not fully integrated into the mechanisms that promote market fairness, 
efficiency, and transparency. In addition to raising regulatory 
fairness concerns, this lack of integration into the national market 
system has had a negative impact on the quality and pricing efficiency 
of secondary markets.\538\
---------------------------------------------------------------------------

    \537\ See Proposing Release, supra note 3, at n.290.
    \538\ For example, the evidence in the Commission's report on 
the NASD and the Nasdaq market pursuant to section 21(a) of the 
Exchange Act suggests that widespread use of Instinet by market 
makers as a private market has had a significant impact on public 
investors and the operation of the Nasdaq market. See NASD 21(a) 
Report, supra note 4.
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C. The Revised Interpretation of ``Exchange''

    For purposes of effectively regulating the securities markets, 
including alternative trading systems, the Commission believes a 
revised interpretation of what constitutes an exchange is in 
order.\539\ Although the Commission has considered many characteristics 
of the modern exchange in revising its interpretation,\540\ it believes 
two elements most accurately reflect the functions and uses of today's 
exchange markets. Under the interpretation in Rule 3b-16, the first 
essential element of an exchange is the bringing together of orders of 
multiple buyers and sellers. This reflects the statutory concept of 
bringing together purchasers and sellers and also reflects the reality 
of today's marketplace--where supply and demand originate from a 
variety of sources, not simply from individual brokers and 
dealers.\541\ The second essential element is that trading on an 
exchange takes place according to established, non-discretionary rules 
or procedures. As discussed above, an essential indication of the non-
discretionary status of rules and procedures is that those rules and 
procedures are communicated to the system's users. Thus, participants 
have an expectation regarding the manner of execution--that is, if an 
order is entered, it will be executed in accordance with those 
procedures and not at the discretion of a counterparty or 
intermediary.\542\
---------------------------------------------------------------------------

    \539\ Courts have consistently upheld an agency's discretion to 
revise earlier interpretations when a revision is reasonably 
warranted by changed circumstances. See, e.g., Rust v. Sullivan, 500 
U.S. 173, 186 (1991). In Rust, the Court stated that ``an initial 
agency interpretation is not instantly carved in stone, and the 
agency, to engage in informed rulemaking, must consider varying 
interpretations and the wisdom of its policy on a continuing 
basis.'' Id. at 186 (quoting Chevron v. Natural Resources Defense 
Council, 467 U.S. 837, 844-45 (1984)). The Court also stated that 
``an agency is not required to `establish rules of conduct to last 
forever,' but rather `must be given ample latitude to adapt its 
rules and policies to the demands of changing circumstances.' '' Id. 
at 186-87 (quoting Motor Vehicles Mfrs. Ass'n of United States v. 
State Farm Mut. Automobile Ins. Co., 463 U.S. 29, 42 (1983)). See 
also Arkansas AFL-CIO v. FCC, 11 F.3rd 1430, 1441 (8th Cir. 1993) 
(deferring to Federal Communications Commission decision to alter 
its interpretation of the statutory term ``operated in the public 
interest'' to meet the changing realities of the broadcast 
industry).
    \540\ See Concept Release, supra note 2, at nn.125-133 and 
accompanying text.
    \541\ This broad conception of ``bringing together'' buyers and 
sellers is consistent with the Delta Release, which emphasized that 
the means employed for bringing together buyers and sellers ``may be 
varied, ranging from a physical floor or trading system * * * to 
other means of intermediation (such as a formal market making system 
or systemic procedures such as a consolidated limit order book or 
regular single price auction).'' Delta Release, supra note 32, at 
1899.
    \542\ The elements of the interpretation are discussed in 
greater detail in Section III, supra.
---------------------------------------------------------------------------

    Some commenters thought the Commission should retain its current 
interpretation of an exchange. For example, TBMA advocated a less 
expansive definition of exchange, and recommended that the Commission 
continue to regulate alternative trading systems within the broker-
dealer framework, crafting appropriate regulations to address 
particular issues presented by unique operations as they develop.\543\ 
TBMA also raised a question about whether, by eliminating the 
requirement that a system provide a reasonable expectation of liquidity 
to be considered an exchange, the Commission's proposal conflicted with 
the statutory definition of ``exchange'' because liquidity is 
``generally understood'' to be a fundamental characteristic of an 
exchange. As noted above, however, today's technology gives market 
participants the ability to access multiple markets for liquidity at 
any given time. As a result, assuring liquidity within a single market 
by posting continuous two-sided quotations is no longer the essential 
characteristic of a market where securities exchange hands.\544\
---------------------------------------------------------------------------

    \543\ See TBMA Letter at 3-4.
    \544\ The Commission also notes that the statutory definition of 
``exchange'' is written in the disjunctive: facilities for bringing 
together purchasers and sellers or facilities performing functions 
commonly performed by stock exchanges. Section 3(a)(1) of the 
Exchange Act, 15 U.S.C. 78c(a)(1). See TBMA Letter, at 8-9 
(recommending that the Commission continue to rely on its 
interpretation in the Delta Release); SIA Letter at 2, 6-7 (a 
significant characteristic of exchanges is structural features that 
create a reasonable expectation of the regular execution of orders 
at posted prices). See also Letter from Christopher J. Carroll, 
Managing Director, Deutsche Bank Securities, Inc. to Jonathan G. 
Katz, Secretary, SEC, dated July 31, 1998 (``DBSI Letter'') at 2; 
NYSE Letter at 2-3, 4-5, 8 (commenting that only alternative trading 
systems meeting the Delta interpretation of exchange should have the 
ability to register with the Commission as an exchange); Instinet 
Letter at 8 (recommending that the Commission retain its current 
interpretation of ``exchange''); CBB Letter at 3 (recommending that 
if the Commission believed its current interpretation of 
``exchange'' in the Delta Release was inadequate, that the 
Commission should simply withdraw that interpretation and rely 
solely on the statutory definition of ``exchange'').
---------------------------------------------------------------------------

    Accordingly, the Commission believes that new Rule 3b-16 more 
accurately describes the range of markets that perform exchange 
functions as understood today. At the same time, the Commission's 
exemption from the exchange definition for many alternative trading 
systems provides a flexible framework, permitting each participant to 
choose the regulatory approach that best serves its own business needs.

D. Other Practical Reasons for Revising the Current Interpretation

1. Additional Flexibility Provided by the National Securities Markets 
Improvement Act of 1996
    As stated above, one principal reason the Commission, to date, has 
interpreted the term ``exchange'' narrowly has been to avoid the 
imposition of unnecessary and burdensome regulatory obligations on 
small and emerging trading systems, which could stifle innovation.\545\ 
The enactment of NSMIA,\546\ however, alleviates the concern that an 
expanded interpretation of the term exchange will inhibit 
innovation.\547\ Specifically,

[[Page 70901]]

NSMIA added section 36(a)(1) to the Exchange Act, which provides that:

    \545\ For example, at the time of the Delta Release, the 
Commission sought to avoid interpreting the term ``exchange'' in a 
way that could unintentionally and inappropriately subject many 
broker-dealers to exchange regulation. One key factor in the 
Commission's decision not to regulate the Delta system as an 
exchange was the concern that doing so would subject traditional 
broker-dealer activities to exchange regulation. Delta Release, 
supra note 32.
    \546\ Pub. L. 104-290, 110 Stat. 3416 (1996). 15 U.S.C. 78mm.
    \547\ Throughout the past 60 years, the Commission has attempted 
to accommodate market innovations within the existing statutory 
framework to the extent possible in light of investor protection 
concerns, without imposing regulation that would stifle or threaten 
the commercial viability of such innovations. For example, at 
various times, the Commission considered the implications of 
evolving market conditions on exchange regulation. See Securities 
Exchange Act Release Nos. 8661 (Aug. 4, 1969), 34 FR 12952 
(initially proposing Rule 15c2-10); 11673 (Sept. 23, 1975), 40 FR 
45422 (withdrawing then-proposed Rule 15c2-10 and providing for 
registration of securities information processors); 26708 (Apr. 13, 
1989), 54 FR 15429 (reproposing Rule 15c2-10); 33621 (Feb. 14, 
1994), 59 FR 8379 (withdrawing proposed Rule 15c2-10).
---------------------------------------------------------------------------

the Commission, by rule, regulation, or order, may conditionally or 
unconditionally exempt any person, security, or transaction, or any 
class or classes of persons, securities, or transactions, from any 
provision or provisions of (the Exchange Act) or of any rule or 
regulation thereunder, to the extent that such exemption is 
necessary or appropriate in the public interest, and is consistent 
with the protection of investors.\548\

    \548\ 15 U.S.C. 78mm(a)(1).
---------------------------------------------------------------------------

    Prior to adoption of NSMIA, the Commission's authority under the 
Exchange Act to reduce or eliminate certain consequences of exchange 
registration was limited.\549\ Section 36, however, allows the 
Commission greater flexibility in regulating new trading systems by 
giving the Commission broad authority to exempt any person from any 
provision of the Exchange Act. As a result, the Commission now has 
greater authority to adopt a more consistent regulatory approach to 
securities markets in general, and particularly for alternative trading 
systems that do not neatly fit into the existing regulatory 
framework.\550\
---------------------------------------------------------------------------

    \549\ Prior to the addition of section 36 to the Exchange Act, 
the Commission could only exempt an exchange from the registration 
provisions of sections 5 and 6 on the basis of an exchange's limited 
volume of transactions. See Section 5 of the Exchange Act, 15 U.S.C. 
78e.
    \550\ See S. Rep. No. 104-293, 104th Cong. 2d Sess. 15 (1996).
---------------------------------------------------------------------------

2. No-action Approach to Alternative Trading Systems Is No Longer 
Workable
    The Commission also believes that the proliferation of new trading 
systems necessitates the revision of the interpretation of the term 
``exchange.'' The no-action review process that the Commission has used 
to date to address hybrid systems that incorporate features of both 
exchanges and broker-dealers worked well and was consistent with the 
protection of investors when relatively few systems applied for no-
action treatment. The no-action process allowed the Division to review 
the system's services and mechanisms and to monitor the impact of such 
systems on a case-by-case basis. This is no longer practicable. Absent 
a revised interpretation of ``exchange,'' the Commission would have to 
continue to respond to an increasing volume of no-action requests from 
developing alternative trading systems that seek to avoid the burdens 
associated with registration as a national securities exchange. The 
Commission's revised interpretation eliminates the need for this no-
action approach. By codifying a regulatory framework that does not rely 
on Commission staff review of each novel system development, the 
Commission believes that technological improvements and enhanced 
services will become available more rapidly.
3. More Rational Treatment of Regulated Entities
    The Commission believes that the revised interpretation of the term 
exchange, in combination with the adoption of Regulation ATS, which 
allows alternative trading systems to register as broker-dealers,\551\ 
is consistent with other goals and provisions of the Exchange Act. The 
new regulatory framework, including the revised interpretation of 
``exchange'' avoids the need for the Commission to draw what are now 
arbitrary distinctions between organizations that perform similar 
functions, avoids classifying alternative trading systems in a manner 
that does not fit the structure of these systems, and squarely 
addresses the regulatory concerns raised by these systems.
---------------------------------------------------------------------------

    \551\ See supra Section IV.A.
---------------------------------------------------------------------------

    Moreover, the Commission's new framework helps assure consistency 
with existing broker-dealer regulations. For those alternative trading 
systems that wish to participate in the markets as exchanges, 
regulation as a national securities exchange is available. However, the 
Commission expects that many alternative trading systems will not elect 
to register as national securities exchanges. Under the Commission's 
proposal, these systems would have to maintain a structure more akin to 
that of traditional broker-dealers and comply with regulatory 
obligations more appropriately tailored to their chosen business 
structure. These obligations include the new requirements for more 
significant alternative trading systems to address the transparency, 
fair access, and systems capacity, integrity, and security concerns 
raised by these particular systems.\552\
---------------------------------------------------------------------------

    \552\ See supra IV.A.2.
---------------------------------------------------------------------------

VIII. Effective Dates and Compliance Dates

    The rules and rule amendments adopted in this release are effective 
on April 21, 1999, except for Exchange Act Rules 301(b)(5)(D) and (E) 
and Rules 301(b)(6)(D) and (E), which shall become effective on April 
1, 2000. Alternative trading systems, however, will only have to comply 
with the public display requirement in Rule 301(b)(3) for fifty percent 
of the securities subject to this requirements on April 21, 1999. 
Alternative trading systems will have to comply with Rule 301(b)(3) for 
all such securities by August 30, 1999.\553\ Prior to April 21, 1999, 
the Commission will publish a schedule of those securities for which 
alternative trading systems must comply with Rule 301(b)(3) on April 
21, 1999.
---------------------------------------------------------------------------

    \553\ Because the rules and rule amendments regarding Regulation 
ATS, exchange registration, and Rule 19b-5 constitute ``major 
rules'' within the meaning of the Small Business Regulatory 
Enforcement Act of 1996, 5 U.S.C. 801 et seq., the rules and rule 
amendments cannot take effect until 60 days after the date of 
publication in the Federal Register. Although the amendments to 
Rules 17a-3 and 17a-4 and repeal of Rule 17a-23 and Form 17A-23 do 
not constitute ``major rules,'' they will become effective at the 
same time as Regulation ATS because they operate in an integrated 
fashion with Regulation ATS.
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IX. Costs and Benefits of the Rules and Amendments

    To assist the Commission in its evaluation of the costs and 
benefits that may result from the rules and amendments, commenters were 
requested to provide analysis and data, if possible, relating to the 
costs and benefits associated with the proposals. The Commission 
initially identified certain costs and benefits associated with its 
changes in the Proposing Release. Although the Commission received 
seventy comment letters, as of December 1, 1998 concerning the proposed 
rules, none of the commenters responded specifically to the request for 
comment on the cost/benefit analysis. Some commenters did raise related 
issues and the Commission will address those comments in this analysis. 
After considering the comments, the Commission continues to believe 
that the benefits of the rules and amendments justify the associated 
costs.

A. Costs and Benefits of the Rules and Amendments Regarding Alternative 
Trading Systems

    The Commission identified several benefits and costs to investors 
and market participants in the Proposing Release with regard to 
alternative trading systems. The Commission is not making any changes 
to the rules or amendments that increase the cost estimates for 
alternative trading system notice, reporting and recordkeeping 
obligations. The most significant change

[[Page 70902]]

the Commission is making in the rules as adopted is to revise the fair 
access provisions. The rules and amendments in the Proposing Release 
provided investors with a right of appeal to the Commission and 
required alternative trading systems to provide investors denied or 
limited access to the system with notice of that action and their right 
to appeal the decision to the Commission. The Commission has decided 
not to adopt the right of appeal provisions and the requirement of 
notice to investors denied or limited access. Instead, alternative 
trading systems with significant volume will be required to provide 
quarterly notices to the Commission on Form ATS-R of all grants, 
denials, and limitations of access as well as descriptive information 
regarding those access decisions. The net effect of these changes to 
the fair access requirements is a decrease, relative to the original 
proposal, in the burdens on alternative trading systems with 
significant volume. Several commenters objected to the proposed fair 
access rules on various grounds.\554\
---------------------------------------------------------------------------

    \554\ See ICI Letter at 4 (stating that requirements would be 
overly burdensome for alternative trading systems); IBEX Letter at 
13 (arguing that appeal process should begin at the SRO level); 
Instinet Letter at 19 (stating that a right of appeal to the 
Commission could lead to frequent frivolous appeals).
---------------------------------------------------------------------------

    Several commenters had general comments with regard to the burdens 
imposed on respondents under Regulation ATS. One commenter argued that 
the Commission should impose only minimal requirements on start-up or 
smaller trading systems.\555\ The alternative trading system rules have 
been tailored to minimize their burden on alternative trading systems 
generally and small systems specifically. Because many of the 
provisions in the rules are triggered by a volume threshold, the 
Commission expects that small alternative trading systems will not have 
sufficient volume to trigger those thresholds and will, therefore, not 
have to comply with those provisions. The recordkeeping and reporting 
requirements with which smaller, lower volume alternative trading 
systems will have to comply under Regulation ATS are substantially 
similar to those with which alternative trading systems currently 
comply. Consequently the costs for smaller alternative trading systems 
should remain unchanged.
---------------------------------------------------------------------------

    \555\ TBMA Letter at 16.
---------------------------------------------------------------------------

    One commenter argued that material changes on Form ATS should be 
reported twenty days after such a change is made rather than twenty 
days before.\556\ The Commission believes that is important to have 
some advance notice of significant changes in order to permit it to 
carry out its market oversight and investor protection functions. By 
requiring notice before such changes are made, the Commission has an 
opportunity to make inquiries to clarify any questions that might 
arise. Currently, alternative trading systems are required to give 
twenty days prior notice of material changes on Part 1-A of Form 17A-
23. This burden remains unchanged under the new rules.
---------------------------------------------------------------------------

    \556\ SIA Letter at 17-18. But see IBEX Letter at 5 (stating 
that the reporting requirements under proposed Regulation ATS were 
not inappropriately burdensome).
---------------------------------------------------------------------------

    Several commenters pointed out areas for possible reductions of 
regulatory overlap. One commenter argued that the Commission should 
eliminate those broker-dealer requirements that would be irrelevant for 
alternative trading systems.\557\ The Commission, however, does not 
believe that the broker-dealer requirements as they apply to 
alternative trading systems, are irrelevant or overly burdensome. 
Another commented that recordkeeping burdens should be coordinated with 
the NASD's OATS program.\558\ These recordkeeping rules do not specify 
the manner in which such records must be maintained, but only that they 
must be made available upon request. Such records may be required for 
other purposes, but it is important to assure that all alternative 
trading systems maintain records sufficient to construct an audit 
trail.
---------------------------------------------------------------------------

    \557\ CBB Letter at 4.
    \558\ Instinet Letter at 20.
---------------------------------------------------------------------------

    One commenter argued that the Commission's rules and amendments 
impose costs and burdens on market innovators rather than encouraging 
such systems.\559\ As discussed above, however, the Commission does not 
intend its new regulatory framework to impose a penalty on systems 
because of their use of technology. The Commission's new framework is 
based on the functions performed by a trading system, not on its use of 
technology.
---------------------------------------------------------------------------

    \559\ Instinet Letter at 10.
---------------------------------------------------------------------------

    Finally, a large number of institutional subscribers to alternative 
trading systems submitted comments within the last two weeks. These 
commenters expressed a number of concerns about the public display 
requirement. Among the concerns voiced by these commenters was a 
concern about decreasing liquidity, limiting a potentially advantageous 
trading strategy, being able to provide best execution for their 
clients, and increasing costs to execute trades. The Commission 
responds to these concerns below.\560\
---------------------------------------------------------------------------

    \560\ See supra Section IV.A.2.c.
---------------------------------------------------------------------------

    The Commission solicited comment on the feasibility of permitting 
alternative trading systems to file forms electronically. Three 
commenters supported electronic filing as an option to reduce the 
burdens on respondents.\561\ While not feasible at this time, the 
Commission intends to make electronic filing an option when it is 
possible.
---------------------------------------------------------------------------

    \561\ See IBEX Letter at 5; SIA Letter at 18; American Century 
Letter at 6.
---------------------------------------------------------------------------

    Three commenters argued that the Commission's rules should not 
apply to debt securities, in part, due to the burdens that such 
requirements would place on a largely decentralized market.\562\ Other 
commenters supported including debt securities within Regulation 
ATS.\563\ The Commission continues to believe that many of the same 
concerns about the trading of equity securities on alternative trading 
systems apply equally to the trading of fixed income securities on 
alternative trading systems. Debt securities are increasingly being 
traded on alternative trading systems, similar to the way that equity 
securities are traded. Accordingly, the Commission's new regulatory 
framework would require alternative trading systems trading debt 
securities, other than alternative trading systems trading solely 
government and related securities, to register as an exchange or 
register as a broker-dealer and comply with Regulation ATS. If an 
alternative trading system chooses to register as a broker-dealer, 
Regulation ATS applies the same notice, recordkeeping, and reporting 
requirements on debt alternative trading systems as apply to equity 
alternative trading systems. Because of the way the debt market 
currently operates, however, the transparency provisions do not apply 
to alternative trading systems that trade debt securities. Only those 
alternative trading systems that trade at least twenty percent of 
certain categories of debt are be subject to the fair access 
requirements \564\ and the provisions governing systems capacity, 
security, and integrity.\565\
---------------------------------------------------------------------------

    \562\ See TBMA Letter at 6-7, 21; SIA Letter at 3, 11; DBSI 
Letter at 1; MSDW Letter at 13.
    \563\ See NYSE Letter at 6; IBEX Letter at 2-3.
    \564\ Rule 301(b)(5), 17 CFR 242.301(b)(5).
    \565\ Rule 301(b)(6), 17 CFR 242.301(b)(6).
---------------------------------------------------------------------------

    Under the rules and amendments in this release, alternative trading 
systems have a choice between registering as a national securities 
exchange or registering as a broker-dealer and complying with 
Regulation ATS. The choice between these two options is

[[Page 70903]]

complex and each alternative trading system will make a choice based on 
its business plan and the role it wishes to play in the market. There 
are several factors that will have an impact on each alternative 
trading system's decision.
    First, the regulatory costs associated with registering and 
operating as a national securities exchange are higher than the 
regulatory costs associated with registering as a broker-dealer and 
complying with Regulation ATS. Second, registered exchanges have 
national market system obligations that require those exchanges to bear 
the expenses associated with joining the CTA, CQS, and ITS plans. To 
offset some of those costs, however, registered exchanges also 
participate in the revenue generated from the sale of quotation 
information. Third, registered exchanges are SROs and, therefore, have 
obligations to surveil trading activity and member conduct on the 
exchange. These obligations can be significant in terms of time, 
personnel, and financial resources. However, a significant advantage to 
a registered exchange of being an SRO is that it is not subject to 
oversight by a competitor. Fourth, registered exchanges are subject to 
the statutory requirement to provide fair access, which requires a 
commitment of resources to consider membership applications and to 
report denials to the Commission and defend any denial decisions before 
the Commission if an appeal is made.
    Because of the range of obligations of registered exchanges, 
operation as an exchange requires a significant investment of financial 
resources. A relatively high volume of trading may be required to 
justify this financial investment. While the advent of for-profit and 
non-member owned exchanges may make it easier to raise the financial 
resources necessary to operate as a registered exchange, the Commission 
does not expect that many alternative trading systems will choose to 
register as exchanges.
    On the other hand, alternative trading systems that register as 
broker-dealers must comply with the filing and conduct obligations 
associated with being a registered broker-dealer including membership 
in an SRO and compliance with that SRO's rules. They must also comply 
with Regulation ATS, which includes filing, recordkeeping and reporting 
obligations. Unlike registered exchanges, alternative trading systems 
are subject to oversight by an SRO, which may operate a competing 
market. Regulation ATS is designed to impose few requirements on lower 
volume alternative trading systems. Only alternative trading systems 
with significant volume are required to link to an SRO and publicly 
display orders, provide investors with fair access, and comply with 
systems capacity, integrity, and security requirements. These 
obligations for alternative trading systems with significant volume are 
similar, although not identical, to obligations of registered 
exchanges. Therefore, it is more likely that a high volume alternative 
trading system will consider the costs and benefits of registering as 
an exchange to be more comparable to the costs and benefits of 
regulation as a broker-dealer alternative trading system. The costs 
associated with regulation as a registered exchange, and with operating 
as a broker-dealer and complying with Regulation ATS are discussed more 
fully below.
1. Benefits
    a. Improved Market Transparency. The Commission's amendments and 
rules enhance transparency of trading on alternative trading systems. 
Transparency of orders helps ensure that publicly available prices 
fully reflect overall supply and demand and helps reduce the negative 
consequences of market fragmentation (e.g., the chance that an order 
for a security in one market will be executed at a price inferior to 
that available at the same time in another market). The Commission has 
been particularly concerned that the development of so-called ``hidden 
markets,'' in which a market participant privately publishes quotations 
at prices superior to the quotation information it disseminates 
publicly, impedes national market system objectives. Some systems that 
permit this activity have become significant markets in their own 
right, but are not currently required to integrate their orders into 
the public quote because they are not registered as national securities 
exchanges or national securities associations.
    For alternative trading systems choosing to register as broker-
dealers, the Commission's amendments and rules improve the transparency 
of orders in systems that account for a significant portion of the 
trading volume in any security. The amendments and rules help to 
incorporate alternative trading system quotes into the national market 
system, thus reducing fragmentation, improving liquidity, facilitating 
price discovery, and narrowing the quoted spread.\566\
---------------------------------------------------------------------------

    \566\ The Office of Management and Budget has recognized that 
although it may be difficult to quantify the benefits of price 
transparency, ``[t]here is a strong consensus among economists that 
regulations requiring the disclosure of information about the price 
and quality of products and services can produce significant 
benefits for consumers and improve the functioning of markets when 
this information would not otherwise be available.'' Office of 
Management and Budget, Draft Report to Congress on the Costs and 
Benefits of Federal Regulations, 63 FR 44034 (Aug. 17, 1998).
---------------------------------------------------------------------------

    Because non-market maker broker-dealers and institutions at times 
enter the best priced orders in an alternative trading system, the 
Commission expects that display of these orders in the public quote 
will also improve the NBBO. For example, of all orders on ECNs by non-
market maker broker-dealers and institutions that could improve the 
NBBO if included in the public quote stream, only about six percent of 
those orders were actually entered into the public quote stream. 
Consequently, about ninety-four percent of those orders that could have 
improved the NBBO were not included in the public quote stream and thus 
did not impact the NBBO. These orders were therefore unavailable to 
some investors, in particular, retail investors, who do not have direct 
access to ECNs. The unavailability of these quotes continues to 
effectively result in a two-tiered market. While the Commission is 
unable to precisely quantify the market impact of these changes, it 
does believe that the benefit for investors will be significant based 
on preliminary estimates.
    Based on an analysis of ECN trading activity during a four day 
period in June 1997 (June 23, 1997 to June 27, 1997), the staff 
estimates that spreads could decrease by as much as four percent for 
Nasdaq issues when non-market maker broker-dealer and institutional 
orders are displayed in the public quote. In making this estimate, the 
staff has assumed an average spread of 35 cents per share, a maximum 
increase of eleven percent for the times that ECNs could narrow the 
inside, and a maximum of 12.5 cents per share improvement. In addition 
to the effects on the bid-ask spread, retail investors and other non-
subscribers will gain access to the liquidity and better prices now 
available only to alternative trading system subscribers. Moreover, 
because many broker-dealers offer retail customers automatic execution 
of their small orders at the publicly quoted price, a better price in 
the public quote potentially improves the price received by thousands 
of broker-dealer customers. Larger orders negotiated between 
institutions and broker-dealers also potentially benefit because the 
price negotiated will reflect a smaller spread. For these reasons, the 
Commission believes that new display and access requirements will 
result in significant benefits to investors.

[[Page 70904]]

    The above data is consistent with the results of the transparency 
improvements achieved through the implementation of the Order Handling 
Rules.\567\ The NASD studied the effect of the Order Handling Rules on 
the Nasdaq market by comparing various measures between a pre-period of 
twenty days in the beginning of 1997 (December 18, 1997 to January 17, 
1998) and a post-period of twenty days in the beginning of 1998 
(January 5, 1998 to February 2, 1998). The success of the Order 
Handling Rules further supports the view that the amendments and rules 
the Commission is adopting today will further investors' opportunities 
to trade at the best prices.
---------------------------------------------------------------------------

    \567\ See supra note 177. Under the Order Handling Rules, market 
makers who enter orders on ECNs are required to reflect those prices 
in their public quotations. In the alternative, the ECN can make the 
best market maker prices publicly available through an SRO.
---------------------------------------------------------------------------

    In its study, the NASD also found that quoted spreads in the Nasdaq 
market decreased by an average of forty-one percent. The NASD estimates 
that this reduction in spreads resulted in annual savings to investors 
of between $284 million and $673 million. Because of the increased 
market transparency provided by the display of institutional and non-
market maker broker-dealer orders, the Commission believes that the 
rules and amendments in this release will also further shrink spreads.
    Finally, the Commission believes that improved transparency of 
orders in alternative trading systems will reduce the potential for 
alternative trading system subscribers to manipulate the public market. 
It has been alleged that institutions and non-market makers 
intentionally influence the market by displaying an order in an 
alternative trading system that locks the price displayed in the public 
market. For example, if the public market is displaying a bid of 20 and 
an offer of 21, an institution or non-market maker might display an 
offer of 20 in an alternative trading system. Market participants often 
then assume that the order in the alternative trading system indicates 
the direction in which the market is moving and begin selling to market 
makers bidding 20, pushing the public market lower. The price in the 
alternative trading system is then canceled and the institution or non-
market maker buys securities at a lower price. This type of activity is 
possible only because institution and non-market maker orders in 
alternative trading systems are not displayed to the public market. The 
Commission believes that the integrity of the public markets is 
threatened when institutions and non-market makers can affect the 
public markets without participating in them.
    The transparency of trading on alternative trading systems that 
choose to register as exchanges will also improve. All registered 
exchanges are expected to participate in the national market system 
plans, such as the CTA, CQS, and ITS. These plans form an integral part 
of the national market system, and contribute greatly to the operation 
of linked, transparent, efficient, and fair markets. In addition to 
improving transparency, alternative trading system participation in 
these market-wide mechanisms will benefit investors by reducing trading 
fragmentation.
    b. Improved Investor Protections. The Commission's amendments and 
rules provide benefits to investors by improving the surveillance of 
trading on alternative trading systems. Adequate surveillance of the 
trading on alternative trading systems is critical to the continued 
integrity of our markets. This is particularly the case with regard to 
alternative trading systems that have a significant percentage of the 
trading volume in one or many issues of securities. The oversight of 
trading activities on alternative trading systems that choose to 
register as broker-dealers will improve because the proposals clarify 
the relationship between SROs and alternative trading systems.
    The notice, reporting, and recordkeeping requirements under 
Regulation ATS also contribute to the Commission's and the SROs' 
ability to effectively oversee alternative trading systems regulated as 
broker-dealers. The Commission believes that these enhancements to the 
surveillance and oversight of alternative trading systems regulated as 
broker-dealers benefit the public by helping to prevent fraud and 
manipulation.
    The surveillance of trading on alternative trading systems that 
choose to register as exchanges under the Commission's proposal will 
also be improved. All registered exchanges are SROs, which have direct 
obligations to surveil the trading on their own markets. The Commission 
believes that, through improved surveillance mechanisms, it will be 
better able to detect fraud and manipulation that could occur on 
alternative trading systems. For example, alternative trading systems 
can be used to artificially narrow the NBBO spreads for the sole 
purpose of trading through a broker-dealer's automatic execution system 
at the artificial prices.\568\ The Commission and the SROs will be able 
to more readily detect such activity through enhanced surveillance. The 
Commission believes that this more direct oversight of trading 
activities will therefore benefit investors and the market generally by 
helping to prevent fraud and manipulation.
---------------------------------------------------------------------------

    \568\ See supra note 5.
---------------------------------------------------------------------------

    c. Fair Access. The Commission's rules require alternative trading 
systems with significant volume to provide a fair opportunity to 
participate in alternative trading systems. Fair and non-discriminatory 
treatment of potential and current subscribers by alternative trading 
systems is important, especially when an alternative trading system 
captures a large percentage of trading volume in a security. Although 
an alternative trading system with significant volume is required to 
provide access to orders that it is required to display in the public 
quote stream, there are other benefits to direct participation on an 
alternative trading system. In particular, participation on an 
alternative trading system allows an investor to enter its own orders, 
view contingent orders not publicly displayed (such as all or none 
orders) and use special features of an alternative trading system, such 
as a negotiation feature or reserve size feature. Accordingly, the 
rules prevent discriminatory denials of access and ensure that market 
participants are not prevented from gaining access to significant 
sources of liquidity.
    d. Systems Capacity, Integrity, and Security. The Commission 
believes that its rules regarding systems capacity, integrity, and 
security of alternative trading systems provide several benefits to the 
marketplace and to investors. Marketplaces are increasingly reliant on 
technology and most of their functions are becoming highly automated. 
Alternative trading systems are subject only to business incentives to 
avoid system breakdowns that may disrupt the market. In the past, 
alternative trading system failures have affected the public market, 
particularly during periods of high trading volume. Some alternative 
trading systems have had prolonged shut-downs during the busiest 
trading sessions due to systems problems. For example, during the past 
year, Instinet, Island, Bloomberg, and Archipelago (operated by Terra 
Nova) have all experienced systems outages due to problems with their 
automated systems. On a number of occasions, ECNs have had to stop 
disseminating market maker quotations in order to keep from closing 
altogether, including during the market decline of October 1997 when 
one significant ECN withdrew its quotes from Nasdaq because of lack of 
capacity. Similarly, a major IDB in non-exempt

[[Page 70905]]

securities experienced serious capacity problems in processing the 
large number of transactions in October 1997 and had to close down 
temporarily.
    The Commission's rules require alternative trading systems that 
handle a significant volume of trades to establish reasonable capacity 
estimates, conduct stress tests, implement procedures to monitor system 
development, review systems vulnerability, and establish adequate 
contingency plans. Investors will benefit from the rules because 
significant systems will be less likely to shut down as a result of 
systems failures and will be better equipped to handle market demand 
and provide liquidity during periods of market stress. The ability of 
alternative trading systems to provide more reliable and consistent 
service in the market benefits investors and the public markets 
generally. The Commission also believes that investors will benefit 
from robust system security provided by ensuring that significant 
alternative trading systems maintain sufficient security measures to 
prevent unauthorized access.
    All currently registered exchanges participate in the Commission's 
automation review program. Alternative trading systems that choose to 
register as exchanges will similarly be expected to participate in this 
program. Under the automation review program, exchanges are expected to 
maintain sufficient systems capacity to meet current and anticipated 
volume levels. The benefits to investors and the public generally, as 
with significant alternative trading systems, will be the assurance 
that systems are reasonably equipped to handle market demand and 
provide liquidity during periods of market stress.
2. Costs
    The alternative trading system rules and amendments have been 
tailored to minimize their burden on alternative trading systems and 
especially small systems. Many of the provisions in the rules and 
amendments are triggered by a volume threshold. The Commission expects 
that small alternative trading systems will not have sufficient volume 
to trigger those thresholds and will therefore not have to comply with 
those provisions. The recordkeeping and reporting requirements with 
which smaller, lower volume alternative trading systems have to comply 
under Regulation ATS are substantially similar to those with which 
alternative trading systems currently comply. Consequently the costs 
for smaller alternative trading systems should remain materially 
unchanged. The paperwork, filing, and recordkeeping costs are discussed 
in the Paperwork Reduction Act section below.
    a. Notice, Reporting, and Recordkeeping. All alternative trading 
systems that will be subject to notice, reporting, and recordkeeping 
requirements under the Commission's new rules are currently subject to 
similar requirements under Rule 17a-23. The requirements under 
Regulation ATS, however, require some additional information that is 
not currently required under Rule 17a-23.
    Under Regulation ATS, alternative trading systems file an initial 
operation report, notices of material systems changes, and quarterly 
reports. The rules also include new Forms ATS and ATS-R to standardize 
reporting of such information and make it more useful for the 
Commission. The rules require information that is not currently 
required under Rule 17a-23, such as greater detail about the system 
operations, the volume and types of securities traded, criteria for 
granting access to subscribers, procedures governing order execution, 
reporting, clearance and settlement, procedures for reviewing systems 
capacity and contingency procedures, and the identity of any other 
entities involved in operating the system.
    Regulation ATS requires staff time to comply with the initial 
notice and amendment requirements. While the Commission has designed 
the requirements in an effort to balance the costs of filing with the 
benefits to be gained from the information, some effort will be 
necessary to gather and file this information. Most of the information, 
however, already exists. Alternative trading systems will only be 
required to gather this information and supply it in the required 
format to the Commission. The periodic updating requirements will also 
require staff time over the life of the alternative trading system to 
comply with the rules.
    The Commission estimates that there are currently about forty-five 
alternative trading systems that will be required to register as 
exchanges or register as broker-dealers and comply with Regulation 
ATS.\569\ The Commission also estimates that, over time, there will be 
approximately three new alternative trading systems each year that 
choose to register as broker-dealers and comply with Regulation 
ATS.\570\ The Commission also estimates that, over time, there will be 
approximately three alternative trading systems that file cessation of 
operations reports each year. Thus, the Commission anticipates that, 
over time, if all forty-five current alternative trading systems choose 
to register as broker-dealers and comply with Regulation ATS, there 
will be approximately forty-five alternative trading systems operating 
each year.
---------------------------------------------------------------------------

    \569\ This estimate is based on filings made with the Commission 
under Rule 17a-23. At the time of the Proposing Release, the 
Commission estimated that forty-three alternative trading systems 
would be required to register as exchanges or broker-dealers and 
comply with Regulation ATS. The Commission now estimates that there 
are forty-five alternative trading systems operating.
    \570\ Based on the Commission's experience over the last three 
years with Rule 17a-23, it appears that there are more than three 
new alternative trading systems per year. However, we expect that in 
the future, there will be approximately three new alternative 
trading systems per year. The rapid growth experienced over the last 
several years is unlikely to continue in perpetuity.
---------------------------------------------------------------------------

    b. Public Display of Orders and Equal Execution Access. Regulation 
ATS requires that alternative trading systems with significant volume 
display their best-priced orders for securities in which they have 5 
percent or more of total trading volume in the public quote. The 
Commission identified the anticipated benefits of this requirement 
above. Below is a discussion of possible costs associated with this 
requirement.
    One possible cost is the impact on institutional order flow to 
alternative trading systems generally. Institutions have several 
options available to them to execute trades. They can send orders to 
block trading desks, a number of different types of alternative trading 
systems, or directly to registered exchanges through broker-dealer 
give-ups. Although not currently displayed to the public, orders sent 
to an alternative trading system by institutions are displayed to other 
alternative trading system subscribers.\571\ Thus, placing large 
orders, or a series of successive small orders, in an alternative 
trading system signals to a large number of sophisticated market 
participants the interest in a particular security.
---------------------------------------------------------------------------

    \571\ A number of ECNs, however, currently display the best 
order in their system in the public quote, regardless of whether 
that order is entered by an institution, market maker or another 
broker-dealer although the Commission's Order Handling Rules only 
require the display of market maker orders. Thus, institutional 
orders sent to these systems are already displayed to the public.
---------------------------------------------------------------------------

    The Commission is not persuaded by commenters that suggest that 
institutions currently willing to use alternative trading systems to 
display their orders to other alternative trading system subscribers, 
including other institutions, market-markers, and broker-dealers, will 
be less willing to use alternative trading systems that must display 
those orders to the public market. Our reasons are as follows. The 
primary group of market participants

[[Page 70906]]

that will benefit from the public display of institutional orders is 
retail investors. Retail investors are not currently alternative 
trading system subscribers. To avoid market impact, institutions try to 
avoid signaling other institutions and market professionals, not retail 
investors. Almost all market professionals and a significant number of 
institutions already subscribe to alternative trading systems. Thus, 
the Commission believes that the additional exposure to the market 
should not affect institutions' use of alternative trading systems. 
Moreover, to the extent that institutions want to display small sized 
orders in the public market, rather than their entire order, they will 
still be able to make use of an alternative trading system's ``reserve 
size'' feature. This will enable institutions to avoid exposing the 
total size of their order to the public market.
    Nonetheless, assuming institutions do have a preference for showing 
their sized orders to other alternative trading system subscribers but 
not the public market, there may be two reactions by institutions. 
First, institutions could choose to move their orders to more opaque 
venues, such as block trading desks. The cost of this movement of 
orders would be a loss of transparency to the limited group of 
alternative trading system subscribers who now benefit from the display 
of institutional orders on alternative trading systems, and the loss of 
business to alternative trading systems. While block trading desks 
would benefit from the increased business, it likely would increase 
institutions' transaction costs. For this reason, as well as those 
discussed above, the Commission believes it unlikely for institutions 
to react this way. Second, because the public display requirement only 
applies to alternative trading systems with five percent or more of the 
volume in a particular security, there is a possibility that 
institutions may move their order flow to smaller alternative trading 
systems in order to avoid the public display requirement. Such 
movements of order flow could benefit some alternative trading systems 
in the form of increased revenue and be a cost to other alternative 
trading systems who lose revenue.
    Currently, alternative trading systems are able to attract 
subscribers because prices in their systems are often better than the 
prices available in the public markets. Because alternative trading 
systems are now required to publicly display their best priced orders 
for securities in which they represent five percent or more of the 
trading volume, the best priced orders for certain securities will also 
be available through the public markets. Alternative trading systems 
will no longer be able to provide subscribers with the unlimited 
ability to avoid public display in the NBBO and possible interaction 
with non-subscribers. Consequently, some subscribers could leave an 
alternative trading system if they think there are fewer advantages 
than before in having direct access to the alternative trading system.
    However, the growth of ECNs since the Order Handling Rules were 
implemented indicates that alternative trading systems can, and are, 
attracting subscribers.\572\ As mentioned above, there are still 
significant benefits to being a subscriber to an alternative trading 
system, including, but not limited to: the ability to enter orders and 
the use of such features as a negotiation feature or a ``reserve size'' 
feature; the ability to access the best priced orders for securities in 
which an alternative trading system represents less than 5 percent of 
the trading volume and therefore is not subject to the transparency 
requirements; and access to the entire ``book,'' not merely the ``top 
of the book,'' that contains important real-time market information 
regarding depth of trading interest. All of these benefits will be 
retained under the new display requirement.
---------------------------------------------------------------------------

    \572\ When the Order Handling Rules were implemented on January 
17, 1997, four ECNs linked to Nasdaq. Today there are a total of 
nine ECNs linked to the public quote stream. See supra note 178.
---------------------------------------------------------------------------

    Despite the impact on high volume alternative trading systems, 
integrating their best-priced orders into the public market is critical 
to the national market system. Section 11A of the Exchange Act directs 
the Commission to facilitate a national market system and to carry out 
Congress' objectives of, among other things, assuring ``the 
practicability of brokers executing investors' orders in the best 
market.'' \573\ The public display requirement adopted today furthers 
the objectives in Section 11A of the Exchange Act by ensuring that the 
public markets reflect the best priced orders displayed in alternative 
trading systems that have a significant trading market in particular 
securities.
---------------------------------------------------------------------------

    \573\ Section 11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k-
1(a)(1)(C).
---------------------------------------------------------------------------

    Several commenters also expressed concern about whether or not 
alternative trading systems will be permitted to continue charging fees 
to non-subscribers that access alternative trading systems publicly 
displayed orders. Currently, alternative trading systems charge a range 
of fees to subscribers. In particular, alternative trading systems may 
allow institutional subscribers to select higher fees and then have 
soft-dollars rebated in an amount equal to the excess above the actual 
cost for execution of a trade. Because of the presence of soft dollars, 
it is difficult to estimate the amount of revenue that alternative 
trading systems receive from institutional subscribers. The Commission 
notes, however, that it is not requiring alternative trading systems to 
change their fee structures. The Commission is merely limiting 
alternative trading systems to charging non-subscribers fees that are 
consistent with equivalent access.\574\ The Commission does not believe 
that such limitations will substantially affect an alternative trading 
system's revenues. In fact, some alternative trading systems may have 
increased revenues from the fees charged to non-subscribers.
---------------------------------------------------------------------------

    \574\ Under the Order Handling Rules, ECNs are limited to 
charging non-subscribers fees consistent with equivalent access.
---------------------------------------------------------------------------

    The rules the Commission is adopting today prohibit an alternative 
trading system from charging fees that would effectively deny non-
subscribers equivalent access to an alternative trading system's 
publicly displayed orders. As long as a fee does not deny equivalent 
access, it would be permissible under these rules. The SROs will be 
able to establish rules to ensure that alternative trading system fees 
are not inconsistent with the standard of equivalent access. Any SRO 
rule impacting an alternative trading system's access fees would have 
to be filed with the Commission for public comment, review, and 
approval. The Commission cannot approve any SRO rule unless it finds 
that such rule is consistent with the Exchange Act, including whether 
the rule will promote ``efficiency, competition, and capital 
formation.'' \575\
---------------------------------------------------------------------------

    \575\ Section 3(f) of the Exchange Act, 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

    As discussed above, one of the expected benefits of displaying the 
best-priced orders in alternative trading systems to all investors is 
that spreads will shrink. The success of the Order Handling Rules 
indicates that the Commission's current proposal should further enhance 
liquidity and price improvement opportunities in the public markets. 
Because non-market maker broker-dealers and institutions at times enter 
the best priced orders in an alternative trading system, the Commission 
expects that display of these orders in the public quote will improve 
the NBBO. As a result, some market markers may experience a loss of 
revenue. For example, a market maker

[[Page 70907]]

may currently be at the NBBO even when an alternative trading system is 
better than that market maker's bid or offer. Accordingly, if the 
better priced institutional or non-market maker broker-dealer order 
were displayed in the public quote, that market maker would not execute 
an order unless it improved its quote. While reduced spreads may 
represent a cost to market makers, as discussed above, it represents a 
corresponding benefit to investors. Moreover, reduced spreads make the 
overall market more efficient by reducing transaction costs. If trading 
is less expensive, all other things being equal, investors can be 
expected to trade more.
    The staff also notes that a market maker is not required to execute 
a customer order at the NBBO if the best available price is represented 
by an alternative trading system quote. Instead, a market maker may 
attempt to execute that customer order against the alternative trading 
system quote. If the market maker acts as agent in effecting the 
customer's trade, it may be entitled to a brokerage fee. Therefore, 
market makers may be able to offset, at least partially, the loss of 
trading profits with additional brokerage revenues.
    c. Fair Access. Under Regulation ATS, alternative trading systems 
with significant volume are required to establish and maintain 
standards for granting access to their system and keep records of such 
standards. In addition, such alternative trading systems must apply 
those standards in a fair and non-discriminatory manner and submit 
certain information regarding grants, denials, and limitations of 
access with their quarterly reports on Form ATS-R. Based on current 
volume estimates, at most two alternative trading systems will be 
initially subject to this requirement. The Paperwork Reduction Act 
section of this release summarizes the filing and recordkeeping costs 
associated with the fair access requirement.
    The fair access requirement, as adopted, differs from that 
proposed. The proposal would have provided market participants who 
believe they had been unfairly denied or limited access to an 
alternative trading system subject to the fair access requirement with 
a right to appeal that alternative trading system's action to the 
Commission. Alternative trading systems subject to the fair access 
requirement would also have been required to provide investors with 
notice of a denial or limitation of access and their right to appeal 
that action to the Commission. The fair access requirement being 
adopted today does not include any right to appeal an alternative 
trading system's access decisions to the Commission. Instead, the 
Commission intends to enforce the prohibition on alternative trading 
systems with significant volume unfairly denying access through its 
inspection and enforcement authority. The Commission believes the fair 
access requirement it is adopting will be less costly to alternative 
trading systems than the one proposed because alternative trading 
systems will not be required to defend their access decisions in 
appeals before the Commission. Moreover, the requirement adopted does 
not require alternative trading systems to send notice of their 
decisions to market participants.
    d. Systems Capacity, Integrity, and Security. The Commission does 
not believe that its amendments and rules requiring alternative trading 
systems to meet certain systems related standards imposes significant 
costs. The standards the Commission is adopting are general standards 
that are consistent with good business practices. In addition, smaller 
alternative trading systems will not be subject to the proposed 
requirements. For those alternative trading systems that do not, for 
business reasons alone, ensure adequate capacity, integrity, and 
security of their systems, there will be costs associated with 
complying with the requirements. The costs associated with upgrading 
systems to an adequate level may include, for example, investing in 
computer hardware and software. In addition, alternative trading 
systems will incur costs associated with the independent review of 
their systems on an annual basis. An independent review should be 
performed by competent, independent audit personnel following 
established audit procedures and standards. If internal auditors are 
used by an alternative trading system to complete the review, these 
auditors should comply with the standards of the EDPAA. If external 
auditors are used, they should comply with the standards of the AICPA 
and the EDPAA. The review must be conducted according to established 
procedures and standards. The costs involved may vary widely depending 
on the business of the alternative trading system. Alternative trading 
systems will also be subject to paperwork burdens and recordkeeping and 
reporting requirements. These requirements are necessary for the 
Commission and the appropriate SROs to ensure compliance with systems 
related requirements. In addition, keeping such records permits 
alternative trading systems to effectively analyze systems problems 
that occur. While alternative trading systems are not required to file 
such documentation with the Commission on a regular basis, the 
Commission recognizes that generating and maintaining such 
documentation will impose some additional costs.
    The notification requirement for material systems outages should 
impose relatively little additional costs on alternative trading 
systems. Moreover, the Commission believes that this small burden is 
justified by the need to keep Commission staff abreast of systems' 
developments and problems. The Paperwork Reduction Act section of this 
release summarizes the costs associated with the recordkeeping and 
reporting burdens of compliance with the systems capacity, integrity, 
and security requirements.
    e. Costs of Exchange Registration. The framework the Commission is 
adopting today for alternative trading systems is designed to allow 
such systems the option of registering as national securities 
exchanges. If an alternative trading system chooses to register as an 
exchange, corresponding regulatory obligations could impose costs on 
such systems, however, the elective nature of exchange regulation under 
the framework the Commission is adopting today ensures that only those 
entities for whom it is cost-effective will choose exchange 
registration and therefore bear the costs.
    For example, exchange-registered alternative trading systems will 
have to be organized to, and have the capacity to, carry out the 
purposes of the Exchange Act, including their own compliance and the 
ability to enforce member compliance with the securities laws. 
Consequently, any newly registered exchange will have to establish 
appropriate surveillance and disciplinary mechanisms. In addition, 
newly registered exchanges will incur certain start-up costs associated 
with this obligation, such as writing rule manuals.
    National securities exchanges currently operating have significant 
assets and expenses in order to carry out their functions. The cost of 
acquiring the necessary assets and the operating funds required to 
carry out the day-to-day functions of a national securities exchange 
are significant. For example, for the fiscal year 1997, the NYSE had 
total assets of $1,174,887,000 and total expenses of $488,811,000. The 
Cincinnati Stock Exchange (``CSE''), currently the only completely 
automated national securities exchange, had total assets of $13,124,585 
and total expenses of $5,343,403. Due to these costs, it appears that 
an alternative trading system will need to have

[[Page 70908]]

significant volume in order to make the benefits of exchange 
registration outweigh the costs.
    As registered exchanges, alternative trading systems will also be 
subject to more frequent inspection by the Commission. As broker-
dealers, alternative trading systems will be inspected on a regular 
basis by any SRO of which they are a member, and by the Commission only 
on an intermittent basis. As registered exchanges, these systems will 
be inspected more regularly by Commission staff, but will, of course, 
no longer be subject to examinations by SROs.
    The Commission inspects different SRO programs on independent 
review cycles. For example, separate inspections are conducted for an 
SRO's surveillance, arbitration, listings, and financial soundness 
programs. Where appropriate, SROs will be examined for other programs 
they may operate, such as index programs. Each type of examination will 
be performed at regular intervals, which are typically two to three 
years. An SRO, however, may expect several examinations throughout a 
particular year, each in a different program. Each examination 
typically involves three to four attorneys and/or accountants from the 
Commission, who spend one week at the SRO, or up to two weeks for 
particularly large programs, to examine records and interview SRO 
personnel. In order to comply with section 17(b) under the Exchange 
Act, an SRO must expend resources to provide copies of relevant 
documents to, and answer questions from, the Commission staff. The cost 
to an SRO of each examination varies greatly depending on the scope of 
the examination and the size or complexity of the SRO's particular 
program.
    In addition, there will also be costs associated with meeting the 
obligations set forth in section 11A of the Exchange Act and the rules 
thereunder. These costs include the costs of joining, or creating new, 
market-wide plans, such as the CQS, CTA, ITS, and OTC-UTP, although 
some of these costs will be offset by the right to share in the 
revenues generated by these plans. For example, to join the CTA plan, 
applicants will be asked to pay, as a condition to entry into the plan, 
an amount that reflects the value of the tangible and intangible assets 
created by the CTA plan that will be available to the applicant. \576\ 
Similarly, new participants in ITS will have to pay a share of the 
development costs, which will reflect a share of the initial 
development costs, which were $721,631, and a share of costs incurred 
after June 30, 1978. \577\ These costs will also include the costs of 
complying with Rule 11Ac1-1(b) under the Exchange Act, \578\ which 
requires national securities exchanges and national securities 
associations to make the best bid, best offer, and aggregate quotation 
size for each security traded on its facilities available to quotation 
vendors for public dissemination.\579\
---------------------------------------------------------------------------

    \576\ The amount to be paid to the CTA plan will vary on a case-
by-case basis and may reflect a current independent valuation of the 
CTA facilities, prior valuations, an assessment of costs contributed 
to the plan by existing members, the estimated usage of the plan 
facilities by the applicant, costs for anticipated system 
modifications to accommodate the applicant, and other relevant 
factors as determined by the current participants. CTA Plan: Second 
Restatement of Plan Submitted to the Securities and Exchange 
Commission Pursuant to Rule 11Aa3-1 under the Securities Exchange 
Act of 1934, May 1974 as restated March 1980 and December 1995, at 
8-9. See supra note 391. The terms of the CQ plan are substantially 
similar with respect to the assessment of a payment upon entry into 
the system. CQ Plan: Restatement of Plan Submitted to the Securities 
and Exchange Commission Pursuant to Rule 11Ac1-1 under the 
Securities Exchange Act of 1934, July 1978, as restated December 
1995, at 8-9. See supra note 392.
    \577\ Plan for the Purpose of Creating and Operating an 
Intermarket Communication Linkage Pursuant to Section 11A(a)(3)(B) 
of the Securities Exchange Act of 1934, Composite: Amendments 
through May 30, 1997, at 78-79.
    \578\ 17 CFR 240.11Ac1-1.
    \579\ The Commission estimates that each national securities 
exchange or national securities association will submit information 
to vendors approximately 24,266,000 times per year, which reporting 
is generally done through automated facilities that conduct the 
reporting on a continuous basis. Due to the continuous nature of the 
information feeds, the Commission does not believe that it is 
feasible to estimate the average cost per response or annual burdens 
hours involved in complying with Rule 11Ac1-1(b) for a new 
registered exchange. 17 CFR 240.11Ac1-1(b).
---------------------------------------------------------------------------

    The Commission notes that the remaining costs will be partially 
offset because the alternative trading systems assuming the costs of 
exchange registration will no longer be regulated as broker-dealers. 
Consequently, they will no longer be obligated to comply with the 
broker-dealer requirements, such as filing and updating Form BD, 
maintaining books and records in accordance with Rules 17a-3 and 17a-4 
under the Exchange Act, and paying fees for membership in an SRO. In 
addition, because exchange-registered alternative trading systems share 
the responsibilities of self-regulation, the regulatory burden carried 
by currently registered exchanges should be reduced. Other benefits 
include the freedom from oversight by a competing SRO, no obligation to 
comply with net capital requirements, the right to establish trading 
and conduct rules, the right to establish fee schedules, the ability to 
directly participate in the national market system mechanisms, and the 
right to share in the profits and benefits produced by the national 
market system mechanisms such as the CQS, CTA, ITS and OTC-UTP 
plans.\580\
---------------------------------------------------------------------------

    \580\ See supra Section III.B.1.
---------------------------------------------------------------------------

    The costs of exchange registration also include certain paperwork, 
filing, and recordkeeping requirements. These costs are discussed in 
the Paperwork Reduction Act section below.
    The Commission anticipates that only a few of the existing 
alternative trading systems would consider registering as a national 
securities exchange. For most of the alternative trading systems 
currently in existence, the Commission believes that the costs and 
obligations discussed above potentially make registering as a national 
securities exchange less commercially viable than registering as a 
broker-dealer and complying with Regulation ATS.

B. Amendments to Application and Related Rules for Registration as an 
Exchange

    The Commission identified several costs and benefits to investors 
and market participants in the Proposing Release with respect to 
amendments to the application and rules for exchange registration. Only 
two commenters identified areas of concern regarding exchange 
registration. These commenters suggested that the Commission was 
seeking to reimpose annual filing requirements previously eliminated in 
1994.\581\ In response, the Commission has made technical modifications 
to Rule 6a-2 to clarify the operation of the rule. The Commission does 
not believe that these filing burdens are reimposed under the rules as 
adopted. These commenters also questioned the value of requiring 
exchanges to compile and submit amendments to Form 1 that contain 
information that has been provided to the Commission throughout the 
year in other contexts. The Commission continues to believe that it is 
important to have all the required information gathered in one place in 
order to make it useful for Commission staff. In addition, the 
additional costs should be minimal because the respondents are required 
only to compile existing documents rather than generate new material.
---------------------------------------------------------------------------

    \581\ See NYSE Letter at 10; Amex Letter at 5-6.
---------------------------------------------------------------------------

1. Benefits
    The Commission believes that the amendments provide benefits to 
organizations that are currently

[[Page 70909]]

registered, or in the future will apply for registration, as national 
securities exchanges. Generally, the Commission expects that the 
regulatory framework discussed in this release accommodates automated 
and for-profit exchanges and makes registering as a national securities 
exchange more commercially viable for possible future exchanges.\582\ 
First, the amendments to Rules 6a-1, 6a-2, and 6a-3 ease compliance 
burdens by simplifying the rule. By simplifying the rule language 
itself, the Commission anticipates that parties attempting to comply 
with Rules 6a-1, 6a-2, and 6a-3 will be better able to understand the 
rules' requirements and comply with them. Much of the information 
required on Form 1 will not change, but the revised form recasts the 
questions and exhibits in a different format that will ease compliance 
and make the responses more relevant to investors and the Commission. 
While national securities exchanges have traditionally been membership-
owned, Form 1 also is revised to accommodate proprietary national 
securities exchanges.
---------------------------------------------------------------------------

    \582\ For example, the International Securities Exchange, which 
announced its intentions to register as a national securities 
exchange on November 10, 1998, would not be able to register as a 
national securities exchange without the changes to the rules as 
adopted today. See International Securities Exchange Will be First 
Fully Electronic Options Exchange in U.S., International Securities 
Exchange Press Release, Nov. 10, 1998.
---------------------------------------------------------------------------

    Second, the amendments give national securities exchanges the 
option of complying with certain ongoing filing requirements by posting 
information on an Internet web site and supplying the location to the 
Commission, instead of filing a complete paper copy with the 
Commission. The Commission anticipates that exchanges will choose to 
use the Internet to comply with Rules 6a-2 and 6a-3 rather than filing 
many exhibits on paper. The availability of such information on the 
Internet will also provide the public with easier and less expensive 
access to the information than requesting paper copies from the 
Commission or the national securities exchanges as currently required. 
In addition, permitting exchanges to use the Internet as a means of 
compliance will reduce expenses associated with clerical time, postage, 
and copying.
    The amended rules also reduce the frequency of certain ongoing 
filings to update the information in Form 1, directly reducing the 
compliance burden on national securities exchanges while still meeting 
investors' and the Commission's need for reasonably current 
information. Specifically, the amendments eliminate exchanges' 
requirement to submit changes to their constitution, their rules, or 
the securities listed on the exchange within ten days. The amendments 
also permit exchanges to file certain information regarding 
subsidiaries and affiliates every three years rather than annually. 
These amendments will conserve registered exchanges' staff time to 
comply with the rules.
2. Costs
    The amendments are intended to simplify the filing requirements and 
reduce the compliance burdens for national securities exchanges and 
will likely impose few additional costs on national securities 
exchanges. Initially, there may be some additional personnel costs 
required to review the proposed rules and revised Form 1, but the 
Commission believes that the simplified requirements will reduce 
overall compliance burdens and costs over time. Reducing the frequency 
of filings for some requirements may result in some information being 
less current. The Commission, however, believes that much of this type 
of information does not change frequently. Moreover, the option of 
posting such information on an Internet web site should encourage more 
frequent updating of current information. Compliance with Rules 6a-1, 
6a-2, and 6a-3 also include certain paperwork costs, which are 
discussed as ``burdens'' in the Paperwork Reduction Act section below.

C. Costs and Benefits of the Repeal of Rule 17a-23 and the Amendments 
to Rules 17a-3 and 17a-4

    The Commission identified several costs and benefits to investors 
and market participants in the Proposing Release with respect to Rules 
17a-23, 17a-3, and 17a-4. One commenter stated that the transfer of 
recordkeeping burdens would impose no additional burdens.\583\
---------------------------------------------------------------------------

    \583\ TBMA Letter at 25-26.
---------------------------------------------------------------------------

    Approximately forty-five of the broker-dealer trading systems 
currently filing reports under Rule 17a-23 will be alternative trading 
systems under the amendments and rules in this release. These trading 
systems will not fall within the definition of ``internal broker-dealer 
system,'' and will, therefore, not be required to maintain records 
under the new provisions of Rules 17a-3(a)(16) and 17a-4(b)(10). In its 
Paperwork Reduction Act analysis, the Commission notes that annual 
aggregate burdens for the recordkeeping obligations under Rule 17a-23 
will be eliminated. Although the reporting requirements under Rule 17a-
23 will be eliminated, alternative trading systems will be subject to 
similar recordkeeping requirements under Regulation ATS.\584\ These 
paperwork ``burdens'' are discussed below in the Paperwork Reduction 
Act section.
---------------------------------------------------------------------------

    \584\ The costs and benefits associated with these recordkeeping 
requirements are discussed in Section IX.A.2.a. supra.
---------------------------------------------------------------------------

D. SRO Pilot Trading System

    The Commission identified several costs and benefits to investors 
and market participants in the Proposing Release with respect to Rule 
19b-5. While the Commission solicited comment on the costs and benefits 
of Rule 19b-5, no comments were received specifically on that point. 
Several commenters did, however, address the Commission's proposal. One 
commenter agreed that Rule 19b-5 would reduce regulatory costs and 
encourage innovation, but believed that the rule's limitations should 
be reduced.\585\ Two other commenters expressed support for the goals 
of Rule 19b-5, but argued that burdens wouldn't be reduced as a 
practical matter due to the limitations of the rule.\586\ In response, 
the Commission notes that it has adopted the rule with some changes 
that should permit SROs more flexibility in taking advantage of the 
temporary exemption from rule filing requirements.
---------------------------------------------------------------------------

    \585\ CBOE Letter at 8-9.
    \586\ See CME Letter at 3-4; PCX Letter at 8.
---------------------------------------------------------------------------

    By permitting SROs to begin operating eligible pilot trading 
systems immediately and to continue operating for two years under a 
flexible regulatory scheme, the Commission believes that Rule 19b-5 
will benefit SROs and investors. Rule 19b-5 will enhance competition in 
the trading markets without imposing significant SRO compliance 
burdens.\587\ Rule 19b-5 will permit the timely implementation of pilot 
trading systems without the widespread dissemination of critical 
business information. Therefore, Rule 19b-5 will reduce SRO costs 
associated with the Commission approval process and improve the 
competitive balance between SROs and alternative trading

[[Page 70910]]

systems that are regulated as broker-dealers.\588\ Moreover, the 
Commission believes that Rule 19b-5 will foster innovation and create a 
streamlined procedure for SROs to operate pilot trading systems and 
will reduce filing costs for SROs pilot trading systems.
---------------------------------------------------------------------------

    \587\ The Commission estimates that the current preparation and 
filing of proposed rule changes pursuant to section 19(b)(2) of the 
Exchange Act to operate a pilot trading system constitute major 
market impact filings requiring approximately 100 hours and $10,000 
to $15,000 of SRO time and money, respectively, for each proposal. 
This does not include the cost to the SRO of any delay in obtaining 
Commission approval or in disclosing business information; nor does 
this include the benefit to an SRO of bringing its new pilot trading 
system to market in a shorter amount of time. The cost per hour and 
per filing is derived from information supplied by the SROs. For the 
purposes of our estimates, we have valued related overhead at 
thirty-five percent of the value of legal work. See GSA Guide to 
Estimating Reporting Costs (1973).
    \588\ The Commission estimates that under current procedures, a 
rule filing for a new pilot trading system takes 90 days, on 
average, from the date of the original submission to be approved. In 
contrast, the expedited treatment of SRO rule changes for pilot 
trading systems in this release permits SROs to operate a pilot 
trading system twenty days after submitting an initial operation 
report on Form PILOT, so long as such system complies with Rule 19b-
5 under the Exchange Act.
---------------------------------------------------------------------------

    The costs of complying with Rule 19b-5 includes certain paperwork, 
filing, and recordkeeping requirements that are discussed below in the 
Paperwork Reduction Act section.

X. Effects on Competition, Efficiency and Capital Formation

    Section 23(a)(2)\589\ of the Act requires that the Commission, when 
promulgating rules under the Exchange Act, to consider the impact any 
rule would have on competition and to not adopt any rule that would 
impose a burden on competition that is not necessary or appropriate in 
the public interest. In the Proposing Release, the Commission solicited 
comment on the effects on competition, efficiency and capital formation 
of the rules and amendments. Specifically, the Commission requested 
commenters to address how the proposed rules and amendments would 
affect competition between and among alternative trading systems, 
broker-dealers, exchanges, investors, and other market participants. 
The Commission received no comments specifically regarding these 
issues.
---------------------------------------------------------------------------

    \589\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    The Commission has considered the rules and rule amendment in light 
of the standards cited in section 23(a)(2) of the Act and believes they 
would not likely impose any significant burden on competition not 
necessary or appropriate in furtherance of the Exchange Act. As 
discussed above in the Cost-Benefit Section, the Commission recognizes 
that some alternative trading systems and their institutional users 
will be affected competitively by the rules adopted today. Nonetheless, 
the Commission believes that the rules and amendments will encourage 
innovation, accommodate the growing role of technology in the 
securities markets, improve transparency for market participants and 
ensure the stability of trading systems with a significant role in the 
markets, thereby furthering the development of a national market system 
in accordance with the goals under section 11A of the Exchange Act. In 
particular, as discussed above in the Cost-Benefit Section, the 
Commission believes that the rules and amendments will significantly 
reduce spreads, thereby benefiting all investors.
    In adopting these rules and amendments, the Commission has 
considered whether the action will protect investors, and promote 
efficiency, competition, and capital formation.\590\ The Commission 
believes that the rules and amendments will allow the Commission to 
better oversee the activities of alternative trading systems and 
integrate alternative trading systems into the national market system. 
The rules and amendments will also better accommodate automated and 
for-profit exchanges and permit SROs to operate pilot trading systems 
temporarily without Commission approval. These steps will help to 
protect investors by preventing discriminatory denials or limitations 
of access, preventing systems related failures, and permitting access 
to best-priced orders. In addition, alternative trading systems should 
continue to compete based on innovation, price, and service rather than 
access to ``hidden markets.''
---------------------------------------------------------------------------

    \590\ 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

    Rules 3a1-1, 3b-16, and Regulation ATS adopted today are intended 
to provide a choice between registering as a broker-dealer and 
registering as an exchange for markets operated as alternative trading 
systems.\591\ In addition, the amendments to Rules 6a-1, 6a-2, and 6a-3 
adopted today are intended to update the requirements for registered or 
exempt exchanges in order to accommodate different forms of 
organization and methods of operation. The Commission believes that 
these changes will create a more efficient market, encourage 
competition among alternative trading systems, and stimulate capital 
formation by making the regulatory framework sufficiently flexible to 
accommodate new or different approaches to exchange formation and 
operation, including automated and for-profit exchanges. The Commission 
further believes that the costs identified in the above analysis are 
not substantial enough to deter any market participants from attempting 
to become an alternative trading system.\592\
---------------------------------------------------------------------------

    \591\ The Commission further believes that repealing Rule 17a-23 
and amending Rules 17a-3 and 17a-4 under the Act will help to create 
a more efficient market, encourage competition, and stimulate 
capital formation innovation.
    \592\ As previously stated, alternative trading systems are able 
to attract subscribers because prices in their systems are often 
better than the prices available in the public markets. Because 
alternative trading systems are now required to publicly display 
their best priced orders for securities in which they represent more 
than 5 percent of the trading volume, the best priced orders for 
certain securities will also be available through the public 
markets. Consequently, some subscribers could leave an alternative 
trading system if they think there are fewer advantages than before 
in having direct access to the alternative trading system. However, 
the growth of ECNs since the Order Handling Rules were implemented 
indicates that alternative trading systems can, and are, attracting 
subscribers. As mentioned above, there are still significant 
benefits to being a subscriber to an alternative trading system, 
including, but not limited to: the ability to enter orders and the 
use of such features as a negotiation feature or a ``reserve size'' 
feature; the ability to access the best priced orders for securities 
in which an alternative trading system represents less than 5 
percent of the trading volume and therefore is not subject to the 
transparency requirements; and access to the entire ``book,'' not 
merely the ``top of the book,'' that contains important real-time 
market information regarding depth of trading interest.
---------------------------------------------------------------------------

    In addition, Rule 19b-5 and Form Pilot are intended to provide SROs 
the opportunity to develop and operate pilot trading systems with less 
cost and time delay. As previously stated, currently, SROs are required 
to submit a rule filing to the Commission and undergo a public notice, 
comment, and approval process, before they operate a new pilot trading 
system. Rule 19b-5 would permit SROs that develop pilot trading systems 
to begin operation shortly after submitting Form PILOT to the 
Commission. One of the consequences of SROs filing rule changes before 
implementation is that the rule filing process informs SROs' 
competitors about the proposed pilot trading system and provides an 
avenue for those competitors to copy, delay, or obstruct implementation 
of a pilot trading system before it can be tested in the marketplace. 
As a result, the Commission believes that proposed Rule 19b-5 and Form 
Pilot should help create a more efficient market, encourage competition 
between SROs and alternative trading systems, and stimulate capital 
formation by creating a streamlined procedure for SROs to operate pilot 
trading systems and reducing filing costs for SROs generally.

XI. Summary of Final Regulatory Flexibility Analysis

    A Final Regulatory Flexibility Analysis (``FRFA'') has been 
prepared in accordance with section 4 of the Regulatory Flexibility Act 
(``RFA'').\593\ The FRFA relates to the adoption of new rules 3a1-
1,\594\ 3b-16,\595\ 19b-5,\596\ Regulation ATS,\597\ new Forms 
ATS,\598\

[[Page 70911]]

ATS-R,\599\ PILOT,\600\ amendments to rules 6a-1,\601\ 6a-2,\602\ 6a-
3,\603\ 11Ac1-1,\604\ 17a-3,\605\ 17a-4,\606\ the Commission's rules of 
practice,\607\ to Form 1, and the repeal of Rule 17a-23\608\ under the 
Exchange Act.\609\ The FRFA notes the potential costs of operation and 
procedural changes that may be necessary to comply with the new rules 
and rule amendments (``new regulatory framework''). A summary of the 
Initial Regulatory Flexibility Analysis (``IRFA'') appeared in the 
Proposing Release.\610\
---------------------------------------------------------------------------

    \593\ 5 U.S.C. 604.
    \594\ 17 CFR 240.3a1-1.
    \595\ 17 CFR 240.3b-16.
    \596\ 17 CFR 240.19b-5.
    \597\ 17 CFR 242.300 et seq.
    \598\ 17 CFR 242.637.
    \599\ 17 CFR 242.638.
    \600\ 17 CFR 249.821.
    \601\ 17 CFR 240.6a-1.
    \602\ 17 CFR 240.6a-2.
    \603\ 17 CFR 240.6a-3.
    \604\ 17 CFR 240.11Ac1-1.
    \605\ 17 CFR 240.17a-3.
    \606\ 17 CFR 240.17a-4.
    \607\ 17 CFR 202.3.
    \608\ 17 CFR 240.17a-23.
    \609\ 15 U.S.C. 78a et seq.
    \610\ See supra note .
---------------------------------------------------------------------------

    As more fully discussed in the FRFA, market participants have 
developed a variety of alternative trading systems that furnish 
services traditionally provided solely by registered exchanges. Our 
current regulatory framework, designed more than six decades ago, 
however, did not foresee many of these trading and business functions. 
Alternative trading systems now handle twenty percent or more of the 
orders in securities listed on Nasdaq, and almost four percent of 
orders in listed securities. Even though these systems provide services 
that are similar to those provided by the registered exchanges and 
Nasdaq, the current regulatory framework largely ignores the market 
functions of alternative trading systems. This creates disparities that 
affect investor protection, market intermediaries, and other markets. 
For example, activity on alternative trading systems is not fully 
disclosed to, or accessible by, public investors and may not be 
adequately surveilled for market manipulation and fraud. Moreover, 
these trading systems have no obligation to provide investors a fair 
opportunity to participate in their systems or to treat their 
participants fairly. In addition, they do not have an obligation to 
ensure that their capacity is sufficient to handle trading demand. 
Because of the increasingly important role of alternative trading 
systems, these differences call into question not only the fairness of 
current regulatory requirements, but also the efficacy of the existing 
national market system structure.
    As described in the FRFA, under the new regulatory framework, the 
Commission will offer trading systems a choice between broker-dealer 
regulation and exchange regulation. Specifically, the Commission 
proposed to allow alternative trading systems to choose whether to 
register as national securities exchanges, or to register as broker-
dealers and comply with additional requirements under proposed 
Regulation ATS depending on their activities and trading volume. In 
conjunction with this proposal, the Commission proposed to repeal Rule 
17a-23, which currently requires alternative trading systems--as well 
as broker-dealer trading systems that are not alternative trading 
systems--to maintain certain records and file reports with the 
Commission. The Commission also proposed amendments to Form 1, which 
securities markets file to register as national securities exchanges, 
and related rules. Finally, to enable registered exchanges and national 
securities associations to better compete in the fast changing 
marketplace, the Commission proposed to temporarily exempt certain 
pilot trading systems operated by such exchanges and associations from 
the rule filing requirements of the Exchange Act.
    In the Proposing Release, the Commission solicited public comment 
on the proposed new rules and rule amendments which were designed to 
resolve many of the concerns raised by alternative trading systems. As 
discussed in the FRFA, commenters generally supported the Commission's 
proposals and welcomed the regulatory flexibility these proposals 
offered. While no public comments were received in response to the 
IRFA, several of the comments were related to the IRFA. Several 
commenters encouraged the Commission to accept electronic filings as a 
means of reducing the burden on market participants. The Commission is, 
in fact, working toward the goal of accepting filings in electronic 
form. One commenter suggested that the Commission impose only minimal 
regulatory requirements, if any, on alternative trading systems that 
trade only minimal volume in order to avoid erecting significant 
barriers to entry and innovation. The Commission believes that the 
requirements of Regulation ATS are minimal for new alternative trading 
systems, especially as compared to the current no-action letter 
process. Regulation ATS sets forth concrete requirements for a system 
to operate, imposes only notice filings, and reserves more burdensome 
requirements for high volume systems. Another commenter stated that the 
reporting requirements under proposed Regulation ATS are similar to 
current Rule 17a-23 and, thus, are not inappropriately burdensome. The 
Commission agrees and notes that most current potential respondents 
under Regulation ATS already have experience with the requirements and 
burdens associated with Rule 17a-23, so Regulation ATS will not impose 
significant new burdens on currently operating alternative trading 
systems.
    The Commission is adopting new Regulation ATS substantially in the 
form it was proposed.
    The FRFA addresses how the proposal would affect broker-dealers 
that operate alternative trading systems and internal broker-dealer 
trading systems that are small entities. As more fully explained in the 
FRFA, the Commission believes that the improved regulatory framework 
provided by Regulation ATS justifies the costs incurred by industry 
participants to comply with Regulation ATS. The FRFA also describes the 
Commission's consideration of significant alternatives to Regulation 
ATS. The FRFA concludes that the alternatives, in the context of a new 
regulatory framework, would not accomplish the stated objectives of 
Regulation ATS. A copy of the FRFA may be obtained by contacting Denise 
Landers, Attorney, Division of Market Regulation, Securities and 
Exchange Commission, 450 Fifth Street, NW., Mail Stop 10-1, Washington 
D.C. 20549.

XII. Paperwork Reduction Act

    As explained in the Proposing Release, certain provisions of the 
rules and rule amendments contain ``collection of information'' 
requirements within the meaning of the Paperwork Reduction Act of 1995 
(44 U.S.C. 3501 et seq.) (``PRA''). Accordingly, the Commission 
submitted the collection of information requirements contained in the 
rules and rule amendments to the Office of Management and Budget 
(``OMB'') for review and were approved by OMB which assigned the 
following control numbers: Form 1, Rules 6a-1 and 6a-2, control number 
3235-0017; Rule 6a-3, control number 3235-0021; Rule 17a-3(a)(16), 
control number 3235-0508; Rule 17a-4(b)(10), control number 3235-0506; 
Rule 19b-5 and Form PILOT, control number 3235-0507; Rule 301, Form ATS 
and Form ATS-R, control number 3235-0509; Rule 302, control number 
3235-0510; and Rule 303, control number 3235-0505. The collections of 
information are in accordance with Section 3507 of the

[[Page 70912]]

PRA.\611\ With regard to Rule 301, Form ATS, and Form ATS-R, Rule 302, 
and Rule 303, the Commission staff has changed its estimate of the 
paperwork burdens slightly due to an increase in the estimated number 
of respondents that will be affected and a change to the fair access 
rules. Accordingly, the Commission has submitted a PRA change worksheet 
to OMB.\612\
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    \611\ 44 U.S.C. 3507.
    \612\ For a further discussion of the changes, see the 
discussions of Rule 301, Form ATS, Form ATS-R, Rule 302, and Rule 
303, infra.
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    The collection of information obligations imposed by the rules and 
rule amendments are mandatory. However, it is important to note that an 
alternative trading system operating as a broker-dealer is optional, 
operation of a national securities exchange is optional, and operating 
a pilot trading system is optional. The information collected, 
retained, and/or filed pursuant to the rules and rule amendments under 
Regulation ATS will be kept confidential to the extent permitted by the 
Freedom of Information Act (5 U.S.C. Sec. 552 et seq.). The information 
collected, retained, and/or filed pursuant to the rules for 
registration as a national securities exchange will not be confidential 
and will be available to the public. The information collected, 
retained, and/or filed pursuant to the rules for operation of pilot 
trading systems will not be confidential and will be made available to 
the public when the pilot trading system starts to operate. An agency 
may not conduct or sponsor, and a person is not required to comply 
with, a collection of information unless it displays a currently valid 
OMB control number.
    The collections of information are necessary for persons to obtain 
certain benefits or to comply with certain requirements. As described 
in the Proposing Release, the rules and rule amendments to which the 
collections of information are related allow the Commission to respond 
to the impact of technological developments in the securities markets 
and permit the Commission to more effectively oversee the growing 
number of alternative trading systems. The collections of information 
are also necessary to permit the Commission to effectively oversee SRO 
pilot trading systems. With the exception of two changes to the final 
rules, there are no material changes to the rules and amendments as 
adopted that affect the burden estimates in the Proposing Release. The 
Commission is adopting different fair access requirements from those it 
published in the Proposing Release. The Commission has determined to 
not adopt the fair access requirements that would have required 
investors denied or limited access to have a right to appeal to the 
Commission and alternative trading systems making access denial or 
limitation decisions to notify such investors of the decision and their 
right of appeal to the Commission. Instead, the Commission has decided 
to adopt rules that require alternative trading systems to report 
quarterly to the Commission a record of all grants, denials, and 
limitations of access as well as other descriptive information 
surrounding the decision. These changes eliminate the proposed 
paperwork burden of providing notice to investors and adds a compliance 
burden on Form ATS-R to report such information to the Commission. 
Aggregate paperwork burdens have also been revised to reflect updated 
information regarding the estimated number of alternative trading 
systems that will be subject to the rules. In the Proposing Release, 
the Commission staff estimated that there were approximately forty-
three alternative trading systems operating. The Commission staff now 
estimates that there are forty-five alternative trading systems 
operating, so the aggregate paperwork burdens have been revised to 
reflect this change.
    The Commission solicited public comment on the collection of 
information requirements contained in the Proposing Release. While the 
Commission received no comments that specifically addressed the PRA 
portion of the release, it did receive several comments that touched on 
PRA related issues.
    Several commenters encouraged the Commission to accept electronic 
filings as a means of reducing the burden on market participants. The 
Commission is, in fact, working toward the goal of accepting filings in 
electronic form. The Commission anticipates that the option of 
electronic filing will be made available to respondents at some point 
in the relatively near future. Several commenters also suggested that 
the Commission reduce the burden on national securities exchanges by 
relieving them of the obligation to file annual amendments to Form 1 
due to the same information being submitted to the Commission in other 
forms periodically throughout the year. The Commission believes that it 
is important to have one complete annual filing that compiles all the 
changes to the information contained on Form 1 throughout the year and 
all other required SRO information. Additionally, the Commission 
believes that such a filing represents only a compilation of existing 
information, so the additional burden of requiring an annual filing is 
largely clerical and generally minimal.
    One commenter suggested that the Commission impose only minimal 
regulatory requirements, if any, on alternative trading systems that 
trade only minimal volume in order to avoid erecting significant 
barriers to entry and innovation. The Commission believes that the 
requirements of Regulation ATS are minimal for new alternative trading 
systems, especially as compared to the current no-action letter 
process. Regulation ATS sets forth concrete requirements for a system 
to operate, imposes only notice filings, and reserves more burdensome 
requirements for high volume systems. Another commenter stated that the 
reporting requirements under proposed Regulation ATS are similar to 
current Rule 17a-23 and, thus, are not inappropriately burdensome. The 
Commission agrees and notes that most current potential respondents 
under Regulation ATS already have experience with the requirements and 
burdens associated with Rule 17a-23, so Regulation ATS will not impose 
significant new burdens on currently operating alternative trading 
systems.
    As noted above in the Cost-Benefit section, below is a summary of 
the paperwork burdens that were identified in the Proposing Release. 
Although not mandated by the PRA, to give regulated entities and others 
an understanding of the paperwork costs, the discussion below provides 
dollar estimates assuming certain labor costs.

A. Form 1, Rules 6a-1 and 6a-2

    These amendments are intended to simplify the filing requirements 
and reduce the compliance burdens for national securities exchanges and 
will likely impose few additional costs on national securities 
exchanges. Initially, there may be some additional personnel costs 
required to review the proposed rules and revised Form 1, but the 
Commission believes that the simplified requirements will reduce 
overall compliance burdens and costs over time. Reducing the frequency 
of filings for some requirements may result in some information being 
less current. The Commission, however, believes that much of this type 
of information does not change frequently. Moreover, the option of 
posting such information on an Internet web site should encourage more 
frequent updating of current information.
    The Commission staff has estimated that each respondent will incur 
an average burden of forty-seven hours to comply with Rule 6a-1 and 
file an

[[Page 70913]]

initial application for registration on Form 1. This represents a two 
hour increase from the current average burden due to the estimated 
additional burden of the added exhibits. The Commission staff has 
estimated that the average additional cost per response will be 
approximately $30.\613\ Because the Commission receives applications 
for registration as an exchange on Form 1 from time to time, and not on 
a predictable basis, it cannot estimate the annual aggregate costs and 
burden hours associated with such filings.\614\
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    \613\ The estimated average additional cost per response of $30 
is derived from two additional hours of clerical work at $15 per 
hour.
    \614\ Since 1991, the Commission has received three total 
applications for registration as a national securities exchange.
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    The Commission notes that it is making no material changes to Rule 
6a-1, Rule 6a-2, or Form 1 from the Proposing Release. Thus, the 
collection of information burdens are not changing from those proposed.

B. Rule 6a-3

    The Commission anticipates that the amendments will not change the 
paperwork burden associated with complying with Rule 6a-3. The 
Commission staff has estimated that the average burden for each 
respondent to comply with Rule 6a-3 is one-half hour per response 
because compliance only requires photocopying existing documents. The 
Commission also estimates that each respondent will file supplemental 
information under Rule 6a-3 approximately twenty-five times per year. 
The estimated average cost per response for each individual respondent 
is $9.50, resulting in an estimated annual average cost burden for each 
respondent of $237.50.\615\
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    \615\ The estimated average cost per response of $9.50 is 
composed of $7.50 for clerical work (0.5 hours at $15 per hour) and 
$2 for printing, supplies, copying, and postage (approximately 
thirty-five percent of the total labor costs). The Commission staff 
has estimated overhead for this collection of information burden, 
and all other collection of information burdens discussed below, 
based on thirty-five percent of total labor costs based on the GSA 
Guide to Estimating Reporting Costs (1973). The estimated average 
annual cost of $237.50 is derived from twenty-five annual filings at 
a cost of $9.50 per filing.
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C. Rule 17a-3(a)(16)

    No additional recordkeeping burdens will be imposed on internal 
broker-dealer systems under the amendments to Rule 17a-3. The 
amendments apply only to systems that are presently subject to the 
recordkeeping requirements of Rule 17a-23. Because the Commission is 
repealing Rule 17a-23 and amending Rules 17a-3 and 17a-4 by 
transferring the recordkeeping requirements from Rule 17a-23, the 
Commission does not anticipate any new recordkeeping costs or burdens 
for respondents.
    Based on Commission experience with the burdens associated with 
Rule 17a-23, the Commission has estimated the burdens that will be 
associated with Rule 17a-3(a)(16). The Commission staff has estimated 
that there will be approximately ninety-four broker-dealers operating 
one hundred twenty-three internal broker-dealer systems that will have 
to make the records described in Rule 17a-3(a)(16). The Commission 
staff has estimated that each respondent will spend approximately 
twenty-seven hours per year keeping the required records under Rule 
17a-3(a)(16) at an annual cost of $1,298.16.\616\ The aggregate burden 
for approximately ninety-four broker-dealers operating internal broker-
dealer trading systems is estimated to be 2,619 hours for a total 
average cost of $122,027.04.\617\
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    \616\ The Commission staff has estimated that an employee of a 
broker-dealer charged to ensure compliance with Commission 
regulations receives annual compensation of $100,000. This 
compensation is the equivalent of $48.08 per hour ($100,000 divided 
by 2,080 payroll hours per year). The estimated annual cost of 
$1,298.16 is derived from twenty-seven burden hours per respondent 
at $48.08 per hour.
    \617\ The estimated aggregate burden of 2,619 hours is derived 
from ninety-four broker-dealer respondents incurring an average 
burden of twenty-seven hours each. The estimated aggregate cost of 
$122,027.04 is derived from ninety-four broker-dealer respondents 
incurring an average burden of $1,298.16 each.
---------------------------------------------------------------------------

D. Rule 17a-4(b)(10)

    No additional recordkeeping burdens will be imposed on internal 
broker-dealer systems under the amendments to Rule 17a-4. The 
amendments apply only to systems that are presently subject to the 
recordkeeping requirements of Rule 17a-23. Because the Commission is 
repealing Rule 17a-23 and amending Rules 17a-3 and 17a-4 by 
transferring the recordkeeping requirements from Rule 17a-23, the 
Commission does not anticipate any new recordkeeping costs or burdens 
for respondents.
    Based on Commission experience with the burdens associated with 
Rule 17a-23, the Commission has estimated the burdens that will be 
associated with Rule 17a-4(b)(10). The Commission staff has estimated 
that there will be approximately ninety-four broker-dealers operating 
one hundred twenty-three internal broker-dealer systems that will have 
to keep the records described in Rule 17a-4(b)(10). The Commission 
staff has estimated that each respondent will spend approximately three 
hours to preserve the required records under Rule 17a-4(b)(10) at an 
annual cost of $144.24.\618\ The aggregate burden for approximately 
ninety-four broker-dealers operating internal broker-dealer trading 
systems is estimated to be two hundred eighty two hours for a total 
average cost of $13,558.56.\619\
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    \618\ The Commission staff has estimated that an employee of a 
broker-dealer charged to ensure compliance with Commission 
regulations receives annual compensation of $100,000. This 
compensation is the equivalent of $48.08 per hour ($100,000 divided 
by 2,080 payroll hours per year). The estimated annual cost of 
$144.24 is derived from three burden hours per respondent at $48.08 
per hour.
    \619\ The estimated aggregate burden of two hundred eighty-two 
hours is derived from ninety-four broker-dealer respondents 
incurring an average burden of three hours each. The estimated 
aggregate cost of $13,558.56 is derived from ninety-four broker-
dealer respondents incurring an average burden of $144.24 each.
---------------------------------------------------------------------------

E. Rule 19b-5 and Form PILOT

    For SROs that choose to operate pilot trading systems and avail 
themselves of the provisions of Rule 19b-5, compliance with Rule 19b-5 
and the filings required on Form PILOT are mandatory. Initial filings 
on Form PILOT are confidential until the pilot system is operational 
and subsequent filings are not confidential. Thus, after a pilot 
trading system starts to operate, all filings on Form PILOT are 
available to the public. Rule 19b-5 reiterates SROs' existing 
recordkeeping obligations under Rule 17a-1, which requires that such 
records be kept for not less than five years, the first two years in an 
easily accessible place.
    The Commission anticipates receiving approximately 6 notices per 
year regarding pilot trading systems on Form PILOT.\620\ An SRO will be 
required to submit a Form PILOT providing detailed operational data and 
update this information quarterly. The Commission staff has estimated 
that an SRO will expend twenty-four hours to file an initial operation 
report and three hours to file a quarterly report and a systems change 
notice.\621\ The Commission also estimates that an SRO will file two 
amendments per year to report changes to the system.\622\ The 
Commission staff has estimated that an SRO will expend $1,242 per 
initial Form PILOT filing and $155 for each quarterly Form PILOT and 
system

[[Page 70914]]

change notice filed.\623\ Thus, the total estimated annual burden for 
SROs to comply with Rule 19b-5 by filing an initial notice on Form 
PILOT is estimated to be one hundred forty-four hours for a total 
average cost of $7,452.\624\ The total estimated annual burden for SROs 
to file systems change notices and quarterly reports on Form PILOT is 
estimated to be one hundred eight hours for a total average cost of 
$5,580.\625\
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    \620\ This estimate is based on a review of past SRO filings 
under section 19(b) of the Exchange Act. The Commission staff has 
estimated that approximately 6 rule filings per year in the past 
could have been filed under Rule 19b-5.
    \621\ The estimates for burden hours involved with filing Form 
PILOT are based on the Commission's experience with similar 
reporting requirements under Rule 17a-23.
    \622\ This estimate is based on the Commission's experience with 
collection of similar information under Rule 17a-23.
    \623\ The estimated average cost of $1,242 to file an initial 
Form PILOT is composed of $800 for in-house professional work 
(sixteen hours at $50 per hour), $120 for clerical work (eight hours 
at $15 per hour) and $322 for printing, supplies, copying, and 
postage (approximately thirty-five percent of the total labor 
costs).
    The total estimated average cost of $155 to file quarterly 
reports and system change notices on Form PILOT is composed of $100 
for in-house professional work (two hours at $50 per hour), $15 for 
clerical work (one hour at $15 per hour) and $40 for printing, 
supplies, copying and postage (approximately thirty-five percent of 
the total labor costs).
    \624\ The estimated average burden of one hundred forty-four 
hours is derived from six SRO respondents incurring an average 
burden of twenty-four hours per filing. The estimated average cost 
of $7,452 is derived from six SRO respondents making six initial 
Form PILOT filings at $1,242 per filing.
    \625\ The estimated average burden of one hundred eight hours is 
derived from six SRO respondents filing four quarterly reports and 
two systems change notices at three burden hours per filing. The 
estimated average cost of $5,580 is derived from six SRO respondents 
filing four quarterly reports and two systems change notices at $155 
per filing.
---------------------------------------------------------------------------

F. Rule 301, Form ATS and Form   ATS-R

    For alternative trading systems that choose to register as a 
broker-dealer, the requirements of Rule 301, Form ATS and Form ATS-R 
are mandatory. All filings required under Rule 301, Form ATS and Form 
ATS-R are considered confidential and are not available to the public. 
All records required to be made under the Rule are required to be 
preserved for three years, the first two years in an easily accessible 
place.
    The alternative trading system amendments and rules have been 
tailored to minimize their burden on alternative trading systems and 
especially small systems. Many of the provisions in the proposed rules 
are triggered by a volume threshold. The Commission expects that small 
alternative trading systems will not have sufficient volume to trigger 
those thresholds and will therefore not have to comply with those 
provisions. The recordkeeping and reporting requirements with which 
smaller, lower volume alternative trading systems have to comply under 
proposed Regulation ATS are substantially similar to those with which 
alternative trading systems currently comply. Consequently the costs 
for smaller alternative trading systems should remain unchanged.
1. Notice, Reporting, and Recordkeeping
    All alternative trading systems that will be subject to notice, 
reporting, and recordkeeping requirements under the Commission's rules 
as adopted today are currently subject to similar requirements under 
Rule 17a-23. The requirements under Regulation ATS, however, require 
some additional information that is not currently required under Rule 
17a-23.
    Under Regulation ATS, alternative trading systems file an initial 
operation report, notices of material systems changes, and quarterly 
reports. The rules also include new Forms ATS and ATS-R to standardize 
reporting of such information and make it more useful for the 
Commission. The rules require information that is not currently 
required under Rule 17a-23, such as greater detail about the system 
operations, the volume and types of securities traded, criteria for 
granting access to subscribers, procedures governing order execution, 
reporting, clearance and settlement, procedures for reviewing systems 
capacity and contingency procedures, and the identity of any other 
entities involved in operating the system.
    Regulation ATS requires staff time to comply with the initial 
notice and amendment requirements. While the Commission has designed 
the requirements in an effort to balance the costs of filing with the 
benefits to be gained from the information, some effort will be 
necessary to gather and file this information. Most of the information, 
however, already exists. Alternative trading systems will only be 
required to gather this information and supply it in the required 
format to the Commission. The periodic updating requirements will also 
require staff time over the life of the alternative trading system to 
comply with the rules.
    The Commission staff has estimated that there are currently about 
forty-five alternative trading systems that will be required to 
register as exchanges or register as broker-dealers and comply with 
Regulation ATS.\626\ The Commission also estimates that, over time, 
there will be approximately three new alternative trading systems each 
year that choose to register as broker-dealers and comply with 
Regulation ATS.\627\
---------------------------------------------------------------------------

    \626\ This estimate is based on filings made with the Commission 
under Rule 17a-23. At the time of the Proposing Release, the 
Commission estimated that forty-three alternative trading systems 
would be required to register as exchanges or broker-dealers and 
comply with Regulation ATS. Since that time, two such alternative 
trading systems have started to operate.
    \627\ Based on the Commission's experience over the last three 
years with Rule 17a-23, it appears that there are more than three 
new alternative trading systems per year. However, we expect that in 
the steady state over time, there will be approximately three new 
alternative trading systems per year. The rapid growth experienced 
over the last several years is unlikely to continue at such a high 
rate in perpetuity.
---------------------------------------------------------------------------

    The Commission also estimates that, over time, there will be 
approximately three alternative trading systems that file cessation of 
operations reports each year. Thus, the Commission anticipates that, 
over time, if all forty-five current alternative trading systems choose 
to register as broker-dealers and comply with Regulation ATS, there 
will be approximately forty-five alternative trading systems operating 
each year.
    The Commission staff has estimated that the average burden per 
respondent to file the initial operations report on Form ATS will be 
twenty hours. This burden is computed by estimating that completing the 
report will require an average of thirteen hours of professional work 
and seven hours of clerical work.\628\ The Commission staff has 
estimated that the average cost per response will be $1,019 
representing the twenty hours and cost of supplies.\629\ If all forty-
five alternative trading systems opt to register as broker-dealers and 
comply with Regulation ATS, the total, one time cost to comply with the 
proposed requirements to file initial operation reports is estimated to 
be $45,855.\630\ The Commission also estimates that, over time, 
approximately three new alternative trading systems will register as 
broker-dealers per year, incurring an annual aggregate burden of sixty 
hours for an average total cost of $3,057 after the first year 
following adoption of Regulation ATS.\631\
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    \628\ This estimate for burden hours of filing Form ATS is based 
on the burdens associated with filing Form 1, adjusted for 
differences between Form 1 and Form ATS. The division between 
professional and clerical time is based on estimates of the 
proportions used in the estimates of burdens for filing Form 1.
    \629\ The estimated average cost per response of $1,019 is 
composed of $650 for in-house professional work (thirteen hours at 
$50 per hour), $105 for clerical work (seven hours at $15 per hour) 
and $264 for printing, supplies, copying, and postage (approximately 
thirty-five percent of the total labor costs).
    \630\ This estimated cost of $45,855 is derived from forty-five 
alternative trading systems filing at an average cost of $1,019 
each.
    \631\ This estimated cost of $3,057 is derived from three new 
alternative trading systems filing at an average cost of $1,019 
each.
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    In addition, the rules require alternative trading systems to amend 
their initial operations report to notify the Commission of material 
systems changes and other changes to the

[[Page 70915]]

information contained in the initial operations report. The Commission 
staff has estimated that each respondent will file six such amendments 
per year.\632\ The Commission staff has estimated that each respondent 
will incur an average burden of two hours per response and incur an 
average cost of $111.50 for each amendment to the initial operation 
report that it submits.\633\ If all forty-five alternative trading 
systems opt to comply with Regulation ATS rather than to register as 
exchanges, the total aggregate cost per year to comply with the 
proposed requirement to file amendments to the initial operation 
reports is estimated to be $30,105.\634\
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    \632\ This estimate is based on the Commission's experience with 
collection of similar information under Rule 17a-23.
    \633\ The estimated average cost per response of $111.50 is 
composed of $75 for in-house professional work (1.5 hours at $50 per 
hour), $7.50 for clerical work (0.5 hours at $15 per hour), and $29 
for printing, supplies, copying, and postage (approximately thirty-
five percent of the total labor costs).
    \634\ This estimated cost of $30,105 is composed of $111.50 cost 
per amendment for forty-five alternative trading systems filing six 
times per year.
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    Alternative trading systems registering as broker-dealers will also 
be required to file quarterly reports on Form ATS-R, reporting 
participating system subscribers, the securities traded on the system, 
and aggregate volume information. The Commission staff has estimated 
that the quarterly reports will cause each respondent to incur an 
average burden of 4 hours per response and incur an average cost of 
$223 for each Form ATS-R that it submits.\635\ The annual burden per 
respondent is estimated to be $892.\636\ If all forty-five alternative 
trading systems opt to register as broker-dealers and comply with 
Regulation ATS, the total cost per year to comply with the requirement 
to file quarterly reports is estimated to be $40,140.\637\
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    \635\ The estimated cost of $223 per response is composed of 
$150 for in-house professional work (three hours at $50 per hour), 
$15 for clerical work (one hour at $15 per hour) and $58 for 
printing, supplies, copying, and postage (approximately thirty-five 
percent of the total labor costs).
    \636\ The estimated annual cost of $892 to file Form ATS-R is 
derived from four quarterly reports at an estimated annual cost of 
$223 per filing.
    \637\ This estimated cost of $40,140 is derived from forty-five 
alternative trading systems with an estimated annual filing cost for 
each of $892.
---------------------------------------------------------------------------

    Finally, alternative trading systems registered as broker-dealers 
will be required to submit a notice and a report on Form ATS when they 
cease operations. The Commission anticipates a total of three such 
filings per year. The Commission staff has estimated that individual 
respondents will incur a burden of two hours to file the cessation 
notice. The Commission staff has estimated that individual respondents 
will incur a cost of $111.50 to file the cessation of operations report 
on Form ATS.\638\ The annual aggregate burden for three alternative 
trading systems to file cessation of operations reports is estimated to 
be $334.50.\639\
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    \638\ The estimated cost of $111.50 per response is composed of 
$75 for in-house professional work (1.5 hours at $50 per hour), 
$7.50 for clerical work (0.5 hours at $15 per hour), and $29 for 
printing, supplies, copying and postage (approximately thirty-five 
percent of the total labor costs).
    \639\ The estimated cost of $334.50 is derived from an average 
of three alternative trading systems filing one cessation of 
operations report per year on Form ATS at an estimated cost of 
$111.50 each.
---------------------------------------------------------------------------

2. Fair Access
    Under Regulation ATS, alternative trading systems with significant 
volume are required to establish and maintain standards for granting 
access to their system and keep records of such standards. In addition, 
alternative trading systems with significant volume are required to 
submit certain information regarding grants, denials, and limitations 
of access with their quarterly reports on Form ATS-R. The Commission 
staff has estimated that each respondent obligated to establish and 
maintain such records will incur a burden of seventeen hours per year 
to make and keep standards for granting access for a total estimated 
cost of $958.50.\640\
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    \640\ The estimated burden of seventeen hours is derived from 
five hours for establishing and maintaining standards for fair 
access and twelve hours to report fair access information on Form 
ATS-R on a quarterly basis (four responses at three hours per 
response). The estimated cost of $958.50 is derived from $650 for 
professional work (thirteen hours at $50 per hour), $60 for clerical 
work (four hours at $15 per hour), and $248.50 for printing, 
supplies, copying, and postage (approximately thirty-five percent of 
the total labor costs). The Commission staff has estimated overhead 
based on thirty-five percent of total labor costs based on the GSA 
Guide to Estimating Reporting Costs (1973). The estimated burden of 
thirteen hours of professional work is derived from five hours for 
establishing and maintaining standards for fair access and eight 
hours (two hours for four quarterly reports on Form ATS-R) to 
compile and report fair access information. The estimated burden of 
four hours of clerical work is derived from one hour per quarter to 
compile and send information on Form ATS-R.
---------------------------------------------------------------------------

    Although these estimates reflect a program change from the 
Proposing Release, the total burdens on respondents are decreasing 
slightly as a result of the program changes. The Commission is 
eliminating the proposal to require alternative trading systems that 
deny investors access to the system to provide them with notice of the 
denial and their right of appeal to the Commission. Under the rules as 
adopted, there is no right of appeal to the Commission. In the 
Proposing Release, the Commission estimated that the burden to comply 
with the notice requirement would be approximately twenty-seven hours 
per year for each respondent. Under the rules as adopted, such 
alternative trading systems are required to submit fair access 
information on Form ATS-R on a quarterly basis. The burden for this 
requirement is only twelve hours per year for each respondent. Thus, 
the changes from the Proposing Release are anticipated to reduce the 
burden on each respondent by approximately fifteen hours per year. The 
Commission staff has estimated that only two respondents will be 
affected by this program change, resulting in an aggregate reduction of 
thirty burden hours for all respondents. This reduction, however, is 
offset by an increase in the estimated number of respondents. 
Specifically, the aggregate paperwork burden for Rule 301, Form ATS, 
and Form ATS-R is increasing by one hundred sixty hours due to updating 
the estimate of the number of potential respondents from forty-three in 
the Proposing Release to forty-five currently.
3. Systems Capacity, Integrity, and Security
    The notification requirement for material systems outages should 
impose relatively little additional costs on alternative trading 
systems. Moreover, the Commission believes that this small burden is 
justified by the need to keep Commission staff abreast of systems' 
developments and problems.
    The Commission staff has estimated that each respondent will incur 
an average annual burden of fifteen hours to comply with the 
recordkeeping requirements associated with the systems capacity, 
integrity, and security provisions of Regulation ATS. The Commission 
staff has estimated that each respondent will make an average of five 
system outage notices per year, for an estimated average burden of 1.25 
hours per year.\641\ The Commission staff has estimated that the total 
estimated average cost of compliance for each respondent will be $85 
per year.\642\ Such alternative trading systems will

[[Page 70916]]

also be required to keep records relating to the steps taken to comply 
with systems capacity, integrity, and security requirements under 
Regulation ATS. The Commission staff has estimated that each respondent 
will incur a burden of ten hours per year to comply with such 
recordkeeping requirements for a total estimated cost of $675 per 
year.\643\ The Commission staff has estimated that two alternative 
trading systems will be required to comply with the systems capacity, 
integrity, and security provisions of Regulation ATS due to their 
significant volume. The estimated aggregate cost for these alternative 
trading systems chose to comply with the systems capacity, integrity, 
and security requirements is $1,520.\644\
---------------------------------------------------------------------------

    \641\ The Commission notes that compliance with the notice 
provision can be achieved by a telephone call, so the burden for 
each notice is minimal. The Commission staff has estimated only 0.25 
hours per notice will be required. The estimate of five system 
outage notices per year is based on the Commission's experience with 
the Automated Review Program.
    \642\ The estimated average cost per response of $17 is composed 
of $12.50 for in-house professional work (0.25 hours at $50 per 
hour) and $4.50 for printing, supplies, copying, and postage 
(approximately thirty-five percent of the total labor costs). The 
estimated annual cost of $85 is derived from five notices at $17 per 
notice.
    \643\ The total estimated cost of $675 is composed of $500 for 
in-house professional work (ten hours at $50 per hour) and $175 for 
printing, supplies, copying, and postage (approximately thirty-five 
percent of the total labor costs).
    \644\ The estimated aggregate cost of $1,520 is derived from two 
alternative trading systems incurring an estimated annual cost of 
$760 each ($85 for providing systems outage notices and $675 for 
recordkeeping requirements).
---------------------------------------------------------------------------

G. Rule 302

    Rule 302 requires alternative trading systems to make certain 
records with respect to trading activity through the alternative 
trading systems. This collection of information will permit the 
Commission to detect and investigate potential market irregularities 
and to ensure investor protection. Such information is not available in 
any other form from any other sources.
    For alternative trading systems that choose to register as a 
broker-dealer, the requirements of Rule 302 are mandatory. All records 
required to be made under Rule 302 are considered confidential and are 
not available to the public. All records required to be made under the 
Rule are required to be preserved for three years, the first two years 
in an easily accessible place.
    The Commission staff has estimated that each alternative trading 
system that chooses to register as a broker-dealer will be required to 
expend an average of thirty-six hours to comply with Rule 302 at an 
average cost of $1,730.88.\645\ If all forty-five alternative trading 
systems opt to register as broker-dealers, rather than as exchanges, 
the total cost for recordkeeping under Rule 302 is estimated to be 
$77,889.60 per year.\646\
---------------------------------------------------------------------------

    \645\ The estimated cost of $1,730.88 is derived from an average 
of thirty-six hours of compliance time at $48.08 per hour. The value 
of compliance time is estimated as follows: an employee of a broker-
dealer charged to ensure compliance with Commission regulations 
receives estimated annual compensation of $100,000. This 
compensation is the equivalent of $48.08 per hour ($100,000 divided 
by 2,080 payroll hours per year).
    \646\ This estimated cost of $77,889.60 is derived from forty-
five alternative trading systems incurring an annual cost of 
$1,730.88 each.
---------------------------------------------------------------------------

    The Commission notes that it is making no material changes to Rule 
302 from the Proposing Release. The collection of information burdens 
are increasing slightly due to an updated estimate of the number of 
respondents and not due to any changes to the rule as proposed.

H. Rule 303

    Rule 303 requires alternative trading systems registered as broker-
dealers to preserve certain records produced under Rule 302, as well as 
standards for granting access to the system and records generated in 
complying with the systems capacity, integrity and security 
requirements for alternative trading systems with significant trading 
volume. Alternative trading systems registered as broker-dealers are 
not required to file such information, but merely to retain it in an 
organized manner and make it available to the Commission upon request.
    For alternative trading systems that choose to register as a 
broker-dealer, the requirements of Rule 303 are mandatory. All records 
required to be made under Rule 303 are considered confidential and are 
not available to the public. All records required to be made under the 
Rule are required to be preserved for three years, the first two years 
in an easily accessible place.
    The Commission staff has estimated that each alternative trading 
system that chooses to register as a broker-dealer will be required to 
expend an average of four hours per year to comply with Rule 303 at an 
average cost of $192.32.\647\ If all forty-five alternative trading 
systems opt to register as broker-dealers, rather than as exchanges, 
the total cost for record preservation is estimated to be $8,654.40 per 
year.\648\
---------------------------------------------------------------------------

    \647\ The estimated cost of $192.32 is derived from an average 
of four hours of compliance time at $48.08 per hour. The value of 
compliance time is estimated as follows: An employee of a broker-
dealer charged to ensure compliance with Commission regulations 
receives estimated annual compensation of $100,000. This 
compensation is the equivalent of $48.08 per hour ($100,000 divided 
by 2,080 payroll hours per year).
    \648\ This estimated cost of $8,654.40 is derived from forty-
five alternative trading systems incurring an annual cost of $192.32 
each.
---------------------------------------------------------------------------

    The Commission notes that it is making no material changes to Rule 
302 from the Proposing Release. The collection of information burdens 
are increasing slightly due to an updated estimate of the number of 
respondents and not due to any changes to the rule as proposed.

XIII. Statutory Authority

    The rules and rule amendments in this release are being adopted 
pursuant to 15 U.S.C. 78 et seq., particularly sections 3(b), 5, 6, 
11A, 15, 17(a), 17(b), 19, 23(a), and 36 of the Exchange Act, 15 U.S.C. 
78c, 78e, 78f, 78k-1, 78o, 78q(a), 78q(b), 78s(b), 78w(a), and 78mm.

List of Subjects

17 CFR Part 202

    Administrative practice and procedure, Securities.

17 CFR Part 240

    Brokers-dealers, Fraud, Issuers, Reporting and recordkeeping 
requirements, Securities.

17 CFR Part 242

    Securities.

17 CFR Part 249

    Reporting and recordkeeping requirements, Securities.

    For the reasons set out in the preamble, Title 17, Chapter II of 
the Code of Federal Regulations is amended as follows.

PART 202--INFORMAL AND OTHER PROCEDURES

    1. The authority citation for part 202 continues to read in part as 
follows:

    Authority: 15 U.S.C. 77s, 77t, 78d-1, 78u, 78w, 7811(d), 79r, 
79t, 77sss, 77uuu, 80a-37, 80a-41, 80b-9, and 80b-11, unless 
otherwise noted.
* * * * *
    2. Paragraph (b) of Sec. 202.3 is revised to read as follows:


Sec. 202.3  Processing of filings.

    (a) * * *
    (b)(1) Applications for registration as brokers, dealers, 
investment advisers, municipal securities dealers and transfer agents 
are submitted to the Office of Filings and Information Services where 
they are examined to determine whether all necessary information has 
been supplied and whether all required financial statements and other 
documents have been furnished in proper form. Defective applications 
may be returned with a request for correction or held until corrected 
before being accepted as a filing. The files of the Commission and 
other sources of information are considered to determine whether any 
person connected with the applicant appears to have engaged in 
activities which would warrant commencement of proceedings on the 
question of denial of registration. The staff confers with applicants 
and makes suggestions in

[[Page 70917]]

appropriate cases for amendments and supplemental information. Where it 
appears appropriate in the public interest and where a basis therefore 
exists, denial proceedings may be instituted. Within forty-five days of 
the date of the filing of a brokerudealer, investment adviser or 
municipal securities dealer application (or within such longer period 
as to which the applicant consents), the Commission shall by order 
grant registration or institute proceedings to determine whether 
registration should be denied. An application for registration as a 
transfer agent shall become effective within 30 days after receipt of 
the application (or within such shorter period as the Commission may 
determine). The Office of Filings and Information Services is also 
responsible for the processing and substantive examination of 
statements of beneficial ownership of securities and changes in such 
ownership filed under the Securities Exchange Act of 1934, the Public 
Utility Holding Company Act of 1935, and the Investment Company Act of 
1940, and for the examination of reports filed pursuant to Sec. 230.144 
of this chapter.
    (2) Applications for registration as national securities exchanges, 
or exemption from registration as exchanges by reason of such 
exchanges' limited volume of transactions filed with the Commission are 
routed to the Division of Market Regulation, which examines these 
applications to determine whether all necessary information has been 
supplied and whether all required financial statements and other 
documents have been furnished in proper form. Defective applications 
may be returned with a request for correction or held until corrected 
before being accepted as a filing. The files of the Commission and 
other sources of information are considered to determine whether any 
person connected with the applicant appears to have engaged in 
activities which would warrant commencement of proceedings on the 
question of denial of registration. The staff confers with applicants 
and makes suggestions in appropriate cases for amendments and 
supplemental information. Where it appears appropriate in the public 
interest and where a basis therefore exists, denial proceedings may be 
instituted. Within 90 days of the date of the filing of an application 
for registration as a national securities exchange, or exemption from 
registration by reason of such exchanges' limited volume of 
transactions (or within such longer period as to which the applicant 
consents), the Commission shall by order grant registration, or 
institute proceedings to determine whether registration should be 
denied as provided in Sec. 240.19(a)(1) of this chapter.

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    3. The authority citation for part 240 continues to read in part as 
follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77eee, 
77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78f, 78i, 78j, 78j-1, 78k, 
78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll(d), 
78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 
80b-11, unless otherwise noted.
* * * * *
    4. Section 240.3a1-1 is added before the undesignated center 
heading ``Definition of `Equity Security' as Used in Sections 12(g) and 
16'' to read as follows:


Sec. 240.3a1-1  Exemption from the definition of ``Exchange'' under 
Section 3(a)(1) of the Act.

    (a) An organization, association, or group of persons shall be 
exempt from the definition of the term ``exchange'' under section 
3(a)(1) of the Act, (15 U.S.C. 78c(a)(1)), if such organization, 
association, or group of persons:
    (1) Is operated by a national securities association;
    (2) Is in compliance with Regulation ATS, 17 CFR 242.300 through 
242.303; or
    (3) Pursuant to paragraph (a) of Sec. 242.301 of Regulation ATS, 17 
CFR 242.301(a), is not required to comply with Regulation ATS, 17 CFR 
242.300 through 242.303.
    (b) Notwithstanding paragraph (a) of this section, an organization, 
association, or group of persons shall not be exempt under this section 
from the definition of ``exchange,'' if:
    (1) During three of the preceding four calendar quarters such 
organization, association, or group of persons had:
    (i) Fifty percent or more of the average daily dollar trading 
volume in any security and five percent or more of the average daily 
dollar trading volume in any class of securities; or
    (ii) Forty percent or more of the average daily dollar trading 
volume in any class of securities; and
    (2) The Commission determines, after notice to the organization, 
association, or group of persons, and an opportunity for such 
organization, association, or group of persons to respond, that such an 
exemption would not be necessary or appropriate in the public interest 
or consistent with the protection of investors taking into account the 
requirements for exchange registration under section 6 of the Act, (15 
U.S.C. 78f), and the objectives of the national market system under 
section 11A of the Act, (15 U.S.C 78k-1).
    (3) For purposes of paragraph (b) of this section, each of the 
following shall be considered a ``class of securities'':
    (i) Equity securities, which shall have the same meaning as in 
Sec. 240.3a11-1;
    (ii) Listed options, which shall mean any options traded on a 
national securities exchange or automated facility of a national 
securities exchange;
    (iii) Unlisted options, which shall mean any options other than 
those traded on a national securities exchange or automated facility of 
a national securities association;
    (iv) Municipal securities, which shall have the same meaning as in 
section 3(a)(29) of the Act, (15 U.S.C. 78c(a)(29));
    (v) Investment grade corporate debt securities, which shall mean 
any security that:
    (A) Evidences a liability of the issuer of such security;
    (B) Has a fixed maturity date that is at least one year following 
the date of issuance;
    (C) Is rated in one of the four highest ratings categories by at 
least one Nationally Recognized Statistical Ratings Organization; and
    (D) Is not an exempted security, as defined in section 3(a)(12) of 
the Act, (15 U.S.C. 78c(a)(12));
    (vi) Non-investment grade corporate debt securities, which shall 
mean any security that:
    (A) Evidences a liability of the issuer of such security;
    (B) Has a fixed maturity date that is at least one year following 
the date of issuance;
    (C) Is not rated in one of the four highest ratings categories by 
at least one Nationally Recognized Statistical Ratings Organization; 
and
    (D) Is not an exempted security, as defined in section 3(a)(12) of 
the Act, (15 U.S.C. 78o);
    (vii) Foreign corporate debt securities, which shall mean any 
security that:
    (A) Evidences a liability of the issuer of such debt security;
    (B) Is issued by a corporation or other organization incorporated 
or organized under the laws of any foreign country; and
    (C) Has a fixed maturity date that is at least one year following 
the date of issuance; and
    (viii) Foreign sovereign debt securities, which shall mean any 
security that:

[[Page 70918]]

    (A) Evidences a liability of the issuer of such debt security;
    (B) Is issued or guaranteed by the government of a foreign country, 
any political subdivision of a foreign country, or any supranational 
entity; and
    (C) Does not have a maturity date of a year or less following the 
date of issuance.
    5. Section 240.3b-16 is added before the undesignated center 
heading ``Registration and Exemption of Exchanges'' to read as follows:


Sec. 240.3b-16  Definitions of terms used in Section 3(a)(1) of the 
Act.

    (a) An organization, association, or group of persons shall be 
considered to constitute, maintain, or provide ``a market place or 
facilities for bringing together purchasers and sellers of securities 
or for otherwise performing with respect to securities the functions 
commonly performed by a stock exchange,'' as those terms are used in 
section 3(a)(1) of the Act, (15 U.S.C. 78c(a)(1)), if such 
organization, association, or group of persons:
    (1) Brings together the orders for securities of multiple buyers 
and sellers; and
    (2) Uses established, non-discretionary methods (whether by 
providing a trading facility or by setting rules) under which such 
orders interact with each other, and the buyers and sellers entering 
such orders agree to the terms of a trade.
    (b) An organization, association, or group of persons shall not be 
considered to constitute, maintain, or provide ``a market place or 
facilities for bringing together purchasers and sellers of securities 
or for otherwise performing with respect to securities the functions 
commonly performed by a stock exchange,'' solely because such 
organization, association, or group of persons engages in one or more 
of the following activities:
    (1) Routes orders to a national securities exchange, a market 
operated by a national securities association, or a broker-dealer for 
execution; or
    (2) Allows persons to enter orders for execution against the bids 
and offers of a single dealer; and
    (i) As an incidental part of these activities, matches orders that 
are not displayed to any person other than the dealer and its 
employees; or
    (ii) In the course of acting as a market maker registered with a 
self-regulatory organization, displays the limit orders of such market 
maker's, or other broker-dealer's, customers; and
    (A) Matches customer orders with such displayed limit orders; and
    (B) As an incidental part of its market making activities, crosses 
or matches orders that are not displayed to any person other than the 
market maker and its employees.
    (c) For purposes of this section the term order means any firm 
indication of a willingness to buy or sell a security, as either 
principal or agent, including any bid or offer quotation, market order, 
limit order, or other priced order.
    (d) For the purposes of this section, the terms bid and offer shall 
have the same meaning as under Sec. 240.11Ac1-1.
    (e) The Commission may conditionally or unconditionally exempt any 
organization, association, or group of persons from the definition in 
paragraph (a) of this section.
    6. Section 240.6a-1 is amended by revising the section heading and 
paragraphs (a) and (b) to read as follows:


Sec. 240.6a-1  Application for registration as a national securities 
exchange or exemption from registration based on limited volume.

    (a) An application for registration as a national securities 
exchange, or for exemption from such registration based on limited 
volume, shall be filed on Form 1 (Sec. 249.1 of this chapter), in 
accordance with the instructions contained therein.
    (b) Promptly after the discovery that any information filed on Form 
1 was inaccurate when filed, the exchange shall file with the 
Commission an amendment correcting such inaccuracy.
* * * * *
    7. Section 240.6a-2 is revised to read as follows:


Sec. 240.6a-2  Amendments to application.

    (a) A national securities exchange, or an exchange exempted from 
such registration based on limited volume, shall file an amendment to 
Form 1, (Sec. 249.1 of this chapter), which shall set forth the nature 
and effective date of the action taken and shall provide any new 
information and correct any information rendered inaccurate, on Form 1, 
(Sec. 249.1 of this chapter), within 10 days after any action is taken 
that renders inaccurate, or that causes to be incomplete, any of the 
following:
    (1) Information filed on the Execution Page of Form 1, or amendment 
thereto; or
    (2) Information filed as part of Exhibits C, F, G, H, J, K or M, or 
any amendments thereto.
    (b) On or before June 30 of each year, a national securities 
exchange, or an exchange exempted from such registration based on 
limited volume, shall file, as an amendment to Form 1, the following:
    (1) Exhibits D and I as of the end of the latest fiscal year of the 
exchange; and
    (2) Exhibits K, M, and N, which shall be up to date as of the 
latest date practicable within 3 months of the date the amendment is 
filed.
    (c) On or before June 30, 2001 and every 3 years thereafter, a 
national securities exchange, or an exchange exempted from such 
registration based on limited volume, shall file, as an amendment to 
Form 1, complete Exhibits A, B, C and J. The information filed under 
this paragraph (c) shall be current as of the latest practicable date, 
but shall, at a minimum, be up to date within 3 months as of the date 
the amendment is filed.
    (d)(1) If an exchange, on an annual or more frequent basis, 
publishes, or cooperates in the publication of, any of the information 
required to be filed by paragraphs (b)(2) and (c) of this section, in 
lieu of filing such information, an exchange may:
    (i) Identify the publication in which such information is 
available, the name, address, and telephone number of the person from 
whom such publication may be obtained, and the price of such 
publication; and
    (ii) Certify to the accuracy of such information as of its 
publication date.
    (2) If an exchange keeps the information required under paragraphs 
(b)(2) and (c) of this section up to date and makes it available to the 
Commission and the public upon request, in lieu of filing such 
information, an exchange may certify that the information is kept up to 
date and is available to the Commission and the public upon request.
    (3) If the information required to be filed under paragraphs (b)(2) 
and (c) of this section is available continuously on an Internet web 
site controlled by an exchange, in lieu of filing such information with 
the Commission, such exchange may:
    (i) Indicate the location of the Internet web site where such 
information may be found; and
    (ii) Certify that the information available at such location is 
accurate as of its date.
    (e) The Commission may exempt a national securities exchange, or an 
exchange exempted from such registration based on limited volume, from 
filing the amendment required by this section for any affiliate or 
subsidiary listed in Exhibit C of the exchange's application for 
registration, as amended, that either:
    (1) Is listed in Exhibit C of the application for registration, as 
amended,

[[Page 70919]]

of one or more other national securities exchanges; or
    (2) Was an inactive subsidiary throughout the subsidiary's latest 
fiscal year.
    Any such exemption may be granted upon terms and conditions the 
Commission deems necessary or appropriate in the public interest or for 
the protection of investors, provided however, that at least one 
national securities exchange shall be required to file the amendments 
required by this section for an affiliate or subsidiary described in 
paragraph (e)(1) of this section.
    8. Section 240.6a-3 is revised to read as follows:


Sec. 240.6a-3  Supplemental material to be filed by exchanges.

    (a)(1) A national securities exchange, or an exchange exempted from 
such registration based on limited volume, shall file with the 
Commission any material (including notices, circulars, bulletins, 
lists, and periodicals) issued or made generally available to members 
of, or participants or subscribers to, the exchange. Such material 
shall be filed with the Commission within 10 days after issuing or 
making such material available to members, participants or subscribers.
    (2) If the information required to be filed under paragraph (a)(1) 
of this section is available continuously on an Internet web site 
controlled by an exchange, in lieu of filing such information with the 
Commission, such exchange may:
    (i) Indicate the location of the Internet web site where such 
information may be found; and
    (ii) Certify that the information available at such location is 
accurate as of its date.
    (b) Within 15 days after the end of each calendar month, a national 
securities exchange or an exchange exempted from such registration 
based on limited volume, shall file a report concerning the securities 
sold on such exchange during the calendar month. Such report shall set 
forth:
    (1) The number of shares of stock sold and the aggregate dollar 
amount of such stock sold;
    (2) The principal amount of bonds sold and the aggregate dollar 
amount of such bonds sold; and
    (3) The number of rights and warrants sold and the aggregate dollar 
amount of such rights and warrants sold.
    9. Section 240.11Ac1-1 is amended by redesignating paragraph 
(c)(5)(ii)(A) as paragraph (c)(5)(ii)(A)(l), paragraph (c)(5)(ii)(B), 
introductory text, as paragraph (c)(5)(ii)(A)(2), paragraph 
(c)(5)(ii)(B)(1) as paragraph (c)(5)(ii)(A)(2)(i), paragraph 
(c)(5)(ii)(B)(2) as paragraph (c)(5)(ii)(A)(2)(ii), in newly designated 
paragraph (c)(5)(ii)(A)(2)(ii) by removing the period and adding in its 
place ``; or'', and adding new paragraph (c)(5)(ii)(B) to read as 
follows:


Sec. 240.11Ac1-1  Dissemination of quotations.

* * * * *
    (c) * * *
    (5) * * *
    (ii) * * *
    (A)(1) * * *
    (B) Is an alternative trading system that:
    (1) Displays orders and provides the ability to effect transactions 
with such orders under Sec. 242.301(b)(3) of this chapter; and
    (2) Otherwise is in compliance with Regulation ATS, Sec. 242.300 
through Sec. 242.303 of this chapter.
* * * * *
    10. Section 240.17a-3 is amended by adding paragraph (a)(16) to 
read as follows:


Sec. 240.17a-3  Records to be made by certain exchange members, brokers 
and dealers.

    (a) * * *
    (16)(i) The following records regarding any internal broker-dealer 
system of which such a broker or dealer is the sponsor:
    (A) A record of the broker's or dealer's customers that have access 
to an internal broker-dealer system sponsored by such broker or dealer 
(identifying any affiliations between such customers and the broker or 
dealer);
    (B) Daily summaries of trading in the internal broker-dealer 
system, including:
    (1) Securities for which transactions have been executed through 
use of such system; and
    (2) Transaction volume (separately stated for trading occurring 
during hours when consolidated trade reporting facilities are and are 
not in operation):
    (i) With respect to equity securities, stated in number of trades, 
number of shares, and total U.S. dollar value;
    (ii) With respect to debt securities, stated in total settlement 
value in U.S. dollars; and
    (iii) With respect to other securities, stated in number of trades, 
number of units of securities, and in dollar value, or other 
appropriate commonly used measure of value of such securities; and
    (C) Time-sequenced records of each transaction effected through the 
internal broker-dealer system, including date and time executed, price, 
size, security traded, counterparty identification information, and 
method of execution (if internal broker-dealer system allows 
alternative means or locations for execution, such as routing to 
another market, matching with limit orders, or executing against the 
quotations of the broker or dealer sponsoring the system).
    (ii) For purposes of paragraph (a) of this section, the term:
    (A) Internal broker-dealer system shall mean any facility, other 
than a national securities exchange, an exchange exempt from 
registration based on limited volume, or an alternative trading system 
as defined in Regulation ATS, Secs. 242.300 through 242.303 of this 
chapter, that provides a mechanism, automated in full or in part, for 
collecting, receiving, disseminating, or displaying system orders and 
facilitating agreement to the basic terms of a purchase or sale of a 
security between a customer and the sponsor, or between two customers 
of the sponsor, through use of the internal broker-dealer system or 
through the broker or dealer sponsor of such system;
    (B) Sponsor shall mean any broker or dealer that organizes, 
operates, administers, or otherwise directly controls an internal 
broker-dealer trading system or, if the operator of the internal 
broker-dealer system is not a registered broker or dealer, any broker 
or dealer that, pursuant to contract, affiliation, or other agreement 
with the system operator, is involved on a regular basis with executing 
transactions in connection with use of the internal broker-dealer 
system, other than solely for its own account or as a customer with 
access to the internal broker-dealer system; and
    (C) System order means any order or other communication or 
indication submitted by any customer with access to the internal 
broker-dealer system for entry into a trading system announcing an 
interest in purchasing or selling a security. The term ``system order'' 
does not include inquiries or indications of interest that are not 
entered into the internal broker-dealer system.
* * * * *
    11. Section 240.17a-4 is amended by revising paragraph (b)(1) and 
adding paragraph (b)(10) to read as follows:


Sec. 240.17a-4.  Records to be preserved by certain exchange members, 
brokers and dealers.

* * * * *
    (b) * * *
    (1) All records required to be made pursuant to paragraphs (a)(4), 
(a)(6), (a)(7), (a)(8), (a)(9), and (a)(10) of Sec. 240.17a-3.
* * * * *

[[Page 70920]]

    (10) All notices relating to an internal broker-dealer system 
provided to the customers of the broker or dealer that sponsors such 
internal broker-dealer system, as defined in paragraph (a)(16)(ii)(A) 
of Sec. 240.17a-3. Notices, whether written or communicated through the 
internal broker-dealer trading system or other automated means, shall 
be preserved under this paragraph (b)(10) if they are provided to all 
customers with access to an internal broker-dealer system, or to one or 
more classes of customers. Examples of notices to be preserved under 
this paragraph (b)(10) include, but are not limited to, notices 
addressing hours of system operations, system malfunctions, changes to 
system procedures, maintenance of hardware and software, and 
instructions pertaining to access to the internal broker-dealer system.
* * * * *


Sec. 240.17a-23  [Removed]

    12. Section 240.17a-23 is removed and reserved.
    13. Section 240.19b-5 is added to read as follows:


Sec. 240.19b-5  Temporary exemption from the filing requirements of 
Section 19(b) of the Act.

Preliminary Notes

    1. The following section provides for a temporary exemption from 
the rule filing requirement for self-regulatory organizations that file 
proposed rule changes concerning the operation of a pilot trading 
system pursuant to section 19(b) of the Act (15 U.S.C. 78s(b), as 
amended). All other requirements under the Act that are applicable to 
self-regulatory organizations continue to apply.
    2. The disclosures made pursuant to the provisions of this section 
are in addition to any other applicable disclosure requirements under 
the federal securities laws.
    (a) For purposes of this section, the term specialist means any 
member subject to a requirement of a self-regulatory organization that 
such member regularly maintain a market in a particular security.
    (b) For purposes of this section, the term trading system means the 
rules of a self-regulatory organization that:
    (1) Determine how the orders of multiple buyers and sellers are 
brought together; and
    (2) Establish non-discretionary methods under which such orders 
interact with each other and under which the buyers and sellers 
entering such orders agree to the terms of trade.
    (c) For purposes of this section, the term pilot trading system 
shall mean a trading system operated by a self-regulatory organization 
that is not substantially similar to any trading system or pilot 
trading system operated by such self-regulatory organization at any 
time during the preceding year, and that:
    (1)(i) Has been in operation for less than two years;
    (ii) Is independent of any other trading system operated by such 
self-regulatory organization that has been approved by the Commission 
pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b));
    (iii) With respect to each security traded on such pilot trading 
system, during at least two of the last four consecutive calendar 
months, has traded no more than 5 percent of the average daily trading 
volume of such security in the United States; and
    (iv) With respect to all securities traded on such pilot trading 
system, during at least two of the last four consecutive calendar 
months, has traded no more than 20 percent of the average daily trading 
volume of all trading systems operated by such self-regulatory 
organization; or
    (2)(i) Has been in operation for less than two years;
    (ii) With respect to each security traded on such pilot trading 
system, during at least two of the last four consecutive calendar 
months, has traded no more than 1 percent of the average daily trading 
volume of such security in the United States; and
    (iii) With respect to all securities traded on such pilot trading 
system, during at least two of the last four consecutive calendar 
months, has traded no more than 20 percent of the average daily trading 
volume of all trading systems operated by such self-regulatory 
organization; or
    (3)(i) Has been in operation for less than two years; and
    (ii)(A) Satisfied the definition of pilot trading system under 
paragraph (c)(1) of this section no more than 60 days ago, and 
continues to be independent of any other trading system operated by 
such self-regulatory organization that has been approved by the 
Commission pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b)); or
    (B) Satisfied the definition of pilot trading system under 
paragraph (c)(2) of this section no more than 60 days ago.
    (d) A pilot trading system shall be deemed independent of any other 
trading system operated by a self-regulatory organization if:
    (1) Such pilot trading system trades securities other than the 
issues of securities that trade on any other trading system operated by 
such self-regulatory organization that has been approved by the 
Commission pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b));
    (2) Such pilot trading system does not operate during the same 
trading hours as any other trading system operated by such self-
regulatory organization that has been approved by the Commission 
pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b)); or
    (3) No specialist or market maker on any other trading system 
operated by such self-regulatory organization that has been approved by 
the Commission pursuant to section 19(b) of the Act, (15 U.S.C. 
78s(b)), is permitted to effect transactions on the pilot trading 
system in securities in which they are a specialist or market maker.
    (e) A self-regulatory organization shall be exempt temporarily from 
the requirement under section 19(b) of the Act, (15 U.S.C. 78s(b)), to 
submit on Form 19b-4, 17 CFR 249.819, proposed rule changes for 
establishing a pilot trading system, if the self-regulatory 
organization complies with the following requirements:
    (1) Form PILOT. The self-regulatory organization:
    (i) Files Part I of Form PILOT, 17 CFR 249.821, in accordance with 
the instructions therein, at least 20 days prior to commencing 
operation of the pilot trading system;
    (ii) Files an amendment on Part I of Form PILOT at least 20 days 
prior to implementing a material change to the operation of the pilot 
trading system; and
    (iii) Files a quarterly report on Part II of Form PILOT within 30 
calendar days after the end of each calendar quarter in which the 
market has operated after the effective date of this section.
    (2) Fair access.
    (i) The self-regulatory organization has in place written rules to 
ensure that all members of the self-regulatory organization have fair 
access to the pilot trading system, and that information regarding 
orders on the pilot trading system is equally available to all members 
of the self-regulatory organization with access to such pilot trading 
system.
    (ii) Notwithstanding the requirement in paragraph (e)(2)(i) of this 
section, a specialist on the pilot trading system may have preferred 
access to information regarding orders that it represents in its 
capacity as specialist.
    (iii) The rules established by a self-regulatory organization 
pursuant to paragraph (e)(2)(i) of this section will be considered 
rules governing the pilot trading system for purposes of the temporary 
exemption under this section.

[[Page 70921]]

    (3) Trading rules and procedures and listing standards.
    (i) The self-regulatory organization has in place written trading 
rules and procedures and listing standards necessary to operate the 
pilot trading system.
    (ii) The rules established by a self-regulatory organization 
pursuant to paragraph (e)(3)(i) of this section will be considered 
rules governing the pilot trading system for purposes of the temporary 
exemption under this section.
    (4) Surveillance. The self-regulatory organization establishes 
internal procedures for the effective surveillance of trading activity 
on the self-regulatory organization's pilot trading system.
    (5) Clearance and settlement. The self-regulatory organization 
establishes reasonable clearance and settlement procedures for 
transactions effected on the self-regulatory organizations pilot 
trading system.
    (6) Types of securities. The self-regulatory organization permits 
to trade on the pilot trading system only securities registered under 
section 12 of the Act, (15 U.S.C. 78l).
    (7) Activities of specialists.
    (i) The self-regulatory organization does not permit any member to 
be a specialist in a security on the pilot trading system and a 
specialist in a security on a trading system operated by such self-
regulatory organization that has been approved by the Commission 
pursuant to section 19(b) of the Act, (15 U.S.C. 78s(b)), or on another 
pilot trading system operated by such self-regulatory organization, if 
such securities are related securities, except that a member may be a 
specialist in related securities that the Commission, upon application 
by the self-regulatory organization, later determines is necessary or 
appropriate in the public interest and consistent with the protection 
of investors;
    (ii) Notwithstanding paragraph (e)(7)(i) of this section, a self-
regulatory organization may permit a member to be a specialist in any 
security on a pilot trading system, if the pilot trading system is 
operated during trading hours different from the trading hours of the 
trading system in which such member is a specialist.
    (iii) For purposes of paragraph (e)(7) of this section, the term 
related securities means any two securities in which:
    (A) The value of one security is determined, in whole or 
significant part, by the performance of the other security; or
    (B) The value of both securities is determined, in whole or 
significant part, by the performance of a third security, combination 
of securities, index, indicator, interest rate or other common factor.
    (8) Examinations, inspections, and investigations. The self-
regulatory organization cooperates with the examination, inspection, or 
investigation by the Commission of transactions effected on the pilot 
trading system.
    (9) Recordkeeping. The self-regulatory organization shall retain at 
its principal place of business and make available to Commission staff 
for inspection, all the rules and procedures relating to each pilot 
trading system operating pursuant to this section for a period of not 
less than five years, the first two years in an easily accessible 
place, as prescribed in Sec. 240.17a-1.
    (10) Public availability of pilot trading system rules. The self-
regulatory organization makes publicly available all trading rules and 
procedures, including those established under paragraphs (e)(2) and 
(e)(3) of this section.
    (11) Every notice or amendment filed pursuant to this paragraph (e) 
shall constitute a ``report'' within the meaning of sections 11A, 
17(a), 18(a), and 32(a), (15 U.S.C. 78k-1, 78q(a), 78r(a), and 
78ff(a)), and any other applicable provisions of the Act. All notices 
or reports filed pursuant to this paragraph (e) shall be deemed to be 
confidential until the pilot trading system commences operation.
    (f)(1)A self-regulatory organization shall request Commission 
approval, pursuant to section 19(b)(2) of the Act, (15 U.S.C. 
78s(b)(2)), for any rule change relating to the operation of a pilot 
trading system by submitting Form 19b-4, 17 CFR 249.819, no later than 
two years after the commencement of operation of such pilot trading 
system, or shall cease operation of the pilot trading system.
    (2) Simultaneous with a request for Commission approval pursuant to 
section 19(b)(2) of the Act, (15 U.S.C. 78s(b)(2)), a self-regulatory 
organization may request Commission approval pursuant to section 
19(b)(3)(A) of the Act, (15 U.S.C. 78s(b)(3)(A)), for any rule change 
relating to the operation of a pilot trading system by submitting Form 
19b-4, 17 CFR 249.819, effective immediate upon filing, to continue 
operations of such trading system for a period not to exceed six 
months.
    (g) Notwithstanding paragraph (e) of this section, rule changes 
with respect to pilot trading systems operated by a self-regulatory 
organization shall not be exempt from the rule filing requirements of 
section 19(b)(2) of the Act, (15 U.S.C. 78s(b)(2)), if the Commission 
determines, after notice to the SRO and opportunity for the SRO to 
respond, that exemption of such rule changes is not necessary or 
appropriate in the public interest or consistent with the protection of 
investors.

PART 242--REGULATIONS M AND ATS

    14. The authority citation for part 242 is revised to read as 
follows:

    Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78i(a), 78j, 
78k-1(c), 78l, 78m, 78mm, 78n, 78o(b), 78o(c), 78o(g), 78q(a), 
78q(b), 78q(h), 78w(a), 78dd-1, 80a-23, 80a-29, and 80a-37.

    15. The part heading for part 242 is revised as set forth above.
    16. Part 242 is amended by adding Regulation ATS, Secs. 242.300 
through 242.303 to read as follows:

Regulation ATS--Alternative Trading Systems

Sec.
242.300  Definitions.
242.301  Requirements for alternative trading systems.
242.302  Recordkeeping requirements for alternative trading systems.
242.303  Record preservation requirements for alternative trading 
systems.

Regulation ATS--Alternative Trading Systems

Preliminary Notes

    1. An alternative trading system is required to comply with the 
requirements in this Regulation ATS, unless such alternative trading 
system:
    (a) Is registered as a national securities exchange;
    (b) Is exempt from registration as a national securities 
exchange based on the limited volume of transactions effected on the 
alternative trading system; or
    (c) Trades only government securities and certain other related 
instruments.
    All alternative trading systems must comply with the antifraud, 
antimanipulation, and other applicable provisions of the federal 
securities laws.
    2. The requirements imposed upon an alternative trading system 
by Regulation ATS are in addition to any requirements applicable to 
broker-dealers registered under section 15 of the Act, (15 U.S.C. 
78o).
    3. An alternative trading system must comply with any applicable 
state law relating to the offer or sale of securities or the 
registration or regulation of persons or entities effecting 
transactions in securities.
    4. The disclosures made pursuant to the provisions of this 
section are in addition to any other disclosure requirements under 
the federal securities laws.


Sec. 242.300  Definitions.

    For purposes of this section, the following definitions shall 
apply:

[[Page 70922]]

    (a) Alternative trading system means any organization, association, 
person, group of persons, or system:
    (1) That constitutes, maintains, or provides a market place or 
facilities for bringing together purchasers and sellers of securities 
or for otherwise performing with respect to securities the functions 
commonly performed by a stock exchange within the meaning of 
Sec. 240.3b-16 of this chapter; and
    (2) That does not:
    (i) Set rules governing the conduct of subscribers other than the 
conduct of such subscribers' trading on such organization, association, 
person, group of persons, or system; or
    (ii) Discipline subscribers other than by exclusion from trading.
    (b) Subscriber means any person that has entered into a contractual 
agreement with an alternative trading system to access such alternative 
trading system for the purpose of effecting transactions in securities 
or submitting, disseminating, or displaying orders on such alternative 
trading system, including a customer, member, user, or participant in 
an alternative trading system. A subscriber, however, shall not include 
a national securities exchange or national securities association.
    (c) Affiliate of a subscriber means any person that, directly or 
indirectly, controls, is under common control with, or is controlled 
by, the subscriber, including any employee.
    (d) Debt security shall mean any security other than an equity 
security, as defined in Sec. 240.3a11-1 of this chapter, as well as 
non-participatory preferred stock.
    (e) Order means any firm indication of a willingness to buy or sell 
a security, as either principal or agent, including any bid or offer 
quotation, market order, limit order, or other priced order.
    (f) Control means the power, directly or indirectly, to direct the 
management or policies of an alternative trading system, whether 
through ownership of securities, by contract, or otherwise. A person is 
presumed to control an alternative trading system, if that person:
    (1) Is a director, general partner, or officer exercising executive 
responsibility (or having similar status or performing similar 
functions);
    (2) Directly or indirectly has the right to vote 25 percent or more 
of a class of voting security or has the power to sell or direct the 
sale of 25 percent or more of a class of voting securities of the 
alternative trading system; or
    (3) In the case of a partnership, has contributed, or has the right 
to receive upon dissolution, 25 percent or more of the capital of the 
alternative trading system.
    (g) Covered security shall have the meaning provided in 
Sec. 240.11Ac1-1(a)(6) of this chapter, provided, however, that a debt 
or convertible debt security shall not be deemed a covered security for 
purposes of Regulation ATS.
    (h) Effective transaction reporting plan shall have the meaning 
provided in Sec. 240.11Aa3-1(a)(3) of this chapter.
    (i) Exchange market maker shall have the meaning provided in 
Sec. 240.11Ac1-1(a)(9) of this chapter.
    (j) OTC market maker shall have the meaning provided in 
Sec. 240.11Ac1-1(a)(13) of this chapter.
    (k) Investment grade corporate debt security shall mean any 
security that:
    (1) Evidences a liability of the issuer of such security;
    (2) Has a fixed maturity date that is at least one year following 
the date of issuance;
    (3) Is rated in one of the four highest ratings categories by at 
least one Nationally Recognized Statistical Ratings Organization; and
    (4) Is not an exempted security, as defined in section 3(a)(12) of 
the Act (15 U.S.C. 78c(a)(12)).
    (l) Non-investment grade corporate debt security shall mean any 
security that:
    (1) Evidences a liability of the issuer of such security;
    (2) Has a fixed maturity date that is at least one year following 
the date of issuance;
    (3) Is not rated in one of the four highest ratings categories by 
at least one Nationally Recognized Statistical Ratings Organization; 
and
    (4) Is not an exempted security, as defined in section 3(a)(12) of 
the Act (15 U.S.C. 78c(a)(12)).
    (m) Commercial paper shall mean any note, draft, or bill of 
exchange which arises out of a current transaction or the proceeds of 
which have been or are to be used for current transactions, and which 
has a maturity at the time of issuance of not exceeding nine months, 
exclusive of days of grace, or any renewal thereof the maturity of 
which is likewise limited.


Sec. 242.301  Requirements for alternative trading systems.

    (a) Scope of section. An alternative trading system shall comply 
with the requirements in paragraph (b) of this section, unless such 
alternative trading system:
    (1) Is registered as an exchange under section 6 of the Act, (15 
U.S.C. 78f);
    (2) Is exempted by the Commission from registration as an exchange 
based on the limited volume of transactions effected;
    (3) Is operated by a national securities association;
    (4)(i) Is registered as a broker-dealer under sections 15(b) or 15C 
of the Act (15 U.S.C. 78o(b), and 78o-5), or is a bank, and
    (ii) Limits its securities activities to the following instruments:
    (A) Government securities, as defined in section 3(a)(42) of the 
Act, (15 U.S.C. 78c(a)(42));
    (B) Repurchase and reverse repurchase agreements solely involving 
securities included within paragraph (a)(4)(ii)(A) of this section;
    (C) Any put, call, straddle, option, or privilege on a government 
security, other than a put, call, straddle, option, or privilege that:
    (1) Is traded on one or more national securities exchanges; or
    (2) For which quotations are disseminated through an automated 
quotation system operated by a registered securities association; and
    (D) Commercial paper.
    (5) Is exempted, conditionally or unconditionally, by Commission 
order, after application by such alternative trading system, from one 
or more of the requirements of paragraph (b) of this section. The 
Commission will grant such exemption only after determining that such 
an order is consistent with the public interest, the protection of 
investors, and the removal of impediments to, and perfection of the 
mechanisms of, a national market system.
    (b) Requirements. Every alternative trading system subject to this 
Regulation ATS, pursuant to paragraph (a) of this section, shall comply 
with the requirements in this paragraph (b).
    (1) Broker-dealer registration. The alternative trading system 
shall register as a broker-dealer under section 15 of the Act, (15 
U.S.C. 78o).
    (2) Notice. (i) The alternative trading system shall file an 
initial operation report on Form ATS, Sec. 249.637 of this chapter, in 
accordance with the instructions therein, at least 20 days prior to 
commencing operation as an alternative trading system, or if the 
alternative trading system is operating as of April 21, 1999, no later 
than May 11, 1999.
    (ii) The alternative trading system shall file an amendment on Form 
ATS at least 20 calendar days prior to implementing a material change 
to the operation of the alternative trading system.
    (iii) If any information contained in the initial operation report 
filed under paragraph (b)(2)(i) of this section becomes inaccurate for 
any reason and has not been previously reported to the

[[Page 70923]]

Commission as an amendment on Form ATS, the alternative trading system 
shall file an amendment on Form ATS correcting such information within 
30 calendar days after the end of each calendar quarter in which the 
alternative trading system has operated.
    (iv) The alternative trading system shall promptly file an 
amendment on Form ATS correcting information previously reported on 
Form ATS after discovery that any information filed under paragraphs 
(b)(2)(i), (ii) or (iii) of this section was inaccurate when filed.
    (v) The alternative trading system shall promptly file a cessation 
of operations report on Form ATS in accordance with the instructions 
therein upon ceasing to operate as an alternative trading system.
    (vi) Every notice or amendment filed pursuant to this paragraph 
(b)(2) shall constitute a ``report'' within the meaning of sections 
11A, 17(a), 18(a), and 32(a), (15 U.S.C. 78k-1, 78q(a), 78r(a), and 
78ff(a)), and any other applicable provisions of the Act.
    (vii) The reports provided for in paragraph (b)(2) of this section 
shall be considered filed upon receipt by the Division of Market 
Regulation, Stop 10-2, at the Commission's principal office in 
Washington, DC. Duplicate originals of the reports provided for in 
paragraphs (b)(2)(i) through (v) of this section must be filed with 
surveillance personnel designated as such by any self-regulatory 
organization that is the designated examining authority for the 
alternative trading system pursuant to Sec. 240.17d-1 of this chapter 
simultaneously with filing with the Commission. Duplicates of the 
reports required by paragraph (b)(9) of this section shall be provided 
to surveillance personnel of such self-regulatory authority upon 
request. All reports filed pursuant to this paragraph (b)(2) and 
paragraph (b)(9) of this section shall be deemed confidential when 
filed.
    (3) Order display and execution access. (i) An alternative trading 
system shall comply with the requirements set forth in paragraph 
(b)(3)(ii) of this section, with respect to any covered security in 
which the alternative trading system:
    (A) Displays subscriber orders to any person (other than 
alternative trading system employees); and
    (B) During at least 4 of the preceding 6 calendar months, had an 
average daily trading volume of 5 percent or more of the aggregate 
average daily share volume for such covered security as reported by an 
effective transaction reporting plan or disseminated through an 
automated quotation system as described in section 3(a)(51)(A)(ii) of 
the Act, (15 U.S.C. 78c(a)(51)(A)(ii)).
    (ii) Such alternative trading system shall provide to a national 
securities exchange or national securities association the prices and 
sizes of the orders at the highest buy price and the lowest sell price 
for such covered security, displayed to more than one person in the 
alternative trading system, for inclusion in the quotation data made 
available by the exchange or association to quotation vendors pursuant 
to Sec. 240.11Ac1-1 of this chapter.
    (iii) With respect to any order displayed pursuant to paragraph 
(b)(3)(ii) of this section, an alternative trading system shall provide 
to any broker-dealer that has access to the national securities 
exchange or national securities association to which the alternative 
trading system provides the prices and sizes of displayed orders 
pursuant to paragraph (b)(3)(ii)(A) of this section, the ability to 
effect a transaction with such orders that is:
    (A) Equivalent to the ability of such broker-dealer to effect a 
transaction with other orders displayed on the exchange or by the 
association; and
    (B) At the price of the highest priced buy order or lowest priced 
sell order displayed for the lesser of the cumulative size of such 
priced orders entered therein at such price, or the size of the 
execution sought by such broker-dealer.
    (4) Fees. The alternative trading system shall not charge any fee 
to broker-dealers that access the alternative trading system through a 
national securities exchange or national securities association, that 
is inconsistent with equivalent access to the alternative trading 
system required by paragraph (b)(3)(iv) of this section. In addition, 
if the national securities exchange or national securities association 
to which an alternative trading system provides the prices and sizes of 
orders under paragraphs (b)(3)(ii) and (b)(3)(iii) of this section 
establishes rules designed to assure consistency with standards for 
access to quotations displayed on such national securities exchange, or 
the market operated by such national securities association, the 
alternative trading system shall not charge any fee to members that is 
contrary to, that is not disclosed in the manner required by, or that 
is inconsistent with any standard of equivalent access established by 
such rules.
    (5) Fair access. (i) An alternative trading system shall comply 
with the requirements in paragraph (b)(5)(ii) of this section, if 
during at least 4 of the preceding 6 calendar months, such alternative 
trading system had:
    (A) With respect to any covered security, 20 percent or more of the 
average daily volume in that security reported by an effective 
transaction reporting plan or disseminated through an automated 
quotation system as described in section 3(a)(51)(A)(ii) of the Act (15 
U.S.C. 78c(a)(51)(A)(ii));
    (B) With respect to an equity security that is not a covered 
security and for which transactions are reported to a self-regulatory 
organization, 20 percent or more of the average daily volume in that 
security as calculated by the self-regulatory organization to which 
such transactions are reported;
    (C) With respect to municipal securities, 20 percent or more of the 
average daily volume traded in the United States;
    (D) With respect to investment grade corporate debt, 20 percent or 
more of the average daily volume traded in the United States;
    (E) With respect to non-investment grade corporate debt, 20 percent 
or more of the average daily volume traded in the United States.
    (ii) An alternative trading system shall:
    (A) Establish written standards for granting access to trading on 
its system;
    (B) Not unreasonably prohibit or limit any person in respect to 
access to services offered by such alternative trading system by 
applying the standards established under paragraph (b)(5)(ii)(A) of 
this section in an unfair or discriminatory manner; and
    (C) Make and keep records of:
    (1) All grants of access including, for all subscribers, the 
reasons for granting such access;
    (2) All denials or limitations of access and reasons, for each 
applicant, for denying or limiting access.
    (D) Report the information required on Form ATS-R, Sec. 249.638 of 
this chapter, regarding grants, denials, and limitations of access.
    (iii) Notwithstanding paragraph (b)(5)(i) of this section, an 
alternative trading system shall not be required to comply with the 
requirements in paragraph (b)(5)(ii) of this section, if such 
alternative trading system:
    (A) Matches customer orders for a security with other customer 
orders;
    (B) Such customers' orders are not displayed to any person, other 
than employees of the alternative trading system; and
    (C) Such orders are executed at a price for such security 
disseminated by an effective transaction reporting plan or through an 
automated quotation system as described in section 3(a)(51)(A)(ii) of

[[Page 70924]]

the Act, (15 U.S.C. 78c(a)(51)(A)(ii)), or derived from such prices.
    (6) Capacity, integrity, and security of automated systems. (i) The 
alternative trading system shall comply with the requirements in 
paragraph (b)(6)(ii) of this section, if during at least 4 of the 
preceding 6 calendar months, such alternative trading system had:
    (A) With respect to any covered security, 20 percent or more of the 
average daily volume reported by the effective transaction reporting 
plan or disseminated through an automated quotation system as described 
in Section 3(a)(51)(A)(ii) of the Act, (15 U.S.C. 78c(a)(51)(A)(ii));
    (B) With respect to equity securities that are not covered 
securities and for which transactions are reported to a self-regulatory 
organization, 20 percent or more of the average daily volume as 
calculated by the self-regulatory organization to which such 
transactions are reported;
    (C) With respect to municipal securities, 20 percent or more of the 
average daily volume traded in the United States;
    (D) With respect to investment grade corporate debt, 20 percent or 
more of the average daily volume traded in the United States;
    (E) With respect to non-investment grade corporate debt, 20 percent 
or more of the average daily volume traded in the United States.
    (ii) With respect to those systems that support order entry, order 
routing, order execution, transaction reporting, and trade comparison, 
the alternative trading system shall:
    (A) Establish reasonable current and future capacity estimates;
    (B) Conduct periodic capacity stress tests of critical systems to 
determine such system's ability to process transactions in an accurate, 
timely, and efficient manner;
    (C) Develop and implement reasonable procedures to review and keep 
current its system development and testing methodology;
    (D) Review the vulnerability of its systems and data center 
computer operations to internal and external threats, physical hazards, 
and natural disasters;
    (E) Establish adequate contingency and disaster recovery plans;
    (F) On an annual basis, perform an independent review, in 
accordance with established audit procedures and standards, of such 
alternative trading system's controls for ensuring that paragraphs 
(b)(6)(ii)(A) through (E) of this section are met, and conduct a review 
by senior management of a report containing the recommendations and 
conclusions of the independent review; and
    (G) Promptly notify the Commission staff of material systems 
outages and significant systems changes.
    (iii) Notwithstanding paragraph (b)(6)(i) of this section, an 
alternative trading system shall not be required to comply with the 
requirements in paragraph (b)(6)(ii) of this section, if such 
alternative trading system:
    (A) Matches customer orders for a security with other customer 
orders;
    (B) Such customers' orders are not displayed to any person, other 
than employees of the alternative trading system; and
    (C) Such orders are executed at a price for such security 
disseminated by an effective transaction reporting plan or through an 
automated quotation system as described in section 3(a)(51)(A)(ii) of 
the Act, (15 U.S.C. 78c(a)(51)(A)(ii)), or derived from such prices.
    (7) Examinations, inspections, and investigations. The alternative 
trading system shall permit the examination and inspection of its 
premises, systems, and records, and cooperate with the examination, 
inspection, or investigation of subscribers, whether such examination 
is being conducted by the Commission or by a self-regulatory 
organization of which such subscriber is a member.
    (8) Recordkeeping. The alternative trading system shall:
    (i) Make and keep current the records specified in Sec. 242.302; 
and
    (ii) Preserve the records specified in Sec. 242.303.
    (9) Reporting. The alternative trading system shall:
    (i) File the information required by Form ATS-R (Sec. 249.638 of 
this chapter) within 30 calendar days after the end of each calendar 
quarter in which the market has operated after the effective date of 
this section; and
    (ii) File the information required by Form ATS-R within 10 calendar 
days after an alternative trading system ceases to operate.
    (10) Procedures to ensure the confidential treatment of trading 
information.
    (i) The alternative trading system shall establish adequate 
safeguards and procedures to protect subscribers' confidential trading 
information. Such safeguards and procedures shall include:
    (A) Limiting access to the confidential trading information of 
subscribers to those employees of the alternative trading system who 
are operating the system or responsible for its compliance with these 
or any other applicable rules;
    (B) Implementing standards controlling employees of the alternative 
trading system trading for their own accounts; and
    (ii) The alternative trading system shall adopt and implement 
adequate oversight procedures to ensure that the safeguards and 
procedures established pursuant to paragraph (b)(10)(i) of this section 
are followed.
    (11) Name. The alternative trading system shall not use in its name 
the word ``exchange,'' or derivations of the word ``exchange,'' such as 
the term ``stock market.''


Sec. 242.302  Recordkeeping requirements for alternative trading 
systems.

    To comply with the condition set forth in paragraph (b)(8) of 
Sec. 242.301, an alternative trading system shall make and keep current 
the following records:
    (a) A record of subscribers to such alternative trading system 
(identifying any affiliations between the alternative trading system 
and subscribers to the alternative trading system, including common 
directors, officers, or owners);
    (b) Daily summaries of trading in the alternative trading system 
including:
    (1) Securities for which transactions have been executed;
    (2) Transaction volume, expressed with respect to equity securities 
in:
    (i) Number of trades;
    (ii) Number of shares traded; and
    (iii) Total settlement value in terms of U.S. dollars; and
    (3) Transaction volume, expressed with respect to debt securities 
in:
    (i) Number of trades; and
    (ii) Total U.S. dollar value; and
    (c) Time-sequenced records of order information in the alternative 
trading system, including:
    (1) Date and time (expressed in terms of hours, minutes, and 
seconds) that the order was received;
    (2) Identity of the security;
    (3) The number of shares, or principal amount of bonds, to which 
the order applies;
    (4) An identification of the order as related to a program trade or 
an index arbitrage trade as defined in New York Stock Exchange Rule 
80A;
    (5) The designation of the order as a buy or sell order;
    (6) The designation of the order as a short sale order;
    (7) The designation of the order as a market order, limit order, 
stop order, stop limit order, or other type or order;
    (8) Any limit or stop price prescribed by the order;
    (9) The date on which the order expires and, if the time in force 
is less than one day, the time when the order expires;
    (10) The time limit during which the order is in force;

[[Page 70925]]

    (11) Any instructions to modify or cancel the order;
    (12) The type of account, i.e., retail, wholesale, employee, 
proprietary, or any other type of account designated by the alternative 
trading system, for which the order is submitted;
    (13) Date and time (expressed in terms of hours, minutes, and 
seconds) that the order was executed;
    (14) Price at which the order was executed;
    (15) Size of the order executed (expressed in number of shares or 
units or principal amount); and
    (16) Identity of the parties to the transaction.


Sec. 242.303  Record preservation requirements for alternative trading 
systems.

    (a) To comply with the condition set forth in paragraph (b)(9) of 
Sec. 242.301, an alternative trading system shall preserve the 
following records:
    (1) For a period of not less than three years, the first two years 
in an easily accessible place, an alternative trading system shall 
preserve:
    (i) All records required to be made pursuant to Sec. 242.302;
    (ii) All notices provided by such alternative trading system to 
subscribers generally, whether written or communicated through 
automated means, including, but not limited to, notices addressing 
hours of system operations, system malfunctions, changes to system 
procedures, maintenance of hardware and software, instructions 
pertaining to access to the market and denials of, or limitations on, 
access to the alternative trading system;
    (iii) If subject to paragraph (b)(5)(ii) of Sec. 242.301, at least 
one copy of such alternative trading system's standards for access to 
trading, all documents relevant to the alternative trading systems 
decision to grant, deny, or limit access to any person, and all other 
documents made or received by the alternative trading system in the 
course of complying with paragraph (b)(5) of Sec. 242.301; and
    (iv) At least one copy of all documents made or received by the 
alternative trading system in the course of complying with paragraph 
(b)(6) of Sec. 242.301, including all correspondence, memoranda, 
papers, books, notices, accounts, reports, test scripts, test results, 
and other similar records.
    (2) During the life of the enterprise and of any successor 
enterprise, an alternative trading system shall preserve:
    (i) All partnership articles or, in the case of a corporation, all 
articles of incorporation or charter, minute books and stock 
certificate books; and
    (ii) Copies of reports filed pursuant to paragraph (b)(2) of 
Sec. 242.301 of this chapter and records made pursuant to paragraph 
(b)(5) of Sec. 242.301 of this chapter.
    (b) The records required to be maintained and preserved pursuant to 
paragraph (a) of this section must be produced, reproduced, and 
maintained in paper form or in any of the forms permitted under 
Sec. 240.17a-4(f) of this chapter.
    (c) Alternative trading systems must comply with any other 
applicable recordkeeping or reporting requirement in the Act, and the 
rules and regulations thereunder. If the information in a record 
required to be made pursuant to this section is preserved in a record 
made pursuant to Sec. 240.17a-3 or Sec. 240.17a-4 of this chapter, or 
otherwise preserved by the alternative trading system (whether in 
summary or some other form), this section shall not require the sponsor 
to maintain such information in a separate file, provided that the 
sponsor can promptly sort and retrieve the information as if it had 
been kept in a separate file as a record made pursuant to this section, 
and preserves the information in accordance with the time periods 
specified in paragraph (a) of this section.
    (d) The records required to be maintained and preserved pursuant to 
this section may be prepared or maintained by a service bureau, 
depository, or other recordkeeping service on behalf of the alternative 
trading system. An agreement with a service bureau, depository, or 
other recordkeeping service shall not relieve the alternative trading 
system from the responsibility to prepare and maintain records as 
specified in this section. The service bureau, depository, or other 
recordkeeping service shall file with the Commission a written 
undertaking in a form acceptable to the Commission, signed by a duly 
authorized person, to the effect that such records are the property of 
the alternative trading system required to be maintained and preserved 
and will be surrendered promptly on request of the alternative trading 
system, and shall include the following provision: With respect to any 
books and records maintained or preserved on behalf of (name of 
alternative trading system), the undersigned hereby undertakes to 
permit examination of such books and records at any time, or from time 
to time, during business hours by representatives or designees of the 
Securities and Exchange Commission, and to promptly furnish to the 
Commission or its designee a true, correct, complete and current hard 
copy of any, all, or any part of, such books and records.
    (e) Every alternative trading system shall furnish to any 
representative of the Commission promptly upon request, legible, true, 
and complete copies of those records that are required to be preserved 
under this section.

PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934

    17. The authority citation for part 249 continues to read in part 
as follows:

    Authority: 15 U.S.C. 78a, et seq., unless otherwise noted;
* * * * * *
    18. Section 249.1 and Form 1 are revised to read as follows:


Sec. 249.1  Form 1, for application for, and amendments to applications 
for, registration as a national securities exchange or exemption from 
registration pursuant to Section 5 of the Exchange Act.

    The form shall be used for application for, and amendments to 
applications for, registration as a national securities exchange or 
exemption from registration pursuant to Section 5 of the Act, (15 
U.S.C. 78e).

    Note: Form 1 does not and the amendments will not appear in the 
Code of Federal Regulations.

OMB APPROVAL
OMB Number: 3235-0017
Expires: 8/31/2001
Estimated Average burden hours per form: 30

Form 1--Application for, and Amendments to Application for, 
Registration as a National Securities Exchange or Exemption From 
Registration Pursuant to Section 5 of the Exchange Act

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Sec. 249.1a and Form 1-A  [Removed]

    19. Section 249.1a and Form 1-A are removed.


Sec. 249.636 and Form 17A-23  [Removed and reserved]

    20. Section 249.636 and Form 17A-23 are removed and reserved.
    21. Section 249.637 and Form ATS are added to read as follows:


Sec. 249.637  Form ATS, information required of alternative trading 
systems pursuant to Sec. 242.301(b)(2) of this chapter.

    This form shall be used by every alternative trading system to file 
required notices, reports and amendments under Sec. 242.301(b)(2) of 
this chapter.

    Note: Form ATS does not and the amendments will not appear in 
the Code of Federal Regulations.
OMB APPROVAL
OMB Number: 3235-0509
Expires: 8/31/2001
Estimated Average burden hours per form: 8

Form ATS--Intial Operation Report, Amendment to Initial Operation 
Report and Cessation of Operations Report of Alternative Trading 
System Activities

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BILLING CODE 8010-01-C

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    22. Section 249.638 and Form ATS-R are added to read as follows:


Sec. 249.638  Form ATS-R, information required of alternative trading 
systems pursuant to Sec. 242.301(b)(8) of this chapter.

    This form shall be used by every alternative trading system to file 
required reports under Sec. 242.301(b)(8) of this chapter.

    Note: Form ATS-R does not and the amendments will not appear in 
the Code of Federal Regulations.
OMB APPROVAL
OMB Number: 3235-0509
Expires: 8/31/2001
Estimated Average burden hours per form: 3.5

Form ATS-R--Quarterly Report of Alternative Trading System 
Activities

BILLING CODE 8010-01-M

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    23. Section 249.821 and Form PILOT are added to read as follows:


Sec. 249.821  Form PILOT, information required of self-regulatory 
organizations operating pilot trading systems pursuant to Sec. 240.19b-
5 of this chapter.

    This form shall be used by all self-regulatory organizations, as 
defined in section 3(a)(26) of the Act, (15 U.S.C 78c(a)(26)), to file 
required information and reports with regard to pilot trading systems 
pursuant to Sec. 240.I20240.19b-5 of this chapter.

    Note: Form PILOT does not and the amendments will not appear in 
the Code of Federal Regulations.
OMB APPROVAL
OMB Number: 3235-0507
Expires: 8/31/2001
Estimated Average burden hours per form: 6

Form PILOT--Initial Operation Report, Amendment to Initial 
Operation Report and Quarterly Report for Pilot Trading Systems 
Operated by Self-Regulatory Organizations

BILLING CODE 8010-01-M

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    By the Commission.

    Dated: December 8, 1998.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-33299 Filed 21-21-98; 8:45 am]
BILLING CODE 8010-01-C