On Dec. 8, 1998, the Securities and Exchange Commission adopted a new regulatory scheme for alternative trading systems (ATS).
The new scheme requires an ATS either to register as a national securities exchange or as a broker dealer and comply with new requirements under Regulation ATS.
The agency has revised its interpretation of the term exchange to apply to ATSs through new rule 3b-16. Previously, the agency relied on the definition in the Securities Exchange Act of 1934 to identify those entities subject to exchange regulation.
Over the past 30 years, the SEC has examined how to apply the term "exchange" to systems that have been variously called proprietary trading systems (PTSs), broker-dealer trading systems, and most recently, ATSs.
In 1990, the SEC excluded PTSs from exchange treatment in its Delta release. In 1995, the SEC adopted rule 17a-23, which treated these systems as broker dealers and imposed certain recordkeeping and notice obligations on PTSs.
Many market participants thought rule 17a-23 ended the debate on regulating these systems. In 1997, however, the SEC questioned its historic treatment of PTSs as broker dealers, ultimately adopting the new regulatory scheme.
New Interpretation
New Securities Exchange Act rule 3b-16 expands the concept of an exchange to mean any "organization, association, or group of persons [that]:
(1) Brings together the orders for securities of multiple buyers and sellers; and
(2) Uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade."
The new interpretation is intended to capture systems that centralize orders, either by the display or the processing and execution of orders. Orders include "any firm indication of a willingness to buy or sell a security, as either principal or agent, including any bid or offer quotation, market order, limit order, or other priced order," and are executable without further meaningful negotiation.
An exchange-run system must deal with multiple buyers and sellers in contrast to systems operated by a single dealer who acts as a counterparty to all trades. Similarly, systems that do not provide for order interaction, such as those that route orders to order-execution facilities, will not qualify as exchanges. In addition, exchanges must use "established, non-discretionary methods" for order interaction.
These methods include rules governing trading conduct and trading facilities that standardize the manner of order interaction, such as computer algorithms. Most importantly, the system operator cannot exercise discretion in working orders.
Regulation ATS
An ATS includes any system that qualifies as an exchange and does not exercise self-regulatory functions. Regulation ATS applies to any ATS that chooses broker-dealer registration over exchange registration, although certain systems are not required to comply with Regulation ATS. These include, among others, those registered, or exempt from registration, as national securities exchanges, and systems operated by national securities associations
The requirements of Regulation ATS are designed to ensure that adequate information about ATSs is available. They are also designed to protect confidential subscriber trading information, and to ensure cooperation in investigations of ATSs and their subscribers.
An ATS with five percent or more of the trading volume in any listed or Nasdaq National Market or Small-Cap security, that displays orders for those securities to more than one subscriber or other user, must link with a self-regulatory organization (SRO) to display the ATS's best bids and offers for those securities on the SRO. The ATS must also provide the SRO's members with access to those bids and offers on equal terms as other bids and offers on the SRO.
An ATS with 20 percent or more of the trading volume for most equity securities and certain categories of debt securities must also provide fair access to membership in the ATS. The ATS must also maintain adequate systems capacity, integrity and security standards.
The Impact
Broker dealers operating ATSs must weigh exchange registration against broker-dealer registration that comes with additional requirements. Some market participants have expressed an interest in becoming stock exchanges. What's their motivation?
For one thing, these market participants may want to capture tape revenue. For another, they may want to avoid being governed by an unrelated SRO, which may, incidentally, operate a competing system.
Whatever the motivation, exchange registration brings with it substantial obligations to fulfill self-regulatory functions. Moreover, membership must be limited to broker dealers, which means institutional and retail customers would no longer be able to directly subscribe to a system that chooses to register as an exchange.
Trading systems created in the future will need to determine if they qualify as exchanges, and if so, these must comply with the new regulations, and must determine which regulatory status best suits their operations.
The ATS rules will greatly expand the transparency of orders in the marketplace, and will, for the first time, require the public display of institutional orders that are displayed in the largest ATSs. Thus, the SEC's dedication to transparency, that drove the order handling rules, has taken a significant step further.
Both sets of rules were launched during highly-favorable market conditions. A more trying environment will provide a more meaningful test.
Sam Scott Miller is a partner of Orrick, Herrington & Sutcliffe LLP in New York. Lauren Mullen is an associate in the firm's Washington D.C. office.
