SEC Modernizes Regulations for Alternative Trading Systems

FOR IMMEDIATE RELEASE	98-127
Agency Streamlines Process of Introducing Products and Operating Pilot Trading Systems

Washington, D.C., December 2, 1998 – The Commission voted today to publish two releases that modernize the Commission's regulatory framework in light of the important role of technology, and the increasing competition, in today's securities markets. The releases adopt the following changes:

• Alternative Trading Systems.  The Commission adopted a new regulatory framework for alternative trading systems. The low cost of technology has allowed new, automated markets – or alternative trading systems – to develop. These systems compete directly with the more traditional exchanges, and now account for about 20% of transactions in Nasdaq securities and 4% of transactions in listed securities. Although these alternative trading systems are markets, they have been regulated as traditional broker- dealers, resulting in certain regulatory gaps. The framework adopted by the Commission today, better integrates alternative trading systems into the regulatory framework for markets, and is flexible enough to accommodate the business objectives of, and the benefits provided by, alternative trading systems.

• Regulatory Relief for Registered Exchanges  The Commission also provided relief to the registered exchanges and the NASD from the requirements to file all proposed rule changes with the Commission for approval. The rule filing requirements, in some cases, hinder exchanges' and the NASD's ability to effectively compete with alternative trading systems, and are not always necessary to the Commission's ability to ensure the protection of investors. The rules the Commission adopted today allow exchanges to operate "pilot trading systems" for up to two years, and to list and trade certain new derivative securities products, without prior Commission approval.

• For-Profit Exchanges  Finally, the Commission today made clear that it will work to accommodate new, or existing, exchanges that wish to operate as for-profit organizations. While U.S. exchanges have historically been organized as member-owned, not-for-profit corporations, some registered exchanges – or systems contemplating registering as exchanges – may find that it makes better business sense to operate as a for-profit organization.

Chairman Arthur Levitt said, "The rules adopted today take an important step toward accomplishing the goal of ensuring the continued strength of America's securities markets in an era of global commerce and intensified competition. They represent common-sense regulation that still ensures investor protection."

Summary of Releases Adopting Changes to the Regulation of Alternative Trading Systems and Relief From the SRO Rule-Filing Requirements

The Commission will also vote on whether to publish a second release adopting amendments to Rule 19b-4, which will permit registered securities exchanges and the NASD to list and trade new derivative securities products without Commission approval.

Reason for the Adopting Releases

• The low cost of technology has enabled the establishment of markets that compete directly with the more traditional exchanges. These markets are referred to by the Commission as alternative trading systems. As reported in the Commission's April 1998 proposing release,¹ volume on these alternative trading systems has significantly increased in recent years. These systems now account for about 20% of transactions in Nasdaq securities and 4% of transactions in listed securities. Although these alternative trading systems are markets, they are currently regulated as traditional broker-dealers, which has resulted in certain regulatory gaps. In general, these gaps do not raise substantial concerns when an alternative trading system has limited trading volume. However, when an alternative trading system has significant volume, the existing regulatory approach does not provide investors with access to the best prices, fails to provide a complete audit trail or adequately surveil trading on alternative trading systems, and creates the potential for market disruption due to system outages.

• In addition, some of the existing regulatory requirements for the registered exchanges and the NASD hinder their ability to effectively compete with alternative trading systems. In particular, registered exchanges and the NASD must solicit public comment on, and obtain Commission approval of, all changes to their rules. In some cases, this requirement can impede their ability to compete, and may not always be necessary for the protection of investors.

• Finally, while U.S. exchanges have historically been organized as member-owned, not-for-profit corporations, some registered exchanges – or those contemplating registering as exchanges – may find that it makes better business sense to operate as a for-profit organization.

How the Commission Is Responding

(1)	Adopting a new regulatory framework for alternative trading systems that better integrates these systems into the national market system and improves investor protection. This new regulatory framework continues to provide alternative trading systems with the flexibility they need to innovate by allowing them to choose between registering as an exchange and registering as a broker-dealer.
(2)	Allowing the registered exchanges and the NASD to: (i) defer seeking Commission approval of low volume pilot trading systems for two years; and (ii) trade new derivative securities products without Commission approval when there are previously approved listing standards.
(3)	Allowing registered exchanges to operate as for-profit businesses.

New Regulatory Framework for Alternative Trading Systems

Choosing to Register as a Broker-Dealer

Most alternative trading systems that are currently operating are relatively small. If these smaller systems choose to register as broker-dealers, their regulatory requirements will be substantially similar to what they currently undertake. As registered broker- dealers, these alternative trading systems will continue to be covered by the oversight of one of the self-regulatory organizations. Provided an alternative trading system has limited volume, it will only have to file a notice with the Commission describing the way it operates, maintain an audit trail, and file quarterly reports.

Under the rules the Commission is adopting today, alternative trading systems with substantial trading volume – and therefore a potentially significant impact on the market – will need to comply with the following additional requirements.

• Alternative trading systems registered as broker- dealers will need to link with a registered exchange or the NASD and publicly display their best priced orders (including institutional orders) for those exchange-listed and Nasdaq securities in which they have 5% or more of the trading volume. Alternative trading systems will also have to allow members of the registered exchanges and the NASD to execute against those publicly displayed orders. Only those orders that participants in an alternative trading system choose to display to more than one other participant will have to be publicly displayed. Accordingly, the portion of orders hidden from view through "reserve size" features in alternative trading systems will not need to be publicly displayed. To monitor the effects of this requirement, however, the Commission is phasing it in. Initially alternative trading systems will only have to publicly display their orders in 50% of the securities subject to this requirements. Ninety days later, the public display requirement will be extended to the remainder of the securities. Alternative trading systems will also not be required to provide access to a security until the public display requirement is effective for that security.

• An alternative trading system with 20% or more of trading volume will also have to ensure that its automated systems meet certain capacity, integrity, and security standards. This is intended to prevent the system outages - - and resulting disruption to the market – experienced by some alternative trading systems during periods of heavy trading volume.

• An alternative trading system with 20% or more of trading volume will also have to refrain from unfairly denying investors access to its system. This requirement will only prohibit unfair discrimination among investors and broker-dealers seeking access. The system will be free to establish fair and objective criteria, such as creditworthiness, to differentiate among potential participants.

Relief for the Registered Exchanges and the NASD

First, the Commission is adopting a rule that temporarily exempts registered exchanges and the NASD from the rule filing requirements so that they may operate – for up to two years --pilot trading systems. During this trial two year period, the pilot trading system will be subject to strict volume limitations. The operator of the pilot trading system will also have to ensure that the trading activity on that system is being adequately surveilled. This rule will enhance the registered exchanges' and the NASD's ability to compete with alternative trading systems registered as broker-dealers and to bring innovative trading systems to market.

Second, the Commission is adopting a rule that creates a streamlined procedure for the registered securities exchanges and the NASD to quickly begin trading new derivative securities products. Under the new rule, if a registered exchange or the NASD has existing trading rules, surveillance procedures, and listing standards that apply to the broad product class covering a new derivative securities product, the new product can be listed or traded without Commission approval.

For-Profit Exchanges

-[1]-   Securities Exchange Act Release No. 39884 (April 17, 1998). This release is available at the Commission's web site (http://www.sec.gov/rules/propridx.htm).

http://www.sec.gov/news/regats.htm
Last update: 10/28/98

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