On November 18, 2015, the U.S. Securities and Exchange Commission (SEC) voted unanimously to propose amendments to Regulation ATS1 that would require alternative trading systems (ATS) that trade NMS stocks2 (i.e., stocks listed on a national securities exchange) (NMS Stock ATSs), including “dark pools,” to publicly disclose detailed information about the operations of the NMS Stock ATS and the activities of the broker-dealer operator and its affiliates. The proposed amendments are intended to enhance transparency and oversight of NMS Stock ATSs.
The proposed amendments would require any new or existing ATS that trades NMS stock to complete proposed Form ATS-N, which would then be made publicly available on the SEC’s website. Proposed Form ATS-N would require significantly more detail about the operations of NMS Stock ATSs than is currently required on Form ATS.
In addition, the proposed rules would amend Regulation ATS to require that the safeguards and procedures to protect the confidential trading information of subscribers now be written. This requirement would apply to all ATSs, including those that do not trade NMS stock.
For broker-dealers that operate an NMS Stock ATS, the proposed rules, if adopted, would demand significantly greater disclosure regarding the manner in which the broker-dealer operates beyond just its operation of an ATS. In particular, broker-dealers that operate an NMS Stock ATS would have to disclose: (i) information about the internalization of orders outside of the NMS Stock ATS by itself or its affiliates; (ii) the identity of all affiliates that may trade on the NMS Stock ATS and information about how each such affiliate connects to and trades on the NMS Stock ATS; and (iii) information about the use of a smart order router (or similar functionality) or algorithm used in connection with operating an NMS Stock ATS. As noted, this information would be made publicly available, potentially resulting in the dissemination of material aspects of the broker-dealer’s business model.
Background – The Current Regulation of ATSs
An ATS3 under the Securities Exchange Act of 1934 (Exchange Act) is an organization, association or group of persons that: (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.4 Pursuant to Rule 3a1-1 under the Exchange Act, ATSs are exempt from the definition of an “exchange” under Section 3(a)(1) of the Exchange Act5 if the ATS complies with Regulation ATS, which requires, among other things, registration as a broker-dealer.6 Absent such an exemption, an ATS would have to register as a national securities exchange to perform the functions of an ATS.
ATSs are currently regulated under a confidential notice regime. ATSs are required to file an initial operation report on Form ATS at least 20 days before commencing operations. An ATS must file material amendments to its Form ATS at least 20 days before implementing a material change and must promptly amend its Form ATS upon discovering that any information in its Form ATS has become inaccurate. For other non-material amendments, an ATS must amend its Form ATS within 30 days after the end of the quarter in which the system operated. ATSs must also report certain information about transactions on the ATS and certain other activities on Form ATS-R within 30 calendar days after the end of each quarter in which the system has operated. Form ATS, all amendments thereto, and Form ATS-R submissions are all “deemed confidential,” meaning that the public cannot access such information unless voluntarily made public by the ATS.
Unlike the registration of a national securities exchange, which requires that the application be “approved” by the SEC, Form ATS merely provides the SEC with “notice” about an ATS’s operations prior to commencing operations. In practice, this has meant that inadequate initial operations reports or amendments are deemed “not filed” by the SEC staff until the defects in the submission are cured.
NMS Stock ATSs
Under the proposal, an NMS Stock ATS would be defined as an ATS that facilitates transactions in NMS stocks. As noted above, NMS Stock ATSs would be required to file Form ATS-N with the SEC, which would then be made publicly available.
The SEC believes that, given the increased source of ATSs as a source of liquidity in NMS stock (15 percent of total share trading volume in Q2 of 2015), the increased complexity of ATSs as trading centers, and the absence of any publicly available disclosures about how such systems operate, amendments to Regulation ATS are necessary to increase the operational transparency of ATSs that trade NMS stock.
The SEC believes that the proposed amendments and disclosures on Form ATS-N will, among other things, provide market participants with useful information to evaluate NMS Stock ATSs as potential trading venues, understand potential conflicts of interest that the broker-dealer operating the NMS Stock ATS may have with respect to its operation of the trading center, and could assist in evaluating whether their broker-dealers have fulfilled their duty of best execution.
Initial Filing and Review Process
Under the proposal, the initial filing of Form ATS-N would require the submission of a Form ATS-N with the SEC no later than 120 calendar days after the effective date of the proposal. An ATS that currently trade NMS stock (a “legacy NMS Stock ATS”) would be permitted to operate pursuant to its previously filed Form ATS pending the SEC’s review of its Form ATS-N.
Within 120 calendar days after the filing of a Form ATS-N, the SEC would declare the Form ATS-N as either “effective” or “ineffective” by order, which would be posted on the SEC’s website. The SEC could extend the review period for Form ATS-N by an additional 120 calendar days for legacy NMS Stock ATSs and up to 90 days for non-legacy NMS Stock ATSs.
The SEC’s review of Form ATS-N submissions would “focus on an evaluation of the completeness and accuracy of the disclosures, and compliance with federal securities laws, including Regulation ATS.” During its review, the SEC and its staff may provide comments to the entity, and may request that the entity supplement information in the Form ATS-N or revise its disclosures on Form ATS-N.
A declaration that a Form ATS-N is “ineffective” would require a notice and opportunity for hearing for the NMS Stock ATS and a finding by the SEC that such action is necessary or appropriate in the public interest, and is consistent with the protection of investors. If an initial filing of Form ATS-N is declared ineffective, the NMS Stock ATS would be prohibited from operating as an NMS Stock ATS, but could subsequently file a new Form ATS-N. The SEC provided a non-exhaustive list of examples explaining that it would declare a Form ATS-N ineffective if it found that the Form ATS-N: (i) contains technical deficiencies (e.g., missing pages); (ii) the entity does not meet the definition an NMS Stock ATS; (iii) fails to describe items in sufficient detail (e.g., time-in-force limitations on an order type); (iv) contains inconsistent disclosures within the Form ATS-N; or (v) reveals non-compliance with the federal securities laws.
Importantly, an order declaring a Form ATS-N effective would not constitute a finding that the NMS Stock ATS’s operations are consistent with the Exchange Act and the rules and regulations thereunder. Rather, the declaration of effectiveness would only address the issue of whether the NMS Stock ATS has complied with the requirements of Form ATS-N and would focus on the disclosures made on the Form ATS-N.
Amendments to an Effective Form ATS-N
The proposal would require an NMS Stock ATS to amend an effective Form ATS-N under different circumstances in a manner comparable to amendments to Form ATS. Similar to initial filings of Form ATS-N, the SEC will issue an order declaring an amendment “effective or ineffective” no later than 30 calendar days from the date of filing with the SEC. A declaration that an amendment to Form ATS-N is “ineffective” would not require notice and an opportunity for hearing. The relevant aspects of each form of an amendment to a Form ATS-N is outlined below:
- Material Amendments: must be filed at least 30 calendar days prior to the date of implementation of a material change to the operations of the NMS Stock ATS or to the activities of the broker-dealer that operates the NMS Stock ATS (broker-dealer operator) or its affiliates that are subject to disclosure on Form ATS-N.
- Material amendments would be publicly disclosed on the SEC’s website upon filing, but would not be effective until the SEC issues an order to that effect.
- An amendment would be considered “material” if “there is a substantial likelihood that a reasonable market participant would consider the change important when evaluating the NMS Stock ATS as a potential trading venue.” This proposed standard would apply to disclosures on Form ATS-N for both the operations of the NMS Stock ATS as well as disclosures relating to the activities of the broker-dealer operator and its affiliates.
- The SEC provided a non-exhaustive list of examples of a material amendment: (1) a broker-dealer operator or its affiliates beginning to trade on the NMS Stock ATS; (2) a change to the broker-dealer operator’s policies and procedures governing the written safeguards and written procedures to protect the confidential trading information of subscribers; (3) a change to the types of participants on the NMS Stock ATS; (4) the introduction or removal of a new order type on the NMS Stock ATS; (5) a change to the order interaction and priority procedures; (6) a change to the segmentation of orders and participants; (7) a change to the manner in which the NMS Stock ATS displays orders or quotes; and (8) a change of a service provider to the operations of the NMS Stock ATS that has access to confidential subscriber trading information.
- Material amendments would be publicly disclosed on the SEC’s website upon filing, but would not be effective until the SEC issues an order to that effect.
- Non-Material Amendments: must be filed within 30 calendar days after the end of each calendar quarter to correct any other information that has become inaccurate for any reason and has not been previously reported to the SEC as a Form ATS-N amendment.
- Corrective Amendments: must be filed promptly to correct information in any previous disclosure on Form ATS-N, after discovery that any information was inaccurate or incomplete when filed.
If the SEC declares a Form ATS-N amendment ineffective, the NMS Stock ATS shall be prohibited from operating pursuant to the ineffective Form ATS-N amendment. The NMS Stock ATS could, however, continue to operate pursuant to a Form ATS-N that was previously declared effective. The SEC stated that it could declare a Form ATS-N amendment ineffective if one or more disclosures on the amended Form ATS-N are materially deficient with respect to their accuracy, currency, completeness or fair presentation.
Suspension, Limitation, or Revocation of the Exemption from the Definition of an Exchange
The proposal also provides a process for the SEC to suspend for a period not exceeding 12 months, limit, or revoke an NMS Stock ATS’s exemption from the definition of the term “exchange” under certain circumstances. The SEC states that it would suspend, limit, or revoke an NMS Stock ATS’s exemption, if it finds, after notice and opportunity for hearing, that, for example, the Form ATS-N contains inaccurate or incomplete responses, the NMS Stock ATS no longer meets the definition of “NMS Stock ATS,” or the NMS Stock ATS has violated or is violating the federal securities laws.
If an NMS Stock ATS was suspended or its exemption from the definition of an exchange was revoked, yet the NMS Stock ATS continued to engage in ATS activity in NMS stocks, it would be operating as an unregistered exchange because it would no longer qualify for the exemption from the definition of an “exchange.” If an NMS Stock ATS’s permitted activity were limited by the SEC, the NMS Stock ATS would be prohibited from operating in a manner otherwise inconsistent with the terms and conditions of the SEC order, and if it did operate in a manner inconsistent with the terms and conditions of the order, the NMS Stock ATS would similarly risk operating as an unregistered national securities exchange.
Proposed Form ATS-N
Proposed Form ATS-N consists of four parts. Parts I and II would require certain basic information such as the name of the NMS Stock ATS and the broker-dealer operator. Part II would also require an NMS Stock ATS to attach three exhibits providing: (i) a copy of any materials provided to subscribers related to the operations of the NMS Stock ATS or the disclosures on Form ATS-N; (ii) a copy of the broker-dealer operator’s most recently filed Schedule A of Form BD disclosing information related to the direct owners of the broker-dealer operator; and (iii) a copy of the broker-dealer operator’s most recently filed Schedule B of Form BD disclosing information related to the indirect owners of the broker-dealer operator.
Part III of proposed Form ATS-N would require disclosures relating to the activities of the broker-dealer operator and its affiliates7 in connection with the NMS Stock ATS. These disclosures are designed to disclose potential conflicts of interests that the broker-dealer operator may have with respect to its operation of the NMS Stock ATS. Part III would require an NMS Stock ATS to provide disclosures relating to the following items:
1. Non-ATS Trading Centers: disclosure of certain information about the internalization of orders outside of the NMS Stock ATS by the broker-dealer operator and its affiliates and how such activity may interact with the NMS Stock ATS.
2. Multiple NMS Stock ATS Operations: disclosure of whether the broker-dealer operator or its affiliates operate another NMS Stock ATS and how such NMS Stock ATSs interact with one another.
3. Products or Services Offered to Subscribers: disclosure of any products or services used in connection with trading on the NMS Stock ATS (e.g., algorithmic trading products, market data feeds) offered by the broker-dealer operator or its affiliates and any differences in the availability of such products or services among subscribers.
4. Arrangements with Unaffiliated Trading Centers: disclosure of any formal or informal arrangements with another trading center regarding access to the NMS Stock ATS, such as preferential order routing arrangements, that the broker-dealer operator or its affiliates may have.
5. Trading Activities on the NMS Stock ATS: disclosure of whether the broker-dealer operator or its affiliates may trade on the NMS Stock ATS; the identity of each such affiliate; the capacity under which each affiliate may trade (e.g., proprietary versus agency); how such affiliates access the NMS Stock ATS; and any means by which a subscriber can avoid trading with the broker-dealer operator or its affiliates on the platform.
6. Smart Order Router (SOR) (or Similar Functionality) or Algorithms: disclosure of whether the broker-dealer operator or any of its affiliates uses a SOR and/or algorithm in connection with the NMS Stock ATS; who operates the SOR or algorithm; and a description of how the SOR/algorithm interacts with the NMS Stock ATS, including any information the SOR/algorithm may have about orders that the SOR/algorithm sends to or receives from the NMS Stock ATS.
7. Shared Employees of the NMS Stock ATS: disclosure of any employee of the broker-dealer operator that services both the NMS Stock ATS and another business unit of the broker-dealer operator (excluding clerical or administrative employees), and a description of the roles of such “shared employees.”
8. Service Providers to the NMS Stock ATS: disclosures of whether any operation, service, or function of the NMS Stock ATS is provided by a person other than the broker-dealer operator; the identity of such service provider; a description of the service performed; and disclosure of whether the service provider or its affiliates may trade on the NMS Stock ATS.
9. Differences in Availability of Services, Functionalities or Procedures: disclosure of any services, functionalities, or procedures of the NMS Stock ATS that are available to or apply to the broker-dealer operator or its affiliates, but are not available to a subscriber.
10. Confidential Treatment of Trading Information: a description of the NMS Stock ATS’s written safeguards and procedures to protect the confidential trading information of subscribers pursuant to Rule 301(b)(10) under Regulation ATS.
Part IV of proposed Form ATS-N would require disclosure relating to the manner of operations of the NMS Stock ATS. These disclosures are meant to capture, among other things, the actual functioning of and order interaction on the NMS Stock ATS. Part IV would require an NMS Stock ATS to provide disclosures relating to the following items:
1. Subscribers: disclosures relating to subscriber eligibility; the terms and conditions of being a subscriber; the different types of subscribers; whether the NMS Stock ATS has any designated liquidity providers; and circumstances under which a subscriber may be limited or denied access to the platform.
2. Hours of Operation: disclosure of the hours that the NMS Stock ATS operates.
3. Types of Orders: disclosure of all available order types or modifiers; any differences in the availability of such orders/modifiers among subscribers; any order size requirements or special handling for odd-lot orders; and the use of indications of interest or conditional orders on the NMS Stock ATS.
4. Connectivity, Order Entry, and Co-location: disclosure of the means by which subscribers may connect or send orders to the NMS Stock ATS (e.g., direct FIX connection or via the broker-dealer operator’s SOR) and any co-location or similar services offered by the NMS Stock ATS.
5. Segmentation of Order Flow and Notice about Segmentation: disclosure of any segmentation of order flow (e.g., classifying orders by market participant type) done by the NMS Stock ATS; notification to subscribers of their segmentation category; and any order preferencing services offered by the NMS Stock ATS.
6. Display of Orders and Trading Interest: disclosure of any means by which orders or other trading interest is displayed or made known outside of the NMS Stock ATS and the identity of the recipients of such information.
7. Trading Services: disclosure of the NMS Stock ATS’s matching methodology; order interaction rules (e.g., priority, pricing); and any other trading procedures (e.g., price improvement functionality).
8. Suspension of Trading, System Disruption or Malfunction: disclosure of any procedures governing trading in the event of a system disruption or malfunction.
9. Opening, Reopening, and Closing Processes, and After Hours Procedures: disclosure of any opening, re-opening, and closing processes, including whether after hours trading is permitted on the NMS Stock ATS.
10. Outbound Routing: disclosure of the circumstances under which orders may be routed out of the NMS Stock ATS; how such routing is performed; and any differences among subscribers with respect to outbound routing.
11. Market Data: disclosure of the use and sources of market data by the NMS Stock ATS to determine the national best bid or offer.
12. Fees: disclosure of the fees, rebates, or other charges of the NMS Stock ATS; the range (e.g., high and low) of such fees; and any differences among subscribers in such fees.
13. Trade Reporting, Clearance and Settlement: disclosure of the NMS Stock ATS’s procedures relating to trade reporting and the clearance and settlement of transactions.
14. Order Display and Execution Access: disclosures relating to additional obligations of an NMS Stock ATS that has crossed certain volume thresholds in Rule 301(b)(3)(i) of Regulation ATS.
15. Fair Access: disclosures relating to additional obligations of an NMS Stock ATS that has crossed certain volume thresholds in Rule 301(b)(5)(i) of Regulation ATS.
16. Market Quality Statistics Published or Provided to Subscribers: disclosure of any execution statistics provided to subscribers, other than those provided pursuant to Rule 605 of Regulation NMS.
Under the proposal, the SEC would make public via posting on the its website, each: (i) order of effectiveness of a Form ATS-N; (ii) order of ineffectiveness of a Form ATS-N; (iii) effective Form ATS-N; (iv) filed Form ATS-N Amendment; (v) order of ineffectiveness of a Form ATS-N Amendment; (vi) notice of cessation of operations of an NMS Stock ATS; and (vii) order suspending, limiting, or revoking the exemption from the definition of an “exchange.” The SEC would not post on its website a filed Form ATS-N before the SEC declares that Form ATS-N effective. In the case of a material amendment to an effective Form ATS-N, the SEC would make such amendment publicly available upon filing, but it would not be effective until so ordered by the SEC within 30 calendar days of filing.
The SEC proposes to make the public aware of which Form ATS-N Amendments filed by NMS Stock ATSs posted on the SEC’s website are pending SEC review and could still be declared ineffective. NMS Stock ATSs that have a website would also be required to post on their website a direct URL hyperlink to the SEC’s website that contains the NMS Stock ATS’s Form ATS-N filings.
Safeguards and Procedures Protecting Subscriber’s Confidential Trading Information
The proposal would also amend Regulation ATS to require all ATSs, including NMS Stock ATSs, to have and maintain written safeguards and procedures to protect the confidential trading information of their subscribers, and written procedures to ensure that those safeguards and procedures are followed. Pursuant to Rule 301(b)(10) of Regulation ATS, all ATSs are required to have such safeguards and procedures, but it is not currently required that they be written. If the proposal is adopted, any ATS that does not already have these policies and procedures in writing would now be required to memorialize them in a written format.
1 See Securities Exchange Act Release No. 76474 (November 18, 2015), available here.
2 An NMS stock is defined as any NMS security other than an option. 17 CFR 242.600(b)(47). An NMS security is “any security or class of securities for which transaction reports are collected, processed and made available pursuant to an effective transaction reporting plan, or an effective national market system plan.” 17 CFR 242.600(b)(46).
3 “ATS” encompasses all ATSs including those that trade NMS stock. References to “NMS Stock ATS” refer solely to the proposed requirements applicable only to an ATS that trades NMS stock.
4 17 CFR 240.3b-16(a).
5 15 U.S.C. 78c(a)(1).
6 17 CFR 240.3a1-1(a)(2).
7 For the purposes of these disclosures, an “affiliate” of the broker-dealer operator would be defined as “any person that, directly or indirectly, controls, is under common control with, or is controlled by, the specified person.” The term “control” under the proposal would mean “the power, directly or indirectly, to direct the management or policies of the broker-dealer of an alternative trading system [broker-dealer operator], whether through ownership of securities, by contract, or otherwise.” Control would be presumed for a director, general partner, or officer, or with a 25 percent voting interest (or capital entitlement in the case of a partnership).
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