Release No. 34-40760

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

Regulation of Exchanges and Alternative Trading Systems
 

V. Broker-Dealer Recordkeeping and Reporting Obligations

A. Elimination of Rule 17a-23

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

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

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

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

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

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

VI. Temporary Exemption of Pilot Trading System Rule Filings

A. Introduction

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

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

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

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

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

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

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

B. Rule 19b-5

The Commission is adopting Rule 19b-5 to provide a temporary exemption from Section 19(b) of the Exchange Act for SRO proposed rule changes concerning the operation of pilot trading systems.

1. Types of Systems Eligible for Exemption Under Rule 19b-5

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

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

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

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

The NYSE commented that the specific provisions of proposed Rule

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

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

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

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

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

2. Scope of Pilot Trading Rule Exemption

The Commission is adopting Rule 19b-5 to provide a temporary exemption from Section 19(b) of the Exchange Act for SRO proposed rule changes concerning the operation of pilot trading systems. This temporary exemption includes all rules related to the operation of pilot trading systems. The Commission defines trading system in paragraph (b) of Rule 19b-5 to include the rules of a self-regulatory organization that:

(i) Determine how the orders of multiple buyers and sellers are brought together; and

(ii) establish non-discretionary methods under which such orders interact with each other and under which the buyers and sellers entering such orders agree to the terms of trade.⁴⁸⁰ The Commission intends this exemption to provide SROs with flexibility to establish and modify the pilot trading system without obtaining prior approval from the Commission. However, this exemption does not include any SRO rules that would fundamentally affect the relationship between an SRO's members and those members' customers, or an SRO's oversight of its members.

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

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

3. SROs' Continuing Obligations Regarding Pilot Trading Systems

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

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

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

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

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

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

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

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

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

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

d. Surveillance. Under the proposal, an SRO would have to establish procedures for the effective surveillance of trading activity on a pilot trading system. In the Proposing Release, the Commission noted the importance of an SRO being able to obtain information necessary to detect and deter market manipulation, illegal trading, and other trading abuses. To satisfy this requirement, the Commission proposed that an SRO have to develop and implement internal surveillance procedures to monitor transactions effected on the pilot trading system, and obtain surveillance information from other markets, both domestic and foreign.

Specifically, in the Proposing Release, the Commission discussed its expectation that there be a comprehensive information sharing agreement (''ISA'') in place between the SRO operating a pilot trading system and any other market trading the securities, or trading the underlying securities of derivative securities products, traded on such pilot trading system.⁵⁰⁰ Such agreements provide a necessary deterrent to manipulation because they facilitate the availability of information needed to fully investigate a potential manipulation. An SRO operating a pilot trading system trading U.S. securities, or new derivative securities products overlying U.S. securities, would have to continue to ensure that all exchanges on which the U.S. securities trade are members of the Intermarket Surveillance Group (''ISG'').⁵⁰¹ The ISG was formed to coordinate, among other things, effective surveillance and investigative information sharing arrangements in the stock and options markets.

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

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domestic and foreign by means of an ISA.⁵⁰²

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

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

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

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

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

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

The Commission notes that Rule 19b-5 does not prohibit an SRO from developing a trading system that permits a member firm to be a specialist in related securities that trade simultaneously on trading systems operated by the same SRO. However, the SRO could not avail itself of the Rule 19b-5 temporary exemption, and instead would have to file proposed rule changes with the Commission under Section 19(b) of the Exchange Act for public notice and comment and obtain Commission approval prior to operating such trading system.

h. Inspections and Examinations. As a condition to the exemption, the Commission proposed that an SRO cooperate with any examination or inspection by the Commission of persons effecting transactions on the pilot trading system. The Commission received no comments on this requirement and is adopting it as proposed.⁵¹⁵ As adopted, the SRO shall cooperate with the examination, inspection, or investigation by the Commission of transactions effected on the pilot trading system. The Commission staff will review SRO compliance with the conditions in Rule 19b-5 through its routine inspections. In order for the Commission staff to determine whether an SRO has properly relied on the exemption under Rule 19b-5, the SRO must maintain at its principal place of business all relevant records and information pertaining to the pilot trading system and the basis for which the SRO relied on the exemption from the rule filing requirement.⁵¹⁶ The Commission notes that if an SRO outsources the operation or maintenance of any aspect of a pilot trading system, such vendor would be considered to be operating a facility of an SRO and therefore would also be subject to Commission examination or inspection.

i. Public Availability of Pilot Trading System Rules. Although pilot trading system rules do not need to be approved by the Commission, the Commission believes the current trading rules and procedures of the pilot trading system should be publicly available. Accordingly, the Commission is adopting a requirement that the SRO make its trading rules and procedures of the pilot trading system publicly available.⁵¹⁷

C. Rule Filing Under Section 19(b)(2) of the Exchange Act Required Within Two Years

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

VII. The Commission's Interpretation of the ''Exchange'' Definition

A. The Commission's Interpretation in Delta

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

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

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

[[Page 70899]]

interpretation, which was upheld by the Seventh Circuit on review,⁵²⁴ the Commission staff has given operators of trading systems that do not enhance liquidity in traditional ways through market makers, specialists, or a single price auction structure, assurances that it would not recommend enforcement action if those systems operated without registering as exchanges.⁵²⁵

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

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

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

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

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

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

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

In addition to the general increase in the volume of trading occurring on alternative trading systems, the actual number of alternative trading systems has skyrocketed. In 1991, the Commission was aware of only a few such systems. Today, over forty such systems are currently operating. The viability of this number of alternative trading systems indicates that these systems account for an increasing proportion of trading and that a growing number of investors use these systems. Moreover, the arrival of trading services on the Internet portends an increasing level of retail interest in alternative means for trading.

As more alternative trading systems have developed to offer varying services to diverse customer bases, the availability of trading information and the accessibility of trading opportunities have become increasingly fragmented. The national market system relies on centralized sources of trading

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opportunities and trading information. Exchange regulation is designed to facilitate centralization and enhance the general public's opportunities to obtain trading information and to access trading interest.

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

C. The Revised Interpretation of ''Exchange''

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

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

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

D. Other Practical Reasons for Revising the Current Interpretation

1. Additional Flexibility Provided by the National Securities Markets Improvement Act of 1996

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

[[Page 70901]]

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

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

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

2. No-action Approach to Alternative Trading Systems Is No Longer Workable

The Commission also believes that the proliferation of new trading systems necessitates the revision of the interpretation of the term ''exchange.'' The no-action review process that the Commission has used to date to address hybrid systems that incorporate features of both exchanges and broker-dealers worked well and was consistent with the protection of investors when relatively few systems applied for no- action treatment. The no-action process allowed the Division to review the system's services and mechanisms and to monitor the impact of such systems on a case-by-case basis. This is no longer practicable. Absent a revised interpretation of ''exchange,'' the Commission would have to continue to respond to an increasing volume of no-action requests from developing alternative trading systems that seek to avoid the burdens associated with registration as a national securities exchange. The Commission's revised interpretation eliminates the need for this no- action approach. By codifying a regulatory framework that does not rely on Commission staff review of each novel system development, the Commission believes that technological improvements and enhanced services will become available more rapidly.

3. More Rational Treatment of Regulated Entities

The Commission believes that the revised interpretation of the term exchange, in combination with the adoption of Regulation ATS, which allows alternative trading systems to register as broker-dealers,⁵⁵¹ is consistent with other goals and provisions of the Exchange Act. The new regulatory framework, including the revised interpretation of ''exchange'' avoids the need for the Commission to draw what are now arbitrary distinctions between organizations that perform similar functions, avoids classifying alternative trading systems in a manner that does not fit the structure of these systems, and squarely addresses the regulatory concerns raised by these systems.

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

⁴³⁸ 17 CFR 240.17a-23.

⁴³⁹ The term ''internal broker-dealer system'' is defined as ''any facility, other than a national securities exchange, an exchange exempt from registration based on limited volume, or an alternative trading system as defined in Regulation ATS * * * that provides a mechanism, automated in full or in part, for collecting, receiving, disseminating, or displaying system orders and facilitating agreement to the basic terms of a purchase or sale of a security between a customer and the sponsor, or between two customers of the sponsor, through use of the internal broker-dealer system or through the broker or dealer sponsor of such system.'' Rule 17a-3(a)(16)(ii)(A), 17 CFR 240.17a-3(a)(16)(ii)(A).

⁴⁴⁰ 17 CFR 240.17a-3 and 240.17a-4.

⁴⁴¹ Only one commenter addressed the Commission's proposal to repeal Rule 17a-23 and amend Rules 17a-3 and 17a-4. This commenter agreed that amended Rules 17a-3 and 17a-4 would impose similar obligations as current Rule 17a-23. TBMA Letter at 25-26.

⁴⁴² Rules 17a-3(a)(16)(i)(B) and (C), 17 CFR 240.17a- 3(a)(16)(i)(B) and (C).

⁴⁴³ See supra note 439.

⁴⁴⁴ The term ''sponsor'' is defined as ''any broker or dealer that organizes, operates, administers, or otherwise directly controls an internal broker-dealer system or, if the operator of the internal broker-dealer system is not a registered broker or dealer, any broker or dealer that, pursuant to contract, affiliation, or other agreement with the system operator, is involved materially on a regular basis with executing transactions in connection with use of the internal broker-dealer system, other than solely for its own account or as a customer with access to the internal broker-dealer system.'' Rule 17a-3(a)(16)(ii)(B), 17 CFR 240.17a-3(a)(16)(ii)(B).

⁴⁴⁵ The term ''system order'' is defined as ''any order or other communication or indication submitted by any customer with access to the internal broker-dealer system for entry into a trading system announcing an interest in purchasing or selling a security,'' but specifically excludes ''inquiries or indications of interest that are not entered into the internal broker-dealer system.'' Rule 17a-3(a)(16)(ii)(C), 17 CFR 240.17a-3(a)(16)(ii)(C).

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

⁴⁴⁷ See Concept Release, supra note 2, 62 FR at 30518-19.

⁴⁴⁸ See Proposing Release, supra note 3 (discussing comments responding to the Concept Release).

⁴⁴⁹ Id. at n.252.

⁴⁵⁰ 15 U.S.C. 78s(b).

⁴⁵¹ The Commission is also adopting measures to relieve SROs of the requirement to file rule changes with the Commission when an SRO wishes to list or trade new derivative securities products. Securities Exchange Act Release No. 40761 (Dec. 8, 1998).

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

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

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

⁴⁵⁵ See paragraph (c) of Rule 19b-5, 17 CFR 240.19b-5(c), for the definition of ''pilot trading system.''

⁴⁵⁶ 17 CFR 249.821.

⁴⁵⁷ Rule 19b-5(f)(1) and (f)(2), 17 CFR 240.19b-5(f)(1) and (f)(2). See also infra Section VI.C.

⁴⁵⁸ Rule 19b-5(c)(3), 17 CFR 240.19b-5(c)(3).

⁴⁵⁹ See infra Section VI.B.

⁴⁶⁰ See Proposing Release, supra note 3, at ns.256-61 and accompanying text.

⁴⁶¹ See Proposing Release, supra note 3, at n.261.

⁴⁶² See Ashton Letter at 2; SIA Letter at 15; CME Letter at 3; Amex Letter at 1; Bloomberg Letter at 6.

⁴⁶³ Rule 19b-5(c)(2), 17 CFR 240.19b-5(c)(2).

⁴⁶⁴ A pilot trading system is ''independent'' of other trading systems if it meets one of the standards set forth in paragraph (d) of Rule 19b-5.

⁴⁶⁵ Rule 19b-5(c)(1), 17 CFR 240.19b-5(c)(1).

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

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

⁴⁶⁸ NYSE Letter at 9.

⁴⁶⁹ ICI Letter at 5.

⁴⁷⁰ See CBOE Letter at 2, 9; CHX Letter at 11; CME Letter at 4; PCX Letter at 8-10.

⁴⁷¹ See CME Letter at 4; PCX Letter at 9-10.

⁴⁷² See NASD Letter at 13; PCX Letter at 9-10.

⁴⁷³ PCX Letter at 9-10.

⁴⁷⁴ Amex Letter at 1, 3.

⁴⁷⁵ See CBOE Letter at 9; CHX Letter at 11.

⁴⁷⁶ See CBOE Letter at 9; NASD Letter at 2, 14.

⁴⁷⁷ CHX Letter at 11.

⁴⁷⁸ 15 U.S.C. 78f(b)(5).

⁴⁷⁹ See supra note 467 and accompanying text.

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

⁴⁸¹ See supra notes 504-505 and accompanying text.

⁴⁸² See Section 6(b)(2) of the Exchange Act, 15 U.S.C. 78f(2). See also Order Handling Rules Adopting Release, supra note.

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

⁴⁸⁴ See discussion infra VI.B.3.i.

⁴⁸⁵ CBOE Letter at 10.

⁴⁸⁶ Examples include computer companies that design and maintain systems and clearing agencies.

⁴⁸⁷ Rule 19b-5(e)(1), 17 CFR 240.19b-5(e)(1).

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

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

⁴⁹⁰ CBOE Letter at 9.

⁴⁹¹ NYSE Letter at 9.

⁴⁹² Amex Letter, p. 2.

⁴⁹³ American Century Letter, p. 6.

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

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

⁴⁹⁶ Rule 19b-5(e)(2)(i), 17 CFR 240.19b-5(e)(2)(i).

⁴⁹⁷ Rule 19b-5(e)(2)(ii), 17 CFR 240.19b-5(e)(2)(ii).

⁴⁹⁸ Rule 19b-5(e)(2)(iii), 17 CFR 240.19b-5(e)(2)(iii).

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

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

⁵⁰¹See ISG Agreement, dated July 14, 1983, amended Jan. 29, 1990. The ISG members are: Amex, BSE, CBOE, CHX, NASD, NYSE, PCX, and Phlx. The major stock index futures exchanges joined the ISG as affiliate members in 1990.

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

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

⁵⁰⁴ 15 U.S.C. 78l(f).

⁵⁰⁵ See Securities Exchange Act Release No. 39505 (Dec. 31, 1997), 63 FR 1515 (Jan. 9, 1998 ).

⁵⁰⁶ Rule 19b-5(e)(6), 17 CFR 240.19b-5(e)(6).

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

⁵⁰⁸ Amex Letter at 4.

⁵⁰⁹ CBOE Letter at 10.

⁵¹⁰ Rule 19b-5(e)(3), 17 CFR 240.19b-5(e)(3).

⁵¹¹ Rule 19b-5(e)(7)(iii), 17 CFR 240.19b-5(e)(7)(iii), defines related securities to mean any two securities in which the value of one security is determined, in whole or significant part, by the performance of the other security; or the value of both securities is determined, in whole or significant part, by the performance of a third security, combination of securities, index, indicator, interest rate or other common factor.

⁵¹² A specialist, for purposes of the pilot trading system rule, means any member that is subject to an SRO requirement to regularly maintain a market in a particular security. Rule 19b-5(a), 17 CFR 240.19b-5(a). The definition of specialist is meant to preclude member firms with exclusive information about buy and sell orders from using unfairly such non-public material market information to their competitive advantage. For instance, a member acting as a specialist on the NYSE also could not simultaneously act as a specialist in related securities on a pilot trading system sponsored by the NYSE. Similarly, a member acting as a designated primary market maker on the CBOE also could not simultaneously act as a designated primary market maker in related securities on a pilot trading system sponsored by the CBOE.

⁵¹³ An SRO also may request an exemption from the limitation under Rule 19b-5(e)(7)(i) by filing an application for an order for exemptive relief under section 36. See 17 CFR 240.0-12.

⁵¹⁴ Rule 19b-5(e)(7), 17 CFR 240.19b-5(e)(7).

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

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

⁵¹⁷ Rule 19b-5(e)(10), 17 CFR 240.19b-5(e)(10). This specific requirement is necessary because Rule 6a-2, as amended, requires exchanges to file its trading rules and procedures only once every three years, while national securities associations have no such publication requirement except through the rule filing process under section 19(b) of the Exchange Act.

⁵¹⁸ Rule 19b-5(f)(1), 17 CFR 240.19b-5(f)(1).

⁵¹⁹ Rule 19b-5(f)(1) and (f)(2), 17 CFR 240.19b-5(f)(1) and (f)(2).

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

⁵²¹ 15 U.S.C. 78c(a)(1).

⁵²² Delta Release, supra note 32. In 1988, the Commission granted Delta temporary registration as a clearing agency to allow it to issue, clear, and settle options executed through a trading system operated by RMJ Securities (''RMJ''). Concurrently, the Commission's Division of Market Regulation issued a letter stating that the Division would not recommend enforcement action against RMJ if its system did not register as a national securities exchange. Subsequently, the Board of Trade of the City of Chicago and the Chicago Mercantile Exchange petitioned the U.S. Court of Appeals for the Seventh Circuit for review of the Commission's actions. Both challenges were premised on the view that RMJ's system unlawfully failed to register as an exchange or obtain an exemption from registration. The Seventh Circuit vacated Delta's temporary registration as a clearing agency, pending publication of a reasoned Commission analysis of whether or not RMJ's system was an exchange within the meaning of the Exchange Act. Board of Trade of the City of Chicago v. Securities and Exchange Commission, 883 F.2d 525 (7th Cir. 1989) (''Delta I''). In 1989, the Commission solicited comment on the issue, and in 1990 published its interpretation of the term ''exchange'' and its determination that RMJ's system did not meet that interpretation.

⁵²³ See Delta Release, supra note 32. The Commission also identified the following factors as supporting the conclusion that the system in Delta should not be classified as an exchange. Unlike a traditional exchange, the system (1) was not open to the participation of retail investors on an agency basis; (2) did not offer limit order protection; and (3) provided a forum for trading instruments that lacked certain indicia of standardization. These factors were admittedly outside the Commission's ''central focus'' in Delta. Id. Moreover, most alternative trading systems that will fall now under the Commission's new interpretation in Rule 3b-16 allow broker-dealer subscribers to act on behalf of retail customers in placing and executing orders on the system; function as limit order books where orders are executed according to time, price, and size priority; and trade standard securities.

⁵²⁴ Board of Trade of the City of Chicago v. SEC, 923 F.2d 1270 (7th Cir. 1991).

⁵²⁵ For a list of no-action letters issued to system sponsors until the end of 1993 and a short history of the Commission's oversight of such systems, see Securities Exchange Act Release No. 33605, 59 FR 8368, 8369-71 (Feb. 18, 1994). See also Letters from the Division of Market Regulation to: Tradebook (Dec. 3, 1996); The Institutional Real Estate Clearinghouse System (May 28, 1996); Chicago Board Brokerage, Inc. and Clearing Corporation for Options and Securities (Dec. 13, 1995).

⁵²⁶ Delta Release, supra note 32, at 1899.

⁵²⁷ Id.

⁵²⁸ Id.

⁵²⁹ See supra note 7.

⁵³⁰ The rules adopted today reflect and facilitate multiple sources of liquidity. Increasing the linkages among markets where significant trading activity occurs--both exchanges and alternative trading systems--will make the overall market for securities more transparent and liquid.

⁵³¹ See Order Handling Rules Adopting Release, supra note 177 at Section III.

⁵³² In fact, an alternative trading system that posts firm orders to buy or sell a security does raise a certain expectation of execution at those quoted prices. The expectation is based on the life of the outstanding orders in the system, rather than on continuous two-sided quotations published by specialists or market makers.

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

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

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

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

⁵³⁷ See Proposing Release, supra note 3, at n.290.

⁵³⁸ For example, the evidence in the Commission's report on the NASD and the Nasdaq market pursuant to section 21(a) of the Exchange Act suggests that widespread use of Instinet by market makers as a private market has had a significant impact on public investors and the operation of the Nasdaq market. See NASD 21(a) Report, supra note 4.

⁵³⁹ Courts have consistently upheld an agency's discretion to revise earlier interpretations when a revision is reasonably warranted by changed circumstances. See, e.g., Rust v. Sullivan, 500 U.S. 173, 186 (1991). In Rust, the Court stated that ''an initial agency interpretation is not instantly carved in stone, and the agency, to engage in informed rulemaking, must consider varying interpretations and the wisdom of its policy on a continuing basis.'' Id. at 186 (quoting Chevron v. Natural Resources Defense Council, 467 U.S. 837, 844-45 (1984)). The Court also stated that ''an agency is not required to `establish rules of conduct to last forever,' but rather `must be given ample latitude to adapt its rules and policies to the demands of changing circumstances.' '' Id. at 186-87 (quoting Motor Vehicles Mfrs. Ass'n of United States v. State Farm Mut. Automobile Ins. Co., 463 U.S. 29, 42 (1983)). See also Arkansas AFL-CIO v. FCC, 11 F.3rd 1430, 1441 (8th Cir. 1993) (deferring to Federal Communications Commission decision to alter its interpretation of the statutory term ''operated in the public interest'' to meet the changing realities of the broadcast industry).

⁵⁴⁰ See Concept Release, supra note 2, at nn.125-133 and accompanying text.

⁵⁴¹ This broad conception of ''bringing together'' buyers and sellers is consistent with the Delta Release, which emphasized that the means employed for bringing together buyers and sellers ''may be varied, ranging from a physical floor or trading system * * * to other means of intermediation (such as a formal market making system or systemic procedures such as a consolidated limit order book or regular single price auction).'' Delta Release, supra note 32, at 1899.

⁵⁴² The elements of the interpretation are discussed in greater detail in Section III, supra.

⁵⁴³ See TBMA Letter at 3-4.

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

⁵⁴⁵ For example, at the time of the Delta Release, the Commission sought to avoid interpreting the term ''exchange'' in a way that could unintentionally and inappropriately subject many broker-dealers to exchange regulation. One key factor in the Commission's decision not to regulate the Delta system as an exchange was the concern that doing so would subject traditional broker-dealer activities to exchange regulation. Delta Release, supra note 32.

⁵⁴⁶ Pub. L. 104-290, 110 Stat. 3416 (1996). 15 U.S.C. 78mm.

⁵⁴⁷ Throughout the past 60 years, the Commission has attempted to accommodate market innovations within the existing statutory framework to the extent possible in light of investor protection concerns, without imposing regulation that would stifle or threaten the commercial viability of such innovations. For example, at various times, the Commission considered the implications of evolving market conditions on exchange regulation. See Securities Exchange Act Release Nos. 8661 (Aug. 4, 1969), 34 FR 12952 (initially proposing Rule 15c2-10); 11673 (Sept. 23, 1975), 40 FR 45422 (withdrawing then-proposed Rule 15c2-10 and providing for registration of securities information processors); 26708 (Apr. 13, 1989), 54 FR 15429 (reproposing Rule 15c2-10); 33621 (Feb. 14, 1994), 59 FR 8379 (withdrawing proposed Rule 15c2-10).

⁵⁴⁸ 15 U.S.C. 78mm(a)(1).

⁵⁴⁹ Prior to the addition of section 36 to the Exchange Act, the Commission could only exempt an exchange from the registration provisions of sections 5 and 6 on the basis of an exchange's limited volume of transactions. See Section 5 of the Exchange Act, 15 U.S.C. 78e.

⁵⁵⁰ See S. Rep. No. 104-293, 104th Cong. 2d Sess. 15 (1996).

⁵⁵¹ See supra Section IV.A.

⁵⁵² See supra IV.A.2.