January 01, 1999
U.S. securities law is generally well crafted to regulate traditional trading floor-based securities exchanges and paper-generating broker/dealer relationships. The law, however, has struggled to keep pace with a new phenomenon brought about by the Internet: the alternative trading system ("ATS") - electronic share trading systems that are not registered with the Securities and Exchange Commission (the "SEC"). The fast growth of ATSs in the securities industry is making such systems a force in the financial marketplace and is straining traditional broker-dealers to compete with the discounted transactional fees and direct market access provided by ATSs. It is estimated that ATSs account for about 20% of aggregate trading in NASDAQ securities and about 4% of US exchange-listed securities. Further, as computer-savvy Generation Xers grow older and acquire more assets, they likely will look increasingly to ATSs for their investment needs. This trend may widen the market-share gap between traditional broker-dealers and ATSs.
The increasing utilization of ATSs has not been unnoticed by the SEC. It has undertaken an effort to both accept this new technology - acknowledging its potential value to the financial marketplace - and regulate it. On December 2, the SEC adopted new regulations to govern ATSs.
What Is An Alternative Trading System?
The term "Alternative Trading System," or "ATS," is not defined in the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and, until recently, has not been regulated by any SEC rules or regulations promulgated thereunder. ATSs are inclusive of "any automated systems that centralize, display, match, cross, or otherwise execute trades, but are not registered with the [SEC] as national securities exchanges or operated by a registered securities association." (Release No. 38672, 62 Fed, Reg. 30485 n.3 (June 4, 1997)). In its attempt to regulate ATSs, the SEC has been mindful of the potential benefits of ATSs while attempting to deal with certain structural ambiguities presented by ATSs.
An ATS may exhibit both traditional broker-dealer and exchange-like properties. Functionally, an ATS usually matches buy and sell orders within its own electronic system. Once the ATS has matched and executed all corresponding orders within its own system, it then generally sends any unfilled orders to established exchanges so that the orders may be filled. ATS configurations are as varied as there are ATS companies. Some of the more noteworthy ATSs and those representative of this categorical diversity are the Arizona Stock Exchange, the Direct Stock Market/NIPHIX joint-venture, and Instinet, all of which are considered ATSs but display very different operational functions and goals. In essence, the concept of an ATS is almost intangible. It may be more accurately categorized by the technological process it employs rather than by the means for which its technology is utilized. The following examples of ATSs have considerably different capabilities, functions and goals within the financial marketplace.
Arizona Stock Exchange
The Arizona Stock Exchange is an example of an ATS that is utilized as an exchange. It is also the only exchange that, to date, has been granted an exemption from the SEC based upon its low trading volume. The Arizona Stock Exchange system limits its use to only institutional investors and broker-dealers looking to enter transactions in government debt instruments and U.S. corporate debt and equity securities. This system operates by comparing the selling and buying prices posted by investors. Based upon the volume of each, the system establishes an "auction price" which is then set in the system for a particular security. Any unmatched orders are routed to an established exchange to be processed.
Direct Stock Market/NIPHIX
An example of the interrelationship between ATSs and broker-dealers is apparent in the relationship between Direct Stock Market Inc. and the NIPHIX ATS. Direct Stock Market of Santa Monica, California is an Internet-based information exchange for direct public offerings of securities. According to Clay Womack, CEO of Direct Stock Market, Direct Stock Market provides investors and securities issuers with a "soup to nuts solution for capital formation" with an emphasis on new offerings. Direct Stock Market utilizes the NIPHIX system to execute its trades. NIPHIX Investments Inc. of Peoria, Illinois, and an SEC registered broker-dealer, operates an Internet-based stock exchange featuring an electronic bid and ask market for new and secondary trading in securities of small business issuers covered by Rule 405 of the Securities Act of 1933, as amended. Like the Arizona Stock Exchange, NIPHIX routs all unfilled orders to established exchanges. Together, Direct Stock Market and NIPHIX provide an electronic marketplace for securities in initial public offerings of start-up companies combined with a secondary trading market to enhance liquidity as an advance step toward later NASDAQ listings.
The Instinet System
Instinet Corporation, a registered broker based in New York and owned by Reuters Group PLC, serves as a securities brokering agent for global institutional clients. Instinet utilizes various Internet technologies and electronic communication links to allow its clients to communicate, negotiate and trade electronically in many markets. Instinet’s technology allows it to accept client orders and execute them in multiple markets, including the 17 worldwide securities exchanges of which it is a member. Instinet is currently the most widely-used ATS. While Instinet provides neither the limited auction trading of the Arizona Stock Exchange for U.S. government and corporate securities nor the Direct Public Offering and secondary trading mechanism of the Direct Stock Market / NIPHIX teaming for smaller-cap companies, it is likely the industry leader for applying advanced technology to agency brokering for institutional trading clients.
Why Are Alternative Trading Systems Important?
The SEC has stated that ATSs promote transparency and increase market efficiency. They give liquidity to smaller-cap companies which have had no market in the past. ATSs allow investors to trade securities at lower costs while circumventing the traditional paper-based exchanges. The discounted transaction fees and direct market access provided by ATSs have made them even more appealing to institutional investors who are always looking to drive down costs within the market. In fact, institutional investors are primarily responsible for the current proliferation of ATSs.
Initially, institutional investors sought to develop an electronic means through which they could expedite orders to the trading floor and circumvent the paper ticket system. These ATS configurations worked so efficiently that the volume per trade on such systems has increased over 300% within the past six years. This has also created an increasing demand on traditional broker-dealers. Faced with the discounted transactional fees and direct market access offered by ATSs, broker-dealers are hard pressed to offer more competitive pricing - in effect lowering their profit margin while trying to maintain the human element ATSs lack - and find a value-added service to compete with ATSs or face losing both institutional and individual investors to the growing ATS market. Currently, there is a multitude of ATS companies and the number is expected to increase exponentially into the new millennium. It is this explosive growth which has pushed ATSs to the forefront of regulatory issues in the securities industry.
SEC Concept Releases And Regulation
In view of the rapid growth of ATSs, the SEC issued a concept release on May 23, 1997 to solicit comments from the securities industry on how best to regulate ATSs. After reviewing numerous comment letters, the SEC issued a set of proposed rules in April 1998. Following further industry commentary, on December 2, 1998, the SEC formally promulgated new regulations to govern ATSs.
SEC Concept Releases Construct Bifurcated Regulatory Framework
The SEC’s first pronouncement on the matter of ATS regulation was contained in a May 23, 1997 concept release. That release sought to solicit comments from the securities industry on the appropriateness and manner of ATS regulation. This first release pointed out that, as a general matter, ATSs were then currently being regulated under the broker-dealer regulatory framework mandated under Section 15b of the Exchange Act. The release discussed several concerns raised by that approach, namely that such broker-dealer regulations were not fully suitable and, indeed, were unduly burdensome to ATSs. The release was concerned about the shortcomings of the broker-dealer regulations to assure marketwide fairness, transparency, integrity and stability in the emerging ATS environment. Moreover, the release pointed out that current regulations made broker-dealers subject to the oversight of self-regulatory organizations (or "SROs"), such as the NASD. This circumstance presented the potential for conflicts of interest as an SRO could see itself as competing with the same ATSs which it is meant to monitor.
To address these concerns, the SEC’s May 1997 concept release proposed the continued use of the traditional broker-dealer regulatory framework, but with specific changes to accommodate ATSs and the SROs which sponsor them. The release added a further and more creative proposal, however, that would expand the definition of "exchange" under the Exchange Act and thereby allow ATSs to be regulated in a manner similar to traditional securities exchanges. (Release No. 34-38672; File No. S7-16-97, dated May 23, 1997) (http://www.sec.gov/rules/concept/3438672.txt).
After reviewing some seventy comment letters from interested members of the securities industry, on April 17, 1998, the SEC formally proposed a series of specific rules and rule amendments regulating ATSs. The SEC’s second release took the two regulatory frameworks outlined in the earlier release and combined them into a flexible ATS regulatory structure whereby ATSs were given the discretion to choose the framework in which they would be regulated based on their practical business models. The SEC proposed that ATSs that chose to be a market participant would register as broker-dealers and those that chose to be a separate securities market would register as securities exchanges. The SEC expressed the hope that this approach would give ATSs the flexibility needed to continue to innovate. (Release No. 34-39884; File No. S7-12-98, dated April 17, 1998) (http://www.sec.gov/rules/propridx.htm).
The first alternative regulatory framework contained a system of continued broker-dealer regulation combined with regulatory modifications. ATSs choosing to be registered as broker-dealers would be required to provide additional audit-trail information to SROs, assist SROs in their surveillance functions, and adapt standard procedures for ensuring adequate system capacity. The proposed rules also provided for a new regulation, Regulation ATS, which would impose additional requirements on ATSs that chose to register as broker-dealers. The SEC noted that a benefit of this regulatory framework is that it would maintain continuity with the current system in which the majority of ATSs are now regulated as broker-dealers.
The second alternative framework sought to integrate ATSs into the national market system as securities exchanges. These exchanges would be grouped into three tiers with each tier containing a different level of regulation based on the ATS’s volume of trading activity. The tiers would range from that of the established national exchanges to limited-volume ATS sites which would be exempt from registration. The SEC believed that implementation of this tiered approach would be effectuated best by broadening the definition of "exchange" to encompass ATSs. By redefining the term "exchange," the SEC hoped to incorporate both existing and future ATSs more adequately into its proposed tiered-regulatory framework.
The rules also proposed that ATSs which elected to be regulated as national securities exchanges would be subject to the same regulatory requirements as existing registered exchanges but with certain modifications. The SEC would try to accommodate the proprietary structure of ATSs 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.
SEC Final Rules On Regulatory Framework
On December 2, 1998, the SEC voted to publish two releases regarding the regulation of ATSs and the adoption of amendments to Rule 19b-4 allowing securities exchanges and the NASD to list and trade new securities derivative products without prior SEC approval. On December 8, 1998, the SEC published two sets of final rules: Regulation of Exchanges and Alternative Trading Systems (Release No. 34-40760; File No. S7-12-98, dated December 8, 1998. Effective Date: April 22, 1999) (http://www.sec.gov/rules/final/34-40760.txt) and Amendment to Rule Filing Requirements for Self-Regulatory Organizations Regarding New Derivative Securities Products (Release No. 34-40761; File No. S7-13-98, dated December 8, 1998. Effective Date: February 22, 1999) (http://www.sec.gov/rules/final/34-40761.htm). In the aggregate, these rules adopt the bifurcated system proposed in the April 1998 release with a few modifications to only the broker-dealer framework and propose measures to aid registered exchanges in the implementation of new technology and derivative financial products. Additionally, the SEC has also amended the filing requirements of registered exchanges to allow for both a new pilot program and ease of reporting restrictions so that the established exchanges may be more competitive with the burgeoning ATS market.
1. Broker-Dealer Modifications
Under the new regulations, an ATS that elects to be regulated as a broker-dealer will be further categorized by its amount of trading volume. If the ATS has a low trading volume then the following requirements apply: (1) the ATS will still be overseen by an SRO; (2) the ATS will have to file a notice of operation with the SEC detailing how it functions; (3) the ATS will have to maintain an audit-trail; and (4) the ATS must file quarterly reports. Should the ATS be considered one of substantial trading volume (i.e. having significant impact on the overall securities market) then its operations will be more heavily regulated as follows: (1) the ATS must link with a registered exchange or the NASD; (2) it must display its best price orders - inclusive of institutional investors - for any exchange-listed securities and for NASDAQ orders where it holds 5% or more of the trading volume; and (3) it must allow the NASD and registered exchanges to execute against its publicly displayed orders. The regulations further require that only those orders that have been displayed to more than one participant must be publicly displayed, thus allowing ATSs to still hide that portion of orders hidden through "reserve side" features. In response to outside concern over this specific provision, the SEC is implementing it in a "phased-in" manner. Initially, ATSs will only have to fulfill this requirement with respect to 50% of the securities which are subject to this provision. After a ninety-day period the requirement will be extended to the rest of the securities that are eligible for such regulation.
Additionally, an ATS with 20% or more of the trading volume in any equity security, or certain categories of debt, also will have to comply with set standards that ensure its systems meet capacity, integrity and security standards. This measure is aimed at remedying system outages which have occurred in the past with various ATSs that were not operating at the proper level to efficiently handle investors. Such systems will also be precluded from unfairly denying investors access to the systems. Such requirement, however, only applies to access provided to investors and broker-dealers.
2. ATSs Registering as "Exchanges"
The SEC has accommodated ATSs electing to register as exchanges by re-interpreting the definition of "exchange" under Section 3(a)(1) of the Exchange Act to reflect a more comprehensive and meaningful interpretation of what is an exchange in today’s electronic marketplace. According to the SEC, the prior interpretation of this definition reflected relatively rigid regulatory requirements and classifications for "exchange(s)" and "broker-dealers." Advancing technology has increasingly blurred these distinctions, and ATSs are today used by market participants as functional equivalents of exchanges. Thus, the SEC has revised Rule 3b-16 interpreting the "exchange" definition to mean "any organization, association, or group of persons that: (1) brings together the orders of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade." The new rule expressly excludes the following systems from the revised interpretation of "exchange": (1) systems that merely route orders to other facilities for execution; (2) systems operated by a single registered market maker to display its own bids and offers and the limit orders of its customers, and to execute trades against such orders; and (3) systems that allow persons to enter orders for execution against the bids and offers of a single dealer."
The SEC has further incorporated several provisions of the April 1998 release - aimed at ensuring ATSs an efficient transition to "registered exchange" status - while maintaining several traditional provisions that promote fairness in the financial marketplace between ATSs and traditional exchanges. These provisions include: (1) SRO delegation of surveillance of non-financial reporting requirements to other parties (inclusive of other SROs); (2) substantial flexibility in the fair representation requirement to ensure efficient adaptation to the new ATS proprietary exchange model; (3) continued industry-wide prohibition on membership for all parties that are not registered broker-dealers or associated with registered broker-dealers; (4) continued industry-wide prohibition on the listing of any securities not registered with the SEC or approved for listing on the particular exchange; and (5) any ATS that elects to be registered as a national exchange will be expected to "integrate itself into the market-wide transaction and quotation reporting plans that are currently being operated by registered exchanges and the NASD."
Collectively, the May 1997 and April 1998 releases were the beginning of an SEC attempt - in conjunction with industry-wide recommendations - to regulate the burgeoning ATS market. Two years and over seventy comment letters later, the SEC has finally set forth guidelines tailored to address the specific regulatory gaps endemic to ATS regulation under the traditional paper-based framework. The SEC has provided ATSs with wide latitude in their transition into the financial marketplace by allowing them to choose between regulation as either broker-dealers or as registered exchanges. However, even though the SEC has striven to make this transition as smooth as possible, it has also retained some traditional safeguards to ensure that traditional broker-dealers and registered exchanges are able to remain competitive with the entrance of ATSs into the financial marketplace.
Sarah Hewitt and Gerard R. Boyce are partners at Brown Raysman Millstein Felder & Steiner LLP. This article is based on a two-part series by their partner, J. Christopher Giancarlo, appearing in the December and January editions of eSecurities: Trading and Regulation on the Internet published by Leader Publications.
Hartford Los Angeles New York Northern NJ San Francisco Shanghai Silicon Valley Washington, DC
Affiliated Sites
www.constructionweblinks.com |
www.technologylawupdate.com |
www.climatelawupdate.com
Copyright ©
