The SEC will likely reevaluate the regulatory framework governing securities exchanges in light of new marketplace dynamics and trading practices. Under the current framework, national exchanges such as the NYSE and Nasdaq serve as special self-regulatory organizations (“SRO”) that establish and enforce rules for members, including broker-dealers. But advances in automation and electronic communication technologies have increasingly enabled broker-dealers to set up alternative trading systems (“ATS”) that compete, sometimes directly, with the national exchanges.
These developments have created problems for both broker-dealers and the national exchanges themselves. National exchanges have regulatory authority over broker-dealers running competing ATSs, raising conflict of interest and unfair competition concerns. At the same time, national exchanges want addressed “the regulatory disparity between registered exchanges and ATSs that currently do not display liquidity in the public quote stream, and yet engage in trading activities that are more akin to traditional exchange trading.”
The Current Framework
The self-regulatory model for national stock exchanges predates the Securities Exchange Act of 1934 (“Exchange Act”), which codified the system of exchanges operating as membership organizations. In addition to bestowing SROs with regulatory and disciplinary authority, the Exchange Act establishes requirements for SROs, including registration with the SEC, SEC approval for rule changes, and minimums for public access to market data.
The SEC began addressing market changes by adopting Regulation ATS and accompanying Rule 3b-16 in December 1998, and Regulation NMS in June 2005. Technological advances had allowed National Association of Securities Dealers, Inc. (“NASD”) to develop the Nasdaq electronic quotation system for over-the-counter stocks, and broker-dealers to develop their own electronic trading systems, resulting in a more competitive and fragmented trading market.
Regulation ATS and Rule 3b-16 set forth conditions for ATSs to avoid Section 6 of the Exchange Act’s SEC registration requirement. Notably, Rule 3a-1(b)(1) provides market share thresholds requiring ATSs with sufficient dominance in the market to register with the SEC as exchanges do.
Regulation NMS placed additional requirements on trading, pricing, and data access to address issues such as trade-throughs that accompanied the rise of ATSs. Notably, Reg NMS requires ATSs’ quotes and customer limit orders to be displayed in the public quotation stream (as exchanges’ must) unless the orders are displayed only to one other person.
The Rise of Dark Pools and Reasons for Rethinking
Today, 35 broker-dealers operate 44 ATSs estimated to account for between 10 and 15 percent of all U.S. equity trading volume. Many ATSs have continued to avoid SEC scrutiny by complying with Regs ATS and NMS. The proliferation of these so-called “dark pools”—invisible to the public markets—has provided additional liquidity to investors who wish to move large blocks of shares without causing major price distortions in the public markets or without immediate detection.
The Securities Industry and Financial Markets Association (“SIFMA”) has argued that these and other market changes (e.g., exchanges’ new profit orientation and outsourcing of SRO functions) have blurred the lines between exchanges and ATSs. As a result, exchanges are both advantaged and disadvantaged. On the one hand, SROs have the power to regulate their members, receive monopolies on certain market data revenues, and enjoy limited liability. On the other, they are burdened by onerous reporting requirements and SEC oversight. Considering these regulatory disparities and their potential to hinder free competition, SIFMA called for an abandonment of the SRO status altogether.
The Road Ahead
Both SEC Chairman Mary Jo White and Commissioner Daniel M. Gallagher have acknowledged the previously discussed problems and stated that SROs’ status merits reconsideration. The SEC has previously taken a two-pronged approach to even the playing field. First, it has been proposed that Reg ATS’s market share thresholds should be lowered to reach more dark pools. Second, the SEC has examined ways to ensure the same levels of pre- and post-trade transparency for investors with regard to both ATSs and exchanges.