[Federal Register Volume 63, Number 82 (Wednesday, April 29, 1998)]
[Proposed Rules]
[Pages 23504-23583]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-10945]



[[Page 23503]]

_______________________________________________________________________

Part II





Securities and Exchange Commission





_______________________________________________________________________



17 CFR Parts 201, 240, 242, and 249



Regulations of Exchanges and Alternative Trading Systems and Proposed 
Amendment to Rule 19b-4; Proposed Rules

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

[[Page 23504]]



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 broker-dealers 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: <a href="/cdn-cgi/l/email-protection#f183849d94dc929e9c9c949f8582b1829492df969e87"><span class="__cf_email__" data-cfemail="0674736a632b65696b6b636872754675636528616970">[email protected]</span></a>. 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

[[Page 23505]]

    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.
---------------------------------------------------------------------------

    \1\ The 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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \2\ Securities Exchange Act Release No. 38672, 62 FR 30485 (May 
23, 1997) (``Concept Release'').
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \3\ Section 36 of the Exchange Act, 15 U.S.C. 78mm, was enacted 
as part of the National Securities Markets Improvement Act of 1996, 
Pub. L. 104-290 (``NSMIA''). See infra Section VI.D.1.
---------------------------------------------------------------------------

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

[[Page 23506]]

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'').
---------------------------------------------------------------------------

    \4\ See 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.
---------------------------------------------------------------------------

    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 broker-dealers, 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\
---------------------------------------------------------------------------

    \5\ The 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.
---------------------------------------------------------------------------

    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 broker-dealer 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.
---------------------------------------------------------------------------

    \6\ See 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.
    \7\ The 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.
---------------------------------------------------------------------------

    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

[[Page 23507]]

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.
---------------------------------------------------------------------------

    \8\ The statutory definition of ``exchange'' appears in section 
3(a)(1) of the Exchange Act, 15 U.S.C. 78c(a)(1).
    \9\ The 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.
    \10\ The 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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \11\ See infra Section III.B.
---------------------------------------------------------------------------

    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 non-discriminatory 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.
---------------------------------------------------------------------------

    \12\ This linkage requirement would not apply to alternative 
trading systems that do not display participant orders to anyone, 
including other system participants. In addition, this requirement 
would not apply to alternative trading systems to the extent that 
they trade securities other than NMS securities. See infra Section 
III.A.2.c.(i).
---------------------------------------------------------------------------

    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 broker-dealers 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 broker-dealer 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\
---------------------------------------------------------------------------

    \13\ 17 CFR 240.17a-23.
    \14\ 17 CFR 240.17a-3.
    \15\ 17 CFR 240.17a-4.
    \16\ See infra Section IV.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \17\ See infra Section V.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \18\ 15 U.S.C. 78c(a)(1).
    \19\ Proposed Rule 3b-12(a).
    \20\ See Delta Release supra note 10. The basis and purpose of 
the revised interpretation is set forth infra Section VI.
---------------------------------------------------------------------------

    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,

[[Page 23508]]

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.
---------------------------------------------------------------------------

    \21\ See infra Section III.B. (discussing registration as a 
national securities exchanges).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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

    \24\ An 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.
    \25\ A crossing system is, typically, one that allows 
participants to enter unpriced orders to buy and sell securities. 
Orders are crossed at specified times at a price derived from 
another market.
    \26\ Matching 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.
    \27\ Currently, debt markets are not centrally organized by a 
single entity, but are nonetheless informally organized around 
interdealer brokers. Interdealer brokers (also called blind brokers 
and brokers' brokers) display, on an anonymous basis, the offers to 
buy and sell securities that are placed with them by subscribers. In 
order to place a bid or offer, a subscriber typically telephones the 
interdealer broker, which enters the order into its system and 
displays it to other subscribers. Some interdealer brokers display 
all bids and offers; others display only the best bid and offer. To 
execute against an offer displayed on the computer screen, a 
subscriber telephones the interdealer broker, although sometimes 
execution may be electronic. The identities of the counterparties 
are, generally, kept confidential through clearance and settlement 
of the trade. Some interdealer brokers, however, reveal the names of 
each counterparty after execution. Traditionally interdealer brokers 
facilitated trading only between dealers. Increasingly, however, 
interdealer brokers are permitting non-dealers to participate in 
their systems.
    \28\ But see infra notes 70 and 71 and accompanying text 
(discussing the exemption for systems that trade exclusively 
government securities).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \29\ This type of system also would be expressly excluded from 
proposed Rule 3b-12 under paragraph (b)(2). See infra Section 
II.C.2.
    \30\ An 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \31\ Proposed Rule 3b-12(c).
---------------------------------------------------------------------------

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 non-discretionary material conditions under which parties 
entering orders agree to

[[Page 23509]]

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 ``non-discretionary 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 non-
discretionary 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 non-discretionary 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\
---------------------------------------------------------------------------

    \32\ See infra Section II.C.3. (discussing the exclusion of 
internal broker-dealer systems from the coverage of proposed Rule 
3b-12).
---------------------------------------------------------------------------

1. Non-Discretionary Material Conditions Established by a Trading 
Facility
    A trading facility that sets non-discretionary 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.
---------------------------------------------------------------------------

    \33\ Whether 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.
    \34\ See Delta Release, supra note 10.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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

    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\
---------------------------------------------------------------------------

    \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.
    \38\ See 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.
---------------------------------------------------------------------------

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

[[Page 23510]]

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.
---------------------------------------------------------------------------

    \40\ A 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.
    \41\ See supra note 9.
---------------------------------------------------------------------------

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'') SuperDOT 
\42\ 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.
---------------------------------------------------------------------------

    \42\ The 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).
    \43\ BRASS is an order routing system operated by Automated 
Securities Clearance, Ltd. (``ASC''). ASC provides system users with 
software and hardware that enables users to enter orders into the 
system which are then routed to an exchange for execution.
    \44\ Proposed Rule 3b-12(b)(1).
---------------------------------------------------------------------------

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 broker-dealer 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\
---------------------------------------------------------------------------

    \45\ Proposed Rule 3b-12(b)(2).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \46\ Proposed Rule 3b-12(b)(3).
---------------------------------------------------------------------------

    While these internal systems automate traditional brokerage 
functions, they still require a broker-dealer to use its discretion to 
handle customer orders. In this situation, a customer that gives its 
order to a broker-dealer 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 
broker-dealer will execute the order as principal or as agent. Although 
a broker-dealer 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 broker-dealer functions and not as a 
means for consolidating the orders of multiple parties.
---------------------------------------------------------------------------

    \47\ For 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.
---------------------------------------------------------------------------

    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.

[[Page 23511]]

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 broker-dealers. 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.
---------------------------------------------------------------------------

    \48\ 15 U.S.C. 78mm.
    \49\ Proposed Rule 3a1-1(b). See infra note 65 for the 
definition of an alternative trading system.
---------------------------------------------------------------------------

    The Commission intends for the exemption provided by proposed Rule 
3a1-1 to make clear that alternative trading systems that register as 
broker-dealers 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.
---------------------------------------------------------------------------

    \50\ Proposed Rule 3a1-1(b).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \51\ Registration 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.
    \52\ Proposed 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.)
    \53\ Any alternative trading system, however, currently operated 
by a national securities association could choose to register as an 
exchange.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \54\ See S. Rep. No. 75, 94th Cong., 1st Sess. 8 (1975) at 2, 8; 
H.R. Rep. No. 229, 94th Cong., 1st Sess 92 (1975).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \55\Pub. L. 94-29, 89 Stat. 97 (1975).
    \56\ See 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.
    \57\ S. Rep. No. 75 supra note 54, at 8-9.
---------------------------------------------------------------------------

    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

[[Page 23512]]

to assure ``fair competition * * * between exchange markets and markets 
other than exchange markets.'' \60\
---------------------------------------------------------------------------

    \58\ S. Rep. No. 75 supra note 54, at 7; see Section 
11A(a)(1)(C) of the Exchange Act, 15 U.S.C. 78k-1(a)(1)(C).
    \59\ See S. Rep. No. 75 supra note 54, at 104-05.
    \60\ Section 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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \61\ See Section 11A(c)(1) of the Exchange Act, 15 U.S.C. 78k-
1(c)(1).
    \62\ S. Rep. No. 75 supra note 54, at 7.
---------------------------------------------------------------------------

    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 broker-dealers. 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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \64\ See supra Section II. (discussing proposed Rule 3b-12).
    \65\ Specifically, 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).
    \66\ Nothing, however, prevents a registered exchange from 
giving up its self-regulatory functions to register as a broker-
dealer.
---------------------------------------------------------------------------

    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 broker-dealer.\69\
---------------------------------------------------------------------------

    \67\ The 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).
---------------------------------------------------------------------------

    In the Concept Release, the Commission solicited comment on whether 
it would be appropriate to exempt government securities broker-dealers 
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

[[Page 23513]]

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.
---------------------------------------------------------------------------

    \70\ See 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 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.
    \71\ Although 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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \72\ Section 15(b)(8) of the Exchange Act, 15 U.S.C. 78o(b)(8).
    \73\ For 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.
    \74\ See infra note 84.
    \75\ Section 15A of the Exchange Act, 15 U.S.C. 78o-3.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \76\ Proposed Rule 301(b)(8).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \77\ Proposed Rule 301(b)(2)(i) and Proposed Form ATS.
    \78\ 17 CFR 240.17a-23. See infra Section IV.A.
---------------------------------------------------------------------------

    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

[[Page 23514]]

alternative trading system ceases operations, it would be required to 
promptly file a notice with the Commission.\81\
---------------------------------------------------------------------------

    \79\ Proposed Rule 301(b)(2)(ii).
    \80\ Proposed 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).
    \81\ Proposed Rule 301(b)(2)(v).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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

    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 so-called ``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\
---------------------------------------------------------------------------

    \83\ See Securities Exchange Act Release No. 36310 (Sept. 29, 
1995), 60 FR 52792 (Oct. 10, 1995) (``Order Handling Rules Proposing 
Release'').
---------------------------------------------------------------------------

    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 non-public 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\
---------------------------------------------------------------------------

    \84\ Following 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'').
    \85\ These 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.
    \86\ The Commission found that ``the ability of market makers to 
attract trading interest through Instinet allowed them to trade 
without using odd-eighth quotes and narrowing the Nasdaq spread.'' 
NASD 21(a) Report, supra note 84, at 20.
    \87\ NASD 21(a) Report, supra note 84, at 18.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \88\ ECNs 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'').
    \89\ To 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).
---------------------------------------------------------------------------

    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 
non-market maker orders, remain undisclosed to the public.\92\ 
Moreover,

[[Page 23515]]

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.
---------------------------------------------------------------------------

    \90\ See Order Handling Rules Adopting Release, supra note 88, 
at 87-96.
    \91\ There 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.
    \92\ Because such trading interest frequently remains 
undisclosed, within certain alternative 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.
---------------------------------------------------------------------------

    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\

    \93\ See 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).

    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 non-market 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?
---------------------------------------------------------------------------

    \94\ A 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.
    \95\ Proposed 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.
---------------------------------------------------------------------------

    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 non-market 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

[[Page 23516]]

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 non-market makers in the 
public quote system.\98\
---------------------------------------------------------------------------

    \96\ See 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 (broker-dealers 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).
    \97\ NYSE 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).
    \98\ Letter 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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \99\ See 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 pre-
trade 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).
    \100\ ABA 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).
    \101\ ABA Letter at 24.
---------------------------------------------------------------------------

    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

[[Page 23517]]

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 
non-participants 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\
---------------------------------------------------------------------------

    \102\ Specialist 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.
    \103\ SIA 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).
    \104\ NYSE 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).
    \105\ Rule 11Ac1-1 under the Exchange Act, 17 CFR 240.11Ac1-1 
(``Quote Rule''). See also Order Handling Rules Adopting Release, 
supra note 88.
---------------------------------------------------------------------------

    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 non-participants 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.
---------------------------------------------------------------------------

    \106\ Securities 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.
---------------------------------------------------------------------------

    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

[[Page 23518]]

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 non-subscriber access to institutions 
that are not broker-dealers?
---------------------------------------------------------------------------

    \107\ Bloomberg 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).
---------------------------------------------------------------------------

(iii) Execution Access Fees
    The Commission agrees with those commenters that suggested that fee 
schedules should not be used to circumvent the ability of non-
participants 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.
---------------------------------------------------------------------------

    \108\ See 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).
    \109\ See 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.
---------------------------------------------------------------------------

    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 broker-dealers 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 non-subscribers 
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 non-participants than would be allowed under the proposed rule. 
The Commission also requests comment on whether there are alternatives 
for assuring fair execution access for non-subscribers 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.
---------------------------------------------------------------------------

    \110\ See, 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).
---------------------------------------------------------------------------

(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.
---------------------------------------------------------------------------

    \111\ Proposed Amended Rule 11Ac1-1(c)(5)(ii) (A) and (B).
    \112\ See supra notes 88-92 and accompanying text.
---------------------------------------------------------------------------

    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,

[[Page 23519]]

unfairly discriminatory actions hurt investors lacking access to the 
system.
---------------------------------------------------------------------------

    \113\ Sections 6(b)(2) and 6(c) of the Exchange Act, 15 U.S.C. 
78f(b)(2) and (c); section 15A(b)(8) of the Exchange Act, 15 U.S.C. 
78o-3(b)(8).
    \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).
---------------------------------------------------------------------------

    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 broker-dealers and that have a significant percentage of 
overall trading volume in a particular security to comply with fair 
access standards, as described in more detail below.\116\
---------------------------------------------------------------------------

    \115\ See supra Section III.A.2.c.(ii).
    \116\ Proposed Rule 301(b)(5).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \117\ See NASD Letter at 7-8; ICI Letter at 3.
    \118\ The Commission understands that the NASD is currently 
reviewing a complaint against an alternative trading system for an 
unreasonable denial of access.
    \119\ See 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).
---------------------------------------------------------------------------

    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-by-security 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?
---------------------------------------------------------------------------

    \120\ Proposed Rule 301(b)(5)(i).
    \121\ Section 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.
---------------------------------------------------------------------------

    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 asset-backed 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\
---------------------------------------------------------------------------

    \122\ Propose 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.
    \123\ Proposed Rule 301(b)(5)(ii).
---------------------------------------------------------------------------

    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

[[Page 23520]]

respect to the appeals process apply to allegations of unfair denials 
of access by alternative trading systems.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \130\ For 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \131\ Securities 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.
    \132\ ARP II, supra note 131, set forth guidance concerning the 
nature of these independent reviews.
---------------------------------------------------------------------------

    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 broker-dealers 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.
---------------------------------------------------------------------------

    \133\ ARP I, supra note 131, 54 FR at 48705; ARP II, supra note 
131, 56 FR at 22490.
    \134\ See ARP I, supra note 131, 54 FR at 48706 n. 17; ARP II, 
supra note 131, 56 FR at 22493 n.15.
    \135\ Proposed Rule 301(b)(6).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

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

    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 asset-backed 
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

[[Page 23521]]

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.
---------------------------------------------------------------------------

    \137\ Proposed Rule 301(b)(6)(ii)(A)-(F)
    \138\ Proposed Rule 301(b)(6)(ii)(G).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \139\ Proposed 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).
    \140\ See ARP II, supra note 131.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \141\ See 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).
    \142\ See 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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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,<SUP>144</SUP> 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.
---------------------------------------------------------------------------

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

    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? <SUP>145</SUP>
---------------------------------------------------------------------------

    \145\ See supra note 121.
---------------------------------------------------------------------------

    f. Examination, inspection, and investigations of subscribers. 
Under the proposed rules, an alternative trading

[[Page 23522]]

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.<SUP>146</SUP> 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,<SUP>147</SUP> 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-
broker-dealer 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.
---------------------------------------------------------------------------

    \146\ Proposed Rule 301(b)(7).
    \147\ The 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.
---------------------------------------------------------------------------

    g. Recordkeeping. Proposed Regulation ATS would require alternative 
trading systems to make and keep the records necessary to create a 
meaningful audit trail.<SUP>148</SUP> Specifically, the Commission 
proposes that alternative trading systems maintain daily summaries of 
trading and time-sequenced 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.<SUP>149</SUP> 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''),<SUP>150</SUP> OATS is an NASD rule and does not cover all 
securities traded through alternative trading systems.
---------------------------------------------------------------------------

    \148\ Proposed Rule 301(b)(8).
    \149\ Proposed Rule 302.
    \150\ Securities Exchange Act Release No. 39729 (March 6, 1998), 
63 FR 12559 (March 13, 1998).
---------------------------------------------------------------------------

    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.<SUP>151</SUP>
---------------------------------------------------------------------------

    \151\ See supra notes 122-123 and accompanying text.
---------------------------------------------------------------------------

    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.<SUP>152</SUP> 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.<SUP>153</SUP>
---------------------------------------------------------------------------

    \152\ Proposed Rule 303.
    \153\ Proposed 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).
---------------------------------------------------------------------------

    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,<SUP>154</SUP> 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,<SUP>155</SUP> 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.<SUP>156</SUP>
---------------------------------------------------------------------------

    \154\ 17 CFR 240.17a-3 and 17 CFR 240.17a-4.
    \155\ 17 CFR 240.17a-4(i).
    \156\ Proposed Rule 303(d).
---------------------------------------------------------------------------

    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.<SUP>157</SUP> 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,<SUP>158</SUP> (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.
---------------------------------------------------------------------------

    \157\ Proposed 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.
---------------------------------------------------------------------------

    Because this release proposes to eliminate Rule 17a-
23,<SUP>159</SUP> data filed by

[[Page 23523]]

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.
---------------------------------------------------------------------------

    \159\ See infra Section IV.A. Rule 17a-23 under the Exchange Act 
generally requires U.S. broker-dealers 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).
---------------------------------------------------------------------------

    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.<SUP>160</SUP> 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.
---------------------------------------------------------------------------

    \160\ Proposed Rule 301(b)(2)(vii).
---------------------------------------------------------------------------

    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 broker-dealer 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.<SUP>161</SUP>
---------------------------------------------------------------------------

    \161\ Proposed Rule 301(b)(10).
---------------------------------------------------------------------------

    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

[[Page 23524]]

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.
---------------------------------------------------------------------------

    \162\ Alternative 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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \163\ Options 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.
---------------------------------------------------------------------------

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 self-regulatory 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.
---------------------------------------------------------------------------

    \164\ Section 6(b) of the Exchange Act, 15 U.S.C. 78f(b).
    \165\ Section 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).
---------------------------------------------------------------------------

    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

[[Page 23525]]

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.
---------------------------------------------------------------------------

    \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).
    \167\ For 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 options-related 
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 options-related 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \168\ For 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.
    \169\ With 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).
    \170\ See 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \171\ See 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).
---------------------------------------------------------------------------

    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

[[Page 23526]]

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.
---------------------------------------------------------------------------

    \173\ See 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).
    \174\ The 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.
    \175\ The 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).
---------------------------------------------------------------------------

    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 broker-dealers. 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.
---------------------------------------------------------------------------

    \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 non-broker-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 broker-
dealers with the Commission or an exemption therefrom) and rules 
thereunder that regulate or prohibit any practice by a broker-
dealer.
    \178\ For 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.
---------------------------------------------------------------------------

    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 broker-dealers, the Commission proposes that 
alternative trading systems that choose to register as exchanges be 
prohibited from including non-broker-dealer participants.
---------------------------------------------------------------------------

    \179\ Section 6(c)(1) of the Exchange Act, 15 U.S.C. 78f(c)(1).
---------------------------------------------------------------------------

    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 ad-hoc 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.
---------------------------------------------------------------------------

    \180\ See Concept Release, supra note 2.
    \181\ 15 U.S.C. 78f(f) and 78o(e).
---------------------------------------------------------------------------

    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-broker-dealer 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-broker-dealer 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.
---------------------------------------------------------------------------

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

    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

[[Page 23527]]

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.
---------------------------------------------------------------------------

    \183\ 15 U.S.C. 78f(c)(1).
    \184\ Exchange members are subject to regulatory action by the 
NYSE for violations of NYSE rules by their customers entering orders 
through the members' SuperDOT terminals.
    \185\ See infra note 255.
    \186\ See supra note 106 and accompanying text.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \187\ 15 U.S.C. 78f(b)(2).
    \188\ 15 U.S.C. 78f(c).
    \189\ Section 15A(b)(8) of the Exchange Act applies similar 
obligations to registered national securities associations. 15 
U.S.C. 78o-3(b)(8).
    \190\ A 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.
---------------------------------------------------------------------------

    In a similar vein, exchanges are prohibited from adopting any anti-
competitive 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.
---------------------------------------------------------------------------

    \191\ Section 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).
    \192\ Section 6(b)(6) of the Exchange Act, 15 U.S.C. 78f(b)(6).
    \193\ Section 23(a) of the Exchange Act, 15 U.S.C. 78w(a).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \194\ See supra notes 131-134 and accompanying text.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \195\ Section 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).
    \196\ Section 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.
    \197\ Rule 12f-5 under the Exchange Act, 17 CFR 240.12f-5.
    \198\ See OTC-UTP plan, infra note 210 and accompanying text.
---------------------------------------------------------------------------

    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

[[Page 23528]]

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\
---------------------------------------------------------------------------

    \199\ 17 CFR 242.100.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \200\ The 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.
    \201\ The 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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \202\ The 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).
    \203\ See infra note 210 and accompanying text for a description 
of the OPRA plan.
    \204\ See infra note 210 and accompanying text for a description 
of the OTC-UTP plan.
---------------------------------------------------------------------------

    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 exchange-
listed 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.
---------------------------------------------------------------------------

    \205\ See 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).
    \206\ Both the CTA and the CQS are presently operated by the 
eight national securities exchanges and the NASD.
    \207\ The 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.
    \208\ See Securities Exchange Act Release No. 37191 (May 9, 
1996), 61 FR 24842 (May 16, 1996).
    \209\ These 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).
    \210\ Similar 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 start-up 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'').
---------------------------------------------------------------------------

    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 
(``trade-throughs'').\213\ Participation in the ITS

[[Page 23529]]

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, trade-throughs, 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.
---------------------------------------------------------------------------

    \211\ To 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.
    \213\ A 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 20\1/8\ for an ITS 
security, the prohibition on trade-throughs would prohibit another 
ITS participant market from buying that security from a customer at 
19\7/8\ or selling that security to a customer at 20\1/2\. In 
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.
    \214\ A 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.
    \215\ The 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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \216\ The 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).
    \217\ For 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.
    \218\ The 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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \221\ 17 CFR 240.6a-1, 240.6a-2, and 240.6a-3.
    \222\ 17 CFR 249.1; 17 CFR 249.1a.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \223\ New 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.
---------------------------------------------------------------------------

    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.

[[Page 23530]]

(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\
---------------------------------------------------------------------------

    \224\ Rule 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.
    \225\ Section 5 of the Exchange Act, 15 U.S.C. 78e.
    \226\ Proposed Rule 6a-1(a).
---------------------------------------------------------------------------

    (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\
---------------------------------------------------------------------------

    \227\ Rule 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.
    \228\ Section 19(b) of the Exchange Act, 15 U.S.C. 78s(b).
    \229\ Proposed Amended Rule 6a-2(a).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \230\ Rules 6a-2(a) under the Exchange Act, 17 CFR 240.6A-2(a)
    \231\ Rule 6a-2(a)(1) under the Exchange Act, 17 CFR 240.6a-
2(a)(1).
    \232\ Rule 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.
    \233\ Rule 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.
    \234\ Rule 6a-2(a)(3) under the Exchange Act, 17 CFR 240.6a-
2(a)(3); Form 1, Exhibit J, 17 CFR 249.1.
    \235\ Rule 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.
    \236\ Amended Rule 6a-2(c) under the Exchange Act.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \237\ Amended 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).
    \238\ Proposed Amended Rule 6a-2(d)(3) under the Exchange Act.
---------------------------------------------------------------------------

(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\
---------------------------------------------------------------------------

    \239\ 17 CFR 240.6a-3.
    \240\ Proposed Amended Rule 6a-3(a) under the Exchange Act.
---------------------------------------------------------------------------

    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

[[Page 23531]]

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.
---------------------------------------------------------------------------

    \241\17 CFR 240.6a-3(c). 
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \242\ 17 CFR 240.17a-23.
---------------------------------------------------------------------------

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 broker-dealers to make and keep records 
regarding the activities of internal broker-dealer systems for non-
alternative 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.
---------------------------------------------------------------------------

    \243\ The 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.
---------------------------------------------------------------------------

    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 broker-
dealer system, and transaction volume information.\245\
---------------------------------------------------------------------------

    \245\ Proposed Rules 17a-3(16)(i)(B) and (C) under the Exchange 
Act.
---------------------------------------------------------------------------

    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 broker-dealer system,'' \246\ ``sponsor,'' \247\ and 
``system order.'' \248\
---------------------------------------------------------------------------

    \246\ See supra note 243.
    \247\ The 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).
    \248\ The 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 broker-dealer system.'' 
Proposed Rule 17a-3(16)(ii)(C).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \249\ Proposed Rules 17a-4(b)(1) and (10) under the Exchange 
Act.
---------------------------------------------------------------------------

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'

[[Page 23532]]

attempts to operate new pilot trading systems for their members.\255\
---------------------------------------------------------------------------

    \250\ See Concept Release, supra note 2, 62 FR at 30518-19.
    \251\ The 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.
    \252\ See CSE Letter at 3; SIA Letter (10/3/97) at 9; OptiMark 
Letter at 8.
    \253\ 15 U.S.C. 78s(b).
    \254\ Today, 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.
    \255\ For example, in November 1990, the NYSE submitted a rule 
filing proposing an after-hours crossing system to automate the 
execution of single stock orders and baskets of securities and 
received Commission approval in May 1991. See Securities Act Release 
Nos. 29237 (May 24, 1991), 56 FR 24853 (May 31, 1991); 32368 (May 
25, 1993), 58 FR 31565 (June 3, 1993). In August 1993, the CHX 
submitted a rule filing to operate the Chicago Match system, an 
electronic matching system that crossed orders entered by the CHX's 
members and non-members including institutional customers, and 
obtained Commission approval in November 1994. See Securities 
Exchange Act Release No. 35030 (Nov. 30, 1994), 59 FR 63141 (Dec. 7, 
1994). More recently, in May 1997, the PCX submitted a rule filing 
for approval of the OptiMark System and received Commission approval 
in September 1997. See Securities Exchange Act Release No. 39086 
(Sept. 17, 1997), 62 FR 50036 (Sept. 24, 1997).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \256\ Section 19(b)(1) of the Exchange Act, 15 U.S.C. 78s(b)(1), 
requires an SRO to file with the Commission any proposed rule or any 
proposed rule change (``proposed rule change'') accompanied by a 
concise general statement of the basis and purpose of the proposal. 
Once a proposed rule change has been filed, the Commission is 
required to publish notice of it and provide an opportunity for 
public comment. The proposed rule change may not take effect unless 
it is approved by the Commission or is otherwise permitted to become 
effective under section 19(b) of the Exchange Act. Section 19(b)(2) 
of the Exchange Act, 15 U.S.C. 78s(b)(2), sets forth the standards 
and time periods for Commission action either to approve a proposed 
rule change or to institute and conclude a proceeding to determine 
whether a proposed rule change should be disapproved. The Commission 
may also approve a proposed rule change on an accelerated basis if 
the Commission finds good cause for so doing and publishes its 
reasons for so finding. Section 19(b)(2)(B) of the Exchange Act, 15 
U.S.C. 78s(b)(2)(B).
    \257\ See Proposed Rule 19b-5(a) for the proposed definition of 
``pilot trading system.''
    \258\ A 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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \259\ Several 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.
    \260\ See 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.
    \261\ Amex Letter at 5.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \262\ Proposed Rule 19b-5(a)(2).
    \263\ Proposed Rule 19b-5(a)(1).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \264\ Proposed Rule 19b-5(b).

---------------------------------------------------------------------------

[[Page 23533]]

    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.
---------------------------------------------------------------------------

    \265\ Proposed Rule 19b-5(a)(3). See also infra Section V.C.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \266\ Although 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.
    \267\ Proposed Rule 19b-5(f).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \268\ Proposed Rule 19b-5(c)(10).
---------------------------------------------------------------------------

    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

[[Page 23534]]

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.
---------------------------------------------------------------------------

    \269\ The Commission believes that a comprehensive ISA requires 
that the parties provide to each other, upon request, information 
about market trading, clearing activity, and the identity of the 
ultimate purchasers and sellers of securities. See Securities 
Exchange Act Release No. 31529 (Nov. 27, 1992), 57 FR 57248 (Dec. 3, 
1992). Similarly, an SRO that operates a pilot trading system that 
trades securities, or derivatives of securities that are listed or 
traded on a foreign market, should have a comprehensive ISA with 
such foreign markets. In addition, the SRO should ensure there are 
no blocking or secrecy laws in the foreign country that would 
prevent or interfere with the transfer of information under the 
comprehensive ISA. If securing a comprehensive ISA is not possible, 
the SRO should contact the Commission. In such instances, the 
Commission may determine that it is appropriate instead to rely on a 
Memorandum of Understanding (``MOU'') between the Commission and the 
foreign regulator. Generally, the Commission has permitted an SRO to 
rely on an MOU in the absence of a comprehensive ISA only if the SRO 
receives an assurance from the Commission that such an MOU can be 
relied on for surveillance purposes and includes, at a minimum, the 
transaction, clearing, and customer information necessary to conduct 
an investigation. See Securities Exchange Act Release No. 35184 
(Dec. 30, 1994), 60 FR 2616 (Jan. 10, 1995). In addition, an SRO 
should endeavor to develop comprehensive ISAs with foreign exchanges 
even if the SRO receives prior Commission approval to rely on an MOU 
in place of a comprehensive ISA.
    \270\ See 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \271\ Securities 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.
    \272\ Proposed Rule 19b-5(c)(6).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \273\ Proposed Rule 19b-5(c)(8).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \274\ Proposed Rule 19b-5(c)(9).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \275\ Proposed Rule 19b-5(e).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \276\ See supra notes 271-272 and accompanying text.
    \277\ See Section 6(b)(2) of the Exchange Act. See also Order 
Handling Rules Adopting Release, supra note 88.

---------------------------------------------------------------------------

[[Page 23535]]

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:
---------------------------------------------------------------------------

    \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 over-the-counter market.'')

    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\
---------------------------------------------------------------------------

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

    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\
---------------------------------------------------------------------------

    \280\ Delta Release, supra note 10.
    \281\ See 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.
    \282\ For a list of no-action letters issued to system sponsors 
until the end of 1993 and a short history of the Commission's 
oversight of such systems, see Securities Exchange Act Release No. 
33605, 59 FR 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).
    \283\ See Delta Release, supra note 10, at 1899.
---------------------------------------------------------------------------

    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 ill-suited, 
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:

    \284\ Id. at 1899. As discussed below, the Commission's new 
general exemptive authority has increased the Commission's 
flexibility in this regard.
    \285\ See Delta Release, supra note 10, at 1900.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \286\ Delta Release, supra note 10, at 1895 (quoting Delta I, 
supra note 281, at 535).

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    While the Delta interpretation provided an appropriate 
interpretation at the time, its emphasis on the ``expectation'' of 
regular execution of

[[Page 23536]]

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\
---------------------------------------------------------------------------

    \288\ See Securities Exchange Act Release No. 28899 (Feb. 20, 
1991), 56 FR 8377 (Feb. 28, 1991).
    \289\ See 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).
    \290\ See Concept Release, supra note 2, at Section II.B.2.
    \291\ For example, the evidence in the Commission's report on 
the NASD and the Nasdaq market pursuant to section 21(a) of the 
Exchange Act suggests that widespread use of Instinet by market 
makers as a private market has had a significant impact on public 
investors and the operation of the Nasdaq market. See NASD 21(a) 
Report, supra note 84.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \292\ See Division of Market Regulation, Market 2000: An 
Examination of Current Equity Market Developments app IV (1994) 
(``Market 2000 Study'').
    \293\ For purposes of this release, the term ``order'' generally 
means any firm trading interest, including both limit orders and 
market maker quotations.
---------------------------------------------------------------------------

    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 non-discretionary rules or procedures. As discussed above, an 
essential indication of the non-discretionary status of rules and 
procedures is that those rules and procedures are communicated to the 
system's users. Thus, participants have an expectation regarding the 
manner of execution--that is, if an order is entered, it will be 
executed in accordance with those procedures and not at the discretion 
of a counterparty or intermediary.\295\
---------------------------------------------------------------------------

    \294\ The 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).
    \295\ The elements of the interpretation are discussed in 
greater detail in Sections II.A. and II.B., supra.
---------------------------------------------------------------------------

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\

[[Page 23537]]

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

    \296\ For example, at the time of the Delta Release, the 
Commission sought to avoid interpreting the term ``exchange'' in a 
way that could unintentionally and inappropriately subject many 
broker-dealers to exchange regulation. One key factor in the 
Commission's decision not to regulate the Delta system as an 
exchange was the concern that doing so would subject traditional 
broker-dealer activities to exchange regulation. Delta Release, 
supra note 10.
    \297\ Pub. L. 104-290, 110 Stat. 3416 (1996). 15 U.S.C. 78mm.
    \298\ Throughout the past 60 years, the Commission has attempted 
to accommodate market innovations within the existing statutory 
framework to the extent possible in light of investor protection 
concerns, without imposing regulation that would stifle or threaten 
the commercial viability of such innovations. For example, at 
various times, the Commission considered the implications of 
evolving market conditions on exchange regulation. See Securities 
Exchange Act Release Nos. 8661 (Aug. 4, 1969), 34 FR 12952 
(initially proposing Rule 15c2-10); 11673 (Sept. 23, 1975), 40 FR 
45422 (withdrawing then-proposed Rule 15c2-10 and providing for 
registration of securities information processors); 26708 (Apr. 13, 
1989), 54 FR 15429 (reproposing Rule 15c2-10); 33621 (Feb. 14, 
1994), 59 FR 8379 (withdrawing proposed Rule 15c2-10).

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\
---------------------------------------------------------------------------

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

    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\
---------------------------------------------------------------------------

    \300\ Prior to the addition of section 36 to the Exchange Act, 
the Commission could only exempt an exchange from the registration 
provisions of sections 5 and 6 on the basis of an exchange's limited 
volume of transactions. See section 5 of the Exchange Act, 15 U.S.C. 
78e.
    \301\ See S. Rep. No. 104-293, 104th Cong. 2d Sess. 15 (1996).
    \302\ Proposed 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.
    \303\ See supra Section II.D.
---------------------------------------------------------------------------

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

    \304\ See supra Section III.A.
    \305\ See supra Section III.B.3.
---------------------------------------------------------------------------

    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 broker-dealers 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\
---------------------------------------------------------------------------

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

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.
---------------------------------------------------------------------------

    \307\ See Concept Release, supra note 2, at Section IV.B.
---------------------------------------------------------------------------

    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 non-traditional 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

[[Page 23538]]

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:
---------------------------------------------------------------------------

    \308\ 15 U.S.C. 78k-1.

    (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\
---------------------------------------------------------------------------

    \309\ Section 3(a)(22)(A) of the Exchange Act, 15 U.S.C. 
78c(a)(22)(A).

    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.
---------------------------------------------------------------------------

    \310\ The 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.

---------------------------------------------------------------------------

[[Page 23539]]

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 broker-dealers. 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 broker-
dealer'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.
---------------------------------------------------------------------------

    \311\ See e.g. At Deadline: New Age Bandits, Traders Magazine, 
February, 1997, at 6.
---------------------------------------------------------------------------

    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 so-called ``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 broker-dealers 
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.
---------------------------------------------------------------------------

    \312\ See Market Quality Monitoring: Overview of 1997 Market 
Changes, NASD Economic Research, at 2.
---------------------------------------------------------------------------

    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

[[Page 23540]]

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 broker-
dealers and comply with Regulation ATS, there would be approximately 43 
alternative trading systems operating each year.
---------------------------------------------------------------------------

    \313\ This estimate is based on filings made with the Commission 
under Rule 17a-23.
    \314\ Based 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.
---------------------------------------------------------------------------

    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

[[Page 23541]]

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 broker-dealers 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\
---------------------------------------------------------------------------

    \315\ This estimate for burden hours of filing Form ATS is based 
on burdens associated with filing 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.
    \316\ The 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).
    \317\ This estimated cost of $43,817 is derived from 43 
alternative trading systems filing at a cost of $1,019 each.
    \318\ This estimated cost of $3,057 is derived from 3 new 
alternative trading systems filing at a cost of $1,019 each.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \319\ This estimate is based on the Commission's experience with 
collection of similar information under Rule 17a-23.
    \320\ The 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).
    \321\ This estimated cost of $28,767 is composed of $111.50 cost 
per amendment for 43 alternative trading systems filing 6 times per 
year.
---------------------------------------------------------------------------

    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 broker-dealers 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\
---------------------------------------------------------------------------

    \322\ The 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).
    \323\ The 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.
    \324\ This estimated cost of $38,356 is derived from 43 
alternative trading systems with an estimated annual filing cost for 
each of $892.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \325\ The 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).
    \326\ The 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \327\ Proposed Rules 301(b)(8), 302, and 303(a)(1).
    \328\ The 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 broker-
dealer 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.
    \329\ This estimated cost of $82,697.60 is derived from 43 
alternative trading systems incurring an annual cost of $1,923.20 
each.
---------------------------------------------------------------------------

    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

[[Page 23542]]

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\
---------------------------------------------------------------------------

    \330\ The 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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \331\ The 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.
    \332\ The 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).
---------------------------------------------------------------------------

    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

[[Page 23543]]

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.
---------------------------------------------------------------------------

    \333\ The 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.
    \334\ The 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.
    \335\ The 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).
    \336\ The 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).
---------------------------------------------------------------------------

    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 6a-2 \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\
---------------------------------------------------------------------------

    \337\ Rule 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).
    \338\ As 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 
6a-2 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).
    \339\ Rule 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.
    \340\ See 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.
    \341\ The 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.
---------------------------------------------------------------------------

    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

[[Page 23544]]

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.
---------------------------------------------------------------------------

    \342\ CTA 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.
    \343\ Plan 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.
    \345\ The 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).
---------------------------------------------------------------------------

    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 broker-dealer 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 exchange-registered alternative trading 
systems would share the responsibilities of self-regulation, 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\
---------------------------------------------------------------------------

    \346\ See supra  Section III.B.1.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \347\ 17 CFR 240.6a-1; 17 CFR 240.6a-2; 17 CFR 240.6a-3.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \348\ These 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.
    \349\ The estimated average annual benefit for each respondent 
of $75 is composed of the savings of 5 hours of clerical work at $15 
per hour.
---------------------------------------------------------------------------

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

[[Page 23545]]

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.
---------------------------------------------------------------------------

    \350\ The estimated average additional cost per response of $30 
is derived from 2 additional hours of clerical work at $15 per hour.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \351\ 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 estimated average annual cost of $237.50 
is derived from 25 annual filings at a cost of $9.50 per filing.
---------------------------------------------------------------------------

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).
---------------------------------------------------------------------------

    \352\ 17 CFR 240.17a-3; 17 CFR 240.17a-4.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \353\ The 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 broker-dealers 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.
    \354\ The 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.
    \355\ The costs and benefits associated with these recordkeeping 
requirements are discussed in Section IX.A.2.a. supra.
---------------------------------------------------------------------------

2. Costs
    No additional recordkeeping burdens would be imposed on internal 
broker-dealer 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

[[Page 23546]]

17a-4(b)(10) and an annual cost of $1,442.40.\356\
---------------------------------------------------------------------------

    \356\ The 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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \357\ See also supra note 340.
---------------------------------------------------------------------------

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 broker-dealers.\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.
---------------------------------------------------------------------------

    \358\ The 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).
    \359\ The 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.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \360\ This 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.
    \361\ The estimates for burden hours involved with filing Form 
PILOT are based on the Commission's experience with similar 
reporting requirements under Rule 17a-23.
    \362\ This estimate is based on the Commission's experience with 
collection of similar information under Rule 17a-23.
    \363\ The estimated average cost of $1,242 to file an initial 
Form PILOT is composed of $800 for in-house 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).
    \364\ The 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.
    \365\ The 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.
---------------------------------------------------------------------------

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 
broker-dealers 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 broker-dealers 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

[[Page 23547]]

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.
---------------------------------------------------------------------------

    \366\ 15 U.S.C. 78w(a)(2).
    \367\ 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \368\ 5 U.S.C. 603.
---------------------------------------------------------------------------

    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 broker-dealers 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.
---------------------------------------------------------------------------

    \369\ Small 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).
---------------------------------------------------------------------------

    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

[[Page 23548]]

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

[[Page 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 broker-dealers 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

[[Page 23550]]

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 one-time 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

[[Page 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 broker-
dealers 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.

[[Page 23552]]

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 Sec. 201.101 is revised to read as follows:


Sec. 201.101  Definitions.

    (a) * * *
    (9) Proceeding means any agency process initiated by an order 
instituting proceedings; or by the filing, pursuant to Sec. 201.410, of 
a petition for review of an initial decision by a hearing officer; or 
by the filing, pursuant to Sec. 201.420, of an application for review 
of a self-regulatory organization or an alternative trading system 
determination; or by the filing pursuant to Sec. 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 Sec. 201.202 is 
revised to read as follows:


Sec. 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 Secs. 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 Sec. 201.210 is revised to read as follows:


Sec. 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 Secs. 201.420 and 201.421.
* * * * *
    5. Paragraph (d)(1) of Sec. 201.401 is revised to read as follows:


Sec. 201.401  Issuance of stays.

* * * * *
    (d) * * * (1) Availability. A motion for a stay of an action by a 
self-regulatory 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 Sec. 201.420, may be made by any person aggrieved thereby.
* * * * *
    6. Section 201.420 is revised to read as follows:


Sec. 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 self-regulatory 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 self-regulatory 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 Sec. 201.421 are 
revised to read as follows:


Sec. 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 Sec. 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 Sec. 242.301 of this 
chapter (Regulation ATS).
* * * * *
    8. Paragraph (a)(2)(ii) of Sec. 201.450 is revised to read as 
follows:


Sec. 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 Sec. 201.420(d);
* * * * *
    9. Paragraph (a)(2)(i) of Sec. 201.460 is revised to read as 
follows:


Sec. 201.460  Record before the Commission.

* * * * *
    (a) * * *
    (2) * * *
    (i) The record certified pursuant to Sec. 201.420(d) by the self-
regulatory

[[Page 23553]]

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:


Sec. 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 
Sec. 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:


Sec. 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:


Sec. 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 (Sec. 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:


Sec. 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

[[Page 23554]]

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:


Sec. 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:


Sec. 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 Sec. 242.301(b)(3) of this chapter; and
    (2) Otherwise is in compliance with Regulation ATS, Sec. 242.300 
through 242.303.
* * * * *
    17. Section 240.17a-3 is amended by adding paragraph (a)(16) to 
read as follows:


Sec. 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, Secs. 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

[[Page 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:


Sec. 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 Sec. 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 Sec. 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.
* * * * *


Sec. 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:


Sec. 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 self-regulatory 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 
self-regulatory 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 self-regulatory 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

[[Page 23556]]

the self-regulatory organization's pilot trading system.
    (6) Types of securities. The self-regulatory 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 self-regulatory 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 Sec. 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, Secs. 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.


Sec. 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 
Sec. 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.

[[Page 23557]]

    (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 Sec. 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 
Sec. 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 Sec. 240.11Aa3-1(a)(3) of this chapter.
    (i) Exchange market maker shall have the meaning provided in 
Sec. 240.11Ac1-1(a)(9) of this chapter.
    (j) OTC market maker shall have the meaning provided in 
Sec. 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.


Sec. 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, Sec. 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 self-regulatory 
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

[[Page 23558]]

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 
Sec. 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 broker-dealer 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 self-regulatory 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 Sec. 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 Sec. 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 Sec. 242.302; 
and
    (ii) Preserve the records specified in Sec. 242.303.

[[Page 23559]]

    (9) Reporting. The alternative trading system shall:
    (i) File the information described in Form ATS-R (Sec. 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.''


Sec. 242.302  Recordkeeping requirements for alternative trading 
systems.

    To comply with the condition set forth in paragraph (b)(8) of 
Sec. 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.


Sec. 242.303  Record preservation requirements for alternative trading 
systems.

    (a) To comply with the condition set forth in paragraph (b)(9) of 
Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 
Sec. 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 Sec. 242.303 is preserved in a record 
made pursuant to Sec. 240.17a-3 or Sec. 240.17a-4 of this chapter, or 
otherwise preserved by the alternative trading system (whether in 
summary or some other form), Sec. 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 Sec. 242.303.
    (d) The records required to be maintained and preserved pursuant to 
Sec. 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

[[Page 23560]]

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:


Sec. 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).

BILLING CODE 8010-01-P
[GRAPHIC] [TIFF OMITTED] TP29AP98.000


[[Page 23561]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.001



[[Page 23562]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.002



[[Page 23563]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.003



[[Page 23564]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.004



[[Page 23565]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.005



[[Page 23566]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.006



[[Page 23567]]

Sec. 249.1a and Form 1-A  [Removed]

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


Sec. 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:


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

[GRAPHIC] [TIFF OMITTED] TP29AP98.007


[[Page 23568]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.008



[[Page 23569]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.009



[[Page 23570]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.010



[[Page 23571]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.011



[[Page 23572]]

    29. Section 249.638 and Form ATS-R are added to read as follows:


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

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

[GRAPHIC] [TIFF OMITTED] TP29AP98.012


[[Page 23573]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.013



[[Page 23574]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.014



[[Page 23575]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.015



[[Page 23576]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.016



[[Page 23577]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.017



[[Page 23578]]

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


Sec. 249.821  Form PILOT, information required of self-regulatory 
organizations operating pilot trading systems pursuant to Sec. 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 Sec. 240.19b-5 of this chapter.

[GRAPHIC] [TIFF OMITTED] TP29AP98.018


[[Page 23579]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.019



[[Page 23580]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.020



[[Page 23581]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.021



[[Page 23582]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.022



[[Page 23583]]

[GRAPHIC] [TIFF OMITTED] TP29AP98.023


    By the Commission.
    Dated: April 21, 1998.
Margaret H. McFarland,
Deptuy Secretary.
[FR Doc. 98-10945 Filed 4-28-98; 8:45 am]
BILLING CODE 8010-01-C


</pre><script data-cfasync="false" src="/cdn-cgi/scripts/5c5dd728/cloudflare-static/email-decode.min.js"></script></body>
</html>