Release No. 34-40760

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

Regulation of Exchanges and Alternative Trading Systems

ACTION: Final rules.

IV. Regulation of Alternative Trading Systems

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

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

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

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

[[Page 70859]]

''subsystems within the national market system.'' ¹¹⁵

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

A. Regulation ATS

1. Scope of Regulation ATS a. Definition of Alternative Trading System

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

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

Because the Commission continues to believe that any system that uses its market power to regulate its participants should be regulated as an SRO, the Commission is adopting the definition of alternative trading system as proposed. The Commission would consider a trading system to be ''governing the conduct of subscribers'' outside the trading system if it imposed on subscribers, as conditions of participation in trading, any requirements for which the trading system had to examine subscribers for compliance. In addition, if a trading system imposed as conditions of participation, directly or indirectly, restrictions on subscribers' activities outside of the trading system, the Commission believes that such a trading system should be a registered exchange or operated by a national securities association. For example, the Commission would not consider a trading system to be an alternative trading system, as defined in Rule 300(a), if that trading system prohibited subscribers from placing orders on its system at prices inferior to those subscribers place on other systems. The Commission believes such rules should only be imposed and enforced by regulatory bodies because of the potential that they may be applied for anti-competitive purposes. The Commission does not intend for this limitation to preclude an alternative trading system from imposing credit conditions on subscribers or requiring subscribers to submit financial information to the alternative trading system. b. Exclusion of Trading Systems Registered as Exchanges or Operated by a National Securities Association

The Commission proposed to exclude from the scope of Regulation ATS certain alternative trading systems that are subject to other appropriate regulations. In particular, Rule 301(a) would exclude alternative trading systems (1) registered as exchanges, (2) exempt from exchange registration based on limited volume,¹²² or (3) operated by a national securities association. These systems are subject to regulation as markets under other provisions of the Exchange Act. The Commission is adopting these exclusions as proposed.

c. Exclusion of Alternative Trading Systems Trading Solely Government and Related Securities

(i) Discussion

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

[[Page 70860]]

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

The Government Securities Act of 1986 (''GSA'') amended the Exchange Act to incorporate new section 15C, which, among other things, established registration and notice requirements for government securities brokers and dealers. Section 15C generally requires government securities brokers and dealers (i.e., 15C firms or specialized government securities brokers and dealers) to register with the Commission and to become members of an SRO (twenty-two firms as of March 1998). Firms that are registered with the Commission as general securities brokers or dealers (i.e., traditional broker-dealers registered under section 15(b) of the Exchange Act) are required to file notice with the Commission of their government securities business (3,023 firms as of April 1998). In addition, financial institutions that engage in government securities broker or dealer activities are required to file notice of such activities with their appropriate regulatory agency (120 institutions as of March 1998).

Under the regulatory structure established by the GSA, the Treasury was granted authority to adopt regulations for all government securities brokers and dealers concerning financial responsibility, protection of investors' funds and securities, recordkeeping, reporting, and audit requirements, and to adopt regulations governing the custody of government securities held by depository institutions. The Government Securities Act Amendments of 1993 (''GSAA'') expanded the authority of the federal regulators and the SROs over government securities transactions. The GSAA, among other things, reauthorized the Treasury's rulemaking responsibilities, granted the Treasury authority to prescribe large position recordkeeping and reporting rules, extended the Commission's antifraud and antimanipulation authority to all government securities brokers and dealers, required government securities brokers and dealers to provide to the Commission on request records of government securities transactions to reconstruct trading in the course of a particular inquiry or investigation, removed the statutory restrictions on the authority of the NASD to extend sales practice rules to its members' transactions in government securities, and provided the bank regulatory agencies with the authority to issue sales practice rules for financial institutions engaged in government securities broker or dealer activities.

The GSA also strengthened the ability of federal regulators to examine, and to bring enforcement actions against, government securities brokers and dealers. The Commission and the SROs have examination and enforcement authority over government securities brokers and dealers registered under section 15C and over the government securities activities of general securities brokers and dealers. The Commission's enforcement authority includes the power to censure, place limitations on the activities, functions, or operations of, suspend for a period not exceeding 12 months, or revoke the registration of the entity. For financial institutions that are government securities brokers or dealers, the institution's appropriate regulatory agency has examination and enforcement authority over the institution. The appropriate regulatory agency must notify the Commission of any sanctions imposed on such institutions, and the Commission must maintain a record of the sanctions.

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

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

(ii) Response to Commenters

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

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

[[Page 70861]]

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

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

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

The Commission does not believe that an alternative trading systems' government securities trading will be subject to more burdensome regulation if it is conducted in the same system as trading in other securities, than if it is conducted in a separate and, therefore, excluded system. Accordingly, the exclusion applies to systems that only trade government and other related securities.

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

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

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

d. Alternative Trading Systems Trading Non-Government Debt Securities

(i) Discussion

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

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

[[Page 70862]]

integrity, and security requirements. Accordingly, the Commission is adopting rules to define these three categories of debt securities. The Commission is deferring any action on requiring alternative trading systems that trade foreign corporate debt or foreign sovereign debt to comply with the fair access and systems capacity, integrity, and security requirements.

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

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

Volume data for the remaining two categories--investment grade and non-investment grade corporate debt--, however, is not currently compiled or published so that alternative trading systems can determine their obligations under Regulation ATS. In order to allow time for logistical arrangements to make such data available, the Commission will not make these fair access and systems capacity, integrity and security provisions of Regulation ATS effective until April 1, 2000.¹⁴⁶

(ii) Response to Commenters

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

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

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

[[Page 70863]]

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

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

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

e. Exemptions From Certain Requirements of Regulation ATS Pursuant to Application to the Commission

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

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

2. Requirements for Alternative Trading Systems Subject to Regulation ATS

Discussed below are the requirements for alternative trading systems subject to Regulation ATS. a. Membership in an SRO

Because alternative trading systems that choose to register as broker-dealers will not themselves have self-regulatory responsibilities, the Commission believes it is important for such systems to be members of an SRO. For this reason, the Commission proposed to require alternative trading systems subject to Regulation ATS to be members of an SRO.

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

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

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

b. Notice of Operation as an Alternative Trading System and Amendments

The Commission proposed to require an alternative trading system registered as a broker-dealer to file a notice with the Commission before commencing operation, amendments to this notice in the event of material changes, and a notice when an alternative trading system ceases operation. The Commission is adopting these requirements as proposed.

More specifically, under Regulation ATS, alternative trading systems are required to file an initial operation report with the Commission on Form ATS at least twenty days prior to commencing operation.¹⁶⁵ Alternative trading systems operating currently must file Form ATS within twenty days of the effective date of these final rules.¹⁶⁶ Form ATS requests information about the alternative trading system, including a detailed description of how it will operate, its prospective subscribers, and the securities it intends to trade. In addition, the alternative trading system is required to describe its existing procedures for reviewing systems capacity, security, and contingency planning. Alternative trading systems are currently required to

[[Page 70864]]

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

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

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

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

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

The Commission, however, believes that twenty days is a short enough period of time that alternative trading systems would not be inconvenienced by the requirement. If a system were only required to provide notice after it commenced operations, the Commission would have no notice of potential problems that might impact investors before the system begins to operate. The Commission also notes that currently broker-dealer trading systems have an identical requirement to file Form 17A-23 with the Commission twenty days prior to commencing operation. The Commission knows of no broker-dealer trading system that was unable to start operating because of the twenty day period. Consequently, the Commission believes the Rule, as adopted, is a reasonable means for the Commission to carry out its functions and imposes no unnecessary burdens on respondents.

The Commission also requested comment on whether the information in Form ATS should remain confidential. Two commenters supported the Commission's proposal to keep confidential the information contained in Form ATS,¹⁷⁴ and one commenter encouraged the public availability of filed information.¹⁷⁵ The Commission continues to believe that notice reports filed with the Commission and the alternative trading system's SRO pursuant to Regulation ATS should be kept confidential. Information required on Form ATS may be proprietary and disclosure of such information could place alternative trading systems in a disadvantageous competitive position. Further, because the Commission wishes to encourage candid and complete filings in order to make informed decisions and track market changes, preserving confidentiality provides respondents with the necessary comfort to make full and complete filings. Finally, based on the Commission's experience with Rule 17a-23 filings, the Commission believes that confidentiality is appropriate.

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

c. Market Transparency

(i) Importance of Market Transparency

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

[[Page 70865]]

public quotation displays (''ECN Display Alternative'').¹⁷⁸

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

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

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

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

(ii) Integration of Orders Into the Public Quotation System

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

(A) New Requirements for Alternative Trading Systems

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

[[Page 70866]]

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

Importantly, the public display requirement in Rule 301(b)(3) applies only to orders in ''covered securities.'' The term ''covered securities'' includes only exchange-listed, Nasdaq NM, and Nasdaq SmallCap securities. Accordingly, alternative trading systems trading equity securities not included within the definition of ''covered security,'' or debt securities, would not be subject to the public display requirement under Regulation ATS.

In the Proposing Release, the Commission proposed a public display requirement substantially similar to the one it is adopting today. The proposal, however, would have only required alternative trading systems to publicly display their best priced orders in a covered security when the system represents ten percent of the trading volume in that security. The Commission decided instead to adopt a five percent threshold in light of the comment letters, many of which supported the public display requirement and recommended that the volume threshold be lower than ten percent.

In the Proposing Release, the Commission proposed that the display requirement be applied on a security-by-security basis and would not have required an alternative trading system to publicly display orders for any securities in which its trading volume accounted for less than ten percent of the total volume for such security. The Commission, however, requested comment on whether an alternative trading system should be required to display the best priced orders in all securities traded in its system, if it reaches the volume threshold in a specified number or percentage of the securities it trades.

After considering the comments on the issue, the Commission is adopting the security-by-security approach as proposed. Although a system that trades more than the volume threshold in a substantial number of securities could be considered a significant market whose best prices in all securities should be transparent, for now the Commission has decided to take the security-by-security approach with a lower volume threshold (five percent) than proposed. The security-by- security approach, among other things, will more readily enable the phase-in of securities subject to the transparency requirements as discussed below.

The Commission emphasizes that, as proposed, Rule 301(b)(3) only requires alternative trading systems to publicly display subscribers' orders that are displayed to more than one other system subscriber. Thus, if an alternative trading system, like some crossing systems, by its design does not display orders to other subscribers, the rules do not require those orders to be integrated into the public quote stream.¹⁸⁹ Similarly, if a portion of a subscriber's order is not displayed to other alternative trading system subscribers, that hidden portion is not subject to the public display requirement in Rule 301(b)(3). Thus, the Commission's rules allow institutions and non- market makers to guard the full size of their orders by using the ''reserve size'' features offered by some alternative trading systems, which allow subscribers to display orders incrementally. For example, a subscriber that wishes to sell 100,000 shares of a given security could place its order in an alternative trading system and specify that only 10,000 shares are to be displayed to other alternative trading system subscribers at a time. In this instance, Rule 301(b)(3) requires that only 10,000 shares be reflected in the public quote. The ability to continue to control how much of their own orders to reveal was a concern of several institutions who commented.¹⁹⁰ Finally, alternative trading systems are not required to provide to the public quote stream orders displayed to only one other alternative trading system subscriber, such as through use of a negotiation feature.

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

Requiring alternative trading systems to furnish to the public quotation system the full size of the best displayed buy and sell orders will ensure that the public quote better reflects true trading interest in a particular security. Furthermore, the Commission believes that institutional investors' orders entered into alternative trading systems provide valuable liquidity, and that displaying such trading interest will substantially strengthen the national market system. Moreover, this public display requirement levels the playing field between market makers--who, when they send customer limit orders to ECNs, the ECN must publicly display that order--and those ECNs, who do not have to display customer limit orders sent directly to the ECN.

In order to monitor the effects of the public display requirement, however, the rules will permit affected alternative trading systems to phase-in institutional orders in covered securities.¹⁹² Before April 21, 1999, the Commission will publish a schedule for the phase-in of individual securities. Fifty percent of the securities subject to the transparency requirement will be phased-in on April 21, 1999 and the remainder of the securities will be phased-in on August 30, 1999.¹⁹³

(B) Response to Comments

The Commission requested comment on whether a ten percent volume

[[Page 70867]]

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

As discussed above, the transparency requirement the Commission is adopting in Rule 301(b)(3) obligates an alternative trading system to disseminate into the public quote the best priced orders in each covered security in which the trading on such system represents more than five percent of total trading volume. The Commission is persuaded by commenters that stated that a ten percent threshold would exclude trading on too many alternative trading systems. The Commission believes that lowering the threshold to five percent will provide more benefits to investors, promote additional market integration, and further discourage two-tier markets. At the same time, the Commission believes that those alternative trading systems with less than five percent of the volume would not add sufficiently to transparency to justify the costs associated with linking to a market.

The Commission requested comment on whether an alternative trading system should be required to display the best priced orders in all securities traded in its system, if it reaches the volume threshold in a specified number or percentage of the securities it trades. Of those commenters addressing this issue, most were in favor of display of the best priced orders in all securities traded on an alternative trading system once that alternative trading system exceeded the volume threshold in some fixed number of securities.¹⁹⁶ The NYSE stated that if an alternative trading system developed a ''general presence'' in the market, for example by reaching the volume threshold in ten or more securities, that alternative trading system should display the best priced orders in all securities it trades. One commenter, however, specifically opposed the display of all securities traded on an alternative trading system rather than mandating display on a security- by-security basis.¹⁹⁷ This commenter also noted that even display on a security-by-security basis may capture a system that trades a significant amount of one security, despite the fact that that security was a minor part of the overall trading in the system. As discussed above, however, the Commission is adopting the rule as proposed.

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

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

[[Page 70868]]

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

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

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

The Commission is not persuaded by commenters that suggest that institutions currently willing to use alternative trading systems to display their orders to other alternative trading system subscribers, including other institutions, market-makers, and broker-dealers, will be less willing to use alternative trading systems that must display those orders to the public market. Our reasons are as follows. The primary group of market participants that will benefit from the public display of institutional orders is retail investors. Retail investors are not currently alternative trading system subscribers. To avoid market impact, institutions try to avoid signaling other institutions and market professionals, not retail investors. Almost all market professionals and a significant number of institutions already subscribe to alternative trading systems. Thus, the Commission believes that the additional exposure to the market should not affect institutions' behavior in their use of alternative trading systems. Moreover, to the extent that institutions want to display small sized orders in the public market, rather than their entire order, they will still be able to make use of an alternative trading system's ''reserve size'' feature. This will enable institutions to avoid exposing the total size of their order to the public market.

The Commission also received numerous comment letters from institutions who expressed similar concerns. Some of these commenters appeared to be concerned that they might be forced to display all orders sent to alternative trading systems, even those orders, or those portions of orders, that are not displayed to any other alternative trading system subscribers.²⁰⁶ To the extent that these letters are concerned with ''full disclosure,'' that concern is misplaced. Instead, the Commission proposed, and is adopting, a public display requirement that applies only to those orders (or those portions of orders) that alternative trading system subscribers

[[Page 70869]]

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

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

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

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

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

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

Nonetheless, the Commission is concerned about commenters' statements that institutions may react to the transparency requirement by shipping more orders upstairs or overseas. The Commission intends to closely monitor the impact of this requirement, and will modify it if harm appears to result.

(iii) Access to Publicly Displayed Orders (A) Application of Access Requirements Under Regulation ATS

The Commission believes that in addition to the display of better alternative trading system prices in the public quotation system, the availability of such trading interest to public investors is an essential element of the national market system. Therefore, the Commission proposed that alternative trading systems afford all non- subscriber broker-dealers equivalent access to the alternative trading system orders displayed in the public quote, similar to the manner in which ECNs currently comply with the ECN Display

[[Page 70870]]

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

The Commission believes that non-subscribing broker-dealers should be able to execute against those alternative trading system orders that are publicly displayed to the same extent as if that price had been reflected in the public quote by a national securities exchange or national securities association. Thus, an alternative trading system should respond to orders entered by non-participants no slower than it responds to orders entered directly by subscribers. The Commission believes that, under current NASD rules, any alternative trading system that allows non-subscribing broker-dealers to execute against publicly displayed alternative trading system orders in the same manner as ECNs linked to the Nasdaq market currently do would comply with this requirement. The NASD does not currently require ECNs to automatically execute orders sent to the ECN through the NASD's SelectNet linkage with the ECN. Any SRO to which alternative trading systems may be linked, may determine that it is necessary for the fair and orderly operation of its market to require that publicly displayed alternative trading system orders be subject to automatic execution. Any such proposed rule change, of course, would have to be filed with the Commission by the SRO, published for comment, and approved by the Commission. The Commission would not approve any such SRO rule unless it finds that such rule is consistent with the Exchange Act. (B) Response to Comments

The Commission asked for comment on whether alternative trading systems should be required to provide non-subscribers with equivalent access to displayed orders. Several commenters responded to this issue. Most of these commenters stated that non-subscribers should be given equivalent access.²¹⁸ Only one commenter cautioned against granting such access. This commenter argued that alternative trading systems and traditional broker-dealers engage in the same business and, therefore, it would impede innovation as well as be unfair to require fair access to trading opportunities on alternative trading systems when the Commission is not proposing to require such access to more traditional broker-dealers.²¹⁹ The Commission does not believe that alternative trading systems and traditional broker-dealers engage in the same business.²²⁰ As discussed above, the Commission believes that the public display of orders on alternative trading systems that are currently displayed only to the subscribers of those alternative trading systems will improve the public securities markets. Without a mechanism to access these orders, any public display requirement is insufficient. Accordingly, the Commission is adopting the fair access requirement.

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

In addition, the Commission asked if there was a feasible way to allow market-wide interaction without linkage to SRO order execution systems, and whether there was a feasible way to grant equivalent non- subscriber access to institutions that are not broker-dealers.

(iv) Execution Access Fees

(A) Limitations on Alternative Trading System Fees Charged to Non- Subscribers

In the Proposing Release, the Commission stated that an alternative trading system's fee schedules should not be used to circumvent the ability of non-participants to access a system's publicly displayed orders.²²³ Because reasonable fees are a component of equal access, the rules the Commission is adopting today prohibit an alternative trading system from setting fees that are inconsistent with the principle of equivalent access to the alternative trading system quotes by members of the SRO to which the alternative trading

[[Page 70871]]

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

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

At such time as quotations in the national market system are reflected in decimals rather than in fractions, the Commission will reconsider the rule's limitation on alternative trading systems charging fees only as permitted by the national securities exchange or national securities association to which they are linked. At that time, the Commission will also consider whether alternative trading systems should be permitted or required to reflect any fee charged in their quotations.

Any rules the exchange or association develops will of course need to be consistent with the goals of promoting competition and protecting investors. The Commission encourages SROs that accept alternative trading system quotes to work with alternative trading systems to develop uniform standards regarding display and execution access by SRO members to alternative trading systems linked to the SRO.²²⁶ In addition, to foster equivalent access to alternative trading systems for exchange-listed securities, the Commission expects Intermarket Trading System (''ITS'') participants to modify ITS Plan requirements where necessary to accommodate alternative trading system participation in the markets of ITS participants, and access to those alternative trading systems through ITS. If the SROs and ITS participants cannot come to terms with affected alternative trading systems within a reasonable time, the Commission will consider exercising its authority to mandate the necessary linkages.

(B) Response to Comments

The Commission requested comment on the fees that alternative trading systems should be permitted to charge non-subscribers under the proposed rules. In addition, the Commission requested comment on whether there were alternatives for assuring fair execution access for non-subscribers other than limiting fees, or another test for determining whether non-subscriber fees assure equal access.

Ten comment letters addressed the issue of fees charged by alternative trading systems for access by non-subscribers. Of these, seven were generally in favor of permitting alternative trading systems to charge some fee to non-subscribers,²²⁷ two were opposed,²²⁸ and one felt the issue needed to be addressed in a separate release by the Commission.²²⁹

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

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

[[Page 70872]]

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

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

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

(v) Amendment to Rule 11Ac1-1 Under the Exchange Act

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

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

d. Fair Access

(i) Importance of Fair Access

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

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

[[Page 70873]]

(ii) Fair Access Requirement

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

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

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

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

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

[[Page 70874]]

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

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

The proposed rules included a right of appeal to the Commission of any denial or limitation of access, as well as a requirement that an alternative trading system notify a person denied or limited access of their right of appeal. The Commission has decided not to adopt these provisions. The Commission is concerned that such a right of appeal would prove burdensome to the alternative trading system, the party denied or limited access, and Commission staff. In addition, commenters generally approved of the goals of fair access, but were not supportive of providing a right of appeal to the Commission.

(iii) Response to Comments

Commenters who addressed the proposed fair access requirement generally agreed with the Commission's goal of ensuring that alternative trading systems with significant volume establish criteria for fairly determining access.²⁵⁷ Two commenters, for various reasons, did not believe that a requirement ensuring fair access by alternative trading systems was necessary.²⁵⁸ Another commenter argued that alternative trading systems that do not display to subscribers should not be required to grant access to non- subscribers.²⁵⁹

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

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

The Commission also requested comment on whether persons denied access to an alternative trading system should have the right to appeal this action to the Commission, what form the appeal should take, and what the appropriate standard for Commission review should be. Five comment letters directly addressed the issue of appeal to the Commission of denials of access.

One commenter favored a right to appeal a denial of access, but stated that the appeal process should begin at the SRO level.²⁶⁵ This commenter stated that appeal to the Commission should occur only if the SRO fails to resolve the dispute. Another commenter, similarly, stated that it believes denials or limitations of access should be handled through current SRO complaint and disciplinary procedures, rather than through procedures used to appeal SRO determinations to the Commission. This commenter stated that it believes formal Commission procedures could blur the allocation of supervisory authority over broker-dealers and could lead to duplicative or inconsistent review proceedings in some cases. Moreover, this commenter was concerned that a

[[Page 70875]]

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

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

e. Capacity, Integrity, and Security Standards

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

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

(i) Application of Capacity, Integrity, and Security Standards

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

The Municipal Securities Rulemaking Board's transaction reporting plan now provides information on the aggregate trading in municipal securities.²⁷⁷ Because similar information for investment grade and non-investment grade corporate debt, however, is not currently available, the system capacity, integrity, and security requirements in Rule 301(b)(6)(D) and (E) will not be made effective until April 1, 2000.²⁷⁸ The Commission is deferring action on the system reliability standards for alternative trading systems trading a substantial portion of the market in foreign corporate debt and foreign

[[Page 70876]]

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

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

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