On January 26, 2022, the U.S. Securities and Exchange Commission (SEC) proposed rules that would (i) expand the types of systems that must comply with Regulation alternative trading systems (Reg ATS); (ii) apply Reg ATS and Regulation Systems Compliance and Integrity (Reg SCI) to systems supporting trading in government securities; and (iii) modify certain disclosure requirements on Form ATS-N (the Proposal).1 The Proposal refines and expands on a similar SEC proposal from September 2020 to extend Reg ATS and Reg SCI to alternative trading systems (ATSs) for government securities.2 The SEC is reproposing the prior proposal with certain changes — in particular, by expanding the scope of Reg ATS to include “communication protocols” that use nonfirm trading interest to bring together buyers and sellers of securities.
The comment deadline is 30 days after publication of the Proposal in the Federal Register. The Proposal is expansive in terms of the entities that would be covered and the obligations that would be imposed under Reg ATS. Given that, market participants should analyze the Proposal carefully and be mindful that the SEC has recently demonstrated a willingness to bring enforcement actions for violations of Reg ATS.3
In connection with the adoption of Reg ATS, the SEC previously adopted Rule 3b-16 under the Securities Exchange Act of 1934 (Exchange Act), which serves to interpret the Exchange Act’s definition of an “exchange.”4 Under current Rule 3b-16, systems that bring together the orders of multiple buyers and sellers for securities using nondiscretionary methods (e.g., by setting rules) generally fall within the definition of an “exchange.”5 Unless an exemption applies, systems falling within the “exchange” definition, as interpreted by Rule 3b-16, are required to register as a national securities exchange or, alternatively, register as a broker-dealer and comply with Regulation ATS.6
As a result of Rule 3b-16’s reference to “orders,” systems that use nonfirm trading interest (rather than firm orders) to bring together multiple buyers and sellers may have been viewed as not within the scope of Rule 3b-16 and therefore not subject to the requirement to register as an exchange or comply with Regulation ATS.7 However, when adopting Regulation ATS in 1998, the SEC stated that even systems purporting to use only “non-firm” indications of interest may nevertheless be considered to be using “orders” if those indications of interest are firm in practice.8 Separately, there is also presently an exclusion from Reg ATS for systems operated by a bank or broker-dealer that trade only government securities.9
The Proposal would amend the regulatory structure regarding Reg ATS to eliminate the current exclusion for government securities ATSs and expand Rule 3b-16 to encompass systems that facilitate trading using nonfirm trading interest, including through systems that are “communication protocols.”
Expanding the Definition of an “Exchange” to Potentially Reach More Market Participants
In the following key ways, the Proposal would expand the interpretation of the “exchange” definition in Rule 3b-16:10
- Replaces “Orders” With “Trading Interest” — Under the Proposal, all references to “orders” throughout Rule 3b-16 would be changed to “trading interest.”
- The term “trading interest” would be defined in proposed Rule 3b-16(e) as an “order”11 or “any non-firm indication of a willingness to buy or sell a security that identifies at least the security and either quantity, direction (buy or sell), or price.”
- Shifts the Focus to Bringing Together Securities Buyers and Sellers Rather Than Bringing Together Securities “Orders” of Multiple Buyers and Sellers — Under the Proposal the first prong of Rule 3b-16 would be revised to refer to a group that brings together “buyers and sellers of securities” rather than a group that brings together the “orders for securities of multiple of buyers and sellers.”
- As a result, the first prong of Rule 3b-16’s interpretation of the “exchange” definition would be a group that “brings together buyers and sellers of securities using trading interest,” which would encompass considerably more systems than are captured under the current rule.
- Notably, the Proposal would also delete the word “multiple” preceding “buyers and sellers.” This is meant to clarify that, for example, a request-for-quote (RFQ) system would not be excluded from coverage by Rule 3b-16(a) simply because a transaction request in such a system typically involves one buyer and multiple sellers (or one seller and multiple buyers).12
- Expands the Interpretation of an “Exchange” to Include “Communication Protocols” — Currently, the second prong of Rule 3b-16’s interpretation of the “exchange” definition requires that the person or group “uses established, non-discretionary methods (whether by providing a trading facility or by setting rules)” under which securities orders interact.
- Under the Proposal, “communication protocols” would be added to capture additional systems that the SEC views as performing the essential functions of an exchange covered by Rule 3b-16. The SEC states that these systems “generally offer the use of non-firm trading interest and establish protocols to prompt and guide buyers and sellers to communicate, negotiate, and agree to the terms of the trade without relying solely on the use of orders.”13
- The term “communication protocols” is not defined in the Proposal, but the SEC describes them as including, among others, RFQ systems electronically displaying firm or nonfirm trading interest (e.g., stream axes), conditional order systems, and negotiation systems that allow users to select certain preapproved participants and then exchange messages for purposes of agreeing to the terms of a trade.14 Without the adoption of a clear definition of “communication protocols,” the term would be subject to potentially broad and evolving interpretation by the SEC staff.
- In addition, the Proposal would modify the second prong of the interpretation to encompass a person or group who “makes available” rather than “uses” established nondiscretionary methods for trading interest interaction. The SEC states that this is intended to capture communication protocols for which the operators “take a more passive role in providing to their participants the means and protocols to interact, negotiate, and come to an agreement.”15
The Proposal does not directly address platforms — such as decentralized exchanges — that may trade digital assets that are securities. Many of these platforms may already be subject to Reg ATS if they use firm orders in respect of trading digital assets that are securities. As a result, the incremental expansion of Reg ATS to cover the broader category of “trading interest” (rather than just “orders”) would not newly ensnare such platforms using firm orders. However, the proposed change to the interpretation of the “exchange” definition to encompass a person or group who “makes available” (rather than “uses”) established nondiscretionary methods for trading interest interaction could be understood to expand Reg ATS to newly reach persons who, for example, provide access to a decentralized exchange that allows for trading of securities instruments.
Government Securities ATSs
Similar to the September 2020 proposal,16 the Proposal would expand the application of Reg ATS to persons who meet the definition of an “exchange” under Rule 3b-16 that trade government securities17 (e.g., U.S. Treasury securities) and agency securities18 (collectively Government Securities ATSs). This would include compliance with Rule 301(b)(5) of Reg ATS (the Fair Access Rule) and Reg SCI in the case of Government Securities ATSs that cross certain volume thresholds for the relevant type of security during at least four of the preceding six calendar months. Key requirements for Government Securities ATSs under the Proposal would include
- Elimination of Exclusion From Reg ATS for Certain Government Securities ATSs — As noted, a Government Securities ATS that limits its activities to only government securities is presently excluded from Reg ATS;19 this exclusion would be eliminated under the Proposal
- Use of Form ATS-N — Government Securities ATSs would file with the SEC using Form ATS-N (currently used only for ATSs trading NMS stocks) rather than the previously proposed Form ATS-G; Form ATS-N would also be modified to contemplate Government Securities ATSs disclosing their operations and other details using the form20
Fair Access Rule Would Apply to ATSs for U.S. Treasury Securities — Government Securities ATSs would become subject to the Fair Access Rule requiring that the ATS not unreasonably prohibit or limit access to the ATS if during four of the preceding six months the ATS accounted for 3% or more of the average weekly dollar volume traded in the United States. This is lower than the 5% threshold that was proposed under the 2020 proposal.
Fair Access Rule (Rule 301(b)(5) of Reg ATS) — The Fair Access Rule is generally designed to ensure that an ATS meeting certain volume thresholds in a particular security is accessible to all market participants as an important source of liquidity. The Proposal would add new requirements to the Fair Access Rule while removing an available exemption from it for certain ATSs:
- Clarifying Share and Dollar Volumes — The Proposal would specify that the Fair Access Rule applies to ATSs that cross the threshold of 5% or more of the daily “share” volume in NMS stock or an equity security that is not NMS stock.
- Similarly, the Proposal would specify that the Fair Access Rule applies to ATSs that cross the threshold of 5% or more of the average daily “dollar” volume for municipal securities, debt securities, and agency securities.21 The threshold for U.S. Treasury securities would be 3% of the average weekly dollar volume.
- Aggregation of Transaction Volume — The Proposal would specify that the volume thresholds for a security or category of securities are to be aggregated among ATSs operated by a common broker-dealer or ATSs operated by affiliated broker-dealers. Affiliation would be broadly defined in proposed Rule 300(c) as “with respect to a specified person, any person that, directly or indirectly, controls, is under common control with, or is controlled by, the specified person.”
- Enhanced Fair Access Standards — Once the applicable thresholds are triggered, the Proposal would specify heightened requirements for ensuring fair access by requiring, among other things, that the ATS establish and apply “reasonable” standards not just for granting accessing to the ATS but also for limiting and denying access to the ATS and to justify why each standard is “fair and not unreasonably discriminatory.”
- Eliminating the Nondisplayed, Customer Order Exemption — Currently, there is an exemption for an ATS that crosses the transaction volume thresholds if (i) the ATS matches customer orders with other customer orders; (ii) the ATS does not display those orders to any person (excluding ATS employees); and (iii) such orders are executed at a price disseminated by an effective transaction reporting plan or derive from such prices. This exemption would be eliminated.22
Regulation SCI — Under the Proposal, the definition of a “SCI ATS” in Rule 1000 of Reg SCI would be amended to include Government Securities ATSs crossing certain volume thresholds.23 Specifically, it would include an ATS that, during at least four of the preceding six months, had (i) with respect to Treasury securities, 5% or more of the average weekly dollar volume in the U.S., or (ii) with respect to agency securities, 5% or more of the average daily dollar volume in the U.S.
Notably, the activity of affiliated ATSs would not be aggregated for purposes of meeting the SCI volume thresholds as they would for purposes of the Fair Access Rule.
Amendments Affecting Both NMS Stock ATSs and Government Securities ATSs
- Extension of SEC Review Period — Under the Proposal, the SEC’s review period for amendments to a Form ATS-N may be extended by an additional 30 days or such longer period as the ATS may agree to in writing. This change may add uncertainty to when Form ATS-N amendments will become effective.
- Under the Proposal, the SEC would have up to 180 days to review an initial Form ATS-N by a new filer, up from 120 days.
- Fee Amendments — A new category of Fee Amendments would be added to Form ATS-N. Changes to the fees charged by the ATS — as disclosed on Part III, Item 18 of Form ATS-N, as revised — would be required the day the fee is changed.
- Contingent Amendments — Under the Proposal, the current category of Order Display and Fair Access Amendments would be renamed as Contingent Amendments.
- Changes to Form ATS-N Disclosures — The Proposal would make a number of changes to Form ATS-N, including these:
- Part I — adding disclosures of the types of securities traded, including repurchase and reverse repurchase agreements
- Part II — requiring an explanation of the circumstances under which the broker-dealer operator or an affiliate of the ATS may be a counterparty to a trade
- Part III — with respect to disclosures regarding the operations of the ATS:
- Item 7, enhanced disclosures related to the trading facilities, trading rules of the ATS, and the manner in which orders and trading interest may interact
- Item 8, detailed disclosures regarding the use of nonfirm trading interest and communication protocols
- Item 9, adding disclosures related to monitoring and surveillance of trading activity on the ATS
- Item 11, adding disclosures regarding functionality to “facilitate trading or communication on, or source pricing for, the ATS” using markets for financial instruments that relate to securities trading on the ATS (e.g., currencies, options)
- Item 13, enhanced disclosure related to the ATS’s ability to segment trading interest or limiting order action among subscribers (absent subscriber instruction)
- Item 15, enhanced disclosures regarding the visibility of trading interest
Form ATS-R Amendments — The SEC is also proposing certain amendments to Form ATS-R, which is the form on which ATSs report quarterly certain transaction volume information, subscriber lists, and securities traded.
- No Longer “Deemed Confidential” — Under the Proposal, Form ATS-R submissions (as well as Form ATS submissions for ATSs that do not trade government securities or NMS stocks) would no longer be “deemed confidential when filed.” Under the revised rule provisions, Form ATS-R and Form ATS submissions would be “accorded confidential treatment subject to applicable law.”
- New Categories of Securities — The Proposal would, among other changes, add new categories for agency securities and U.S. Treasury Securities and bifurcate the corporate debt securities between U.S. corporate bonds and non-U.S. corporate bonds.
- Disclosures for Repurchase Agreements and Reverse Repurchase Agreements — The Proposal would amend Form ATS-R to include disclosures for the total unit and dollar volume of Repurchase Agreements and Reverse Repurchase Agreements on different types of securities that trade via the ATS.
- Electronic Submission — The Proposal would allow for electronic submission of Form ATS-R and Form ATS, which are currently required to be filed as paper copies. Since the COVID-19 pandemic, however, the SEC has allowed for submissions to be filed electronically.
* * *
To the extent the Proposal is adopted by the SEC, many systems that support trading in all types of securities using nonfirm trading interest would have to comply with Regulation ATS, including becoming a registered broker-dealer. Systems that have limited their activity to just trading U.S. Treasury securities would also become subject to Reg ATS and the heightened disclosure obligations under Form ATS-N. Additionally, current NMS Stock ATSs must comply with the additional disclosure obligations based on the changes to Form ATS-N.
1Securities Exchange Act Release No. 94062 (January 26, 2022), https://www.sec.gov/rules/proposed/2022/34-94062.pdf.
2For details of the September 2020 proposal, please see Sidley’s client alert here.
3In re tZERO ATS, LLC Securities Exchange Act Release No. 93938 (January 10, 2022), https://www.sec.gov/litigation/admin/2022/34-93938.pdf.
4Section 3(a)(1) of the Exchange Act defines an exchange as "a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange."
517 CFR 240.3b-16.
6See Rule 3a1-1 under the Exchange Act, 17 CFR 240.3a1-1.
7Exchange Act Release No. 40760, 63 FR 70844, 70850 (Dec. 22, 1998) (Reg ATS Adopting Release) (“In general, the Commission intends to read the definition of ‘order’ broadly and will not consider systems to fall outside the definition in Rule 3b–16 based solely on a system’s labeling of indications of interest as ‘not firm’ ”).
8Generally speaking, the difference between “firm” and “non-firm” trading interest is that “firm” trading interest is able to be acted on to create a trade without further negotiation, while “non-firm” trading interest requires some further negotiation or “firm up” by potential counterparties before a trade is entered.
917 CFR 242.301(a)(4). When adopting this exemption in 1998, the SEC noted that “government securities are subject to other forms of regulation that help to ensure that those markets are fair and orderly.” See Reg ATS Adopting Release at 70859.
10Rule 3b-16(a) currently provides: “An organization, association, or group of persons shall be considered to constitute, maintain, or provide ‘a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange,’ as those terms are used in section 3(a)(1) of the [Exchange] Act, (15 U.S.C. 78c(a)(1)), if such organization, association, or group of persons: (1) Brings together the orders for securities of multiple buyers and sellers; and (2) Uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.” Rule 3b-16(b) provides certain exclusions from the definition.
11The term “order” is already defined in Rule 3b-16(c) as any firm indication of a willingness to buy or sell a security, as either principal or agent, including any bid or offer quotation, market order, limit order, or other priced order.
12Proposal at 38 (“Under current Rule 3b-16(a), whether a system meets the ‘multiple’ prong depends on whether the system, when viewed in its entirety, includes more than one buyer and more than one seller and is not determined on a transaction-by-transaction basis”).
13Proposal at 19.
14Proposal at 19-22.
15Proposal at 40.
16For details of the September 2020 proposal, please see Sidley’s client alert here.
1715 U.S.C. 78c(a)(42).
18The term “agency security” would be defined in proposed Rule 300(p) to mean “a debt security issued or guaranteed by a U.S. executive agency, as defined in 5 U.S.C. 105, or government-sponsored enterprise, as defined in 2 U.S.C. 622(8).”
1917 CFR 240.301(a)(4).
20For details regarding the requirements of Form ATS-N, please see Sidley’s client alert here.
21These same changes specifying “dollar” volume thresholds would be applied to Rule 301(b)(6).
22There is a similar exception under Rule 301(b)(6), which requires certain ATSs crossing 20% of the average daily dollar volume for municipal securities and debt securities for four of the preceding six months to comply with certain capacity, integrity, and security requirements, which would also be deleted under the Proposal.
2317 CFR 242.1000.
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