23504 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Parts 201, 240, 242 and 249

[Release No. 34–39884; File No. S7–12–98]

RIN 3235–AH41

Regulation of Exchanges and

Alternative Trading Systems

AGENCY: Securities and Exchange

Commission.

ACTION: Proposed rules.

SUMMARY: The Securities and Exchange

Commission today is proposing new

rules and rule amendments to allow

alternative trading systems to choose

whether to register as national securities

exchanges, or to register as brokerdealers and comply with additional

requirements under proposed

Regulation ATS depending on their

activities and trading volume. The

Commission is also proposing

amendments to Form 1 and related rules

regarding registration as a national

securities exchange. Finally, the

Commission is proposing to exclude

from the rule filing requirements certain

pilot trading systems operated by

national securities exchanges and

national securities associations. These

proposals would more effectively

integrate the growing number of

alternative trading systems into the

national market system, accommodate

the registration of proprietary

alternative trading systems as

exchanges, and provide an opportunity

for registered exchanges to better

compete.

DATES: Comments should be submitted

on or before July 28, 1998.

ADDRESSES: Interested persons should

submit three copies of their written

data, views and opinions to Jonathan G.

Katz, Secretary, Securities and Exchange

Commission, 450 Fifth Street, NW.,

Washington, DC 20549. Comments also

may be submitted electronically at the

following E-mail address: rulecomments@sec.gov. All comment letters

should refer to File No. S7–12–98. All

submissions will be made available for

public inspection and copying at the

Commission’s Public Reference Room,

Room 1024, 450 Fifth Street, NW.,

Washington DC 20549. Electronically

submitted comment letters will be

posted on the Commission’s Internet

web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT:

Elizabeth King, Senior Special Counsel,

at (202) 942–0140, Marianne Duffy,

Special Counsel, at (202) 942–4163,

Constance Kiggins, Special Counsel, at

(202) 942–0059, Lauren Mullen, Special

Counsel, at (202) 942–0196, Kevin

Ehrlich, Attorney, at (202) 942–0778,

and Denise Landers, Attorney, at (202)

942–0137, Division of Market

Regulation, Securities and Exchange

Commission, Stop 10–1, 450 Fifth

Street, NW., Washington, DC 20549. For

questions or comments regarding

securities registration issues raised in

this release, contact David Sirignano,

Associate Director, at (202) 942–2870,

Division of Corporation Finance,

Securities and Exchange Commission,

Stop 3–1, 450 Fifth Street, NW.,

Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Executive Summary

A. Introduction

B. Need for a New Regulatory Framework

for Alternative Trading Systems

C. The Concept Release

D. Current Proposal

E. Conclusion

II. Proposed Rule 3b–12 under the Exchange

Act

A. Consolidates the Orders of Multiple

Parties

B. Non-discretionary Material Conditions

1. Non-discretionary Material Conditions

Established by a Trading Facility

2. Non-discretionary Material Conditions

Established by Setting Rules

C. Systems Not Included in Proposed Rule

3b–12

1. Order Routing Systems

2. Dealer Quotation Systems

3. Internal Broker-dealer Order

Management and Execution Systems

D. Exemption from the Definition of

‘‘Exchange’’ for Certain Alternative

Trading Systems

III. Regulation of Alternative Trading

Systems

A. Regulation ATS

1. Scope of Regulation ATS

2. Requirements for Alternative Trading

Systems Subject to Regulation ATS

a. Membership in an SRO

b. Notice of Operation as an Alternative

Trading System and Amendments

c. Market Transparency

(i) Integration of Orders into the Public

Quotation System

(ii) Access to Publicly Displayed Orders

(iii) Execution Access Fees

(iv) Amendment to Rule 11Ac1–1 under

the Exchange Act

d. Fair Access

e. Capacity, Integrity, and Security

Standards

f. Examination, Inspection, and

Investigations of Subscribers

g. Recordkeeping

h. Reporting and Form ATS–R

i. Procedures to Ensure Confidential

Treatment of Trading Information

j. Name of Alternative Trading Systems

B. Registration as a National Securities

Exchange

1. Benefits of Registration as a National

Securities Exchange

2. Responsibilities of Registered National

Securities Exchanges

a. Self-Regulatory Responsibilities

b. Fair Representation

c. Membership on a National Securities

Exchange

d. Fair Access

e. Compliance with ARP Guidelines

f. Registration of Securities

g. NMS Participation

h. Uniform Trading Standards

3. Application for Registration as an

Exchange

a. Revisions to Form 1

b. Amendments to Rules 6a–1, 6a–2, and

6a–3 under the Exchange Act

(i) Application for Registration as an

Exchange or Exemption Based on

Limited Volume of Transactions

(ii) Periodic Amendments

(iii) Supplemental Material

IV. Broker-Dealer Recordkeeping and

Reporting Obligations

A. Elimination of Rule 17a–23

B. Amendments to Rules 17a–3 and 17a–

4

V. Temporary Exemption of Pilot Trading

System Rule Filings

A. Introduction

B. Proposed Rule 19b–5

1. Proposed Definition of a Pilot Trading

System

2. SROs’ Continuing Obligations Regarding

Pilot Trading Systems

a. Notice and Filings to the Commission

b. Trading Rules and Procedures

c. Surveillance

d. Clearance and Settlement

e. Types of Securities

f. Procedures to Ensure the Confidentiality

of Trading

g. Inspections and Examinations

C. Rule Filing Under Section 19(b)(2) of the

Exchange Act Required Within Two

Years

D. Compliance With Other Federal

Securities Laws

E. Request for Comment on Proposed Rule

19b–5

VI. The Commission’s Interpretation of the

‘‘Exchange’’ Definition

A. The Commission’s Interpretation in

Delta

B. The Growing Significance of Alternative

Trading Systems in the National Market

System

C. The Proposed Reinterpretation of

‘‘Exchange’’

D. Other Practical Reasons for Revising the

Current Interpretation

1. Additional Flexibility Provided by the

National Securities Markets

Improvement Act of 1996

2. No-action Approach to Alternative

Trading Systems is No Longer Workable

3. More Rational Treatment of Regulated

Entities

VII. Approaches Not Proposed

A. Tiered Exchange Approach

B. SIP Approach

VIII. Request for Public Comments

IX. Costs and Benefits of the Proposed Rules

and Amendments

A. Costs and Benefits of the Proposals

Regarding Alternative Trading Systems

1. Benefits
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23505

1The Commission used the term ‘‘alternative

trading system’’ in the Concept Release, see infra

note 2, to describe trading systems not registered as

exchanges. This term encompasses some systems

that previous Commission releases called

‘‘proprietary trading systems,’’ ‘‘broker-dealer

trading systems,’’ and ‘‘electronic communications

networks.’’ The latter two terms are defined in

Rules 17a–23 and 11Ac1–1 under the Exchange Act,

17 CFR 240.17a–23 and 240.11Ac1–1, respectively,

and trigger specific regulatory obligations under

those rules. In this release, the Commission is

proposing to define the term ‘‘alternative trading

system.’’ See Proposed Rule 300(a).

2Securities Exchange Act Release No. 38672, 62

FR 30485 (May 23, 1997) (‘‘Concept Release’’).

3Section 36 of the Exchange Act, 15 U.S.C.

78mm, was enacted as part of the National

Securities Markets Improvement Act of 1996, Pub.

L. 104–290 (‘‘NSMIA’’). See infra Section VI.D.1.

a. Improved Surveillance on Alternative

Trading Systems

b. Improved Market Transparency

c. Fair Access

d. Systems Capacity, Integrity, and

Security

2. Costs

a. Notice, Reporting, and Recordkeeping

b. Public Display of Orders and Equal

Execution Access

c. Fair Access

d. Systems Capacity, Integrity, and

Security

e. Costs of Exchange Registration

B. Proposed Amendments to Application

and Related Rules for Registration as an

Exchange

1. Benefits

2. Costs

C. Costs and Benefits of the Proposed

Repeal of Rule 17a–23 and the Proposed

Amendments to Rules 17a–3 and 17a–4

1. Benefits

2. Costs

D. SRO Pilot Trading System

1. Benefits

2. Costs

E. Request for Comment

X. Effects on Efficiency, Competition, and

Capital Formation

XI. Initial Regulatory Flexibility Analysis

XII. Paperwork Reduction Act

A. Form 1, Rules 6a–1 and 6a–2

B. Rule 6a–3

C. Rule 17a–3(a)(16)

D. Rule 17a–4(b)(10)

E. Rule 19b–5 and Form PILOT

F. Rule 301, Form ATS and Form ATS–R

G. Rule 302

H. Rule 303

I. Request for Comment

XIII. Statutory Authority

I. Executive Summary

A. Introduction

Technological developments have

changed our markets in many ways.

They have greatly expanded the number

of investment and execution choices,

increased market efficiency, and

reduced trading costs. Market

participants have incorporated

technology into their businesses to

provide investors with an increasing

array of services, and to furnish these

services during more hours, often at

lower prices. Many of these trading and

business functions, however, were not

foreseen by a regulatory framework

designed more than six decades ago. In

particular, market participants have

developed a variety of alternative

trading systems 1 that furnish services

traditionally provided solely by

registered exchanges. Consequently, the

distinctions between markets,

intermediaries, and service providers

have blurred.

In light of these changes, in May 1997,

the Securities and Exchange

Commission (‘‘Commission’’ or ‘‘SEC’’)

published a Concept Release,2 which

requested comment on ways to update

the regulatory framework for alternative

trading systems. In the Concept Release,

the Commission considered two

principal alternatives for the regulation

of alternative trading systems. First, the

Concept Release solicited comment on

incorporating these systems into a

tiered-exchange regulation framework,

under which alternative trading systems

would be subject to requirements

tailored to their size and role in the

market. Second, comment was solicited

on increasing the Commission’s

oversight of alternative trading systems

through enhanced broker-dealer

regulation.

After reviewing the comment letters

and current market conditions, the

Commission is proposing to address the

activities of alternative trading systems

by combining the two approaches

discussed in the Concept Release. Under

today’s proposal, alternative trading

systems would be able to choose

whether to: (1) Register as national

securities exchanges under sections 5

and 6 of the Exchange Act; or (2) register

as broker-dealers and comply with the

additional requirements being proposed

as new Regulation ATS.

B. Need for a New Regulatory

Framework for Alternative Trading

Systems

The federal securities laws have

served the markets well. This basic

regulatory structure has enabled the

United States to have the safest, most

liquid securities markets in the world.

One of the principal reasons for these

markets’ success is the widely

acknowledged benefit of securities

markets that are free from fraud and

manipulation. Moreover, the securities

laws—to a great extent—have provided

a level playing field so that competition

among market participants can thrive. In

addition, the Commission has worked to

apply and implement the federal

securities laws in a way that encourages

our securities markets to take advantage

of the many benefits of technology.

As a result, investors have available a

wide range of options for executing their

securities trades. In particular,

alternative trading systems now handle

more than twenty percent of the orders

in securities listed on The Nasdaq Stock

Market (‘‘Nasdaq’’), which represents an

almost one percent increase from the

previous year. Alternative trading

systems also continue to trade almost

four percent of orders in listed

securities. Even though these systems

provide services that are similar to those

provided by the registered exchanges

and Nasdaq, most alternative trading

systems are regulated as broker-dealers.

This creates disparities that affect

investors, market intermediaries, and

other markets. For example, activity on

alternative trading systems is not fully

disclosed to, or accessible by, public

investors and may not be adequately

surveilled for market manipulation and

fraud. Moreover, these trading systems

have no obligation to provide investors

a fair opportunity to participate in their

systems or to treat their participants

fairly. In addition, they do not have an

obligation to ensure that their capacity

is sufficient to handle trading demand.

Because of the increasingly important

role of alternative trading systems, these

differences call into question not only

the fairness of current regulatory

requirements, but also the efficacy of the

existing national market system

(‘‘NMS’’) structure.

In 1996 Congress provided the

Commission with greater flexibility in

regulating new trading systems by

adding Section 36 to the Securities

Exchange Act of 1934 (‘‘Exchange Act’’).

This Section gives the Commission

broad authority to exempt any person

from any of the provisions of the

Exchange Act.3 As a result, the

Commission now has a greater ability to

adopt a regulatory approach more

tailored to today’s securities markets,

which will allow the Commission to

integrate trading on alternative markets

more fully into the NMS, without

jeopardizing the commercial viability of

these markets. The Commission is also

now able to exempt registered

exchanges from requirements that are

unnecessary or inappropriate.

C. The Concept Release

On May 23, 1997, the Commission

issued the Concept Release soliciting

comment on ways to update the

regulatory framework in light of the

dramatic changes in the U.S. securities
23506 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

4See Concept Release, supra note 2. The Concept

Release also solicited comment on the

Commission’s regulation of foreign market activities

in the United States. The proposals discussed in

this release, however, do not address issues relating

to foreign market activities in the U.S.

5The comment letters and a summary of

comments have been placed in Public File S7–16–

97, which is available for inspection in the

Commission’s Public Reference Room.

6See infra Section III.A. As discussed in the

Concept Release, the government securities market

is subject to its own specialized oversight structure.

For this reason, the Commission does not believe

it is necessary to change the regulation of

alternative trading systems to the extent that they

exclusively trade government securities. See infra

notes 70 and 71 accompaning text.

7The Commission notes that organizations that

conduct a regulatory function with respect to their

members are excluded from the definition of

alternative trading system. Consequently, such

system would have to register as national securities

exchanges. See infra notes 65 and 66 and

accompanying text.

8The statutory definition of ‘‘exchange’’ appears

in section 3(a)(1) of the Exchange Act, 15 U.S.C.

78c(a)(1).

9The Commission would consider a customer

order displayed by a dealer in its quote to be the

‘‘dealer’s quote’’ for purposes of this exclusion, if

a customer order were displayed solely to comply

with a Commission or SRO rule.

markets brought about by new and

evolving technology.4 The Concept

Release began a dialogue about how the

Commission should best respond to the

legal and regulatory challenges created

by both existing—and future—

technological developments. In

particular, the Commission asked for

comment on how to effectively oversee

alternative trading systems in general,

and especially those that are becoming

increasingly significant market centers.

Although these alternative trading

systems perform the functions of a

market, they are not required to surveil

their markets for manipulative activity,

to make all of their quotes public, to

treat participants fairly, or to maintain

adequate capacity to prevent outages.

Thus, as these alternative trading

systems are increasingly used for trade

execution, the existing regulations fail

to provide investors with access to the

best prices, or to integrate these systems

fully into the NMS, including the

surveillance and enforcement

mechanisms operated by the registered

exchanges and the National Association

of Securities Dealers, Inc. (‘‘NASD’’).

The Concept Release solicited

commenters’ views on two principal

approaches to address these concerns.

Under the first approach, alternative

trading systems would be incorporated

into the Commission’s regulation of

exchanges under a three-tiered

framework. Under the second approach,

alternative trading systems would

continue to be regulated as brokerdealers, but would be required to

comply with rules designed to improve

their transparency and surveillance, as

well as their systems capacity, integrity,

and security. A wide variety of market

participants, including self-regulatory

organizations (‘‘SROs’’), traditional

broker-dealers, and alternative trading

systems, provided the Commission with

thoughtful comments on both of these

approaches.5

In general, commenters supported the

Commission’s efforts to make the

regulatory structure more responsive to

technological innovation and agreed

that the current structure should be

revised to apply enhanced linkage,

surveillance, and other requirements to

alternative trading systems. A number of

commenters agreed that technology has

made the line between broker-dealers

and exchanges more difficult to draw

and that the roles of broker-dealers and

exchanges are becoming increasingly

interchangeable. Many commenters

emphasized the need to make any new

regulatory scheme flexible enough to

accommodate the varying needs and

structures of these market participants.

Commenters differed considerably,

however, on what the Commission’s

goals should be in enhancing the

oversight of alternative trading systems,

the extent of change necessary, and how

to best achieve enhanced oversight.

Consequently, there were few instances

in which commenters were in

consensus. Nevertheless, commenters

did, generally, express a preference for

continuing to regulate alternative

trading systems as broker-dealers, rather

than incorporating them into exchange

regulation.

While some commenters argued that

the importance of some electronic

markets as trading venues justifies the

imposition of exchange regulation,

several regional exchanges and other

market participants were not convinced

that the exchange approach would

fulfill the regulatory goals outlined in

the Concept Release. Many commenters

believed integrating alternative trading

systems into existing surveillance

mechanisms could impose burdens on

both the market as a whole and the

Commission. Many commenters noted

that this approach could potentially

lead to uneven and fragmented market

oversight. At the heart of many of these

objections was the fear that alternative

trading systems would be forced to

submit to some degree of exchange

regulation, albeit modified for most

systems, which could lead to structural

changes. Commenters also feared that an

exchange-based regulatory approach

could frustrate innovation and reduce

the benefits offered by alternative

trading systems.

D. Current Proposal

Technological developments continue

to change market structure. The

Commission firmly believes that there

should be a regulatory framework in

place that makes sense both for current

and future securities markets. This

regulatory framework should encourage

market innovation without

compromising basic investor

protections.

After considering the comment letters,

the Commission is proposing to address

the activities of alternative trading

systems by combining the two

approaches discussed in the Concept

Release. This combined approach

should allay commenters’ concerns that

a new regulatory scheme would not be

flexible enough to accommodate the

business objectives of, and the benefits

provided by, alternative trading

systems. Specifically, the Commission is

proposing to allow an alternative

trading system to choose whether to: (1)

Register as a national securities

exchange under sections 5 and 6 of the

Exchange Act; or (2) register as a brokerdealer and comply with the additional

requirements being proposed as new

Regulation ATS.6 The proposal set forth

in this release is intended—to the extent

consistent with the federal securities

laws—to allow alternative trading

systems to choose the market role that

works best for them.7 At the same time,

this proposal is designed to preserve the

benefits of a competitive market

structure that has greatly enhanced

market liquidity, transparency, and

efficiency.

To implement this approach, the

Commission is proposing Rule 3b–12

under the Exchange Act, which would

define terms used in the statutory

definition of ‘‘exchange’’ 8 to encompass

most alternative trading systems. This

new rule would include any

organization, association, person, group

of persons, or system that: (1)

Consolidates orders of multiple parties;

and (2) sets non-discretionary material

conditions (whether by providing a

trading facility or by setting rules) under

which subscribers entering such orders

agree to the terms of a trade. Proposed

Rule 3b–12 would specifically exclude

those systems that only: (1) Route orders

to a registered exchange, a market

operated by a national securities

association, or any broker-dealer; (2)

display the quotes of a single dealer and

allows persons to enter orders for

execution against such dealer’s quotes; 9

or (3) provide the means for a single

broker-dealer to internally manage its

customers’ orders, including crossing or
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23507

10The Commission’s current interpretation of

‘‘exchange’’ is set forth in Securities Exchange Act

Release No. 27611 (Jan. 12, 1990), 55 FR 1980, 1900

(Jan. 19, 1990) (‘‘Delta Release’’). See infra Section

II for a discussion of proposed Rule 3b–12.

11See infra Section III.B.

12This linkage requirement would not apply to

alternative trading systems that do not display

participant orders to anyone, including other

system participants. In addition, this requirement

would not apply to alternative trading systems to

the extent that they trade securities other than NMS

securities. See infra Section III.A.2.c.(i).

13 17 CFR 240.17a–23.

14 17 CFR 240.17a–3.

15 17 CFR 240.17a–4.

16See infra Section IV.

17See infra Section V.

18 15 U.S.C. 78c(a)(1).

19Proposed Rule 3b–12(a).

20See Delta Release supra note 10. The basis and

purpose of the revised interpretation is set forth

infra Section VI.

matching such orders with each other

provided that (i) those orders are not

displayed to any person other than the

broker-dealer and its employees and (ii)

those orders are not executed according

to a predetermined procedure that is

communicated to the customers.

Because most alternative trading

systems are not encompassed by the

Commission’s current interpretation of

‘‘exchange,’’ 10 the Commission is also

proposing to revise its interpretation to

better reflect the ever-evolving securities

markets and to give alternative trading

systems the option of registering as

national securities exchanges.

For alternative trading systems that

choose to register as national securities

exchanges, the Commission is proposing

to accommodate their proprietary

structure by amending the application

for registration and providing guidance

on ways for proprietary markets to meet

their fair representation requirements as

non-membership national securities

exchanges.11

For alternative trading systems that

choose to register as broker-dealers, the

Commission is proposing new

Regulation ATS, which would require

alternative trading systems to comply

with additional requirements designed

to address the concerns raised by their

market activities. To provide for

continuing innovation and competition

through the introduction of new

alternative trading systems, the

Commission proposes that systems with

limited volume be required only to: (1)

File with the Commission a notice of

operation and quarterly reports; and (2)

maintain records, including an audit

trail of transactions. If, however, an

alternative trading system with

significant trading volume chooses to

register as a broker-dealer—instead of as

an exchange—the Commission believes

it is in the public interest to integrate its

activities into the NMS. Therefore, in

addition to the requirements for smaller

alternative trading systems, significant

volume alternative trading systems that

trade NMS securities would be required

to link with a registered market in order

to disseminate the best priced orders

displayed in their systems (including

institutional orders) into the public

quote stream. They would also be

required to comply with the same

market rules governing execution

priorities and obligations that apply to

members of the registered market.12 In

addition, alternative trading systems

with significant volume in any security,

whether equity or debt, would be

required to: (1) Grant or deny access

based on standards established by the

trading system and applied in a nondiscriminatory manner; and (2) establish

procedures to ensure adequate systems

capacity, integrity, and contingency

planning. These requirements would

more actively integrate those significant

alternative trading systems into NMS

mechanisms. Moreover, because

alternative trading systems that choose

to register as broker-dealers would not

be required to surveil activities on their

markets, the Commission intends to

work with the SROs to improve the

SROs’ ongoing, real-time surveillance

for market manipulation and fraud and

to develop surveillance and

examination procedures specifically

targeted to alternative trading systems

they supervise.

The Commission is also proposing to

repeal Rule 17a–23.13 This rule was

adopted to provide the Commission

with certain information about the

activities of automated markets operated

by broker-dealers. Alternative trading

systems would continue to provide the

Commission with information about

their activities either as registered

exchanges or as registered brokerdealers subject to Regulation ATS. Some

broker-dealer trading systems that are

currently subject to Rule 17a–23,

however, would not be alternative

trading systems. The Commission

believes that these internal brokerdealer systems should, nevertheless,

continue to keep records of trading

conducted through these systems.

Therefore, the Commission is proposing

to amend Rules 17a–3 14 and 17a–4 15

under the Exchange Act to require that

records of these transactions be

maintained. Internal broker-dealer

trading systems would, however, no

longer have to report any information to

the Commission.16

Finally, the Commission is proposing

to allow SROs, without filing for

approval with the Commission, to

operate pilot trading systems for no

more than two years. These pilot trading

systems would be subject to specific

conditions, including limitations on

their trading volumes.17

E. Conclusion

The explosive growth of alternative

trading systems over the past several

years has significant implications for

market regulation. The Commission

believes it is critical to develop a

regulatory framework that both

accommodates traditional market

structures and provides sufficient

flexibility to ensure that new markets

promote fairness, efficiency, and

transparency. While the questions

raised by technological developments in

the U.S. markets could be addressed in

a variety of ways, the Commission

preliminarily believes that the

regulatory approach proposed today

would be the most effective way to

facilitate these goals.

II. Proposed Rule 3b–12 Under the

Exchange Act

As part of this new approach, the

Commission is proposing new Rule 3b–

12 under the Exchange Act. This rule

would define terms used in the statutory

definition of ‘‘exchange,’’ found in

section 3(a)(1) of the Exchange Act.18

The statutory definition of ‘‘exchange’’

includes a ‘‘market place or facilities for

bringing together purchasers and sellers

of securities or for otherwise performing

with respect to securities the functions

commonly performed by a stock

exchange.’’ The new rule would define

these terms to be any organization,

association, or group of persons that: (1)

Consolidates orders of multiple parties;

and (2) sets non-discretionary material

conditions (whether by providing a

trading facility or by setting rules) under

which parties entering such orders agree

to the terms of a trade.19 The

Commission recognizes that the

proposed rule would revise the current

interpretation of the term ‘‘exchange,’’

as set forth in the Delta Release.20

The Commission believes that the

proposed rule is an important element

of its proposed new regulatory

framework for alternative trading

systems. As discussed above, the rapid

growth and technological advancements

of alternative trading systems have

eroded the distinctions between the

roles played by alternative trading

systems and by traditional exchanges.

Many alternative trading systems

provide services more akin to exchange

functions than broker-dealer functions,
23508 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

21See infra Section III.B. (discussing registration

as a national securities exchanges).

22 In the Concept Release, the Commission

suggested expanding its interpretation of the term

exchange ‘‘to include any organization that both: (1)

Consolidates orders of multiple parties; and (2)

provides a facility through which, or sets material

conditions under which, participants entering such

orders may agree to the terms of a trade.’’ See

Concept Release, supra note 2, at 50.

23See infra Section II.C. (discussing paragraph (b)

of proposed Rule 3b–12).

24An electronic bulletin board on which

subscribing broker-dealers may post indications of

interest in securities they wish to trade, and

advertise trades they have recently conducted,

would be considered to consolidate orders. For

example, AutEx operates such a bulletin board.

AutEx, however, would not be an exchange under

the proposed interpretation because it does not set

non-discretionary material conditions under which

parties entering orders agree to the terms of a trade.

AutEx does not require that the price and quantity

quoted on the screen be firm, nor does AutEx set

priorities that govern trades. Further, transactions

resulting from posted indications of interest, if any,

are executed outside AutEx. See infra Section II.B.

discussing paragraph (a)(2) of proposed Rule 3b–12.

25A crossing system is, typically, one that allows

participants to enter unpriced orders to buy and sell

securities. Orders are crossed at specified times at

a price derived from another market.

26Matching systems allow participants to enter

limit orders and match those orders with other

orders in the system. Participants are able to view

unmatched limit orders in the system’s book. The

sponsor of a matching system typically acts as

riskless principal with respect to matched orders,

or contracts with another broker-dealer to perform

this function.

27Currently, debt markets are not centrally

organized by a single entity, but are nonetheless

informally organized around interdealer brokers.

Interdealer brokers (also called blind brokers and

brokers’ brokers) display, on an anonymous basis,

the offers to buy and sell securities that are placed

with them by subscribers. In order to place a bid

or offer, a subscriber typically telephones the

interdealer broker, which enters the order into its

system and displays it to other subscribers. Some

interdealer brokers display all bids and offers;

others display only the best bid and offer. To

execute against an offer displayed on the computer

screen, a subscriber telephones the interdealer

broker, although sometimes execution may be

electronic. The identities of the counterparties are,

generally, kept confidential through clearance and

settlement of the trade. Some interdealer brokers,

however, reveal the names of each counterparty

after execution. Traditionally interdealer brokers

facilitated trading only between dealers.

Increasingly, however, interdealer brokers are

permitting non-dealers to participate in their

systems.

28But see infra notes 70 and 71 and

accompanying text (discussing the exemption for

systems that trade exclusively government

securities).

29This type of system also would be expressly

excluded from proposed Rule 3b–12 under

paragraph (b)(2). See infra Section II.C.2.

30An example of this type of system is CP Direct

in which issuers offer to sell their commercial paper

to the customers of CS First Boston. See Bruce Rule,

PSA Panels Embrace Internet for Institutional

Trading; and Regulators Love the Audit Trail,

Investment Dealers’ Digest, Nov. 18, 1996

(discussing CP Direct). The converse situation—i.e.,

where there is one buyer and multiple sellers for

a given instrument—would also not meet the

‘‘multiple parties’’ requirement. The Commission,

however, is not aware of any system that currently

operates this way.

31Proposed Rule 3b–12(c).

such as matching counterparties’ orders,

executing trades, operating limit order

books, and facilitating active price

discovery. For many of these systems,

regulation as a market would more

appropriately fit their economic

functions. Thus, a broader interpretation

of exchange is needed to cover markets

that engage in activities functionally

equivalent to markets currently

registered as national securities

exchanges. Moreover, because in some

cases exchange regulation may better

meet these systems’ business objectives,

the Commission believes that alternative

trading systems should have the option

to register as national securities

exchanges.21 The proposed rule would

help modernize the Commission’s

approach to these systems because it

would adapt the concept of what is

‘‘generally understood’’ to be an

exchange to reflect changes in the

markets brought about by automated

trading. In addition, proposed Rule 3b–

12 would closely reflect the statutory

concept of ‘‘bringing together’’ buying

and selling interests.

The Concept Release set forth a

similar interpretation.22 In response to

commenters’ concerns that any revised

interpretation of exchange should not be

so broad as to include traditional

brokerage activities, proposed Rule 3b–

12 would specifically exclude certain

systems whose activities the

Commission does not believe rise to the

level of being an ‘‘exchange.’’ 23 These

specific exclusions are designed to

clarify the types of activities the

Commission would not consider to be

exchange activities under proposed Rule

3b–12.

A. Consolidates the Orders of Multiple

Parties

In order to be an exchange, a system

must satisfy the first part of proposed

Rule 3b–12(a)—consolidate orders of

multiple parties. This incorporates the

concept of ‘‘bringing together

purchasers and sellers of securities’’ set

forth in the definition of ‘‘exchange’’ in

section 3(a)(1) of the Exchange Act. A

system would be consolidating orders if

it displayed trading interest entered on

the system to system users. This would

include consolidated quote screens,

such as the system operated by

Nasdaq.24 A system would also be

consolidating orders if it receives

subscribers’ orders centrally for future

processing and execution. For example,

limit order matching book systems that

allow subscribers to display buy and

sell offers in particular securities and to

obtain execution against matching offers

contemporaneously entered or stored in

the system would be considered to

consolidate orders. This type of

consolidation is currently performed by

systems that consolidate orders

internally for crossing 25 or matching,26

as well as floor based markets that

impose trading rules. In addition,

interdealer brokers 27 would be

considered to consolidate orders,

regardless of their level of automation.28

On the other hand, systems that merely

provide information, such as

information vendors, would not be

viewed as consolidating orders.

Consolidation thus means that each

order entered in the system for a given

security has the opportunity to interact

with other orders entered into the

system for the same security.

In addition, the system’s

consolidation of orders must be of

multiple parties—i.e., multiple buyers

and multiple sellers. Systems designed

for the purpose of executing orders

against a single counterparty, such as

the dealer operating the system, would

not be considered to have multiple

parties. Thus a single counterparty that

buys and sells securities through a

system, where other parties entering

orders only execute against the single

designated counterparty, would not

meet the requirements of the first part

of proposed Rule 3b–12.29 However, the

mere interpositioning of a designated

counterparty as riskless principal for

settlement purposes after the purchasing

and selling counterparties to a trade

have been matched would not, by itself,

mean that the system does not have

multiple parties. In addition, a system

that has multiple sellers, but only one

seller for each instrument, and multiple

buyers for that instrument would not be

considered to meet the ‘‘multiple

parties’’ requirement.30

Finally, the proposed rule would

make clear that the consolidation must

be of participants’ ‘‘orders.’’ The term

‘‘order’’ would be defined in paragraph

(c) of proposed Rule 3b–12 to include

any firm indication of a willingness to

buy or sell a security, whether made on

a principal or agency basis.31 Firm

indications of buying or selling interest

would specifically include bid or offer

quotations, market orders, limit orders,

and any other priced order.

B. Non-Discretionary Material

Conditions

In addition to consolidating the orders

of multiple parties, in order to be an

‘‘exchange’’ under proposed Rule 3b–12,

a system would have to set nondiscretionary material conditions under

which parties entering orders agree to
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23509

32See infra Section II.C.3. (discussing the

exclusion of internal broker-dealer systems from the

coverage of proposed Rule 3b–12).

33Whether or not a bulletin board would be

considered an exchange under the proposed rule

would also depend on whether it met the other

elements of the definition.

34See Delta Release, supra note 10.

35See Delta Release, supra note 10, at 1897.

36 15 U.S.C. 78k–1.

37 15 U.S.C. 78o–3. As a registered securities

information processor, Nasdaq does not have SRO

responsibilities itself. The NASD delegates to NASD

Regulation, Inc. (‘‘NASDR’’), the wholly owned

regulatory subsidiary of the NASD, its SRO

responsibilities to surveil trading conducted on

Nasdaq and the OTC Bulletin Boards, and to

enforce compliance by its members (and persons

associated with its members) with applicable laws

and rules. If Nasdaq registered as an exchange, it

would have its own SRO responsibilities, but the

Commission does not expect this to increase

Nasdaq’s current burden. Nasdaq also surveils

trading conducted on its market and refers potential

violations to NASDR. The Commission is prepared

to use its authority under sections 17 and 19 of the

Exchange Act, 15 U.S.C. 78q and 78s, to allocate

any obligations Nasdaq would have to enforce

compliance by its members (and persons associated

with its members) with the federal securities laws

to NASDR. See also infra note 166.

38See infra notes 51–53 and accompanying text

(discussing Proposed Rule 3a1–1(a)(1), which

explicitly exempts any systems operated by a

national securities association from the definition of

the term ‘‘exchange’’).

39 15 U.S.C. 78f.

the terms of the trade. A system may

establish non-discretionary material

conditions either by providing a trading

facility or by setting rules governing

trading among subscribers. The

Commission intends for ‘‘nondiscretionary material conditions’’ to

include any conditions that dictate the

terms of trading among the multiple

counterparties entering orders into the

system. In other words, such conditions

would include those that set procedures

or priorities under which open terms of

the trade will later be determined. For

example, a system that trades limited

partnership units might set nondiscretionary material conditions even

though approval from the general

partner is required prior to settlement.

Similarly, systems that allow the trading

price to be determined at some

designated future date on the basis of

pre-established criteria (such as the

weighted average trading price for the

security on the specified date in a

specified market) would be setting nondiscretionary material conditions.

Trading rules or trading facilities that

do not determine the manner of

execution or the means for agreeing to

the terms of a trade would not be

considered to set non-discretionary

material conditions. Similarly, rules that

merely address the means of

communication with a system (for

example, software or hardware tools

that subscribers may use in accessing

the system), would not satisfy this

element of proposed Rule 3b–12.

Further, conditions would not be

deemed material and non-discretionary

unless they were communicated to

subscribers. Thus, broker-dealers’

internal order management and

execution systems would not be

exchanges.32

1. Non-Discretionary Material

Conditions Established by a Trading

Facility

A trading facility that sets nondiscretionary material conditions would

include a traditional exchange floor

where specialists are available to receive

orders, or a computer system (whether

comprised of software, hardware,

protocols, or any combination thereof)

through which orders may interact, or

any other trading mechanism that

provides a means or location for the

execution of orders. For example, the

Commission would consider the use of

an algorithm by an electronic trading

system that sets trading procedures and

priorities to be a trading facility that sets

non-discretionary material conditions.

The Commission would attribute the

activities of a trading facility to a system

if that facility is offered by the system

directly or indirectly (such as where a

system arranges for a third party or

parties to offer the trading facility).

Thus, if a system arranges for a third

party vendor to distribute software to

enable persons to access the system, that

system would be deemed to have

established a trading facility, even

though system participants gained

access via a third party provider.

Similarly, if a bulletin board operator

contracted with another party to provide

execution facilities for the bulletin

board users, the bulletin board would be

deemed to have established a trading

facility because it took affirmative steps

to arrange for the necessary exchange

functions for its users.33 In addition, if

an organization arranged for separate

entities to provide different pieces of a

trading system which together met the

definition contained in paragraph (a) of

proposed Rule 3b–12, the organization

responsible for arranging the collective

efforts would be deemed to have

established a trading facility. For

example, the arrangement between the

Delta Government Options Corporation

(‘‘Delta’’), RMJ Options Trading

Corporation, and Security Pacific

National Trust Company, as described

in a 1990 Commission release,34 would

together be an exchange. In this case,

the arranging organization, Delta, would

be considered the exchange under

proposed Rule 3b–12.

2. Non-Discretionary Material

Conditions Established by Setting Rules

Alternatively, a system can establish

non-discretionary material conditions

through the imposition of rules under

which parties entering orders on the

system may agree to the terms of a trade.

For example, the NASD imposes basic

rules by which securities will be traded

on Nasdaq. Specifically, it imposes

affirmative obligations on market

makers in Nasdaq National Market

(‘‘Nasdaq NM’’) and SmallCap

securities, including obligations to post

firm and two-sided quotes.

In addition, the Commission would

consider rules imposing execution

priorities, such as time and price

priority rules, to be non-discretionary

material conditions. Similarly, the

Commission would consider a system

that standardizes the material terms of

instruments traded on the system, such

as the system operated by Delta at the

time the Commission published the

Delta Release, 35 to set non-discretionary

material conditions.

The Commission believes it is

appropriate to include markets, such as

that operated by the NASD, in proposed

Rule 3b–12, although it comprises a

dealer market. Through Nasdaq, market

participants act in concert to centralize

and disseminate trading interest and

establish the basic rules by which

securities will be traded. The

Commission believes that Nasdaq

performs what today is generally

understood to be the functions

commonly performed by a stock

exchange. Nasdaq, however, is currently

registered as a securities information

processor under Section 11A of the

Exchange Act 36 and is operated by the

NASD, a registered securities

association under Section 15A of the

Exchange Act.37 Because the

requirements currently applicable to a

registered securities association are

virtually identical to the requirements

applicable to registered exchanges, the

Commission does not believe it is

necessary or appropriate in the public

interest to require Nasdaq to register as

an exchange.38 Under the proposal,

however, Nasdaq could choose to

register under Section 6 of the Exchange

Act as an exchange.39

C. Systems Not Included in Proposed

Rule 3b–12

The Commission also asked in the

Concept Release whether certain

specific brokerage functions should be

excluded from any revised exchange

regulatory scheme. The Concept Release
23510 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

40A number of commenters named specific

brokerage activities that they believed should not be

considered exchange activities. Commenters

specifically feared that the revised interpretation of

exchange set forth in the Concept Release would

capture internal crossing networks, block trading

desks, third market makers, OTC market makers,

and dealer markets.

41See supra note 9.

42The NYSE’s SuperDOT (Designated Order

Turnaround) system enables firms to transmit

market and limit orders in all NYSE-listed

securities directly to the specialist post for

execution. Some NYSE members also allow selected

institutional customers to route their orders through

the members’ connection to SuperDOT. A similar

system is operated by the American Stock Exchange

(‘‘Amex’’) (Automated Post Execution Reporting

system, or AutoPERS).

43BRASS is an order routing system operated by

Automated Securities Clearance, Ltd. (‘‘ASC’’). ASC

provides system users with software and hardware

that enables users to enter orders into the system

which are then routed to an exchange for execution.

44Proposed Rule 3b–12(b)(1).

45Proposed Rule 3b–12(b)(2).

46Proposed Rule 3b–12(b)(3).

47For example, a block positioner may ‘‘shop’’

the order around in an attempt to find a contra-side

order that has been placed with another trader. In

some cases, the block positioner may take the other

side of the order, keeping the block as a proprietary

position. This decision is dictated by market

conditions and typically lies within the block

positioner’s discretion.

noted that unlike organized markets,

traditional broker-dealer activities do

not involve the systematic interaction of

customer orders where the customers

themselves are informed of and have an

opportunity to agree to the terms of their

trades (or agree to the priorities under

which the terms will be set). The

Concept Release specifically mentioned

several types of activities that could be

considered traditional brokerage

activities, including routine

intermediary functions performed by

brokers, such as block positioning, the

automation of internal order

management where the matching of

customer orders is incidental to the

order management activities, the

automation of order routing and

execution for a single market maker, and

other types of trading where the broker

has discretion as to the means of

execution.

Commenters widely agreed that

automated brokerage functions should

not be encompassed by the meaning of

the term ‘‘exchange.’’ 40 The

Commission agrees. The Commission

has included paragraph (b) of proposed

Rule 3b–12 to clarify those types of

systems that the Commission does not

believe should be encompassed within

paragraph (a) of proposed Rule 3b–12.

Paragraph (b) of Rule 3b–12 would

expressly exclude: (1) Systems that

merely route orders to other execution

facilities; (2) systems that allow

customers of a dealer to execute solely

against the dealer’s inventory; 41 and (3)

systems that allow a broker-dealer to

cross or match customer orders

internally at the broker-dealer’s

discretion. These exclusions are

intended to make clear that paragraph

(a) of proposed Rule 3b–12 does not

cover customary brokerage activity.

1. Order Routing Systems

Systems that merely route orders to an

exchange or broker-dealer for execution,

like the New York Stock Exchange’s

(‘‘NYSE’s’’) SuperDOT42 system and

BRASS,43 would be explicitly excluded

from proposed Rule 3b–12,44 because

they do not consolidate orders. Instead,

all orders entered into a routing system

are sent to another facility that

consolidates orders. In addition, routing

systems do not set non-discretionary

material conditions under which parties

entering orders agree to the terms of the

trade.

2. Dealer Quotation Systems

A sophisticated market maker that

develops a system to disseminate its

own quotations to the public, or to

allow its customers to direct orders for

execution solely against that market

maker’s inventory, is conducting brokerdealer activity. Such systems automate

the order routing and execution

mechanisms of a single market maker

and guarantee that the market maker

will execute orders submitted to it at its

own posted quotation for the security

or, for example, at the inside price

quoted on Nasdaq. Because single

market maker systems merely provide a

more efficient means of communicating

the trading interest of separate

customers to one dealer, they should not

be considered exchanges. Therefore, the

Commission proposes that systems that

display the quotes of a single dealer and

allow customers to execute solely

against those quotes be excluded under

paragraph (b) of proposed Rule 3b–12. 45

3. Internal Broker-Dealer Order

Management and Execution Systems

Finally, a system that provides the

means for a single broker-dealer to

internally manage its customers’ orders,

including crossing or matching such

orders with each other, would be

specifically excluded from paragraph (a)

of proposed Rule 3b–12, if : (1) No

orders were displayed to persons other

than the broker-dealer’s employees; and

(2) customer orders were not executed

according to a predetermined procedure

that is communicated to the customer.46

For example, broker-dealers may

automate part of their intermediary

function by developing internal

programs that allow traders within a

firm to search and match orders with

customer orders of other traders within

the same firm, or with orders and quotes

of other traders. Such systems, however,

generally serve as a means of providing

information regarding a firm’s customer

orders solely to the employees of the

broker-dealer operating the system to

facilitate the employees’ crossing of

customer orders on a discretionary

basis, as described below.

While these internal systems

automate traditional brokerage

functions, they still require a brokerdealer to use its discretion to handle

customer orders. In this situation, a

customer that gives its order to a brokerdealer typically gives discretion to that

broker-dealer to select the market where

the order will ultimately be executed,

how the order may be split up or

‘‘worked,’’ and whether the brokerdealer will execute the order as

principal or as agent. Although a brokerdealer may disclose its standard

practices to customers, ultimately these

execution decisions are left to the

discretion of the broker-dealer,

consistent with its statutory

responsibilities.47 Unless otherwise

agreed, customers have no other

expectations that the broker-dealer will

handle the order in accordance with its

general broker-dealer obligations. The

Commission views this type of system

as merely automating traditional brokerdealer functions and not as a means for

consolidating the orders of multiple

parties.

Similarly, while block trading desks

provide a central location where

employees of a single broker-dealer

trade side-by-side, they do not

systematically consolidate the customer

orders handled by those employees.

Although an employee may ultimately

match a customer order with another

customer order from a trader sitting

across the room, this does not operate as

an organized mechanism for ensuring

that customer orders are matched,

crossed, or otherwise centralized.

The Commission is seeking comment

on whether paragraph (a) of proposed

Rule 3b–12 accurately captures the

fundamental features of an exchange as

that term is commonly understood, and

whether the proposed exclusions from

the definition are appropriate. In

addition, the Commission seeks

comment on whether there are other

types of activities or organizations that

should be specifically excluded from

proposed Rule 3b–12.
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23511

48 15 U.S.C. 78mm.

49Proposed Rule 3a1–1(b). See infra note 65 for

the definition of an alternative trading system.

50Proposed Rule 3a1–1(b).

51Registration as a national securities association

under Section 15A of the Exchange Act is

voluntary. 15 U.S.C. 78o–3. Currently the only

national securities association is the NASD, which

operates Nasdaq.

52Proposed Rule 3a1–1(a)(1) See also Proposed

Rule 301(a)(3) (excluding alternative trading

systems operated by a national securities

association from the scope of proposed Regulation

ATS.)

53Any alternative trading system, however,

currently operated by a national securities

association could choose to register as an exchange.

54See S. Rep. No. 75, 94th Cong., 1st Sess. 8

(1975) at 2, 8; H.R. Rep. No. 229, 94th Cong., 1st

Sess 92 (1975).

55Pub. L. 94–29, 89 Stat. 97 (1975).

56See S. Rep. No. 75, supra note 54. ‘‘[T]he

increasing tempo and magnitude of the changes that

are occurring in our domestic and international

economy make it clear that the securities markets

are due to be tested as never before,’’ and that it

was, therefore, important to assure ‘‘that the

securities markets and the regulations of the

securities industry remain strong and capable of

fostering (the) fundamental goals (of the Exchange

Act) under changing economic and technological

conditions.’’ Id. at 3.

57S. Rep. No. 75 supra note 54, at 8–9.

58S. Rep. No. 75 supra note 54, at 7; see Section

11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k1(a)(1)(C).

59See S. Rep. No. 75 supra note 54, at 104–05.

D. Exemption From the Definition of

‘‘Exchange’’ for Certain Alternative

Trading Systems

Section 36 of the Exchange Act 48

gives the Commission broad authority to

exempt any person, security, or

transaction from provisions of the

Exchange Act and the rules thereunder.

Such an exemption may be subject to

conditions. Using this authority, the

Commission is proposing Rule 3a1–1,

which would exempt any alternative

trading system that complies with

Regulation ATS from the definition of

‘‘exchange.’’ 49 The Commission

believes that this proposed exemption is

in the public interest and will promote

efficiency, competition, and capital

formation because it has the effect of

providing alternative trading systems

with the option of positioning

themselves in the marketplace as either

registered exchanges or as brokerdealers. The Commission believes that

allowing alternative trading systems to

make a business decision about how to

register with the Commission would

encourage the development of new and

innovative trading facilities. The

Commission also believes that the

proposed exemption is consistent with

the protection of investors.

The Commission intends for the

exemption provided by proposed Rule

3a1–1 to make clear that alternative

trading systems that register as brokerdealers and comply with proposed

Regulation ATS should not be treated as

national securities exchanges. The

Commission believes that the proposed

requirements in Regulation ATS would

address the market-like functions of

alternative trading systems without

treating them as exchanges under the

Exchange Act, with the attendant

requirements applicable to exchanges.

An alternative way that the Commission

could accomplish this would be to

create an exclusion from the definition

in paragraph (a) of proposed Rule 3b–12

for alternative trading systems that

register as broker-dealers and comply

with the provisions of proposed

Regulation ATS. The Commission

requests comment on whether this

alternative is preferable to today’s

proposed exemption from the definition

of ‘‘exchange’’ under Rule 3a1–1.

As described more fully below, an

alternative trading system exempt from

the definition of ‘‘exchange’’ under

proposed Rule 3a1–1 would still have to

meet certain requirements in proposed

Regulation ATS, including broker-dealer

registration, notice of operations, and

recordkeeping and reporting. Trading

systems with significant volume would

also have requirements regarding market

transparency, fair access, and systems

capacity, integrity, and security.

Paragraph (b)(1) of proposed Rule 3a1–

1 would also condition the exemption

on the absence of a Commission

determination that the exemption in a

particular case would not be necessary

or appropriate in the public interest or

consistent with the protection of

investors.50 If the Commission

determined to exercise this authority, it

would be required to provide notice to

the affected alternative trading system

and an opportunity for that alternative

trading system to respond. The

Commission would not expect to

exercise this authority on a regular

basis, but intends for it to be used only

in extraordinary circumstances. The

Commission requests comment on the

scope, form, and conditions of the

proposed exemption in Rule 3a1–1.

In addition, because national

securities associations are subject to

requirements virtually identical to those

applicable to national securities

exchanges,51 proposed Rule 3a1–1

would also exempt from the definition

of ‘‘exchange’’ any system operated by

a national securities association.52 The

Commission believes that the regulation

of alternative trading systems operated

by a national securities association is

adequate, and therefore, that such

systems should not be required to

register either as exchanges, or as

broker-dealers and comply with

Regulation ATS. Consequently, under

the proposals in this release, alternative

trading systems operated by national

securities associations could continue to

operate as they do now.53

III. 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.54 The Commission

believes that it is consistent with

Congress’ goals to integrate significant

alternative trading systems into the

NMS.

In the 1975 Amendments, Congress

specifically endorsed the development

of an NMS, and sought to clarify and

strengthen the Commission’s authority

to promote the achievement of such a

system.55 Because of uncertainty as to

how technological and economic

changes would affect the securities

markets, Congress explicitly rejected

mandating specific components of an

NMS.56 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 NMS in accordance

with Congressional goals and

objectives.57

Congress identified two paramount

objectives in the development of an

NMS: 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.58 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.59 In particular, Congress

found that it was in the public interest
23512 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

60Section 11A(a)(1)(C)(ii) of the Exchange Act, 15

U.S.C. 78k-1(a)(1)(C)(ii). A fundamental goal of an

NMS was to ‘‘achieve a market characterized by

economically efficient executions, fair competition,

(and the) broad dissemination of basic market

information.’’ S. Rep. No. 75 supra note 54, at 101.

61See Section 11A(c)(1) of the Exchange Act, 15

U.S.C. 78k–1(c)(1).

62S. Rep. No. 75 supra note 54, at 7.

63 In addition to its authority under Section 11A

of the Exchange Act, 15 U.S.C. 78k–1, the

Commission is proposing Regulation ATS pursuant

to its rulemaking power under other parts of the

Exchange Act, including Sections 3(b) (power to

define terms), 15(b)(1) (registration and regulation

of broker-dealers), 15 (c)(2) (prescribing means

reasonably designed to prevent fraud), 17(a) (books

and records requirements), 17(b) (inspection of

records), 23(a)(1) (general power to make rules and

classify persons, securities, and other matters), and

36 (general exemptive authority). 15 U.S.C. 78c(b),

78o(b)(1), 78o(c)(2), 78q(a), 78q(b), 78w(a)(1), and

78mm, respectively. For a discussion on the general

exemptive authority in section 36 of the Exchange

Act, 15 U.S.C. 78mm, see supra Section VI.D.1.

64See supra Section II. (discussing proposed Rule

3b–12).

65Specifically, the proposed definition of

‘‘alternative trading system’’ is any ‘‘organization,

association, person, group of persons, or system (1)

(t)hat 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 within the meaning

of (Rule) 3b–12 of [the Exchange Act]; and (2) [t]hat

does not: (A) (s)et 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

(B) [d]iscipline subscribers other than by exclusion

from trading.’’ Proposed Rule 300(a).

66Nothing, however, prevents a registered

exchange from giving up its self-regulatory

functions to register as a broker-dealer.

67The term ‘‘government security’’ is defined in

section 3(a)(42) of the Exchange Act. 15 U.S.C.

78c(a)(42).

68 In 1989 Treasury Secretary Nicholas F. Brady

announced an initiative for the reduction of third

world indebtedness. Under the Brady Plan, U.S.

creditor banks and a debtor country agree to convert

some of the country’s existing debt, which generally

carries a floating market interest rate, into a bond

that carries a fixed, often below market, interest

rates. These bonds are referred to as Brady Bonds.

69 In other words, these systems would not be

required to register as either an exchange or to

comply with the requirements of Regulation ATS.

Proposed Rule 301(a)(4).

70See generally DEPARTMENT OF THE TREASURY,

SECURITIES AND EXCHANGE COMMISSION, AND BOARD

OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM,

JOINT STUDY OF THE REGULATORY SYSTEM FOR

GOVERNMENT SECURITIES (MARCH 1998); DEPARTMENT

OF THE TREASURY, REPORT OF THE SECRETARY OF THE

TREASURY ON SPECIALIZED GOVERNMENT SECURITIES

BROKERS AND DEALERS (JULY 1995) (‘‘1995 TREASURY

REPORT’’).

The Government Securities Act of 1986 (‘‘GSA’’)

amended the Exchange Act to incorporate new

Section 15C, which, among other things,

established registration and notice requirements for

government securities brokers and dealers. Section

15C generally requires government securities

brokers and dealers (i.e., 15C firms or specialized

government securities brokers and dealers) to

register with the Commission and to become

members of an SRO (22 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 as 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

to assure ‘‘fair competition * * *

between exchange markets and markets

other than exchange markets.’’ 60

To further NMS goals, Congress

granted the Commission broad authority

to make rules, including those to: (i)

Prevent the use and publication of

deceptive trade and order information;

(ii) assure the prompt, accurate, and

reliable distribution of quotation and

transaction information; (iii) enable

non-discriminatory access to such

information; and (iv) assure that all

broker-dealers transmit and direct

orders for securities in a manner

consistent with the operation of an

NMS.61 Moreover, Congress recognized

that in order to implement NMS goals,

the Commission would need to classify

markets, firms, and securities and

facilitate the development of

‘‘subsystems within the national market

system.’’ 62

The Commission believes its proposal

today advances NMS 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 NMS

mechanisms, and the quality of public

secondary markets. Under the

Commission’s proposal, those

alternative trading systems that have the

most significant effect on our markets

would be required to integrate their

trading into NMS mechanisms.

Alternative trading systems could

choose to register either as national

securities exchanges or as brokerdealers. Systems that elect broker-dealer

regulation would be integrated into the

NMS under proposed Regulation ATS if

they have significant trading volume.63

Discussed in Section III.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 would be

obligated—like currently registered

exchanges—to participate in the NMS

mechanisms. Section III.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

The Commission is proposing Rule

300(a) under Regulation ATS, which

would define the term ‘‘alternative

trading system’’ as any system that: (1)

Would constitute, maintain, or provide

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 proposed Rule 3b–12 of

the Exchange Act; 64 and (2) would not

regulate its members or surviel its own

market.65 This proposed definition

excludes trading systems that conduct a

regulatory function because the

Commission believes that self-regulatory

systems should be registered as

exchanges.66

Under proposed Regulation ATS,

alternative trading systems would have

to register as broker-dealers and comply

with certain additional requirements

depending on their volume. Any

alternative trading system that is

registered as an exchange or that is

exempt from such registration either

because of its limited volume or because

it is operated by a national securities

association would be excluded from the

scope of the proposed regulation. In

addition, any alternative trading system

that trades only government

securities,67 Brady Bonds,68 and

repurchase and reverse repurchase

agreements involving government

securities or Brady Bonds would be

excluded as long as the alternative

trading system is registered as a brokerdealer.69

In the Concept Release, the

Commission solicited comment on

whether it would be appropriate to

exempt government securities brokerdealers from any new regulatory scheme

for alternative trading systems.

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.70 Unlike
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23513

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.

71Although all marketable Treasury notes, bonds,

and zero-coupon securities are listed on the NYSE,

exchange trading volume is a small fraction of the

total over-the-counter volume in these instruments.

See U.S. Department of the Treasury, U.S.

Securities and Exchange Commission, and Board of

Governors of the Federal Reserve System, Joint

Report on the Government Securities Market 26

(1992).

72Section 15(b)(8) of the Exchange Act, 15 U.S.C.

78o(b)(8).

73For example, the structural reforms undertaken

by the NASD since August 1996 should aid in

ensuring the independence of NASDR and

insulating its staff from the commercial interests of

Nasdaq.

74See infra note 84.

75Section 15A of the Exchange Act, 15 U.S.C.

78o-3.

76Proposed Rule 301(b)(8).

77Proposed Rule 301(b)(2)(i) and Proposed Form

ATS.

78 17 CFR 240.17a–23. See infra Section IV.A.

79Proposed Rule 301(b)(2)(ii).

80Proposed Rule 301(b)(2)(iii). Alternative

trading systems would also be required to file an

amendment to Form ATS to correct any previously

filed information that has been discovered to have

been inaccurate when filed. Proposed Rule

301(b)(2)(iv).

surveillance of trading in equities and

other instruments traded primarily on

registered exchanges,71 surveillance of

trading in government securities is

coordinated among the Treasury, the

Commission, and the Board of

Governors of the Federal Reserve

System.

The Commission believes that any

further regulation of alternative trading

systems that trade these types of

government and other related securities

is not necessary in light of the

specialized oversight structures for

these markets. Because of this

specialized oversight structure,

excluding alternative trading systems

that solely trade government securities

and other related securities from this

proposal should not weaken

coordination of overall market oversight

or create competitive inequities among

differently regulated entities that

perform similar functions.

The Commission requests comment

on its proposal to exempt alternative

trading systems that trade solely

government and other related securities

from the proposed regulatory framework

described in this release. The

Commission also requests comments on

whether other alternative trading

systems that exclusively trade securities

with special characteristics should be

exempt from Regulation ATS.

2. Requirements for Alternative Trading

Systems Subject to Regulation ATS

Discussed below are the proposed

requirements for alternative trading

systems that would be subject to

Regulation ATS.

a. Membership in an SRO. Because

alternative trading systems that choose

to register as broker-dealers would not

themselves have self-regulatory

responsibilities, the Commission

believes it is important for such systems

to be members of an SRO. Most

alternative trading systems are currently

registered as broker-dealers and,

therefore, are also members of an SRO.72

The Commission believes it is

appropriate to continue to require

alternative trading systems that register

as broker-dealers to be SRO members.

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 managed using the

Commission’s oversight.73 The

Commission understands some

alternative trading systems may have

concerns about SROs abusing their

regulatory authority for competitive

reasons. The Commission considers it

part of its own oversight responsibility

over SROs to prevent such actions by

SROs.74 Further, an alternative trading

system that wished to avoid potential

conflicts of interest altogether could

choose to register as an exchange. The

Commission 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.75 Such a national securities

association could be established solely

for purposes of overseeing the activities

of alternative trading systems.

The Commission expects SROs to

enhance their current surveillance of

alternative trading systems to provide a

consolidated view of the market through

an integrated audit trail. SROs should

also incorporate relevant information

regarding the entities trading on such

systems into their existing surveillance

programs. The proposed enhanced

recordkeeping requirements for

alternative trading systems should aid

SRO oversight considerably in this

regard.76

b. Notice of operation as an

alternative trading system and

amendments. Under proposed

Regulation ATS, alternative trading

systems would be required to file an

initial operation report with the

Commission on Form ATS at least 20

days prior to commencing operation.77

Form ATS requests information about

the alternative trading system, including

how it will operate, its prospective

subscribers, and the securities it intends

to trade. In addition, the alternative

trading system would have to describe

procedures for reviewing systems

capacity, security, and contingency

planning. Form ATS is not an

application and the Commission would

not ‘‘approve’’ an alternative trading

system before it began to operate. Form

ATS would, instead, be a notice to the

Commission. Because alternative

trading systems would be required to

register as broker-dealers under

Regulation ATS, proposed Form ATS

would request only information about

an alternative trading system’s market

activities that would not be included in

the information filed on Form BD.

Alternative trading systems are

currently required to report most of this

information on Part I of Form 17a–23,

which the Commission is proposing to

repeal.78

An alternative trading system would

also be required to notify the

Commission of material changes to its

operation by filing an amendment to

Form ATS at least 20 calendar days

prior to implementing such changes.79

A material change would include,

among other things, any change to the

operating platform of an alternative

trading system. Further, changes to the

types of securities traded on, or to the

types of subscribers to an alternative

trading system would be material

changes. Alternative trading systems

would be required to notify the

Commission in quarterly amendments

of any changes to the information on

Form ATS that had not been reported in

a previous amendment.80 Finally, if an
23514 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

81Proposed Rule 301(b)(2)(v).

82Proposed Rule 301(b)(2)(vii).

83See Securities Exchange Act Release No. 36310

(Sept. 29, 1995), 60 FR 52792 (Oct. 10, 1995)

(‘‘Order Handling Rules Proposing Release’’).

84Following the filing of several class action

lawsuits alleging collusion among Nasdaq market

makers, and public allegations that Nasdaq market

makers routinely refused to trade at their published

quotes, intentionally reported transactions late in

order to hide trades from other market participants,

and engaged in other market practices detrimental

to individual investors, the Commission opened a

formal inquiry to investigate the functioning of the

Nasdaq market and to determine whether the NASD

was complying fully with its obligations as an SRO.

In 1996, as a result of the investigation, the

Commission instituted enforcement proceedings

against the NASD pursuant to section 19(h) of the

Exchange Act and issued a report under section

21(a) of the Exchange Act detailing the

Commission’s findings. 15 U.S.C. 78s and 78u(a).

See SEC, REPORT PURSUANT TO SECTION 21(A) OF THE

SECURITIES EXCHANGE ACT OF 1934 REGARDING THE

NASD AND THE NASDAQ MARKET (1996) (‘‘NASD 21(A)

REPORT’’).

85These conclusions are based on Instinet and

SelectNet data for the months April through June

1994. See NASD 21(a) Report, supra note 84, at

notes 48 to 52 and accompanying text.

86The Commission found that ‘‘the ability of

market makers to attract trading interest through

Instinet allowed them to trade without using oddeighth quotes and narrowing the Nasdaq spread.’’

NASD 21(a) Report, supra note 84, at 20.

87NASD 21(a) Report, supra note 84, at 18.

88ECNs include any automated trading

mechanism that widely disseminates market maker

orders to third parties and permits such orders to

be executed through the system, other than crossing

systems. See Securities Exchange Act Release No.

37619A (Sept. 6, 1996), 61 FR 48290 (Sept. 12,

1996) (‘‘Order Handling Rules Adopting Release’’).

89To date, six trading systems have elected to

display quotes under the ECN Display Alternative.

See Letters dated Jan. 17, 1997 from Richard R.

Lindsey, Director, Division of Market Regulation,

SEC to: Charles R. Hood, Senior V.P. and General

Counsel, Instinet Corporation (recognizing Instinet

as an ECN); Joshua Levine and Jeffrey Citron, Smith

Wall Associates (recognizing the Island System as

an ECN); Gerald D. Putnam, President, Terra Nova

Trading, LLC (recognizing the TONTO System, now

known as Archipelago, as an ECN); and Roger D.

Blanc, Wilkie Farr & Gallagher (counsel to

Bloomberg) (recognizing Bloomberg Tradebook as

an ECN). See also Letter dated October 6, 1997 from

Richard R. Lindsey, Director, Division of Market

Regulation, SEC to Matthew G. Maloney, Dickstein

Shapiro Morin & Oshinsky LLP (counsel to Spear,

Leeds & Kellogg) (recognizing the REDI System as

an ECN); and Letter dated February 4, 1998 from

Robert L.D. Colby, Deputy Director, Division of

Market Regulation, SEC, to Linda Lerner, General

Counsel, All-Tech Investment Group, Inc.

(recognizing the Attain System as an ECN).

90See Order Handling Rules Adopting Release,

supra note 88, at 87–96.

91There is divergence among ECNs in the extent

to which they have chosen to integrate non-market

maker orders into the prices they display to the

public. Of the six ECNs that are currently linked to

Nasdaq, three ECNs display to the public the best

prices of any orders entered into their systems

(including both market makers and institutions).

The other three ECNs display to the public only

orders of market makers, unless institutional

customers of these ECNs choose to have their orders

so displayed.

92Because such trading interest frequently

remains undisclosed, within certain alternative

alternative trading system ceases

operations, it would be required to

promptly file a notice with the

Commission.81

An alternative trading system would

be required to provide a duplicate of

each of these filings to surveillance

personnel designated by the SRO of

which it is a member.82 The

Commission is also proposing that the

initial operation report, any

amendments, and the report filed when

an alternative trading system ceases

operation be kept confidential. The

Commission, however, requests

comment on whether the information

filed on Form ATS should be public.

The Commission solicits comment on

the notice requirements in proposed

Form ATS. Specifically, the

Commission seeks comment on whether

such requirements would be

burdensome for alternative trading

systems, and if so, whether the burden

is inappropriate. The Commission also

seeks comment on the proposed

frequency of filings and whether more

or less frequent filings would be

preferable. Finally, the Commission

seeks comment on whether it would be

appropriate to permit or to require

electronic filing of Form ATS and all

subsequent amendments.

c. Market transparency. The

Commission for many years has been

concerned that the development of socalled ‘‘hidden markets,’’ in which a

market maker or specialist privately

publishes quotations at prices superior

to the quotation information it

disseminates publicly, impedes NMS

objectives. Over the course of the last

decade, certain alternative trading

systems that allow subscribers to

disseminate significant trading interest

to other system subscribers without

making this trading interest known to

the public market have become

significant markets in their own right.

Because these systems are not registered

as national securities associations or

national securities exchanges, they are

not currently required to integrate into

the public quote the prices at which

their subscribers are willing to trade.

The use of these systems to facilitate

transactions in securities at prices not

incorporated into the NMS has resulted

in fragmented and incomplete

dissemination of quotation information.

Recent evidence suggests that the

failure of the current regulatory

approach to fully integrate trading on

alternative trading systems into NMS

mechanisms has impaired the quality

and pricing efficiency of secondary

equity markets, particularly in light of

the explosive growth in trading volume

on such alternative trading systems.

Although these systems are available to

some market participants, they

frequently are not available to the

general investing public. The ability of

market makers and specialists to display

different and potentially superior prices

on alternative trading systems than

those displayed on markets available to

the general public created, in the past,

the potential for a two-tiered market.83

For example, during the

Commission’s recent investigation of

Nasdaq trading,84 analyses of trading in

the two most significant trading systems

for Nasdaq securities (Instinet and

SelectNet) revealed that the majority of

bids and offers displayed by market

makers in these systems were better

than those posted publicly on Nasdaq.85

Moreover, the Commission found that,

because market makers could trade with

other market professionals through nonpublic alternative trading systems, they

did not have a sufficient economic

incentive to adjust their public

quotations to reflect more competitive

prices.86 Ultimately, the wider spreads

quoted publicly by market makers

increased the transaction costs paid by

public customers, impaired the ability

of some institutional investors to obtain

favorable prices in some securities, and

placed institutions at a potential

disadvantage in price negotiations.87

In response to these findings, the

Commission took steps to bring greater

transparency into the trading

environment of certain alternative

trading systems. 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 electronic

communications networks (‘‘ECNs’’).88

The new 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 public

quotation displays (‘‘ECN Display

Alternative’’).89

These rules, however, were not

intended to fully coordinate trading on

alternative trading systems with public

market trading.90 While these rules have

helped integrate orders on certain

alternative trading systems into the

public quotation system, they only

affect trading that is conducted by

market makers and specialists, unless

the system voluntarily undertakes to

disclose institutional orders that reflect

the best prices.91 In many cases,

institutional orders, as well as nonmarket maker orders, remain

undisclosed to the public.92 Moreover,
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23515

trading systems non-market maker participants are

able to display prices that lock and cross the public

quotations. If the quotes of such participants were

disclosed to the public, the Commission believes it

would result in improved price opportunities for

public investors.

93See SEC, STATEMENT OF THE SECURITIES AND

EXCHANGE COMMISSION ON THE FUTURE STRUCTURE OF

THE SECURITIES MARKETS (FEB. 2, 1972), 37 FR 5286

(FEB. 4, 1972) (EMPHASIS ADDED).

94A covered security would be defined in the

same way as it is under Rule 11Ac1–1(a)(6) under

the Exchange Act. 17 CFR 240.11Ac1–1.

Specifically, a ‘‘covered security’’ would be any

security reported by an effective transaction

reporting plan and any other security for which a

transaction report, last sale data, or quotation

information is disseminated through an automated

quotation system as described in section

3(a)(51)(A)(ii) of the Exchange Act, 15 U.S.C.

78c(a)(51)(A)(ii). See Proposed Rule 300(g).

Accordingly, a covered security would include all

exchange-listed securities, Nasdaq NM securities,

and Nasdaq SmallCap securities.

95Proposed Rule 301(b)(3)(ii)(A). These orders

would then be included in the quotation data made

available to quotation vendors by national securities

exchanges and national securities associations

pursuant to Rule 11Ac1–1 under the Exchange Act,

17 CFR 240.11Ac1–1.

whether an ECN reflects the best priced

quotations in the public quotation

system on behalf of market makers and

specialists that participate in its system

is voluntary.

Because certain trading interest on

alternative trading systems is not

integrated into the NMS, 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.93

In addition, the Commission believes

that it may be inconsistent with

congressional goals for an NMS that the

best trading opportunities are made

accessible only to those customers who,

due to their size or sophistication, can

avail themselves of prices in alternative

trading systems not currently available

in the public quotation system. 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.

Accordingly, as described in more

detail below, the Commission is

proposing to further enhance

transparency of orders displayed on

alternative trading systems to ensure

that publicly displayed prices more

fully reflect market-wide supply and

demand. Specifically, the Commission

proposes that alternative trading

systems with significant volume be

required to disseminate their best priced

orders (including institutional and nonmarket maker orders) into the public

quotation system. Further, the

Commission is proposing that

alternative trading systems subject to

these display requirements provide

brokers and dealers with access to

displayed orders.

(i) Integration of Orders Into the Public

Quotation System

Under Proposed Rule 301(b)(3), the

Commission proposes to further

integrate alternative trading system

quotes (priced orders) into the NMS. To

accomplish this, an alternative trading

system that displays subscriber orders to

more than one person (other than

alternative trading system employees)

would be required to disseminate in the

public quotation system the best priced

orders in a covered security 94 in which,

during at least four of the last six

months, it traded more than ten percent

of the aggregated average daily share

volume for such security.95 The

Commission requests comment on

whether the proposed volume threshold

would effectively ensure that alternative

trading systems comprising a significant

percentage of the market are subject to

basic market transparency requirements.

In particular, the Commission requests

comment on whether different volume

thresholds are more appropriate for

certain securities or types of alternative

trading systems. Should the volume

threshold be more or less than ten

percent, or calculated on a basis other

than four of the preceding six months?

The Commission is proposing that the

display requirement be applied on a

security-by-security basis. Thus, an

alternative trading system would not

have to display the best orders for any

securities in which its trade volume

accounted for less than ten percent of

the total volume for such security. The

Commission, however, requests

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. If commenters

believe this type of requirement would

be appropriate, the Commission

requests comment on what number or

percentage of securities would be an

appropriate threshold to mandate

display of the best priced orders of all

securities. It should also be noted that

the Commission is not proposing to

require alternative trading systems to

publicly display orders for securities in

which no quotation data is

disseminated. This means that trading

systems—regardless of their size—

would not have to publicly disseminate

orders for fixed-income securities or

equity securities that are not traded on

an exchange or through Nasdaq.

The Commission is proposing today

only to require 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, this

proposal would not require those orders

to be integrated into the public quote

stream. In addition alternative trading

systems would not be 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.

In this regard, the Commission’s

proposal would 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

these subscribers to display orders

incrementally. For example, such a

subscriber that wished 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 were

to be displayed to other alternative

trading system subscribers at a time. In

this situation, only 10,000 shares would

be required to be reflected in the public

quote. Because the Commission would

only require that an alternative trading

system publicly display those orders

that are displayed to alternative trading

system participants, these subscribers

could shield their orders from public

view if they chose not to display their

orders to other participants.

However, if the institution or nonmarket maker subscriber specified that

the entire 100,000 share order were to

be displayed to all subscribers at once,

the order would have to be publicly

displayed if it were the best priced order

in the alternative trading system. The

Commission, however, requests

comment on whether alternative trading

systems should be required to display
23516 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

96See Letter from Robert H. Forney, President and

Chief Executive Officer, Chicago Stock Exchange, to

Jonathan G. Katz, Secretary, SEC, dated Oct. 3, 1997

(‘‘CHX Letter’’) at 1, 13–14 (the integration of

alternative trading systems into the NMS and the

transition to decimal trading highlights the need for

Commission action in establishing minimum

trading increments for NMS securities); Letter from

Craig S. Tyle, General Counsel, Investment

Company Institute, to Jonathan G. Katz, Secretary,

SEC, dated Oct. 3, 1997 (‘‘ICI Letter’’) at 2, 6

(Commission should enhance the NMS by requiring

specialists and market makers to provide access to

their limit orders in the same manner as alternative

trading systems and by establishing linkages

between alternative trading systems, market makers,

and exchanges); Letter from Adam W. Gurwitz, Vice

President Legal and Secretary, Cincinnati Stock

Exchange, to Jonathan G. Katz, Secretary, SEC,

dated Oct. 2, 1997 (‘‘CSE Letter’’) at 2 (brokerdealers that operate alternative trading systems

should make all orders in those systems available

to the public quotation system); Letter from Charles

J. Henry, President and Chief Operating Officer,

Chicago Board Options Exchange, to Jonathan G.

Katz, Secretary, SEC, dated Oct. 2, 1997 (‘‘CBOE

Letter’’) at 4 (development of alternative trading

systems should occur within the framework of the

NMS); Letter from Daniel Parker Odell, Assistant

Secretary, NYSE, to Jonathan G. Katz, Secretary,

SEC, dated Oct. 17, 1997 (‘‘NYSE Letter’’) at 4 (the

best way to advance transparency is by enhancing

the dissemination of, and access to alternative

trading systems market interest through existing

NMS facilities); Letter from Robert W. Seijas and

Joel M. Surnamer, Co-Presidents, The Specialist

Association, to Jonathan G. Katz, Secretary, SEC,

dated Oct. 24, 1997 (‘‘Specialist Assoc. Letter’’) at

2 (alternative trading systems that trade NMS

securities operate largely outside the NMS; this

situation should be corrected).

97NYSE Letter at 4. See also Letter from R.

Warren Langley, President and Chief Operating

Officer, Pacific Exchange, to Jonathan G. Katz,

Secretary, SEC, dated Oct. 20, 1997 (‘‘PCX Letter’’)

at 18 (to achieve complete transparency, it is

necessary to publicly disseminate information

regarding the size and price of all prospective

interest for each security, as well as the trade price

and volume of completed transactions from all

markets trading that security).

98Letter from John C. Conley, Secretary, NASD,

Nasdaq, and NASD Regulation, to Jonathan G. Katz,

Secretary, SEC, dated Oct. 10, 1997 (‘‘NASD

Letter’’) at 7. See also Letter from Kenneth

Pasternak, President and CEO, and Walter Raquet,

Managing Director, Knight Securities, LP, to

Jonathan G. Katz, Secretary, SEC, dated Sept. 11,

1997 (‘‘Knight Letter’’) at 3 (the continued

exemption of non-market maker information from

the public quotation system is damaging to

competing over-the-counter market makers, and

inconsistent with fair and reasonable regulation).

99See Letter from Daniel Jamieson, to Jonathan G.

Katz, Secretary, SEC, dated July 23, 1997

(‘‘Jamieson Letter’’) at 4–5; Letter from Jonathan R.

Macey, J. DuPratt White Professor of Law and

Director, John M. Olin Program in Law and

Economics, Cornell Law School and Maureen

O’Hara, Robert W. Purcell Professor of Finance,

Cornell University, to Jonathan G. Katz, Secretary,

SEC, dated Oct 1. 1997 (‘‘Macey and O’Hara Letter’’)

at 44–45; Letter from William A. Lupien, Chairman

and Chief Executive Officer, OptiMark

Technologies, Inc., to Jonathan G. Katz, Secretary,

SEC, dated Oct. 6, 1997 (‘‘OptiMark Letter’’)

at 6–7; Letter from Sam Scott Miller, Orrick,

Herrington & Sutcliffe, LLP, to Jonathan G. Katz,

Secretary, SEC, dated Oct. 3, 1997 (‘‘OHS Letter (10/

3/97)’’) at 14–15 (institutions and other non-market

maker subscribers should not be required to

sacrifice the benefits of limiting the size of their

displayed orders because of their use of

technology); Letter from Douglas M. Atkin, Instinet,

to Jonathan G. Katz, Secretary, SEC, dated Oct. 3,

1997 (‘‘Instinet Letter’’) at 12–15 (mandating pretrade transparency could result in illiquid markets);

Letter from John M. Liftin, Chair, Committee on

Federal Regulation of Securities and Roger D. Blanc,

Chair, Subcommittee on Market Regulation,

American Bar Association, to Jonathan G. Katz,

Secretary, SEC, dated Oct. 1, 1997 (‘‘ABA Letter’’)

at 22–24; Letter from Lou Eccleston and Kevin M.

Foley, Bloomberg L.P., to Jonathan G. Katz,

Secretary, SEC, dated Oct. 3, 1997 (‘‘Bloomberg

Letter’’) at 8–9; ICI Letter at 3. Cf. Letter from A.B.

Krongard, Chairman, SIA Task Force on Alternative

Trading System Concept Release, Securities

Industry Association, to Jonathan G. Katz,

Secretary, SEC, dated Oct. 3, 1997 (‘‘SIA Letter (10/

3/97)’’) at 13 (tentatively supporting the display of

the prices of the institutional orders in alternative

trading systems, but not the size of such orders).

100ABA Letter at 24. See also Macey and O’Hara

Letter at 45 (commenting that requiring institutional

orders to be displayed would reduce market

liquidity by reducing both trading volume and

investors’ incentives to engage in searches for better

priced orders).

101ABA Letter at 24.

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.

This proposal is consistent with many

commenters’ recommendation that

alternative trading systems be required

to display all orders in the public

quotation system and that alternative

trading systems be more fully

incorporated into the NMS.96 For

example, the NYSE suggested that the

Commission extend the Order Handling

Rules to further integrate alternative

trading system trading interest into the

NMS, perhaps by matching an

alternative trading system with an SRO

to reflect that alternative trading

system’s trading interest in the SRO’s

quotation.97 The NASD similarly

suggested that transparency could be

improved and market fragmentation

minimized by requiring the inclusion of

non-market maker order information in

the NBBO. The NASD pointed out the

continued existence of a ‘‘two-tier

market,’’ despite the new Order

Handling Rules, because of the absence

of any requirement for ECNs to display

orders from institutions and other nonmarket makers in the public quote

system.98

The Commission preliminarily

believes that in light of the significant

trading volume on some alternative

trading systems, integration of these

orders into the NMS may be essential to

prevent the development of a two-tiered

market. In response to commenters’

concerns that a loss of trading

anonymity would adversely affect the

value that alternative trading systems

provide to institutions, the

Commission’s proposal would allow an

alternative trading system to 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, would

preserve the benefits associated with

anonymity. Moreover, the Commission

preliminarily 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 would give institutions the

ability to keep their full trading interest

private. Requiring high volume

alternative trading systems to furnish to

the public quotation system the full size

of the best displayed buy and sell orders

would 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 may substantially

strengthen the NMS.

A number of commenters

recommended that the Commission not

require alternative trading systems to

publicly display all orders in the public

quotation system.99 The Commission

understands that some commenters

were concerned that a requirement to

display institutional trading interest in

the public quotation system might

increase its market impact.100 The types

of impact which concerned these

commenters included adverse effects on

volatility, resulting in worse trade

executions for institutional trading

interests.101

Moreover, some commenters have

expressed concerns that requiring the

public display of institutional orders

may create a disincentive for

institutions to continue to route their

orders to any alternative trading system

subject to such a requirement. These

commenters believe that a public

display requirement would encourage

institutions to route their orders to

execution venues that do not offer any

pre-trade transparency.

In light of these concerns, the

Commission requests 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
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23517

102Specialist Assoc. Letter at 10 (recommending

that alternative trading systems be required to

afford all non-participant broker-dealers equivalent

access to orders in their systems); Letter from Jeffery

T. Brown, Smith Lodge & Schneider (for Block

Trading Inc.), to Jonathan G. Katz, Secretary, SEC,

dated Oct. 7, 1997 (‘‘SLS Letter’’) at 4.

103SIA Letter (10/3/97) at 13. See also ABA Letter

at 24 (commenting that the Commission consider

whether the present SelectNet linkage to ECN prices

provides an adequate model on which to base any

future non-subscriber access to alternative trading

system orders). But see Letter from Dan Sheridan,

Head of Market Regulation, London Stock

Exchange, to Richard R. Lindsey, Director, Division

of Market Regulation, SEC, dated Sept. 2, 1997

(‘‘LSE Letter’’) at 8 (recommending that alternative

trading systems be able to restrict access to

executions if a particular non-participant is a credit

risk, has a history of unresolved positions, or

outstanding fees).

104NYSE Letter at 4. See also PCX Letter at 30

(noting that non-participant broker-dealers should

have ‘‘reasonable’’ access to execute orders in an

alternative trading system, but this access does not

necessarily have to be as quick or convenient as

direct participants’ access to orders in the

alternative trading system).

105Rule 11Ac1–1 under the Exchange Act, 17

CFR 240.11Ac1–1 (‘‘Quote Rule’’). See also Order

Handling Rules Adopting Release, supra note 88.

106Securities Exchange Act Release No. 39718

(Mar. 4, 1998), 63 FR 12124 (Mar. 12, 1998). The

Integrated Order Delivery and Execution System

would feature a voluntary central limit order file

that all market participants would be able to access

either directly or through an Integrated Order

Delivery and Execution System participant.

Registered NASD members and certain customers

they sponsor would be able to deliver various sized

orders through the Integrated Order Delivery and

Execution System to electronically access displayed

quotations. Orders would remain anonymous until

they are executed.

107Bloomberg Letter at 6–7 (recommending that

the Commission establish an alternative to the

SelectNet linkage for non-participant execution

against displayed ECN orders which would allow

an ECN to directly connect non-participants to its

system without the three-second delay that

currently accompanies access through SelectNet).

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.

In addition, the alternative approach

would contain a separate provision

requiring an alternative trading system

to provide its institutional subscribers

with an ongoing opportunity to decide

whether or not to make their orders

available for display to the public

quotation system. Such a provision

would require an institutional

subscriber to affirmatively make the

decision to opt out of displaying its

orders to the public quote. In this

regard, an alternative trading system

would have to provide that any default

setting offered by the system would be

set for public display, unless the

institutional subscriber affirmatively

indicated otherwise. Further, the

Commission would interpret this

provision to prohibit an alternative

trading system from taking any action to

discourage its institutional subscribers

from choosing to display their orders to

the public quote. Except for these

differences, this alternative would

operate in the same fashion as proposed

Rule 301(b)(3). The Commission

requests comment on whether such an

alternative would sufficiently address

the Commission’s concerns with

transparency and fragmentation in the

markets.

The Commission encourages

commenters to address whether the

proposed transparency requirements

achieve the Commission’s goals of

minimizing the negative effects of

fragmented markets, and to offer

suggestions for other ways to achieve

this goal. The Commission also requests

comments and data regarding

institutional use of alternative trading

systems and the resulting impact of this

proposal on market liquidity and

pricing. In addition, the Commission

requests comment on the most efficient

method of integrating an alternative

trading system’s orders into the

quotation system of a national securities

exchange or national securities

association. Finally, the Commission

requests comment on whether

institutional orders above a certain size

should not be required to be displayed.

If so, commenters are requested to

specify what size order above which it

would be appropriate to allow

institutions to elect not to publicly

display.

(ii) Access to Publicly Displayed Orders

The Commission is also proposing

that alternative trading systems be

required to provide non-subscriber

broker-dealers equivalent access to the

orders alternative trading systems

would be required to disseminate in the

public quotation system. The

Commission agrees with those

commenters who stressed the

importance of equivalent access for nonparticipants and stated that requiring

alternative trading systems to display

prices in the public quotation system

would not go far enough to facilitate the

best execution of customer orders

without a mechanism to access orders at

those prices.102 For example, the SIA

commented that it would be reasonable

to require alternative trading systems to

provide non-participants access to

orders in alternative trading systems,

provided that access is offered through

an entity that meets the general

standards for system participants (e.g.,

credit quality or net worth) and that

access is provided through an entity that

can provide appropriate clearance and

settlement (unless the alternative

trading system provides a clearance and

settlement mechanism).103 The NYSE

noted that fostering transparency and

market coordination also requires

enhanced access to alternative trading

systems through the Intermarket

Trading System (‘‘ITS’’).104 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 NMS.

Therefore, the Commission is proposing

that alternative trading systems afford

all non-subscriber broker-dealers

equivalent access to orders displayed in

the public quote, similar to the manner

in which ECNs currently comply with

the ECN Display Alternative under the

Quote Rule.105

In particular, the Commission

believes that an alternative trading

system should allow non-subscribing

broker-dealers to execute against the

best priced order to the same extent as

would be possible had that price 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 nonparticipants no slower than it responds

to orders entered directly by

subscribers. In addition, the

Commission 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.

For example, under the Integrated Order

Delivery and Execution System

proposed by the NASD,106 alternative

trading systems linked to Nasdaq would

be required to take automatic executions

up to the displayed size of orders in

their systems. The Integrated Order

Delivery and Execution System would

replace Nasdaq’s Small Order Execution

System (‘‘SOES’’) and SelectNet (and

related NASD rules), while maintaining

features of each.

In its letter commenting on the

Concept Release, Bloomberg suggested

that alternative trading systems should

be permitted to establish a direct

connection with non-participants so

that alternative trading systems would

not be affected by any delay caused by

an SRO’s system to which it is

linked.107 The Commission questions

whether this proposal is feasible,

however, because such a connection

would not permit the non-participant’s
23518 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

108See LSE Letter at 7; Bloomberg Letter at 11.

See also Knight Letter at 8 (all fees charged by

SelectNet, SOES, or an ECN should be borne by the

taker of liquidity and should be based upon actual

costs to ensure that fees are not subsidizing other

activities).

109See Letter from Junius W. Peake, Mofort

Distinguished Professor of Finance, University of

Northern Colorado, to Jonathan G. Katz, Secretary,

SEC, dated July 14, 1997 (‘‘Peake Letter (7/14/97)’’)

at 15; ABA Letter at 24; PCX Letter at 31.

110See, e.g., NASD Rule 4623. Securities

Exchange Act Release Nos. 38156 (Jan. 10, 1997),

62 FR 2415 (Jan. 16, 1997); 38008 (Dec. 2, 1996),

61 FR 64550 (Dec. 5, 1996).

111Proposed Amended Rule 11Ac1–1(c)(5)(ii) (A)

and (B).

112See supra notes 88–92 and accompanying text.

113Sections 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).

114 ‘‘Restraints on membership cannot be justified

as achieving a valid regulatory purpose and,

therefore, constitute an unnecessary burden on

competition and an impediment to the development

of a nation market system.’’ H.R. Rep. No. 123, 94th

Cong. 1st Sess. 53 (1975).

order to interact with any orders, other

than those in the alternative trading

system. In addition, a non-participant

order sent through an SRO’s system

would not reach an alternative trading

system that had provided a direct link

for non-participants in lieu of a link to

the SRO. The Commission asks for

comment on whether the proposal to

require alternative trading systems to

provide equivalent access to displayed

orders is appropriate and whether there

are any reasons that non-participants of

alternative trading systems should not

be able to access such orders. Is there a

feasible way to allow market-wide order

interaction without linkage to SRO

order execution systems? Is there a

feasible way to grant equivalent nonsubscriber access to institutions that are

not broker-dealers?

(iii) Execution Access Fees

The Commission agrees with those

commenters that suggested that fee

schedules should not be used to

circumvent the ability of nonparticipants to access a system’s

publicly displayed orders.108 The

Commission also understands that

competitive forces will help determine

appropriate fees.109 Therefore, although

reasonable fees are a component of

equal access, the Commission is not

proposing to set specific fees that

alternative trading systems may charge.

Rather, the fees would be determined by

the system’s internal cost structure.

The Commission, however, intends

that fees charged not have the effect of

denying non-subscribers access to the

alternative trading system’s publicly

displayed orders. Under Regulation

ATS, the Commission proposes to

prohibit alternative trading systems

subject to the display and execution

access requirements under proposed

Rule 301(b)(3) from charging brokerdealers for access to publicly displayed

orders in excess of the fee charged by

the alternative trading system to a

substantial proportion of its existing

broker-dealer subscribers. Specifically,

under proposed Rule 301(b)(4), the

highest fee an alternative trading system

would be permitted to charge nonsubscribers would be the lesser of the

fee charged by the alternative trading

system to a substantial portion of its

existing broker-dealer subscribers or the

fee permitted under the rules of the

applicable national securities exchange

or national securities association. The

Commission preliminarily 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 be authorized to assure

that fees charged by alternative trading

systems to non-subscribers are

consistent with fees typically charged

by the exchange or association for

access to displayed orders. Therefore, if

the exchange or association did not

permit any fees for access to the quotes

on the system operated by the exchange

or association, the exchange or

association could prohibit the

alternative trading system from charging

fees to non-subscribers, regardless of the

fees it charged to subscribers.

Alternatively, the exchange or

association could use this authority to

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.

The Commission requests comment

on whether there are any reasons that

alternative trading systems should be

allowed to charge higher fees to nonparticipants than would be allowed

under the proposed rule. The

Commission also requests comment on

whether there are alternatives for

assuring fair execution access for nonsubscribers or another test for

determining whether the non-subscriber

fees assure equal access. Finally, the

Commission requests comment on

whether fees should be included in the

price of an order quoted to the public.

The Commission is aware that while

orders are displayed in fractions this

might prove untenable, but would like

commenters’ views on this approach

assuming orders are quoted in decimals.

If this approach is taken, how would

variations in a pricing schedule be taken

into account?

The proposed rule is intended to

ensure that no alternative trading

system sets fees that render its system

inaccessible to the investing public

through non-participant broker-dealers.

Further, 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.110 In addition, to foster equivalent

access to alternative trading systems for

exchange-listed securities, the

Commission would expect 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.

(iv) Amendment to Rule 11Ac1–1 under

the Exchange Act

The Commission is also proposing an

amendment to Rule 11Ac1–1 under the

Exchange Act (‘‘Quote Rule’’).111 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.112 Today’s proposed

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. 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.113 These requirements

are intended to ensure that markets treat

investors fairly.114 Under the current

regulatory approach, however, there is

no regulatory redress for unfair denials

or limitations of access by alternative

trading systems. The availability of

redress for such actions 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,
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23519

115See supra Section III.A.2.c.(ii).

116Proposed Rule 301(b)(5).

117See NASD Letter at 7–8; ICI Letter at 3.

118The Commission understands that the NASD

is currently reviewing a complaint against an

alternative trading system for an unreasonable

denial of access.

119See Jamieson Letter at 7; SLS Letter at 4; Letter

from Christopher J. Carroll, Concept Release Task

Force, The Bond Market Association, to Jonathan G.

Katz, Secretary, SEC, dated Oct. 3, 1997 (‘‘Bond

Market Assoc. Letter’’) at 10–11. See also OptMark

Letter at 5–6 (commenting that unreasonable

denials of access raise concerns about

anticompetitive behavior); LSE Letter at 9

(commenting that alternative trading systems not be

required to make the system available to the public

generally, but that such systems should not

discriminate unfairly and that objective access

standards for admission and acceptance should be

established by alternative trading systems, subject

to oversight by the Commission or the SROs).

120Proposed Rule 301(b)(5)(i).

121Section 3(a)(11) of the Exchange Act, 15 U.S.C.

78c(a)(11); 17 CFR 240.3a11–1. Options and limited

partnerships are included within the definition of

an equity security.

122Propose Rule 303(a)(1)(iii). The Commission

would expect an alternative trading system to

maintain a record of its standards at each point in

time. If the alternative trading systems amends or

modifies its access standards, the records kept

should reflect historic standards, as well as current

standards.

123Proposed Rule 301(b)(5)(ii).

124 17 CFR 201.420.

125 17 CFR 201.410.

126 17 CFR 201.101(a)(9).

127 17 CFR 201.202(a).

128 17 CFR 201.210(a)(1).

129 17 CFR 201.421.

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

proposing to require alternative trading

systems with significant trading volume

to publicly display their best bid and

offer and provide equal execution access

to those orders,115 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

participation in an alternative trading

system, access to the best bid and offer

through an SRO is an incomplete

substitute. Therefore, the Commission

proposes to require alternative trading

systems that are registered as brokerdealers 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.116

While some commenters did not

believe fair access requirements were

warranted, they based this conclusion

on their belief that denials of access

have not been a problem.117 The

Commission, however, is aware of

instances in which alternative trading

systems applied access standards

inconsistently.118 Consequently, the

Commission agrees with commenters

who recommended that alternative

trading systems provide fair access to

subscribers if such systems attain a

significant proportion of trading in a

security.119

Specifically, the Commission is

proposing 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 more than twenty percent

of the average daily share volume in any

equity security or category of debt.120

For equity securities,121 the proposed

volume threshold is on a security-bysecurity basis. Accordingly, if an

alternative trading system accounts for

greater than twenty percent of the share

volume in any equity security, it would

be subject to the proposed fair access

requirements with respect to that

security. The Commission requests

comment on whether the twenty percent

threshold is appropriate, or whether the

volume threshold should be higher or

lower than twenty percent. The

Commission also requests comment on

the best method for an alternative

trading system to notify interested

parties that its system had reached the

volume threshold in a given security.

Should the designated examining

authority, for example, publish such

information for its members?

For debt securities, the Commission

proposes that if an alternative trading

system accounts for more than twenty

percent of the volume in any category of

debt security, the alternative trading

system would be subject to the fair

access requirements with respect to that

category. The Commission requests

comment on the appropriate categories

of debt securities and whether the

twenty percent volume threshold is

appropriate. For example, the

Commission would like comments on

categories such as mortgage and assetbacked securities (private label issues

only), municipal securities, corporate

debt securities, foreign corporate debt

securities, and sovereign debt securities.

The Commission also requests comment

on whether categories of debt securities

should be further divided based on an

instrument’s maturity, credit rating, or

other criteria. The Commission also

requests comment on the best sources of

data for the volume of a particular debt

category.

For alternative trading systems that

meet the proposed volume thresholds,

the Commission is proposing to require

those alternative trading systems to

establish standards for granting access

to trading on its system. An alternative

trading system would be required to

maintain these standards in its

records,122 but would not be required to

provide the Commission with such

standards, unless a person denied or

limited access to the alternative trading

system appealed that action to the

Commission. In addition, the alternative

trading system would be prohibited

from unreasonably prohibiting or

limiting any person with respect to

access to its services and would be

required to provide notice to any person

denied or limited access to the

alternative trading system that they have

a right to appeal the alternative trading

system’s action to the Commission

under the Commission’s Rules of

Practice.123

This right to appeal would be created

through several amendments to the

Commission’s Rules of Practice. In

particular, the Commission proposes to

amend Rule 420 under the

Commission’s Rules of Practice 124 to

allow a person who is aggrieved by an

alternative trading system determination

that prohibits or limits that person’s

access to services to file an application

for review by the Commission. The

Commission also proposes to amend

Rule 410 under the Commission’s Rules

of Practice 125 so that a person who is

aggrieved by a limitation or prohibition

of access can move for a stay of action

by the alternative trading system

pending an appeal. Finally, the

Commission proposes to amend Rules

101(a)(9),126 202(a),127 210(a)(1),128 and

421 under the Commission’s Rules of

Practice 129 to include references to

alternative trading systems so that the

Commission’s Rules of Practice with
23520 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

130For example, the Commission has reorganized

that the creditworthiness of a counterparty is a

legitimate concern of market participants. See Letter

from Richard R. Lindsey, Director, Division of

Market Regulation, SEC, to Richard Grasso,

Chairman and Chief Executive Officer, NYSE, dated

Nov. 22, 1996 at 17.

131Securities Exchange Act Release No. 27445

(Nov. 16, 1989), 54 FR 48704 (‘‘ARP I’’); Securities

Exchange Act Release No. 29185 (May 9, 1991), 56

FR 22489 (‘‘ARP II’’). ARP I and ARP II were

published in response to operational difficulties

experienced by SRO automated systems during the

October 1987 market break. These releases

predicted future capacity requirements, emphasized

the need to maintain accurate trade and quote

information, and discussed the degree to which

computer automation has become, and is likely to

increase as, an intergral part of securities trading.

132ARP II, supra note 131, set forth guidance

concerning the nature of these independent

reviews.

133ARP I, supra note 131, 54 FR at 48705; ARP

II, supra note 131, 56 FR at 22490.

134See ARP I, supra note 131, 54 FR at 48706 n.

17; ARP II, supra note 131, 56 FR at 22493 n.15.

135Proposed Rule 301(b)(6).

136Proposed Rule 301(b)(6)(i).

respect to the appeals process apply to

allegations of unfair denials of access by

alternative trading systems.

These provisions are based on the

principle that qualified market

participants should have fair access to

the nation’s securities markets.

Alternative trading systems would

remain free to have reasonable

standards for access. Such standards

should act to prohibit unreasonably

discriminatory denials of access. A

denial of access would be reasonable,

for example, if it were based on

objective standards. For example, an

alternative trading system could

establish minimum capital or credit

requirements for subscribers. Similarly,

an alternative trading system could

reasonably deny access to investors

based on an unfavorable disciplinary

history. 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 based solely on the

trading strategy of a potential

participant.

The Commission requests comment

on its proposal to prohibit alternative

trading systems with significant volume

from unfairly discriminating against

market participants in providing access.

The Commission seeks commenters

views regarding appropriate reasons for

denying market participants access to an

alternative trading system.130 The

Commission would also like

commenters’ views on whether the

proposed fair access requirement would

achieve the Commission’s goal of

promoting fair access to systems having

a significant portion of the market in a

particular security. The Commission

requests comment on whether an

alternative trading system should be

required to provide fair access to all

securities it trades when it reaches the

twenty percent threshold in a security.

Should fair access be granted only with

respect to those securities that have

reached the threshold, or with respect to

all securities? Should access be granted

to all after a certain number or

percentage of securities traded have

reached the twenty percent threshold? If

so, what number or percentage? In

addition, the Commission would like

commenters’ views on whether persons

denied access to an alternative trading

system should have the right to appeal

this action to the Commission, the form

the appeal should take, and the

appropriate standard for Commission

review.

e. Capacity, integrity, and security

standards. In November 1989 and May

1991, the Commission published two

policy statements regarding the use of

technology in the securities markets.131

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.132 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.

The automation review program was

established because of ‘‘the impact that

systems failures have on public

investors, broker-dealer risk exposure,

and market efficiency.’’133 While this

program did not directly apply to

alternative trading systems, the

Commission noted that all brokerdealers should engage in systems testing

and use the policy statement as a

guideline.134 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 is proposing to require

alternative trading systems with

significant volume to meet certain

systems capacity, integrity, and security

standards.135 These proposed

requirements would be similar to those

standards SROs currently follow under

the automation review program.

Under proposed Rule 301(b)(6),

certain alternative trading systems

registered as broker-dealers would be

required to comply with requirements

designed to ensure adequate systems

capacity, integrity, and security. These

requirements would apply to an

alternative trading system if during four

of the preceding six months it had more

than twenty percent of the aggregate

daily share volume in any equity

security or in a specified category of

debt security.136 For equity securities,

the proposed volume thresholds are on

a security-by-security basis.

Accordingly, if any one equity security

traded on an alternative trading system

accounts for more than twenty percent

of the share volume in that security, the

alternative trading system would be

required to meet the proposed capacity,

integrity, and security requirements.

With respect to debt securities, the

proposed volume threshold would be

applied to categories of debt securities.

As discussed in regard to the fair access

requirements, the Commission is

preliminarily considering categorizing

debt securities as: mortgage and assetbacked securities (private issue only),

municipal securities, corporate debt

securities, foreign corporate debt

securities, and sovereign debt securities.

These categories could be further broken

down into subcategories based on

factors such as date of maturity and

rating. As stated above, alternative

trading systems subject to proposed

Regulation ATS would be required to

meet the proposed capacity, integrity,

and security requirements if the

alternative trading system accounted for

more than twenty percent of the volume

in a category of debt securities.

An alternative trading system that

meets these volume thresholds would

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
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23521

137Proposed Rule 301(b)(6)(ii)(A)–(F)

138Proposed Rule 301(b)(6)(ii)(G).

139Proposed Rule 301(b)(6). Regulation ATS

would also require alternative trading systems to

preserve documentation relating to their efforts to

meet the requirements of this rule. See Proposed

Rule 303(a)(1)(iv).

140See ARP II, supra note 131.

141See Letter from Joanne T. Medero, Barclays

Global Investors, to Jonathan G. Katz, Secretary,

SEC, dated Oct. 3, 1997 (‘‘BGI Letter’’) at 3 (any

alternative trading system that is perceived by

customers or potential customers as posing

execution risks will not be used); Bloomberg Letter

at 4 (competition will provide sufficient impetus for

alternative trading systems to maintain adequate

capacity); Peake Letter (7/14/97) at 16 (customers of

alternative trading systems presumably need to be

satisfied as to the quality of the vendor); Jamieson

Letter at 4–6 (if alternative trading systems do not

work customers will not use them); LSE Letter 8–

9 (users will take their business elsewhere if an

alternative trading system fails); OptiMark Letter at

7 (capacity should not be regulated because

alternative trading systems make up a small portion

of the market resulting in a relatively little market

impact); Macey and O’Hara Letter at 47; OHS Letter

(10/3/97) at 17. See also Letter from Joseph T.

McLaughlin, Managing Director and General

Counsel, Credit Suisse First Boston, to Jonathan G.

Katz, Secretary, SEC, dated Oct. 7, 1997 (‘‘CSFB

Letter’’) at 18 (commenting that capacity concerns

are misplaced for most systems, but for larger

alternative trading systems, the Commission could

impose heightened regulation regarding capacity to

the extend that the Commission determines that the

failure of a particular system could result in risks

comparable to the failure of a national securities

exchange).

142See Letter from Scott L. Fagin, LIMITrader, to

Jonathan G. Katz, Secretary, SEC, dated June 26

1997 (‘‘Fagin Letter’’) at 3; Letter from Thomas J.

Jordan, Executive Director, Financial Information

Forum, to Jonathan G. Katz, Secretary, SEC, dated

Oct. 3, 1997 (‘‘FIF Letter’’) at 1; Letter from Robert

C. Weaver, Attorney, to Jonathan G. Katz, Secretary,

SEC, dated Oct. 2, 1997 (‘‘Weaver Letter’’) at 7;

Specialist Assoc. Letter at 12 (the Commission

should develop criteria for alternative trading

systems to safeguard the integrity and security of

their trading systems); PCX Letter at 28; NYSE

Letter at 5 (although alternative trading systems

have strong incentives to ensure their systems have

adequate capacity, to the extent that market forces

do not provide adequate protection, the

Commission should require alternative trading

systems to certify at specified intervals that they

have adequate capacity, subject to SRO oversight).

See also ICI Letter at 4 (commenting that it could

support a periodic reporting requirement, but

substantive regulation might impede innovation).

143 In addition, the United States General

Accounting Office (‘‘GAO’’) has conducted several

studies on the subject of computer systems and

their role in the financial markets. Generally, the

GAO has recommended that the Commission take

steps to improve systems capacity, integrity, and

security. See GAO, Stronger System Controls and

Oversight Needed to Prevent NASD Computer

Outages (Dec. 1994) (regarding Nasdaq system

outages); GAO, Stock Markets: Information Vendors

Need SEC Oversight to Control Automation Risks

(Jan. 1992) (regarding risk assessments of automated

operations of stock market information

dissemination vendors); GAO, Computer Security

Controls at Five Stock Exchanges Need

Strengthening (Aug. 1991) (regarding systems

related risks at stock markets); GAO, Active

Oversight of Market Automation by SEC and CRTC

Needed (Apr. 1991) (regarding automation risks of

the securities and futures markets); GAO, Tighter

Computer Security Needed (Jan. 1990) (regarding

the Common Message Switch system and the

Intermarket Trading System operated by the

Securities Industry Automation Corporation and the

Nasdaq system operated by the NASD).

144Proposed Rule 301(b)(6)(ii).

145See supra note 121.

recovery plans. An alternative trading

system would be 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.137 In addition, alternative

trading systems subject to this provision

would be required to notify the

Commission staff of material systems

outages and material systems

changes.138 This information would

enable Commission staff to maintain an

understanding of the operation of

alternative trading systems generally

and to identify potential problems and

trends that may require attention.

Finally, under proposed Regulation

ATS, alternative trading systems that

meet the volume levels set forth above

would be required to perform an annual

independent review of the systems that

support order entry, order handling,

execution, order routing, transaction

reporting and trade comparison.139 As

discussed in greater detail in the

Commission’s May 1991 Policy

Statement,140 an independent review

should be performed by competent,

independent audit personnel following

established audit procedures and

standards. If internal auditors are used

by an alternative trading system to

complete the review, these auditors

should comply with the standards of the

Institute of Internal Auditors and the

Electronic Data Processing Auditors

Association (‘‘EDPAA’’). If external

auditors are used, they should comply

with the standards of the American

Institute of Certified Public Accountants

and the EDPAA.

Some commenters suggested that the

Commission need not regulate capacity

of alternative trading systems because

market forces would ensure that such

systems maintain sufficient capacity.141

A number of commenters, however, said

that systems integrity was a concern. In

fact, several commenters recommended

that the Commission develop general

minimum criteria to assure that

alternative trading systems maintain

sufficient systems capacity.142

The Commission’s experience has

shown that market forces have not been

a sufficient incentive for ensuring

adequate capacity.143 For example,

during the past year, Instinet, Island,

Bloomberg, and Archipelago (operated

by Terra Nova) have all experienced

system outages due to problems with

their automated systems. On a number

of occasions, ECNs have had to stop

disseminating market maker quotations

in order to keep from closing altogether,

including during the market decline of

October 1997 when one significant ECN

withdrew its quotes from Nasdaq

because of lack of capacity. Similarly, a

major interdealer broker in non-exempt

securities experienced serious capacity

problems in processing the large

number of transactions in October 1997

and had to close down temporarily.

Investors and other market

participants increasingly rely on

alternative trading systems to buy and

sell securities. The ability of these

markets to meet the demands of market

participants is directly related to the

reliability of their automated systems.

For this reason, alternative trading

systems have significant business

incentives to ensure that their systems

have adequate capacity so that

participants’ orders do not experience

unnecessary delays. The proposed

systems capacity, integrity, and security

rules,144 are intended as a back-up to

ensure that alternative trading systems

that have a significant role in the market

maintain sufficient systems and

procedures to avoid or minimize the

effects of potential systems problems in

the secondary markets. Alternative

trading systems that have a significant

role in the marketplace should be able

to handle reasonably foreseeable volume

surges and be prepared for reasonably

anticipated future volume increases.

The Commission requests comment

on whether the volume thresholds

stated above are appropriate for the

imposition of these capacity, integrity,

and security standards. What volume

thresholds would be most appropriate,

and what is the best method of

calculating them? Are there other

capacity, integrity, and security

standards that would be more

appropriate, or other ways to monitor

alternative trading systems capacity? In

addition, the Commission would like

commenters’ views on whether the

categories and subcategories of debt

discussed above are appropriate and

feasible. If commenters believe other

categories or subcategories of debt

should be used, the Commission

requests suggestions. The Commission

also asks for comment on whether the

volume thresholds for limited

partnerships and options should be

based on categories of securities rather

than on a security by security basis.

Would this method better reflect an

alternative trading system’s market

impact? 145

f. Examination, inspection, and

investigations of subscribers. Under the

proposed rules, an alternative trading
23522 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

146Proposed Rule 301(b)(7).

147The Commission is aware of several incidents

involving the manipulation of quotations through

alternative trading systems. The participants who

engaged in this manipulation were able to gain a

profit as a result.

148Proposed Rule 301(b)(8).

149Proposed Rule 302.

150Securities Exchange Act Release No. 39729

(March 6, 1998), 63 FR 12559 (March 13, 1998).

151See supra notes 122–123 and accompanying

text.

152Proposed Rule 303.

153Proposed Rule 303(b). Rule 17a–4(f) provides

for the maintenance of records on microfilm,

microfiche, or electronic storage media. The

Commission recognizes that alternative trading

systems will likely generate much of the

information in electronic form and generally may

wish to keep records in electronic format. 17 CFR

240.17a–4(f).

154 17 CFR 240.17a–3 and 17 CFR 240.17a–4.

155 17 CFR 240.17a–4(i).

156Proposed Rule 303(d).

157Proposed Rule 301(b)(9).

158 17 CFR 230.144A. Brokers and others who use

alternative trading systems to trade Rule 144A

eligible securities and other types of restricted

securities should make sure those systems are

structured to permit the traders’ compliance with

their obligations under Rule 144A and under the

Securities Act of 1933.

159See infra Section IV.A. Rule 17a–23 under the

Exchange Act generally requires U.S. broker-dealers

system would be required to cooperate

with the Commission’s or an SRO’s

inspection or examination of the

alternative trading system or any of the

alternative trading system’s

subscribers.146 Presently, the

Commission has the authority to inspect

and examine any member of any

national securities exchange or any

national securities association directly.

This is because all such members are

broker-dealers. Alternative trading

systems, however, also have certain

other subscribers, such as banks, to

which the Commission’s inspection

authority does not extend. Because

alternative trading systems could be

used by subscribers to manipulate the

market in a security,147 it is imperative

that alternative trading systems

cooperate in all inspections and

examinations. Although neither the

Commission nor the SROs have the

authority to directly inspect non-brokerdealer subscribers of alternative trading

systems, any relevant trading

information involving such subscribers

would be maintained by the alternative

trading system, under its recordkeeping

requirements, and be required to be

made available upon request to its SRO

or the Commission.

g. Recordkeeping. Proposed

Regulation ATS would require

alternative trading systems to make and

keep the records necessary to create a

meaningful audit trail.148 Specifically,

the Commission proposes that

alternative trading systems maintain

daily summaries of trading and timesequenced records of order information,

including the date and time the order

was received, the date, time, and price

at which the order was executed, and

the identity of the parties to the

transaction. In addition, alternative

trading systems would be required to

maintain a record of subscribers and any

affiliations between subscribers and the

alternative trading system.149 While

some of the information that would be

required by the proposed rule will also

be required under the NASD’s Order

Audit Trail System (‘‘OATS’’),150 OATS

is an NASD rule and does not cover all

securities traded through alternative

trading systems.

This proposal also requires alternative

trading systems to keep records of all

notices provided to subscribers,

including notices addressing hours of

operation, system malfunctions, changes

to system procedures and instructions

pertaining to access to the alternative

trading system. In addition, alternative

trading systems would be required to

keep documents made (if any) in the

course of complying with the systems

capacity, integrity, and security

standards in Proposed Rule 301(b)(6).

These documents would include all

reports to an alternative trading system’s

senior management, and records

concerning current and future capacity

estimates, the results of any stress tests

conducted, procedures used to evaluate

the anticipated impact of new systems

when integrated with existing systems,

and records relating to arrangements

made with a service bureau to operate

any automated systems. These records

would allow the Commission to

examine whether alternative trading

systems are complying with the

requirements under Proposed Rule

301(b)(6). Finally, an alternative trading

system subject to the fair access

requirements discussed above would be

required to keep a record of its access

standards.151

The Commission proposes that these

records be kept for at least three years,

the first two years in an easily accessible

place. Proposed Regulation ATS also

would require some records, such as

partnership articles and articles of

incorporation, to be kept for the life of

the alternative trading system.152 The

Commission is proposing to allow

alternative trading systems to keep

records in any form broker-dealers are

permitted to keep records under Rule

17a–4(f) under the Exchange Act.153

The Commission recognizes that

alternative trading systems subject to

proposed Regulation ATS would be

subject to the recordkeeping

requirements for broker-dealers under

Rules 17a–3 and 17a–4 of the Exchange

Act,154 which may require that some of

the same records be made and kept.

Proposed Regulation ATS would not

require an alternative trading system to

duplicate trading records maintained in

the course of its normal recordkeeping

operations, provided that the alternative

trading system could sort and retrieve

system records separately upon request.

In addition, as broker-dealers are

currently permitted to do,155 proposed

Regulation ATS would permit an

alternative trading system to retain a

service bureau, depository, or other

recordkeeping service to maintain

required records on behalf of the

alternative trading system as long as the

designated party agrees to make the

records available to the Commission

upon request.156

The Commission believes that the

records it is proposing to require

alternative trading systems to make and

keep are records that alternative trading

systems would otherwise keep as part of

their business, and that therefore these

proposed requirements would not place

undue burdens upon alternative trading

systems.

h. Reporting and Form ATS–R.

Proposed Regulation ATS would require

alternative trading systems to file with

the Commission transaction reports

within 30 calendar days of the end of

each calendar quarter on Form ATS–

R.157 Specifically, proposed Form ATS–

R would require alternative trading

systems to report total volume in terms

of number of units traded and dollar

value for the following categories of

securities: (1) Listed equity securities,

(2) Nasdaq NM securities, (3) Nasdaq

SmallCap securities, (4) equity

securities that are eligible for resale

pursuant to Rule 144A under the

Securities Act of 1933,158 (5) penny

stocks, (6) equity securities not included

in (1)–(5), (7) rights and warrants, (8)

listed options, and (9) unlisted options.

In addition, alternative trading systems

would have to report the total dollar

value for: (1) Corporate debt securities,

(2) government securities, (3) municipal

securities, (4) mortgage related

securities, and (5) debt securities not

included in (1)–(4). The Commission is

also proposing that alternative trading

systems file after-hours trading

information in listed equity, Nasdaq

NM, and Nasdaq SmallCap securities, as

well as listed options. This information

would permit the Commission to

monitor the trading on alternative

trading systems.

Because this release proposes to

eliminate Rule 17a–23,159 data filed by
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23523

that sponsor broker-dealer trading systems to

provide a description of their systems to the

Commission and report transaction volume and

other information on a quarterly basis. This rule

also requires that such broker-dealers keep records

regarding system activity and to make such records

available to the Commission. 17 CFR 240.17a–23.

See also Securities Exchange Act Release No. 35124

(Dec. 20, 1994), 59 FR 66702 (Dec. 28, 1994).

160Proposed Rule 301(b)(2)(vii). 161Proposed Rule 301(b)(10).

alternative trading systems on Form

ATS–R would replace the information

currently filed on Form 17A–23 by

broker-dealers operating trading

systems, although proposed Form ATS–

R modifies what broker-dealer trading

systems are currently required to file on

Part II of Form 17a–23. By creating a

template for alternative trading systems

to file periodic reporting data, the

information would be filed in a more

uniform manner and would be more

useful to the Commission. For example,

this information would be used by

Commission staff to develop

examination modules for the inspection

of alternative trading systems. It would

also be used by the Commission staff to

further understand the effect of

alternative trading systems on the

securities markets. In addition, the

Commission is now proposing to ask for

information about the volume of

particular types of securities that are not

listed on an exchange or traded on

Nasdaq. These new reporting

requirements on Form ATS–R should

improve the quality of the data that the

Commission gathers. Due to the highly

automated nature of alternative trading

system operations and the experiences

with Rule 17a–23, the Commission does

not anticipate that gathering and

submitting the data required on Form

ATS–R would be overly burdensome.

Alternative trading systems would

also be required to make reports on

Form ATS–R available to surveillance

personnel of any SRO of which they are

a member.160 Alternative trading

systems would not be required to

routinely provide these reports to their

SRO, but would be required to make

such reports available upon request of

the SRO. The Commission, however,

requests comment on whether

alternative trading systems should be

required routinely to provide reports

made on Form ATS–R to their SROs.

The Commission solicits comment on

the transaction reporting requirements

and Form ATS–R. In particular, the

Commission solicits comment on the

frequency and scope of transaction

reporting requirements proposed in

Regulation ATS, as well as the

appropriateness of permitting Form

ATS–R to be filed electronically.

i. Procedures to ensure confidential

treatment of trading information. The

proposed rules would require

alternative trading systems to have in

place safeguards and procedures to

protect trading information and to

separate alternative trading system

functions from other broker-dealer

functions, including proprietary and

customer trading. The Commission

believes that the sensitive nature of the

trading information subscribers send to

alternative trading systems requires

such systems to take certain steps to

ensure the confidentiality of such

information.

In inspections of some ECNs, the

Commission staff found that some of the

broker-dealers operating ECNs used the

same personnel to operate the ECN as

they did for more traditional brokerdealer activities, such as handling

customer orders that were received by

telephone. This situation creates the

potential for misuse of the confidential

trading information in the ECN, such as

customers’ orders receiving preferential

treatment, or customers receiving

material confidential information about

orders in the ECN. The rules the

Commission is proposing today are

designed to eliminate the potential for

abuse of the confidential trading

information that subscribers send to

alternative trading systems. The

Commission recognizes that some

alternative trading systems combine

traditional brokerage services with their

systems. The proposed rules are not

intended to preclude these services;

rather, they are designed to prevent the

misuse of private customer information

in the system for the benefit of other

customers, the alternative trading

system operator, or its employees.

Therefore, the Commission is

proposing that: (i) Information, such as

the identity of subscribers and their

orders, be available only to those

employees of the alternative trading

system who operate the system or are

responsible for its compliance with the

proposed rules; (2) the alternative

trading system have in place procedures

to ensure that all its employees are

unable to use any confidential

information for proprietary or customer

trading, unless the customer agrees; and

(3) procedures exist to ensure that

employees of the alternative trading

system cannot use such information for

trading in their own accounts.161

The Commission expects that existing

alternative trading systems will

implement procedures such as these as

quickly as possible, if they do not

already have them in place. These

procedures should be clear and

unambiguous and presented to all

employees, regardless of whether they

have direct responsibility for the

operation of the alternative trading

system. Presently, many broker-dealers

employ various means to ensure that

sensitive information does not flow

from one division to another. These

methods include physical separation,

written procedures, separate personnel,

and restricted access. The Commission

believes that firewalls such as these

could be used by broker-dealers that

operate alternative trading systems to

ensure that sensitive information

regarding the alternative trading system

is contained in the proper unit of the

broker-dealer.

The Commission is not proposing

specific procedures because it believes

that the broker-dealers who operate the

alternative trading systems are in the

best position to know what procedures

would best prevent abuses. Experience

has demonstrated, however, the

potential for abuse and the Commission

regards these procedures as essential.

Commenters are encouraged to

comment on these requirements,

including how to prevent misuse of

customer confidential information while

offering brokerage services. If

commenters believe specific procedures

would be more beneficial, the

Commission requests that suggestions

be included with the comments.

j. Name of alternative trading systems.

Under proposed Rule 301(b)(11), the

Commission proposes to prohibit an

alternative trading system registered as

a broker-dealer from using the term

‘‘exchange’’ in its name. The

Commission believes that use of the

term ‘‘exchange’’ by a system not

regulated as an exchange would be

deceptive and could mislead investors

that such alternative trading system is

registered as a national securities

exchange. The Commission believes that

the proposed regulatory framework

provides alternative trading systems

with the flexibility to position

themselves as either exchanges or

broker-dealers. The Commission does

not propose to dictate which form of

regulation an alternative trading systems

chooses, but it is important that the

investing public not be confused about

the market role such systems have

chosen to assume. Accordingly, the

Commission believes that if an

alternative trading system chooses to

register as a broker-dealer under

Regulation ATS, it should not use the

term ‘‘exchange’’ in its name.

The Commission requests comment

on issues raised by the proposed

prohibition on alternative trading

systems registered as broker-dealers

under Regulation ATS from using the
23524 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

162Alternative trading systems that continue to be

regulated as broker-dealers would remain subject to

oversight by national securities exchanges and the

NASD, in their self-regulatory capacities. See supra

Section III.A.2.a.

163Options Clearing Corporation By-laws, Art.

VII, Sections 1 and 4. Registered exchanges that are

members of the Options Clearing Corporation are

also able to use registration and disclosure materials

tailored for standardized options.

164Section 6(b) of the Exchange Act, 15 U.S.C.

78f(b).

165Section 19(b) of the Exchange Act, 15 U.S.C.

78s(b). If Nasdaq chose to register as an exchange,

the Commission notes that any rules governing

trading on Nasdaq that have been filed by the NASD

and approved by the Commission would not

constitute proposed rules changes for purposes of

Section 19(b) of the Exchange Act. See also infra.

Section V (discussing a proposed temporary rule

filing exemption).

166 17 CFR 240.17d–2. Securities Exchange Act

Release No. 12935 (Oct. 28, 1976), 41 FR 49093

(Nov. 8, 1976). In addition to the regulatory

responsibilities it otherwise has under the Exchange

Act, the SRO to which a firm is designated under

these plans assumes regulatory responsibilities

allocated to it. Under Rule 17d–2(c), the

Commission may declare any joint plan effective if,

after providing notice and opportunity for

comment, it determines that the plan is necessary

or appropriate in the public interest and for the

protection of investors, to foster cooperation and

coordination among the SROs, to remove

impediments to and foster the development of a

national market system and a national clearance

and settlement system, and in conformity with the

factors set forth in section 17(d) of the Exchange

Act. 15 U.S.C. 78q(d). The Commission has

approved plans filed by the equity exchanges and

the NASD for the allocation of regulatory

responsibilities pursuant to Rule 17d–2. See, e.g.,

Securities Exchange Act Release Nos. 13326 (Mar.

3, 1977), 42 FR 13878 (Mar. 14, 1977) (NYSE/

Amex); 13536 (May 12, 1977), 42 FR 26264 (May

23, 1977) (NYSE/BSE); 14152 (Nov. 9, 1977), 42 FR

59339 (Nov. 16, 1977) (NYSE/CSE); 13535 (May 12,

1977), 42 FR 26269 (May 23, 1977) (NYSE/CHX);

13531 (May 12, 1977), 42 FR 26273 (May 23, 1977)

(NYSE/PSE); 14093 (Oct. 25, 1977), 42 FR 57199

(Nov. 1, 1977) (NYSE/Phlx); 15191 (Sep. 26, 1978),

43 FR 46093 (Oct. 5, 1978) (NASD/BSE, CSE, CHX

and PSE); and 16858 (May 30, 1980), 45 FR 37927

(June 5, 1980) (NASD/BSE, CSE, CHX and PSE).

term ‘‘exchange’’ in their names, and

whether other terms, such as ‘‘stock

market’’ are similarly misleading. The

Commission also requests comment on

whether it is misleading for other types

of systems, such as bulletin board

systems, to use the term ‘‘stock market’’

in their name.

B. Registration as a National Securities

Exchange

1. Benefits of Registration as a National

Securities Exchange

Registration as a national securities

exchange provides several attractive

benefits that may make this option more

suitable to the business objectives of

certain alternative trading systems. The

primary advantage of exchange

registration is the relative autonomy that

exchanges enjoy in their daily

operation. Exchanges are SROs, and are

thus subject to surveillance and

oversight only by the Commission.

Consequently, any alternative trading

system that elects exchange registration

would not be subject to oversight by a

competing national securities exchange

or national securities association.162

Similarly, as a national securities

exchange, an alternative trading system

would be able to establish its own rules

of conduct, trading rules, and fee

structures for external access. An

alternative trading system registered as

a broker-dealer, on the other hand,

would have to comply with the rules of

the SRO to which it belongs, including

any rules regarding the automatic

execution of small orders.

In addition, systems that elect to

register as exchanges may gain added

prestige and investor confidence. As a

registered exchange, an alternative

trading system would be able to

establish listing standards, which could

promote investor confidence in the

quality of the securities listed on the

alternative trading system. In addition,

registered exchanges can become direct

participants in the NMS mechanisms,

such as the ITS, Consolidated Tape

Association (‘‘CTA’’), and the

Consolidated Quotation System

(‘‘CQS’’). Direct participation in these

systems may provide a higher degree of

transparency and execution

opportunities for alternative trading

system subscribers. As direct

participants in the NMS mechanisms,

registered exchanges are also entitled to

share in the profits generated by the

NMS systems, such as revenue from

CTA fees. Further, only exchanges are

eligible to be participants of the Options

Clearing Corporation and thereby

determine such matters as listing,

registration, clearance, issuance and

exercise of options contracts.163

2. Responsibilities of Registered

National Securities Exchanges

A fundamental objective of the

Commission’s proposal is to create

regulations that are sufficiently flexible

to accommodate the chosen business

objectives of the various alternative

trading systems, including those that

elect to register as exchanges.

Nevertheless, the Commission views

certain exchange obligations as

fundamental to the fair and efficient

operation of exchanges in the

marketplace and critical for the

protection of investors. Thus, the

Commission proposes to require those

alternative trading systems that choose

to register as exchanges to satisfy these

fundamental exchange obligations in

order to ensure that the goals of market

regulation, as set forth in the Exchange

Act, are met. The Commission requests

comment on whether any exemptions

from exchange regulatory provisions

would be necessary or appropriate to

enable alternative trading systems to

register as exchanges.

a. Self-regulatory responsibilities. One

of the central functions performed by

exchanges under the current regulatory

structure is the self-regulatory function,

which includes the implementation and

enforcement of rules for trading on the

exchange, and surveillance of members’

trading and sales activities. The selfregulatory role of exchanges is vital to

the effective management of the

securities industry. Therefore, as a

prerequisite for the Commission’s

approval of an exchange’s application

for registration, an exchange would have

to organize and have the capacity to

carry out the purposes of the Exchange

Act. Specifically, an exchange would

have to be able to enforce compliance by

its members and persons associated

with its members with the federal

securities laws and the rules of the

exchange. The exchange’s rules would

have to be designed to prevent

fraudulent and manipulative acts and

practices, to promote just and equitable

principles of trade, and to refrain from

imposing any unnecessary or

inappropriate burdens on competition,

among other things.164 In addition, once

registered, an exchange would have to

submit copies of any proposed rule

changes to the Commission for

approval.165 As part of its compliance

activities, an exchange must maintain

procedures to surveil for violations such

as insider trading and manipulation on

its facilities. While an exchange is

required to have adequate measures in

place, not all exchanges must use the

same procedures. Their surveillance

procedures, while fundamentally

similar in effect, can be tailored to the

particular requirements of each

exchange and will depend on the nature

of trading that occurs and the type of

securities that are traded on the

exchange.

The Commission would consider,

however, measures to reduce the

surveillance burdens for exchanges. The

Commission believes that some of the

self-regulatory obligations for exchanges

may be contracted to another party. Rule

17d-2 under the Exchange Act permits

SROs to establish joint plans for

allocating the regulatory responsibilities

imposed by the Exchange Act with

respect to common members.166 The

Commission has previously permitted

existing SROs to contract with each
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23525

167For example, the Commission has approved a

regulatory plan filed by the Amex, CBOE, NASD,

NYSE, PCX, and the Phlx that divides the oversight

responsibilities among these SROs for common

members, by designating each participating SRO as

the options examination authority for a portion of

the common members. This designated SRO has

sole regulatory responsibility for certain optionsrelated trading matters. See Securities Exchange Act

Release No. 20158 (Sept. 8, 1983), 48 FR 41265

(Sept. 14, 1983). The SRO designated under the

plan as a broker-dealer’s options examination

authority is responsible for conducting optionsrelated sales practice examinations and

investigating options-related customer complaints

and terminations for cause of associated persons.

The designated SRO is also responsible for

examining a firm’s compliance with the provisions

of applicable federal securities laws and the rules

and regulations thereunder, its own rules, and the

rules of any SRO of which the firm is a member.

Id.

168For example, while exchanges are required to

enforce compliance by their members (and persons

associated with their members) with applicable

laws and rules, the Commission has used its

authority under sections 17 and 19 of the Exchange

Act to allocate oversight of common members to

particular exchanges, and to exempt exchanges

from enforcement obligations with respect to

persons that are associated with a member, but that

are not engaged in the securities business. See 17

CFR 240.17d–2; 17 CFR 240.19g2–1.

169With respect to a common member, section

17(d)(1) of the Exchange Act authorizes the

Commission, by rule or order, to relieve an SRO of

the responsibility to receive regulatory reports, to

examine for and enforce compliance with

applicable statutes, rules, and regulations, or to

perform other specified regulatory functions. 15

U.S.C. 78q(d)(1).

170See Securities Exchange Act Release No.

23192 (May 1, 1986) 51 FR 17426 (May 12, 1986).

Moreover, section 108 of NSMIA. supra note 3,

adds a provision to section 17 of the Exchange Act

that calls for improving coordination of supervision

of members and elimination of any unnecessary and

burdensome duplication in the examination

process.

171See Delta Release, supra note 10, at 1900. In

Board of Trade of the City of Chicago v. Securities

and Exchange Commission, 923 F.2d 1270 (7th Cir.

1991) (Delta II), the court stated that:

The Delta system cannot register as an exchange

because the statute requires that an exchange be

controlled by its participants, who in turn must be

registered brokers or individuals associated with

such brokers. So all the financial institutions that

trade through the Delta system would have to

register as brokers, and [the system sponsors] would

have to turn over the ownership and control of the

system to the institutions. The system would be

kaput.

Id. at 1272–73.

172 15 U.S.C. 78f(b)(3).

173See Securities Exchange Act Release No.

14531 (Mar. 6, 1978), 43 FR 10288 (Mar. 10, 1978).

See also Securities Exchange Act Release No. 16900

(June 17, 1980), 45 FR 41920 (June 23, 1980).

other to allocate non-financial

regulatory responsibilities.167 An SRO

participating in a regulatory plan is

relieved of regulatory responsibilities

with respect to a broker-dealer member

of such an SRO, if those regulatory

responsibilities have been designated to

another SRO under the regulatory plan.

These programs would also be

applicable to alternative trading systems

that choose to register as exchanges.

These plans permit an SRO to allocate

its oversight obligations with respect to

certain members’ compliance with

various requirements, but do not permit

an SRO to allocate its oversight

obligations with respect to the activities

taking place on its market. The

Commission believes that the

enforcement and disciplinary actions for

violations relating to transactions

executed in an SRO’s market or rules

unique to that SRO should continue to

be retained by that SRO. Existing

exchanges generally employ personnel

and establish extensive programs to

fulfill this responsibility. Fully

automated exchanges, however, might

be able to contract with other exchanges

to perform certain oversight activities

while retaining ultimate responsibility

for ensuring that these activities are

performed. For example, fully

automated exchanges can produce

comprehensive, instantaneous

automated records that can be

monitored remotely. As a result, it may

be possible for such an exchange to

contract with another exchange to

perform its day-to-day enforcement and

disciplinary activities. The Commission

could consider whether allowing an

automated market to do so would be

consistent with the public interest.

In addition, existing Commission

initiatives and SRO plans that

coordinate supervision of broker-dealers

that are members of more than one SRO

(‘‘common members’’) would also apply

to alternative trading systems that

choose to register as exchanges.168 In

order to avoid unnecessary regulatory

duplication, the Commission appoints a

single SRO as the designated examining

authority (‘‘DEA’’) to examine common

members for compliance with the

financial responsibility requirements.169

When an SRO has been named as a

common member’s DEA, all other SROs

to which the common member belongs

are relieved of the responsibility to

examine the firm for compliance with

applicable financial responsibility

rules.170 Consistent with past

Commission action, the Commission

could continue to designate one SRO,

such as the NASD or the NYSE, as the

primary DEA for common members of

exchanges.

b. Fair Representation. The

Commission understands that certain

obligations may be inconsistent with the

proprietary nature of alternative trading

systems. For example, a major obstacle

to the regulation of proprietary

alternative trading systems as exchanges

has been the concern that they would be

subject to certain exchange obligations

incompatible with their structures.171

Specifically, section 6(b)(3) of the

Exchange Act requires that exchanges

have member controlled boards of

directors and assure the ‘‘fair

representation’’ of their members in the

selection of their boards of directors.172

Without some modification, the current

application of these requirements could

inappropriately dictate the corporate

governance choices of alternative

trading systems that register as

exchanges and could prevent them from

adopting innovative means of carrying

out self-regulatory obligations. In

particular, for a proprietary system, the

‘‘fair representation’’ obligations strictly

applied could require the customers of

a system to govern the system. Customer

control of a commercial enterprise could

change the relationship of the system to

its subscribers, could foreseeably

conflict with the profit-driven nature of

the organization, and could impose a

public structure on a private enterprise.

The Commission therefore proposes to

allow non-membership, for-profit

alternative trading systems that choose

to register as exchanges some flexibility

in satisfying the ‘‘fair representation’’

requirement in the Exchange Act.

The Commission believes that ‘‘fair

representation’’ does not necessarily

require exchanges to be owned by their

members. For example, in the past, the

Commission has stated that registered

clearing agencies may employ several

methods to comply with the fair

representation standard.173 These

methods include: (1) Solicitation of

board of director nominations from all

participants; (2) selection of candidates

for election to the board of directors by

a nominating committee which would

be composed of, and selected by, the

participants or representatives chosen

by participants; (3) direct participation

by participants in the election of

directors through the allocation of

voting stock to all participants based on

their usage of the clearing agency; or (4)

selection by participants of a slate of

nominees for which stockholders of the

clearing agency would be required to

vote their share. Other structures may

also provide independent, fair

representation in the material decision

making processes of an exchange that is

not owned by its subscribers. For

example, an alternative trading system

that registers as an exchange might be

able to fulfill this requirement by

establishing an independent subsidiary

that has final, binding responsibility for

bringing and adjudicating disciplinary

proceedings and rule making processes

for the exchange, and ensuring that the

governance of such subsidiary equitably
23526 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

174The Commission notes that the proprietary

exchange Easdaq, a recognized secondary market in

Belgium, has established a ‘‘regulatory authority’’

that has a degree of independence from Easdaq’s

board of directors.

175The Commission in the past has approved

exchange rules limiting the voting rights of ‘‘special

access’’ or non-equity members as consistent with

section 6(b)(3) of the Exchange Act, 15 U.S.C.

78f(b)(3). See, e.g., Securities Exchange Act Release

No. 22959 (Feb. 28, 1986), 51 FR 8060 (Mar. 7,

1986) (approving rule change by NYSE establishing

‘‘electronic access membership’’ with restricted

voting rights).

176 15 U.S.C. 78f(a) and 78s(a).

177 15 U.S.C. 78f(c)(1). Section 6(c)(1), adopted in

1975, prohibits exchanges from granting new

memberships to non-broker-dealers. At the time this

Section was adopted, one non-broker-dealer

maintained membership on an exchange. This nonbroker-dealer was not affected by the prohibition

and continues to maintain its membership. Section

15(e) of the Exchange Act, 15 U.S.C. 78o(e), gives

the Commission authority to require any member of

a registered exchange that is not required to register

with the Commission as a broker-dealer to comply

with any provision of the Exchange Act (other than

section 15(a) which requires registration of brokerdealers with the Commission or an exemption

therefrom) and rules thereunder that regulate or

prohibit any practice by a broker-dealer.

178For example, institutional investors may

include commercial banks, mutual funds, insurance

companies and pension funds. These institutions

may be subject to regulatory oversight by other

federal agencies, and may be regulated for purposes

that differ from the regulatory goals of the Exchange

Act.

179Section 6(c)(1) of the Exchange Act, 15 U.S.C.

78f(c)(1).

180See Concept Release, supra note 2.

181 15 U.S.C. 78f(f) and 78o(e).

182 15 U.S.C. 78o(e).

183 15 U.S.C. 78f(c)(1).

represents the exchange’s

participants.174 As another possibility,

certain directors appointed to the board

to represent the interests of trading

members or participants could be

limited to considering certain topics

relating to system use and rules, while

consideration of ownership issues could

be restricted to board members

representing the interests of the owners

or stockholders.175 What constitutes fair

representation for a particular exchange

would be determined in the context of

that system’s application for registration

under Sections 6(a) and 19(a) under the

Exchange Act, subject to public notice

and comment.176 The Commission

solicits commenters’ views regarding

application of the fair representation

requirement to alternative trading

systems that choose to register as

exchanges.

c. Membership on a national

securities exchange. Section 6(c)(1) of

the Exchange Act 177 prohibits

exchanges from granting new

membership to any person not

registered as a broker-dealer, or

associated with a broker-dealer. In the

Concept Release, however, the

Commission sought commenters’ views

on whether to allow institutional

membership on national securities

exchanges. Most commenters opposed

institutional membership on exchanges,

voicing myriad concerns. Some

commenters thought that institutional

membership would be contrary to the

purposes of the Exchange Act and

would create a competitive

disadvantage for registered brokerdealers. A number of commenters

opposed any arrangement that would

allow a class of members or participants

to be subject to less restrictive

regulations than another class. Other

commenters feared that the practical

implications would overwhelm

Commission resources as the

Commission tried to decide which rules

should apply to institutions and which

should not. In addition, a number of

commenters feared that institutional

exchange membership would subject

institutions to unwarranted oversight by

exchanges and the Commission or to

duplicative or inconsistent regulations

for those institutions that are already

subject to oversight by other federal

agencies.178 Some commenters were

concerned about the ability of

exchanges or the Commission to

exercise appropriate oversight over

institutions and questioned the ability

of an exchange to reject the membership

or direct access of an institution with a

questionable operating history.

After reviewing commenters’

concerns, as well as considering the

practical effects that institutional

membership or access may have on

other exchange members and on the

effective oversight of exchange trading,

the Commission is not proposing to

exempt national securities exchanges

from the prohibition on membership by

non-broker-dealers.179 Thus, just as

currently registered exchanges are

required to limit membership to brokerdealers, the Commission proposes that

alternative trading systems that choose

to register as exchanges be prohibited

from including non-broker-dealer

participants.

The legislative history of the

Exchange Act contemplates possible

direct institutional access to exchange

execution facilities.180 In addition,

sections 15(e) and 6(f) of the Exchange

Act 181 would permit the Commission to

subject institutional members to all

exchange rules and relevant Exchange

Act provisions. The Commission,

however, believes that, in order to

ensure the central goals of exchange

regulation, it would have to subject

institutional members or participants to

the majority of rules and regulations to

which broker-dealers are currently

subject. This would undermine most

benefits an institution would receive by

not having to register as a broker-dealer.

At the same time, it would impose adhoc regulatory burdens on the

Commission and the exchanges as they

tried to impose critical rules and

regulations on institutions. Thus, the

Commission does not believe that

allowing institutional membership on

exchanges is currently practical or

serves the best interests of investors or

the markets generally.

The Commission is also concerned

about the systemic risks that direct

institutional access may pose to the

national clearance and settlement

systems. If institutional investors were

granted exchange membership or direct

access to exchanges, they would need to

arrange for the clearance and settlement

of their trades. This would likely be

accomplished by the direct membership

of such investors in one or more of the

national clearance and settlement

corporations. They would also need to

demonstrate and maintain financial

creditworthiness. The Commission

could, pursuant to section 15(e) of the

Exchange Act,182 require non-brokerdealer institutions to comply with risk

management obligations, including the

requirements to maintain certain

minimum levels of net capitalization

and appropriate books and records.

Insufficient net capital and incomplete

books and records could compromise

financial soundness, audit trails, and

other general risk management

objectives that are critical to sound

markets and clearance and settlement

systems. If these important risk

management measures could not be

assured for institutions, the health of the

markets and the national clearance and

settlement systems could be

jeopardized. As discussed above, the

Commission believes that this course

would effectively require non-brokerdealer institutions to comply with the

same requirements imposed on

registered broker-dealers. Without such

requirements, institutional membership

on an exchange may also conflict with

an exchange’s obligation to have rules

that foster the efficient clearance and

settlement of securities transactions.

Accordingly, the Commission

continues to believe that exchange

membership should continue to be

limited to registered broker-dealers and

persons associated with registered

broker-dealers in accordance with

section 6(c)(1) of the Exchange Act.183

Institutions, however, would continue

to be able to access alternative trading

systems registered as exchanges through
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23527

184Exchange members are subject to regulatory

action by the NYSE for violations of NYSE rules by

their customers entering orders through the

members’ SuperDOT terminals.

185See infra note 255.

186See supra note 106 and accompanying text.

187 15 U.S.C. 78f(b)(2).

188 15 U.S.C. 78f(c).

189Section 15A(b)(8) of the Exchange Act applies

similar obligations to registered national securities

associations. 15 U.S.C. 78o–3(b)(8).

190A denial of access would be reasonable, for

example, if it were based on objective standards,

such as capital and credit requirements, and if these

standards were applied fairly.

191Section 6(b)(8) of the Exchange Act, 15 U.S.C.

78f(b)(8); section 15A(b)(9) of the Exchange Act, 15

U.S.C. 78o–3(b)(9).

192Section 6(b)(6) of the Exchange Act, 15 U.S.C.

78f(b)(6).

193Section 23(a) of the Exchange Act, 15 U.S.C.

78w(a).

194See supra notes 131–134 and accompanying

text.

195Section 12(a) of the Exchange Act makes it

unlawful for any member, broker, or dealer to effect

any transaction in any security (other than an

exempted security) on a national securities

exchange unless a registration statement has been

filed with the Commission and is in effect as to

such security for such exchange in accordance with

the provisions of the Exchange Act and the rules

and regulations thereunder. 15 U.S.C. 78l(a).

Section 12(b) of the Exchange Act, 15 U.S.C. 781(b),

contains procedures for the registration of securities

on a national securities exchange. Section 12(a)

does not apply to exchanges that the Commission

has exempted from registration as national

securities exchanges. See, e.g., Securities Exchange

Act Release No. 28899 (Feb. 20, 1991), 56 FR 8377

(Feb. 29, 1991). See also, Securities Exchange Act

Release No. 37271 (June 3, 1996), 61 FR 29145 (June

7, 1996).

196Section 12(f) of the Exchange Act, 15 U.S.C.

78l(f). Under section 12(f) of the Exchange Act, 15

U.S.C. 78l(f), exchanges cannot trade securities not

registered on an exchange or classified as Nasdaq

NM securities (such as Nasdaq SmallCap or OTC

securities) without Commission action. Section

12(f) of the Exchange Act authorizes the

Commission to permit the extension of UTP to any

security registered otherwise than on an exchange.

The OTC–UTP plan which provides UTP for

Nasdaq NM securities, is the only extension to date

approved by the Commission. See OTC–UTP plan,

infra note 210. Thus, registered exchanges cannot

currently trade Nasdaq SmallCap securities or

exempted securities that are not separately listed on

the exchange.

197Rule 12f–5 under the Exchange Act, 17 CFR

240.12f–5.

198See OTC–UTP plan, infra note 210 and

accompanying text.

a registered broker-dealer member of

such a trading system, similar to the

way in which institutions currently

have direct access to the NYSE through

SuperDOT terminals given to them by

NYSE members.184 For example, the

OptiMark System 185 enables

institutions to directly enter orders in

the OptiMark system through an

exchange member. Similarly, Nasdaq’s

proposed Integrated Order Delivery and

Execution System would provide

institutional access to Nasdaq through

Nasdaq primary market makers.186 This

form of access should not impose

significant costs or burdens on

institutions or on broker-dealers

providing such access. The Commission

believes that this approach would

readily serve institutional investors’

needs without compromising important

regulatory objectives.

The Commission, however, is

soliciting comment on whether

institutions should be permitted to be

members of a registered exchange.

d. Fair access. The Commission

would continue to require all national

securities exchanges to ensure the fair

access of registered broker-dealers in

accordance with sections 6(b)(2) 187 and

6(c) 188 of the Exchange Act, which

prohibit discriminatory denials of

access and discriminatory treatment of

members.189 The obligation to ensure

fair access for members does not,

however, restrict the authority of a

national securities exchange or national

securities association from maintaining

reasonable standards for access.190 The

securities industry and the general

public need access to exchanges to

ensure the best execution of orders and

view exchanges as venues for trading

that are open to all qualified persons.

Thus, the Commission believes that it is

consistent with the objectives of the

Exchange Act to prevent any

discriminatory denial of access on an

alternative trading system that elects to

register as a national securities

exchange.

In a similar vein, exchanges are

prohibited from adopting any anticompetitive rules.191 To further

emphasize the goal of vigorous

competition, Congress required the

Commission to consider the competitive

effects of exchange rules,192 as well as

the Commission’s own rules.193 The fair

access and fair competition

requirements in the Exchange Act are

intended to ensure that national

securities exchanges and national

securities associations operating

markets treat investors and their

participants fairly, consistent with the

expectations of the investing public.

Accordingly, the Commission proposes

to require all alternative trading systems

registered as exchanges to comply with

these requirements of the Exchange Act.

e. Compliance with ARP Guidelines.

All national securities exchanges are

expected to maintain sufficient systems

capacity to handle foreseeable trading

volume. The Commission believes that

adequate capacity is vital to the efficient

operation of exchanges, particularly

during periods of high volume or

volatility, such as have been

experienced in the past year. To ensure

adequate systems capacity, the

Commission established the automation

review program.194 All exchanges and

the NASD currently participate in this

program. Given the highly automated

nature of most alternative trading

systems, the Commission would expect

any alternative trading system that

registers as an exchange to comply with

the policies and procedures outlined by

the Commission in its policy statements

concerning the automation review

program, including cooperation with

any reviews conducted by the

Commission.

f. Registration of securities. Securities

traded on a national securities exchange

must be registered with the Commission

and approved for listing on the

exchange.195 In addition, national

securities exchanges are permitted to

trade securities listed on other

exchanges and Nasdaq pursuant to

unlisted trading privileges, or UTP.196

Alternative trading systems that choose

to register as exchanges would be

required to have rules for trading the

class or type of securities it seeks to

trade pursuant to UTP.197 Moreover, to

trade Nasdaq NM securities, these

systems would have to become

signatories to an existing plan governing

such trading.198 These requirements

ensure that investors have adequate

information and that all relevant trading

activity in a security is reported to, and

surveilled by, the exchange on which it

is listed. Alternative trading systems

that choose to register as national

securities exchanges would be subject to

these requirements. Therefore such

alternative trading systems could only

trade listed securities and would have to

comply with Commission regulations

governing UTP. These requirements

would not apply to alternative trading

systems that choose to register as

broker-dealers.

The Commission is not proposing that

alternative trading systems that choose

to register as broker-dealers and be

regulated under Regulation ATS be

limited in the types of securities they

trade. The Commission, however,

solicits comment on whether securities

traded on all alternative trading systems

should be registered under section 12 of

the Exchange Act. Alternatively, the

Commission requests comment on

whether a securities registration

requirement should apply when the

trading volume on the alternative

trading system, or in any particular

security traded through an alternative

trading system, reaches a specified

level. If so, the Commission requests

comment on what the appropriate

volume threshold should be. Because
23528 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

199 17 CFR 242.100.

200The Commission notes that any market maker

in a security that posts quotations in an alternative

trading system that is a ‘‘quotation medium’’ under

Rule 15c2–11 of the Exchange Act, 17 CFR

240.15c2–11, currently would have to comply with

Rule 15c2–11, which requires market makers to

obtain fundamental information about an issuer

prior to initiating or resuming quotes.

201The Commission has requested comment in a

release proposing changes to Rule 15c2–11 under

the Exchange Act on whether the information that

would be required by such amendment should

continue to apply to quotations in alternative

trading systems. See Securities Exchange Act

Release No. 39670 (Feb. 17, 1998), 63 FR 9661 (Feb.

25, 1998).

202The CTA provides vendors and other

subscribers (including alternative trading systems)

with consolidated last sale information for stocks

admitted to dealings on any exchange. The CQS

gathers quotations from all market makers in

exchange-listed securities and disseminates them to

vendors and other subscribers. The ITS is a

communications system designed to facilitate

trading among competing markets by providing

each market participating in the ITS pursuant to a

plan approved by the Commission (‘‘ITS plan’’)

with order routing capabilities based on current

quotation information. See e.g., Securities Exchange

Act Release Nos. 37191 (May 9, 1996), 61 FR 24842

(May 16, 1996); 17532 (Feb. 10, 1981), 46 FR 12919

(Feb. 18, 1981); 23365 (June 23, 1986), 51 FR 23865

(July 1, 1986) (Cincinnati Stock Exchange/ITS

linkage); 18713 (May 6, 1982) 47 FR 20413 (May 12,

1982) (NASD’s CAES/ITS linkage); 28874 (Feb. 12,

1991), 56 FR 6889 (Feb. 20, 1991) (Chicago Board

Options Exchange/ITS linkage).

203See infra note 210 and accompanying text for

a description of the OPRA plan.

204See infra note 210 and accompanying text for

a description of the OTC–UTP plan.

205See Rules 11 Ac1–1(b)(1) and 11Aa3–2(c)

under the Exchange Act, 17 CFR 240.11Ac1–1(b)(1)

and 240.11Aa3–2(c).

206Both the CTA and the CQS are presently

operated by the eight national securities exchanges

and the NASD.

207The CTA plan also contains a provision for

entities other than participants to report directly to

the CTA as ‘‘other reporting parties.’’ Pursuant to

this provision, parties other than a national

securities exchange or association may be permitted

to provide transaction data directly to the CTA.

Alternative trading systems that do not elect to

register as exchanges would be eligible for

participation in the CTA plan pursuant to this

provision; however, as non-member participants,

these systems would neither be obligated to pay the

required fees and expenses to the plan, nor able to

share in the plan’s profits.

208See Securities Exchange Act Release No.

37191 (May 9, 1996), 61 FR 24842 (May 16, 1996).

209These fees represent the ‘‘tangible and

intangible assets’’ provided by the plans to the new

participant. See infra notes 342–343 (discussing

entry fees for the CTA, CQS, and ITS plans).

210Similar to the CTA and CQS plans, the OTC–

UTP plan governing trading of Nasdaq NM

securities, provides for the collection,

consolidation, and dissemination of quotation and

transaction information for Nasdaq NM securities

by its participants. Any national securities

exchange where Nasdaq NM securities are traded

may become a full participant of the OTC–UTP

plan. The plan also provides that new participants

pay a share of development costs, share ongoing

operating costs, and are entitled to share in the

plans’ profits. See Joint Self-Regulatory

Organization Plan Governing the Collection,

Consolidation and Dissemination of Quotation and

Transaction Information for Exchange-listed

Nasdaq/National Market System Securities and for

Nasdaq/National Market System Securities Traded

on Exchanges on an Unlisted Trading Privilege

Basis (‘‘OTC–UTP plan’’). Securities Exchange Act

Release No. 24407 (Apr. 29, 1987), 52 FR 17349

(May 7, 1987). See also Securities Exchange Act

Release No. 36985 (Mar. 18, 1996), 61 FR 12122

(Mar. 25, 1996).

The OPRA plan also provides for the collection

and dissemination of last sale and quotation

information with respect to options that are traded

on the participant exchanges. Under the terms of

this plan, any national securities exchange whose

rules governing the trading of standardized options

have been approved by the Commission may

become a party to the OPRA plan. The plan

provides that any new party, as a condition of

becoming a party, must pay a share of OPRA’s startup costs. It also provides for revenue sharing among

all parties. The OPRA plan was approved pursuant

to section 11A of the Exchange Act and Rule 11a3–

2 thereunder. See Securities Exchange Act Release

No. 17638 (Mar. 18, 1981) (‘‘OPRA plan’’).

211To become a participant in ITS, an exchange

or association must subscribe to, and agree to

comply and to enforce compliance with, the

provisions of the plan. See ITS plan, supra note

202, at section 3(c).

212 ITS also establishes a procedure that allows

specialists to solicit pre-opening interest in a

security from specialists and market makers in

other markets, thereby allowing these specialists

and market makers to participate in the opening

transaction. Participation in an opening transaction

can be especially important when the price of a

security has changed since the previous close.

213A trade-through occurs when an ITS

participant purchases securities at a lower price or

sells at a higher price than that available in another

ITS participant market. For example, if the NYSE

is displaying a bid of 20 and an offer of 201⁄8 for

an ITS security, the prohibition on trade-throughs

would prohibit another ITS participant market from

buying that security from a customer at 197⁄8 or

selling that security to a customer at 201⁄2. In

some unregistered securities traded

through alternative trading systems may

be foreign securities traded on foreign

markets, the Commission requests

comment on whether any volume

threshold should be measured against

worldwide trading volume, similar to

the test for ‘‘average daily trading

volume’’ under Rule 100 of Regulation

M.199

The Commission also requests

comment on whether there are other

ways to ensure that information about

unregistered securities traded on

alternative trading systems is available

to investors.200 The Commission

requests comment on whether the

proposed amendments to Rule 15c2–11

would address this concern.201

g. NMS participation. Any alternative

trading system that elects to register as

a national securities exchange would

also be expected to become a participant

in the market-wide transaction and

quotation reporting plans currently

operated by registered exchanges and

the NASD. These plans comprise the

CQS, the CTA, the ITS,202 the Options

Price Reporting Authority (‘‘OPRA’’),203

and the Nasdaq/National Market

System/Unlisted Trading Privileges

(‘‘OTC–UTP’’).204 These plans link

trading, quotation, and reporting for all

registered exchanges and the NASD and

are responsible for the transparent,

efficient, and fair operation of the

securities markets. These plans form the

backbone of the NMS and participation

in these plans by all registered

exchanges is vital to the success of the

NMS.

Participation in effective quote and

transaction reporting plans and

procedures would, therefore, be

mandatory for any newly registered

exchange, as it is now for currently

registered exchanges.205 The CTA and

the CQS, which make quote and

transaction information in exchangelisted securities available to the public,

satisfy the requirements for effective

quote and transaction reporting plans

and procedures.206 Both of these plans

have provisions governing the entry of

participants to the plans,207 and allow

any national securities exchange or

registered national securities association

to become a participant.208 New

participants are required to pay certain

entry fees to the existing participants.209

Participants in these plans share in the

income and expenses associated with

the plans’ operations.210 While national

securities exchanges are required to

participate in an effective quote and

transaction reporting plan, the specific

plans are not mandated. Accordingly, if

the CTA and the CQS plans’ terms are

not compatible with the structure of

alternative trading systems that register

as exchanges, new plans could be

formed to satisfy this requirement. Such

initiatives may prove cumbersome, and

would have to satisfy the goals of

consolidation of quotes and trading

information. It may ultimately be

advisable for the participants of existing

plans to work with newly registered

exchanges to meet any special needs

posed by the new exchanges.

In addition to requiring participation

by newly registered exchanges in some

or all of the effective quote and

transaction reporting plans described

above, the Commission would expect

newly registered exchanges to

participate in ITS,211 or an equivalent

system if one were developed. ITS

provides trading links between market

centers and enables a broker or dealer

who participates in one market to

execute orders, as principal or agent, in

an ITS security at another market center,

through the system.212 ITS rules require

that the members of participant markets

avoid initiating a purchase or sale at a

worse price than that available on

another ITS participant market (‘‘tradethroughs’’).213 Participation in the ITS
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23529

addition, each participant market has in place rules

to implement the ITS Trade-Through Rule. See, e.g.,

NASD Rule 5262. The plan also provides a

mechanism for satisfying a market aggrieved by

another market’s trade-through.

214A locked market occurs when an ITS

participant disseminates a bid for an ITS security

at a price that equals or exceeds the price of the

offer for the security from another ITS participant

or disseminates an offer for an ITS security at a

price that equals or is less than the price of the bid

for the security from another ITS participant. The

plan provides a mechanism for resolving locked

markets.

215The ITS block trade policy provides that the

member who represents a block size order shall, at

the time of execution of the block trade, send or

cause to be sent, through ITS to each participating

ITS market center displaying a bid (or offer)

superior to the execution price a commitment to

trade at the execution price and for the number of

shares displayed with that market center’s better

priced bid (or offer).

216The Commission may suspend trading in any

security for up to 10 days, and all trading on any

national securities exchange or otherwise, for up to

90 days pursuant to sections 12(k)(1)(A) and (B) of

the Exchange Act. 15 U.S.C. 781(k)(1)(A) and (B).

217For example, a newly registered exchange

would be required under Rule 11Ac1–1 under the

Exchange Act, 17 CFR 240.11Ac1–1, to halt trading

when neither quotation nor transaction information

can be disseminated.

218The Commission has found that trading halt

rules instituted by a national securities exchange or

a national securities association are consistent with

the objectives of section 6(b)(5) of the Exchange Act.

15 U.S.C. 78f(b)(5). See, e.g., Securities Exchange

Act Release Nos. 39582 (Jan. 26, 1998), 63 FR 5408

(Feb. 2, 1998); 26198 (Oct. 19, 1988), 53 FR 41637

(Oct. 24, 1988). See, e.g., Amex Rule 117, NASD

Rule 4120(a)(3), and NYSE Rules 80B and 717.

There is no requirement that exchanges or

associations of securities dealers employ identical

trading halt rules, and these rules may vary

according to the needs of the individual market.

219 15 U.S.C. 78f.

220 If circuit breakers are imposed in one market,

but not in another, overall market disruptions

caused by trading imbalances can migrate from one

market to the next, and efforts to stabilize such

imbalances during periods of heavy trading and

extreme volatility would be subverted. See also

Securities Exchange Act Release No. 39846 (Apr. 9,

1998) (approving proposed changes to SRO rules

regarding circuit breakers).

221 17 CFR 240.6a–1, 240.6a–2, and 240.6a–3.

222 17 CFR 249.1; 17 CFR 249.1a.

223New Exhibit E would require an exchange to

describe, among other things, the means of access

to the electronic trading system, the procedures

governing display of quotes and/or orders,

execution, reporting, clearance, and settlement.

New Exhibit L would require an exchange to

describe its criteria for membership, conditions

under which members may be subject to suspension

or termination, and procedures that would be

involved in such suspension or termination.

Proposed Amended Form 1.

would give users of these new

exchanges access to other ITS

participant markets. Moreover,

participation in ITS would require new

exchanges to comply with other

applicable ITS rules and policies on

matters such as, for example, tradethroughs, locked markets,214 and block

trades.215 As with the quote and

transaction reporting plans, alternative

trading systems that register as

exchanges would have to be integrated

into ITS, or another system that links

markets for trading purposes would

have to be created to accomplish full

integration of the newly registered

exchanges into the NMS. In either case,

the linkage system would need to

accommodate certain practices

important to alternative trading system

users that may be incompatible with

current ITS requirements.

The Commission solicits comment on

issues raised by integration of new

exchanges in ITS. It also requests

comment on what changes would be

necessary to NMS mechanisms to

accommodate the registration of

alternative trading systems as exchanges

and what steps would need to be taken

to integrate alternative trading systems

registered as exchanges into the NMS

mechanisms.

h. Uniform trading standards. In

addition to participation in NMS

mechanisms, alternative trading systems

that register as exchanges would be

required to comply with any

Commission-instituted trading halt

relating to securities traded on or

through its facilities.216 Newly

registered exchanges would be required

in some instances to adopt trading halt

rules to comply with certain

Commission rules.217 Newly registered

exchanges would also have the

authority and be expected to impose

trading halts for individual securities,

for classes of securities, and for their

system as a whole under the appropriate

circumstances.218 The Commission does

not believe that this requirement would

present any undue burden for

alternative trading systems that elect to

register as national securities exchanges

because most alternative trading

systems are already subject to the

imposition of trading halts as members

of the NASD.

In addition, to promote the orderly

operation of the securities markets in

accordance with Section 6 of the

Exchange Act,219 the Commission

would expect all newly registered

national securities exchanges to

implement circuit breaker rules to

temporarily halt trading during periods

of extraordinary market volatility or

unusual market declines. Circuit

breakers have been adopted to help

stabilize the markets and allow the

realignment of order imbalances due to

such extreme volatility and believes that

for circuit breakers to be effective, all

markets must impose corresponding

circuit breakers.220

3. Application for Registration as an

Exchange

Rules 6a–1, 6a–2, and 6a–3 under the

Exchange Act 221 set forth the

application process for registration as a

national securities exchange, for seeking

an exemption from the Commission

based on limited volume, and the

ongoing filing requirements for

registered or exempted exchanges. The

Commission is proposing to revise these

rules to clarify the requirements for

registration as an exchange and to

accommodate the registration as

exchanges of automated and proprietary

trading systems. The Commission is also

proposing to revise Form 1, the

application used by exchanges to

register or to apply for an exemption

based on limited volume, and to repeal

Form 1–A.222

a. Revisions to Form 1. Form 1 would

be revised by reorganizing and

redesignating the Statement and the

Exhibits. In addition, because the

Commission expects applicants using

Form 1 to be fully or partially

automated, the Commission is

proposing to revise some of the

information requested in Form 1 so that

it is more applicable to automated

exchanges. In particular, the

Commission is proposing to add two

new exhibits asking an exchange to

describe the way any of its electronic

trading system operates, and the criteria

used by the exchange in admitting

members.223 The information requested

on Form 1 would also be updated to

reflect new forms of exchange

organization, including the possibility

that an exchange is owned by

shareholders, rather than members.

Further, if an exchange is not owned by

its members, those trading on the

exchange would be considered

participants or subscribers, rather than

members. The Commission is proposing

to amend Form 1 to reflect this

possibility. Finally, the Commission is

proposing that exchanges use Form 1,

rather than Form 1–A, to file

amendments. Therefore, the

Commission is proposing to repeal Form

1–A.

b. Amendments to Rules 6a–1, 6a–2,

and 6a–3 under the Exchange Act. The

proposed amendments to Rules 6a–1,

6a–2, and 6a–3 under the Exchange Act

are designed to reduce some of the filing

burdens for exchanges and to allow

exchanges to comply with the filing

requirements by posting information on

an Internet web page.
23530 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

224Rule 6a–1(a) under the Exchange Act, 17 CFR

240.6a–1(a). Rule 6a–1 also requires an exchange,

promptly after discovering that any information in

its statement or any exhibit or amendment thereto

was inaccurate when filed, to file with the

Commission an amendment correcting such

inaccuracy. 17 CFR 240.6a–1.

225Section 5 of the Exchange Act, 15 U.S.C. 78e.

226Proposed Rule 6a–1(a).

227Rule 6a–3(a) under the Exchange Act, 17 CFR

240.6a–3(a). An exchange need not file notices

within 10 days of any changes to Exhibits E, F, L,

and M of Form 1 concerning the exchange’s, and

its affiliates’ and subsidiaries’, financial statements,

the securities admitted to unlisted trading

privileges on the exchange, and the unregistered

securities trading on the exchange. Id.

228Section 19(b) of the Exchange Act, 15 U.S.C.

78s(b).

229Proposed Amended Rule 6a–2(a).

230Rules 6a–2(a) under the Exchange Act, 17 CFR

240.6A–2(a)

231Rule 6a–2(a)(1) under the Exchange Act, 17

CFR 240.6a–2(a)(1).

232Rule 6a–2(a)(2) under the Exchange Act, 17

CFR 240.6a–2(a)(2); Form 1, Exhibits E and F, 17

CFR 249.1.

233Rule 6a–2(a)(3) under the Exchange Act 17

CFR 240.6a–2(a)(3); Form 1, Exhibits G and H, 17

CFR 249.1.

234Rule 6a–2(a)(3) under the Exchange Act, 17

CFR 240.6a–2(a)(3); Form 1, Exhibit J, 17 CFR 249.1.

235Rule 6a–2(a)(3) under the Exchange Act, 17

CFR 240.6a–2(a)(3); Form 1, Exhibits L and M, 17

CFR 249.1.

236Amended Rule 6a–2(c) under the Exchange

Act.

237Amended Rule 6a–2(d)(3) under the Exchange

Act. Currently, in lieu of filing certain information

in paper with the Commission, an exchange is

permitted to refer to materials published by, or in

cooperation with, the exchange that contain the

required information or to make the information

available upon request at its office, instead of filing

that information in paper. Rules 6a–2(a)(3) and 6a–

2(b) under the Exchange Act, 17 CFR 240.6a–2(a)(3)

and 6a–2(b). These alternatives would continue to

be available to exchanges. Proposed Amended Rule

6a–2(d)(1)–(2).

238Proposed Amended Rule 6a–2(d)(3) under the

Exchange Act.

239 17 CFR 240.6a–3.

240Proposed Amended Rule 6a–3(a) under the

Exchange Act.

(i) Application for Registration as an

Exchange or Exemption Based on

Limited Volume of Transactions

Rule 6a–1 generally requires an

applicant for registration as an

exchange, or for exemption from

registration, to file an application with

the Commission on Form 1 together

with accompanying exhibits.224

Currently, the only exemption from

registration available to an exchange is

under section 5 of the Exchange Act,

which permits the Commission to grant

an exemption ‘‘by reason of the limited

volume of transactions effected on such

exchange.’’ 225 Because proposed

Regulation ATS would provide another

exemption from exchange registration,

under which exchanges would not use

Form 1, the Commission is proposing to

amend Rule 6a–1 to clarify that Form 1

should only be used by an exchange to

apply for registration or for an

exemption from registration under

section 5 of the Exchange Act based on

such exchange’s limited volume of

transactions.226

(ii) Periodic Amendments.

Once registered, or exempted from

registration based on its limited volume

of transactions, current Rule 6a–3

requires an exchange to file with the

Commission written notice of actions

that render inaccurate certain

information filed in its application.227

This notice must be filed within 10 days

after such action is taken. The

Commission is proposing to relieve

exchanges from some of these

requirements. Under the proposed

amendments, an exchange would no

longer have to file notices within 10

days of changes to: (1) Its constitution,

articles of incorporation or association,

or by-laws; (2) written rulings or settled

practices of any governing board or

committee of the exchange that have the

effect of rules or interpretations; and (3)

the schedule of securities listed on the

exchange. These types of changes are

required to be filed with the

Commission under section 19(b) of the

Exchange Act and must be approved by

the Commission.228 In addition, rather

than exchanges filing these changes in

the form of a notice, as is currently

required under paragraph (a) of Rule 6a–

3, the Commission is proposing a

technical change that would require

changes to be filed in the form of an

amendment on Form 1.229

In addition, Rule 6a–2 currently

requires each registered or exempted

exchange to file an annual amendment

on Form 1–A.230 This annual

amendment must include: (1) Any

changes since the last annual

amendment to the basic information

about an exchange filed in the

Statement to Form 1;231 (2) consolidated

financial statements of the exchange and

unconsolidated financial statements for

the exchange and each affiliate and

subsidiary of the exchange; 232 (3)

information about the exchange’s

affiliates and subsidiaries, including the

officers, governors, or members of

standing committees of the affiliates,

and its subsidiaries; 233 (4) a list of the

officers, governors, or members of

standing committees of the exchange;

(5) a list of all member organizations of

the exchange; 234 and (6) schedules of all

securities admitted to unlisted trading

privileges, and of all unregistered

securities trading, on the exchange.235

The Commission is proposing to

eliminate the requirement to file an

annual amendment to reflect changes in

the information currently filed on the

Statement to Form 1. As discussed

above, the Commission is proposing that

most of this information be filed on the

Execution Page of Revised Form 1.

Changes to this information would

continue to be required to be filed with

the Commission within 10 days. The

Commission, however, no longer

believes it is necessary to also receive an

annual amendment summarizing all

changes in the past year. The

Commission is proposing to eliminate

the requirement that information about

the exchange’s affiliates and

subsidiaries filed on Exhibit C to

Revised Form 1, and the information

about an exchange’s officers, governors,

or members of standing committees

filed on Exhibit J to Revised Form 1, be

included as part of an annual

amendment. Because exchanges are

required to notify the Commission of

changes to this information within 10

days, the Commission believes it would

be adequate if exchanges file complete

Exhibits C and J only every three

years.236

Finally, the Commission is proposing

to reduce the filing burdens on national

securities exchanges and exchanges

exempt from registration by reason of

the limited volume of transactions by

allowing such exchanges to comply

with certain filing requirements by

maintaining the information on an

Internet web page and providing the

location of such web site to the

Commission.237 The proposed

amendments would permit national

securities exchanges to also post certain

information on an Internet web site and

submit that location to the Commission

in lieu of filing the information in hard

copy.238

(iii) Supplemental Material

Paragraph (b) of Rule 6a–3 currently

requires registered exchanges, or

exchanges exempt from registration

based on their limited volume of

transactions, to furnish to the

Commission copies of all materials

issued or made available to members.239

The proposed changes would continue

to require exchanges to provide the

Commission with such materials, but as

an alternative to filing such information

on paper, the Commission is proposing

that exchanges be permitted to make the

information available on an Internet

web site and provide the Commission

with the location of the web site.240

The Commission is not proposing to

change the requirement in paragraph (c)

of Rule 6a–3 that registered exchanges

file transaction reports within fifteen

days after the end of each calendar
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23531

24117 CFR 240.6a–3(c).

242 17 CFR 240.17a–23.

243The term ‘‘international broker-dealer system’’

would be 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.’’ Proposed Rule 17a–3(16)(ii)(A) under

the Exchange Act.

244 17 CFR 240.17a–3 and 240.1–7a–4.

245Proposed Rules 17a–3(16)(i)(B) and (C) under

the Exchange Act.

246See supra note 243.

247The term ‘‘sponsor’’ would be 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.’’

Proposed Rule 17a–3(16)(ii)(B).

248The term ‘‘system order’’ would be 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 will

specifically exclude ‘‘inquiries or indications of

interest that are not entered into the internal brokerdealer system.’’ Proposed Rule 17a–3(16)(ii)(C).

249Proposed Rules 17a–4(b)(1) and (10) under the

Exchange Act.

250See Concept Release, supra note 2, 62 FR at

30518–19.

251The Pacific Exchange stated that the

‘‘restrictions, procedural requirements or pricing

restraints to which the exchange is subject[,] * * *

[t]he relative burdens and benefits, obligations and

opportunities, administrative requirements and

entrepreneurial incentives imposed on or available

to the traditional exchange versus the [alternative

trading systems] are seriously skewed.’’ PCK Letter

at 11. See also CSE Letter at 3; SIA Letter (10/3/

97) at 9; OptiMark Letter at 8.

252See CSE Letter at 3; SIA Letter (10/3/97) at 9;

OptiMark Letter at 8.

253 15 U.S.C. 78s(b).

254Today, the Commission is also proposing 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. Under

this proposal, the SRO would have to have trading

rules, procedures, and listing standards for the

product class in which the new derivative securities

product is included, and have surveillance

procedures for this product class. Securities

Exchange Act Release No. 39885, Apr. 20, 1998.

month containing information regarding

the volume of stocks, bonds, rights, and

warrants sold on the exchange.241 The

Commission, however, solicits comment

on whether to permit such information

to be filed electronically with the

Commission and whether changing the

monthly filing requirement to a

quarterly filing requirement would

appropriately reduce burdens on

registered exchanges.

IV. Broker-Dealer Recordkeeping and

Reporting Obligations

A. Elimination of Rule 17a–23

Under the proposals in the release,

the most significant alternative trading

systems would be required to register as

exchanges or register as broker-dealers

and comply with the requirements

under proposed Regulation ATS. These

systems are currently subject to

recordkeeping and reporting

requirements under Rule 17a–23 under

the Exchange Act.242 These alternative

trading systems would be 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 therefore proposing to

eliminate duplicative recordkeeping and

reporting obligations for these systems

by repealing Rule 17a–23 and moving

its recordkeeping requirements (as they

apply to broker-dealers that are not also

alternative trading systems) to the

broker-dealer recordkeeping rules.

B. Amendments to Rules 17a–3 and

17a–4

Certain trading systems that are

operated by broker-dealers would not be

affected by today’s proposals, and

therefore would not be required to

register as exchanges or comply with

Regulation ATS. This residual group of

internal broker-dealer systems 243 would

continue to be regulated under the

traditional broker-dealer regulatory

scheme. The Commission is proposing

to amend Rules 17a–3 and 17a–4 under

the Exchange Act 244 to require brokerdealers to make and keep records

regarding the activities of internal

broker-dealer systems for nonalternative trading systems. These

proposed recordkeeping requirements

are similar to the recordkeeping

requirements under current Rule 17a–

23. The Commission believes that these

recordkeeping requirements continue to

be valuable for the oversight and

inspections of internal broker-dealer

systems by the Commission and by the

SROs.

These amendments would require

broker-dealers to keep records of any of

its customers that have access to its

internal broker-dealer system, as well as

any affiliations between those customers

and the broker-dealer. Broker-dealers

would also be required to keep daily

trading summaries, including

information on the types of securities

for which transactions have been

executed through the internal brokerdealer system, and transaction volume

information.245

To clarify the application of Rule 17a–

3, the Commission also is proposing to

add definitions, for the purposes of the

rule, for the terms ‘‘internal brokerdealer system,’’ 246 ‘‘sponsor,’’ 247 and

‘‘system order.’’ 248

The Commission is also proposing to

amend Rule 17a–4 under the Exchange

Act to require that the records that

would be required under the

amendments to Rule 17a–3 be preserved

for three years, the first two years in an

accessible place.249 The proposed

amendment would also require 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.

V. Temporary Exemption of Pilot

Trading System Rule Filings

A. Introduction

In contrast to registered exchanges,

alternative trading systems are not

required to submit rule filings for

Commission approval. This difference

creates a disadvantage for registered

exchanges competing with alternative

trading systems. 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.250 Several 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,’’ 251 and attributed

it, in part, to exchanges’ inability to

implement new trading systems before

submitting a rule filing and receiving

Commission approval.252 In response to

these concerns and to make existing

markets more competitive, the

Commission is proposing a temporary

exemption for SROs that would defer

the rule filing requirements of section

19(b) under the Exchange Act 253 for

pilot trading systems (‘‘pilot trading

system rule’’).254 In formulating the

pilot trading system rule, the

Commission draws on its experience in

the past several years with SROs’
23532 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

255For 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

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 nonmembers 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).

256Section 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)(B) of the Exchange Act, 15

U.S.C. 78s(b)(2)(B).

257See Proposed Rule 19b–5(a) for the proposed

definition of ‘‘pilot trading system.’’

258A pilot trading system that exceeds certain

volume limits would have to file for permanent

approval before the two-year period expires.

Proposed Rule 19b–5(d) and (e). See also infra

Section V.B.

259Several commenters specifically supported the

Commission’s suggestion that SROs be relieved of

the rule filing requirement, in some way, when

operating a pilot trading system. See Peake Letter

(7/14/97) at 27–28; Jamieson Letter at 20; CSE Letter

at 1–3 (stating expedited treatment of proposed

pilot trading system rules would have the added

benefit of reducing the costs of uncertainty and

easing regulatory burdens on exchanges and the

Commission); Weaver Letter at 18; Letter from

Leopold Korins, Chairman and Chief Executive

Officer, Philadelphia Stock Exchange, to Jonathan

G. Katz, Secretary, SEC, dated Oct. 8, 1997 (‘‘Phlx

Letter’’) at 5–6; PCX Letter at 37–38 (suggesting

minimum requirements for pilot trading systems);

SIA Letter (10/3/97) at 9; ABA Letter at 33.

260See Letter from James F. Duffy, Executive Vice

President & General Counsel Legal & Regulatory

Policy, American Stock Exchange, to Jonathan G.

Katz, Secretary, SEC, dated Nov. 12, 1997 (‘‘Amex

Letter’’) at 5–6; CSE Letter at 3; SIA Letter (10/3/

97) at 9.

261Amex Letter at 5.

262Proposed Rule 19b–5(a)(2).

263Proposed Rule 19b–5(a)(1).

264Proposed Rule 19b–5(b).

attempts to operate new pilot trading

systems for their members.255

Currently, SROs are required to

submit a rule filing to the Commission

and undergo a public notice, comment,

and approval process, before they

operate a new pilot trading system.256

The proposed pilot trading system rule

would permit SROs that develop ‘‘pilot

trading systems,’’ 257 to begin operation

shortly after submitting new Form

PILOT to the Commission. During the

operation of the pilot trading system,

the sponsoring SRO would have to

submit to the Commission quarterly

reports, as well as amendments to Form

PILOT concerning material changes to

the pilot trading system. Before two

years have expired, the SRO must

submit a rule filing to obtain from the

Commission permanent approval of the

pilot trading system or cease operation

of the trading system.258

The Commission believes its

proposed pilot trading system rule

would address many of the concerns

raised by commenters.259 One of the

consequences of SROs filing rule

changes before implementation is that

the rule filing process informs SROs’

competitors about the proposed pilot

trading system and provides an avenue

for those competitors to copy, delay, or

obstruct implementation of a pilot

trading system before it can be tested in

the marketplace.260 According to one

commenter, the rule filing process

hinders innovation because registered

exchanges do not realize the full

competitive benefits of their efforts.261

Inherent in the rule filing process is

public disclosure of the SROs’ business

plans for trading systems prior to their

operation. This gives SROs’ competitors

access to their plans for proposed

trading systems. 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.

The proposed pilot trading system rule

is designed to allow 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.

The Commission recognizes that

domestic markets must compete with

less regulated foreign markets and

broker-dealers and that such

competition spurs innovation and

benefits the marketplace. The

Commission agrees with commenters

that excessive regulation of traditional

exchanges, alternative trading systems,

or other markets hinders these markets’

ability to compete and survive in the

global arena. The proposed pilot trading

system rule responds to SROs’ need for

a more balanced competitive playing

field.

B. Proposed Rule 19b–5

Proposed Rule 19b–5 would provide a

temporary exemption for SRO proposed

rule changes concerning the operation

of pilot trading systems to defer the rule

filing requirements of Section 19(b) of

the Exchange Act.

1. Proposed Definition of a Pilot Trading

System

Under paragraph (a) of proposed Rule

19b–5, a trading system operated by an

SRO would be a ‘‘pilot trading system’’

if it met one of the definitions. First, a

trading system would be a ‘‘pilot 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 share

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

share trading volume of all trading

systems operated by the SRO.262

Second, a trading system operated by an

SRO for less than two years would also

be considered a ‘‘pilot trading system’’

if, during at least two of the last four

consecutive calendar months it traded

no more than five percent of the U.S.

average daily share trading volume of

each security traded on the trading

system, and were independent of any

other trading system operated by the

same SRO. 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 share trading volume

of all trading systems operated by the

SRO.263

The Commission would consider a

trading system to be ‘‘independent’’ if it

satisfies one of the following criteria.

First, a pilot trading system would be

deemed independent if it trades

securities different from securities

traded on any trading system operated

by the same SRO that has been

approved by the Commission. Second, a

pilot trading system would be deemed

independent if it does not operate

during the same trading hours as any

other trading system operated by the

same SRO that has been approved by

the Commission. Finally, a pilot trading

system would be deemed independent

provided no specialist or market maker

on any other trading system operated by

the same SRO trades on the pilot trading

system securities in which they are a

market maker or specialist.264
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23533

265Proposed Rule 19b–5(a)(3). See also infra

Section V.C.

266Although the Commission would continue to

accept paper versions of these documents, the

Commission encourages SROs to submit filings on

computer diskette in an appropriate word

processing format.

267Proposed Rule 19b–5(f).

268Proposed Rule 19b–5(c)(10).

269The 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’’)

Continued

If a trading system exceeds the

volume thresholds set forth in

paragraphs (a)(1) or (a)(2) of proposed

Rule 19b–5, it would be allowed to

continue to operate for 60 more days

under this exemption.265 During this 60

day period, the Commission expects

that an SRO would file for permanent

approval of the trading system. The

Commission requests comment on its

proposed definition of a pilot trading

system. Specifically, the Commission

would like comment on whether the

proposed two-year time period, trading

volume limits, and independence

criteria are too broad or too narrow.

Commenters are asked to provide

specific reasons for any concerns about

the proposed definition and to suggest

alternatives.

2. SROs’ Continuing Obligations

Regarding Pilot Trading Systems

Based upon the Commission’s

experience with reviewing new pilot

trading system proposals submitted by

SROs, the Commission believes that to

be consistent with the Exchange Act,

SROs operating pilot trading systems

should satisfy the requirements

discussed below. An SRO’s failure to

comply with these conditions would

compromise its ability to rely on the

proposed pilot trading system rule. The

Commission seeks comment on whether

there are any additional conditions with

which SROs should be required to

comply in order to be temporarily

exempt from the rule filing

requirements. The Commission also

requests comment on whether any of the

conditions described below are

unnecessary.

a. Notice and filings to the

Commission. Under proposed Rule 19b–

5, SROs would be required to provide

written notice, and information about

the operation of a pilot trading system,

to the Commission on new Form PILOT.

The SRO could commence operation of

the pilot trading system 20 days after

this filing is complete.266 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 20 days before commencing

operation. This 20-day delayed

operational date, triggered by the filing

date, provides the Commission time to

review Form PILOT for compliance by

the SRO with the pilot trading system

rule. The Commission believes, for

example, that an SRO proposing to

operate a pilot trading system that

provides trading privileges, such as

priority of execution, preferential fees or

access to trade information to SRO

members and not to non-member

subscribers, would not be in the public

interest nor consistent with the

protection of investors. Such proposed

rule changes for trading systems,

therefore, would not be exempt from

section 19(b) of the Exchange Act.267

The Commission could also determine,

after notice to the SRO and 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.

Proposed Form PILOT would require

an SRO to provide, as part of the initial

operation report, 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

subscribers to the pilot trading system;

and (4) the names of entities assisting in

the operation of the pilot trading

system. An SRO would also have to file

an amendment to Form PILOT at least

20 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.

In addition, an SRO would be

required to submit a quarterly report on

Form PILOT. The quarterly report

would include information about the

trading volume effected on the pilot

trading system during the most recent

calendar quarter. Under paragraph

(c)(10) of proposed Rule 19b–5,

information reported by an SRO on

Form PILOT would be deemed

confidential.268 The Commission seeks

comment on whether the Commission

should deem all information filed on

Form PILOT to be confidential. The

Commission requests comment on

whether additional information should

be requested on Form PILOT. The

Commission seeks comment on whether

an alternative treatment of information

filed on Form PILOT, for example, that

information on Form PILOT is publicly

available unless an SRO specifically

requests confidential treatment, would

better protect investors.

b. Trading rules and procedures. The

SRO would have to adopt and

implement trading rules and procedures

necessary to operate the pilot trading

system in a manner consistent with the

Exchange Act. For example, the SRO

would have to have appropriate trading

rules and procedures to promote the fair

and orderly trading of securities on the

pilot trading system, including: (1)

Position limits and 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. The SRO, however,

would not be required to file these

trading rules and procedures with the

Commission, provided they applied

only to trading conducted on the pilot

trading system.

c. Surveillance. The SRO would also

have to establish procedures for the

effective surveillance of trading activity

on the pilot trading system. It is

important that the SRO be able to obtain

information necessary to detect and

deter market manipulation, illegal

trading, and other trading abuses. To

satisfy this requirement, an SRO would

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, there should 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.269 Such agreements provide a
23534 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

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.

270See 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.

271Securities traded on a pilot trading system

would be limited to those securities listed on the

sponsoring SRO, or traded on the SRO pursuant to

unlisted trading privileges. 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. 15 U.S.C. 78l(f). For

example, exchanges are permitted to trade certain

over-the-counter securities pursaunt to a

Commission order or rule. See Securities Exchange

Act Release No. 39505 (Dec. 31, 1997), 63 FR 1515

(Jan. 9, 1998). This ensures that securities traded on

the pilot trading system have provided adequate

disclosure to investors and that all relevant trading

activity in a security is reported to, and surveilled

by, the SRO on which the security is listed.

272Proposed Rule 19b–5(c)(6).

273Proposed Rule 19b–5(c)(8).

274Proposed Rule 19b–5(c)(9).

275Proposed Rule 19b–5(e).

276See supra notes 271–272 and accompanying

text.

277See Section 6(b)(2) of the Exchange Act. See

also Order Handling Rules Adopting Release, supra

note 88.

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’’).270 The ISG was formed to

coordinate, among other things,

effective surveillance and investigative

information sharing arrangements in the

stock and options markets.

d. Clearance and settlement. An SRO

would have to establish reasonable

clearance and settlement procedures for

transactions effected on the pilot trading

system. The integrity of the trading

markets depends on the timely and

coordinated clearance and settlement of

transactions. For this reason, the

Commission believes that an SRO

operating a pilot trading system should

ensure that the necessary linkages to

clearing agencies exist for all pilot

trading system users. 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 corporation member through

which the user will clear its trades.

e. Types of securities. Because a pilot

trading system would be operated by an

SRO, it would be limited to trading

registered or exempted securities.271 In

addition, a pilot trading system would

not be eligible for the exemption if it

trades derivative securities, such as

options, warrants, or hybrid products,

the value of which are based, in whole

or in part, on the value of or interest in

any security traded on another trading

system operated by the SRO. The

converse would also be true. A pilot

trading system would not be eligible for

the exemption if it trades any security

or instrument, the derivative of which is

traded on another trading system

operated by the SRO.272 SROs

contemplating trading systems that

would trade these types of derivative

securities would have to continue to

submit rule filings under section

19(b)(2) of the Exchange Act.

f. Procedures to ensure the

confidentiality of trading. An SRO

operating a pilot trading system would

also have to ensure that it has

procedures to prevent the misuse of

confidential information regarding

trading on the pilot trading system. For

example, to the extent that the identity

of a person trading on the pilot trading

system is confidential, the SRO should

limit access to the information. In

particular, only employees of the SRO

who operate the pilot trading system, or

are responsible for the SRO’s

compliance with applicable law, should

have access to confidential information

about the identity of persons effecting

transactions on the pilot trading system

and the trading information itself. The

SRO also should implement procedures

for its employees regarding trading by

employees for their own accounts.

Finally, the SRO would have to adopt

and implement adequate oversight

procedures to ensure that the above

safeguards concerning confidentiality

are followed.

g. Inspections and examinations. The

SRO would have to cooperate with any

examination or inspection by the

Commission of persons effecting

transactions on the pilot trading system.

The Commission staff would review

SRO compliance with the conditions in

proposed Rule 19b–5 through its routine

inspections. The Commission notes that

if an SRO outsources the development,

operation, or maintenance of the

operation 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.273

In order for the Commission staff to

determine whether an SRO has properly

relied on the proposed exemption under

Rule 19b–5, the SRO would have to

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 proposed

exemption from the rule filing

requirement.274

C. Rule Filing Under Section 19(b)(2) of

the Exchange Act Required Within Two

Years

Within two years of a pilot trading

systems’ commencement of operation,

an SRO would have to 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. After a formal notice

and comment period, the Commission

would approve the pilot trading system

for operation on a permanent basis or

institute proceedings to determine

whether to disapprove the proposed

rule change. Simultaneous with its

request for Commission approval under

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.275

D. Compliance With Other Federal

Securities Laws

The Commission notes that Proposed

Rule 19b–5 does not relieve SROs from

any other obligation under the federal

securities laws, except the requirement

to file a proposed rule change with the

Commission prior to commencing

operation of a pilot trading system. For

example, an SRO that fails to provide

fair access to its pilot trading system

would not be operating in a manner

consistent with the Exchange Act. In

addition, the SRO would have to ensure

that securities listed and traded on the

pilot trading system comply with,

among other things, the registration

requirements of the Exchange Act.276

An SRO would also continue to be

required to enforce compliance with its

own rules and the federal securities

laws, including members’ compliance

with the Order Handling Rules.277
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23535

278 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 overthe-counter market.’’)

279 15 U.S.C. 78c(a)(1).

280 Delta Release, supra note 10.

281See Delta Release, supra note 10, at 1900. 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. See Delta Release,

supra note 10.

282For 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

8363, 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).

283See Delta Release, supra note 10, at 1899.

284 Id. at 1899. As discussed below, the

Commission’s new general exemptive authority has

increased the Commission’s flexibility in this

regard.

285See Delta Release, supra note 10, at 1900.

286 Delta Release, supra note 10, at 1895 (quoting

Delta I, supra note 281, at 535).

287 Delta II, supra note 171, 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.

E. Request for Comment on Proposed

Rule 19b–5

The Commission seeks comments on

proposed Rule 19b–5 under the

Exchange Act. Comments should

address whether the proposed

temporary exemption of SRO proposed

rule changes relating to the operation of

pilot trading systems provides

appropriate regulation of such pilot

trading systems. The Commission also

requests comment on whether this

proposed temporary exemption would

help to level the competitive playing

field between SROs and alternative

trading systems.

As an alternative to the temporary

exemption proposed today, the

Commission requests comment on the

benefits or disadvantages of allowing

SROs to file proposed rule changes

relating to pilot trading systems under

the expedited approval process under

section 19(b)(3)(A) of the Exchange Act.

The Commission could allow an SRO to

submit, under section 19(b)(3)(A) of the

Exchange Act, the proposed rule

changes concerning pilot trading

systems. An SRO could then begin

operating the pilot trading system

immediately after filing. Under this

alternate framework, an SRO proposed

rule change would be published for

comment and could be abrogated by the

Commission. Specifically, the

Commission asks commenters whether

the public disclosure required in the

proposed rules filed under section

19(b)(3)(A) of the Exchange Act would

achieve the purpose of encouraging SRO

pilot trading systems.

VI. The Commission’s Interpretation of

the ‘‘Exchange’’ Definition

A. The Commission’s Interpretation in

Delta

Congress drafted the statutory

language defining the term exchange to

be broad, permitting the Commission to

apply the definition flexibly as the

securities markets evolve over time.278

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.279

Although the Exchange Act definition

of ‘‘exchange’’ is quite broad, in the

1990 Delta Release,280 the Commission

interpreted the definition 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.’’ 281 Based on the

interpretation upheld by the Seventh

Circuit, 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.282 The Delta Release,

nonetheless, 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).’’ 283

In explaining why the Commission

interpreted the exchange definition

relatively narrowly, in 1990 the

Commission expressed the concern that

‘‘including (Delta) within 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 illsuited, thus ignoring the Congressional

and judicial mandate to apply flexibly

the definition of the term ‘exchange’ to

the economic realm.’’ 284 The

Commission indicated, however, that

the Exchange Act itself does not

preclude a proprietary trading system

such as Delta from coming within the

exchange definition.285 Moreover, the

Commission recognized, however, that

its interpretation of the exchange

definition in 1990 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.’’ 286

The United States Court of Appeals

for the Seventh Circuit Court affirmed

the Commission’s decision that Delta

was not an exchange within the

meaning of section 3(a)(1) of the

Exchange Act. Significantly, the court

thought the language of the statute

broad enough ‘‘to embrace the Delta

system,’’ but concluded that the

Commission was not compelled to

interpret it to do so.287

While the Delta interpretation

provided an appropriate interpretation

at the time, its emphasis on the

‘‘expectation’’ of regular execution of
23536 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

288See Securities Exchange Act Release No.

28899 (Feb. 20, 1991), 56 FR 8377 (Feb. 28, 1991).

289See Letter from Richard G. Ketchum to Daniel

T. Brooks, Cadwalader, Wickersham & Taft (Aug. 8,

1986) (stating the Commission staff would not

recommend Instinet for an enforcement action if it

did not register with the Commission as a national

securities exchange).

290See Concept Release, supra note 2, at Section

II.B.2.

291For 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 84.

292See DIVISION OF MARKET REGULATION, MARKET

2000: AN EXAMINATION OF CURRENT EQUITY MARKET

DEVELOPMENTS APP IV (1994) (‘‘MARKET 2000

STUDY’’).

293For purposes of this release, the term ‘‘order’’

generally means any firm trading interest, including

both limit orders and market maker quotations.

294The Exchange Act, coupled with relevant

legislative history, appears to provide the

Commission with ample authority to revise its

interpretation of an exchange, See, e.g., supra

Section VI.A. Courts have also 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).

295The elements of the interpretation are

discussed in greater detail in Sections II.A. and

II.B., supra.

296For 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 brokerdealer activities to exchange regulation. Delta

Release, supra note 10.

297Pub. L. 104–290, 110 Stat. 3416 (1996). 15

U.S.C. 78mm.

298Throughout 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

orders at quoted prices may no longer

reflect changing market structures.

Moreover, the Delta approach has

resulted in the anomaly of small volume

entities being found to raise an

expectation of liquidity and being

regulated as exchanges (such as the

Arizona Stock Exchange),288 while

larger volume entities that avoid certain

design features are found not to raise

this expectation and are regulated as

broker-dealers (such as Instinet).289 In

addition, 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.290

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 NMS has had a

negative impact on the quality and

pricing efficiency of secondary

markets.291

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.292 In

the Concept 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 293 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 40 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.

The securities markets rely on

centralized sources of trading

opportunities and trading information.

Exchange regulation is designed to

protect this centralization function and

to make the opportunity to obtain

trading information and to access

trading interest accessible to the general

public. As more alternative trading

systems develop and offer varying

services to diverse customer bases, the

availability of trading information and

the accessibility of trading opportunities

may become increasingly fragmented.

C. The Proposed Reinterpretation 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.294 Although the

Commission has considered many

characteristics of the modern exchange

in revising its interpretation, it believes

two elements most accurately reflect the

functions and uses of today’s exchange

markets. Under the interpretation

proposed in Rule 3b–12, the first

essential element of an exchange would

be the consolidation of orders of

multiple parties. This reflects the

statutory concept of bringing together

purchasers and sellers and also reflects

the idea of a marketplace where supply

and demand originate from a variety of

sources, not simply from individual

brokers and dealers. The second

essential element would be that trading

on an exchange is guided by stated nondiscretionary 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.295

D. Other Practical Reasons for Revising

the Current Interpretation

1. Additional Flexibility Provided by

the National Securities Markets

Improvement Act of 1996

One principal reason the Commission,

to date, 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.296 The

recent enactment of NSMIA,297

however, alleviates the concern that an

expanded interpretation of the term

exchange would inhibit innovation.298
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23537

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).

299 15 U.S.C. 78mm(a)(1).

300Prior 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.

301See S. Rep. No. 104–293, 104th Cong. 2d Sess.

15 (1996).

302Proposed Rule 3a1–1 would also exempt from

the definition of ‘‘exchange,’’ any system that is

operated by a national securities association. See

supra Section II.D.

303See supra Section II.D.

304See supra Section III.A.

305See supra Section III.B.3.

306See supra Section III.A.2.c., d., and e.

307See Concept Release, supra note 2, at Section

IV.B.

Specifically, 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.299

Prior to adoption of NSMIA, the

Commission’s authority under the

Exchange Act to reduce or eliminate

certain consequences of exchange

registration was limited.300 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.301 The

Commission is proposing Rule 3a1–1

under the Exchange Act, which would

exempt from the definition of

‘‘exchange’’ systems that are registered

as broker-dealers and in compliance

with Regulation ATS.302 This

exemption, together with the revised

interpretation of ‘‘exchange,’’ would

provide a choice to alternative trading

systems to register as national securities

exchanges or as broker-dealers.303

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 noaction 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 noaction requests from developing

alternative trading systems that seek to

avoid the burdens associated with

registration as a national securities

exchange. The Commission’s proposal

would eliminate the need for this noaction 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

proposed revised interpretation of the

term exchange, in combination with the

proposal to allow alternative trading

systems to register as broker-dealers in

accordance with proposed Regulation

ATS,304 is consistent with other goals

and provisions of the Exchange Act. The

proposed revised interpretation of

‘‘exchange’’ should avoid the need for

the Commission to draw arbitrary

distinctions between organizations that

perform similar functions. This should

avoid classifying an alternative trading

system in a manner that does not fit the

structure of the system, nor squarely

addresses the regulatory concerns raised

by the system. Another significant

advantage of the proposed revised

interpretation of ‘‘exchange’’ is that it

will allow exchanges to be organized as

proprietary systems, thereby

accommodating recent market

developments.305

Moreover, the Commission’s proposal

would help 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 would be 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 brokerdealers and comply with regulatory

obligations more appropriately tailored

to their chosen business structure.

These obligations would 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.306

VII. Approaches Not Proposed

A. Tiered Exchange Approach

In the Concept Release, the

Commission explored the possibility of

expanding the interpretation of

‘‘exchange’’ to capture the majority of

alternative trading systems operating

today, and then to adopt differing levels

of regulation for three different classes

of ‘‘exchanges.’’ 307 The classes, or

‘‘tiers,’’ would vary depending on the

size and significance of the trading

systems included in each class. The first

tier would have consisted of those that

have limited volume or do not establish

trading prices. This tier would include

most alternative trading systems. The

Commission suggested that systems

included in this tier could be exempted

from most traditional exchange

requirements.

The second tier of exchanges under

this approach would have consisted of

alternative trading systems that

resemble traditional exchanges because

of their significant volume of trading

and active price discovery. The

Commission discussed whether these

systems should be regulated as national

securities exchanges, with some

exemptions from traditional exchange

regulation to eliminate barriers that

would make it difficult for these nontraditional markets to comply with full

exchange regulation, such as the

membership and access requirements.

Finally, a third tier of exchanges

would have encompassed traditional

membership exchanges. The

Commission suggested that these

exchanges continue to be regulated as

national securities exchanges, with

some accommodations to reduce

unnecessary regulatory requirements

that make it difficult for currently

registered exchanges to remain

competitive in a changing business

environment. The Commission

suggested, for example, further
23538 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

308 15 U.S.C. 78k–1.

309Section 3(a)(22)(A) of the Exchange Act, 15

U.S.C. 78c(a)(22)(A).

310The Commission’s cost estimates in Section IX

are derived from its experience with similar

reporting and recordkeeping requirements as

reflected in a number of submissions made

pursuant to the paperwork Reduction Act of 1995.

44 U.S.C. 3501 et seq.

accelerating rule filing and approval

procedures.

While comments varied with respect

to the tiered approach, commenters

generally opposed this approach, fearing

that it would weaken competition by

alternative trading systems and

discourage growth and innovation.

Some commenters noted that the

burdens of exchange regulation would

be heavy for many alternative trading

systems, and that the tiered approach

would require the Commission to draw

arbitrary lines between different

systems, which could result in systems

that perform virtually identical

functions being subject to different

regulatory requirements. Commenters

also disagreed on how distinctions

should be drawn between the tiers. In

this vein, some commenters thought

that the tiered approach would inhibit

the full development of innovative

systems if such growth would cause the

system to be regulated under a more

burdensome regulatory tier. A few

commenters also suggested that it would

be inappropriate to relax standards for

smaller start-up trading systems because

investors may need more protection

with respect to these systems than for

larger more established systems.

For these reasons, the Commission

has decided not to pursue the tiered

exchange regulation approach discussed

in the Concept Release. The

Commission believes that the approach

it is proposing is preferable because it

will enable trading systems to elect the

regulation most appropriate for the

services they provide, and takes into

account size in applying particular

requirements. This approach can foster

innovation while concurrently

regulating trading systems in a manner

more fitting to their respective market

roles.

B. SIP Approach

The Division also considered an

alternative that would require all or

some portion of alternative trading

systems to register as securities

information processors (‘‘SIPs’’) under

section 11A of the Exchange Act.308 The

1975 Amendments create a framework

for regulating SIPs, which are defined as

persons engaged in the business of:

(i) collecting, processing, or preparing for

distribution or publication, or assisting,

participating in, or coordinating the

distribution or publication of, information

with respect to transactions in or quotations

for any security * * * or (ii) distributing or

publishing * * * on a current and

continuous basis, information with respect to

such transactions or quotations.309

To implement this alternative, the

Commission would have to adopt rules

designed to address the transparency,

capacity, access, and surveillance of the

systems classified as SIPs. Like the

exchange approach, the Commission has

determined that the SIP approach would

not be as workable as the approach

proposed today. In many respects, the

rules the Commission would have to

adopt under the SIP approach would

parallel exchange regulatory

requirements, but would not be able to

address all of the concerns regarding

alternative trading systems’ activities.

For example, markets regulated as SIPs

would not be required to enforce

participants’ compliance with the

securities laws. In addition, alternative

trading systems would continue to be

only partially integrated into the NMS

because SIPs are not required to join

market-wide plans, such as the CQS,

CTA, ITS, and OPRA. Finally, because

SIPs and exchanges are defined in the

Exchange Act as mutually exclusive

categories, a market classified as a SIP

could not elect to register as an

exchange, even if that market’s volume

exceeded that of registered exchanges.

VIII. Request for Public Comments

The Commission seeks comments on

adopting the proposals as described in

this release. In addition to the requests

for comments throughout the release,

the Commission asks commenters to

address whether the proposed

amendments and rules provide

appropriate regulation of alternative

trading systems. Commenters should

also address whether the proposed

amendments and rules provide a

feasible regulatory structure for

alternative trading systems registered as

broker-dealers and national securities

exchanges. Commenters may also wish

to discuss whether there are any legal or

policy reasons why the Commission

should consider a different approach. In

addition to responding to the specific

issues presented in this release, the

Commission encourages commenters to

provide any information to supplement

the information and assumptions

contained herein regarding the

functioning of secondary markets, the

roles of market participants, the

advantages and disadvantages of the

proposed reforms and the expectations

of investors. The Commission also

invites commenters to provide views

and data as to the costs and benefits

associated with the proposed changes

discussed above in comparison to the

costs and benefits of the statutory

framework. For purposes of the Small

Business Regulatory Enforcement

Fairness Act of 1996, the Commission is

also requesting information regarding

the potential impact of the proposed

amendments and rules on the economy

on an annual basis. If possible,

commenters should provide empirical

data to support their views. Comments

should be submitted by July 28, 1998.

IX. Costs and Benefits of the Proposed

Rules and Amendments

The growing significance of

alternative trading systems has caused

the Commission to reconsider its

oversight of such systems through

existing broker-dealer regulation. Even

though they perform the functions of a

market, alternative trading systems that

trade a significant volume of securities

currently are not obligated to surveil

their markets for manipulative activity,

to make all of their quotes public, to

treat participants fairly, or to maintain

adequate systems capacity to prevent

outages. As a result, the existing

regulatory approach has resulted in

inferior or denied access for investors to

the best prices, incomplete audit trails

and surveillance of trading on

alternative trading systems, and market

disruption due to systems outages.

The Commission is proposing to

allow alternative trading systems to

choose between broker-dealer regulation

or exchange regulation. In addition, to

enable registered exchanges to better

compete with alternative trading

systems regulated as broker-dealers, the

Commission is proposing that SROs be

permitted to operate pilot trading

systems for a limited period of time

before undergoing the full notice,

comment, and approval process

required for an SRO rule change. The

Commission preliminarily believes that

any costs associated with this proposal

would be offset by benefits to investors

and other market participants such as

reducing market fragmentation,

enhancing investor access to the best

prices, and encouraging market

innovation. The Commission has

identified below certain costs 310 and

benefits associated with its proposed

changes and encourages commenters to

identify, discuss, analyze, and supply

relevant data regarding any additional

costs or benefits.
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23539

311See e.g. At Deadline: New Age Bandits,

Traders Magazine, February, 1997, at 6.

312See Market Quality Monitoring: Overview of

1997 Market Changes, NASD Economic Research, at

2.

A. Costs and Benefits of the Proposals

Regarding Alternative Trading Systems

1. Benefits

a. Improved surveillance on

alternative trading systems. The

Commission’s proposal would provide

benefits to investors by improving the

surveillance of trading on alternative

trading systems. Adequate surveillance

of the trading on alternative trading

systems is critical to the continued

integrity of our markets. This is

particularly the case with regard to

alternative trading systems that have a

significant percentage of the trading

volume in one or many issues of

securities. The oversight of trading

activities on alternative trading systems

that choose to register as broker-dealers

would improve because the proposals

clarify the relationship between SROs

and alternative trading systems.

The proposed notice, reporting, and

recordkeeping requirements under

Regulation ATS would also contribute

to the Commission’s and the SROs’

ability to effectively oversee alternative

trading systems regulated as brokerdealers. The Commission believes that

these enhancements to the surveillance

and oversight of alternative trading

systems regulated as broker-dealers

would benefit the public by helping to

prevent fraud and manipulation.

The surveillance of trading on

alternative trading systems that choose

to register as exchanges under the

Commission’s proposal would also be

improved. All registered exchanges are

SROs, which have direct obligations to

surveil the trading on their own

markets. The Commission believes that,

through improved surveillance

mechanisms, it would be better able to

detect fraud and manipulation that

could occur on alternative trading

systems. For example, alternative

trading systems can be used to

artificially narrow the national best bid

and offer (‘‘NBBO’’) spreads for the sole

purpose of trading through a brokerdealer’s automatic execution system at

the artificial prices.311 The Commission

and the SROs would be able to more

readily detect such activity through

enhanced surveillance. The Commission

believes that this more direct oversight

of trading activities would therefore

benefit investors and the market

generally by helping to prevent fraud

and manipulation.

b. Improved market transparency. The

Commission’s proposal would enhance

transparency of trading on alternative

trading systems. Transparency of orders

helps ensure that publicly available

prices fully reflect overall supply and

demand and helps reduce the negative

consequences of market fragmentation

(e.g., the chance that an order for a

security in one market will be executed

at a price inferior to that available at the

same time in another market). The

Commission has been particularly

concerned that the development of socalled ‘‘hidden markets,’’ in which a

market participant privately publishes

quotations at prices superior to the

quotation information it disseminates

publicly, impedes NMS objectives.

Some systems that permit this activity

have become significant markets in their

own right, but are not currently required

to integrate their orders into the public

quote because they are not registered as

national securities exchanges or

national securities associations.

For alternative trading systems

choosing to register as broker-dealers,

the Commission is proposing to improve

the transparency of orders in systems

that account for a significant portion of

the trading volume in any security. The

proposed rules would help to

incorporate alternative trading system

quotes into the NMS, thus reducing

fragmentation, improving liquidity,

facilitating price discovery, and

narrowing the quoted spread. In

particular, the Commission believes that

the current proposal would extend the

transparency improvements achieved

through the implementation of the

Order Handling Rules. Since the

adoption of the Order Handling Rules in

January 1997, quoted spreads have

decreased by an average of 41%, ECNs

were alone at the inside quote

approximately 11% of the time, and the

average daily number of quote updates

attributable to ECNs was about 68% of

the number of quote updates

attributable to market makers, with

ECNs accounting for 272,427 quote

updates as compared to 403,233 for

market makers.312 The success of the

Order Handling Rules indicates that the

Commission’s current proposal, which

would achieve similar transparency for

a greater number of orders in alternative

trading systems, could further enhance

liquidity and price improvement

opportunities. Because non-market

maker broker-dealers and institutions at

times enter the best priced orders in an

alternative trading system, the

Commission expects that display of

these orders in the public quote would

improve the NBBO. For example, of all

orders by non-market maker brokerdealers and institutions that could

improve the NBBO if included in the

public quote stream, only 6% of those

orders were actually entered into the

public quote stream. Consequently,

about 94% of those orders that could

have improved the NBBO were not

included in the public quote stream and

thus did not improve the NBBO. The

Commission requests comment on how

often the display of non-market maker

broker-dealer and institutional orders

could improve the NBBO.

The transparency of trading on

alternative trading systems that choose

to register as exchanges would also

improve. All registered exchanges are

expected to participate in the NMS

plans, such as the CTA, CQS, and ITS.

These plans form an integral part of the

NMS, and contribute greatly to the

operation of linked, transparent,

efficient, and fair markets. In addition to

improving transparency, alternative

trading system participation in these

market-wide mechanisms would benefit

investors by reducing inefficiency and

trading fragmentation.

c. Fair access. The Commission

believes that its proposal to require

alternative trading systems with

significant volume to notify investors

denied access of their right to appeal

that denial, and to provide regulatory

redress for unfair denials of access,

would help ensure that market

participants are provided a fair

opportunity to participate in alternative

trading systems. Fair treatment of

potential and current subscribers by

alternative trading systems is important,

especially when an alternative trading

system captures a large percentage of

trading volume in a security. Although

an alternative trading system with

significant volume would be required to

provide access to orders that it is

required to display in the public quote

stream, there are other benefits to

participation on an alternative trading

system that the Commission believes an

alternative trading system should not

unfairly discriminate in granting access.

In particular, participation on an

alternative trading system allows an

investor to enter its own orders, view

contingent orders not publicly

displayed (such as all or none orders)

and use special features of an alternative

trading system, such as a negotiation

feature or reserve size feature.

Under the current regulatory

approach, there is no regulatory redress

for unfair denials or limitations of

access by alternative trading systems.

The availability of redress for such

actions may not be critical when market

participants are able to substitute the

services of one alternative trading
23540 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

313This estimate is based on filings made with

the Commission under Rule 17a–23.

314Based on the Commission’s experience over

the last 3 years with Rule 17a–23, it appears that

there are more than 3 new alternative trading

systems per year. However, we expect that in the

steady state over time, there would be

approximately 3 new alternative trading systems

per year. The rapid growth experienced over the

last several years is unlikely to continue at such a

high rate in perpetuity.

315This estimate for burden hours of filing Form

ATS is based on burdens associated with filing

system with those of another. However,

when an alternative trading system has

a significantly large percentage of the

volume of trading, discriminatory

actions hurt investors lacking access to

the system. The proposals would

prevent discriminatory denials of access

and ensure that market participants are

not prevented from gaining access to

significant sources of liquidity.

d. Systems capacity, integrity, and

security. The Commission believes that

its proposal regarding systems capacity,

integrity, and security of alternative

trading systems would provide several

benefits to the marketplace and to

investors. Marketplaces are increasingly

reliant on technology and most of their

functions are becoming highly

automated. Alternative trading systems

are subject only to business incentives

to avoid system breakdowns that may

disrupt the market. In the past,

alternative trading system failures have

affected the public market particularly

during periods of high trading volume.

Some alternative trading systems have

had prolonged shut-downs during the

busiest trading sessions due to systems

problems. For example, during the past

year, Instinet, Island, Bloomberg, and

Archipelago (operated by Terra Nova)

have all experienced systems outages

due to problems with their automated

systems. On a number of occasions,

ECNs have had to stop disseminating

market maker quotations in order to

keep from closing altogether, including

during the market decline of October

1997 when one significant ECN

withdrew its quotes from Nasdaq

because of lack of capacity. Similarly, a

major interdealer broker in non-exempt

securities experienced serious capacity

problems in processing the large

number of transactions in October 1997

and had to close down temporarily.

The Commission’s proposals would

require alternative trading systems that

handle a significant volume of trades to

establish reasonable capacity estimates,

conduct stress tests, implement

procedures to monitor system

development, review systems

vulnerability, and establish adequate

contingency plans. Investors would

benefit from the proposals because

significant systems would be less likely

to shut down as a result of systems

failures and would be better equipped to

handle market demand and provide

liquidity during periods of market

stress. The ability of alternative trading

systems to provide more reliable and

consistent service in the market would

benefit investors and the public markets

generally. The Commission also believes

that by ensuring that significant

alternative trading systems maintain

sufficient security measures from

unauthorized access, investors would

benefit from robust system security.

All currently registered exchanges

participate in the Commission’s

automated review program. Alternative

trading systems that choose to register

as exchanges would similarly be

expected to participate in this program.

Under the automation review program,

exchanges are expected to maintain

sufficient systems capacity to meet

current and anticipated volume levels.

The benefits to investors and the public

generally, as with significant alternative

trading systems, would be the assurance

that systems are reasonably equipped to

handle market demand and provide

liquidity during periods of market

stress.

2. Costs

The alternative trading system

proposals have been tailored to

minimize their burden on alternative

trading systems and especially small

systems. Many of the provisions in the

proposed rules are triggered by a

volume threshold. The Commission

expects that small alternative trading

systems would not have sufficient

volume to trigger those thresholds and

would therefore not have to comply

with those provisions. The

recordkeeping and reporting

requirements with which smaller, lower

volume alternative trading systems

would have to comply under proposed

Regulation ATS are substantially similar

to those with which alternative trading

systems currently comply. Consequently

the costs for smaller alternative trading

systems should remain unchanged.

a. Notice, reporting, and

recordkeeping. All alternative trading

systems that would be subject to notice,

reporting, and recordkeeping

requirements under the Commission’s

proposal are currently subject to similar

requirements under Rule 17a–23. The

requirements proposed today under

Regulation ATS would, however,

require some additional information

that is not currently required under Rule

17a–23.

Under proposed Regulation ATS,

alternative trading systems would file

an initial operation report, notices of

material systems changes, and quarterly

reports. The proposals also include new

Forms ATS and ATS–R to standardize

reporting of such information and make

it more useful for the Commission. The

proposed rules would require

information that is not currently

required under Rule 17a–23, such as

greater detail about the system

operations, the volume and types of

securities traded, criteria for granting

access to subscribers, procedures

governing order execution, reporting,

clearance and settlement, procedures for

reviewing systems capacity and

contingency procedures, and the

identity of any other entities involved in

operating the system.

Proposed Regulation ATS would

require staff time to comply with the

initial notice and amendment

requirements. While the Commission

has designed the requirements in an

effort to balance the costs of filing with

the benefits to be gained from the

information, some effort would be

necessary to gather and file this

information. Most of the information,

however, already exists. Alternative

trading systems would only be required

to gather this information and supply it

in the required format to the

Commission. The periodic updating

requirements would also require staff

time over the life of the alternative

trading system to comply with the

proposed rules.

The Commission estimates that there

are currently about 43 alternative

trading systems that would be required

to register as exchanges or register as

broker-dealers and comply with

Regulation ATS.313 The Commission

also estimates that, over time, there

would be approximately 3 new

alternative trading systems each year

that choose to register as broker-dealers

and comply with Regulation ATS.314

The Commission also estimates that,

over time, there would be

approximately 3 alternative trading

systems that file cessation of operations

reports each year. Thus, the

Commission anticipates that, over time,

if all 43 current alternative trading

systems choose to register as brokerdealers and comply with Regulation

ATS, there would be approximately 43

alternative trading systems operating

each year.

The Commission estimates that the

average burden per respondent to file

the initial operations report on Form

ATS would be 20 hours. This burden is

computed by estimating that completing

the report would require an average of

13 hours of professional work and 7

hours of clerical work.315 The
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23541

Form 1, adjusted for differences between Form 1

and Form ATS. The division between professional

and clerical time is based on estimates of the

proportions used in the estimates of burdens for

filing Form 1.

316The estimated average cost per response of

$1,019 is composed of $650 for in-house

professional work (13 hours at $50 per hour), $105

for clerical work (7 hours at $15 per hour) and $264

for printing, supplies, copying, and postage

(approximately 35% of the total labor costs). The

Commission estimates overhead based on 35% of

total labor costs based on the GSA Guide to

Estimating Reporting Costs (1973).

317This estimated cost of $43,817 is derived from

43 alternative trading systems filing at a cost of

$1,019 each.

318This estimated cost of $3,057 is derived from

3 new alternative trading systems filing at a cost of

$1,019 each.

319This estimate is based on the Commission’s

experience with collection of similar information

under Rule 17a–23.

320The estimated average cost per response of

$111.50 is composed of $75 for in-house

professional work (1.5 hours at $50 per hour), $7.50

for clerical work (0.5 hours at $15 per hour), and

$29 for printing, supplies, copying, and postage

(approximately 35% of the total labor costs). The

Commission estimates overhead based on 35% of

total labor costs based on the GSA Guide to

Estimating Reporting Costs (1973).

321This estimated cost of $28,767 is composed of

$111.50 cost per amendment for 43 alternative

trading systems filing 6 times per year.

322The estimated cost of $223 per response is

composed of $150 for in-house professional work (3

hours at $50 per hour), $15 for clerical work (1 hour

at $15 per hour) and $58 for printing, supplies,

copying, and postage (approximately 35% of the

total labor costs). The Commission estimates

overhead based on 35% of total labor costs based

on the GSA Guide to Estimating Reporting Costs

(1973).

323The estimated annual cost of $892 to file Form

ATS–R is derived from 4 quarterly reports at an

estimated annual cost of $223 per filing.

324This estimated cost of $38,356 is derived from

43 alternative trading systems with an estimated

annual filing cost for each of $892.

325The estimated cost of $111.50 per response is

composed of $75 for in-house professional work

(1.5 hours at $50 per hour), $7.50 for clerical work

(0.5 hours at $15 per hour), and $29 for printing,

supplies, copying and postage (approximately 35%

of the total labor costs). The Commission estimates

overhead based on 35% of total labor costs based

on the GSA Guide to Estimating Reporting Costs

(1973).

326The estimated cost of $334.50 is derived from

an average of 3 alternative trading systems filing 1

cessation of operations report per year on Form

ATS at an estimated cost of $111.50 each.

327Proposed Rules 301(b)(8), 302, and 303(a)(1).

328The estimated cost of $1,923.20 is derived

from an average of 40 hours of compliance time at

$48.04 per hour. The value of compliance time is

estimated as follows: an employee of a brokerdealer charged to ensure compliance with

Commission regulations receives estimated annual

compensation of $100,000. This compensation is

the equivalent of $48.08 per hour ($100,000 divided

by 2,080 payroll hours per year). The estimate of

40 hours encompasses an estimated 36 burden

hours for recordkeeping requirements under

proposed Rule 302 and an estimated 4 burden hours

for record preservation requirements under

proposed Rule 303.

329This estimated cost of $82,697.60 is derived

from 43 alternative trading systems incurring an

annual cost of $1,923.20 each.

Commission estimates that the average

cost per response would be $1,019

representing the 20 hours and cost of

supplies.316 If all 43 alternative trading

systems opted to register as brokerdealers and comply with Regulation

ATS, the total, one time cost to comply

with the proposed requirements to file

initial operation reports is estimated to

be $43,817.317 The Commission also

estimates that, over time, approximately

3 new alternative trading systems will

register as broker-dealers per year,

incurring an annual aggregate burden of

60 hours for an average total cost of

$3,057 after the first year following

adoption of Regulation ATS.318

In addition, the proposed rules would

require alternative trading systems to

amend their initial operations report to

notify the Commission of material

systems changes and other changes to

the information contained in the initial

operations report. The Commission

estimates that each respondent would

file 6 such amendments per year.319 The

Commission estimates that each

respondent would incur an average

burden of 2 hours per response and

incur an average cost of $111.50 for each

amendment to the initial operation

report that it submits.320 If all 43

alternative trading systems opted to

comply with Regulation ATS rather

than to register as exchanges, the total

aggregate cost per year to comply with

the proposed requirement to file

amendments to the initial operation

reports is estimated to be $28,767.321

Alternative trading systems

registering as broker-dealers would also

be required to file quarterly reports on

Form ATS–R, reporting participating

system subscribers, the securities traded

on the system, and aggregate volume

information. The Commission estimates

that the quarterly reports would cause

each respondent to incur an average

burden of 4 hours per response and

incur an average cost of $223 for each

Form ATS–R that it submits.322 The

annual burden per respondent would be

$892.323 If all 43 alternative trading

systems opted to register as brokerdealers and comply with Regulation

ATS, the total cost per year to comply

with the proposed requirement to file

quarterly reports is estimated to be

$38,356.324

Finally, alternative trading systems

registered as broker-dealers would be

required to submit a notice and a report

on Form ATS when they cease

operations. The Commission anticipates

a total of 3 such filings per year. The

Commission estimates that individual

respondents would incur a burden of 2

hours to file the cessation notice. The

Commission estimates that individual

respondents would incur a cost of

$111.50 to file the cessation of

operations report on Form ATS.325 The

annual aggregate burden for 3

alternative trading systems to file

cessation of operations reports is

estimated to be $334.50.326

The proposed recordkeeping

requirements under Regulation ATS

would require alternative trading

systems registered as broker-dealers to

keep and make available to the

Commission and the appropriate SRO,

upon request, records of: (1) The

identities of subscribers to the system;

(2) daily summaries of trading in the

system; (3) time-sequenced records of

specified order information in the

system; (4) all notices provided to

subscribers; and (5) all documents

relating to the system’s compliance with

the capacity, security, and integrity

standards set forth in Proposed Rule

301(b)(6) under Regulation ATS.327 The

Commission estimates that each

alternative trading system that chooses

to register as a broker-dealer would be

required to expend an average of 40

hours per year, at an estimated average

cost of $1,923.20, to comply with these

proposed recordkeeping

requirements.328 If all 43 alternative

trading systems opted to register as

broker-dealers, rather than as exchanges,

the total cost for both recordkeeping and

record preservation is estimated to be

$82,697.60 per year.329 The Commission

notes that it is soliciting comment on

the feasibility of permitting alternative

trading systems to file all reports

electronically, which could ease the

burdens on alternative trading systems.

b. Public display of orders and equal

execution access. Proposed Regulation

ATS would require some market

participants to modify their current

quotation dissemination systems.

Because alternative trading systems

would be required to display the best

bid and offer regardless of the party

entering the order, additional burdens

could possibly be imposed on

institutions choosing to use different

order entry methods to avoid display.

Accordingly, the possibility exists that

alternative trading systems could suffer

decreased liquidity if institutional

customers reduced their reliance on

alternative trading systems for trading

activities. The Commission believes that

its proposals reduce the likelihood of

this occurrence. Moreover, the

Commission preliminarily believes that

any costs would be offset by the benefits

enjoyed by the public market as a whole

in the form of less fragmentation,

increased liquidity, and the equal

opportunity to obtain the best bids and
23542 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

330The estimated cost of $337.50 to establish and

maintain standards for granting access is composed

of $250 for in-house professional work (5 hours at

$50 per hour) and $87.50 for printing, supplies,

copying, and postage (approximately 35% of the

total labor costs). The Commission estimates

overhead based on 35% of total labor costs based

on the GSA Guide to Estimating Reporting Costs

(1973).

331The estimated cost of $20.25 per response is

composed of $15 for clerical work (1 hour at $15

per hour) and $5.25 for printing, supplies, copying,

and postage (approximately 35% of the total labor

costs). The Commission estimates overhead based

on 35% of total labor costs based on the GSA Guide

to Estimating Reporting Costs (1973). The estimated

annual cost of $546.75 is derived from 27 notices

at $20.25 per notice.

332The estimated aggregate burden of 64 hours is

derived from 32 hours per respondent. The burden

of 32 hours per respondent is composed of 5 hours

for recordkeeping and 27 hours for notice

requirements. The estimated aggregate cost of

$1,768.50 is derived from 2 alternative trading

systems each incurring an estimated annual burden

of $884.25 ($546.75 for notice requirements and

$337.50 for recordkeeping requirements).

333The Commission notes that compliance with

the notice provision can be achieved by a telephone

call, so the burden for each notice is minimal. The

Commission estimates only 0.25 hours per notice

would be required.

334The estimated average cost per response of $17

is composed of $12.50 for in-house professional

work (0.25 hours at $50 per hour) and $4.50 for

printing, supplies, copying, and postage

(approximately 35% of the total labor costs). The

Commission estimates overhead based on 35% of

total labor costs based on the GSA Guide to

Estimating Reporting Costs (1973). The estimated

annual cost of $85 is derived from 5 notices at $17

per notice.

335The total estimated cost of $675 is composed

of $500 for in-house professional work (10 hours at

$50 per hour) and $175 for printing, supplies,

copying, and postage (approximately 35% of the

total labor costs). The Commission estimates

overhead based on 35% of total labor costs based

on the GSA Guide to Estimating Reporting Costs

(1973).

offers in the market. The Commission

estimates that 3 alternative trading

systems would be required to comply

with the display provisions of proposed

Regulation ATS due to their significant

volume.

c. Fair access. The proposal would

require alternative trading systems to

provide fair access and to notify

investors denied access that they can

appeal this denial to the Commission

and that investors are able to appeal

denials to the Commission. These

requirements would likely impose little

additional cost on most alternative

trading systems. First, only alternative

trading systems with significant volume

would be subject to this requirement.

Second, as long as a significant

alternative trading system establishes

legitimate criteria for participation and

applies those criteria consistently, there

would be few, if any fair access

complaints. Nevertheless, in the event

investors are denied access, there may

be some additional costs to alternative

trading systems associated with

notifying investors of their right to

appeal this action to the Commission,

and potentially from defending appeals.

The Commission, however,

preliminarily believes that the benefits

of fair access outweigh the potential

costs. The Commission believes that

without redress for denials of access,

alternative trading systems could deny

access unfairly.

Under proposed Regulation ATS,

alternative trading systems with

significant volume would be required to

establish and maintain standards for

granting access to their system and keep

records of such standards. The

Commission estimates that each

respondent obligated to establish and

maintain such records would incur a

burden of 5 hours per year to make and

keep standards for granting access for a

total cost of $337.50.330

Based on the Commission’s

experience with denials of access to

markets, the Commission estimates that

alternative trading systems would, on

average, deny or limit access 27 times

annually. The Commission estimates

that respondents would incur a burden

of 1 hour for each required notice to

investors for an estimated annual cost to

each respondent of $546.75.331 The

Commission estimates that

approximately 2 alternative trading

systems would be required to comply

with the fair access requirements due to

their significant volume. The estimated

aggregate burden for these alternative

trading systems to comply with the fair

access requirements under Regulation

ATS would be 64 hours for a total

average aggregate cost of $1,768.50.332

The Commission requests comment on

the costs described above with respect

to the fair access provision of proposed

Regulation ATS.

d. Systems capacity, integrity, and

security. The Commission does not

believe that its proposals to require

alternative trading systems to meet

certain systems related standards would

impose significant costs. The standards

the Commission is proposing are general

standards that are consistent with good

business practices. In addition, smaller

alternative trading systems would not be

subject to the proposed requirements.

For those alternative trading systems

that would not, for business reasons

alone, ensure adequate capacity,

integrity, and security of their systems,

there would be costs associated with

complying with the proposed

requirements. The costs associated with

upgrading systems to an adequate level

may include, for example, investing in

computer hardware and software. In

addition, alternative trading systems

would incur costs associated with the

independent review of their systems on

an annual basis. The review must be

performed by independent reviewers,

but those reviewers may be employees

of the alternative trading system, or

third party reviewers. The review must

be conducted according to established

procedures and standards. The costs

involved may vary widely depending on

the business of the alternative trading

system. Accordingly, the Commission is

requesting comment on the costs that

may be associated with both internal

and external reviews. Alternative

trading systems would also be subject to

recordkeeping requirements to

document the steps taken to comply

with proposed Regulation ATS. These

requirements would be necessary for the

Commission and the appropriate SROs

to ensure compliance with systems

related requirements. In addition,

keeping such records would permit

alternative trading systems to effectively

analyze systems problems that occur.

While alternative trading systems are

not required to file such documentation

with the Commission on a regular basis,

the Commission recognizes that

generating and maintaining such

documentation would impose some

additional costs.

The notification requirement for

material systems outages should impose

relatively little additional costs on

alternative trading systems. Moreover,

the Commission believes that this small

burden is justified by the need to keep

Commission staff abreast of systems’

developments and problems.

The Commission estimates that each

respondent would incur an average

annual burden of 15 hours to comply

with the recordkeeping requirements

associated with the systems capacity,

integrity, and security provisions of

proposed Regulation ATS. The

Commission estimates that each

respondent would make an average of 5

system outage notices per year, for an

estimated average burden of 1.25 hours

per year.333 The Commission estimates

that the total estimated average cost of

compliance for each respondent would

be $85 per year.334 Such alternative

trading systems would also be required

to keep records relating to the steps

taken to comply with systems capacity,

integrity, and security requirements

under Regulation ATS. The Commission

estimates that each respondent would

incur a burden of 10 hours per year to

comply with such recordkeeping

requirements for a total cost of $675 per

year.335 The Commission estimates that

2 alternative trading systems would be

required to comply with the systems
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23543

336The estimated aggregate cost of $1,520 is

derived from 2 alternative trading systems incurring

an estimated annual cost of $760 each ($85 for

providing systems outage notices and $675 for

recordkeeping requirements).

337Rule 6a-1 currently requires that Form 1 be

filed with the Commission upon registration with

the Commission as a national securities exchange

or upon applying for an exemption from

registration. This is the only time a Form 1 is filed.

The estimated average cost per response of $3,719

is composed of $2,000 for professional work (20

hours at $100 per hour), $500 for in-house

professional work (10 hours at $50 per hour), $255

for clerical work (17 hours at $15 per hour) and

$964 for printing, supplies, copying, and postage

(approximately 35% of the total labor costs). The

Commission estimates overhead based on 35% of

total labor costs based on the GSA Guide to

Estimating Reporting Costs (1973).

338As proposed to be amended, Rule 6a-2 would

require that an exchange, whether registered as a

national securities exchange or exempted from

registration, file with the Commission a new Form

1 to reflect amendments to those items contained

in the previously filed Form 1. The Commission

believes that the proposed amendments to Rule 6a2 would reduce the filing obligations for all

respondents. See supra Section III.B.3.b. The

Commission estimates that the average cost per

response, as reduced by the proposed amendments

to Rule 6a–2, would be $1,215. This estimate is

composed of $750 for in-house professional work

(15 hours at $50 per hour), $150 for clerical work

(10 hours at $15 per hour) and $315 for printing,

supplies, copying, and postage (approximately 35%

of the total labor costs). The Commission estimates

overhead based on 35% of total labor costs based

on the GSA Guide to Estimating Reporting Costs

(1973).

339Rule 6a-3 currently requires that an exchange,

whether registered as a national securities exchange

or exempted from registration, file with the

Commission information regarding any material

issued or made generally available to members of,

or participants or subscribers to, the exchange, and

a monthly report detailing the number of shares of

stocks, bonds, rights, and warrants traded on the

exchange’s facilities and the aggregate dollar

amount of such securities. The Commission is

proposing to amend Rule 6a-3, but only to simplify

the language of the rule. The proposed amendments

would not change the material terms of the rule. See

supra Section III.B.3.b. The Commission receives

approximately 25 filings pursuant to Rule 6a-3 per

year from 9 respondents, for a total of 225

responses. The estimated average cost per response

of $9.50 is composed of $7.50 for clerical work (0.5

hours at $15 per hour) and $2 for printing, supplies,

copying, and postage (approximately 35% of the

total labor costs). The Commission estimates

overhead based on 35% of total labor costs based

on the GSA Guide to Estimating Reporting Costs

(1973). The total annual average cost for 225

responses is estimated to be $2,137.50.

340See also Rule 19b–4 under the Exchange Act

and Form 19b–4. The Commission currently

receives approximately 600 rule filings per year

from approximately 25 respondents. The estimated

average cost per response of $1,890 is composed of

$1,250 for in-house professional work (25 hours at

$50 per hour), $150 for clerical work (10 hours at

$15 per hour), and $490 for printing, supplies,

copying, and postage (approximately 35% of the

total labor costs). The Commission estimates

overhead based on 35% of total labor costs based

on the GSA Guide to Estimating Reporting Costs

(1973). Major rule filings can cost substantially

more than $1,890, but account for less than

approximately one percent of the total annual rule

filings. The Commission estimated that these rule

filings can cost up to approximately $10,000 to

$15,000 per filing.

341The estimated average cost per respondent is

$2,500, which is composed of 50 hours of in-house

professional work per year at $50 per hour. There

are currently 8 registered national securities

exchanges and 1 national securities association that

are subject to Rule 17a–1, for an annual estimated

450 burden hours and a cost of $22,500. Other

entities, such as registered clearing agencies and the

Municipal Securities Rulemaking Board are also

subject to the rule, but have not been reflected in

this estimate because the changes proposed in this

release would not affect those entities.

capacity, integrity, and security

provisions of proposed Regulation ATS

due to their significant volume. The

estimated aggregate cost for these

alternative trading systems chose to

comply with the systems capacity,

integrity, and security requirements

would be $1,520.336 The Commission

requests comment on the costs and

benefits associated with systems

capacity, integrity, and security.

e. Costs of exchange registration. The

proposed framework for alternative

trading systems is designed to allow

such systems the option of registering as

national securities exchanges. If an

alternative trading system chooses to

register as an exchange, corresponding

regulatory obligations could impose

costs on such systems; however, these

costs would be assumed voluntarily.

For example, exchange-registered

alternative trading systems would have

to be organized to, and have the

capacity to be able to, carry out the

purposes of the Exchange Act, including

their own compliance and the ability to

enforce member compliance with the

securities laws. Consequently, any

newly registered exchange would have

to establish appropriate surveillance

and disciplinary mechanisms. In

addition, newly registered exchanges

would incur certain start-up costs

associated with this obligation, such as

writing rule manuals. This is the same

standard that currently registered

exchanges meet. Because the costs

associated with these requirements may

vary dramatically, the Commission is

seeking comment on the estimated costs

for compliance with these requirements.

The costs of exchange registration

would also include filing a Form 1

pursuant to Rule 6a-1 under the

Exchange Act 337 and complying with

other filing obligations under Rules 6a2 338 and 6a-3 under the Exchange

Act.339 In addition, national securities

exchanges incur costs in the preparation

of proposed rule changes for submission

to the Commission for approval.340

Section 19(b) of the Exchange Act

requires an SRO to file with the

Commission proposed amendments to

its constitution, articles of

incorporation, by-laws, rules, and other

similar instruments or interpretations of

these instruments. Registered exchanges

are also required to maintain certain

records pursuant to Rule 17a–1 under

the Exchange Act.341

As registered exchanges, alternative

trading systems would also be subject to

more frequent inspection by the

Commission. As broker-dealers,

alternative trading systems would be

inspected on a regular basis by any SRO

of which they are a member, and by the

Commission only on an intermittent

basis. As registered exchanges, these

systems would be inspected more

regularly by Commission staff, but

would—of course—no longer be subject

to examinations by SROs.

The Commission inspects different

SRO programs on independent review

cycles. For example, separate

inspections are conducted for an SRO’s

surveillance, arbitration, listings, and

financial soundness programs. Where

appropriate, SROs would be examined

for other programs they may operate,

such as index programs. Each type of

examination would be performed at

regular intervals, which are typically

two to three years. An SRO, however,

may expect several examinations

throughout a particular year, each in a

different program. Each examination

typically involves three to four attorneys

and/or accountants from the

Commission, who spend one week at

the SRO, or up to two weeks for

particularly large programs, to examine

records and interview SRO personnel.

In order to comply with section 17(b)

under the Exchange Act, an SRO must

expend resources to provide copies of

relevant documents to, and answer

questions from, the Commission staff.

The cost to an SRO of each examination

varies greatly depending on the scope of

the examination and the size or

complexity of the SRO’s particular

program. Therefore, the Commission is

not able to quantify a meaningful

average cost to the SROs for compliance

with the Commission examination

program, and requests comment on the

specific costs that may be involved.

In addition, there would also be costs

associated in meeting the obligations set

forth in section 11A of the Exchange Act

and the rules thereunder. These costs

would include the costs of joining, or

creating new, market-wide plans, such

as the CQS, CTA, ITS, and OTC–UTP,

although some of these costs would be

offset by the right to share in the

revenues generated by these plans. For

example, to join the CTA plan,

applicants would be asked to pay, as a

condition to entry into the plan, an

amount that reflects the value of the

tangible and intangible assets created by
23544 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

342CTA Plan: Second Restatement of Plan

Submitted to the Securities and Exchange

Commission Pursuant to Rule 11Aa3–1 under the

Securities Exchange Act of 1934, May, 1974 and

restated March 1980 and December 1995, at 8–9.

The amount to be paid to the CTA plan will vary

on a case-by-case basis and may reflect a current

independent valuation of the CTA facilities, prior

valuations, an assessment of costs contributed to

the plan by existing members, the estimated usage

of the plan facilities by the applicant, costs for

anticipated system modifications to accommodate

the applicant, and other relevant factors as

determined by the current participants. The terms

of the CQ Plan are substantially similar with respect

to the assessment of a payment upon entry into the

system. CQ Plan: Restatement of Plan Submitted to

the Securities and Exchange Commission Pursuant

to Rule 11Ac1–1 under the Securities Exchange Act

of 1934, July 1978, as restated December 1995, at

8–9.

343Plan for the Purpose of Creating and

Operating an Intermarket Communication Linkage

Pursuant to section 11A(a)(3)(B) of the Securities

Exchange Act of 1934, Composite: Amendments

through May 30, 1997, at 78–79.

344 17 CFR 240.11Ac1–1.

345The Commission estimates that each national

securities exchange or national securities

association will submit information to vendors

approximately 24,266,000 times per year, which

reporting is generally done through automated

facilities that conduct the reporting on a continuous

basis. Due to the continuous nature of the

information feeds, the Commission does not believe

that it is feasible to estimate the average cost per

response or annual burdens hours involved in

complying with Rule 11Ac1-1(b). 17 CFR

240.11Ac1–1(b).

346See supra Section III.B.1.

347 17 CFR 240.6a–1; 17 CFR 240.6a–2; 17 CFR

240.6a–3.

348These estimates are based on the

Commission’s experience with Rule 6a–2 and Form

1–A filings. The Commission expects the current

filing burdens of 30 hours to be lessened under the

proposed rules, thus the estimated burden of hours

required has been adjusted downward. The

Commission notes that the proposed rules will

eliminate Form 1–A and incorporate the updating

obligations into the revised Form 1.

349The estimated average annual benefit for each

respondent of $75 is composed of the savings of 5

hours of clerical work at $15 per hour.

the CTA plan that would be available to

the applicant.342 Similarly, new

participants in ITS would have to pay

a share of the development costs, which

will reflect a share of the initial

development costs, which were

$721,631, and a share of costs incurred

after June 30, 1978.343 These costs

would also include the costs of

complying with Rule 11Ac1–1(b) under

the Exchange Act,344 which requires

national securities exchanges and

national securities associations to make

the best bid, best offer, and aggregate

quotation size for each security traded

on its facilities available to quotation

vendors for public dissemination.345

These costs will vary depending on the

nature and size of the systems involved,

and the Commission requests comment

on the costs involved.

The Commission notes that the

remaining costs would at least partially

be offset because the alternative trading

systems assuming the costs of exchange

registration would no longer be

regulated as broker-dealers.

Consequently, they would no longer be

obligated to comply with the brokerdealer requirements, such as filing and

updating Form BD, maintaining books

and records in accordance with Rules

17a–3 and 17a–4 under the Exchange

Act, and paying fees for membership in

an SRO. In addition, because exchangeregistered alternative trading systems

would share the responsibilities of selfregulation, the regulatory burden carried

by currently registered exchanges

should be reduced. Other benefits

include the freedom from oversight by

a competing SRO, the right to establish

trading and conduct rules, the right to

establish fee schedules, the ability to

directly participate in the NMS

mechanisms, and the right to share in

the profits and benefits produced by the

NMS mechanisms such as the CQS,

CTA, ITS and OTC–UTP plans.346

B. Proposed Amendments to

Application and Related Rules for

Registration as an Exchange

The Commission is proposing

amendments to Rules 6a–1, 6a–2, and

6a–3 under the Exchange Act,347 which

require exchanges that elect to register

to file Form 1 and comply with certain

information updating and monthly

reporting requirements. The proposed

amendments would describe the filing

requirements for national securities

exchanges in a more clear and concise

manner.

1. Benefits

The Commission believes that the

proposed amendments would provide

benefits to organizations that are

currently registered, or in the future

apply for registration, as a national

securities exchange. First, the proposed

amendments to Rules 6a–1, 6a–2, and

6a–3 would ease compliance burdens by

simplifying the rule. By simplifying the

rule language itself, the Commission

anticipates that parties attempting to

comply with Rules 6a–1, 6a–2 and 6a–

3 would be better able to understand the

rules’ requirements and comply with

them. Much of the information required

on Form 1 would not change, but the

revised form would recast the questions

and exhibits in a different format that

would ease compliance and make the

responses more relevant to investors

and the Commission. While national

securities exchanges have traditionally

been membership-owned, Form 1 would

also be revised to accommodate

proprietary national securities

exchanges.

Second, the proposed amendments

would give national securities

exchanges the option of complying with

certain ongoing filing requirements by

posting information on an Internet web

site and supplying the location to the

Commission, instead of filing a

complete paper copy with the

Commission. The Commission

anticipates that exchanges would

choose to use the Internet to comply

with Rules 6a–2 and 6a–3 rather than

filing many exhibits on paper. The

availability of such information on the

Internet would also provide the public

with easier and less expensive access to

the information than requesting paper

copies from the Commission or the

national securities exchanges as

currently required. In addition,

permitting exchanges to use the Internet

as a means of compliance would reduce

expenses associated with clerical time,

postage, and copying.

The proposed amended rules would

also reduce the frequency of certain

ongoing filings to update the

information in Form 1, directly reducing

the compliance burden on national

securities exchanges while still meeting

investors’ and the Commission’s need

for reasonably current information.

Specifically, the proposed amendments

would eliminate exchanges’

requirement to submit changes to their

constitution, their rules, or the

securities listed on the exchange within

10 days. The proposed amendments

would also permit exchanges to file

certain information regarding

subsidiaries and affiliates every three

years rather than annually. These

proposed amendments would conserve

registered exchanges’ staff time to

comply with the rules.

The Commission estimates that the

proposals would specifically reduce the

annual burdens that each respondent

would incur to comply with Rule 6a–2

by approximately 5 hours. Thus, the

Commission anticipates that

respondents would spend an average of

25 hours on an annual basis to comply

with amended Rule 6a–2.348 The

estimated average benefit to each

individual respondent is $75 per

year.349 These estimates represent a

decrease of the estimated burden that

currently exists, so exchanges would

benefit from reduced filing burdens.

2. Costs

The proposed rules are intended to

simplify the filing requirements and

reduce the compliance burdens for

national securities exchanges and would

likely impose few additional costs on
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23545

350The estimated average additional cost per

response of $30 is derived from 2 additional hours

of clerical work at $15 per hour.

351The estimated average cost per response of

$9.50 is composed of $7.50 for clerical work (0.5

hours at $15 per hour) and $2 for printing, supplies,

copying, and postage (approximately 35% of the

total labor costs). The Commission estimates

overhead based on 35% of total labor costs based

on the GSA Guide to Estimating Reporting Costs

(1973). The estimated average annual cost of

$237.50 is derived from 25 annual filings at a cost

of $9.50 per filing.

352 17 CFR 240.17a–3; 17 CFR 240.17a–4.

353The estimated average benefit for alternative

trading systems of $19,350 is composed of 43

alternative trading systems saving 30 hours of

clerical work at $15 per hour. The estimated

average benefit for alternative trading systems of

1,290 hours is composed of 43 alternative trading

systems saving 30 hours each. The cost per hour

and per filing is derived from the Commission’s

review of the Form 17A–23 supplied by the brokerdealers currently subject to Rule 17a–23.

The Commission notes, however, that alternative

trading systems would be subject to recordkeeping

requirements under Proposed Regulation ATS. See

supra Section IX.A.2.a.

354The estimated aggregate burden of 2,252 is

composed of 528 hours for initial reports (22 initial

reports at 24 hours each), 1,716 hours for quarterly

reports (143 quarterly reports at 12 hours per year—

4 quarters at 3 hours each) and 8 hours for cessation

reports (4 cessation reports at 2 hours each). The

estimated total cost of $33,780 is composed of 2,252

hours of clerical work at $15 per hour. The

Commission notes, however, that alternative trading

systems would be subject to reporting requirements

under proposed Regulation ATS. See supra Section

IX.A.2.a.

355The costs and benefits associated with these

recordkeeping requirements are discussed in

Section IX.A.2.a. supra.

national securities exchanges. Initially,

there may be some additional personnel

costs required to review the proposed

rules and revised Form 1, but the

Commission believes that the proposed

simplified requirements would reduce

overall compliance burdens and costs

over time. Reducing the frequency of

filings for some requirements may result

in some information being less current.

The Commission, however, believes that

much of this type of information does

not change frequently. Moreover, the

option of posting such information on

an Internet web site should encourage

more frequent updating of current

information.

The Commission notes that it is

soliciting comment on the feasibility of

permitting the filings required under the

proposed amendments to be filed

electronically, which would further

reduce the compliance burdens and

costs.

The Commission estimates that each

respondent would incur an average

burden of 47 hours to comply with Rule

6a–1 and file an initial application for

registration on Form 1. This represents

a 2 hour increase from the current

average burden due to the estimated

additional burden of the added exhibits.

The Commission estimates that the

average additional cost per response

would be approximately $30.350

Because the Commission receives

applications for registration as

exchanges on Form 1 from time to time,

it cannot estimate the annual aggregate

costs and burden hours associated with

such filings. The Commission therefore

requests comment on such costs and

burden hours.

The Commission anticipates that the

proposals would not change the burdens

associated with complying with Rule

6a–3. The Commission estimates that

the average burden for each respondent

to comply with Rule 6a–3 is one-half

hour per response because compliance

only requires photocopying existing

documents. The Commission also

estimates that each respondent would

file supplemental information under

Rule 6a–3 approximately 25 times per

year. The estimated average cost per

response for each individual respondent

is $9.50, resulting in an estimated

annual average burden for each

respondent of $237.50.351

C. Costs and Benefits of the Proposed

Repeal of Rule 17a–23 and the Proposed

Amendments to Rules 17a–3 and 17a–

4

Rule 17a–23 currently imposes certain

recordkeeping and reporting

requirements on broker-dealer trading

systems. In conjunction with its other

proposals, the Commission is proposing

to repeal Rule 17a–23 and amend Rules

17a–3 and 17a–4 under the Exchange

Act 352 to eliminate all reporting

requirements under Rule 17a–23 and to

transfer certain recordkeeping

requirements from Rule 17a–23 to Rules

17a–3(a)(16) and 17a–4(b)(10).

The new recordkeeping requirements

under Rules 17a–3(a)(16) and 17a–

4(b)(10) would apply solely to a limited

group of broker-dealer systems, defined

in the proposed amendment to Rule

17a–3 as ‘‘internal broker-dealer

systems.’’ These are systems that would

not be encompassed under proposed

Rule 3b–12 under the Exchange Act.

Systems that would be alternative

trading systems under the Commission’s

proposals in this release would not be

subject to the recordkeeping

requirements under amended Rules

17a–3 and 17a–4. Moreover, the

reporting obligations currently under

Rule 17a–23 would be eliminated

entirely.

1. Benefits

Approximately 43 of the broker-dealer

trading systems currently filing reports

under Rule 17a–23 would be alternative

trading systems under the proposals in

this release. These trading systems

would not fall within the proposed

definition of ‘‘internal broker-dealer

system,’’ and would, therefore, not be

required to maintain records under the

new provisions of Rules 17a–3(a)(16)

and 17a–4(b)(10). Accordingly, the

Commission estimates that the annual

aggregate costs and annual aggregate

burden for the recordkeeping

obligations under Rule 17a–23 would be

reduced by $19,350 and 1,290 hours,

respectively.353 In addition, all

reporting requirements under Rule 17a–

23 would be eliminated. The

Commission estimates that the annual

aggregate costs and annual aggregate

burden for the reporting obligations

under Rule 17a–23 of $15,764 and 2,252

hours, respectively, would, therefore, be

eliminated.354 The Commission notes,

however, that alternative trading

systems would be subject to

recordkeeping requirements under

proposed Regulation ATS.355

2. Costs

No additional recordkeeping burdens

would be imposed on internal brokerdealer systems under the proposed

amendments to Rules 17a–3 and 17a–4.

The proposed amendments would apply

only to systems that are presently

subject to the recordkeeping

requirements of Rule 17a–23. Because

the Commission is proposing to repeal

Rule 17a–23 and amend Rules 17a–3

and 17a–4 by transferring the

recordkeeping requirements from Rule

17a–23, the Commission does not

anticipate any new recordkeeping costs

or burdens for respondents.

Based on Commission experience

with the burdens associated with Rule

17a–23, the Commission has estimated

the burdens that would be associated

with proposed Rule 17a–3(a)(16) and

17a–4(b)(10). The Commission estimates

that there would be approximately 94

broker-dealers operating 123 internal

broker-dealer systems that would have

to keep the records described in

proposed Rules 17a–3(a)(16) and 17a–

4(b)(10). The Commission estimates that

each respondent would spend

approximately 27 hours keeping the

required records under Rule 17a–

3(a)(16). The Commission also estimates

that each respondent would spend

approximately 3 hours to preserve the

required records under Rule 17a–

4(b)(10). Thus, the Commission

estimates that each respondent would

incur a burden of 30 hours per year

complying with Rules 17a–3(a)(16) and
23546 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

356The Commission estimates that an employee

of a broker-dealer charged to ensure compliance

with Commission regulations receives annual

compensation of $100,000. This compensation is

the equivalent of $48.08 per hour ($100,000 divided

by 2,080 payroll hours per year). The estimated

annual cost of $1,442.40 is derived from 30 burden

hours per respondent at $48.08 per hour.

357See also supra note 340.

358The Commission estimates that the current

preparation and filing of proposed rule changes

pursuant to section 19(b)(2) of the Exchange Act to

operate a pilot trading system constitute major

market impact filings requiring approximately 100

hours and $10,000 to $15,000 of SRO time and

money, respectively, for each proposal. This does

not include the cost of the SRO of any delay in

obtaining Commission approval or in disclosing

business information; nor does this include the

benefit to an SRO of bringing its new pilot trading

system to market in a shorter amount of time. The

cost per hour and per filing is derived from

information supplied by the SROs. For the purposes

of our estimates, we have valued related overhead

at 35% of the value of legal work. See GAS Guide

to Estimating Reporting Costs (1973).

359The Commission estimates that under current

procedures, a proposed rule filing for a new pilot

trading system takes 90 days, on average, from the

date of the original submission to be approved. In

contrast, the proposed expedited treatment of SRO

rule changes for pilot trading systems permits SROs

to operate a pilot trading system 20 days after

submitting an initial operation report on proposed

Form PILOT, so long as such product complies with

proposed Rule 19b–5 under the Exchange Act.

360This estimate is based on a review of past SRO

filings under Section 19(b) of the Exchange Act. The

Commission estimates that approximately 6 rule

filings per year in the past could have been filed

under the proposed Rule 19b–5.

361The estimates for burden hours involved with

filing Form PILOT are based on the Commission’s

experience with similar reporting requirements

under Rule 17a–23.

362This estimate is based on the Commission’s

experience with collection of similar information

under Rule 17a–23.

363The estimated average cost of $1,242 to file an

initial Form PILOT is composed of $800 for inhouse professional work (16 hours at $50 per hour),

$120 for clerical work (8 hours at $15 per hour) and

$322 for printing, supplies, copying, and postage

(approximately 35% of the total labor costs). The

Commission estimates overhead based on 35% of

total labor costs based on the GSA Guide to

Estimating Reporting Costs (1973).

The estimated average cost of $155 to file

quarterly reports and system change notices on

Form PILOT is composed of $100 for in-house

professional work (2 hours at $50 per hour), $15 for

clerical work (1 hour at $15 per hour) and $40 for

printing, supplies, copying and postage

(approximately 35% of the total labor costs). The

Commission estimates overhead based on 35% of

total labor costs based on the GSA Guide to

Estimating Reporting Costs (1973).

364The estimated average burden of 144 hours is

derived from 6 SRO respondents incurring an

average burden of 24 hours per filing. The estimated

average cost of $7,452 is derived from 6 SRO

respondents making 6 initial Form PILOT filings at

$1,242 per filing.

365The estimated average burden of 108 hours is

derived from 6 SRO respondents filing 4 quarterly

reports and 2 systems change notices at 3 burden

hours per filing. The estimated average cost of

$5,580 is derived from 6 SRO respondents filing 4

quarterly reports and 2 systems change notices at

$155 per filing.

17a–4(b)(10) and an annual cost of

$1,442.40.356

D. SRO Pilot Trading System

Under proposed Rule 19b–5, SRO rule

changes to operate pilot trading systems

would be temporarily exempt from the

rule filing requirement of section 19(b)

of the Exchange Act.357

1. Benefits

By permitting SROs to begin operating

eligible pilot trading systems

immediately and to continue operating

for two years under a flexible regulatory

scheme, the Commission preliminarily

believes that proposed Rule 19b–5

would benefit SROs and investors. As

proposed, Rule 19b–5 would enhance

competition in the trading markets

without imposing significant SRO

compliance burdens.358 Proposed Rule

19b–5 would permit the timely

implementation of pilot trading systems

without the widespread dissemination

of critical business information.

Therefore, the proposal should reduce

SRO costs associated with the

Commission approval process and

improve the competitive balance

between SROs and alternative trading

systems that are regulated as brokerdealers.359 Moreover, the Commission

believes that proposed Rule 19b–5

would foster innovation and create a

streamlined procedure for SROs to

operate pilot trading systems and would

reduce filing costs for SROs pilot

trading systems.

2. Costs

The Commission anticipates receiving

approximately 6 notices per year

regarding pilot trading systems on

proposed Form PILOT.360 An SRO

would be required to submit a Form

PILOT providing detailed operational

data and update this information

quarterly. The Commission estimates

that an SRO would expend 24 hours to

file an initial operation report and 3

hours to file a quarterly report and a

systems change notice.361 The

Commission also estimates that an SRO

would file 2 amendments per year to

report changes to the system.362 The

Commission estimates that an SRO

would expend $1,242 per initial Form

PILOT filing and $155 for each quarterly

Form PILOT and system change notice

filed.363 Thus, the total estimated

annual burden for SROs to comply with

proposed Rule 19b–5 by filing an initial

notice on Form PILOT is estimated to be

144 hours for a total average cost of

$7,452.364 The total estimated annual

burden for SROs to file systems change

notices and quarterly reports on Form

PILOT is estimated to be 108 hours for

a total average cost of $5,580.365

E. Request for Comment

The Commission requests data to

quantify the costs and the value of the

benefits described above. The

Commission seeks estimates of these

costs and benefits, as well as any costs

and benefits not already defined, that

may result from the adoption of these

proposed amendments and rules.

The Commission requests comment

on the estimate of the number of

alternative trading systems that would

be permitted to register as brokerdealers and comply with Regulation

ATS, the number of new alternative

trading systems that would choose to

register as broker-dealers and comply

with Regulation ATS each year in the

future, and the number of alternative

trading systems registered as brokerdealers that file cessation of operations

reports each year.

In addition, the Commission requests

comment on the costs and benefits

associated with the Commission’s

proposals with respect to notice,

reporting, and recordkeeping for

alternative trading systems choosing to

register as broker-dealers. The

Commission specifically requests

comment on the costs and benefits for

all market participants associated with

the filing requirements on Form ATS

and ATS–R and the feasibility of

permitting such forms to be filed

electronically.

The Commission also requests

comment on the costs and benefits

associated with the Commission’s

proposals to improve surveillance on

alternative trading systems. The

Commission specifically requests

comment on the benefits for all market

participants associated with preventing

fraud and manipulation on alternative

trading systems.

The Commission requests comment

on the costs associated with the

Commission’s proposals to improve

market transparency and equal

execution access, and the benefits

associated with improving transparency,

reducing market fragmentation, and

meeting NMS goals.

The Commission requests comment

on the costs associated with the

Commission’s proposals to ensure fair

access to alternative trading systems

registered as broker-dealers, as well as

the benefits associated with preventing

discriminatory denials of access and

providing the avenue of appeal to the

Commission for investors denied access

to such systems.

The Commission requests comment

on the costs and benefits associated
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23547

366 15 U.S.C. 78w(a)(2).

367 15 U.S.C. 78c(f).

368 5 U.S.C. 603.

369Small entities are considered broker-dealers

with total capital (net worth plus subordinated

liabilities) of less than $500,000 on the date in the

prior fiscal year as of which its audited financial

statements were prepared pursuant to Rule 17a–5(d)

under the Exchange Act, 17 CFR 240.17a–5(d) or,

if not required to file such statements, a broker or

dealer that had total capital (net worth plus

subordinated liabilities) of less than $500,000 on

the last day of the preceding fiscal year (or in the

time that it has been in business, if shorter); and

is not affiliated with any person (other than a

natural person) that is not a small business or small

organization. 17 CFR 240.0–10(c).

with the Commission’s proposals to

improve systems capacity, integrity, and

security. The Commission specifically

requests comment on the costs

associated with maintaining adequate

systems related procedures, safeguards,

and documentation.

The Commission requests comment

on the costs and benefits associated

with exchange registration. The

Commission specifically requests

comment on the costs and benefits

associated with providing alternative

trading systems with the option to

register as national securities exchanges

under sections 5 and 6 of the Exchange

Act.

The Commission requests comment

on the costs and benefits associated

with the Commission’s proposed

amendments to Rules 17a–3, 17a–4, and

repeal of Rule 17a–23. The Commission

specifically requests comment on the

costs to internal broker-dealer systems

of continuing to maintain records under

Rules 17a–3(a)(16) and 17a–4(b)(10),

and the benefits of eliminating the

reporting requirements.

The Commission requests comment

on the costs and benefits associated

with the Commission’s proposal to

temporarily exempt SRO pilot trading

systems from section 19(b) rule filing

requirements. The Commission

specifically requests comment on the

costs and benefits for all market

participants associated with such a

temporary exemption from rule filing

and the associated filing requirements

on Form PILOT.

The Commission generally requests

comment on the competitive benefits or

anticompetitive effects that may impact

any market participants if the proposals

are adopted as proposed. The

Commission also requests comment on

what impact the proposals, if adopted,

would have on efficiency and capital

formation. Commenters should provide

analysis and empirical data to support

their views on the costs and benefits

associated with the proposal.

X. Effects on Efficiency, Competition,

and Capital Formation

Section 23(a) of the Exchange Act 366

requires that the Commission, when

promulgating rules under the Exchange

Act, to consider the anti-competitive

effects of such rules, if any, and to

balance any impact against the

regulatory benefits gained in furtherance

of the purposes of the Act. Section 3(f)

of the Exchange Act requires the

Commission, when engaged in

rulemaking, to consider or determine

whether an action is necessary or

appropriate in the public interest, and

whether the action would promote

efficiency, competition, and capital

formation.367 The Commission has

considered the proposed rules and

amendments in light of these standards

and preliminarily believes that they

would not impose any significant

burden on competition not necessary or

appropriate in furtherance of the

purposes of the Exchange Act.

The rules and amendments are

intended to provide a choice between

registering as a broker-dealer and

registering as an exchange for markets

operated as alternative trading systems.

By using volume thresholds to trigger

fair access, market transparency, and

coordination, and systems capacity,

integrity, and security requirements, the

Commission’s proposals would not

unduly burden small, start-up

alternative trading systems, and would

therefore foster competition. The

proposals would also improve

surveillance and recordkeeping for all

alternative trading systems, which

would improve investor confidence in

such systems and help maintain fair and

orderly markets. Moreover, the

proposals offer SROs the opportunity to

develop and operate pilot trading

systems with less cost and time delay.

This would help to foster innovation

and create benefits for investors.

Nonetheless, the Commission solicits

comments on the impact of the

proposed rules and amendments on

competition. Specifically, the

Commission requests commenters to

address how the proposed rules and

amendments would affect competition

between and among alternative trading

systems, broker-dealers, exchanges,

investors, and other market participants.

Finally, commenters should consider

the proposed amendments’ and rules’

effect on efficiency and capital

formation.

XI. Initial Regulatory Flexibility

Analysis

The Commission has prepared an

Initial Regulatory Flexibility Analysis

(‘‘IRFA’’) in accordance with the

Regulatory Flexibility Act (‘‘RFA’’) 368

regarding proposed new Rules 3a1–1,

3b–12, 19b–5, Regulation ATS, new

Forms ATS, ATS–R and PILOT, and

amended Rules 6a–1, 6a–2, 6a–3, 17a–

3, 17a–4, the Commission’s Rules of

Practice, amendments to Form 1 and the

repeal of Rule 17a–23. The following

summarizes the IRFA.

As set forth in greater detail in the

IRFA, the proposed rules create the

option for an alternative trading system

to register as a national securities

exchange or as a broker-dealer and

comply with additional requirements

depending on their activities and

trading volume. The IRFA also states

that proposed amendments will exclude

pilot trading systems operated by

national securities exchanges or

national securities associations from

rule filing requirements.

The IRFA sets forth the statutory

authority for the proposed rules. The

IRFA also discusses the effect of the

proposed rules on small entities.369 The

IRFA states that the proposed rules

would not affect small entities, as the

Commission expects that alternative

trading systems will generally be brokerdealers with total capital of at least

$500,000. The Commission estimates

that there are approximately forty-three

total alternative trading systems

presently in existence, with 5 of those

estimated to be small entities.

The IRFA recognizes that, in order to

provide a reasonable option to

registration as a national securities

exchange, any Commission proposals

must strike a balance between fostering

innovation and providing real investor

protections. In order to assure that

alternative trading systems are

adequately organized and fairly

operated, the Commission believes it is

necessary and reasonable to require any

alternative trading system to supply

basic, descriptive information before it

starts operating and periodically to

supply aggregate transaction data to the

Commission. The Commission expects

relatively few small entities to start such

enterprises, but believes that the

regulatory burdens established in the

proposed rules are reasonable.

In addition, by utilizing volume

thresholds to trigger additional

requirements the Commission

anticipates that starting and developing

alternative trading systems would not be

unduly burdened by the proposed filing

requirements. Once an alternative

trading system achieves significant

market influence, it is reasonable to

expect those systems to comply with

fair access, order display, and systems
23548 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

capacity, integrity, and security

requirements in order to protect

investors and assure a fair secondary

market.

The proposed rules would require all

alternative trading systems to file an

initial notice on Form ATS. Alternative

trading systems would have periodic

reporting requirements to amend Form

ATS as the information changes over

time. The IRFA further notes that

alternative trading systems would be

required to make quarterly transaction

reports on Form ATS–R. The IRFA

states that alternative trading systems

would also be required to maintain

records relating to trading activities and,

if meeting certain volume thresholds,

records relating to systems capacity,

integrity and security, fair access and

order display. The Commission believes

that these filing requirements are offset

by the benefits to investors, the market

as a whole and the Commission’s ability

to keep up with market developments

and changes.

The initial notice requirement on

Form ATS is a one-time filing and the

transaction reports required on Form

ATS–R are only required four times per

year. The proposed rules will require

alternative trading systems to file some

information not currently required

under Rule 17a–23. This information

will include quarterly reports describing

the securities traded through the system

and subscribers to the system.

Additionally, the proposed rules will

require alternative trading systems to

file more detailed information

concerning the characteristics of the

system than is currently required. The

Commission believes that the additional

burdens created by these requirements

will be offset by eliminating the filing

requirements under Rule 17a–23. Small

entities are unlikely to meet the volume

thresholds that would require additional

recordkeeping and filing requirements

for fair access and systems capacity,

integrity and security.

The proposed rules would exempt

pilot trading systems operated by

national securities exchanges and

national securities associations from

rule filing requirements. The IRFA

further states that the proposed rule

changes will reduce the filing burdens

associated with filing an initial Form 1

and the required subsequent

amendments. The Commission believes

that these changes reduce the filing

burdens on national securities

exchanges and exchanges exempt from

registration under section 5 based on the

limited volume of transactions effected

on such exchanges. All national

securities exchanges are too large to be

considered small entities. For exchanges

exempt from registration under section

5 pursuant to the limited volume of

transactions effected on such exchanges,

the proposed rules will help to reduce

the filing burdens by clarifying current

filing requirements and supplying

additional means of compliance.

As explained further in the IRFA, the

Commission has considered other

alternatives to the proposed rules. The

Commission believes that it would be

inconsistent with the purposes of the

Act to exempt small entities from the

proposed rules.

The IRFA includes information

concerning the solicitation of comments

with respect to the IRFA generally, and

in particular, the number of small

entities that would be affected by the

proposed rules. Cost-benefit information

reflected in the ‘‘Costs and Benefits of

the Proposed Rules and Amendments’’

and ‘‘Effects on Efficiency, Competition

and Capital Formation’’ sections of this

Release is also reflected in the IRFA. A

copy of the IRFA may be obtained by

contacting Kevin Ehrlich, Division of

Market Regulation, Securities Exchange

Commission, 450 Fifth Street, NW.,

Washington, DC. 20549.

XII. Paperwork Reduction Act

Certain provisions of the proposed

rules and rule amendments contain

‘‘collection of information’’

requirements within the meaning of the

Paperwork Reduction Act of 1995 (44

U.S.C. 3501 et seq.), and the

Commission has submitted them to the

Office of Management and Budget

(‘‘OMB’’) for review in accordance with

44 U.S.C. 3507(d) and 5 CFR 1320.11.

The title for the collections of

information are: ‘‘Form 1, Rules 6a–1

and 6a–2’’ ‘‘Rule 6a–3,’’ ‘‘Rule 17a–

3(a)(16),’’ ‘‘Rule 17a–4(b)(10),’’ ‘‘Rule

19b–5 and Form PILOT,’’ ‘‘Rule 301,

Form ATS and Form ATS–R,’’ ‘‘Rule

302,’’ ‘‘Rule 303,’’ all under the

Exchange Act. ‘‘Form 1, Rules 6a–1 and

6a–2’’ and ‘‘Rule 6a–3,’’ which the

Commission is proposing to amend,

contain currently approved collections

of information under OMB control

numbers 3235–0017 and 3235–0021.

The proposed rules and rule

amendments are necessary to respond to

the impact of technological

developments in the securities markets

and permit the Commission to more

effectively oversee the growing number

of alternative trading systems. An

agency may not sponsor, conduct, or

require response to an information

collection unless a currently valid OMB

control number is displayed.

A. Form 1, Rules 6a–1 and 6a–2

Rule 6a–1 and Form 1 currently

require any organization seeking to

operate as a national securities

exchange, or as an exchange exempt

from registration based on limited

volume to file a Form 1. Form 1 requires

the organization to describe its

operation. The amendments to Rule 6a–

1 would simplify and clarify the

requirements to make them easier to

understand. The revised Form 1

introduces a fill-in-the-blank format,

reconfigures the exhibits for clarity, and

updates the requests for information to

accommodate new organizational

models of exchanges. The collection of

information would be necessary to

permit the Commission to determine

that an exchange applying for

registration complies with the

provisions of the Exchange Act

governing exchange registration and

statutory requirements for registration.

The Commission requires such

information to protect investors and the

public interest. There are no other

means of obtaining this information and

it is not available in consolidated form

in any other location. The respondents

to this information collection are those

entities wishing to become registered as

an exchange. Applications for

registration on Form 1 are made on a

one-time basis. The Commission

receives Form 1 filings from time to

time. For purposes of the Paperwork

Reduction Act, the staff assumes that a

maximum of one filing per year would

be made, imposing a burden of 47 hours

per response and a cost of $2,000.

The Commission also proposes to

amend Rule 6a–2 which contains

requirements for exchanges to file

amendments updating the information

initially filed on Form 1. Proposed Rule

6a–2 revises the filing requirements to

ease the frequency of filing certain

exhibits and offer the choice of making

certain information publicly available

on the Internet in lieu of making paper

filings. The collection of information

would be necessary to permit the

Commission to determine whether the

exchanges are complying with the

Exchange Act and keeping such

information consolidated and current.

The information is also made available

to members of the public who may wish

to comment on the information

provided. The likely respondents to this

information collection are those entities

registered as an exchange or exempt

from registration under section 5 based

on the limited volume of transactions

effected on those exchanges. Currently,

eight exchanges and one exempt

exchange make such filings. The
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23549

Commission estimates that revised Rule

6a–2 would decrease the filing burden

for each respondent by 5 hours for an

average burden for each respondent of

25 hours per filing. The Commission

estimates that each exchange would

respond 1 time per year and incur an

average burden of 25 hours. The

Commission estimates that the aggregate

burden for all exchanges to comply with

Rule 6a–2 would be 225 hours. The

Commission bases its projections on its

prior experience with exchange filings

pursuant to Rules 6a–1 and 6a–2. The

total estimated burden for Form 1 would

be 272 hours (47 hours for one initial

filing and 225 hours for nine

amendments).

For exchanges that choose to register

and operate as a national securities

exchange, the provisions of Rules 6a–1

and 6a–2 as well as the requirements of

Form 1 are mandatory. All filings made

with the Commission pursuant to Rules

6a–1 and 6a–2 on Form 1 are not

confidential and are available to the

public. National securities exchanges

would still be obligated by Rule 17a–1

to preserve records for 5 years, the first

2 years in an easily accessible place.

The Commission notes that it is

imposing no additional recordkeeping

requirements under proposed Rules 6a–

1 or 6a–2, but is only reiterating

currently existing obligations.

B. Rule 6a–3

Rule 6a–3 currently requires that

registered exchanges file with the

Commission copies of information made

available to the members, subscribers, or

participants. The collection of

information is necessary to permit the

Commission to determine whether

exchanges are complying with the

Exchange Act and to enable the

Commission to carry out its statutory

obligations and protect investors. The

proposed rule changes would help

simplify the rule language and provide

registered exchanges with the option of

making the information available on the

Internet in lieu of paper filings. Further,

the proposed rule also recognizes that

modern exchanges may have

participants or subscribers rather than

members. The respondents are

exchanges or exchanges exempt from

registration based on limited volume.

Currently, eight exchanges and one

exchange exempt from registration

based on limited volume are required to

comply with the rule. The Commission

expects no additional filing burdens as

a result of this proposed rule change.

The estimated burden for each exchange

is 0.5 hours for each submission

pursuant to Rule 6a–3. The Commission

anticipates that each respondent would

file 25 amendments per year for a total

burden of 12.5 hours per year for each

respondent. The Commission

anticipates that the total estimated

aggregate annual burden for 9

respondents would be 112.5 hours. The

Commission does not anticipate that the

burdens associated with Rule 6a–3

would change in a material manner.

For exchanges that choose to register

and operate as a national securities

exchange, the provisions of Rule 6a–3

are mandatory. All filings made with the

Commission pursuant to Rule 6a–3 are

not confidential and are available to the

public. National securities exchanges

would still be obligated by Rule 17a–1

to preserve records for 5 years, the first

2 in an easily accessible place.

C. Rule 17a–3(a)(16)

The proposed amendments to Rule

17a–3 would require a broker-dealer

that operates an internal broker-dealer

system to make certain records

regarding the daily trading activity of

that system. The collection of

information would be necessary to

permit the Commission and SROs to

determine whether broker-dealers are

complying with the Commission’s

financial responsibility programs,

antifraud and antimanipulation rules, as

well as other Commission and SRO

rules. The Commission cannot obtain

such information by any other means

because broker-dealers are the only

entities that produce, and have access

to, such information. Broker-dealers

currently comply with substantially

similar recordkeeping requirements

under current Rule 17a–23, so there

would be no net additional burden on

broker-dealer respondents. The

Commission estimates that there would

be 94 respondents affected. Based on the

Commission’s prior experience with the

burdens associated with Rule 17a–23,

for the purposes of the proposed

amendments to Rule 17a–3, the

Commission estimates that each

respondent would incur a burden of 27

hours to comply with the recordkeeping

requirements. Thus, the total aggregate

burden for broker-dealers operating

internal broker-dealer systems to

comply with the proposed

recordkeeping requirements under

amended Rule 17a–3 would be 2,538

hours.

For alternative trading systems that

choose to register as a broker-dealer, the

proposed amendments to Rule 17a–3 are

mandatory. The records required to be

made are considered confidential and

are not available to the public. All

records required under the proposed

amendment to Rule 17a–3 would be

preserved for not less than 3 years, the

first 2 in an easily accessible place.

D. Rule 17a–4(b)(10)

The proposed amendments to Rule

17a–4 would require a broker-dealer

that operates an internal broker-dealer

system to keep records it makes

pursuant to under Rule 17a–3(a)(16).

The proposed amendments would also

require broker-dealers to keep

information that is supplied to

subscribers, such as system notices. The

Commission estimates that there are 94

broker-dealers that would be affected.

Based on the Commission’s prior

experience with the burdens associated

with Rule 17a–23, for purposes of the

proposed amendments to Rule 17a–4,

the Commission estimates that each

respondent would incur an annual

burden of 3 hours to comply with the

record preservation requirements. Thus,

the total aggregate burden for brokerdealers operating internal broker-dealer

systems to comply with the record

preservation requirements under

amended Rule 17a–4(b)(10) would be

282 hours.

For alternative trading systems that

choose to register as a broker-dealer, the

proposed amendments to Rule 17a–4 are

mandatory. The records required to be

preserved are considered confidential

and are not available to the public. All

records required under the proposed

amendments to Rule 17a–4 would be

preserved for not less than 3 years, the

first 2 years in an easily accessible

place.

E. Rule 19b–5 and Form PILOT

Proposed Rule 19b–5 contains a

requirement that SROs file a Form

PILOT to notify the Commission of their

intent to operate a pilot trading system.

Proposed Rule 19b–5 also requires that

SROs keep records containing the rules

and procedures relating to each pilot

trading system. SROs would be

temporarily exempt from the rule filing

requirements under section 19(b) of the

Exchange Act for any rule changes

associated with the pilot trading system.

Because such systems can have an

impact on the market, this collection of

information would be necessary to

inform the Commission of the existence

and manner of operation of such pilot

trading systems. The Commission has

proposed that the SROs also must meet

certain criteria in order to operate a

pilot trading system. Notice to the

Commission on Form PILOT is

necessary to determine whether the

SROs are meeting those criteria.

Additionally, the recordkeeping

requirement is necessary because the

Commission would need to review this
23550 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

information during an examination to

determine compliance by the SRO with

the federal securities laws. By

permitting SROs to merely keep such

information on hand instead of

affirmatively filing it, the Commission

believes it balances the need for access

to the information with minimizing

burdens on SROs. The respondents to

this information collection would be

SROs who wish to develop and

introduce pilot trading systems.

Respondents would be required to file

one initial Form PILOT before

commencing operation of each pilot

trading system. Respondents would also

be required to file quarterly reports and

systems change notices on Form PILOT.

Based on the Commission’s experience

with section 19(b) rule filings, the

Commission estimates that there would

be 6 such respondents per year. Under

Rule 19b–5, each respondent would file

one initial Form PILOT filing before

commencing operation of the pilot

trading system and 4 quarterly reports

on Form PILOT. In addition, the

Commission anticipates that each

respondent would file 2 systems change

notices each year on Form PILOT. Based

on the Commission’s experience with

similar section 19(b) rule filings, the

Commission estimates that each

respondent would incur a burden of 24

hours to file an initial operation report

and an annual burden of 12 hours to file

quarterly reports on Form PILOT. The

Commission also estimates that each

respondent would incur an annual

burden of 6 hours to file 2 systems

change notices on Form PILOT. Thus,

the aggregate burden for respondents to

file initial reports on Form PILOT

would be 144 hours and the annual

aggregate burden for respondents to file

quarterly reports and systems change

notices on Form PILOT would be 108

hours. Thus, the Commission estimates

that the total aggregate burden for

respondents under proposed Rule 19b–

5 would be 252 hours.

For SROs that choose to operate pilot

trading systems and avail themselves to

the provisions of Rule 19b–5,

compliance with Rule 19b–5 and the

filings required on Form PILOT are

mandatory. Proposed Rule 19b–5

reiterates SROs’ existing recordkeeping

obligations under Rule 17a–1, which

requires that such records be kept for

not less than 5 years, the first 2 years in

an easily accessible place.

F. Rule 301, Form ATS and Form

ATS–R

Proposed Rule 301 requires

alternative trading systems that do not

register as national securities exchanges

to meet certain requirements.

Specifically, alternative trading systems

would be required to file an initial

notice prior to operating, supply notices

of material changes to the system

operation prior to implementing those

changes, file quarterly amendments

notifying the Commission of changes to

the system that have not been reflected

in an earlier amendment and when it

ceases operations as an alternative

trading system. Alternative trading

systems would also be required to file

quarterly transaction reports on Form

ATS–R detailing the type and volume of

securities traded through the alternative

trading system. An alternative trading

system that meets certain volume

thresholds would be required to notify

investors denied or permitted only

limited access to the system that they

have a right to appeal the alternative

trading systems’ action to the

Commission. In addition, the proposed

rule would require alternative trading

systems that meet certain volume

thresholds to notify the Commission of

systems outages and keep any records

made in the process of complying with

the systems capacity, integrity and

security requirements under Rule 301.

The Commission estimates that there

would be 43 alternative trading systems

that would be respondents under the

proposed rule. The Commission also

estimates that, over time, approximately

3 new alternative trading systems would

choose to register as a broker-dealer and

comply with Regulation ATS each year

and that 3 alternative trading systems

would file cessation of operations

reports on Form ATS and cease

operating. Thus, the Commission

anticipates that approximately 43

alternative trading systems will incur

burdens each year under proposed

Regulation ATS. Each would file a onetime notice of initial operation report on

Form ATS. The Commission estimates

that alternative trading systems would

file 2 amendments per year to reflect

material changes to information on

Form ATS and 4 quarterly amendments

to reflect other changes. In addition,

alternative trading systems would be

required to file 4 reports per year on

Form ATS–R. The Commission also

estimates that 3 alternative trading

systems would file cessation of

operations reports on Form ATS on an

annual basis.

The Commission estimates that 2

alternative trading systems would meet

the volume thresholds that trigger fair

access obligations and would, therefore,

be required to maintain records of its

access standards and provide notice to

investors denied or limited access to the

system of their right to appear a denial

or limitation of access to the

Commission. Based on the

Commission’s experience with denials

of access to markets, the Commission

estimates that such systems would have

to send 27 denial or limitation of access

notices per year. The Commission also

believes that 2 alternative trading

systems would meet the trading volume

thresholds that trigger the systems

capacity, integrity and security

requirements and would, therefore, be

required to maintain records relating to

these requirements and notify the

Commission of system outages. Based

on the Commission’s experience with

systems’ outages in the markets, the

Commission anticipates that such

systems would provide 5 systems’

outage notices per year.

The Commission’s estimates for

burden hours associated with filing

Form ATS are based on the

Commission’s experience with filings

made pursuant to Rules 6a–1, 6a–2, 6a–

3 and 17a–23. While the burden

estimates have been based on prior

Commission experience, they have been

adjusted to reflect the specific nature of

each requirement.

The Commission estimates that each

respondent filing an initial operation

report on Form ATS would incur an

average burden of 20 hours. Thus, the

aggregate burden for 3 alternative

trading systems to file initial operations

reports on Form ATS would be 60

hours.

The Commission estimates that each

respondent filing an amendment on

Form ATS would incur an average

annual burden of 12 hours. Thus, the

average annual aggregate burden for 43

alternative trading systems to file 6

amendments each to the initial

operation report on Form ATS would be

1,032 hours.

The Commission estimates that each

respondent filing quarterly reports on

Form ATS–R would incur an average

annual burden of 16 hours. Thus, the

average annual aggregate burden for 43

alternative trading systems to file

quarterly reports on Form ATS–R would

be 688 hours.

The Commission estimates that each

respondent filing a cessation of

operation report on Form ATS would

incur an average burden of 2 hours.

Thus, the average annual aggregate

burden for 3 alternative trading systems

to file cessation of operations reports on

Form ATS would be 6 hours.

The Commission estimates that each

respondent obligated to establish and

keep standards for granting access to its

system would incur a burden of 5 hours.

Thus, the average annual aggregate

burden for 2 alternative trading systems

to establish and keep standards for
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23551

granting access to its system to comply

with such standards would be 10 hours.

The Commission estimates that each

respondent obligated to provide notices

to investors denied or limited access to

such system would incur a burden of 1

hour per notice, or 27 hours per year.

Thus, the annual aggregate burden for 2

alternative trading systems to provide

investors notice of a denial or limitation

decision and their right of appeal to the

Commission would be 54 hours.

The Commission estimates that each

respondent obligated to comply with the

systems capacity, integrity and security

requirements would incur an average

burden of 10 hours. Thus, the annual

aggregate burden for 2 alternative

trading systems to make records relating

to steps taken to comply with the

systems capacity, integrity and security

requirements would be 20 hours.

The Commission estimates that each

respondent obligated to provide

systems’ outage notices to the

Commission would provide 5 such

notices per year and that such systems

would incur a burden of 0.25 hours per

notice, or 1.25 hours per year. Thus, the

annual aggregate burden for 2

alternative trading systems to provide

investors notice of a denial or limitation

decision and their right of appeal to the

Commission would be 2.5 hours.

For alternative trading systems that

choose to register as a broker-dealer, the

requirements of Rule 301, Form ATS

and Form ATS–R are mandatory. All

filings required under Rule 301, Form

ATS and Form ATS–R are considered

confidential and are not available to the

public. All records required to be made

under the proposed Rule would be

preserved for 3 years, the first 2 years

in an easily accessible place.

G. Rule 302

Proposed Rule 302 would require

alternative trading systems to make

certain records with respect to trading

activity through the alternative trading

systems. This collection of information

would permit the Commission to detect

and investigate potential market

irregularities and to ensure investor

protection. Such information is not

available in any other form from any

other sources. The Commission

estimates 43 alternative trading systems

would be required to comply with this

proposed rule. The Commission

believes that most alternative trading

systems will keep such information in

the course of business, so the additional

burdens of compliance would be

minimal. Based on the Commission’s

experience with the burdens associated

with recordkeeping requirements under

Rule 17a–23, the Commission estimates

that the annual burden for each

respondent to comply with the

recordkeeping requirements under

proposed Rule 302 would be 36 hours

and that the annual aggregate burden for

43 alternative trading systems to comply

with Rule 302 would be 1,548 hours.

For alternative trading systems that

choose to register as a broker-dealer, the

requirements of Rule 302 are

mandatory. All records required to be

made under Rule 302 are considered

confidential and are not available to the

public. All records required to be made

under the proposed Rule would be

preserved for 3 years, the first 2 years

in an easily accessible place.

H. Rule 303

Proposed Rule 303 requires

alternative trading systems registered as

broker-dealers to preserve certain

records produced under Rule 302, as

well as standards for granting access to

the system and records generated in

complying with the systems capacity,

integrity and security requirements for

alternative trading systems with

significant trading volume. Alternative

trading systems registered as brokerdealers would not be required to file

such information, but merely retain it in

an organized manner and make it

available to the Commission upon

request. The Commission believes that

most alternative trading systems will

keep such information in the course of

business, so the additional burdens of

compliance would be minimal. The

Commission estimates that 43 such

alternative trading systems would be

required to comply with Rule 303.

Based on the Commission’s experience

with the burdens associated with record

preservation requirements under Rule

17a–23, the Commission estimates that

the annual burden for each respondent

to comply with the recordkeeping

requirements under proposed Rule 303

would be 4 hours and that the annual

aggregate cost for 43 alternative trading

systems to comply with Rule 303 would

be 1,172 hours.

For alternative trading systems that

choose to register as a broker-dealer, the

requirements of Rule 303 are

mandatory. All records required to be

made under Rule 303 are considered

confidential and are not available to the

public. All records required to be made

under the proposed Rule would be

preserved for 3 years, the first 2 years

in an easily accessible place.

I. Request for Comment

Pursuant to 44 U.S.C. 3506(c)(2)(B),

the Commission solicits comments to:

(i) Evaluate whether the proposed

collections of information are necessary

for the proper performance of the

functions of the agency, including

whether the information will have

practical utility;

(ii) Evaluate the accuracy of the

agency’s estimate of the burden of the

proposed collections of information;

(iii) Enhance the quality, utility, and

clarity of the information to be

collected;

(iv) Minimize the burden of the

collections of information on those who

are to respond, including through the

use of automated collection techniques

or other forms of information

technology.

Persons desiring to submit comments

on the collection of information

requirements should direct them to the

Office of Management and Budget,

Attention: Desk Officer for the

Securities and Exchange Commission,

Office of Information and Regulatory

Affairs, Washington, DC 20503, and

should also send a copy of their

comments to Jonathan G. Katz,

Secretary, Securities and Exchange

Commission, 450 Fifth Street, NW.,

Washington, DC 20549 with reference to

File No. S7–12–98. OMB is required to

make a decision concerning the

collections of information between 30

and 60 days after publication, so a

comment to OMB is best assured of

having its full effect if OMB receives it

within 30 days of publication.

XIII. Statutory Authority

The proposed rules and rule

amendments in this release are being

proposed pursuant to 15 U.S.C. 78a et

seq., particularly sections 3(b), 5, 6,

11A, 15, 17(a), 17(b), 19(b), 23(a), and 36

of the Exchange Act, 15 U.S.C. 78c, 78e,

78f, 78k–1, 78o, 78q(a), 78q(b), 78s(b),

78w(a), and 78mm.

List of Subjects

17 CFR Part 201

Administrative practice and

procedure, Equal access to justice,

Securities.

17 CFR Part 240

Brokers-dealers, Fraud, Issuers,

Reporting and recordkeeping

requirements, Securities.

17 CFR Part 242

Securities.

17 CFR Part 249

Reporting and recordkeeping

requirements, Securities.

For the reasons set out in the

preamble, Title 17, Chapter II of the

Code of Federal Regulations is proposed

to be amended as follows.
23552 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

PART 201—RULES OF PRACTICE

1. The authority citation for part 201

continues to read as follows:

Authority: 15 U.S.C. 77f, 77g, 77h, 77h–1,

77j, 77s, 77u, 78c(b), 78d–1, 78d–2, 78l, 78m,

78n, 78o(d), 78o–3, 78s, 78u–2, 78u–3, 78v,

78w, 79c, 79s, 79t, 79z–5a, 77sss, 77ttt, 80a–

8, 80a–9, 80a–37, 80a–38, 80a–39, 80a–40,

80a–41, 80a–44, 80b–3, 80b–9, 80b–11, and

80b–12 unless otherwise noted.

2. Paragraph (a)(9) of § 201.101 is

revised to read as follows:

§ 201.101 Definitions.

(a) * * *

(9) Proceeding means any agency

process initiated by an order instituting

proceedings; or by the filing, pursuant

to § 201.410, of a petition for review of

an initial decision by a hearing officer;

or by the filing, pursuant to § 201.420,

of an application for review of a selfregulatory organization or an alternative

trading system determination; or by the

filing pursuant to § 201.430, of a notice

of intention to file a petition for review

of a determination made pursuant to

delegated authority;

* * * * *

3. The introductory text of paragraph

(a) of § 201.202 is revised to read as

follows:

§ 201.202 Specifications of procedures by

parties in certain proceedings.

(a) Motion to specify procedures. In

any proceeding other than an

enforcement or disciplinary proceeding

or a proceeding to review a

determination by a self-regulatory

organization or an alternative trading

system pursuant to §§ 201.420 and

201.421, a party may, at any time up to

20 days prior to the start of a hearing,

make a motion to specify the procedures

necessary or appropriate for the

proceeding, with particular reference to:

* * * * *

4. Paragraph (a)(1) of § 201.210 is

revised to read as follows:

§ 201.210 Parties, limited participants and

amici curiae.

(a) Parties in an enforcement or

disciplinary proceeding or a proceeding

to review a self-regulatory organization

or an alternative trading system

determination. (1) Generally. No person

shall be granted leave to become a party

or a non-party participant on a limited

basis in an enforcement or disciplinary

proceeding or a proceeding to review a

determination by a self-regulatory

organization or an alternative trading

system pursuant to §§ 201.420 and

201.421.

* * * * *

5. Paragraph (d)(1) of § 201.401 is

revised to read as follows:

§ 201.401 Issuance of stays.

* * * * *

(d) * * * (1) Availability. A motion

for a stay of an action by a selfregulatory organization for which the

Commission is the appropriate

regulatory agency or a limitation or

prohibition of access by an alternative

trading system, for which action review

may be sought pursuant to § 201.420,

may be made by any person aggrieved

thereby.

* * * * *

6. Section 201.420 is revised to read

as follows:

§ 201.420 Appeal of determinations by

self-regulatory organizations and

alternative trading systems.

(a) Application for review; when

available. (1) An application for review

by the Commission may be filed by any

person who is aggrieved by a selfregulatory organization determination as

to which a notice is required to be filed

with the Commission pursuant to

section 19(d)(1) of the Exchange Act, 15

U.S.C. 78s(d)(1). Such determinations

include any:

(i) Final disciplinary sanction;

(ii) Denial or conditioning of

membership or participation;

(iii) Prohibition or limitation in

respect to access to services offered by

that self-regulatory organization or a

member thereof; or

(iv) Bar from association.

(2) An application for review by the

Commission may be filed by any person

who is aggrieved by an alternative

trading system determination as to

which a notice is required to be filed

with the Commission pursuant to

paragraph (a)(5) of § 242.301 of this

chapter (Regulation ATS). Such

determination includes any prohibition

or limitation in respect to access to

services offered by the alternative

trading system.

(b) Procedure. An application for

review may be filed with the

Commission pursuant to § 201.151

within 30 days after notice of the

determination was filed with the

Commission pursuant to sections

19(d)(1) of the Exchange Act, 15 U.S.C.

78s(d)(1) or paragraph (a)(5) of § 242.301

of this chapter (Regulation ATS), and

received by the aggrieved person

applying for review. The application

shall be served by the applicant on the

self-regulatory organization or the

alternative trading system, whichever is

applicable. The application shall

identify the determination complained

of, set forth in summary form a brief

statement of alleged errors in the

determination and supporting reasons

therefor and state an address where the

applicant can be served with the record

index. The application shall be

accompanied by the notice of

appearance required by § 201.102(d).

(c) Determination not stayed. Filing

an application for review with the

Commission pursuant to paragraph (b)

of this section shall not operate as a stay

of the complained of determination

made by the self-regulatory organization

or the alternative trading system unless

the Commission otherwise orders either

pursuant to a motion filed in accordance

with § 201.401 or on its own motion.

(d) Certification of the record; service

of the index. Fourteen days after receipt

of an application for review or a

Commission order for review, the selfregulatory organization or the

alternative trading system shall certify

and file with the Commission one copy

of the record upon which the action

complained of was taken, and shall file

with the Commission three copies of an

index to such record, and shall serve

upon each party one copy of the index.

7. The section heading and paragraph

(a) of § 201.421 are revised to read as

follows:

§ 201.421 Commission consideration of

determinations by self-regulatory

organizations and alternative trading

systems.

(a) Commission review other than

pursuant to a petition for review. The

Commission may, on its own initiative,

order review of any determination by a

self-regulatory organization or an

alternative trading system that could be

subject to an application for review

pursuant to § 201.420(a) within 40 days

after notice thereof was filed with the

Commission pursuant to Section

19(d)(1) of the Exchange Act, 15 U.S.C.

78s(d)(1) or paragraph (a)(5) of § 242.301

of this chapter (Regulation ATS).

* * * * *

8. Paragraph (a)(2)(ii) of § 201.450 is

revised to read as follows:

§ 201.450 Briefs filed with the

Commission.

(a) * * *

(2) * * *

(ii) Receipt by the Commission of an

index to the record of a determination

of a self-regulatory organization or an

alternative trading system filed pursuant

to § 201.420(d);

* * * * *

9. Paragraph (a)(2)(i) of § 201.460 is

revised to read as follows:

§ 201.460 Record before the Commission.

* * * * *

(a) * * *

(2) * * *

(i) The record certified pursuant to

§ 201.420(d) by the self-regulatory
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organization or the alternative trading

system;

* * * * *

PART 240—GENERAL RULES AND

REGULATIONS, SECURITIES

EXCHANGE ACT OF 1934

10. The authority citation for part 240

continues to read in part as follows:

Authority: 15 U.S.C. 77c, 77d, 77g, 77j,

77s, 77z–2, 77eee, 77ggg, 77nnn, 77sss, 77ttt,

78c, 78d, 78f, 78i, 78j, 78j–1, 78k, 78k–1, 78l,

78m, 78n, 78o, 78p, 78q, 78s, 78u–5, 78w,

78x, 78ll(d), 78mm, 79q, 79t, 80a–20, 80a–23,

80a–29, 80a–37, 80b–3, 80b–4 and 80b–11,

unless otherwise noted.

* * * * *

11. Section 240.3a1–1 is added before

the undesignated center heading

‘‘Definition of ‘Equity Security’ as Used

in Sections 12(g) and 16’’ to read as

follows:

§ 240.3a1–1 Exemption from the definition

of ‘‘Exchange’’ under Section 3(a)(1) of the

Act.

(a) An organization, association, or

group of persons shall be exempt from

the definition of the term ‘‘exchange’’

under section 3(a)(1) of the Act (15

U.S.C. 78c(a)(1)), if such organization,

association, or group of persons:

(1) Is operated by a national securities

association; or

(2) Is an alternative trading system

and is in compliance with Regulation

ATS, 17 CFR 242.300 through 242.303.

(b) Notwithstanding paragraph (a) of

this section, an organization,

association, or group of persons shall

not be exempt under this section from

the definition of ‘‘exchange,’’ if:

(1) The Commission determines, after

notice to the alternative trading system

and an opportunity for the alternative

trading system to respond, that such an

exemption would not be necessary or

appropriate in the public interest or

consistent with the protection of

investors; or

(2) The organization, association, or

group of persons is registered as an

exchange under section 6 of the Act (15

U.S.C. 78f).

(c) Alternative trading system has the

same meaning as under § 242.300(a) of

this chapter.

12. Section 240.3b–12 is added before

the undesignated center heading

‘‘Registration and Exemption of

Exchanges’’ to read as follows:

§ 240.3b–12 Definitions of terms used in

Section 3(a)(1) of the Act.

(a) An organization, association, or

group of persons shall be considered to

constitute, maintain, or provide ‘‘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 those terms are used in

section 3(a)(1) of the Act (15 U.S.C.

78c(a)(1)), if such organization,

association, or group of persons:

(1) Consolidates orders of multiple

parties; and

(2) Sets non-discretionary material

conditions (whether by providing a

trading facility or by setting rules) under

which the parties entering such orders

agree to the terms of a trade.

(b) An organization, association, or

group of persons shall not be considered

to constitute, maintain, or provide ‘‘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,’’ solely because such

organization, association, or group of

persons:

(1) Routes orders to a national

securities exchange, a market operated

by a national securities association, or a

broker-dealer;

(2) Displays the quotes of a single

dealer and allows persons to enter

orders for execution against such

dealer’s quotes; or

(3) Provides the means for a single

broker-dealer to internally manage

customers’ orders, including crossing or

matching such orders with each other,

provided however that:

(i) Customers’ orders are not

displayed to any person, other than the

broker-dealer and its employees; and

(ii) Customers’ orders are not

executed according to a predetermined

procedure that is communicated to such

customers.

(c) For purposes of this section the

term order means any firm indication of

a willingness to buy or sell a security,

as either principal or agent, including

any bid or offer quotation, market order,

limit order, or other priced order.

13. Section 240.6a–1 is amended by

revising the section heading and

paragraphs (a) and (b) to read as follows:

§ 240.6a–1 Application for registration as a

national securities exchange or exemption

from registration based on limited volume.

(a) An application for registration as

a national securities exchange, or for

exemption from such registration based

on limited volume, shall be filed on

Form 1 (§ 249.1 of this chapter), in

accordance with the instructions

contained therein.

(b) Promptly after the discovery that

any information filed on Form 1 was

inaccurate when filed, the exchange

shall file with the Commission an

amendment correcting such inaccuracy.

* * * * *

14. Section 240.6a–2 is revised to read

as follows:

§ 240.6a–2 Amendments to application.

(a) A national securities exchange, or

an exchange exempted from such

registration based on limited volume,

shall file an amendment, which shall set

forth the nature and effective date of the

action taken and shall provide any new

information and correct any information

rendered inaccurate, on Form 1, 17 CFR

240.249.1, within 10 days after any

action is taken that renders inaccurate,

or that causes to be incomplete, any of

the following:

(1) Information filed on the Execution

Page of Form 1, or amendment thereto;

or

(2) Information filed as part of Exhibit

C, F, G, I, J, K or M, or any amendments

thereto.

(b) On or before June 30 of each year,

a national securities exchange, or an

exchange exempted from such

registration based on limited volume,

shall file, as an amendment to Form 1,

the following:

(1) Exhibits D and H, as of the end of

the latest fiscal year of the exchange;

and

(2) Exhibits J, K, and M and, which

shall be up to date as of the latest date

practicable within 3 months of the date

the amendment is filed.

(c) On or before June 30, 2001 and

every 3 years thereafter, a national

securities exchange, or an exchange

exempted from such registration based

on limited volume, shall file, as an

amendment to Form 1, complete

Exhibits A, B, C and H. The information

filed under this paragraph (c) shall be

current as of the latest practicable date,

but shall, at a minimum, be up to date

within 3 months as of the date the

amendment is filed.

(d)(1) If an exchange, on an annual or

more frequent basis, publishes, or

cooperates in the publication of, any of

the information required to be filed by

paragraphs (b)(2) and (c) of this section,

in lieu of filing such information, an

exchange may:

(i) Identify the publication in which

such information is available, the name,

address, and telephone number of the

person from whom such publication

may be obtained, and the price of such

publication; and

(ii) Certify to the accuracy of such

information as of its publication date.

(2) If an exchange keeps the

information required under paragraphs

(b)(2) and (c) of this section up to date

and makes it available to the
23554 Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules

Commission and the public upon

request, in lieu of filing such

information, an exchange may certify

that the information is kept up to date

and is available to the Commission and

the public upon request.

(3) If the information required to be

filed under paragraphs (b)(2) and (c) of

this section is available continuously on

an Internet web site controlled by an

exchange, in lieu of filing such

information with the Commission, such

exchange may:

(i) Indicate the location of the Internet

web site where such information may be

found; and

(ii) Certify that the information

available at such location is accurate as

of its date.

(e) The Commission may exempt a

national securities exchange, or an

exchange exempted from such

registration based on limited volume,

from filing the amendment required by

this section for any affiliate or

subsidiary listed in Exhibit C of the

exchange’s application for registration,

as amended, that either:

(1) Is listed in Exhibit C of the

application for registration, as amended,

of one or more other national securities

exchanges; or

(2) Was an inactive subsidiary

throughout the subsidiary’s latest fiscal

year. Any such exemption may be

granted upon terms and conditions the

Commission deems necessary or

appropriate in the public interest or for

the protection of investors, provided

however, that at least one national

securities exchange shall be required to

file the amendments required by this

section for an affiliate or subsidiary

described in paragraph (e)(1) of this

section.

15. Section 240.6a–3 is revised to read

as follows:

§ 240.6a–3 Supplemental material to be

filed by exchanges.

(a)(1) A national securities exchange,

or an exchange exempted from such

registration based on limited volume,

shall file with the Commission any

material (including notices, circulars,

bulletins, lists, and periodicals) issued

or made generally available to members

of, or participants or subscribers to, the

exchange. Such material shall be filed

with the Commission within 10 days

after issuing or making such material

available to members, participants or

subscribers.

(2) If the information required to be

filed under paragraph (a)(1) of this

section is available continuously on an

Internet web site controlled by an

exchange, in lieu of filing such

information with the Commission, such

exchange may:

(i) Indicate the location of the Internet

web site where such information may be

found; and

(ii) Certify that the information

available at such location is accurate as

of its date.

(b) Within 15 days after the end of

each calendar month, a national

securities exchange or an exchange

exempted from such registration based

on limited volume, shall file a report

concerning the securities sold on such

exchange during the calendar month.

Such report shall set forth:

(1) The number of shares of stock sold

and the aggregate dollar amount of such

stock sold;

(2) The principal amount of bonds

sold and the aggregate dollar amount of

such bonds sold; and

(3) The number of rights and warrants

sold and the aggregate dollar amount of

such rights and warrants sold.

16. Section 240.11Ac1–1 is amended

by redesignating paragraph (c)(5)(ii)(A)

as paragraph (c)(5)(ii)(A)(1), paragraph

(c)(5)(ii)(B) as paragraph (c)(5)(ii)(A)(2),

paragraph (c)(5)(ii)(B)(1) as paragraph

(c)(5)(ii)(A)(2)(i), paragraph

(c)(5)(ii)(B)(2) as paragraph

(c)(5)(ii)(A)(2)(ii), in newly designated

paragraph (c)(5)(ii)(A)(2)(ii) removing

the period and adding in its place ‘‘; or’’,

and adding paragraph (c)(5)(ii)(B) to

read as follows:

§ 240.11Ac1–1 Dissemination of

quotations.

* * * * *

(c) * * *

(5) * * *

(ii) * * *

(A)(1) * * *

(B) Is an alternative trading system

that:

(1) Displays orders and provides the

ability to effect transactions with such

orders under § 242.301(b)(3) of this

chapter; and

(2) Otherwise is in compliance with

Regulation ATS, § 242.300 through

242.303.

* * * * *

17. Section 240.17a–3 is amended by

adding paragraph (a)(16) to read as

follows:

§ 240.17a–3 Records to be made by certain

exchange members, brokers and dealers.

(a) * * *

(16)(i) The following records

regarding any internal broker-dealer

system of which such a broker or dealer

is the sponsor:

(A) A record of the broker’s or dealer’s

customers that have access to an

internal broker-dealer system sponsored

by such broker or dealer (identifying

any affiliations between such customers

and the broker or dealer);

(B) Daily summaries of trading in the

internal broker-dealer system,

including:

(1) Securities for which transactions

have been executed through use of such

system; and

(2) Transaction volume (separately

stated for trading occurring during

hours when consolidated trade

reporting facilities are and are not in

operation):

(i) With respect to equity securities, in

number of trades, number of shares, and

total U.S. dollar value;

(ii) With respect to debt securities, in

total U.S. dollar value; and

(iii) With respect to other securities,

in number of trades, number of units of

securities, and in dollar value, or other

appropriate commonly used measure of

value of such securities; and

(C) Time-sequenced records of each

transaction effected through the internal

broker-dealer system, including date

and time executed, price, size, security

traded, counterparty identification

information, and method of execution

(if internal broker-dealer system allows

alternative means or locations for

execution, such as routing to another

market, matching with limit orders, or

executing against the quotations of the

broker or dealer sponsoring the system).

(ii) For purposes of this paragraph the

term:

(A) Internal broker-dealer system

shall mean 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, §§ 242.300 through

242.303 of this chapter, 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;

(B) Sponsor shall mean any broker or

dealer that organizes, operates,

administers, or otherwise directly

controls an internal broker-dealer

trading 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 on a regular

basis with executing transactions in

connection with use of the internal

broker-dealer system, other than solely
Federal Register / Vol. 63, No. 82 /Wednesday, April 29, 1998 / Proposed Rules 23555

for its own account or as a customer

with access to the internal broker-dealer

system; and

(C) System order means 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. The term ‘‘system order’’ does

not include inquiries or indications of

interest that are not entered into the

internal broker-dealer system.

18. Section 240.17a–4 is amended by

revising paragraph (b)(1) and adding

paragraph (b)(10) to read as follows:

§ 240.17a–4 Records to be preserved by

certain exchange members, brokers and

dealers.

* * * * *

(b) * * *

(1) All records required to be made

pursuant to paragraphs (a) (4), (6), (7),

(8), (9), and (10) of § 240.17a–3.

* * * * *

(10) All notices relating to an internal

broker-dealer system provided to the

customers of the broker or dealer that

sponsors such internal broker-dealer

system, as defined in paragraph

(a)(16)(ii)(A) of § 240.17a–3. Notices,

whether written or communicated

through the internal broker-dealer

trading system or other automated

means, shall be preserved under this

paragraph (b)(10) if they are provided to

all customers with access to an internal

broker-dealer system, or to one or more

classes of customers. Examples of

notices to be preserved under this

paragraph (b)(10) include, but are not

limited to, notices addressing hours of

system operations, system malfunctions,

changes to system procedures,

maintenance of hardware and software,

and instructions pertaining to access to

the internal broker-dealer system.

* * * * *

§ 240.17a–23 [Removed and reserved]

19. Section 240.17a–23 is removed

and reserved.

20. Section 240.19b–5 is added to

read as follows:

§ 240.19b–5 Temporary exemption from

the filing requirements of Section 19(b) of

the Act.

Preliminary Notes

1. The following section provides for a

temporary exemption from the rule filing

requirement for self-regulatory organizations

that file proposed rule changes concerning

the operation of a pilot trading system

pursuant to section 19(b) of the Act (15

U.S.C. 78s(b), as amended). All other

requirements under the Act that are

applicable to self-regulatory organizations

continue to apply.

2. The disclosures made pursuant to the

provisions of this section are in addition to

any other applicable disclosure requirements

under the federal securities laws.

(a) For purposes of this section, the

term pilot trading system shall mean a

trading system operated by a selfregulatory organization that is not

substantially similar to any pilot trading

system operated by such self-regulatory

organization at any time during the

preceding year, and that:

(1)(i) Has been in operation for less

than two years;

(ii) Is independent of any other

trading system operated by such selfregulatory organization that has been

approved by the Commission pursuant

to section 19(b) of the Act, (15 U.S.C.

78s(b));

(iii) With respect to each security

traded on such pilot trading system,

during at least two of the last four

consecutive calendar months, has

traded no more than 5% of the average

daily share trading volume of such

security in the United States; and

(iv) With respect to all securities

traded on such pilot trading system,

during at least two of the last four

consecutive calendar months, has

traded no more than 20% of the average

daily share trading volume of all trading

systems operated by such self-regulatory

organization; or

(2)(i) Has been in operation for less

than two years;

(ii) With respect to each security

traded on such pilot trading system,

during at least two of the last four

consecutive calendar months, has

traded no more than 1% of the average

daily share trading volume of such

security in the United States; and

(iii) With respect to all securities

traded on such pilot trading system,

during at least two of the last four

consecutive calendar months, has

traded no more than 20% of the average

daily share trading volume of all trading

systems operated by such self-regulatory

organization; or

(3)(i) Has been in operation for less

than two years; and

(ii)(A) Satisfied the definition of pilot

trading system under paragraph (a)(1) of

this section no more than 60 days ago,

and continues to be independent of any

other trading system operated by such

self-regulatory organization that has

been approved by the Commission

pursuant to section 19(b) of the Act, (15

U.S.C. 78s(b)); or

(B) Satisfied the definition of pilot

trading system under paragraph (a)(2) of

this section no more than 60 days ago.

(b) A pilot trading system shall be

deemed independent of any other

trading system operated by a selfregulatory organization if:

(1) Such pilot trading system trades

securities other than the issues of

securities that trade on any other trading

system operated by such self-regulatory

organization that has been approved by

the Commission pursuant to section

19(b) of the Act, (15 U.S.C. 78s(b)); or

(2) Such pilot trading system does not

operate during the same trading hours

as any other trading system operated by

such self-regulatory organization that

has been approved by the Commission

pursuant to section 19(b) of the Act, (15

U.S.C. 78s(b)); or

(3) No specialist or market maker on

any other trading system operated by

such self-regulatory organization that

has been approved by the Commission

pursuant to section 19(b) of the Act, (15

U.S.C. 78s(b)), is permitted to effect

transactions on the pilot trading system

in securities in which they are a

specialist or market maker.

(c) A self-regulatory organization shall

be exempt temporarily from the

requirement under section 19(b) of the

Act, (15 U.S.C. 78s(b)), to submit a

proposed rule change on Form 19b–4,

17 CFR 249.819, if the self-regulatory

organization complies with the

requirements in this paragraph (c).

(1) Scope of exemption. Such

proposed rule change relates to the

operation of a pilot trading system.

(2) Form PILOT. The self-regulatory

organization:

(i) Files Part I of Form PILOT, 17 CFR

249.821, in accordance with the

instructions therein, at least 20 days

prior to commencing operation of the

pilot trading system;

(ii) Files an amendment on Part I of

Form PILOT at least 20 days prior to

implementing a material change to the

operation of the pilot trading system;

and

(iii) Files a quarterly report on Part II

of Form PILOT within 30 calendar days

after the end of each calendar quarter in

which the market has operated after the

effective date of this section.

(3) Trading rules and procedures and

listing standards. The self-regulatory

organization has in place trading rules

and procedures and listing standards

necessary to operate the pilot trading

system.

(4) Surveillance. The self-regulatory

organization establishes internal

procedures for the effective surveillance

of trading activity on the self-regulatory

organization’s pilot trading system.

(5) Clearance and settlement. The

self-regulatory organization establishes

reasonable clearance and settlement

procedures for transactions effected on
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the self-regulatory organization’s pilot

trading system.

(6) Types of securities. The selfregulatory organization:

(i) Permits to trade on the pilot

trading system only securities listed on

a national securities exchange or to

which unlisted trading privileges have

been extended pursuant to a rule,

regulation, or order of the Commission

under section 12(f) of the Act, (15 U.S.C.

78l(f));

(ii) Does not permit to trade on the

pilot trading system any security or

instrument, such as an option, warrant

or hybrid product, the value of which is

based, in whole or in part, upon the

performance of any security that is

traded on another trading system

operated by such self-regulatory

organization that has been approved by

the Commission pursuant to section

19(b) of the Act, (15 U.S.C. 78s(b)); and

(iii) Does not permit to trade on the

pilot trading system any security or

instrument, such as an equity security,

the derivative of which is traded on

another trading system operated by such

self-regulatory organization that has

been approved by the Commission

pursuant to section 19(b) of the Act, (15

U.S.C. 78s(b)).

(7) Procedures to ensure the

confidential treatment of trading

information. The self-regulatory

organization has in place adequate

safeguards and procedures relating to

the treatment of trading information.

Such safeguards and procedures shall

include:

(i) Limiting access to the confidential

information regarding the identity of

members, and other persons, effecting

transactions on the pilot trading system,

as well as such members’ and other

persons’ confidential trading

information, to those employees of the

self-regulatory organization who are

operating the pilot trading system or are

responsible for such pilot trading

system’s compliance with these or any

other applicable rules;

(ii) Implementing standards

controlling the self-regulatory

organization employees’ trading for

their own accounts; and

(iii) Adopting and implementing

adequate oversight procedures to ensure

that the safeguards and procedures

outlined in paragraphs (c)(7)(i) and (ii)

of this section are followed.

(8) Examinations, inspections, and

investigations of subscribers. The selfregulatory organization and its members

cooperate with the examination,

inspection, or investigation by the

Commission of transactions effected on

the pilot trading system.

(9) Recordkeeping. The self-regulatory

organization shall retain at its principal

place of business and make available to

Commission staff for inspection, all the

rules and procedures relating to each

pilot trading system operating pursuant

to this section for a period of not less

than five years, the first two years in an

easily accessible place, as prescribed in

§ 240.17a–1.

(10) Every notice or amendment filed

pursuant to this paragraph (c) shall

constitute a ‘‘report’’ within the

meaning of sections 11A, 17(a), 18(a),

and 32(a), (15 U.S.C. 78k–1, 78q(a),

78r(a), and 78ff(a)), and any other

applicable provisions of the Act. All

notices or report filed pursuant to this

paragraph (c) shall be deemed to be

confidential.

(d) A self-regulatory organization

shall request Commission approval,

pursuant to section 19(b)(2) of the Act,

(15 U.S.C. 78s(b)), for any rule change

relating to the operation of a pilot

trading system by submitting Form 19b–

4, 17 CFR 249.819, no later than two

years after the commencement of

operation of such pilot trading system,

or shall cease operation of the pilot

trading system.

(e) Simultaneous with a request for

Commission approval pursuant to

section 19(b)(2) of the Act, (15 U.S.C.

78s(b)(2)), a self-regulatory organization

may request Commission approval

pursuant to section 19(b)(3)(A) of the

Act, (15 U.S.C. 78s(b)(3)(A)), for any

rule change relating to the operation of

a pilot trading system by submitting

Form 19b–4, 17 CFR 249.819, effective

immediate upon filing, to continue

operations of such trading system for a

period not to exceed six months.

(f) Notwithstanding paragraph (c) of

this section, rule changes with respect

to pilot trading systems operated by a

self-regulatory organization shall not be

exempt from the rule filing

requirements of section 19(b) of the Act,

(15 U.S.C. 78s(b)(2)), if the Commission

determines, after notice to the SRO and

opportunity for the SRO to respond, that

exemption of such changes would not

be necessary or appropriate in the

public interest or consistent with the

protection of investors.

PART 242—REGULATIONS M AND

ATS

21. The authority citation for part 242

is revised to read as follows:

Authority: 15 U.S.C. 77g, 77q(a), 77s(a),

78b, 78c, 78i(a), 78j, 78k–1(c), 78l, 78m, 78

mm, 78n, 78o(b), 78o(c), 78o(g), 78q(a),

78q(b), 78q(h), 78w(a), 78dd–1, 80a–23, 80a–

29, and 80a–37.

22. The part heading for part 242 is

revised as set forth above.

23. Part 242 is amended by adding

Regulation ATS, §§ 242.300 through

242.303 to read as follows:

Regulation ATS—Alternative Trading

Systems

Sec.

242.300 Definitions.

242.301 Requirements for alternative

trading systems that are not national

securities exchanges.

242.302 Recordkeeping requirements for

alternative trading systems.

242.303 Record preservation requirements

for alternative trading systems.

Regulation ATS—Alternative Trading

Systems

Preliminary Notes

1. An alternative trading system is required

to comply with the requirements in this

Regulation ATS, unless such alternative

trading system:

(a) Is registered as a national securities

exchange;

(b) Is exempt from registration as a national

securities exchange based on the limited

volume of transactions effected on the

alternative trading system; or

(c) Trades only government securities and

certain other related instruments.

All alternative trading systems must

comply with the antifraud, antimanipulation,

and other applicable provisions of the federal

securities laws.

2. The requirements imposed upon an

alternative trading system by Regulation ATS

are in addition to any requirements

applicable to broker-dealers registered under

Section 15 of the Act, (15 U.S.C. 78o).

3. An alternative trading system must

comply with any applicable state law relating

to the offer or sale of securities or the

registration or regulation of persons or

entities effecting transactions in securities.

4. The disclosures made pursuant to the

provisions of this section are in addition to

any other disclosure requirements under the

federal securities laws.

§ 242.300 Definitions.

For purposes of this section, the

following definitions shall apply:

(a) Alternative trading system means

any organization, association, person,

group of persons, or system:

(1) That 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 within the meaning of

§ 240.3b–12 of this chapter; and

(2) That does not:

(i) 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

(ii) Discipline subscribers other than

by exclusion from trading.
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(b) Subscriber means any person that

has entered into a contractual agreement

with an alternative trading system to

access such alternative trading system

for the purpose of effecting transactions

in securities or submitting,

disseminating, or displaying orders on

such alternative trading system,

including a customer, member, user, or

participant in an alternative trading

system. A subscriber, however, shall not

include a national securities exchange

or national securities association.

(c) Affiliate of a subscriber means any

person that, directly or indirectly,

controls, is under common control with,

or is controlled by, the subscriber,

including any employee.

(d) Debt security shall mean any

security other than an equity security, as

defined in § 240.3a11–1 of this chapter,

as well as non-participatory preferred

stock.

(e) Order means any firm indication of

a willingness to buy or sell a security,

as either principal or agent, including

any bid or offer quotation, market order,

limit order, or other priced order.

(f) Control means the power, directly

or indirectly, to direct the management

or policies of an alternative trading

system, whether through ownership of

securities, by contract, or otherwise. A

person is presumed to control an

alternative trading system, if that

person:

(1) Is a director, general partner, or

officer exercising executive

responsibility (or having similar status

or performing similar functions);

(2) Directly or indirectly has the right

to vote 25% or more of a class of voting

security or has the power to sell or

direct the sale of 25% or more of a class

of voting securities of the alternative

trading system; or

(3) In the case of a partnership, has

contributed, or has the right to receive

upon dissolution, 25% or more of the

capital of the alternative trading system.

(g) Covered security shall have the

meaning provided in § 240.11Ac1–

1(a)(6) of this chapter, provided,

however, that a debt or convertible debt

security shall not be deemed a covered

security for purposes of Regulation ATS.

(h) Effective transaction reporting

plan shall have the meaning provided in

§ 240.11Aa3–1(a)(3) of this chapter.

(i) Exchange market maker shall have

the meaning provided in § 240.11Ac1–

1(a)(9) of this chapter.

(j) OTC market maker shall have the

meaning provided in § 240.11Ac1–

1(a)(13) of this chapter.

(k) Corporate debt security shall mean

any security, other than an exempted

security, that evidences a liability of the

issuer and that has a maturity date that

is at least one year following the date of

issuance.

§ 242.301 Requirements for alternative

trading systems that are not national

securities exchanges.

(a) Scope of section. An alternative

trading system shall comply with the

requirements in paragraph (b) of this

section, unless such alternative trading

system is:

(1) Registered as an exchange under

section 6 of the Act, (15 U.S.C. 78f);

(2) Exempt from registration as an

exchange based on the limited volume

of transactions effected;

(3) Operated by a national securities

association; or

(4) Registered as a broker-dealer under

sections 15(b), or 15C of the Act, (15

U.S.C. 78o(b), and 78o–5), and trades

only the following types of securities:

(i) Government securities, as defined

in section 3(a)(42) of the Act, (15 U.S.C.

78c(a)(42));

(ii) Debt securities that:

(A) Are issued pursuant to the Brady

Plan debt-restructuring program; and

(B) Have all of their principal

payments guaranteed by the issuance of

government securities; and

(iii) Repurchase and reverse

repurchase agreements solely involving

securities included within paragraphs

(a)(4)(i) and (a)(4)(ii) of this section.

(b) Requirements. Every alternative

trading system subject to this Regulation

ATS, pursuant to paragraph (a) of this

section, shall comply with the

requirements in this paragraph (b).

(1) Broker-dealer registration. The

alternative trading system shall register

as a broker-dealer under section 15 of

the Act, (15 U.S.C. 78o).

(2) Notice. (i) The alternative trading

system shall file an initial operation

report on Form ATS, § 249.637 of this

chapter, in accordance with the

instructions therein, at least 20 days

prior to commencing operation as an

alternative trading system, or if the

alternative trading system is operating

as of (effective date of rule), no later

than (60 days following effective date).

(ii) The alternative trading system

shall file an amendment on Form ATS

at least 20 calendar days prior to

implementing a material change to the

operation of the alternative trading

system.

(iii) If any information contained in

the initial operation report filed under

paragraph (b)(2)(i) of this section

becomes inaccurate for any reason and

has not been previously reported to the

Commission as an amendment on Form

ATS, the alternative trading system

shall file an amendment on Form ATS

correcting such information within 30

calendar days after the end of each

calendar quarter in which the

alternative trading system has operated.

(iv) The alternative trading system

shall promptly file an amendment on

Form ATS correcting information

previously reported on Form ATS after

discovery that any information filed

under paragraphs (b)(2)(i), (ii) or (iii) of

this section was inaccurate when filed.

(v) The alternative trading system

shall promptly file a cessation of

operations report on Form ATS in

accordance with the instructions therein

upon ceasing to operate as an alternative

trading system.

(vi) Every notice or amendment filed

pursuant to this paragraph (b)(2) shall

constitute a ‘‘report’’ within the

meaning of sections 11A, 17(a), 18(a),

and 32(a), (15 U.S.C. 78k–1, 78q(a),

78r(a), and 78ff(a)), and any other

applicable provisions of the Act.

(vii) The reports provided for in

paragraph (b)(2) of this section shall be

considered filed upon receipt at the

Commission’s principal office in

Washington, DC. Duplicate originals of

the reports provided for in paragraphs

(b)(2)(i) through (v) of this section must

be filed with surveillance personnel

designated as such by any selfregulatory organization of which the

alternative trading system is a member

simultaneously with filing with the

Commission. Duplicates of the reports

required by paragraph (b)(9) of this

section shall be provided to surveillance

personnel of such self-regulatory

authority upon request. All reports filed

pursuant to this paragraph (b)(2) and

paragraph (b)(9) of this section shall be

deemed confidential when filed.

(3) Order display and execution

access. (i) An alternative trading system

shall comply with the requirements set

forth in paragraph (b)(3)(ii) of this

section if, with respect to any covered

security in which the alternative trading

system:

(A) Displays subscriber orders to any

person (other than alternative trading

system employees); and

(B) During at least 4 of the preceding

6 calendar months, had an average daily

trading volume greater than 10% of the

aggregate average daily share volume for

such covered security as reported by an

effective transaction reporting plan or

disseminated through an automated

quotation system as described in section

3(a)(51)(A)(ii) of the Act, (15 U.S.C.

78c(a)(51)(A)(ii)).

(ii) Such alternative trading system

shall:

(A) Provide to a national securities

exchange or national securities

association (or an exclusive processor

acting on behalf of one or more national
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securities exchanges or national

securities associations) the prices and

sizes of the orders at the highest buy

price and the lowest sell price for such

covered security displayed to more than

one person in the alternative trading

system and ensure that such prices and

sizes are included in the quotation data

made available by the exchange,

association or exclusive processor to

quotation vendors pursuant to

§ 240.11Ac1–1 of this chapter; and

(B) Provide to any broker-dealer that

has access to a national securities

exchange or national securities

association, to which the alternative

trading system provides the prices and

sizes of displayed orders pursuant to

paragraph (b)(3)(ii)(A) of this section,

the ability to effect a transaction with

such orders that is:

(1) Equivalent to the ability of such

member to effect a transaction with

other orders displayed on the exchange

or by the association; and

(2) At the price of the highest priced

buy order or lowest priced sell order

displayed for the lesser of the

cumulative size of such priced orders

entered therein at such price, or the size

of the execution sought by the member.

(4) Fees. The alternative trading

system shall not charge any fee to

members of a national securities

exchange or national securities

association for access to the alternative

trading system required by paragraph

(b)(3)(ii)(B) of this section that is:

(i) In excess of the highest fee the

alternative trading system charges a

substantial proportion of its brokerdealer subscribers for access made

available to subscribers by the

alternative trading system; or

(ii) Prohibited by rules of the national

securities exchange or national

securities association, to which the

alternative trading system provides the

prices and sizes of orders under

paragraph (b)(3)(ii)(B) of this section,

that are designed to assure consistency

with standards for access to quotations

displayed on the market operated by

such national securities exchange or

national securities association.

(5) Fair access. (i) An alternative

trading system shall comply with the

requirements in paragraph (b)(5)(ii) of

this section, if during at least 4 of the

preceding 6 calendar months, such

alternative trading system had:

(A) With respect to any covered

security, greater than 20% of the average

daily share volume in that security

reported by the effective transaction

reporting plan or disseminated through

an automated quotation system as

described in section 3(a)(51)(A)(ii) of the

Act (15 U.S.C. 78c(a)(51)(A)(ii));

(B) With respect to an equity security

that is not a covered security and for

which transactions are reported to a

self-regulatory organization, greater than

20% of the average daily share volume

in that security as calculated by the selfregulatory organization to which such

transactions are reported; or

(C) With respect to any category of

debt security, including corporate debt

securities, greater than 20% of the

average daily volume traded in the

United States.

(ii) An alternative trading system

shall:

(A) Establish standards for granting

access to trading on its system;

(B) Not unreasonably prohibit or limit

any person in respect to access to

services offered by such alternative

trading system; and

(C) Within 24 hours of prohibiting or

limiting, directly or indirectly, any

person’s access to any services offered

by an alternative trading system, such

alternative trading system shall send

notice to such person stating that such

person has the right to appeal to the

Commission the action taken by such

alternative trading system.

(iii) If any alternative trading system

meeting the standards in paragraph

(b)(5)(i) of this section, directly or

indirectly, prohibits or limits access to

the services offered, any person

aggrieved thereby may file with the

Commission a written motion for a stay

of such prohibition or limitation

pursuant to § 201.401 of this chapter.

(iv) Applications to the Commission

for review of any prohibition or

limitation of access to services offered

by an alternative trading system shall be

made pursuant to § 201.420 of this

chapter.

(v) Every notice filed pursuant to this

paragraph (b)(5) shall constitute a

‘‘report’’ within the meaning of sections

11A, 17(a), 18(a), and 32(a) (15 U.S.C.

78q(a), 78r(a), and 78ff(a)), and any

other applicable provisions, of the Act.

(vi) All reports filed pursuant to this

paragraph (b)(5) shall be deemed

confidential when filed.

(6) Capacity, integrity, and security of

automated systems. (i) The alternative

trading system shall comply with the

requirements in paragraph (b)(6)(ii) of

this section, if during at least 4 of the

preceding 6 calendar months, such

alternative trading system had an

average daily share volume:

(A) With respect any covered security,

greater than 20% of the average daily

share volume reported by the effective

transaction reporting plan or

disseminated through an automated

quotation system as described in section

3(a)(51)(A)(ii) of the Act, (15 U.S.C.

78c(a)(51)(A)(ii));

(B) With respect to equity securities

that are not covered securities and for

which transactions are reported to a

self-regulatory organization, greater than

20% of the average daily share volume

as calculated by the self-regulatory

organization to which such transactions

are reported; or

(C) With respect to category of debt

security, including corporate debt

securities, greater than 20% of the

average daily volume traded in the

United States.

(ii) With respect to those systems that

support order entry, order routing,

execution, transaction reporting, and

trade comparison, the alternative

trading system shall:

(A) Establish reasonable current and

future capacity estimates;

(B) Conduct periodic capacity stress

tests of critical systems to determine

such system’s ability to process

transactions in an accurate, timely, and

efficient manner;

(C) Develop and implement

reasonable procedures to review and

keep current its system development

and testing methodology;

(D) Review vulnerability of its

systems and data center computer

operations to internal and external

threats, physical hazards, and natural

disasters;

(E) Establish adequate contingency

and disaster recovery plans;

(F) On an annual basis, perform an

independent review, in accordance with

established audit procedures and

standards, of such alternative trading

system’s controls for ensuring that

paragraphs (b)(6)(ii)(A) through (E) of

this section are met, and conduct a

review by senior management of a

report containing the recommendations

and conclusions of the independent

review; and

(G) Promptly notify the Commission

staff of material systems outages and

significant systems changes.

(7) Examinations, inspections, and

investigations of subscribers. The

alternative trading system shall permit

the examination and inspection, of its

premises, systems, and records, and

cooperate with the examination,

inspection, or investigation of

subscribers, whether such examination

is being conducted by the Commission

or by a self-regulatory organization of

which such subscriber is a member.

(8) Recordkeeping. The alternative

trading system shall:

(i) Make and keep current the records

specified in § 242.302; and

(ii) Preserve the records specified in

§ 242.303.
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(9) Reporting. The alternative trading

system shall:

(i) File the information described in

Form ATS–R (§ 249.638 of this chapter)

within 30 calendar days after the end of

each calendar quarter in which the

market has operated after the effective

date of this section; and

(ii) File the information described in

Form ATS–R within 10 calendar days

after an alternative trading system

ceases to operate.

(10) Procedures to ensure the

confidential treatment of trading

information. The alternative trading

system shall have in place adequate

safeguards and procedures to protect

subscribers’ confidential trading

information. Such safeguards and

procedures shall include:

(i) Limiting access to the confidential

trading information of subscribers to

those employees of the alternative

trading system who are operating the

system or responsible for its compliance

with these or any other applicable rules;

(ii) Implementing standards

controlling employees of the alternative

trading system trading for their own

accounts; and

(iii) Adopting and implementing

adequate oversight procedures to ensure

that the safeguards and procedures

outlined in paragraphs (b)(6)(ii)(A), (B)

and (C) of this section are followed.

(11) Name. The alternative trading

system shall not use in its name the

word ‘‘exchange,’’ or derivations of the

word ‘‘exchange.’’

§ 242.302 Recordkeeping requirements for

alternative trading systems.

To comply with the condition set

forth in paragraph (b)(8) of § 242.301, an

alternative trading system shall make

and keep current the following records:

(a) A record of subscribers to such

alternative trading system (identifying

any affiliations between the alternative

trading system and subscribers to the

alternative trading system);

(b) Daily summaries of trading in the

alternative trading system including:

(1) Securities for which transactions

have been executed;

(2) Transaction volume, expressed

with respect to equity securities in:

(i) Number of trades;

(ii) Number of shares traded; and

(iii) Total U.S. dollar value; and

(3) Transaction volume, expressed

with respect to debt securities in:

(i) Number of trades; and

(ii) Total U.S. dollar value; and

(c) Time-sequenced records of order

information in the alternative trading

system, including:

(1) Date and time (expressed in terms

of hours, minutes, and seconds) that the

order was received;

(2) Identity of the security;

(3) The number of shares or bonds to

which the order applies;

(4) An identification of the order

related to a program trade or an index

arbitrage trade as defined in New York

Stock Exchange Rule 80A;

(5) The designation of the order as a

buy or sell order;

(6) The designation of the order as a

short sale order;

(7) The designation of the order as a

market order, limit order, stop order,

stop limit order, or other type or order;

(8) Any limit or stop price prescribed

by the order;

(9) The date on which the order

expires and, if the time in force is less

than one day, the time when the order

expires;

(10) The time limit during which the

order is in force;

(11) Any instructions to modify or

cancel the order;

(12) Date and time (expressed in terms

of hours, minutes, and seconds) that the

order was executed;

(13) Price at which the order was

executed;

(14) Size of the order executed

(expressed in number of shares or units

or principal amount);

(15) The type of account, i.e., retail,

wholesale, employee, proprietary, or

any other type of account designated by

the alternative trading system, for which

the order is submitted; and

(16) Identity of the parties to the

transaction.

§ 242.303 Record preservation

requirements for alternative trading

systems.

(a) To comply with the condition set

forth in paragraph (b)(9) of § 242.301, an

alternative trading system shall preserve

the following records:

(1) For a period of not less than three

years, the first two years in an easily

accessible place, an alternative trading

system shall preserve:

(i) All records required to be made

pursuant to § 242.302;

(ii) All notices provided by such

alternative trading system to subscribers

generally, whether written or

communicated through automated

means, including, but not limited to,

notices addressing hours of system

operations, system malfunctions,

changes to system procedures,

maintenance of hardware and software,

instructions pertaining to access to the

market and denials of, or limitations on,

access to the alternative trading system;

(iii) If subject to paragraph (b)(5)(ii) of

§ 242.301, at least one copy of such

alternative trading system’s standards

for access to trading; and

(iv) At least one copy of all

documents made or received by the

alternative trading system in the course

of complying with paragraph (b)(6) of

§ 242.301, including all correspondence,

memoranda, papers, books, notices,

accounts, reports, test scripts, test

results, and other similar records.

(2) During the life of the enterprise

and of any successor enterprise, an

alternative trading system shall

preserve:

(i) All partnership articles or, in the

case of a corporation, all articles of

incorporation or charter, minute books

and stock certificate books; and

(ii) Copies of reports filed pursuant to

paragraphs (b)(2) and (b)(5) of § 242.301.

(b) The records required to be

maintained and preserved pursuant to

paragraph (a) of this section must be

produced, reproduced, and maintained

in paper form or in any of the forms

permitted under § 240.17a–4(f) of this

chapter.

(c) Alternative trading systems must

comply with any other applicable

recordkeeping or reporting requirement

in the Act, and the rules and regulations

thereunder. If the information in a

record required to be made pursuant to

§ 242.303 is preserved in a record made

pursuant to § 240.17a–3 or § 240.17a–4

of this chapter, or otherwise preserved

by the alternative trading system

(whether in summary or some other

form), § 242.303 shall not require the

sponsor to maintain such information in

a separate file, provided that the

sponsor can promptly sort and retrieve

the information as if it had been kept in

a separate file as a record made

pursuant to this section, and preserves

the information in accordance with the

time periods specified in paragraph

(a)(1) of § 242.303.

(d) The records required to be

maintained and preserved pursuant to

§ 242.303 may be prepared or

maintained by a service bureau,

depository, or other recordkeeping

service on behalf of the alternative

trading system. An agreement with a

service bureau, depository, or other

recordkeeping service shall not relieve

the alternative trading system from the

responsibility to prepare and maintain

records as specified in this section. The

service bureau, depository, or other

recordkeeping service shall file with the

Commission a written undertaking in a

form acceptable to the Commission,

signed by a duly authorized person, to

the effect that such records are the

property of the alternative trading

system required to maintain and

preserve such records and will be

surrendered promptly on request of the
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alternative trading system and including

the following provision:

With respect to any books and records

maintained or preserved on behalf of

[name of alternative trading system], the

undersigned hereby undertakes to

permit examination of such books and

records at any time or from time to time

during business hours by

representatives or designees of the

Securities and Exchange Commission,

and to promptly furnish to the

Commission or its designee a true,

correct, complete and current hard copy

of any or all or any part of such books

and records.

(e) Every alternative trading system

shall furnish to any representative of the

Commission promptly upon request,

legible, true, and complete copies of

those records that are required to be

preserved under this section.

PART 249—FORMS, SECURITIES

EXCHANGE ACT OF 1934

24. The authority citation for part 249

continues to read in part as follows:

Authority: 15 U.S.C. 78a, et seq., unless

otherwise noted.

* * * * *

25. Section 249.1 and Form 1 are

revised to read as follows:

§ 249.1 Form 1, for application for, and

amendments to applications for,

registration as a national securities

exchange or exemption from registration

pursuant to Section 5 of the Exchange Act.

The form shall be used for application

for, and amendments to applications for,

registration as a national securities

exchange or exemption from registration

pursuant to section 5 of the Exchange

Act, (15 U.S.C. 78e).

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§ 249.1a and Form 1–A [Removed]

26. Section 249.1a and Form 1-A are removed.

§ 249.636 and Form ATS [Removed and reserved]

27. Section 249.636 and Form 17A–23 are removed and reserved.

28. Section 249.637 and Form ATS are added to read as follows:

§ 249.637 Form ATS, information required of alternative trading systems pursuant to § 242.301(b)(2) of this chapter.

This form shall be used by every alternative trading system to file required notices, reports and amendments under

§ 242.301(b)(2) of this chapter.
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29. Section 249.638 and Form ATS–R are added to read as follows:

§ 249.638 Form ATS–R, information required of alternative trading systems pursuant to § 242.301(b)(8) of this chapter.

This form shall be used by every alternative trading system to file required reports under § 242.301(b)(8) of this

chapter.
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30. Section 249.821 and Form PILOT are added to read as follows:

§ 249.821 Form PILOT, information required of self-regulatory organizations operating pilot trading systems pursuant to § 204.19b–

5 of this chapter.

This form shall be used by all self-regulatory organizations, as defined in Section 3(a)(26) of the Act, (15 U.S.C.

78c(a)(26)), to file required information and reports with regard to pilot trading systems pursuant to § 240.19b–5 of

this chapter.
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By the Commission. Dated: April 21, 1998.

Margaret H. McFarland,

Deptuy Secretary.

[FR Doc. 98–10945 Filed 4–28–98; 8:45 am]

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