Regulation of Exchanges and Alternative Trading Systems
Federal RegisterDec 22, 1998
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 202, 240, 242 and 249
[Release No. 34-40760; File No. S7-12-98]
RIN 3235-AH41
Regulation of Exchanges and Alternative Trading Systems
AGENCY: Securities and Exchange Commission.
ACTION: Final rules.
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SUMMARY: The Securities and Exchange Commission today is adopting new
rules and rule amendments to allow alternative trading systems to
choose whether to register as national securities exchanges, or to
register as broker-dealers and comply with additional requirements
under Regulation ATS, depending on their activities and trading volume.
The Commission is also adopting amendments to rules regarding
registration as a national securities exchange, repealing Rule 17a-23,
and amending the books and records rules by transferring the
recordkeeping requirements from Rule 17a-23 to Rules 17a-3 and 17a-4 as
they apply to broker-dealer internal trading systems. Finally, the
Commission is excluding from the rule filing requirements for self-
regulatory organizations certain pilot trading systems operated by
national securities exchanges and national securities associations.
These rules will more effectively integrate the growing number of
alternative trading systems into the national market system,
accommodate the registration of proprietary alternative trading systems
as exchanges, and provide an opportunity for registered exchanges to
better compete with alternative trading systems.
DATES: Effective Date: April 21, 1999, except Secs. 242.301(b)(5)(i)(D)
and (E) and Secs. 242.301(b)(6)(i) (D) and (E), which shall become
effective on April 1, 2000.
Compliance Date: Prior to April 21, 1999, the Commission will
publish a schedule of those securities with respect to which
alternative trading systems must comply with Sec. 242.301(b)(3) on
April 21, 1999 and those securities with respect to which alternative
trading systems must comply with Sec. 242.301(b)(3) on August 30, 1999.
See Section VIII of this release.
FOR FURTHER INFORMATION CONTACT: Elizabeth King, Senior Special
Counsel, at (202) 942-0140, Marianne Duffy, Special Counsel, at (202)
942-4163, Constance Kiggins, Special Counsel, at (202) 942-0059, Kevin
Ehrlich, Attorney, at (202) 942-0778, Denise Landers, Attorney, at
(202) 942-0137 and John Roeser, Attorney, at (202) 942-0762, Division
of Market Regulation, Securities and Exchange Commission, Stop 10-1,
450 Fifth Street, NW, Washington, DC 20549. For questions or comments
regarding securities registration issues raised in this release,
contact David Sirignano, Associate Director, at (202) 942-2870,
Division of Corporation Finance, Securities and Exchange Commission,
Stop 3-1, 450 Fifth Street, NW, Washington, DC 20549.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
II. Executive Summary of Final Rules
A. New Interpretation of ``Exchange''
B. Exemption for Regulated Alternative Trading Systems
C. Regulation ATS
D. For-Profit Exchanges
E. Temporary Exemption from Rule Filing Requirements for SROs'
Pilot Trading Systems
III. Rule 3b-16 under the Exchange Act
A. Brings Together the Orders of Multiple Buyers and Sellers
1. To Bring Together
2. Multiple Buyers and Sellers
3. Definition of ``Order''
B. Established, Non-Discretionary Methods
1. Established, Non-Discretionary Methods Provided by a Trading
Facility
2. Established, Non-Discretionary Methods Provided by Setting
Rules
C. Systems Excluded From Rule 3b-16
1. Order Routing Systems
2. Dealer Systems
D. Examples of Systems Illustrating Application of Rule 3b-16
1. Examples of Systems Included Within Rule 3b-16
2. Examples of Systems Not included Within Rule 3b-16
E. Exemption from the Definition of ``Exchange''
F. Commission's Authority to Require Registration as an Exchange
IV. Regulation of Alternative Trading Systems
A. Regulation ATS
1. Scope of Regulation ATS
a. Definition of Alternative Trading System
b. Exclusion of Trading Systems Registered as Exchanges or
Operated by a National Securities Association
c. Exclusion of Alternative Trading Systems Trading Solely
Government and Related Securities
(i) Discussion
(ii) Response to Commenters
d. Alternative Trading Systems Trading Non-Government Debt
Securities
(i) Discussion
(ii) Response to Commenters
e. Exemptions from Certain Requirements of Regulation ATS
Pursuant to Application to the Commission
2. Requirements for Alternative Trading Systems Subject to
Regulation ATS
a. Membership in an SRO
b. Notice of Operation as an Alternative Trading System and
Amendments
c. Market Transparency
(i) Importance of Market Transparency
(ii) Integration of Orders into the Public Quotation System
(A) New Requirements for Alternative Trading Systems
(B) Response to Comments
(iii) Access to Publicly Displayed Orders
(A) Application of Access Requirements under Regulation ATS
(B) Response to Comments
(iv) Execution Access Fees
(A) Limitations on Alternative Trading System Fees Charged to
Non-Subscribers
(B) Response to Comments
(v) Amendment to Rule 11Ac1-1 under the Exchange Act
d. Fair Access
(i) Importance of Fair Access
(ii) Fair Access Requirement
(iii) Response to Comments
e. Capacity, Integrity, and Security Standards
(i) Application of Capacity, Integrity, and Security Standards
(ii) Response to Comments
f. Examination, Inspection, and Investigations of Subscribers
g. Recordkeeping
h. Reporting and Form ATS-R
i. Procedures to Ensure Confidential Treatment of Trading
Information
B. Registration as a National Securities Exchange
1. Self-Regulatory Responsibilities
2. Fair Representation
(i) Public Directors
(ii) Fair Representation of Exchange Members
3. Membership on a National Securities Exchange
4. Fair Access
5. Compliance with ARP Guidelines
6. Registration of Securities
7. National Market System Participation
8. Uniform Trading Standards
9. Proposed Rule Changes
C. Application for Registration as an Exchange
1. Revisions to and Repeal of Form 1-A
2. Amendments to Rules 6a-1, 6a-2, and 6a-3 under the Exchange
Act
a. Rule 6a-1 Application for Registration as an Exchange or
Exemption Based on Limited Volume of Transactions
b. Rule 6a-2 Periodic Amendments
c. Rule 6a-3 Supplemental Material
D. National Securities Exchanges Operating Alternative Trading
Systems
V. Broker-Dealer Recordkeeping and Reporting Obligations
A. Elimination of Rule 17a-23
B. Amendments to Rules 17a-3 and 17a-4
VI. Temporary Exemption of Pilot Trading System Rule Filings
A. Introduction
B. Rule 19b-5
1. Types of Systems Eligible for Exemption Under Rule 19b-5
a. Definition of Pilot Trading System
b. Response to Comments on the Proposed Definition of Pilot
Trading System
c. Adopted Definition of Pilot Trading System
[[Page 70845]]
2. Scope of Pilot Trading Rule Exemption
3. SRO's Continuing Obligations Regarding Pilot Trading Systems
a. Notice and Filings to the Commission
b. Fair Access
c. Trading Rules and Procedures
d. Surveillance
e. Clearance and Settlement
f. Types of Securities
g. Activities of Specialists
h. Inspections and Examinations
i. Public Availability of Pilot Trading System Rules
C. Rule Filing Under Section 19(b)(2) of the Exchange Act
Required Within Two Years
VII. The Commission's Interpretation of the ``Exchange'' Definition
A. The Commission's Interpretation in Delta
B. The Growing Significance of Alternative Trading Systems in
the National Market System
C. The Revised Interpretation of ``Exchange''
D. Other Practical Reasons for Revising the Current
Interpretation
1. Additional Flexibility Provided by the National Securities
Markets Improvement Act of 1996
2. No-action Approach to Alternative Trading Systems is No
Longer Workable
3. More Rational Treatment of Regulated Entities
VIII. Effective Dates and Compliance Dates
IX. Costs and Benefits of the Rules and Amendments
A. Costs and Benefits of the Rules and Amendments Regarding
Alternative Trading Systems
1. Benefits
a. Improved Market Transparency
b. Improved Investor Protections
c. Fair Access
d. Systems Capacity, Integrity, and Security
2. Costs
a. Notice, Reporting, and Recordkeeping
b. Public Display of Orders and Equal Execution Access
c. Fair Access
d. Systems Capacity, Integrity, and Security
e. Costs of Exchange Registration
B. Amendments to Application and Related Rules for Registration
as an Exchange
1. Benefits
2. Costs
C. Costs and Benefits of the Repeal of Rule 17a-23 and the
Amendments to Rules 17a-3 and 17a-4
D. SRO Pilot Trading System
X. Effects on Competition, Efficiency and Capital Formation
XI. Summary of Final Regulatory Flexibility Analysis
XII. Paperwork Reduction Act
A. Form 1, Rules 6a-1 and 6a-2
B. Rule 6a-3
C. Rule 17a-3(a)(16)
D. Rule 17a-4(b)(10)
E. Rule 19b-5 and Form PILOT
F. Rule 301, Form ATS and Form ATS-R
1. Notice, Reporting, and Recordkeeping
2. Fair Access
3. Systems Capacity, Integrity, and Security
G. Rule 302
H. Rule 303
XIII. Statutory Authority
I. Introduction
Today the Securities and Exchange Commission (''Commission'' or
``SEC'') is adopting a regulatory framework for alternative trading
systems,\1\ to strengthen the public markets for securities, while
encouraging innovative new markets. During the past three years, the
Commission has undertaken a reevaluation of its regulatory framework
for markets because of substantial changes in the way securities are
traded. Market participants have incorporated technology into their
businesses to provide investors with an increasing array of services,
and to furnish these services more efficiently, and often at lower
prices. The current regulatory framework, however, designed more than
six decades ago, did not envision many of these trading and business
functions. In particular, market participants have developed a variety
of alternative trading systems that furnish services traditionally
provided solely by registered exchanges.
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\1\ The term ``alternative trading system'' is defined in Rule
300(a), 17 CFR 242.300(a). This term encompasses some systems that
previous Commission releases called proprietary trading systems,
broker-dealer trading systems, and electronic communication
networks.
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To better understand the questions raised by technological
developments in the U.S. markets, in May 1997, the Commission published
a concept release exploring ways to respond to the rapid technological
developments affecting securities markets and, in particular, the
growing significance of alternative trading systems (``Concept
Release'').\2\ After taking into consideration the comments submitted
in response to the Concept Release, in April 1998, the Commission
proposed a new regulatory framework for alternative trading systems
(``Proposing Release'').\3\
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\2\ Securities Exchange Act Release No. 38672 (May 23, 1997), 62
FR 30485 (June 4, 1997). The comment letters to the Concept Release
and a summary of these comments have been placed in Public File S7-
16-97, which is available for inspection in the Commission's Public
Reference Room.
\3\ Securities Exchange Act Release No. 39884 (Apr. 17, 1998),
63 FR 23504 (Apr. 29, 1998). The comment letters to the Proposing
Release and a summary of those comments received as of August 25,
1998 have been placed in Public File S7-12-98, which is available
for inspection in the Commission's Public Reference Room.
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Alternative trading systems now handle more than twenty percent of
the orders in securities listed on The Nasdaq Stock Market
(``Nasdaq''), and almost four percent of orders in exchange listed
securities. These systems operate markets similar to the registered
exchanges and Nasdaq. Over time, an alternative trading system may
become the primary market for some securities. Yet these markets are
private, available only to chosen subscribers, and are regulated as
broker-dealers, not in the way registered exchanges and Nasdaq are
regulated. This creates disparities that affect investor protection and
the operation of the markets as a whole.
Our national market system, as it has evolved since 1975, has
sought the benefits of both market centralization--deep, liquid
markets--and competition. To achieve these benefits, the national
market system has maintained equally regulated, individual markets,
which are linked together to make their best prices publicly known and
accessible. Alternative trading systems have remained largely outside
the national market system. For example, the evidence in the
Commission's report on the National Association of Securities Dealers,
Inc. (``NASD'') and Nasdaq suggested that widespread use of Instinet by
market makers as a private market had a significant impact on public
investors and the operation of the Nasdaq market.\4\ Through Instinet,
market makers were able to quote prices better than those made
available to public investors. This private market developed only
because the activity on alternative trading systems is not fully
disclosed, or accessible, to public investors. Moreover, these trading
systems have no obligation to provide investors a fair opportunity to
participate in their systems or to treat their participants fairly.
These systems may also not be adequately surveilled for market
manipulation and fraud. In fact, market participants can manipulate the
prices in the public securities markets through the use of alternative
trading systems.\5\ In addition, alternative trading systems have no
obligation to ensure that their systems are sufficient to handle rapid
increases in trading volume as occurs in times of market volatility,
and at times they have failed to do so. Because of the increasingly
important role of alternative trading systems, these differences are
inconsistent with the national market system goals set forth
[[Page 70846]]
by Congress in the 1975 amendments to the Securities Exchange Act of
1934 (``1975 Amendments'') \6\ and call into question the fairness of
current regulatory requirements.
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\4\ See SEC, Report Pursuant to Section 21(a) of the Securities
Exchange Act of 1934 Regarding the NASD and the Nasdaq Market (1996)
(``NASD 21(a) Report'').
\5\ See In the Matter of Ian and Lawrence Fishman, Securities
Exchange Act Release No. 40115 (June 24, 1998) (finding that the
Fishman brothers manipulated the national best bid and offer in
violation of Section 10(b) and Rule 10b-5 under the Exchange Act by
coordinating the entry of orders routed to alternative trading
systems).
\6\ Pub. L. 29, 89 Stat. 97 (1975). Congress granted to the
Commission authority in 1975 to adopt rules that promote (1)
economically efficient execution of securities transactions, (2)
fair competition, (3) transparency, (4) investor access to the best
markets, and (5) the opportunity for investors' orders to be
executed without the participation of a dealer. See S. Rep. No. 75,
94th Cong., 1st Sess. 8 (1975); H.R. Rep. No. 229, 94th Cong., 1st
Sess 92 (1975). See also section 11A(a)(1) of the Exchange Act, 15
U.S.C. 78k-1(a)(1).
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In 1996, Congress provided the Commission with greater flexibility
to regulate new trading systems by giving the Commission broad
authority to exempt any person from any of the provisions of the
Securities Exchange Act of 1934 (``Exchange Act'') and impose
appropriate conditions on their operation.\7\ This new exemptive
authority, combined with the ability to facilitate a national market
system, provides the Commission with the tools it needs to adopt a
regulatory framework that addresses its concerns about alternative
trading systems without jeopardizing the commercial viability of these
markets. In the Proposing Release, the Commission proposed ways to use
these tools to adopt new rules and rule amendments designed to resolve
many of the concerns raised by alternative trading systems, better
integrate these systems into our national market system structure, and
make the benefits of these systems available to more investors.
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\7\ Section 36 of the Exchange Act, 15 U.S.C. 78mm, was enacted
as part of the National Securities Markets Improvement Act of 1996,
Pub. L. 104-290 (``NSMIA''). See infra Section VII.D.1.
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In response to its Proposing Release,\8\ the Commission received
seventy comment letters.\9\ Commenters generally supported the
Commission's proposals and welcomed the regulatory flexibility these
proposals offered.\10\ Many commenters agreed with the Commission that
the regulatory structure needs to be modernized to better integrate
alternative trading systems into the national market system.\11\ For
example, several commenters expressed the view that, on balance, the
proposed regulatory framework for alternative trading systems
represented a preferable alternative to the current regulation of these
systems as broker-dealers, which is not only inadequate for many
alternative trading systems, but also results in disparate regulatory
treatment of exchange markets and their alternative trading system
competitors.\12\ Other commenters believed that the Commission's
proposal was a step in the right direction, both from a competitive
business perspective and from an investor protection and fair
regulation perspective. While some commenters thought that the
Commission should continue the present framework for alternative
trading systems,\13\ most believed that the proposal provided a
framework that could maintain a competitive balance among the markets
offering services to investors.\14\ Other commenters were pleased by
the Commission's determination to allow market participants to engage
in business decisions regarding how to register with the
Commission.\15\ Commenters also generally supported the Commission's
proposal to allow for-profit exchanges,\16\ and generally supported the
proposed temporary exemption for pilot trading systems.\17\
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\8\ See supra note 3.
\9\ This is the number of comment letters received by the
Commission as of the close of business on December 1, 1998.
\10\ Some commenters, however, suggested that the better
approach would be for the Commission to retain its present
regulatory framework for alternative trading systems. See, e.g.,
Letter from Robin Roger, Principal and Counsel, Morgan Stanley Dean
Witter to Jonathan G. Katz, Secretary, SEC, dated Sept. 11, 1998
(``MSDW Letter'') at 3-4; Letter from Christopher J. Carroll and W.
Hal Hinkle, Co-Chairs, ATS Task Force, The Bond Market Association
to Jonathan G. Katz, Secretary, SEC, dated July 28, 1998 (``TBMA
Letter'') at 2, 8-12; Letter from Lee B. Spencer, Jr., Chairman, SIA
Federal Regulation Committee and Perry L. Taylor, Jr., Chairman, SIA
Alternative Trading System Subcommittee, Securities Industry
Association to Jonathan G. Katz, Secretary, SEC, dated July 31, 1998
(``SIA Letter'') at 2, 5. Another commenter suggested that the
Commission solicit comment again on the broader issues discussed in
the Concept Release. See Letter from Louis C. Magill, President,
Corporate Capital Securities, Inc. to Jonathan G. Katz, Secretary,
SEC, dated July 27, 1998 (``Corporate Capital Letter'') at 4.
\11\ See, e.g., Letter from Joanne Moffic-Silver, Secretary and
General Counsel, Chicago Board Options Exchange to Jonathan G. Katz,
Secretary, SEC, dated July 28, 1998 (``CBOE Letter'') at 3; Letter
from John C. Katovich, Senior Vice President and General Counsel,
OptiMark Technologies Inc. to Jonathan G. Katz, Secretary, SEC,
dated Aug. 13, 1998 (``OptiMark Letter'') at 1.
\12\ See, e.g., CBOE Letter at 3.
\13\ See, e.g., SIA Letter at 1, 5-6.
\14\ See, e.g., Letter from Joan C. Conley, Corporate Secretary,
National Association of Securities Dealers, Inc. to Jonathan G.
Katz, Secretary, SEC, dated Aug. 10, 1998 (``NASD Letter'') at 1-2.
\15\ See, e.g., Letter from Douglas M. Atkin, Chief Executive
Officer, Instinet International to Jonathan G. Katz, Secretary, SEC,
dated Aug. 3, 1998 (``Instinet Letter'') at 1, 7; Letter from
Frederic W. Rittereiser, President and Chief Executive Officer and
William W. Uchimoto, Executive Vice President and General Counsel,
Ashton Technology Group, Inc. to Jonathan G. Katz, Secretary, SEC,
dated July 28, 1998 (``Ashton Letter'') at 1; Letter from Mary Sue
Fisher, Managing Director, Legal and Compliance, Chicago Board
Brokerage, LLC to Jonathan G. Katz, Secretary, SEC, dated July 29,
1998 (``CBB Letter'') at 1-2.
\16\ See, e.g., TBMA Letter at 4; Letter from Larry E. Fondren,
President, Integrated Bond Exchange, Inc. to Jonathan G. Katz,
Secretary, SEC, dated July 27, 1998 (``IBEX Letter'') at 13.
\17\ See, e.g., Letter from Craig S. Tyle, General Counsel,
Investment Company Institute to Jonathan G. Katz, Secretary, SEC,
dated July 28, 1998 (``7/28/98 ICI Letter'') at 5; Letter from James
E. Buck, Senior Vice President and Secretary, New York Stock
Exchange, Inc. to Jonathan G. Katz, Secretary, SEC, dated July 28,
1998 (``NYSE Letter'') at 9; Letter from Robert H. Forney, President
and Chief Executive Officer, Chicago Stock Exchange to Jonathan G.
Katz, Secretary, SEC, dated July 30, 1998 (``CHX Letter'') at 11;
Letter from T. Eric Kilcollin, President and Chief Executive
Officer, Chicago Mercantile Exchange to Jonathan G. Katz, Secretary,
SEC, dated Aug. 5, 1998 (``CME Letter'') at 4; Letter from James F.
Duffy, Executive Vice President and General Counsel, Legal and
Regulatory Policy, American Stock Exchange, Inc. to Jonathan G.
Katz, Secretary, SEC, dated Aug. 18, 1998 (``Amex Letter'') at 1;
Ashton Letter at 2; CBOE Letter at 3, 8-9. See infra Section VI for
a discussion of the temporary exemption for pilot trading systems.
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The Commission believes that its regulation of markets should both
accommodate traditional market structures and provide sufficient
flexibility to ensure that new markets promote fairness, efficiency,
and transparency. In adopting a new regulatory framework for
alternative trading systems today, the Commission has incorporated
suggestions and responded to requests for clarification made by
commenters. The Commission believes that this regulatory approach
effectively addresses commenters' concerns while carefully tailoring a
regulatory framework that is flexible enough to accommodate the
evolving technology of, and benefits provided by, alternative trading
systems.
While the revised regulatory scheme implemented today is designed
to address changes in the way securities are traded, the Commission's
assessment of the impact that these systems may have on the trading of
unregistered securities (i.e. of both domestic and foreign issuers),
and of the appropriate regulatory posture to these developments, is
still ongoing. This matter and the broader issues involving recent
trends and initiatives that give U.S. investors greater and more
instantaneous access to foreign securities markets create tensions
between competing Commission goals. The Commission, for example, wishes
to foster developments that enable U.S. investors to execute securities
trades more efficiently, but it also desires that foreign securities
traded in U.S. markets have full and fair disclosure. These tensions
and issues will be addressed by the Commission in the future.
II. Executive Summary of Final Rules
The final rules seek to establish a regulatory framework that makes
sense both for current and future securities
[[Page 70847]]
markets. This regulatory framework should encourage market innovation
while ensuring basic investor protections. The Commission continues to
believe that the approach outlined in the Proposing Release will
accomplish these goals. In general, this approach gives securities
markets a choice to register as exchanges, or to register as broker-
dealers and comply with Regulation ATS.\18\ The Commission believes the
framework it is adopting meets the varying needs and structures of
market participants and is flexible enough to accommodate the business
objectives of, and the benefits provided by, alternative trading
systems. The principal components of this new framework are discussed
below.
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\18\ 17 CFR 242.300-303.
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A. New Interpretation of ``Exchange''
A fundamental component of the new regulatory framework is new Rule
3b-16. This rule interprets key language in the statutory definition of
``exchange'' under section 3(a)(1) of the Exchange Act.\19\ Rule 3b-16
reflects a more comprehensive and meaningful interpretation of what an
exchange is in light of today's markets. Until now, the Commission's
interpretation of the exchange definition reflected relatively rigid
regulatory requirements and classifications for ``exchange'' and
``broker-dealers.'' Advancing technology has increasingly blurred these
distinctions, and alternative trading systems today are used by market
participants as functional equivalents of exchanges. Accordingly, the
Commission's new interpretation of exchange contained in Rule 3b-16\20\
encompasses these equivalent markets and the Commission's new general
exemptive authority enables it to craft a new regulatory framework.
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\19\ 15 U.S.C. 78c(a)(1).
\20\ 17 CFR 240.3b-16.
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The statutory definition of ``exchange'' includes a ``market place
or facilities for bringing together purchasers and sellers of
securities or for otherwise performing with respect to securities the
functions commonly performed by a stock exchange.''\21\ In response to
commenters' concerns and suggestions, the Commission has carefully
revised Rule 3b-16 to define these terms to mean any organization,
association, or group of persons that: (1) Brings together the orders
of multiple buyers and sellers; and (2) uses established, non-
discretionary methods (whether by providing a trading facility or by
setting rules) under which such orders interact with each other, and
the buyers and sellers entering such orders agree to the terms of a
trade.\22\
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\21\ 15 U.S.C. 78c(a)(1).
\22\ Rule 3b-16(a), 17 CFR 240.3b-16(a).
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Rule 3b-16 explicitly excludes those systems that the Commission
believes perform only traditional broker-dealer activities. The
Commission modified these exclusions to address issues raised by
commenters. Rule 3b-16 now expressly excludes the following systems
from the revised interpretation of ``exchange'': (1) Systems that
merely route orders to other facilities for execution; (2) systems
operated by a single registered market maker to display its own bids
and offers and the limit orders of its customers, and to execute trades
against such orders; and (3) systems that allow persons to enter orders
for execution against the bids and offers of a single dealer.\23\
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\23\ Rule 3b-16(b), 17 CFR 240.3b-16(b).
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B. Exemption for Regulated Alternative Trading Systems
The framework the Commission adopts today uses the Commission's new
exemptive authority to allow most alternative trading systems to choose
to be regulated either as exchanges or as broker-dealers. Rule 3a1-1
exempts most alternative trading systems from the definition of
``exchange,'' and therefore the requirement to register as an exchange,
if they comply with Regulation ATS. However, any system exercising
self-regulatory powers, such as regulating its members' or subscribers'
conduct when engaged in activities outside of that trading system, must
register as an exchange or be operated by a national securities
association. This is because self-regulatory activities in the
securities markets must be subject to Commission oversight under
Section 19 of the Exchange Act.\24\ Thus any system exercising self-
regulatory powers will not be permitted the option of registering as a
broker-dealer.
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\24\ 15 U.S.C. 78s.
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In addition, the Commission can determine that a dominant
alternative trading system should be registered as an exchange. An
alternative trading system would first have to exceed certain volume
levels and the Commission, after notice and an opportunity for the
alternative trading system to respond, would have to determine that an
exemption from exchange regulation is not necessary or appropriate in
the public interest or consistent with the protection of investors,
taking into account the requirements of exchange registration and the
objectives of the national market system.\25\ At this time, however,
the Commission does not believe that it is necessary or appropriate
under this provision that any alternative trading system register as an
exchange.
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\25\ Rule 3a1-1(b)(1), 17 CFR 240.3a1-1(b)(1).
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C. Regulation ATS
The Commission is adopting new Regulation ATS, substantially in the
form proposed, to impose essential elements of market-oriented
regulation on alternative trading systems. This new regulation
addresses the concerns raised by the market activities of alternative
trading systems that choose to register as broker-dealers. To allow new
markets to start, without disproportionate burdens, a system with less
than five percent of the trading volume in all securities it trades is
required only to: (1) File with the Commission a notice of operation
and quarterly reports; (2) maintain records, including an audit trail
of transactions; and (3) refrain from using the words ``exchange,''
``stock market,'' or similar terms in its name.
If, however, an alternative trading system with five percent or
more of the trading volume in any national market system security
chooses to register as a broker-dealer--instead of as an exchange--the
Commission believes it is in the public interest to integrate its
activities into the national market system. In addition to the
requirements for smaller alternative trading systems, Regulation ATS
requires alternative trading systems that trade five percent or more of
the volume in national market system securities to be linked with a
registered market in order to disseminate the best priced orders in
those national market system securities displayed in their systems
(including institutional orders) into the public quote stream.\26\ Such
alternative trading systems must also comply with the same market rules
governing execution priorities and obligations that apply to members of
the registered exchange or national securities association to which the
alternative trading system is linked.\27\
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\26\ Rule 301(b)(3), 17 CFR 240.301(b)(3). Alternative trading
systems will only have to comply with this rule for fifty percent of
securities on April 21, 1999. By August 30, 1999, alternative
trading systems will have to comply with this rule for all
securities. Prior to April 21, 1999, the Commission will publish a
schedule of those individual securities for which alternative
trading systems must comply with Rule 301(b)(3) on April 21, 1999.
See infra notes 192-193-and 216-217-and accompanying text.
\27\ This linkage requirement would not apply to alternative
trading systems that do not display participant orders to anyone,
including other system participants. In addition, this requirement
would not apply to alternative trading systems to the extent that
they trade securities other than national market system securities.
See infra Section IV.A.2.c.(ii).
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[[Page 70848]]
In addition, alternative trading systems with twenty percent or
more of the trading volume in any single security, whether equity or
debt, would be required to: (1) Grant or deny access based on objective
standards established by the trading system and applied in a non-
discriminatory manner; and (2) establish procedures to ensure adequate
systems capacity, integrity, and contingency planning. The Commission
believes that these requirements will better integrate those
significant alternative trading systems into national market system
mechanisms. Moreover, because alternative trading systems that choose
to register as broker-dealers are not required to surveil activities on
their markets, the Commission intends to work with the self-regulatory
organizations (``SROs'') to ensure that they can operate ongoing, real-
time surveillance for market manipulation and fraud and develop
surveillance and examination procedures specifically targeted to
alternative trading systems they oversee.
D. For-Profit Exchanges
In this release, the Commission also expresses its view that
registered exchanges may structure themselves as for-profit
organizations. This will allow alternative trading systems, which are
typically proprietary, to choose to register as exchanges without
changing their organizational structure. In addition, currently
registered exchanges--which are all membership organizations--could
choose to demutualize. This release provides guidance on ways for
proprietary markets to meet their fair representation requirements as
non-membership national securities exchanges.\28\
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\28\ See infra Section IV.B.2.
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E. Temporary Exemption From Rule Filing Requirements for SROs' Pilot
Trading Systems
To help reduce competitive impediments to innovation by SROs, the
Commission is allowing them to start new trading systems without
preapproval by the Commission. The Commission is adopting Rule 19b-5 to
permit SROs, without filing for approval with the Commission, to
operate new pilot trading systems for up to two years. These pilot
trading systems will be subject to specific conditions, including
limitations on their trading volumes.\29\
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\29\ See infra Section VI. The purpose of this new rule is to
provide registered exchanges and national securities associations
with a greater opportunity to compete with alternative trading
systems registered as broker-dealers and with foreign markets.
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III. Rule 3b-16 Under the Exchange Act
The Commission today is adopting new Rule 3b-16 under the Exchange
Act. This rule defines terms used in the statutory definition of
``exchange,'' found in section 3(a)(1) of the Exchange Act.\30\ The
statutory definition of ``exchange'' includes a ``market place or
facilities for bringing together purchasers and sellers of securities
or for otherwise performing with respect to securities the functions
commonly performed by a stock exchange.'' The new rule interprets these
terms to include any organization, association, or group of persons
that: (1) Brings together the orders of multiple buyers and sellers;
and (2) uses established, non-discretionary methods (whether by
providing a trading facility or by setting rules) under which such
orders interact with each other, and the buyers and sellers entering
such orders agree to the terms of a trade.\31\ This rule revises the
current interpretation of the term ``exchange,'' as set forth in the
Delta Release.\32\
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\30\ 15 U.S.C. 78c(a)(1).
\31\ Rule 3b-16(a), 17 CFR 240.3b-16(a). In the Proposing
Release, the Commission proposed to define the terms in the
definition of ``exchange'' to be ``any organization, association, or
group of persons that: (1) Consolidates orders of multiple parties;
and (2) sets non-discretionary material conditions (whether by
providing a trading facility or by setting rules) under which
parties entering such orders agree to the terms of a trade.'' See
Proposing Release, supra note 3.
\32\ See Securities Exchange Act Release No. 27611 (Jan. 12,
1990), 55 FR 1980, 1900 (Jan. 19, 1990) (``Delta Release''). See
infra Section VII for a further discussion of the Delta Release and
the basis and purpose of the revised interpretation.
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New Rule 3b-16 is an important element of the Commission's new
regulatory framework for alternative trading systems. As discussed
above, the rapid growth and technological advancements of alternative
trading systems have eroded the distinctions between the roles played
by alternative trading systems and by traditional exchanges.
Alternative trading systems today provide services more akin to
exchange functions than broker-dealer functions, such as matching
counterparties' orders, executing trades, operating limit order books,
and facilitating active price discovery. For many of these systems,
regulation as a market more appropriately fits their economic
functions. Rule 3b-16 defines terms in the statutory definition of
exchange to include markets that engage in activities functionally
equivalent to markets currently registered as national securities
exchanges. Moreover, because in some cases exchange regulation may
better meet these systems' business objectives, the Commission believes
that alternative trading systems should have the option to register as
national securities exchanges.\33\ The rule helps modernize the
Commission's approach to these systems because it adapts the concept of
what is ``generally understood'' to be an exchange to reflect changes
in the markets brought about by automated trading. In addition, in
light of recent technological developments, Rule 3b-16 more closely
reflects the statutory concept of ``bringing together'' buying and
selling interests.
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\33\ See infra Section IV.B. (discussing registration as a
national securities exchange). Under Section 5 of the Exchange Act,
an exemption may be granted to an exchange from registration as a
national securities exchange on the basis of low volume, or expected
low volume. Currently, there is only one exchange, the Arizona Stock
Exchange (``AZX''), that is operating under a limited volume
exemption. See Securities Exchange Act Release No. 28899 (Feb. 20,
1991), 56 FR 8377 (Feb. 28, 1991). In addition, the Commission
solicited comment on whether Tradepoint Financial Networks, plc
should be granted a limited volume exemption. See Securities
Exchange Act Release No. 40161 (July 2, 1998), 45 FR 41920 (July 9,
1998).
The Commission believes that the low volume exemption continues
to be appropriate for some exchanges, such as an exchange that, for
example, disciplines its members (other than by excluding them or
limiting them from trading based on objective criteria, such as
creditworthiness), or has other self-regulatory attributes that
exclude it from the definition of alternative trading system, Rule
300(a), and therefore preclude it from making the choice to register
as a broker-dealer. Any exchange seeking a low volume exemption
would, of course, have to have low volume. The Commission believes
that the low volume exemption would be inappropriate for any
alternative trading system that can register as a broker-dealer and
comply with Regulation ATS, and that the conditions under Regulation
ATS should generally be met by any alternative trading system
falling within Rule 3b-16, including an alternative trading system
that, for other reasons, seeks a low volume exemption.
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The Proposing Release sought comment on whether the proposed
definition captures the fundamental features of an exchange as that
term is generally understood today. The Commission received several
comments supportive of its proposed revision to the interpretation of
``exchange.'' For example, the NASD commented that this new definition
``is not inappropriate, particularly with the express exclusion for
internal broker-dealer systems.'' \34\ Other commenters also supported
broadening the Commission's interpretation of what constitutes an
exchange and agreed that the proposed rule accurately identified the
fundamental features of a securities ``exchange.'' \35\ On the other
hand, some commenters questioned the basis and need for the Commission
to move away from its interpretation in Delta. The
[[Page 70849]]
Commission responds to these comments below in Section VII.
---------------------------------------------------------------------------
\34\ NASD Letter at 3, n.4.
\35\ See CME Letter at 2; IBEX Letter at 4.
---------------------------------------------------------------------------
Finally, one commenter expressed concern that the proposed revision
to the Commission's interpretation of ``exchange'' would encompass
every market participant providing electronic or other technologically
advanced trading service.\36\ The Commission does not intend for the
distinction between exchanges and broker-dealers to turn on automation,
and does not believe that its revised interpretation of ``exchange''
has this effect. In particular, the Commission notes that paragraph (a)
of new Rule 3b-16 does not contain the word automation, but is instead
descriptive of those activities the Commission considers to be the
activities of a ``market'' where buyers and sellers meet and includes
purely floor-based exchanges, as well as fully automated ones.
Moreover, paragraph (b) clearly excludes certain systems that--even
though automated--are not exchanges, such as automated single dealer
systems.
---------------------------------------------------------------------------
\36\ Instinet Letter at 7.
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The language of Rule 3b-16 the Commission is adopting today
modifies the language the Commission proposed in response to
commenters' suggestions and concerns, and their requests for
clarification. The discussion below is intended to further explain how
the Commission envisions that its new interpretation of ``exchange''
will be applied and responds to specific requests for clarification by
commenters.
A. Brings Together the Orders of Multiple Buyers and Sellers
In order to be covered by the definition in Rule 3b-16, a system
must satisfy the first part of Rule 3b-16(a)--brings together the
orders of multiple buyers and sellers. This emphasizes the concept of
``bringing together purchasers and sellers of securities'' set forth in
the definition of ``exchange'' in section 3(a)(1) of the Exchange Act.
While the intent is the same, the language in Rule 3b-16(a)(1) has been
modified from the proposal to address the concerns of some of the
commenters who requested that the definition be clarified.
1. To Bring Together
The Commission is adopting the language ``brings together'' in Rule
3b-16, rather than ``consolidates'' as originally proposed. While the
Commission believes that ``consolidates'' and ``brings together'' have
the same meaning, the latter more closely mirrors the language in the
statute and is a plainer use of language.
A system brings together orders if it displays, or otherwise
represents, trading interests entered on the system to system users.
These systems include consolidated quote screens, such as the system
operated by Nasdaq. A system also brings together orders if it receives
subscribers' orders centrally for future processing and execution. For
example, a limit order matching book that allows subscribers to display
buy and sell orders in particular securities and to obtain execution
against matching orders contemporaneously entered or stored in the
system ``brings together orders.'' These activities are currently
performed by systems that bring together orders internally for crossing
\37\ or matching,\38\ as well as floor-based markets that impose
trading rules. In addition, interdealer brokers (``IDBs'') \39\ bring
together orders, regardless of their level of automation.\40\
Accordingly, a system ``brings together orders'' when orders entered in
the system for a given security have the opportunity to interact with
other orders entered into the system for the same security.
---------------------------------------------------------------------------
\37\ A crossing system is, typically, one that allows
participants to enter unpriced orders to buy and sell securities.
Orders are crossed at specified times at a price derived from
another market.
\38\ Matching systems allow participants to enter priced limit
orders and match those orders with other orders in the system.
Participants are able to view unmatched limit orders in the system's
book. The sponsor of a matching system typically acts as riskless
principal or a dealer firm on behalf of the system acts as riskless
principal, with respect to matched orders, or contracts with another
broker-dealer to perform this function.
\39\ Currently, debt markets are not centrally organized by a
single entity, but are nonetheless informally organized around
interdealer brokers. Interdealer brokers (also called blind brokers
and brokers' brokers) display, on an anonymous basis, the offers to
buy and sell securities that are placed with them by subscribers. In
order to place a bid or offer, a subscriber typically telephones the
interdealer broker, which enters the order into its system and
displays it to other subscribers. Some interdealer brokers display
all bids and offers; others display only the best bid and offer. To
execute against an offer displayed on the computer screen, a
subscriber telephones the interdealer broker, although sometimes
execution may be electronic. The identities of the counterparties
are, generally, kept confidential through clearance and settlement
of the trade. Some interdealer brokers, however, reveal the names of
each counterparty after execution. Traditionally interdealer brokers
facilitated trading only between dealers. Increasingly, however,
interdealer brokers are permitting non-dealers to participate in
their systems.
\40\ But see infra notes 123-130 and accompanying text
(discussing the exclusion from Regulation ATS for alternative
trading systems that trade exclusively government, and other
related, securities).
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2. Multiple Buyers and Sellers
In addition, to satisfy paragraph (a)(1) of Rule 3b-16, a system
must bring together orders of multiple buyers and multiple sellers. The
Commission proposed to use the term ``multiple parties'' in paragraph
(a)(1) of Rule 3b-16, rather than the term ``multiple buyers and
sellers.'' The Commission believes that this modification to the
language proposed in Rule 3b-16 addresses the concerns of those
commenters who requested that the Commission clarify that systems in
which there is only a single seller, such as systems that permit
issuers to sell their own securities to investors, would not be
included within Rule 3b-16. While such systems have multiple buyers
(i.e., investors), they have only one seller for each security (i.e.,
issuers) and, therefore, do not meet the multiple buyers and sellers
test. An example of this type of system is CP Direct in which an issuer
can offer to sell its commercial paper to the customers of CS First
Boston.\41\ Another example of systems that do not meet the multiple
buyers and sellers criteria are systems in which securities are offered
by a single seller at successively lower prices. In addition, systems
designed for the purpose of executing orders against a single
counterparty, such as the dealer operating a system, would not be
considered to have multiple buyers and sellers. Thus a single
counterparty that buys and sells securities through a system, where
other parties entering orders only execute against the single
designated counterparty, would not meet the requirements of the first
part of Rule 3b-16.\42\ However, the mere interpositioning of a
designated counterparty as riskless principal for settlement purposes
after the purchasing and selling counterparties to a trade have been
matched would not, by itself, mean that the system does not have
multiple buyers and sellers.
---------------------------------------------------------------------------
\41\ See Bruce Rule, PSA Panels Embrace Internet for
Institutional Trading; and Regulators Love the Audit Trail,
Investment Dealers' Digest, Nov. 18, 1996 (discussing CP Direct).
The converse situation--i.e., where there is one buyer and multiple
sellers for a given instrument--would also not meet the ``multiple
buyers and sellers'' requirement. The Commission, however, is not
aware of any system that currently operates this way.
\42\ This type of system would also be expressly excluded from
Rule 3b-16 under paragraph (b)(2). See infra Section III.C.2.
---------------------------------------------------------------------------
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).
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The label put on an order--``firm'' or ``not firm''--is not
dispositive. For example, a system claiming it displays only
``indications of interest'' that are not orders, may be covered by the
new interpretation of ``exchange'' if those indications are, in fact,
firm in practice. In general, the Commission intends to read the
definition of ``order'' broadly and will not consider systems to fall
outside the definition in Rule 3b-16 based solely on a system's
labeling of indications of interest as ``not firm.'' Instead, what
actually takes place between the buyers and sellers interacting in a
particular system will determine whether indications of interest are
``firm'' or not. At a minimum, an indication of interest will be
considered firm if it can be executed without the further agreement of
the person entering the indication. Even if the person must give its
subsequent assent to an execution, however, the indication will still
be considered firm if this subsequent agreement is always, or almost
always, granted so that the agreement is largely a formality. For
instance, indications of interest where there is a clear or prevailing
presumption that a trade will take place at the indicated price, based
on understandings or past dealings, will be viewed as orders.
Generally, however, a system that displays bona fide, non-firm
indications of interest--including, but not limited to, indications of
interest to buy or sell a particular security without either prices or
quantities associated with those indications--will not be displaying
``orders'' and, therefore, not fall within Rule 3b-16.
Nevertheless, the price or size of an indication of interest may be
either explicit or may be inferred from the facts and circumstances
accompanying the indication. For example, an indication of interest
will be considered to include a price if the system in which the
indication of interest is entered defaults automatically to a price
pegged to another market, index, rate, or other variable, or if the
person entering such indication indicates that such person is
interested in trading at a price pegged to another market, index, rate,
or other variable, which includes ``market'' orders.
The same commenter expressed concern that the proposed definition
of order could have the effect of including markets within the
definition of ``exchange'' that quote prices over the telephone for a
potential transaction.\46\ As discussed above, whether or not a
particular system is an exchange does not turn solely on the level of
automation used: ``orders'' can be given over the telephone, as well as
electronically.
---------------------------------------------------------------------------
\46\ TBMA Letter at 15.
---------------------------------------------------------------------------
The Commission emphasizes that merely because a system ``brings
together orders of multiple buyers and sellers,'' does not mean that
the system is an exchange. In order to fall within Rule 3b-16, a system
must also satisfy the requirements in paragraph (a)(2). Thus, whether
or not an ``order'' is part of a system that falls within the new
interpretation of ``exchange'' depends upon the activities of that
system taken as a whole. For example, a system could display
subscribers' ``orders'' to other market participants, but would not be
encompassed by Rule 3b-16 if subscribers contacted each other and
agreed to the terms of their trades outside of the system.\47\ Unless a
system also establishes rules or operates a trading facility under
which subscribers can agree to the terms of their trades, the system
will not be included within Rule 3b-16, even if it brings together
``orders.''
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\47\ These bulletin board types of systems were described in no-
action letters from the staff. See Letter dated June 24, 1996 from
Catherine McGuire, Chief Counsel, Division of Market Regulation,
SEC, Jack W. Murphy, Chief Counsel, Division of Investment
Management, SEC, and Martin P. Dunn, Chief Counsel, Division of
Corporate Finance, SEC to Barry Reder, Coblentz, Cahen, McCabe and
Breyer, LLP (counsel to Real Goods Trading Corporation); Letter
dated Aug. 5, 1996 from Catherine McGuire, Chief Counsel, Division
of Market Regulation, SEC to: Bruce D. Stuart, Esq. (counsel to
PerfectData Corporation); and Letter dated April 17, 1996 from
Abigail Arms, Associate Director, Division of Corporate Finance,
SEC, and Catherine McGuire, Associate Director, Division of Market
Regulation, SEC to Andrew Klein (President and Chief Executive
Officer of Spring Street Brewing Company).
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Finally, the NYSE commented that the Commission's definition of
``order'' appeared to cover trading interest that, in the Order
approving the Pacific Exchange (``PCX'') Application of the OptiMark
System (``OptiMark Order''), the Commission did not consider to be an
order. In the OptiMark Order, the Commission took the position that the
profiles entered into OptiMark are not bids or offers under Rule 11Ac1-
1 (``Firm Quote Rule'').\48\ The Commission's definition of ``order''
in paragraph (c) of Rule 3b-16 is intended to be broader than the terms
bid and offer in the Firm Quote Rule.\49\ Therefore, it is possible for
an indication of interest to be an ``order'' under Rule 3b-16, without
being a bid or offer under the Firm Quote Rule.
---------------------------------------------------------------------------
\48\ See Securities Exchange Act Release No. 39086 (Sept. 17,
1997), 62 FR 50036 (Sept. 24, 1997). In approving OptiMark, the
Commission stated that OptiMark's unique design warrants a non-
traditional approach in determining whether to require the
dissemination of trading interest expressed through operation of
OptiMark.
\49\ See Rule 11Ac1-1(c), 17 CFR 240.11Ac1-1(c).
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B. Established, Non-Discretionary Methods
In addition to bringing together the orders of multiple parties, to
be included within Rule 3b-16, a system would have to use established,
non-discretionary methods * * * under which such orders interact with
each other and the buyers and sellers entering orders agree to the
terms of the trade. A system uses established non-discretionary methods
either by providing a trading facility or by setting rules governing
trading among subscribers. The Commission intends for ``established,
non-discretionary methods'' to include any methods that dictate the
terms of trading among the multiple buyers and sellers entering orders
into the system. Such methods include those that set procedures or
priorities under which open terms of a trade may be determined. For
example, traditional exchanges' rules of priority, parity, and
precedence are ``established, non-discretionary methods,'' as are the
trading algorithms of electronic systems. Similarly, systems that
determine the trading price at some designated future date on the basis
of pre-established
[[Page 70851]]
criteria (such as the weighted average trading price for the security
on the specified date in a specified market or markets) are using
established, non-discretionary methods. A requirement that the trade
subsequently be ratified does not avoid this element. For example, a
system that trades limited partnership units might use established,
non-discretionary methods even though approval from the general partner
is required prior to settlement. Rules that merely supply the means of
communication with a system (for example, software or hardware tools
that subscribers may use in accessing a system), however, do not
satisfy this element of Rule 3b-16.
In general, where customers of a broker-dealer exercise control
over their own orders in a trading system operated by the broker-
dealer, that broker-dealer is unlikely to be viewed as using
discretionary methods in handling the order. An example of systems that
the Commission believes do not use established, non-discretionary
methods are traditional block trading desks. Block trading desks
generally retain some discretion in determining how to execute a
customer's order, and frequently commit capital to satisfy their
customers' needs. For example, a block positioner may ``shop'' the
order around in an attempt to find a contra-side interest with another
investor. In some cases, the block positioner may take the other side
of the order, keeping the block as a proprietary position. While block
trading desks do cross customers' orders, these crosses are not done
according to fixed non-discretionary methods, but instead are based on
the block trading desks' ability to find a contra-side to the order. It
may cross two customer orders, or it may assemble a block of several
customer orders with completion dependent on its willingness to take a
proprietary position for part of the block. Execution prices, size of
the proprietary position and agency compensation may all be part of a
single negotiated deal. Consequently, the Commission would not consider
traditional block trading desks to be using established, non-
discretionary methods and, therefore, they would not fall within Rule
3b-16.
In addition, systems that merely provide information to subscribers
about other subscribers' trading interest, without facilities for
execution, do not fall within paragraph (a) of Rule 3b-16. One
commenter asked the Commission to clarify that such systems would not
be viewed as exchanges.\50\ While such vendors may allow buyers and
sellers to find each other, they do not provide a facility or set rules
under which those orders interact with each other. Accordingly, the
Commission agrees with this commenter that such systems are not
exchanges.
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\50\ MSDW Letter at 11.
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In contrast, when a customer gives a broker-dealer flexibility in
how to handle an order, it relinquishes a degree of control over that
order. The Commission recognizes that broker-dealers exercising
discretion or judgment over customer orders may use internal systems to
trade and manage these orders. The mere use of these systems does not
make a broker an exchange, unless those systems themselves predetermine
the handling and execution practices for the order, replacing the
broker-dealer's judgment and flexibility in working the order.
One commenter suggested that the lack of display of customer orders
outside the broker-dealer should be determinative of whether the system
was an exchange.\51\ The Commission notes that it is possible for a
system to use established, non-discretionary methods even if orders are
not displayed. For example, the OptiMark System--by design--does not
display participants' indications of interest. There is, however, no
discretion exercised by the operator of the OptiMark System; the trade
optimization calculations are established, non-discretionary methods.
---------------------------------------------------------------------------
\51\ MSDW Letter, pp. 7-8.
---------------------------------------------------------------------------
Finally, the Commission proposed to explicitly exclude from the
revised interpretation of ``exchange'' trading systems that allow a
single broker-dealer to internally manage its customers' orders.\52\
The Commission was concerned that such systems might technically be
covered by paragraph (a) of Rule 3b-16 if they occasionally crossed or
matched customer orders. Because the Commission believes that these
systems have generally automated traditional brokerage functions, it
proposed to clearly exclude them from the revised interpretation of
``exchange.'' Several commenters noted their agreement with the
Commission's proposed exclusion of these internal broker-dealer systems
from its reinterpretation of ``exchange,'' \53\ but requested that the
Commission clarify it. In particular, the Securities Industry
Association (``SIA'') and The Bond Market Association (``TBMA'')
requested that the Commission clarify the intended meaning of the terms
``predetermined procedures'' and ``communicated to customers'' as used
in the proposed exclusion.\54\
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\52\ Proposed Rule 3b-12(b)(2).
\53\ See NASD Letter at 3, n.4; TBMA Letter at 3, 14; SIA Letter
at 3, 10; MSDW Letter at 5-6.
\54\ See TBMA Letter at 3, 14-15; SIA Letter at 3, 10-11.
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The Commission intended to exclude a number of different types of
systems under this proposed exclusion. First, this exclusion was
intended to cover internal systems operated by market makers to
automate the management of their customer orders, including the display
of customer limit orders, and to match those displayed orders with
other customer orders. The Commission is now adopting a more specific
exclusion to cover these types of systems.
In addition, in large part, the Commission intended to exclude
systems that automate the management of customer orders that require a
broker-dealer to use its discretion. These types of systems would not
be included within paragraph (a) of Rule 3b-16 because--like
traditional block trading desks--they do not use established, non-
discretionary methods. The purpose of the proposed exclusion for
internal broker-dealer systems was to exclude traditional internal
systems created to increase efficiency rather than to provide a non-
discretionary trading system for customers. In light of the comments on
the proposed exclusion for internal broker-dealer systems and the
difficulty of distinguishing among internal systems on this basis, the
Commission now believes it is better not to attempt to set specific
requirements that internal broker-dealer systems must meet in order to
be excluded from Rule 3b-16. Instead, the Commission is clarifying that
trading systems that do not use established, non-discretionary methods
fail to meet the two-part test in paragraph (a) and are, therefore, not
included within the revised interpretation of ``exchange.''
1. Established, Non-Discretionary Methods Provided by a Trading
Facility
As stated previously, a trading system that uses established, non-
discretionary methods would include a traditional exchange floor where
specialists are responsible for executing orders. It would also include
a computer system (whether comprised of software, hardware, protocols,
or any combination thereof) through which orders interact, or any other
trading mechanism that provides a means or location for the bringing
together and execution of orders. For example, the Commission considers
the use of an algorithm by an electronic trading system that sets
trading procedures and priorities to be a trading facility that uses
established, non-discretionary methods.
[[Page 70852]]
The Commission will attribute the activities of a trading facility
to a system if that facility is offered by the system directly or
indirectly (such as where a system arranges for a third party or
parties to offer the trading facility). Thus, if a system that brings
together the orders of multiple parties arranges for a third party
vendor to distribute software that establishes non-discretionary
methods under which orders interact, that system will fall within Rule
3b-16. Similarly, if a bulletin board operator contracted with another
party to provide execution facilities for the bulletin board users, the
bulletin board will be deemed to have established a trading facility
because it took affirmative steps to arrange for the necessary exchange
functions for its users.\55\ In addition, if an organization arranges
for separate entities to provide different pieces of a trading system,
which together meet the definition contained in paragraph (a) of Rule
3b-16, the organization responsible for arranging the collective
efforts will be deemed to have established a trading facility. For
example, the arrangement between the Delta Government Options
Corporation (``Delta''), RMJ Options Trading Corporation, and Security
Pacific National Trust Company, as described in a 1990 Commission
release,\56\ would together meet the definition set forth in Rule 3b-
16. Moreover, a trading system that falls within the Commission's
interpretation of ``exchange'' in Rule 3b-16 will still be considered
an ``exchange,'' even if it matches two trades and routes them to
another system or exchange for execution. Whether or not the actual
execution of the order takes place on the system is not a determining
factor of whether the system falls under Rule 3b-16.
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\55\ Whether or not a bulletin board will be considered an
exchange under the rule will also depend on whether it meets the
other elements of the definition.
\56\ See Delta Release, supra note 32. The Commission notes that
the arrangement between these entities no longer exists, and that
Delta, in its current form, would not fit the new interpretation of
the definition of exchange.
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2. Established, Non-Discretionary Methods Provided by Setting Rules
Alternatively, a system may use established, non-discretionary
methods through the imposition of rules under which parties entering
orders on the system agree to the terms of a trade. For example, if a
system imposes affirmative quote obligations on its subscribers, such
as obligations to post two-sided quotations or to post quotations no
worse than the quotes subscribers post on other systems, the Commission
will consider it to be using established, non-discretionary methods.
In addition, rules imposing execution priorities, such as time and
price priority rules, would be ``established, non-discretionary
methods.'' Similarly, a system that standardizes the material terms of
instruments traded on the system, such as the system operated by Delta
at the time the Commission published the Delta Release,\57\ will be
considered to use established, non-discretionary methods.
---------------------------------------------------------------------------
\57\ See id., at 1897.
---------------------------------------------------------------------------
Similarly, Nasdaq's use of established, non-discretionary methods
bring it within the revised interpretation of ``exchange'' in Rule 3b-
16. The NASD imposes basic rules by which securities are traded on
Nasdaq. Specifically, it imposes affirmative obligations on market
makers in Nasdaq National Market (``Nasdaq NM'') and SmallCap
securities, including obligations to post firm and two-sided quotes. It
also operates the Small Order Execution System (``SOES'') and SelectNet
systems, requiring market makers to accept executions or orders for
execution in these securities. Through Nasdaq, market participants act
in concert to centralize and disseminate trading interest and establish
the basic rules by which securities are traded. The Commission believes
that Nasdaq performs what today is generally understood to be the
functions commonly performed by a stock exchange. Nasdaq, however, is
currently registered as a securities information processor under
section 11A of the Exchange Act \58\ and is operated by the NASD, a
registered securities association under Section 15A of the Exchange
Act.\59\ Because the requirements currently applicable to a registered
securities association are virtually identical to the requirements
applicable to registered exchanges, the Commission does not believe it
is necessary or appropriate in the public interest to require Nasdaq to
register as an exchange.\60\ Under the rules the Commission is adopting
today, however, Nasdaq could choose to register under section 6 of the
Exchange Act as a national securities exchange.\61\
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\58\ 15 U.S.C. 78k-1.
\59\ 15 U.S.C. 78o-3. The NASD, parent of Nasdaq, is the self-
regulatory organization. The NASD delegates to NASD Regulation, Inc.
(``NASDR''), the wholly owned regulatory subsidiary of the NASD, its
SRO responsibilities to surveil trading conducted on Nasdaq and the
OTC Bulletin Boards, and to enforce compliance by its members (and
persons associated with its members) with applicable laws and rules.
Nasdaq also surveils trading conducted on its market and refers
potential violations to NASDR. See also infra note 342.
\60\ See infra notes 93-94 and accompanying text (discussing
Rule 3a1-1(a)(1), which explicitly exempts any system operated by a
national securities association from the definition of the term
``exchange'').
\61\ 15 U.S.C. 78f. If Nasdaq registered as an exchange, it
would have its own SRO responsibilities, but the Commission does not
expect this to increase Nasdaq's current burden. In view of the
NASD's SRO status the Commission could use its authority under
Sections 17 and 19 of the Exchange Act, 15 U.S.C. 78q and 78s, to
delegate any obligations Nasdaq would have as a registered exchange
to enforce compliance by its members (and persons associated with
its members) with the federal securities laws to NASDR.
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C. Systems Excluded From Rule 3b-16
The Proposing Release specifically excluded from the proposed,
revised interpretation of ``exchange'' several types of activities that
could be considered traditional brokerage activities: order routing
systems, dealer quotation systems, and internal broker-dealer order
management and execution systems. Commenters widely agreed that
automated broker-dealer functions should not be encompassed in the
meaning of ``exchange.'' \62\ The Commission agrees. Commenters did,
however, ask for clarification about the application of the exclusions
in paragraph (b). In particular, some commenters appeared to
misunderstand Rule 3b-16 as requiring that a system fall within one of
the exclusions in paragraph (b) in order to be outside of the revised
interpretation of ``exchange.'' This was not the Commission's intent. A
system is not included within the revised interpretation of
``exchange'' if: (1) It fails to meet the two-part test in paragraph
(a) of Rule 3b-16; or (2) it falls within one of the exclusions in
paragraph (b).
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\62\ See SIA Letter at 3, 10-11; DBSI Letter at 3; NASD Letter
at 4; TBMA Letter at 3, 14.
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The Commission has included paragraph (b) of Rule 3b-16 to
explicitly exclude some systems that the Commission believes are not
exchanges. Paragraph (b) of Rule 3b-16 expressly excludes: (1) Systems
that merely route orders to other execution facilities; and (2) systems
that allow persons to enter orders for execution against the bids and
offers of a single dealer, and systems that automate the activities of
registered market markers.
Two commenters asked the Commission to exclude from the revised
interpretation of ``exchange'' all correspondent clearing
relationships, as well as agreements among broker-dealers to handle
their respective order flow.\63\ The Commission has excluded routing
systems under Rule 3b-16(b)(1). Whether or not correspondent clearing
[[Page 70853]]
relationships are excluded, however, depends on the nature of the
systems used in that relationship. The Commission does not believe that
systems operated by clearing firms should be excluded simply because
their correspondents participate in them. The Commission believes that
such an exclusion would be overly broad.
---------------------------------------------------------------------------
\63\ See TBMA Letter at 14, n.26; SIA Letter at 10-11, n.18.
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One commenter questioned whether IDBs are the functional equivalent
of internal broker-dealer systems and, therefore, should be excluded
from Rule 3b-16.\64\ The Commission believes that most screen-based
IDBs function by displaying, on an anonymous basis, the offers to buy
and sell securities that are placed with them by subscribers. While
typically a subscriber uses a telephone to place the orders and
ordinarily use the telephone to request execution, multiple buyers and
sellers are involved, and generally customers view some or all orders
on screens. Thus, IDBs bring together the orders of multiple buyers and
sellers. Where an IDB has set procedures under which it executes
subscriber orders against displayed or retained orders in a
predetermined fashion, the methods by which these orders are brought
together likely would be established and non-discretionary. The
Commission believes that IDBs that function in this fashion are covered
by Rule 3b-16. If an IDB does not display orders or communicate them
verbally to customers, and does not execute orders according to pre-
determined, well-understood rules, it may not be covered by the rules
the Commission is adopting today. As a general matter, however, the
Commission believes that most IDBs would be covered by the definition
in Rule 3b-16(a) and not excluded by any of its exclusions.
---------------------------------------------------------------------------
\64\ TBMA Letter at 14, n.25 (suggesting that the Commission
expressly recognize the possibility that some IDBs may be able to
rely on the exclusion for internal broker-dealer systems).
---------------------------------------------------------------------------
In addition, one commenter recommended that any entity that has the
discretion to commit capital to a trade be excluded from Rule 3b-16,
because broker-dealers commit capital, but exchanges do not.\65\ The
Commission generally views the willingness to predictably commit
capital as a traditional broker-dealer activity. For this reason it is
explicitly excluding registered market maker and single dealer systems,
which commit capital in all--or almost all--trades. In addition,
broker-dealers frequently commit capital as part of their block trading
desk activities. As discussed above, the Commission does not believe
that traditional block trading desks are covered under paragraph (a) of
Rule 3b-16. However, the Commission does not believe that a system
engaging in activities as a market should be excluded from the scope of
Rule 3b-16 simply because the broker-dealer operating the system may
participate as a dealer in that system.
---------------------------------------------------------------------------
\65\ SIA Letter at 3-4, 6-7, 9.
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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.
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\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.
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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.
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\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.
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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.
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\74\ Third market firms are NASD member firms that execute
orders for exchange-listed securities.
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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.
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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\
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\76\ Rule 11Ac1-4(b)(1)(i), 17 CFR 240.11Ac1-4(b)(1)(i).
\77\ Proposing Release, supra note 3, at n.9.
\78\ Rule 3b-16(b)(2)(ii), 17 CFR 240.3b-16(b)(2)(ii).
---------------------------------------------------------------------------
Two other commenters expressed their support for the single dealer
exclusion.\79\ One of these commenters, however, suggested that the
Commission modify the exclusion so that trading systems that display
the quotes of a dealer and its affiliates and allow persons to execute
against those quotes be excluded from Rule 3b-16.\80\ The Commission is
adopting the exclusion from Rule 3b-16 for single dealer systems, but
does not agree with this commenter that a dealer's affiliates should be
included in the exclusion.
---------------------------------------------------------------------------
\79\ See SIA Letter at 10; DBSI Letter at 3.
\80\ DBSI Letter at 3.
---------------------------------------------------------------------------
In addition, one commenter requested that the Commission clarify
whether the exclusion for dealer quotation systems would apply to
systems that allow other broker-dealers to execute against a single
dealer's quotations.\81\ The Commission intends for this exclusion to
cover dealer quotation systems that permit other broker-dealers to
execute against the dealer's quotations and realizes that its use of
the term ``customer'' in the proposal would preclude this. Accordingly,
the Commission is adopting the exclusion in paragraph (b)(2) so that it
encompasses single dealer systems that allow any person to enter orders
for execution against that dealer's quotes.\82\ A single dealer system
could also match orders that are not displayed to any person other than
the dealer and its employees, provided this matching is only incidental
to its primary activity as a dealer.\83\
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\81\ SIA Letter at 11.
\82\ Rule 3b-16(b)(4), 17 CFR 240.3b-16(b)(4).
\83\ Rule 3b-16(b)(2)(i), 17 CFR 240.3b-16(b)(2)(i).
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D. Examples of Systems Illustrating Application of Rule 3b-16
The following examples are provided to illustrate various
applications of Rule 3b-16.\84\ While these examples are intended to
provide guidance, the application of Rule 3b-16 will be fact-specific.
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\84\ These systems may also implicate other provisions of the
federal securities laws.
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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.
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\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\
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\86\ 15 U.S.C. 78mm.
\87\ 17 CFR 240.3a1-1.
\88\ 17 CFR 240.3a1-1(a)(2). See infra note and accompanying
text for the definition of an alternative trading system.
\89\ 17 CFR 240.3a1-1(a)(3). See notes--and accompanying text.
\90\ 17 CFR 240.3a1-1(a)(1).
\91\ See infra Section III.F.
\92\ Rule 3a1-1(b), 17 CFR 240.3a1-1(b).
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The Commission has determined that this exemption is in the public
interest and will promote efficiency, competition, and capital
formation because it has the effect of providing alternative trading
systems with the option of positioning themselves in the marketplace as
either registered exchanges or as broker-dealers. The Commission
believes that allowing alternative trading systems to make a business
decision about how to register with the Commission will continue to
encourage the development of new and innovative trading facilities. The
Commission has also determined that this exemption is consistent with
the protection of investors because investors will benefit from
conditions governing an alternative trading system, in particular
Regulation ATS's enhanced transparency, market access, system
integrity, and audit trail provisions.
Moreover, because national securities associations are subject to
requirements virtually identical to those applicable to national
securities exchanges,\93\ Rule 3a1-1 also exempts from the definition
of ``exchange'' any alternative trading system operated by a national
securities association.\94\ The Commission believes that the regulation
of alternative trading systems operated by a national securities
association is adequate, and therefore, that such systems should not be
required to register either as exchanges, or as broker-dealers and
comply with Regulation ATS. Consequently, trading systems operated by
national securities associations may continue to operate as they do
now.
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\93\ Registration as a national securities association under
section 15A of the Exchange Act is voluntary. 15 U.S.C. 78o-3.
Currently the only national securities association is the NASD,
which operates Nasdaq.
\94\ Rule 3a1-1(a)(1). See also Rule 301(a)(3) (excluding
alternative trading systems operated by a national securities
association from the scope of proposed Regulation ATS).
---------------------------------------------------------------------------
Finally, in response to a commenter's request that the Commission
clarify that the exemption from the definition of ``exchange'' provided
in Rule 3a1-1(a)(2) includes broker-dealers that are excluded from the
scope of Regulation ATS by Rule 301(a),\95\ the Commission is adding
paragraph (a)(3) to Rule 3a1-
[[Page 70857]]
1. The Commission intended for broker-dealers that perform only
activities delineated in Rule 301(a) to be exempt from the definition
of exchange under Rule 3a1-1, and is making this clear by adding this
new paragraph.\96\
---------------------------------------------------------------------------
\95\ Instinet Letter at 8, n.11.
\96\ 17 CFR 240.3a1-1(a)(3).
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The Commission intends for the exemption provided by Rule 3a1-1 to
make clear that alternative trading systems that register as broker-
dealers and comply with Regulation ATS not be regulated as national
securities exchanges. The Commission believes that the requirements in
Regulation ATS as adopted will address the market-like functions of
alternative trading systems without imposing requirements applicable to
exchanges that might not fit comfortably with certain alternative
trading systems' structures and businesses.
In the Proposing Release, the Commission requested comment on
whether an exclusion from the definition in Rule 3b-16 for alternative
trading systems that register as broker-dealers and comply with the
provisions of Regulation ATS would be preferable to the exemption under
Rule 3a1-1. Several commenters expressed a preference for an exclusion,
rather than an exemption.\97\ Most of these commenters were concerned
that foreign regulators would view these systems, currently registered
as broker-dealers, as exchanges if they were now exempted from the
definition of exchange rather than excluded from it. The Commission
believes that its new framework being adopted today represents a
carefully balanced approach to the regulation of markets that is
grounded in the particular statutory structure of the Exchange Act.
First, the Commission notes that its exemption for alternative trading
systems applies to the definition of an exchange. By exempting
alternative trading systems from this definition, the Commission is
making clear its view that these systems should not be treated as
exchanges under the Exchange Act or in any other context. Moreover, the
Commission does not intend its interpretation of exchange to be used
outside of the Exchange Act context. The Commission strongly cautions
against applying this interpretation in other contexts where its
effects will differ from those under the Exchange Act. The Commission
also believes that application in another context of only one element
of the structure adopted today would be inappropriate and would
seriously call into question the validity of the interpretation in that
context.
---------------------------------------------------------------------------
\97\ See TBMA Letter at 12-13 (expressing concern that foreign
regulators might be influenced by the Commission's categorization of
a system as an ``exchange,'' even if that system chose to be
regulated in the U.S. as a broker-dealer); Instinet Letter at 3, 6-
7, 13-14 and 6-7, n.9 (stating that classifying a securities firm as
an exchange in the U.S. could significantly impair a firm's ability
to participate in foreign markets * * * because a number of foreign
regulators may regard all broker-dealers covered by the expanded
`exchange' definition as `exchanges'). See also CBB Letter at 3.
---------------------------------------------------------------------------
Another concern raised by at least one commenter was that investors
could be influenced in how they view a trading system, if such trading
system is included within the Commission's interpretation of
``exchange.'' \98\ The Commission believes that investors' views of
systems are shaped more by the functions those systems perform than by
the way they are classified. The Commission also believes that the
enhanced regulation of alternative trading systems that choose to
remain registered as broker-dealers that is provided by Regulation ATS
provides more protection for the investors who use these systems.
---------------------------------------------------------------------------
\98\ TBMA Letter at 12.
---------------------------------------------------------------------------
In the Proposing Release, the Commission also requested comment on
the scope, form, and conditions of the exemption in Rule 3a1-1.
Commenters generally approved of the Commission's proposal to allow
alternative trading systems the choice to register as exchanges or be
exempt from the definition of ``exchange'' by registering as broker-
dealers and complying with Regulation ATS.\99\ One commenter questioned
whether national securities exchanges would have the choice to register
as alternative trading systems, in effect ceasing to act as SROs and
electing instead to be regulated as a broker-dealer under Regulation
ATS.\100\ The Commission believes that, as a general matter, national
securities exchanges do have this choice under the rules the Commission
is adopting today.\101\ Any national securities exchange making this
choice would, of course, be required to give up its SRO functions and
privileges, and to register as a broker-dealer and become a member of a
national securities association or other SRO.\102\ That organization
would then act as the SRO for this alternative trading system. If a
national securities exchange chose, as part of this restructuring, to
allow its members to form their own national securities association to
operate this new alternative trading system, that alternative trading
system would be run directly by a national securities association, and,
as stated above, would be regulated in a manner that was equivalent to
being regulated as a national securities exchange.\103\
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\99\ See Letter from Mike Cormack, Manager, Equity Trading,
American Century to Jonathan G. Katz, Secretary, SEC, dated Aug. 12,
1998 (``American Century Letter'') at 1-2 (supporting the
Commission's proposal to permit alternative trading systems to
register as exchanges because it would provide an option for
innovators, and noting alternative trading systems' objection to the
NASD's proposed central limit order book based on the belief that an
SRO regulating alternative trading systems should not operate a
competing system); NASD Letter at 3 (commenting that both
registration as an exchange and Regulation ATS ``generally appear to
ensure that alternative trading systems operate with the appropriate
levels of investor protection, while affording alternative trading
systems the necessary flexibility to choose between different models
of regulation''); CME Letter at 3 (generally supporting the
additional requirements for alternative trading systems because they
will improve investor protection and lessen the regulatory disparity
that currently exists between alternative trading systems and
traditional exchanges); Instinet Letter at 7, n.10 (stating that the
Commission should modify the exemption in Rule 3a1-1 from exchange
registration so that alternative trading systems that, while acting
in good faith, fail to comply fully with each of the technical
requirements of Regulation ATS do not violate Sections 5 and 6 of
the Exchange Act); ICI Letter at 2; IBEX Letter at 4.
\100\ CHX Letter at 6 (questioning why traditional exchanges
should not have the opportunity to make the same choice as
alternative trading systems, and commenting that SROs should be
permitted to form subsidiaries that were alternative trading systems
registered as broker-dealers).
\101\ In making this significant decision, a national securities
exchange would have to follow its constitution and by-laws
(including provisions concerning membership votes), and any
applicable state law requirements.
\102\ Section 15(b)(8) of the Exchange Act requires any broker-
dealer engaging in transactions other than solely on a national
securities exchange of which it is a member, to become a member of a
national securities association. 15 U.S.C. 78o(b)(8).
\103\ The Commission does not mean to imply that national
securities exchanges cannot make this choice. The Commission is
merely pointing out that if a national securities exchange does so,
it cannot continue to act as its own SRO.
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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).
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Specifically, under Rule 3a1-1(b), if an organization, association,
or group of persons meets certain, specified volume levels, the
Commission could consider whether registration as an exchange is
necessary. The Commission will not consider making an assessment
whether a particular system should register as an exchange unless that
system, during three of preceding four calendar quarters had: (1) Fifty
percent or more of the average daily dollar trading volume in any
security and five percent or more of the average daily dollar trading
volume in any class of security; or (2) Forty percent or more of the
average daily dollar trading volume in any class of securities. The
Commission would also provide such a system with notice and an
opportunity to respond before determining that exemption from
registration as an exchange is not appropriate in the public interest.
In making that determination, the Commission would take into account
the requirements for exchange registration under section 6 of the
Exchange Act and the objectives of the national market system under
section 11A of the Exchange Act. For example, it may not be consistent
with the protection of investors or in the public interest for a
trading system that is the dominant market, in some important segment
of the securities market, to be exempt from registration as an exchange
if competition cannot be relied upon to ensure fair and efficient
trading structures in that case. In that case it may be necessary for
the Commission's greater oversight authority over registered exchanges
to apply.\105\ As another example, if the Commission believed that an
exemption under Rule 3a1-1 for a particular trading system that meets
the volume thresholds would create systemic risk or lead to instability
in the securities markets' infrastructure, it could determine that an
exemption from registration as an exchange was not appropriate in the
public interest or consistent with the protection of investors.
---------------------------------------------------------------------------
\105\ The Commission does not mean to imply that the NASD will
be required to register Nasdaq as a national securities exchange. As
stated above, because Nasdaq is operated by a national securities
association, it is currently subject to requirements virtually
identical to those applicable to national securities exchanges. Any
alternative trading system, however, currently operated by a
national securities association could choose to register as an
exchange.
---------------------------------------------------------------------------
The Commission believes that there are alternative trading systems
operating today that exceed the volume levels in paragraph (b)(1) of
Rule 3a1-1. However, the Commission does not believe at this time that
there are any alternative trading systems--given their current
operations--for which the exemption from the definition of exchange in
paragraph (a) of Rule 3a1-1 is not appropriate.
In addition, under section 19(c)(3) of the Exchange Act,\106\ the
Commission has the authority to promulgate rules for the de-
registration of an exchange. In order to ensure a smooth transition for
exchanges that wish to de-register and become registered broker-dealers
subject to Regulation ATS, the Commission will consider promulgating
de-registration rules. Such rules would also give the Commission the
opportunity to formally consider whether certain exchanges should be
prohibited from de-registering, just as Rule 3a1-1(b) gives the
Commission the opportunity to consider whether certain alternative
trading systems registered as broker-dealers should be compelled to
register as exchanges.
---------------------------------------------------------------------------
\106\ 15 U.S.C. 78s(c)(3).
---------------------------------------------------------------------------
IV. Regulation of Alternative Trading Systems
Securities markets have become increasingly interdependent. The use
of technology permits market participants to link products, implement
complex hedging strategies across markets and across products, and
trade on multiple markets simultaneously. While these opportunities
benefit many investors, they may also create misallocations of capital,
widespread inefficiency, and trading fragmentation if markets are not
coordinated. In addition, a lack of coordination among markets has the
potential to increase system-wide risks. Congress adopted the 1975
Amendments, in part, to address these negative effects of potentially
fragmented markets.\107\ The Commission believes that it is consistent
with Congress' goals to integrate significant alternative trading
systems into the national market system.
---------------------------------------------------------------------------
\107\ See S. Rep. No. 75, 94th Cong., 1st Sess. 8 (1975) at 2,
8; H.R. Rep. No. 229, 94th Cong., 1st Sess 92 (1975).
---------------------------------------------------------------------------
In the 1975 Amendments, Congress specifically endorsed the
development of an national market system, and sought to clarify and
strengthen the Commission's authority to promote the achievement of
such a system.\108\ Because of uncertainty as to how technological and
economic changes would affect the securities markets, Congress
explicitly rejected mandating specific components of an national market
system.\109\ Instead, Congress recognized that the securities markets
dynamically change and, accordingly, granted the Commission broad
authority to oversee the implementation, operation, and regulation of
the national market system in accordance with Congressional goals and
objectives.\110\
---------------------------------------------------------------------------
\108\ See supra note 6.
\109\ See S. Rep. No. 75. supra note 107. ``(T)he increasing
tempo and magnitude of the changes that are occurring in our
domestic and international economy make it clear that the securities
markets are due to be tested as never before,'' and that it was,
therefore, important to assure ``that the securities markets and the
regulations of the securities industry remain strong and capable of
fostering (the) fundamental goals (of the Exchange Act) under
changing economic and technological conditions.'' Id. at 3.
\110\ S. Rep. No. 75 supra note 107, at 8-9.
---------------------------------------------------------------------------
Congress identified two paramount objectives in the development of
an national market system: the maintenance of stable and orderly
markets with maximum capacity, and the centralization of all buying and
selling interest so that each investor has the opportunity for the best
possible execution of his or her order, regardless of where the
investor places the order.\111\ In addition, Congress directed the
Commission to remove present and future competitive restrictions on
access to market information and order systems, and to assure the equal
regulation of markets, exchange members, and broker-dealers effecting
transactions in the national market system.\112\ In particular,
Congress found that it was in the public interest to assure ``fair
competition * * * between exchange markets and markets other than
exchange markets.'' \113\
---------------------------------------------------------------------------
\111\ S. Rep. No. 75 supra note 107, at 7; see Section
11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k-1(a)(1)(C).
\112\ See S. Rep. No. 75 supra note 107, at 104-05.
\113\ Section 11A(a)(1)(C)(ii) of the Exchange Act, 15 U.S.C.
78k-1(a)(1)(C)(ii). A fundamental goal of a national market system
was to ``achieve a market characterized by economically efficient
executions, fair competition, (and the) broad dissemination of basic
market information.'' S. Rep. No. 75 supra note 107, at 101.
---------------------------------------------------------------------------
To further national market system goals, Congress granted the
Commission broad authority to make rules, including those to: (1)
Prevent the use and publication of deceptive trade and order
information; (2) assure the prompt, accurate, and reliable distribution
of quotation and transaction information; (3) enable non-discriminatory
access to such information; and (4) assure that all broker-dealers
transmit and direct orders for securities in a manner consistent with
the operation of a national market system.\114\ Moreover, Congress
recognized that in order to implement national market system goals, the
Commission would need to classify markets, firms, and securities and
facilitate the development of
[[Page 70859]]
``subsystems within the national market system.'' \115\
---------------------------------------------------------------------------
\114\ See Section 11A(c)(1) of the Exchange Act, 15 U.S.C. 78k-
1(c)(1).
\115\ S. Rep. No. 75 supra note 107, at 7.
---------------------------------------------------------------------------
The Commission believes the rules it is adopting today advance
national market system goals. At present, alternative trading systems
are not fully integrated into the national market system, leaving gaps
in market access and fairness, systems capacity, transparency, and
surveillance. These concerns, together with the increasing significance
of alternative trading systems, call into question the fairness of
current regulatory requirements, the effectiveness of existing national
market system mechanisms, and the quality of public secondary markets.
Under the rules the Commission is adopting today, alternative trading
systems that have the most significant effect on our markets will be
required to integrate their trading into national market system
mechanisms. Alternative trading systems may choose to register either
as national securities exchanges or as broker-dealers. Systems that
elect broker-dealer regulation will be integrated into the national
market system under Regulation ATS if they have significant trading
volume.\116\ Discussed in Section IV.A. below are the requirements for
alternative trading systems that choose to register as broker-dealers
and comply with Regulation ATS. Any alternative trading system that
registers as a national securities exchange will be obligated--as
currently registered exchanges are--to participate in the national
market system mechanisms. Section IV.B. contains a discussion of the
requirements applicable to alternative trading systems that choose to
register as exchanges.
---------------------------------------------------------------------------
\116\ In addition to its authority under section 11A of the
Exchange Act, 15 U.S.C. 78k-1, the Commission is adopting Regulation
ATS pursuant to its rulemaking power under other parts of the
Exchange Act, including sections 3(b) (power to define terms),
15(b)(1) (registration and regulation of broker-dealers), 15(c)(2)
(prescribing means reasonably designed to prevent fraud), 17(a)
(books and records requirements), 17(b) (inspection of records),
23(a)(1) (general power to make rules and classify persons,
securities, and other matters), and 36 (general exemptive
authority). 15 U.S.C. 78c(b), 78o(b)(1), 78o(c)(2), 78q(a), 78q(b),
78w(a)(1), and 78mm, respectively. For a discussion on the general
exemptive authority in section 36 of the Exchange Act, 15 U.S.C.
78mm, see infra Section VII.D.1.
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A. Regulation ATS
1. Scope of Regulation ATS
a. Definition of Alternative Trading System
The Commission proposed to define the term ``alternative trading
system'' as any system that: (1) Constitutes, maintains, or provides a
marketplace or facilities for bringing together purchasers and sellers
of securities or for otherwise performing with respect to securities
the functions commonly performed by a stock exchange under Exchange Act
Rule 3b-16; \117\ and (2) does not set rules governing the conduct of
subscribers other than the conduct of such subscribers' trading on such
organization, association, person, group of persons, or system, or
discipline subscribers other than by exclusion from trading.\118\ This
proposed definition would have the effect of precluding any trading
system that performs self-regulatory functions from opting to register
as a broker-dealer, rather than as an exchange. Such a system would
consequently be required to register as an exchange or be operated by a
national securities association. Nothing, however, would prevent a
registered exchange from giving up its self-regulatory functions and
choosing instead to comply with Regulation ATS.\119\
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\117\ See supra Section III (discussing Rule 3b-16).
\118\ Rule 300(a), 17 CFR 242.300(a).
\119\ See supra note and accompanying text. The Commission has
the authority to require significant markets to remain registered as
exchanges. See supra Section III.F.
---------------------------------------------------------------------------
The Commission received only one comment on this proposed
definition. This commenter suggested that the proposed definition for
alternative trading systems was too complex and should instead, simply
be defined as an exchange that does not set conduct rules or discipline
subscribers.\120\ Under the framework the Commission is adopting today,
an alternative trading system is exempt from the definition of an
exchange if it registers as a broker-dealer and complies with
Regulation ATS.\121\
---------------------------------------------------------------------------
\120\ PCX Letter at 3.
\121\ Rule 3a1-1(a)(2), 17 CFR 240.3a1-1(a)(2).
---------------------------------------------------------------------------
Because the Commission continues to believe that any system that
uses its market power to regulate its participants should be regulated
as an SRO, the Commission is adopting the definition of alternative
trading system as proposed. The Commission would consider a trading
system to be ``governing the conduct of subscribers'' outside the
trading system if it imposed on subscribers, as conditions of
participation in trading, any requirements for which the trading system
had to examine subscribers for compliance. In addition, if a trading
system imposed as conditions of participation, directly or indirectly,
restrictions on subscribers' activities outside of the trading system,
the Commission believes that such a trading system should be a
registered exchange or operated by a national securities association.
For example, the Commission would not consider a trading system to be
an alternative trading system, as defined in Rule 300(a), if that
trading system prohibited subscribers from placing orders on its system
at prices inferior to those subscribers place on other systems. The
Commission believes such rules should only be imposed and enforced by
regulatory bodies because of the potential that they may be applied for
anti-competitive purposes. The Commission does not intend for this
limitation to preclude an alternative trading system from imposing
credit conditions on subscribers or requiring subscribers to submit
financial information to the alternative trading system.
b. Exclusion of Trading Systems Registered as Exchanges or Operated by
a National Securities Association
The Commission proposed to exclude from the scope of Regulation ATS
certain alternative trading systems that are subject to other
appropriate regulations. In particular, Rule 301(a) would exclude
alternative trading systems (1) registered as exchanges, (2) exempt
from exchange registration based on limited volume,\122\ or (3)
operated by a national securities association. These systems are
subject to regulation as markets under other provisions of the Exchange
Act. The Commission is adopting these exclusions as proposed.
---------------------------------------------------------------------------
\122\ See supra note 33.
---------------------------------------------------------------------------
c. Exclusion of Alternative Trading Systems Trading Solely Government
and Related Securities
(i) Discussion
In addition, the Commission proposed that any alternative trading
system that trades only government securities,\123\ Brady Bonds, and
repurchase and reverse repurchase agreements involving government
securities or Brady Bonds be excluded from the scope of Regulation ATS,
as long as the alternative trading system is registered as a broker-
dealer. The Commission believes that alternative trading systems
trading only government securities raise several of the structural
issues raised by alternative trading systems trading equity and other
debt securities. Nevertheless, the Commission recognizes that
government securities are subject to other forms of regulation that
help to ensure that those markets are fair and orderly. In particular,
[[Page 70860]]
government securities broker-dealers are currently regulated jointly by
the Commission, U.S. Department of the Treasury (``Treasury''), and
federal banking regulators, under the Exchange Act (particularly the
provisions of the Government Securities Act of 1986) and the federal
banking laws.\124\ Unlike surveillance of trading in equities and other
instruments traded primarily on registered exchanges,\125\ surveillance
of trading in government securities is coordinated among the Treasury,
the Commission, and the Board of Governors of the Federal Reserve
System.
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\123\ The term ``government security'' is defined in section
3(a)(42) of the Exchange Act, 15 U.S.C. 78c(a)(42).
\124\ See generally Department of the Treasury, Securities and
Exchange Commission, and Board of Governors of the Federal Reserve
System, Joint Study of the Regulatory System for Government
Securities (March 1998); Department of the Treasury, Report of the
Secretary of the Treasury on Specialized Government Securities
Brokers and Dealers (July 1995) (``1995 Treasury Report'').
The Government Securities Act of 1986 (``GSA'') amended the
Exchange Act to incorporate new section 15C, which, among other
things, established registration and notice requirements for
government securities brokers and dealers. Section 15C generally
requires government securities brokers and dealers (i.e., 15C firms
or specialized government securities brokers and dealers) to
register with the Commission and to become members of an SRO
(twenty-two firms as of March 1998). Firms that are registered with
the Commission as general securities brokers or dealers (i.e.,
traditional broker-dealers registered under section 15(b) of the
Exchange Act) are required to file notice with the Commission of
their government securities business (3,023 firms as of April 1998).
In addition, financial institutions that engage in government
securities broker or dealer activities are required to file notice
of such activities with their appropriate regulatory agency (120
institutions as of March 1998).
Under the regulatory structure established by the GSA, the
Treasury was granted authority to adopt regulations for all
government securities brokers and dealers concerning financial
responsibility, protection of investors' funds and securities,
recordkeeping, reporting, and audit requirements, and to adopt
regulations governing the custody of government securities held by
depository institutions. The Government Securities Act Amendments of
1993 (``GSAA'') expanded the authority of the federal regulators and
the SROs over government securities transactions. The GSAA, among
other things, reauthorized the Treasury's rulemaking
responsibilities, granted the Treasury authority to prescribe large
position recordkeeping and reporting rules, extended the
Commission's antifraud and antimanipulation authority to all
government securities brokers and dealers, required government
securities brokers and dealers to provide to the Commission on
request records of government securities transactions to reconstruct
trading in the course of a particular inquiry or investigation,
removed the statutory restrictions on the authority of the NASD to
extend sales practice rules to its members' transactions in
government securities, and provided the bank regulatory agencies
with the authority to issue sales practice rules for financial
institutions engaged in government securities broker or dealer
activities.
The GSA also strengthened the ability of federal regulators to
examine, and to bring enforcement actions against, government
securities brokers and dealers. The Commission and the SROs have
examination and enforcement authority over government securities
brokers and dealers registered under section 15C and over the
government securities activities of general securities brokers and
dealers. The Commission's enforcement authority includes the power
to censure, place limitations on the activities, functions, or
operations of, suspend for a period not exceeding 12 months, or
revoke the registration of the entity. For financial institutions
that are government securities brokers or dealers, the institution's
appropriate regulatory agency has examination and enforcement
authority over the institution. The appropriate regulatory agency
must notify the Commission of any sanctions imposed on such
institutions, and the Commission must maintain a record of the
sanctions.
\125\ Although all marketable Treasury notes, bonds, and zero-
coupon securities are listed on the NYSE, exchange trading volume is
a small fraction of the total over-the-counter volume in these
instruments. See U.S. Department of the Treasury, U.S. Securities
and Exchange Commission, and Board of Governors of the Federal
Reserve System, Joint Report on the Government Securities Market 26
(1992).
---------------------------------------------------------------------------
The Commission is adopting this proposed exclusion from Regulation
ATS with some modifications.\126\ Specifically, the Commission is
eliminating Brady Bonds from the types of securities an alternative
trading system can trade and fall within this exclusion. The Commission
received no comments specifically addressing the trading of Brady Bonds
by alternative trading systems. Based on information the Commission has
available about trading on alternative trading systems, however, the
Commission is not aware of any systems trading Brady Bonds that do not
also trade other non-government securities, most typically other
emerging market debt. Accordingly, no alternative trading systems
trading Brady Bonds would have been exempt under the proposals.
Further, the Commission does not treat Brady Bonds in the same manner
as government securities in other contexts. Moreover, the significance
of Brady Bonds in the market is diminishing.
---------------------------------------------------------------------------
\126\ In other words, these systems are not required to register
as either an exchange or to comply with the requirements of
Regulation ATS. Rule 301(a)(4), 17 CFR 242.301(a)(4).
---------------------------------------------------------------------------
In addition, the Commission is expanding the exclusion in two
respects. First, the Commission is adding commercial paper \127\ and
certain options on government securities \128\ to the types of
securities alternative trading systems may trade without being subject
to Regulation ATS. The Commission believes this expansion is
appropriate because commercial paper does not require registration even
as a broker-dealer, and because the term ``government securities''
includes certain options on government securities for purposes of
sections 15C and 17A of the Exchange Act.\129\ Second, the Commission
is expanding this exclusion from Regulation ATS to include alternative
trading systems that are banks and that trade solely government
securities, repurchase and reverse repurchase agreements on government
securities, certain options of government securities, and commercial
paper because of banks' traditional role in the government securities
market.\130\
---------------------------------------------------------------------------
\127\ Rule 301(a)(4)(ii)(E), 17 CFR 242.301(a)(4)(ii)(E). The
term ``commercial paper'' is defined in Rule 300(m), 17 CFR
242.300(m). This definition is based on the definition of commercial
paper as set forth in 12 CFR 541.5, an Office of Thrift Supervision
regulation that defines commercial paper, and section 3(a)(3) of the
Securities Act of 1933, which uses identical language to identify
these securities as one category of exempted securities.
\128\ Rule 301(a)(4)(D), 17 CFR 242.301(a)(4)(D).
\129\ Section 3(a)(42) of the Exchange Act, 15 U.S.C.
78c(a)(42).
\130\ Rule 301(a)(4), 17 CFR 242.301(a)(4).
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(ii) Response to Commenters
The Commission solicited comment on whether it was appropriate to
exclude from the regulatory framework for alternative trading systems
those alternative trading systems trading solely government and other
related securities. Of those commenters who addressed this issue, most
were in favor of excluding such systems. Most of these commenters
agreed with the Commission that alternative trading systems trading
government securities are subject to their own specialized oversight
structure and, therefore, were appropriately excluded from the scope of
the Commission's proposal.\131\ Only one commenter opposed the proposed
exclusion of alternative trading systems that trade government
securities.\132\
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\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.
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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.
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\133\ TBMA Letter at 13, n.21.
\134\ See supra note 97 and accompanying text.
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In addition, this same commenter encouraged the Commission to
consider the effects of the proposed rules on banks that operate
alternative trading systems. In particular, this commenter noted that
the exclusion for alternative trading systems that trade government
securities applied only if the alternative trading system registered as
a broker-dealer, not if the alternative trading system were a
bank.\135\ The Commission did not intend to require banks trading
government securities to register as broker-dealers and, therefore,
Rule 301(a)(4), as adopted, excludes from Regulation ATS alternative
trading systems that trade government securities if these systems are
registered as broker-dealers or are banks.
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\135\ TBMA Letter at 17.
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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\
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\136\ See TBMA Letter at 17; Instinet Letter at 8, n.11; CBB
Letter at 3-4.
\137\ Instinet Letter at 8, n.11.
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The Commission does not believe that an alternative trading
systems' government securities trading will be subject to more
burdensome regulation if it is conducted in the same system as trading
in other securities, than if it is conducted in a separate and,
therefore, excluded system. Accordingly, the exclusion applies to
systems that only trade government and other related securities.
Government securities are not ``covered securities'' \138\ and,
therefore, are not subject to the transparency requirements of
Regulation ATS. In addition, an alternative trading system is only
required to comply with the fair access requirements for those
securities (or categories of securities) in which it represents twenty
percent or more of the total volume. The fair access requirement does
not apply to government securities regardless of whether government
securities trading is conducted in the same alternative trading system
as securities subject to the fair access requirements or in a separate
alternative trading system. Finally, the capacity, integrity, and
security requirements would never be triggered by an alternative
trading system's government securities trading. If, however, the
trading in other securities on that same system exceeds the twenty
percent threshold, an alternative trading system in which government
securities are traded would have to meet the capacity, integrity, and
security standards. Nevertheless, it seems unlikely that an alternative
trading system would choose to create a separate alternative trading
system for its government securities trading solely for the privilege
of trading government securities on a system with lesser capacity,
integrity, and security than the system on which other securities are
traded. Therefore, the Commission does not believe that it will be
necessary, as a practical matter, for an alternative trading system to
restructure its system to avail itself of the government securities
exclusion.
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\138\ See infra note 180 and accompanying text for the
definition of ``covered security.''
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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.
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\139\ CBB Letter at 3.
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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.
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\140\ CBB Letter at 3-4.
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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.
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\141\ The proposal would not require an alternative trading
system to publicly display its best orders in fixed income
securities.
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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.
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\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).
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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.
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\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.
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Volume data for the remaining two categories--investment grade and
non-investment grade corporate debt--, however, is not currently
compiled or published so that alternative trading systems can determine
their obligations under Regulation ATS. In order to allow time for
logistical arrangements to make such data available, the Commission
will not make these fair access and systems capacity, integrity and
security provisions of Regulation ATS effective until April 1,
2000.\146\
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\146\ Due to the Commission's concerns regarding the Year 2000
computer technology conversion process, no new Commission rules
requiring major computer reprogramming will be made effective
between June 1, 1999 and March 31, 2000. See Securities Exchange Act
Release No. 40377 (Aug. 27, 1998), 63 FR 47501 (Sept. 3, 1998).
Accordingly, because the logistical framework for investment grade
and non-investment grade corporate debt data has not been fully
developed, the Commission is not making Rules 301(b)(5)(D) and (E)
and Rules 301(b)(6)(D) and (E) effective until after the moratorium
is lifted.
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(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 tr
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