The proposal would require certain systems and platforms currently not subject to any registration requirements to register as broker-dealers and ATSs.

On January 26, 2022, the Securities and Exchange Commission (SEC) issued a set of proposed amendments (Proposal) regarding the regulation of alternative trading systems (ATSs) that would, among other things, substantially expand the definition of an “exchange” as interpreted by Rule 3b-16 under the Securities Exchange Act of 1934 (the Exchange Act) to capture “Communication Protocol Systems.” Specifically, Rule 3b-16’s interpretation of the “exchange” definition would be broadened in several meaningful aspects, including by removing the current requirement that a platform needs to bring together “firm orders” to be deemed an “exchange.”

The Proposal also would make several other changes and adjustments to the existing regulatory framework regarding ATSs, including eliminating certain existing exemptions in relation to government securities, amending the Fair Access Rule to require aggregation of the average transaction volumes of ATSs operated by affiliated broker-dealers, expanding disclosure requirements under Form ATS-N (for ATSs that trade NMS and certain other securities), and switching to an electronic filing system for Form ATS and Form ATS-R.

This post, which  is the first of a series that will discuss the Proposal, specifically focuses on the proposed expansion of Rule 3b-16 and what constitutes an “exchange,” which could have wide-ranging ramifications in the securities industry.

Definition of “Exchange” in the Current Version of Rule 3b-16

Exchange Act Section 3(a)(1) defines an “exchange,” in relevant part, 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.” The current version of Exchange Act Rule 3b-16(a), which was implemented in 1998 as part of Regulation ATS, further interprets the above phrase as a platform that (i) “brings together the orders for securities of multiple buyers and sellers” and (ii) “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”. Significantly, the current rule defines “order” in this context as a “firm indication of a willingness to buy or sell a security … including any bid or offer quotation, market order, limit order, or other priced order.” In line with this current definition of “order” and, as the SEC has indicated in the 1998 adopting release for Reg ATS, “systems that displayed bona fide, non-firm indications of interest” are not currently captured by Rule 3b-16.

On the basis of this existing regulatory framework, a platform that facilitates communications among counterparties (e.g., broker-dealers) regarding potential securities transactions but that does not rise to the level of facilitating interactions involving firm orders, generally has not been viewed as required to register an ATS. Moreover, as long as such a platform does not otherwise meet the indicia of engaging in broker-dealer activity, such as receiving securities transaction-based compensation or otherwise participating at key points in the chain of distribution of a securities transaction, it has not been viewed as required to register as a broker-dealer. This understanding has been supported by a longstanding line of no-action letters that the SEC issued to various primary and secondary market securities communications platforms (e.g., Evare LLC, July, 29, 1998, Broker-To-Broker Networks, Inc. December 1, 2000, Neptune Networks, Ltd., March 4, 2020).

The SEC’s Rationale for Its Proposed Expansion

In presenting the rationale behind its proposed expansion of what constitutes an “exchange,” the SEC stated in the Proposal that advances in technology since the establishment in 1998 of Rule 3b-16 has made “trading in securities…more electronic” and has specifically made Communication Protocol Systems “a preferred method for market participants to discover prices, find a counterparty and execute a trade, particularly for government securities and other fixed income markets.” As examples of such communication protocol systems that have become widely-used, the SEC specifically listed (i) “Request-for-Quote” (RFQ) systems, which allow market participants to obtain quotes for a particular security by sending messages to one or more potential respondents, (ii) “Stream Axe” systems, which permit users to display continuous firm or non-firm trading interests that can serve as a starting point of negotiation with other users, and (iii) “Conditional Order” systems, which facilitate communications of trading interests that may not be executable until after the user takes subsequent action (e.g., by requiring participants to firm up the order later in the process).

The SEC stated in the Proposal that these platforms effectively fulfill the same function as an “exchange” in today’s marketplace and yet, by virtue of not being required to register as ATSs, are not subject to the disclosure and other investor protection requirements of the ATS regulatory regime. The SEC also noted that they believe the statutory definition of “exchange” in Exchange Act 3(a)(1) is broad enough to capture these systems since they are “market places” for bringing together purchases and sellers of securities.

Expansion of Rule 3b-16(a) to Capture Communication Protocol Systems

The SEC’s proposed amendments to Rule 3b-16(a) can be summarized as follows:

• Bringing Together Buyers and Sellers Using Trading Interests. The proposed amendments replace the requirement that the platform “brings together the [firm] orders of multiple buyers and sellers” with the requirement that the platform “brings together buyers and sellers of securities using trading interest.” As such, the amended definition would look to how users of the platform interact with one another rather than how their orders interact. Moreover, the amendments would expand the scope of the definition beyond platforms that use firm orders to platforms that use “trading interests.” “Trading interest” is defined to include firm orders as well as “non-firm indications of a willingness to buy or sell a security that identifies at least the security and either quantity, direction (buy or sell), or price.” The SEC clarified in the release that it preliminarily believed that a message only indicating a security without indicating the quantity, direction, or price would not be a trading interest. The SEC stated at the same time, however, that if the platform permitted a user to respond to such a message with a response that contains a symbol and quantity, direction, or price and if the sender of the initial message can accept such response, then both the response and its acceptance would each be viewed as trading interests, since they each specify the security in addition to at least one of quantity, direction, or price. Of course, this proposed amendment is a dramatic expansion from a “firm order,” as a message that identifies a security and indicates an interest in buying or selling (without an indication of price or size) would be captured, and one could wonder whether that should be sufficient to fall within the statutory ambit of a “market place.” Finally, the proposed amendments would remove the word “multiple” to clarify that systems, such as RFQ systems, that facilitate transactions between one counterparty and multiple other counterparties would still fall within the definition.

• Making Available Established Non-Discretionary Methods. The proposed amendments would replace “uses established non-discretionary methods” with “makes available established non-discretionary methods.” This amended definition would significantly expand the scope of the rules to capture systems that passively provide a protocol or merely provide access to such protocol to “interact, negotiate, and come to an agreement” regarding a securities transaction. In connection with this change, the SEC also clarified that the term “non-discretionary,” used in both the current and the proposed definitions, does not refer to the lack of discretion exercised by the platform users but rather to the lack of discretion exercised by the platform provider (i.e., by virtue of a protocol with an independently functioning logic).

Limited Exceptions

The SEC acknowledged certain limited exceptions to the broadened definition:

• Bulletin Boards. The SEC stated that it continued to believe “bulletin boards” should not fall within the “exchange” definition. In doing so, however, the SEC construed this exception narrowly as “systems that passively display trading interest … but do not provide means for buyers and sellers to contact each other and agree to the terms of the trade on the system.”
• Web Chat Providers. The SEC stated that systems that only provide general connectivity for persons to communicate without protocols, such as utilities or electronic web chat providers, would not fall within the “exchange” definition “because such providers are not specifically designed to bring together buyers and seller[s] of securities or provide procedures or parameters for buyers and sellers [of] securities to interact.” But, the SEC noted that additional functionality that would permit such interactions could fall within the definition.
• Issuer Systems. A specific exclusion from the definition would be included for systems that an issuer uses to sell its own securities to investors.

The Commissioners Weigh In

The Proposal failed to garner unanimous support among the Commissioners.

• Chairman Gary Gensler published a statement in support of the Proposal, stating it would “promote resilience and greater access” in the securities market. According to Chairman Gensler, the Proposal seeks to modernize the meaning of exchange in line with how technology and markets have evolved since the term was originally defined when the SEC adopted Reg ATS in 1998. The proposed changes, he added, would “cover platforms for all kinds of asset classes that bring together buyers and sellers.”
• Commissioner Caroline A. Crenshaw published a statement in support of the Proposal, stating that the Proposal is aligned with the SEC’s mission to ensure fair competition in its regulation of exchanges and ATSs. Entities performing similar functions ought to be regulated in a similar fashion, she noted. The Proposal would provide important investor protections, and impose the same operational transparency and disclosure rules to ATSs trading government securities as those that apply to ATSs that trade National Market System (NMS) stocks.
• Commissioner Hester M. Peirce published a statement of dissent, asserting that the Proposal is reasonable in its broad outlines, but is generally “too wide-ranging” and “too unwieldy to facilitate careful consideration.” The expanded definition of exchange, she noted, is overbroad and could result in deterring innovation. She raised serious concerns regarding the limited comment period (30 days) allotted in the Proposal. The “unconscionably reckless” brevity of the comment period could deprive the public and SEC of the opportunity “to devote careful attention to thinking through the full implications” of the Proposal. Commenting on the Proposal via a separate channel, she specified that the Proposal’s expansive language could threaten DeFi protocols and crypto trading platforms.

Timeline

The Proposal seeks public comment on 224 (often multipart) questions, with a 30-day comment period that starts from the date of the Proposal’s publication in the Federal Register. Final rule changes would be in place after the SEC receives and considers comments on the proposals, makes any changes in response to comments, and formally adopts the rule amendments.

Key Takeaways

The SEC’s proposed amendments would significantly expand what constitutes an “exchange.” This expansion would also effectively supplant a long-standing line of SEC no-action letters in this area. The SEC seemed to acknowledge this result in a footnote in the Proposal in which it stated that its existing no-action letters in this area would be deemed moot to the extent inconsistent with the amended definition.

From an industry perspective, the amendments would require a wide range of service providers to the securities industry that are not currently regarded as “exchanges” to register as broker-dealers and ATSs. This requirement could have significant impacts on such service providers and the recipients of their services.