Release No. 34-40760

63 Fed. Reg. 70843 - Dec. 22, 1998

Regulation of Exchanges and Alternative Trading Systems

ACTION: Final rules.
 

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.

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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.

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

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

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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.

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.

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

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

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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.

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-16²⁰ encompasses these equivalent markets and the Commission's new general exemptive authority enables it to craft a new regulatory framework.

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

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

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.

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.

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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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

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

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

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.

The Commission believes that the low volume exemption continues to be appropriate for some exchanges, such as an exchange that, for example, disciplines its members (other than by excluding them or limiting them from trading based on objective criteria, such as creditworthiness), or has other self-regulatory attributes that exclude it from the definition of alternative trading system, Rule 300(a), and therefore preclude it from making the choice to register as a broker-dealer. Any exchange seeking a low volume exemption would, of course, have to have low volume. The Commission believes that the low volume exemption would be inappropriate for any alternative trading system that can register as a broker-dealer and comply with Regulation ATS, and that the conditions under Regulation ATS should generally be met by any alternative trading system falling within Rule 3b-16, including an alternative trading system that, for other reasons, seeks a low volume exemption.

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

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Commission responds to these comments below in Section VII.

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.

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.

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.

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

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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.

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.

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.

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.''

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.

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

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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.

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.

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

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.

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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.

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.

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

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).

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

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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.

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.

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.

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.

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.

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.

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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.

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.

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

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.

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

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.

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.

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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

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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.

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

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.

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-

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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

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.

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.

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

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

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particular entity's exemption under the rule.

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.

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.

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.

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.

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).

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.

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.

¹⁸ 17 CFR 242.300-303.

¹⁹ 15 U.S.C. 78c(a)(1).

²⁰ 17 CFR 240.3b-16.

²¹ 15 U.S.C. 78c(a)(1).

²² Rule 3b-16(a), 17 CFR 240.3b-16(a).

²³ Rule 3b-16(b), 17 CFR 240.3b-16(b).

²⁴ 15 U.S.C. 78s.

²⁵ Rule 3a1-1(b)(1), 17 CFR 240.3a1-1(b)(1).

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).

²⁸ See infra Section IV.B.2.

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.

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.

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).

³⁴ NASD Letter at 3, n.4.

³⁵ See CME Letter at 2; IBEX Letter at 4.

³⁶ Instinet Letter at 7.

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).

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.

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

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).

⁴⁶ TBMA Letter at 15.

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).

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).

⁵⁰ MSDW Letter at 11.

⁵¹ MSDW Letter, pp. 7-8.

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.

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.

⁵⁷ See id., at 1897.

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.

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

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

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).

⁶⁵ SIA Letter at 3-4, 6-7, 9.

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.

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.

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

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.

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).

⁷⁹ See SIA Letter at 10; DBSI Letter at 3.

⁸⁰ DBSI Letter at 3.

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).

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

⁸⁵ In some cases, however, the systems operated by the interdealer brokers may fall within Rule 3b-16. See supra System F.

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.