SEC Proposes Regulations for Venues Trading Treasuries with Corporate Bonds and Munis on the Horizon

In light of the Concept Release, market participants should expect that the SEC may eventually propose additional regulatory requirements under Regulation ATS for fixed income ATSs comparable to the existing structure for NMS stock ATSs and the proposed structure for government securities ATSs. That prospect as with adoption of the proposal will, of course, be decided by the next administration at the SEC. An overview of the Proposal and the Concept Release are provided below.

The deadline for comments on the Proposal is 60 days after publication of the Proposal in the Federal Register, which deadline will likely be final week of 2020 calendar year or first week of 2021.⁶ 

Government Securities ATSs and Form ATS-G

Background

In adopting Regulation ATS in 1998, the SEC determined to exclude systems exclusively supporting trading in government securities⁷ from the requirements of Regulation ATS because “government securities are subject to other forms of regulation that help to ensure that those markets are fair and orderly.”⁸ As a result, today, a trading system matching buyers and sellers solely in government securities and certain related instruments⁹ need not comply with Regulation ATS, provided the system is operated by a registered broker-dealer or a bank.¹⁰

This would change under the Proposal. All systems supporting trading in government securities that meet the SEC’s definition of an “exchange”¹¹ will need to comply with Regulation ATS. In particular, a bank operating such a system would need to become a broker-dealer, if not already so registered, in order to comply with the Proposal.

Form ATS-G

Under the Proposal, a government securities ATS would file disclosures with the SEC pursuant to Form ATS-G, which would then be made publicly available on the SEC’s website. Form ATS-G primarily consists of three parts pertaining to (i) basic identifying information regarding the government securities ATS and broker-dealer operator, (ii) a description of the other activities of the broker-dealer operator and its affiliates, and (iii) disclosures relating to the manner of operations of the government securities ATS.

The disclosure requirements on proposed Form ATS-G are substantively similar to those required on Form ATS-N except that Form ATS-G does not require disclosures relating to routing orders to other trading venues as well as order display and execution access.¹² Proposed Form ATS-G also adds a disclosure requirement not contained in Form ATS-N pertaining to interactions or functionality with related markets (e.g., futures, swaps, currencies, fixed income markets) offered by a government securities ATS.¹³

Regulation SCI and Fair Access Requirements

Under the Proposal, government securities ATSs must comply with Regulation SCI¹⁴and the fair access requirements under Rule 301(b)(5) of Regulation ATS¹⁵ if they trigger certain trading volume thresholds. Specifically, an ATS must comply with these additional requirements if, for four of the preceding six calendar months, it accounts for 5% or more of the average weekly volume of either U.S. Treasury securities (i.e., securities issued by the Department of Treasury) or agency securities (i.e., securities issued or guaranteed by a U.S. executive agency).

The general purpose of applying Regulation SCI to a high-volume ATS is to promote systems and operational integrity of the core technology used by trading venues with significant volume in a particular type of security and to facilitate SEC oversight. Similarly, the purpose of requiring a high-volume ATS to comply with Regulation ATS’s fair access rule, which generally requires an ATS to establish standards for fair and reasonable access to the ATS, is to ensure that market participants are not unreasonably denied access from important sources of liquidity for a particular security. Both requirements apply to ATSs trading other types of securities that hit comparable volume thresholds.

Concept Release on Enhanced Disclosures for Fixed Income ATSs

The purpose of the Concept Release is for the SEC to solicit information that “will ultimately inform regulatory policy” regarding fixed income electronic trading platforms, including their operations, services, fees, market data, and participants.¹⁶ This initiative to enhance regulatory requirements for fixed income ATSs has been on the horizon for several years — having been recommended by the SEC’s Fixed Income Advisory Committee (FIMSAC) in 2017,¹⁷ supported by Chairman Jay Clayton and other Commissioners,¹⁸ and noted as next up for consideration when the SEC adopted enhanced disclosures for NMS stock ATSs in 2018.¹⁹

The primary concern with respect to fixed income ATSs noted by FIMSAC in 2017 was a lack of regulatory harmonization across different venues arising from differences in trading protocols or business models of the various platforms and resulting in a regulatory framework where some firms are regulated as ATSs while others are regulated as broker-dealers or not at all by the SEC.²⁰ In the FIMSAC’s view, differing regulatory requirements “complicate efforts to improve the efficiency and resiliency of fixed income trading markets.”²¹

The fixed income markets differ from the equities markets in many respects that are likely to have meaningful implications for proposed changes to Regulation ATS applicable to fixed income ATSs. For example, the number of distinct bonds trading in the secondary market is an order of magnitude greater than for NMS stock.²² A single large corporation may have just one equity trading symbol but approximately 1,500 CUSIP numbers for various fixed income issuances.²³ The increased volume of different instruments makes sourcing liquidity for particular bonds more challenging and explains in part why fixed income trading occurs to a much larger degree through interdealer markets rather than electronic platforms. In this regard, commenters on the Concept Release may wish to consider the following:

• Application of the Definition of an “Exchange” to Request for Quote Systems: There is no clear distinction between a request-for-quote system that may not be subject to Regulation ATS and a system that performs the functions of an exchange and is therefore subject to Regulation ATS. Operators of certain systems may believe their system performs mere negotiation and communication functions, rather than exchange functions of bringing together the orders of multiple buyers and sellers for securities using nondiscretionary methods. Without clear regulatory guidance, however, negotiation/communication systems could be considered to be performing exchange functions depending on the rules ultimately proposed by the SEC.²⁴
• Application of Fair Access Requirements and Regulation SCI: Any proposed changes to the fair access requirements and Regulation SCI volume thresholds could be problematic for fixed income ATSs. Currently, a fixed income ATS must account for 5% of the average daily volume for all corporate debt securities and/or municipal securities to trigger these regulatory requirements. However, if these thresholds were to be relaxed or revised to apply, for example, to 5% of the average daily volume of just a single given bond, small ATSs could find themselves subject to onerous additional regulatory obligations just for having done a single trade on a thinly traded bond. This could raise barriers to entry for small firms and chill competition.
• Price Discovery: NMS stock ATSs rely on the quoted prices on national securities exchanges to inform the prices at which trades may occur and there is intermarket price protection across equities. There is no comparable pricing authority or guarantee that a bond trading on a particular venue is the best available price for that bond. Consequently, disclosures relating to how orders and quotes are priced or any other pricing inputs from other markets should consider this fact.
• Different Types of Fixed Income Securities: There are numerous different types of fixed income securities including corporate bonds, municipal securities, mortgage-backed securities, and money markets. Many of these transactions clear and settle a different manner.
• Transition from Primary to Secondary Markets: One might expect disclosures relating to how a fixed income ATS begins to conduct secondary trading in a particular security after its primary issuance. Such disclosures could be of substantial benefit to market participants who might not be aware of venues that conduct trading in a recently issued bond.
• Overlapping Regulatory Requirements: If the SEC were to propose a separate set of regulatory disclosures for fixed income ATSs (e.g., Form ATS-F), a system supporting trading in both fixed income securities and government securities may have to separately file pursuant to two separate forms for effectively the same system. It’s also possible given differences in how varying fixed income securities trade that there could be several different forms, such as Form ATS-MB (for MBS) and Form ATS-MU (municipal securities). This could duplicate or triplicate disclosure requirements for ATSs that support trading in multiple different types of securities

¹ Securities Exchange Act of 1934 Release No. 90019 (September 28, 2020) [Federal Register publication pending] https://www.sec.gov/rules/proposed/2020/34-90019.pdf. The Concept Release begins on page 199 of the Proposal. While the most significant portion of the Proposal relates to government securities ATSs, the SEC also proposed various other amendments to Regulation ATS including (1) requiring that Forms ATS and ATS-R be filed with the SEC electronically through the EDGAR database, (2) eliminating confidential treatment of the types of securities that an ATS trades, (3) updating certain portions of Form ATS-N, (4) requiring NMS stock ATSs to post their Form ATS-N on their websites, and (5) removing exclusions for certain types of “passive” ATSs from the requirements of Rules 301(b)(5) and (b)(6) of Regulation ATS.

² In another effort to bring transparency to fixed income markets, the Financial Industry Regulatory Authority (FINRA) recently solicited comment on “pennying,” which involves a dealer, after receiving a customer order, initiating a bid or offer wanted auction process on behalf of a customer, reviewing the auction responses, and then executing the customer order itself at a price that either matches or slightly improves the best priced auction response. FINRA Regulatory Notice 20-29, Corporate Bonds (Aug. 17, 2020).

³ SEC, Division of Economic and Risk Analysis, U.S. Credit Market Interconnectedness and the Effects of the COVID -19 Economic Shock (October 2020). The SEC held a roundtable discussion to discuss the issues raised in the report on October 14, 2020.

⁴ See our previous client alert detailing the disclosure regime for NMS stock ATSs available here.

⁵ A single ATS trading multiple types of these securities would be separately responsible for disclosures pursuant to each form.

⁶ Publication of the Proposal in the Federal Register has not yet occurred as of the date of this writing. 

⁷ The term “government securities” is defined in Section 3(a)(42) of the Securities Exchange Act of 1934 (Exchange Act). 15 U.S.C. 78c(a)(42).

⁸ Securities Exchange Act Release No. 40760, 63 FR 70844, 70859 (Dec. 22, 1998) (Regulation ATS Adopting Release).

⁹ These related instruments are (i) repurchase and reverse repurchase agreements involving government securities, (ii) unlisted options on government securities, and (iii) commercial paper. 17 CFR 242.301(a)(4).

¹⁰ Id.

¹¹ 17 CFR 240.3b-16 (interpreting the definition of an “exchange” under Section 3(a)(1) of the Exchange Act).

¹² Proposal at 80. See Form ATS-N, Part III, Item 16 (Order Routing) and Item 24 (Order Display and Execution Access).

¹³ See proposed Form ATS-G, Part III, Item 16 (Related Markets).

¹⁴ 17 CFR 242.1000 et seq.

¹⁵ 17 CFR 242.301(b)(5).

¹⁶ Proposal at 201.

¹⁷ See FIMSAC, Recommendation for the SEC to Review the Framework for the Oversight of Electronic Trading Platforms for Corporate and Municipal Bonds (July 16, 2018).

¹⁸ See, e.g., Statement of Commissioner Robert Jackson, Final Rules Regarding Regulation ATS (Alternative Trading Systems) (July 18, 2018); Statement of Chairman Jay Clayton, Opening Statement at the SEC Open Meeting (July 18, 2018).

¹⁹ Exchange Act Release No. 83663, 83 FR 38768, 38783 (Aug. 7, 2018) (NMS stock ATS Adopting Release).

²⁰ Proposal at 199-200.

²¹ Id.

²² See, e.g., Bruce Mizrach, Office of the Chief Economist, FINRA, Analysis of Corporate Bond Liquidity at 2 (December 2015) (noting that in the first nine months of 2015, 33,945 distinct bonds were traded).

²³ See, e.g., SIFMA Insights, Fixed Income Market Structure Primer at 5 (July 2018).

²⁴ Notably, the SEC specifically mentioned in the short Concept Release both RFQ platforms and negotiation systems as part of its consideration. Proposal at 201.