SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 240 Release No. 34-38672; International Series Release No. IS-1085; File No. S7-16-97 Regulation of Exchanges AGENCY: Securities and Exchange Commission. ACTION: Concept Release. SUMMARY: The Securities and Exchange Commission ("SEC" or "Commission") is reevaluating its approach to the regulation of exchanges and other markets in light of technological advances and the corresponding growth of alternative trading systems and cross-border trading opportunities. Accordingly, the Commission is soliciting comment on a broad range of questions concerning the oversight of alternative trading systems, national securities exchanges, foreign market activities in the United States, and other related issues. Following receipt of public comment, the Commission will determine whether rulemaking is appropriate. DATES: Comments must be received on or before [insert date 90 days after date of publication in the Federal Register]. 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, N.W., Washington, D.C. 20549. Comments may also be submitted electronically at the following e-mail address: rule-comments@sec.gov. All comment letters should refer to File No. S7-16-97; this file number should be included on the subject line if comments are submitted using e-mail. All submissions will be available for public inspection and copying at the Commission's Public Reference Room, Room 1024, 450 Fifth Street, N.W., Washington D.C. 20549. Electronically submitted comment letters will be posted on the Commission's Internet web site (http://www.sec.gov). FOR FURTHER INFORMATION CONTACT: For questions or comments regarding this release, contact: Kristen N. Geyer, Special Counsel, at (202) 942-0799; Gautam S. Gujral, Special Counsel, at (202) 942-0175; Marie D'Aguanno Ito, Special Counsel, at (202) 942-4147; Paula R. Jenson, Deputy Chief Counsel, at (202) 942-0073; or Elizabeth K. King, Special Counsel, at (202) 942- 0140, Division of Market Regulation, Securities and Exchange Commission, Mail Stop 5-1, 450 Fifth Street, N.W., Washington, D.C. 20549. For questions or comments regarding corporate disclosure and securities registration issues raised in this release, contact David Sirignano, Associate Director, at (202) 942-2870, Division of Corporation Finance, Securities and Exchange Commission, Mail Stop 3-1, 450 Fifth Street, N.W., Washington, D.C. 20549. SUPPLEMENTARY INFORMATION: Table of Contents I. Executive Summary A. Purpose of Concept Release B Alternatives for Revising Domestic Market Regulation C. Alternatives for Revising Regulation Applicable to Foreign Market Activities in the United States D. Conclusion II. Regulation of Domestic Markets A. Technological Advances B. Market Regulation 1. The Current Regulatory Approach Applies ======END OF PAGE 2====== Inappropriate Regulation to Alternative Trading Systems 2. The Current Regulatory Approach Impedes Effective Regulation a. Market Access and Fairness b. Market Transparency and Coordination c. Market Surveillance d. Market Stability and Systemic Risks C. Conclusion III. Approaches to Market Oversight A. Regulatory Structure B. Regulatory Tools IV. Proposals Under Consideration to Integrate Alternative Trading Systems into the Existing Regulatory Structure for Market Oversight A. Integrating Alternative Trading Systems into the National Market System Through Broker-Dealer Regulation 1. Fully Integrating the Orders of All Market Participants into the Public Quotation System and Facilitating Public Access to Such Orders 2. Improving the Surveillance of Trading Conducted on Alternative Trading Systems 3. Ensuring Adequate Capacity of Alternative Trading Systems 4. Potential Problems with Regulating Alternative ======END OF PAGE 3====== Trading Systems Under the Broker-Dealer Regulatory Scheme a. Alternative Trading Systems Would Not Be Subject to Requirements Designed to Assure Fair Treatment of Investors b. Broker-Dealers that Operate Alternative Trading Systems Will Still Be Required to Comply with Potentially Inapplicable Regulation and Be Subject to Oversight by SROs c. Alternative Trading Systems Will Be Free to Engage in Anticompetitive Activities 5. Conclusion B. Integrating Alternative Trading Systems into Market Regulation Through Exchange Regulation 1. Creating a New Category Called "Exempted Exchanges" for Smaller and Passive Alternative Trading Systems a. Low Impact Markets b. Passive Markets c. Requirements for Exempted Exchanges 2. The Application of Exchange Regulation to Alternative Trading Systems That Are Not Exempted Exchanges a. Using the Commission's Exemptive Authority to Encourage Innovation and to ======END OF PAGE 4====== Eliminate Barriers to Non-Traditional Exchanges (i) The Commission Could Consider Permitting Institutional Access to Exchanges (ii) The Commission Could Consider Ways in Which Alternative Exchanges Can Meet Fair Representation Requirements 3. Expanding the Commission's Interpretation of "Exchange" a. Effects of Expanding the Commission's Interpretation of "Exchange" on Selected Types of Alternative Trading Systems (i) Broker-Dealer Activities (ii) Organized Dealer Markets (iii) Information Vendors and Bulletin Boards (iv) Interdealer Brokers 4. Effect of Broadening the Definition of "Exchange" a. Regulation of Securities Trading on Alternative Trading Systems b. Integration with National Market System Mechanisms and Existing Exchange Practices (i) Inter-Market Plans (A) Quotation and Transacting Reporting (B) Intermarket Trading System (ii) Uniform Trading Standards c. Oversight of Non-Broker-Dealers That ======END OF PAGE 5====== Have Access to Exchanges and Clearance and Settlement of Non-Broker-Dealer Trades d. Application of Broker-Dealer Regulation to Certain Exchanges C. Conclusion V. The Commission Could Consider Ways in Which Requirements Might Be Reduced or Expedited for Registered Exchanges A. Ways to Further Expedite Rule Filings B. Surveillance and Enforcement VI. Costs and Benefits of Revising the Regulation of Domestic Markets VII. Regulation of Foreign Market Activities in the United States A. The Need for A Clear Regulatory Structure to Address U.S. Investors' Electronic Cross-Border Trading 1. The Applicability of the U.S. Regulatory Structure to the Activities of Access Providers Has Not Been Expressly Addressed 2. U.S. Investors' Ability to Trade Directly on a Foreign Market And Investor Protection Concerns Under the Federal Securities Laws B. Regulating Foreign Market Activities in the United States 1. Sole Reliance on Foreign Markets' Home Country Regulation ======END OF PAGE 6====== 2. Requiring Foreign Markets to Register as National Securities Exchanges 3. Regulating Access Providers to Foreign Markets a. Access Providers to U.S. Members of Foreign Markets b. Broker-Dealer Access Providers c. Requirements Applicable to Access Providers (i) Conditions Relating to the Type of Foreign Market (ii) Conditions Relating to Type of Persons and Securities (iii)Recordkeeping, Reporting, Disclosure, and Antifraud Requirements C. Addressing the Differences Between U.S. and Foreign Markets' Listed Company Disclosure Standards D. Costs and Benefits of Revising Regulation of Foreign Market Activities in the United States E. Conclusion VIII. Summary of Requests for Comment I. Executive Summary A. Purpose of Concept Release Stock markets play a critical role in the economic life of the United States. The phenomenal growth of the U.S. markets over the past 60 years is a direct result of investor confidence in those markets. Technological trends over the past two decades have also contributed greatly to this ======END OF PAGE 7====== success. In particular, technology has provided a vastly greater number of investment and execution choices, increased market efficiency, and reduced trading costs. These developments have enhanced the ability of U.S. exchanges to implement efficient market linkages and advanced the goals of the national market system ("NMS"). At the same time, however, technological changes have posed significant challenges for the existing regulatory framework, which is ill- equipped to respond to innovations in U.S. and cross-border trading. Specifically, two key developments highlight the need for a more forward- looking, flexible regulatory framework: (1) the exponential growth of trading systems that present comparable alternatives to traditional exchange trading; and (2) the development of automated mechanisms that facilitate access to foreign markets from the United States. The Commission estimates that alternative trading systems<(1)> currently handle almost 20 percent of the orders<(2)> in over-the- <(1)> Trading systems not registered as exchanges have been referred to in previous Commission releases as "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 Securities Exchange Act of 1934 ("Exchange Act"), 17 CFR 240.17a-23 and 240.11Ac1-1, respectively. The term "alternative trading systems" will be used throughout this release to refer generally to automated systems that centralize, display, match, cross, or otherwise execute trading interest, but that are not currently registered with the Commission as national securities exchanges or operated by a registered securities association. <(2)> For purposes of this release, the term "order" generally means any firm trading interest, including both limit orders and market maker quotations. ======END OF PAGE 8====== counter ("OTC") stocks and almost 4 percent of orders in securities listed on the New York Stock Exchange ("NYSE"). The explosive growth of alternative trading systems over the past several years has significant implications for public secondary market regulation. Even though many of these systems provide essentially the same services as traditional markets, most alternative trading systems are regulated as broker-dealers. As a result, they have been subject to regulations designed primarily to address traditional brokerage, rather than market, activities. For example, these systems are typically subject to oversight by self-regulatory organizations ("SROs") that themselves operate exchanges or quotation systems, which raises inherent competitive concerns. At the same time, alternative trading systems are not fully integrated into the national market system. As a result, activity on alternative trading systems is not fully disclosed to, or accessible by, public investors. The trading activity on these systems 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, nor do they have an obligation to ensure that they have sufficient capacity to handle trading demand. These concerns together with the increasingly important role 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. The impact of technological change has not been limited to domestic markets. Foreign markets, information vendors, and broker-dealers have developed automated systems that enable U.S. persons to trade directly on ======END OF PAGE 9====== foreign markets from the United States. The Commission to date has not addressed the regulatory status of entities that limit their activities to providing U.S. investors access to foreign markets. As a result, many foreign markets have been reluctant to provide these services directly to U.S. investors. This has highlighted the need to establish standards that can accommodate U.S. investors' growing interest in cross-border trading, and better ensure that this type of cross-border trading is subject to appropriate safeguards. At the same time, improved foreign market access would mean that U.S. investors can trade securities of companies listed solely on foreign markets as easily as securities of companies that satisfy the Commission's disclosure and reporting requirements. This would raise additional questions as to how to craft a regulatory scheme that provides sufficient information to investors about the securities they trade. These and other questions raised by the application of the existing regulatory approach to technologically changing markets are only likely to multiply as technology facilitates ways of trading and enables the creation of market structures that were unimaginable a few years ago. In light of these issues, the Commission is now reevaluating its regulation of the markets, particularly its oversight of alternative trading systems, registered exchanges, and foreign market activities in the United States. In doing so, the Commission seeks to develop a forward-looking and enduring approach that will permit diverse markets to evolve and compete, while preserving market-wide transparency, fairness, and integrity. The issues raised by technology in the domestic markets are summarized in Part B below and discussed in greater detail in Sections II through VI. The issues raised by technology in the foreign markets are summarized in Part C below ======END OF PAGE 10====== and discussed in greater detail in Section VII of this release. B. Alternatives for Revising Domestic Market Regulation The questions raised by technological developments in the U.S. markets could be addressed in a variety of ways. As an initial matter, the Commission is soliciting comment on whether the current statutory and regulatory framework remains appropriate in light of the myriad new means of trading securities made possible by emerging and evolving technologies. The Commission is also soliciting comment on alternative ways of addressing these issues within the existing securities law framework. The release discusses two alternatives in particular that would integrate alternative trading systems more fully into mechanisms that promote market-wide transparency, investor protection, and fairness. First, the Commission could continue to regulate alternative trading systems as broker-dealers and develop rules applicable to these systems, and their supervising SROs that would more actively integrate these systems into NMS mechanisms. The Commission could, for example, require alternative trading systems to provide additional audit trail information to SROs, to assist SROs in their surveillance functions, and to adopt standard procedures for ensuring adequate system capacity and the integrity of their system operations. The Commission could then require SROs to integrate trading on alternative trading systems into their ongoing, real- time surveillance for market manipulation and fraud, and to develop surveillance and examination procedures specifically targeted to alternative trading systems they supervise. In addition, the Commission could require alternative trading systems to make all orders in their systems available to their supervising SROs, and require such SROs to ======END OF PAGE 11====== incorporate those orders into the public quotation system. The Commission could also require that alternative trading systems provide the public with access to these orders on a substantially equivalent basis as provided to system participants. Alternatively, the Commission could integrate alternative trading systems into the national market system as securities exchanges, by adopting a tiered approach to exchange regulation. The first tier, under this type of approach, could consist of the majority of alternative trading systems, those that have limited volume or do not establish trading prices, which could be exempt from traditional exchange requirements. For example, exempt exchanges could be required to file an application and system description with the Commission, report trades, maintain an audit trail, develop systems capacity and other operational standards, and cooperate with SROs that inspect their regulated participants. Most alternative trading systems currently regulated as broker-dealers would be exempt exchanges. The second tier of exchanges under this approach could consist of alternative trading systems that resemble traditional exchanges because of their significant volume of trading and active price discovery. These systems could be regulated as national securities exchanges. The Commission could then use its exemptive authority to eliminate barriers that would make it difficult for these non-traditional markets to register as exchanges, by exempting such systems from any exchange registration requirements that are not appropriate or necessary in light of their business structure or other characteristics. For example, the Commission could exempt alternative trading systems that register as exchanges from ======END OF PAGE 12====== requirements that exchanges have a traditional membership structure, and from requirements that limit exchange participation to registered broker- dealers. The Commission could also use its exemptive authority to reduce or eliminate those exchange requirements that are incompatible with the operation of for-profit, non-membership alternative trading systems. This approach could integrate these alternative trading systems more fully into NMS mechanisms and the plans governing those systems, potentially by requiring these systems to become members of those plans.<(3)> Because alternative trading systems differ in several key respects from currently registered exchanges, this could require revision of those plans in order to accommodate diverse and evolving trading systems. Finally, a third tier of exchanges, consisting of traditional membership exchanges, could continue to be regulated as national securities exchanges. The Commission could then use its exemptive authority to reduce overall exchange requirements. In this regard, the Commission is considering ways to reduce unnecessary regulatory requirements that make it difficult for currently registered exchanges to remain competitive in a changing business environment. The Commission, for example, could further accelerate rule filing and approval procedures for national securities exchanges and securities associations, and allow fully automated exchanges to meet their regulatory requirements in non-traditional ways. One way for the Commission to implement this tiered approach would be to expand its interpretation of the definition of "exchange." For example, the Commission could reinterpret the term "exchange" to include any <(3)> See infra notes 162 to 175 and accompanying text. ======END OF PAGE 13====== 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. C. Alternatives for Revising Regulation Applicable to Foreign Market Activities in the United States The questions raised by the activities of foreign markets in the United States could also be addressed in a number of ways. As an initial matter, any proposal should address questions about the lack of comparable information about securities of non-reporting foreign companies. In addition, any approach to regulating access to foreign markets from the U.S. should address the issue of whether sufficient information is disclosed to U.S. investors regarding the risks of trading on foreign markets and whether the Commission has the ability to enforce the antifraud provisions of the U.S. securities laws. This release describes a number of different ideas for addressing foreign market activity in the United States, including applying traditional exchange regulation to foreign markets that seek to enter the United States. At the other extreme, the Commission could rely solely on home country regulation of the foreign market. Alternatively, the Commission could take an intermediate approach by establishing regulatory requirements for entities that provide U.S. persons with direct access to foreign markets ("access providers"), regardless of whether the entity is the foreign market itself, a broker-dealer, or another service provider. Such access providers could be required to comply with limited recordkeeping, reporting, and disclosure requirements, as well as the ======END OF PAGE 14====== antifraud provisions of the federal securities laws. Under this type of approach, an access provider that provides a U.S. member of a foreign market with direct access to that foreign market's trading facilities would register as a securities information processor ("SIP") under Section 11A of the Exchange Act. Foreign markets, information vendors, and other access providers could be required to register as SIPs, or to conduct their U.S. activities through another registered SIP. As a condition of registration, SIPs could also be limited to trading foreign securities that are registered with the Commission under the Exchange Act or limited to dealing with sophisticated parties. Broker-dealers that act as access providers could be required to comply with the same, limited recordkeeping, reporting, disclosure, and antifraud requirements as SIPs. The Commission could also permit broker- dealer access providers to provide both retail and sophisticated investors with electronic links to foreign markets, and to provide such links to foreign markets that trade U.S. and foreign securities, regardless of whether those securities are registered with the Commission. This approach might provide adequate protections to U.S. investors trading on foreign markets, while facilitating greater transparency. In creating an appropriate regulatory scheme to address U.S. investor access to unregistered foreign securities, the Commission seeks to balance the desire to craft a forward-looking and enduring approach to the oversight of the securities markets with concerns that U.S. investors have access to full and complete disclosure about the securities they trade. The Commission has been working directly with fellow regulators around the world on a variety of initiatives to improve the efficiency of cross-border ======END OF PAGE 15====== capital flows. D. Conclusion Regulation should not be static. Changes in the markets should be accompanied by corresponding changes in market regulation. In light of the rapid pace of technological advancements during the past two decades, it is critical to develop a regulatory framework that both accommodates traditional market structures and provides sufficient flexibility to ensure that markets of the future promote fairness, efficiency, and transparency. The purpose of this release is to facilitate a dialogue as to how this can best be achieved. II. Regulation of Domestic Markets A. Technological Advances Securities markets serve several basic functions that are critical to facilitating investment and, as a result, materially influence the long- term financial security of a large segment of the population.<(4)> For example, markets provide the forum for individuals to invest in securities and for financial instruments to be readily converted into cash when needed. Securities markets also serve as a fundamental indicator of national and international economic health, in part because they reveal investors' judgments about the potential earning capacity of corporations.<(5)> They help to raise and efficiently allocate <(4)> See generally 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, at 9 (1963) (hereinafter Special Study). <(5)> Essentially, securities markets centralize information about buying and selling interest, (continued...) ======END OF PAGE 16====== capital by providing a reliable means of valuing assets and facilitating the flow of capital into private enterprise. They also allocate capital toward productive uses by providing a forum where stocks can compete for investment dollars.<(6)> U.S. securities markets have been highly successful at fulfilling these functions and are consistently the world's largest, most liquid, efficient, and fair.<(7)> Moreover, U.S. <(5)>(...continued) either by physically or electronically centralizing order interaction, or by centralizing quote and trading information. Because of this interaction of supply and demand, a stock price is considered by many to be the best estimate by investors of the present value of a company's future earnings. As a result of such beliefs, stock prices influence investment calculations, the allocation of resources, company business decisions, and economic planning. See 2 Thomas Lee Hazen, Treatise on the Law of Securities Regulation, 10.1, at 4 (3d ed. 1995); U.S. Congress, Office of Technology Assessment, Pub. No. OTA-CIT-469, Electronic Bulls & Bears: U.S. Securities Markets & Information Technology at 3, 26 (1990) (hereinafter Electronic Bulls & Bears). See generally Jack Clark Francis, Investment Analysis and Management 57, 196-97 (4th ed. 1986). <(6)> See generally Electronic Bulls & Bears, supra note 5, at ch. 2; Francis, supra note 5, at 57. <(7)> As of December 31, 1996, there were 3,530 securities trading on the NYSE, representing 2907 NYSE-listed companies. Market Records Shattered in 1996, The Exchange (NYSE), Jan./Feb. 1997, at 1-2. In addition, as of December 31, 1996, the Nasdaq Stock Market ("Nasdaq") listed over 6300 stocks of 5556 companies, and dollar volume on that market has grown to almost equal that of the NYSE. Conversation with staff of Corporate Communications, National Association of Securities Dealers, Inc. ("NASD") (Feb. 21, 1997). In 1996, the average daily share volume on Nasdaq was 543,839,000 shares and the total dollar volume was $3,301.8 billion. During that same period, the NYSE's average daily share volume was 409,893,000 (continued...) ======END OF PAGE 17====== markets have continued to attract foreign listings and investors even as other markets become more competitive.<(8)> This success has come about, in part, because the strength and stability of U.S. markets have allowed people throughout the world to feel confident investing a large percentage of their personal wealth in the future of companies trading on those markets. The ability of U.S. markets to use technology to increase efficiency, reduce the costs of trading, and respond to changing investor demands has also contributed significantly to the success of our markets. Over the past three decades, technology has transformed U.S. markets. Investors, particularly the growing institutional investor base, now have numerous alternatives to traditional exchange trading and the OTC market. Similarly, market participants (including broker-dealers, issuers, and service providers) have integrated technological advancements into their trading and marketing activities.<(9)> For example, some broker- <(7)>(...continued) shares and its total dollar volume was $4,063.7 billion. See Market Records Shattered in 1996, The Exchange (NYSE), Jan./Feb. 1997, at 1-2. <(8)> Both the NYSE and Nasdaq have experienced significant growth in foreign company listings. Foreign company listings on the NYSE increased from 106 in 1991 to 290 as of the end of 1996. Similarly, foreign listings on Nasdaq increased from 185 in 1991 to 320 as of the end of 1996. Conversation with staff of NYSE (Feb. 21, 1997); Conversation with staff of Corporate Communications, NASD (Feb. 21, 1997); New York Stock Exchange, Inc., 1995 Annual Report 3 (1995); National Association of Securities dealers, Inc., 1996 Nasdaq Fact Book 37 (1996). <(9)> See, e.g., Letter from Catherine McGuire, Chief Counsel, Division of Market Regulation, SEC, to (continued...) ======END OF PAGE 18====== dealers have made communications with retail customers more efficient by offering various services through the Internet.<(10)> As technology has broadened the services that can be delivered by both markets and market intermediaries, market services have become unbundled from traditional brokerage or exchange services. While some entities that perform brokerage services have also begun to perform some of the traditional functions of a stock exchange, other entities (including information vendors, service bureaus, and routing services) now provide many of the services historically provided by exchanges and broker-dealers. One significant example of this has been the development and growing popularity of alternative trading systems, such as the Real-Time Trading Service operated by Instinet Corporation ("Instinet"), The Island System ("Island"),<(11)> Portfolio System for Institutional Trading <(9)>(...continued) Jere W. Glover, Chief Counsel for Advocacy, U.S. Small Business Administration, and Gregory J. Dean, Jr., Assistant Chief Counsel for Banking and Finance, U.S. Small Business Administration (Oct. 26, 1996); Letter from Catherine McGuire, Chief Counsel, Division of Market Regulation, SEC, to Bruce D. Stuart, Esq. (Aug. 5, 1996); and Letter from Catherine McGuire, Chief Counsel, Division of Market Regulation, SEC, to Barry Reder, Esq. (June 24, 1996). <(10)> See Arthur M. Louis, Schwab Plays Catchup: Broker Faces Tough Internet Competition, S.F. Chron., Nov. 26, 1996, at C1. See also Letter from Richard R. Lindsey, Director, Division of Market Regulation, SEC, to Scott W. Campbell, Vice President and Associate General Counsel, Charles E. Schwab & Co. (Nov. 27, 1996). <(11)> Island is operated by Datek Securities Corp., a registered broker-dealer. Island, Instinet, and other "matching" systems (such as Tradebook, which is operated by Bloomberg Tradebook LLC) allow (continued...) ======END OF PAGE 19====== ("POSIT"),<(12)> and the Arizona Stock Exchange ("AZX"),<(13)> which allow institutions and other market participants to electronically execute trades in a variety of ways.<(14)> These and other alternative trading systems have grown to account for a significant percentage of the trading volume of the U.S. securities markets, particularly within the last five years. In 1994, the Commission's Division of Market Regulation reported that alternative trading systems accounted for 13 percent of the volume in Nasdaq securities and 1.4 percent <(11)>(...continued) participants to display firm, priced orders to other participants and to execute automatically against other orders in the system. <(12)> POSIT is operated by ITG Inc., a registered broker-dealer. POSIT and other "crossing" systems allow participants to enter unpriced orders, which are then executed with matching interest at a single price, typically derived from the primary public market for each crossed security. <(13)> AZX and other "single-price auction" systems allow participants to enter priced orders, which the system then compares to determine the single price at which the largest volume of orders can be executed. All orders are then matched and executed at that price. <(14)> In addition to these systems, more than 140 broker-dealers have notified the Commission that they operate some type of alternative trading system, either internally for their own traders or for their customers and other market participants. Registered broker-dealers that operate or otherwise sponsor alternative trading systems are required to comply with periodic reporting and recordkeeping requirements pursuant to Rule 17a-23 under the Exchange Act. 17 CFR 240.17a-23. See generally Division of Market Regulation, Market 2000: An Examination of Current Equity Market Developments app. IV (1994) (hereinafter Market 2000 Study) (general description of proprietary trading systems). ======END OF PAGE 20====== of the trading volume in NYSE-listed securities.<(15)> In comparison, the Commission estimates that alternative trading systems currently handle almost 20 percent of the orders in Nasdaq securities and almost 4 percent of orders in NYSE-listed stocks. Technology has also significantly altered the operation of exchange and OTC markets. For example, most exchanges have designed systems that allow members to route orders electronically to the exchange for execution.<(16)> The NYSE has also established after-hours crossing systems that automate the execution of single stock orders and baskets of securities,<(17)> and the Cincinnati Stock Exchange ("CSE") is now a fully automated exchange where members effect transactions through <(15)> See Market 2000 Study, supra note 14, at Study II- 13. <(16)> 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. Similar systems are operated by the following exchanges: the American Stock Exchange ("Amex") (Automated Post Execution Reporting System, or AutoPERS), the Boston Stock Exchange ("BSE") (BSE Automated Communication and Order Routing Network, or BEACON), the Chicago Board Options Exchange ("CBOE") (the RAES system), the Chicago Stock Exchange ("CHX") (Midwest Automatic Execution System, or MAX), the Pacific Exchange ("PCX") (Pacific Computerized Order Access System, or P/COAST), and the Philadelphia Stock Exchange ("Phlx") (Phlx Automated Communication and Execution System, or PACE). <(17)> See Securities Exchange Act Release No. 29237 (May 24, 1991), 56 FR 24853 (May 31, 1991); Securities Exchange Act Release No. 32368 (May 25, 1993), 58 FR 31565 (June 3, 1993). ======END OF PAGE 21====== computers located in their own offices.<(18)> Dealer markets have been similarly transformed. Dealer markets traditionally consisted of loosely organized groups of individual dealers that traded securities OTC, without formal consolidation of orders or trading. As individual dealers and associations of dealers have employed technology to make OTC markets more efficient, however, dealer markets in certain instruments have become organized to such an extent that they have assumed many of the characteristics of exchange markets. This is particularly true in markets that trade instruments that are also listed on registered exchanges. For example, the Nasdaq market, operated by the National Association of Securities Dealers, Inc. ("NASD"), consolidates trading interest of multiple dealers on a computer screen that is displayed in real-time to its members and provides a mechanism for dealers to update displayed quotations.<(19)> Additional services, such as SelectNet, allow dealers in the Nasdaq market to trade electronically. Through this technology, the NASD has been able to coordinate the dealer market more efficiently. <(18)> First organized in 1884, the CSE initially operated with a physical trading floor which it began phasing out in 1976. SEC, Report on the Practice of Preferencing Pursuant to Section 510(c) of the National Securities Markets Improvement Act of 1996, 24 (1997) (hereinafter Preferencing Report). <(19)> Like exchange markets, the NASD imposes obligations on market makers to provide a continuous source of liquidity for Nasdaq-traded securities, establishes minimum qualifications that issuers must meet in order for their securities to be quoted on the consolidated computer screen, and sets enforceable rules that govern the priorities dealers must give to certain orders. ======END OF PAGE 22====== Overall, these developments have benefited investors by increasing efficiency and competition, reducing costs, and spurring further technological advancement of the entire market. In particular, for those market participants that have access to alternative trading systems, these systems have provided opportunities for the direct execution of orders without the active participation of an intermediary. Alternative markets are likely to grow as technology continues to drive the evolution of the equity markets. B. Market Regulation Whether trading electronically or through human intervention, investors are more likely to trade on a market when prices are current and reflect the value of securities, when they are confident that they will be able to buy and sell securities easily and inexpensively, and when they believe that they can trade on a market without being defrauded or without other investors having an unfair advantage. The competition for global investment capital among the world's exchanges and the many opportunities available to U.S. and foreign investors make it more important than ever for U.S. exchanges to protect these investor interests in order to attract order flow. Appropriate regulation is often necessary to protect these interests, by helping to ensure fair and orderly markets, to prevent fraud and manipulation, and to promote market coordination and competition for the benefit of all investors.<(20)> <(20)> Experience in both the United States and world markets has repeatedly shown that commercial incentives alone are insufficient to protect investors adequately and ensure fair markets. In adopting the Exchange Act, Congress noted that, however zealously exchange authorities may (continued...) ======END OF PAGE 23====== In the United States, Congress decided that these goals should be achieved primarily through the regulation of exchanges and through authority it granted to the Commission in 1975 ("1975 Amendments")<(21)> to adopt rules that promote (1) economically efficient execution of securities transactions, (2) fair competition, (3) transparency, (4) investor access to the best markets, and (5) the opportunity for investors' orders to be executed without the participation of a dealer.<(22)> In promulgating the Exchange Act, Congress gave the Commission means to achieve these and other goals of regulation,<(23)> by requiring every market that meets the definition <(20)>(...continued) supervise the business conduct of their members, the interests with which they are connected frequently conflict with the public interest. H.R. Rep. No. 1383, 73rd Cong., 2d Sess. at 4 (1934); S. Rep. No. 792, 73rd Cong., 2d Sess. (1934). See also 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) (hereinafter Future Structure Statement). Legislative history to key Exchange Act amendments adopted in 1975 also points to the need for regulation. See, e.g., S. Rep. No. 75 and H.R. Rep. No. 229, infra note 22. See also SEC, Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq Market (1996) (hereinafter NASD 21(a) Report). <(21)> Pub. L. No. 29, 89 Stat. 97 (1975). <(22)> See S. Rep. No. 75, 94th Cong., 1st Sess. 8 (1975); H.R. Rep. No. 229, 94th Cong., 1st Sess 92 (1975). See also Exchange Act 11A(a)(1), 15 U.S.C. 78k-1(a)(1). <(23)> Congress also directed the Commission in the 1975 Amendments to advance the concept of equal regulation so that persons enjoying similar privileges, performing similar functions, and (continued...) ======END OF PAGE 24====== of "exchange" under the Exchange Act to either register as a national securities exchange or be exempted from registration on the basis of limited transaction volume.<(24)> Congress also gave the exchanges authority to enforce their members' compliance with the goals of the securities laws and, in 1983, required every broker-dealer to become a member of an exchange<(25)> or securities association.<(26)> As SROs, every registered exchange and securities association is required to assist the Commission in assuring fair and honest markets, to have effective mechanisms for enforcing the goals of regulation, and to submit <(23)>(...continued) having similar potential to affect markets would be treated equally. The Commission was charged with ensuring that no member or class of members had an unfair advantage over other members as a result of a disparity in regulation not necessary or appropriate to further the objectives of the Exchange Act. See H.R. Rep. No. 229, supra note 22. <(24)> There are currently eight registered national securities exchanges and one exempted exchange. AZX (formerly known as Wunsch Auction Systems) was exempted from the registration requirements of Sections 5 and 6 of the Exchange Act, 15 U.S.C. 78e and 78f, based on the exchange's expected limited volume in trading of securities. See Securities Exchange Act Release No. 28899 (Feb. 20, 1991), 56 FR 8377 (Feb. 29, 1991) (hereinafter AZX Exemptive Order). See also Securities Exchange Act Release No. 37271 (June 3, 1996), 61 FR 29145 (June 7, 1996). <(25)> Markets operated by registered securities associations serve many of the same functions as exchanges. Registered securities associations are regulated under Section 15A of the Exchange Act, 15 U.S.C. 78o-1, and are subject to requirements that are virtually identical to those applicable to registered exchanges under the Exchange Act. <(26)> See Pub. L. No. 38, 97 Stat. 205 (1983). ======END OF PAGE 25====== their rules for Commission review. This statutory structure has given the Commission ample authority to oversee securities markets and ensure compliance with the Exchange Act. Although regulation cannot prevent all manipulation, fraud, or collusion, it has proven effective in ridding markets of the most egregious of these practices and consequently in inspiring a high degree of investor confidence. As a result of the technologically-driven developments discussed above, however, the distinctions among market service providers have become blurred, making it more difficult to determine whether any particular entity operates as an exchange, OTC market, broker, or dealer. For example, alternative trading systems incorporate features of both traditional markets and broker-dealers. Like traditional exchanges, alternative trading systems centralize orders and give participants control over the interaction of their orders. Like traditional broker-dealers, alternative trading systems are proprietary and, in some cases, maintain trading desks that facilitate participant trading. Because the activities of alternative trading systems include both traditional exchange and broker-dealer functions, it is often unclear whether such systems should register as exchanges, broker-dealers, or both. Under the existing statutory structure enacted by Congress, however, exchanges and broker- dealers are subject to significantly different obligations and responsibilities. To date, the Commission has regulated many alternative markets as broker-dealers, rather than as exchanges, in order to foster the development of innovative trading mechanisms within the existing statutory ======END OF PAGE 26====== framework.<(27)> The determination as to whether any particular alternative trading system should be regulated as an exchange or broker- dealer has been decided on a case-by-case basis.<(28)> This regulatory approach has had two significant, unintended effects: (1) it has subjected alternative trading systems to a regulatory scheme that is not particularly suited to their market activities; and (2) it has impeded effective integration, surveillance, enforcement, and regulation of the U.S. markets as a whole. 1. The Current Regulatory Approach Applies Inappropriate Regulation to Alternative Trading Systems As broker-dealers, alternative trading systems are subject to regulation designed primarily to address traditional brokerage activities rather than market activities.<(29)> For example, broker-dealers are <(27)> See infra notes 120 to 124 and accompanying text. <(28)> Since 1991, the Commission staff has given operators of trading systems assurances that it would not recommend enforcement action if those systems operated without registering as exchanges. As a result, to date, many automated trading markets have not been required to register as exchanges and have instead been regulated as broker-dealers. For a list of no-action letters issued to system sponsors until the end of 1993 and a short history of the Commission's oversight of such systems, see Securities Exchange Act Release No. 33605, 59 FR 8368, 8369-71 (Feb. 18, 1994) ("Rule 17a-23 Proposing Release"). See also Letters from the Division of Market Regulation to: Tradebook (Dec. 31, 1996); The Institutional Real Estate Clearinghouse System (May 28, 1996); Chicago Board Brokerage, Inc. and Clearing Corporation for Options and Securities (Dec. 13, 1995). <(29)> Broker-dealers have a responsibility under the Exchange Act for ensuring their own (and their (continued...) ======END OF PAGE 27====== required to become members of the Securities Investor Protection Corporation ("SIPC"). While this membership is designed to protect customer funds and securities held by brokers, few alternative trading systems hold customer funds or securities.<(30)> In addition, broker-dealers are required to be members of an SRO. Thus, alternative trading systems are subject to oversight by exchanges and the NASD, which operate their own markets. Because these markets often compete with alternative trading systems for order flow, there is an inherent conflict <(29)>(...continued) employees') compliance with the federal securities laws and with the rules of all relevant SROs. Broker-dealer requirements generally focus on ensuring adequate employee supervision, financial responsibility and sufficient capital, and fair dealing with customers, including protection of customers' securities and funds, and monitoring sales practices. <(30)> Rather than hold customer funds or securities, most alternative trading systems require their customers to arrange for trades executed on the system to be cleared through another broker- dealer. See, e.g., Letter from Brandon Becker, Director, Division of Market Regulation, SEC, to Lloyd H. Feller, Esq., Morgan, Lewis & Bockius (Sep. 9, 1993) (Lattice trading system to have trades cleared and settled by a registered broker- dealer designated by respective system participants); Letter from Larry E. Bergmann, Associate Director, Division of Market Regulation, SEC, to Larry E. Fondren, Intervest Financial Services, Inc. (Nov. 24, 1992) (CrossCom Trading Network to use WFS Clearing Services, Inc.); Letter from William H. Heyman, Director, Division of Market Regulation, SEC, to Daniel T. Brooks, Cadwalader, Wickersham & Taft (Nov. 25, 1991) (LIMITrader to use Mabon Securities Corp. as its initial clearing broker); and Letter from William H. Heyman, (then) Deputy Director, Division of Market Regulation, SEC, to Richard S. Soroko, Esq., Lippenberger, Thompson & Welch (May 16, 1991) (Portfolio Trading Services, Inc. to use Ernst & Company as its clearing broker). ======END OF PAGE 28====== between SROs' competitive concerns as markets and their regulatory obligations to oversee alternative trading systems. Regulating alternative trading systems as traditional broker-dealers, therefore, requires compliance by these systems with obligations that, in many cases, are not pertinent to their principal activities. As discussed below, traditional broker-dealer regulation also fails to address concerns raised by alternative trading systems' market activities. 2. The Current Regulatory Approach Impedes Effective Regulation The Commission has repeatedly evaluated whether the case-by-case no- action approach has permitted adequate Commission oversight of secondary trading markets, particularly in light of the growth and evolving market significance of such systems. Prior to 1993, the low volume and relatively small number of alternative trading systems appeared to justify such an approach. In 1993, for example, in an attempt to evaluate the effects of regulating alternative trading systems as broker-dealers, the Commission's Division of Market Regulation conducted a study of the U.S. equity markets.<(31)> This study concluded that, at that time, the Commission did not have sufficient regular information to evaluate the effects of alternative trading systems on the U.S. securities markets. Therefore, the Division of Market Regulation recommended that the Commission closely monitor the impact of the proliferation of such systems. In response to this recommendation, the Commission adopted a recordkeeping and reporting rule, Rule 17a-23, specifically for broker-dealers that <(31)> See Market 2000 Study, supra note 14. ======END OF PAGE 29====== operate alternative trading systems.<(32)> Because traditional broker-dealer regulation is not designed to apply to markets such as alternative trading systems, gaps have developed in the structures designed to ensure marketwide fairness, transparency, integrity, and stability. As discussed in greater detail below, the regulation of the most significant alternative trading systems under traditional broker- dealer regulation calls into question the accuracy of public quotation and trade information, and the fairness of the public secondary markets.<(33)> In addition, such regulation may impair the detection <(32)> 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 activity to the Commission 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). <(33)> Commenters have repeatedly suggested that the regulatory disparity between exchanges and broker- dealers gives a competitive advantage to alternative trading systems. Concern about this regulatory dichotomy has been voiced by many commenters. Industry and congressional commenters at various times since 1991 have questioned whether regulating alternative trading systems differently from exchanges is advisable. The NYSE, for example, has stated that: [R]egulation of participants in our securities markets should be governed by the principle of "functional regulation": entities that perform similar functions should be subject to similar regulation . . . firms that establish a market place for providing execution of transactions in securities pursuant to their own trading rules should be regulated in a manner similar to exchanges, regardless of whether they are also (continued...) ======END OF PAGE 30====== and elimination of fraudulent and manipulative trading, and the mechanisms to ensure fair and equitable oversight and competition among markets. a. Market Access and Fairness While institutional investors are now the dominant players in U.S. financial markets,<(34)> the United States still has the highest percentage of direct individual participation in the stock markets.<(35)> Because the needs and interests of small individual investors, money managers, wealthy speculators, and large pension plans are not always the same,<(36)> market regulation is intended to ensure that these diverse investors are treated fairly and have fair access to investment opportunities. <(33)>(...continued) brokers and dealers. The name given an entity should not control the manner in which it is regulated. Testimony of Edward A. Kwalwasser, Exec. V.P., NYSE, before the Telecommunications and Finance Subcommittee, Committee on Energy and Commerce, U.S. House of Representatives, at 5- 6 (May 26, 1993) (hereinafter Testimony of Edward A. Kwalwasser). <(34)> In 1960, institutions owned only 14.2 percent of the total $425 billion outstanding U.S. equity securities. By the end of the third quarter of 1996, the percentage had grown to 52.3% of the total $9,387 billion of outstanding U.S. equity securities. Conversation with staff of the Securities Industry Association (Feb. 21, 1997). <(35)> From 1989 to 1995, the percentage of U.S. households having direct or indirect stock holdings jumped from 31.7% to over 41%. See Arthur B. Kennickell and Annika E. Sunden, Family Finances in the U.S.: Recent Evidence from the Study of Consumer Finances, Fed. Reserve Bull., Jan. 1997, at 1. <(36)> Electronic Bulls & Bears, supra note 5, at 29. ======END OF PAGE 31====== Specifically, the Exchange Act requires registered exchanges and securities associations to consider the public interest in administering their markets, to allocate reasonable fees equitably,<(37)> and to establish rules designed to admit members fairly.<(38)> While these provisions are based on the principle that qualified market participants should have fair access to the nation's securities markets, they are not intended to limit exchanges from having reasonable standards for access.<(39)> Rather, fair access requirements are intended to prohibit unreasonably discriminatory denials of access. A denial of access would be reasonable, for example, if it were based on unbiased standards, such as capital and credit requirements, and if these standards were applied fairly. The Exchange Act also requires registered exchanges and securities associations to establish rules that assure fair representation of members and investors in selecting directors and administering their organizations.<(40)> The purpose of this requirement is to protect the rights and interests of the diverse members of registered exchanges and <(37)> Exchange Act 6(b)(4), 15 U.S.C. 78f(b)(4); Exchange Act 15A(b)(5), 15 U.S.C. 78o-3(b)(5). <(38)> Exchange Act 6(b)(2) and 6(c), 15 U.S.C. 78f(b)(2) and (c); Exchange Act 15A(b)(8); 15 U.S.C. 78o- 3(b)(8). <(39)> "[R]estraints 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 national market system." H.R. Rep. No. 123, 94th Cong., 1st Sess. 53 (1975). <(40)> Exchange Act 6(b)(3), 15 U.S.C. 78f(b)(3); Exchange Act 15A(b)(4), 15 U.S.C. 78o-3(b)(4). ======END OF PAGE 32====== securities associations. In addition, because registered exchanges and securities associations are also SROs, they exercise governmental powers, such as the imposition of disciplinary sanctions on their members. Fair representation on the body responsible for disciplining members is, therefore, critical to the impartial enforcement of SRO rules. Market regulation is also designed to remove barriers to fair competition, by prohibiting the rules of registered exchanges and securities associations from being anticompetitive,<(41)> and by providing for Commission review of the rules of registered exchanges and securities associations.<(42)> To further emphasize the goal of vigorous competition, Congress required the Commission to consider the competitive effects of exchange rules,<(43)> as well as the Commission's own rules.<(44)> The Commission's authority to review the actions of registered exchanges and securities associations has prevented the implementation of numerous rules that would have been anticompetitive or otherwise detrimental to the market. For example, in December 1990, the American Stock Exchange ("Amex") submitted a rule proposal to the Commission that would have excluded the orders of competing dealers (i.e., regional <(41)> Exchange Act 6(b)(8), 15 U.S.C. 78f(b)(8); Exchange Act 15A(b)(9), 15 U.S.C. 78o-3(b)(9). <(42)> Exchange Act 19(b)(1), 15 U.S.C. 78s(b)(1). See infra notes 188 to 205 and accompanying text (discussion of obligations of exchanges and securities associations to file rules and rule changes with the Commission). <(43)> Exchange Act 6(b)(6), 15 U.S.C. 78f(b)(6). <(44)> Exchange Act 23(a), 15 U.S.C. 78w(a)(2). ======END OF PAGE 33====== exchange specialists and third market makers) from its order routing system and would have imposed trading restrictions on competing dealers in Amex securities. Because the exclusions and restrictions applied only to competing dealers and not to other off-floor broker-dealers trading for their own accounts, the proposal raised market access and competitive concerns.<(45)> After receiving numerous negative public comments regarding the Amex's proposal, the Commission staff recommended that the Amex either amend or withdraw the proposal.<(46)> Similarly, several exchanges have proposed prohibiting customer orders from being executed through the exchanges' automated systems for guaranteed execution of small customer orders, if those customers used computer and communications technology to generate and transmit those orders. Such a proposal, if implemented, would have had the effect of discouraging the use of new, innovative technology. The tendency to try to discourage innovation in order to protect existing practices is not new. In 1987, for example, the Commission set aside the NYSE's denial of the requests of two of its members for permission to install telephone connections on the floor to <(45)> Securities Exchange Act Release No. 28741 (Jan. 3, 1991), 56 FR 1038 (Jan. 10, 1991). The proposal would have required that orders for the account of competing dealers: (1) yield priority and parity to all other off-floor orders; (2) accept parity with orders for an account of an Amex specialist; and (3) be excluded from the Amex's order routing system, the Post Executions Reporting system. The Amex subsequently amended its proposal. Securities Exchange Act Release No. 30161 (Jan. 7, 1992), 57 FR 1502 (Jan. 14, 1992). <(46)> See Market 2000 Study, supra note 14, at app. III, at 11. In 1994, the Amex withdrew its proposal. ======END OF PAGE 34====== enable the members to communicate with their customers.<(47)> The fair access and treatment requirements in the Exchange Act are intended to ensure that exchanges and securities associations operating markets treat investors and their participants fairly. Under the current regulatory approach, however, there is no regulatory redress for unfair denials or limitations of access by alternative trading systems, or for unreasonably discriminatory actions taken against, or retaliatory fees imposed upon, participants in these systems. The availability of redress for such discriminatory actions may not be critical when alternative trading systems disclose any discriminatory practices to their participants and 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 no other serious competitor, such as when it has a significantly large percentage of the volume of trading, discriminatory actions may be anticompetitive because market participants must use such trading system to remain competitive. Similarly, significant changes in the operations of alternative trading systems are not subject to either Commission or SRO review -- even those changes that may be anticompetitive, unfair to a particular group of market participants, or that have significant effects on the primary public markets. b. Market Transparency and Coordination Securities markets have become increasingly interdependent because of the opportunities technology provides to link products, implement complex <(47)> See In the Matter of the Application of William J. Higgins and Michael D. Robbins, Admin. Proc. No. 3-6609, Securities Exchange Act Release No. 24429 (May 6, 1987). ======END OF PAGE 35====== hedging strategies across markets, and trade on multiple markets simultaneously. While these opportunities benefit many investors, they can also create misallocations of capital, widespread inefficiency, and trading fragmentation if markets do not coordinate. Moreover, a lack of coordination among markets can increase system-wide risks. Congress adopted the 1975 Amendments, in part, to address these potential negative effects of a proliferation of markets.<(48)> In the 1975 Amendments, Congress specifically endorsed the development of a national market system, and sought to clarify and strengthen the Commission's authority to promote the achievement of such a system. Because of uncertainty as to how technological and economic changes would affect the securities markets, Congress explicitly rejected mandating specific components of a national market system.<(49)> Instead, Congress granted the Commission "maximum flexibility in working out the specific details" and "broad discretionary powers" to implement the development of a national market system in accordance with the goals of the 1975 Amendments.<(50)> <(48)> See generally S. Rep. No. 75 and H.R. Rep. No. 229, 94th Cong., supra note 22. <(49)> S. Rep. No. 75, supra note 22, at 2, 8; H.R. Rep. No. 229, supra note 22. "[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." S. Rep. No. 75, supra note 22, at 3. <(50)> S. Rep. No. 75 and H.R. Rep. No. 229, supra note 22. ======END OF PAGE 36====== The SROs and the Commission have worked hard to achieve these goals.<(51)> Recent evidence suggests that the failure of the current regulatory approach to fully coordinate trading on alternative trading systems into national market systems 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 institutions, orders on these systems frequently are not available to the general investing public. The ability of market makers and specialists to display different and potentially superior prices on these alternative trading systems than those displayed to the general public created, in the past, the potential for a two-tiered market.<(52)> For example, during the Commission's recent investigation of Nasdaq <(51)> For example, the Intermarket Communications Group links the Commission, the Commodity Futures Trading Commission, and the SROs for the major securities and futures markets. During periods of market stress this interagency and intermarket coordination helps to minimize uncertainty and improve communication for the benefit of investors trading in all U.S. markets. In addition, market- wide trading halts imposed by circuit breaker procedures limit credit risk by providing a brief respite amid frenetic trading, which allows market participants to ensure the solvency of their counterparties. These planned, coordinated trading halts also facilitate price discovery by providing an opportunity to publicize order imbalances in order to attract value traders, and cushion the impact of market movements that would otherwise damage a market's infrastructure. <(52)> See Securities Exchange Act Release No. 36310 (Sept. 29, 1995), 60 FR 52792 (Oct. 10, 1995) (hereinafter Order Handling Rules Proposing Release). ======END OF PAGE 37====== trading,<(53)> 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.<(54)> Moreover, the Commission found that, because they could trade with other market professionals through non-public alternative trading systems, market makers did not have a sufficient economic incentive to adjust their public quotations to reflect more competitive prices.<(55)> Ultimately, the wider spreads quoted publicly by market makers increased the transaction costs paid by public customers, impaired the ability of some institutional <(53)> 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. See NASD 21(a) Report, supra note 20. <(54)> These conclusions are based on Instinet and SelectNet data for the months April through June 1994. See NASD 21(a) Report, supra note 20, at notes 48 to 52 and accompanying text. <(55)> 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 20, at 20. ======END OF PAGE 38====== investors to obtain favorable prices in those securities, and placed institutions at a potential disadvantage in price negotiations.<(56)> In response to these findings, the Commission recently took steps to bring greater transparency into the trading environment of certain alternative trading systems. In September 1996, the Commission adopted 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, or ECNs.<(57)> The new rules permit an ECN to fulfill these obligations on behalf of market makers using its system, by submitting its best market maker bid/ask quotations to an SRO for inclusion into public quotation displays ("ECN Display Alternative"). These rules, however, were not intended to fully coordinate trading on alternative trading systems with public market trading. While these rules will help integrate orders on certain trading systems into the public quotation system, they only affect trading that is conducted by market makers and specialists; activity of other participants on alternative trading systems remains undisclosed to the public market unless the system <(56)> NASD 21(a) Report, supra note 20, at 18. <(57)> 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) (hereinafter Order Handling Rules Adopting Release). Currently, all ECNs are broker-dealer trading systems, as defined in Exchange Act Rule 17a-23, and are sponsored through registered broker-dealers. ======END OF PAGE 39====== voluntarily undertakes to disclose all of its best bid/ask prices.<(58)> Moreover, whether an ECN reflects the best bid/ask quotations on behalf of market makers and specialists that participate in its system is wholly voluntary.<(59)> Specifically, ECNs are under no obligation to integrate orders submitted into their systems into the public quotation system, and the central quotation system is not currently <(58)> Because such trading interest 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 also disclosed to the public, it could result in improved price opportunities for public investors. There is already 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 four ECNs that are currently linked to Nasdaq, two ECNs display to the public the best prices of any orders entered into their systems (including both market makers and institutions). One ECN displays to the public the best price of any visible order entered into its system by market makers or institutions, but does not display any orders that are designated as "reserve orders" (which may interact with orders entered into the ECN's system, but are not generally displayed to participants in the ECN). The fourth ECN displays to the public only orders of market makers and those institutional customers that affirmatively choose to have their orders so displayed. <(59)> To date, four trading systems have elected to display quotes under the ECN alternative. See Letters dated January 17, 1997 from Richard R. Lindsey, Director, 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). ======END OF PAGE 40====== required to accept ECNs as participants. Because a majority of trading interest on alternative trading systems is not integrated into the national market system, price transparency is impaired and dissemination of quotation information is incomplete. These developments are contrary to the goals the Commission enunciated over twenty years ago when it noted that an essential purpose of a national market system is 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.<(60)> This development also thwarts congressional goals for a national market system, where the best trading opportunities are to be made accessible to all customers, not just those customers who, due to their size or sophistication, may avail themselves of prices in alternative trading systems not currently available in the public quotation system. c. Market Surveillance Market regulation critically enhances the Commission's ability to surveil market activity as a whole in order to prevent fraud and manipulation, which can jeopardize market integrity and stability. Exchanges and securities associations such as the NASD act as SROs and, as <(60)> Future Structure Statement, supra note 20, at 9-10 (emphasis added). See also, SEC, Policy Statement of the Securities and Exchange Commission on the Structure of a CentralMarket System 25-28 (1973). ======END OF PAGE 41====== such, are responsible not only for complying with the Exchange Act, but also for carrying out the purposes of the Exchange Act, principally by enforcing member compliance with the provisions of the Exchange Act and the rules promulgated thereunder, as well as the exchanges' or associations' own rules.<(61)> This requires exchanges and securities associations to establish rules and procedures to prevent fraud and manipulation and promote just and equitable principles of trade, typically by establishing audit trails, surveillance, and disciplinary programs. It also requires exchanges and securities associations to enforce the antifraud provisions of the federal securities laws.<(62)> These requirements are essential to ensure that SROs implement the goals established by Congress vigilantly and effectively. In addition, exchanges and securities associations serve a critical regulatory function by establishing and enforcing just and equitable principles of trade, and by providing a mechanism for preventing inappropriate behavior that damages market integrity, even if such behavior does not rise to the level of fraud under the Exchange Act. As a result of these requirements, exchanges and securities associations carry out much of the day-to-day surveillance for, and initial investigation of, trading improprieties, rule violations, and fraud. Although the broker-dealers that operate many of the alternative trading systems have certain obligations to individual customers, because these systems are not SROs, they do not have the same market-wide <(61)> Exchange Act 6(b)(1), (5), and (6), 15 U.S.C. 78f(b)(1), (5), and (6); Exchange Act 15A(b)(2), 15 U.S.C. 78o-3(b)(2). <(62)> Id. ======END OF PAGE 42====== enforcement and surveillance obligations as registered exchanges and the NASD. Moreover, SROs' current programs to surveil their own markets for fraud, insider trading, and market manipulation do not extend to observing quote activity on alternative trading systems. Specifically, although trades executed through certain alternative trading systems are reported to the NASD by either broker-dealer participants in such systems or by the broker-dealer operating the market,<(63)> the NASD may not receive a consolidated picture of trading activity on alternative trading systems. Because activity on alternative trading systems is only reported to an SRO after a trade has been executed, SROs cannot fully supervise SROs' members' activities on those systems.<(64)> In addition, because alternative trading systems are often reported as the counterparty to all trades between institutions executed through their systems, SRO surveillance mechanisms may not be able to identify the true counterparties of those trades. As a result, fraudulent or manipulative activity that an institution is carrying on through an alternative trading system may be masked by the overall activities of the system's other participants, and go uninvestigated. As more institutions use alternative trading systems to trade with each other, rather than with intermediaries, this could result in significant volume that is not integrated into SRO surveillance <(63)> Broker-dealers that operate trading systems have the same reporting obligations as other broker- dealers. For trades executed on an alternative trading system, this means that, depending on the circumstances, market makers and broker-dealers trading on the system will report their own trades, and that the broker-dealer sponsor of the system will undertake to report trades between non-broker-dealers. <(64)> See NASD 21(a) Report, supra note 20. ======END OF PAGE 43====== operations. Finally, alternative trading systems that compete with systems operated by SROs have repeatedly questioned whether particular SRO actions were driven by competitive, rather than regulatory motives. Thus, adequate oversight of alternative trading systems by SROs may be hindered by competitive concerns. d. Market Stability and Systemic Risks SROs have substantial, ongoing commitments to maintain sufficient system capacity, integrity, and security. The Commission has instituted a program to monitor capacity planning at SROs, so that it can take preemptive action if necessary, and meets with the SROs on a regular basis and reviews various aspects of their computer operations. In contrast, the Division of Market Regulation's experience in administering the Order Handling Rules and other broker-dealer rules has revealed that, in many cases, ECNs and other alternative trading systems may have serious capacity problems.<(65)> Even though they have significant trading volume, under the current regulatory scheme ECNs and other alternative trading systems are not required to have sufficient computer capacity to meet ongoing trading demand or to withstand periods of extreme market volatility or other short-term surges in trading volume. Failure to integrate alternative trading systems into the Commission's programs to review and <(65)> The Commission is aware of several occasions on which significant alternative trading systems had to stop disseminating market maker quotations in order to keep from closing altogether due to insufficient system capacity. In one recent occurrence, an interruption in service at an ECN immediately following a key market announcement appears to have seriously affected options market makers' ability to trade the equities underlying their options. ======END OF PAGE 44====== enhance the capacity of alternative trading systems jeopardizes efforts to ensure that all trade execution centers will remain operational during periods of market stress. C. Conclusion In sum, the current regulation of alternative trading systems does not address the market activities performed by such systems. As a result, such regulation may not have effectively met the congressional goals of protecting market participants from fraud and manipulation, promoting market coordination and stability, and ensuring regulatory fairness and fair competition. Question 1: The Commission seeks comment on the concerns identified above and invites commenters to identify other issues raised by the current approach to regulating alternative trading systems. Question 2: Are the concerns raised in this release with regard to the operation of alternative trading systems under the current regulatory approach unique to such systems? To what extent could these concerns be raised by broker-dealers that do not operate alternative trading systems, such as a broker-dealer that matches customer orders internally and routes them to an exchange for execution or a broker-dealer that arranges for other broker- dealers to route their customer orders to it for automated execution? III. Approaches to Market Oversight The Commission recognizes that, in order to promote efficiency, competition, and capital formation in the securities industry, creation of new markets or the evolution of existing ones must not be inhibited. At ======END OF PAGE 45====== the same time, the Commission continues to believe that fair and measured market oversight is valuable to protect investors, ensure the integrity and fairness of markets, and otherwise promote the goals reflected in the Exchange Act. As the problems discussed above illustrate, the current approach for regulating alternative trading systems may not effectively accomplish these objectives. New technologies are continually facilitating innovative means of trading securities, resulting in qualitatively different market structures. In the next decade, the continued growth of the Internet will present even more opportunity for change in financial services. This release solicits comment on whether the current statutory and regulatory framework is appropriate in light of these myriad developments and new means of trading securities made possible by emerging technologies. The release then seeks comment on specific alternatives for addressing these objectives within the existing securities law framework. A. Regulatory Structure As technology continues to drive the evolution of markets, the variety and combinations of services offered by markets and intermediaries will continue to blur the distinctions among these entities. Under the Exchange Act, such distinctions determine the obligations and responsibilities of each entity towards customers and the market as a whole. In particular, the Exchange Act categorizes market participants based on their primary activities, such as an "exchange" function or a "broker-dealer" function. Although Congress defined the terms "exchange," "broker," and "dealer" broadly enough to accommodate changes in how these entities carry out their business, they could not anticipate the variety of entities that would ======END OF PAGE 46====== develop. The Commission invites commenters to analyze whether, in light of technological advances, market participants might be appropriately regulated without reference to distinctions between markets and intermediaries. In the alternative, the Commission solicits comment on whether new regulatory categories are needed for entities that combine both market and intermediary functions. The Commission also solicits comment on what oversight should apply to these categories. In addition, as explained above, exchanges and broker-dealer intermediaries each play critical roles in supervising securities activities. The Commission solicits comment on how any changes to the regulatory approach would affect these roles. Finally, the Commission solicits comment on how any changes to the current statutory and regulatory structure made to accommodate market innovations could be accomplished without undue cost to existing market participants, which have invested significantly to comply with the existing structure. Question 3: What regulatory approaches would best address the concerns raised by the growth of alternative trading systems and the needs of the market? Is the current approach the most appropriate one? Question 4: What should be the objectives of market regulation? Are the goals and regulatory structure incorporated by Congress in the Exchange Act appropriate in light of technological changes? Are business incentives adequate to accomplish these goals? Question 5: Are the regulatory categories defined in the Exchange Act sufficiently flexible to accommodate changes in market structure? If ======END OF PAGE 47====== not, what other categories would be appropriate? How should such categories be defined? B. Regulatory Tools Technological changes also have significant implications for the tools the Commission relies on to achieve the goals incorporated by Congress into the Exchange Act. As discussed in greater detail in Sections IV and V below, the Commission currently regulates markets largely through its registration, rule filing, examination, and enforcement programs. In light of the changes discussed above, the Commission solicits comment on whether these are effective means of accomplishing congressional goals, and, if not, what other means might be more appropriate. For example, many Commission regulations require market participants to deliver written documents. In order to give broker-dealers and investment advisers the flexibility to comply with these requirements in the most cost-effective and efficient manner, the Commission has issued interpretative guidance regarding the use of electronic communications to fulfill the delivery requirements of the federal securities laws.<(66)> Rather than specifying acceptable types of electronic delivery, the Commission specified the standards that entities had to achieve in meeting their delivery requirements electronically, leaving it to each entity to determine the best way to meet each standard. This approach allows broker-dealers and investment advisers to avail themselves of technological innovations without first obtaining regulatory approval. <(66)> See Securities Exchange Act Release No. 36345, 60 FR 53458 (Oct. 6, 1995); Securities Exchange Act Release No. 36346, 60 FR 53468 (Oct. 6, 1995); Securities Exchange Act Release No. 37183 (May 9, 1996), 61 FR 24652 (May 15, 1996). ======END OF PAGE 48====== The Commission solicits comment on whether such a standard-oriented approach would be appropriate for the regulation of markets, and, if so, what these standards should be. Question 6: Can the Commission regulate markets effectively through standard-oriented regulation of the type described above? Question 7: How could the Commission enforce compliance with the Exchange Act under such a standard-oriented approach? Question 8: Is the current regulatory framework an effective form of oversight, in light of technological changes? Are there other regulatory techniques that would be comparably effective? If so, would the implementation of such techniques be consistent with congressional goals reflected in the Exchange Act? IV. Proposals Under Consideration to Integrate Alternative Trading Systems into the Existing Regulatory Structure for Market Oversight Within the existing regulatory framework, the issues currently associated with alternative trading systems could be addressed in large part by integrating alternative trading systems more effectively into national market system mechanisms. Discussed below are two alternative means of effecting such integration. First, the Commission could continue to regulate alternative trading systems as broker-dealers and attempt to integrate these systems more effectively into market regulation mechanisms through a series of rules applicable to broker-dealers operating such systems and to SROs overseeing such systems. Second, the Commission could regulate alternative trading systems as exchanges by expanding the interpretation of the term "exchange" to cover those alternative trading systems that engage in many of the same activities as currently registered ======END OF PAGE 49====== exchanges, such as operating an electronic limit order book, or matching or crossing participant orders. The Commission could then follow a tiered approach to regulating those alternative trading systems classified as exchanges. The first tier under this approach would consist of those alternative trading systems that have low volume or a passive pricing structure. These trading systems would not be required to register as national securities exchanges (or as broker-dealers, to the extent that such trading systems do not also perform customary brokerage functions),<(67)> but would be subject to limited requirements. The second tier under this approach would consist of those alternative trading systems with a large volume of trading and active price discovery, but that do not have membership structures. The Commission could require these trading systems to register as exchanges, but would use its new exemptive authority to eliminate unnecessary or inappropriate requirements.<(68)> Finally, the third tier under this approach <(67)> See infra notes 183 to 184 and accompanying text. <(68)> The National Securities Markets Improvement Act of 1996 (hereinafter 1996 Amendments), Pub. L. 104- 290, added Section 36 to the Exchange Act, 15 U.S.C. 78mm, which authorizes the Commission to conditionally or unconditionally exempt any person, security, or transaction, or any class thereof, from any provision of the Exchange Act or rule thereunder, so long as the exemption is necessary or appropriate in the public interest and is consistent with the protection of investors. Section 36 of the Exchange Act does not authorize the Commission to exempt persons, securities, transactions, or classes thereof from Section 15C of the Exchange Act or rules and regulations issued under that section. Section 15C establishes registration requirements for government securities brokers and government securities dealers and gives the U.S. Department (continued...) ======END OF PAGE 50====== would consist of those traditional exchanges that have membership governance structures. Any new regulatory approach to oversight of alternative trading systems should promote efficiency, competition, and capital formation in the securities industry, without inhibiting the development of new markets. At the same time, it is critical to address the problems discussed above. The Commission solicits comment on the two alternatives for addressing these issues discussed below, and on whether there are other alternatives that may address the Commission's concerns. Question 9: Are there viable alternatives within the existing Exchange Act structure, other than those discussed below, that would address the concerns raised by the growth of alternative trading systems and congressional goals in adopting the Exchange Act? A. Integrating Alternative Trading Systems into the National Market System Through Broker-Dealer Regulation In order to rectify the shortcomings discussed in Section II of this release, the Commission could build upon its current regulation of alternative trading systems as broker-dealers. In particular, alternative trading systems could be overseen and integrated into the NMS through a combination of broker-dealer regulation and regulation of the SROs that <(68)>(...continued) of the Treasury authority to promulgate rules governing the activities of these entities. All of the exemptions pursuant to Section 36 of the Exchange Act that the Commission is considering in this concept release could be granted by rule or regulation. If the Commission determined instead to issue orders granting exemptive applications, it would need to adopt procedures for doing so pursuant to Section 36. ======END OF PAGE 51====== supervise these systems. The Commission took a similar approach in its recent adoption of the Order Handling Rules (which are designed to integrate a portion of the trading on ECNs into market transparency mechanisms) and in its adoption of Rule 17a-23 (which established recordkeeping and reporting requirements specifically tailored to broker- dealers operating trading systems). As discussed below, these broker-dealer regulations could include requiring those broker-dealers that operate alternative trading systems to make all orders of participants in those systems available to the public quotation system. The Commission could also require alternative trading systems to provide the public with access to such systems in order to interact with the orders posted by participants of such systems. In addition, the Commission could impose additional requirements on both the broker-dealers that operate alternative trading systems and their SROs in order to more effectively integrate these systems into SRO surveillance mechanisms. For example, the Commission could require broker-dealers that operate alternative trading systems to provide more audit trail information to their SROs, which would help SROs execute their oversight functions, and could require SROs to use this additional information to integrate these systems into their surveillance programs. Finally, the Commission could adopt measures that would help to ensure that alternative trading systems have adequate systems capacity. Question 10: What types of alternative trading systems would it be appropriate to regulate in this manner? 1. Fully Integrating the Orders of All Market Participants into the Public Quotation System and Facilitating Public Access ======END OF PAGE 52====== to Such Orders In its efforts to increase competition and transparency in the market, the Commission has encouraged the development of NMS mechanisms, such as the Consolidated Tape Association ("CTA"), the Consolidated Quotation System ("CQS") and the Intermarket Trading System ("ITS"). These mechanisms make information about trading interest, prices, and volume widely available to market participants. The Commission has worked to continuously update and improve the NMS to reflect technological advances. For example, the new Order Handling Rules require market makers and specialists to make available publicly any superior prices they privately offer through ECNs. As an alternative, the new rules permit, but do not require, an ECN to fulfill these obligations on behalf of the market maker or specialist by submitting the ECN's best bid and offer to an SRO for inclusion into the public quotation system. As discussed above,<(69)> however, these rules were not intended to integrate all trading on alternative trading systems into the NMS. These rules focus only on ensuring that market maker and specialist activity on alternative trading systems is reflected in their public quotations. As a result, institutional orders on ECNs remain largely undisclosed to the public, thus hiding the aggregate trading interest on alternative trading systems from public view. Therefore, it might be appropriate to require broker-dealers that operate alternative trading systems to report all orders<(70)> submitted by participants, <(69)> See supra notes 57 to 60 and accompanying text. <(70)> Firm prices for securities, whether such firm prices are labeled as "orders," "quotes," or (continued...) ======END OF PAGE 53====== including those of non-broker-dealer participants, for integration into the public quotation system. If alternative trading systems are required in some manner to publicly display the orders of all participants, they could also be required to provide the public with the ability to execute against those orders. Under the Order Handling Rules, an ECN that voluntarily displays market makers' and specialists' quotations to the public must also provide an equal opportunity for participants and non-participants to execute their orders against such quotations. Non-participants, however, may only access market maker and specialist quotations on those ECNs. Alternative trading systems could be required to provide non-participants with the ability to execute against all orders in their system, including those of institutions, in a manner equivalent to that offered participants of the systems. Non- participants would be granted access on a real-time basis under this approach and could be charged reasonable fees for such access. Question 11: If the Commission decided to further integrate alternative trading systems into the NMS through broker-dealer regulation, should it require alternative trading systems to submit all orders displayed in their systems into the public quotation system? If not, how should the Commission ensure adequate transparency? <(70)>(...continued) otherwise, could be included in the public quotation system. Priced orders entered into alternative trading systems where the orders are widely disseminated and executable could be viewed as the functional equivalent of quotations, and like quotations, would play a key role in the price discovery process. See also Order Handling Rules Adopting Release, supra note 57, at 116. ======END OF PAGE 54====== Question 12: If the Commission requires alternative trading systems to submit all orders displayed in their systems into the public quotation system, how can duplicate reporting by alternative trading systems and their participant broker-dealers be prevented? Question 13: Are there other methods for integrating all orders submitted into alternative trading systems into the public quotation system? Question 14: Are there any reasons that orders available in alternative trading systems should not be available to the public? Question 15: If the Commission requires alternative trading systems to allow non-participants to execute against orders of system participants, how should it ensure that non-participants are granted equivalent access? Question 16: If the Commission requires alternative trading systems to allow non-participants to execute against orders of system participants, how should it determine whether the fees charged to non- participants by such systems are reasonable and do not have the effect of denying access to orders? Question 17: Are there any reasons that non-participants should not be able to execute against orders of participants in alternative trading systems? 2. Improving the Surveillance of Trading Conducted on Alternative Trading Systems As discussed below, alternative trading systems may not be subject to real-time surveillance for market manipulation and fraud. Broker-dealers that operate these systems are not required to actively surveil the conduct ======END OF PAGE 55====== of system participants to ensure against fraud and manipulation. Instead, as discussed above, these surveillance responsibilities lie with the SROs. SROs, however, do not actively incorporate alternative trading systems into their real-time surveillance programs, and broker-dealer trade reporting conventions restrict SRO surveillance capabilities. Trading by institutions on alternative trading systems is effectively hidden from SRO programs designed to detect fraud and manipulation. SRO surveillance systems generate "alerts" that, in their most basic form, indicate when trading in a particular security is outside of normal trading patterns, such as when a previously inactive entity suddenly begins actively trading. Broker-dealers operating alternative trading systems, however, are not required to report the identities of the counterparties to a trade to their supervising SRO. Instead, the broker-dealer may report the trade to the SRO as its own trade. Therefore, SRO surveillance programs do not "look through" the alternative trading system to the actual counterparties conducting the trading on such systems. Because the SRO system views the broker-dealer operating the system as the counterparty to trades, unusual trading activity of a participant in an alternative trading system may not trigger an alert. While the anonymity provided by the broker-dealer trading system reporting the trade may be desirable to some because it allows traders to hide their trading strategies from other market participants, it also represents an opportunity for market manipulation that is increasingly difficult for SROs to detect. In addition, SRO surveillance programs typically are constructed around activity in particular securities. Several alternative trading systems are designed to provide a liquid market in securities that are not ======END OF PAGE 56====== traded on exchanges or Nasdaq, such as limited partnerships and certain