Alternative Trading Systems

On Monday, September 28, 2020, the U.S. Securities and Exchange Commission (“SEC”) proposed to extend the scope of Regulation ATS to trading in government securities. Regulation ATS (“Alternative Trading Systems”) was originally adopted by the SEC in 1998 in response to the then growth of trading of equity securities not registered on a securities exchange. See my previous blog post, “Keeping Securities Disclosure in the Pink: Amendments to SEC Rule 15c-1.” The SEC decided that such trading would occur with or without regulatory oversight, and created the concept of a trading venue that was not an ”exchange” with all of its formal requirements under Section 6 of the Securities Exchange Act of 1934, as amended (the “34 Act”).

As an ATS, it would still be subject to SEC regulation and information gathering. The ATS’s for non-exchange listed securities grew from that time, leading, in 2014, to the SEC recognition of the OTS ATS (an electronic trading platform for non-exchange listed securities on two of the trading facilities operated by the OTS Markets Group). This, in turn, caused the equity securities traded on those two OTS facilities to be seen so as to secondary exemptions from registration or separate disclosure regulation by (as of November 2018) over 30 state “Blue Sky” regulators.

Government Securities: A Growing Market

Since its earliest iteration, Regulation ATS has had an exemption for trading platforms that traded only government securities (esp. U.S. Treasuries and Agencies). This distinction arose partly from the origins of Regulation as applicable to stock trading venues, and partly from the recognition that government securities and their offering and sale were (and are) not subject to the regulatory jurisdiction of the SEC. See in connection with these points previous blog post, “SEC Focus on Municipal Securities: Disclosure and Enforcement – The Peculiar Structure of the Municipal Securities Disclosure Regime.” However, as matters have evolved over time, and especially after 9/11 (2001), the Great Recession (2007-2009), and most recently the coronavirus (COVID-19) pandemic (2020, especially in March and again in September) the markets for government securities have experienced temporary “seizures,” which threatened the financial stability not just of the American economy, but literally of the entire world. Government securities form the basis for overnight liquidity involving the use of both:

• Repurchase Agreements (“Repos”) in which one bank “lends” a government security overnight to another, which simultaneously agrees to repurchase it at a slightly higher price (the interest) the next day

• Reverse Repurchase Agreements (“Reverse Repos”) in which one back “sells” a government security overnight to another bank, which simultaneously agrees to sell it back the next day at a slightly higher price

In each of the cited events, the markets froze, only to have the “seizure” unstuck by massive, aggressive action by the Board of Governors of the Federal Reserve System (the “Fed”). In the most recent event last September, the interest rate on overnight Repos went from about 1% to 5% in less than one week, causing the Fed to inject some $80 billion as an emergent intervention to free up the clog in the pipes of the financial system. In an address on September 29, 2020, at a Conference on the U.S. Treasury Market sponsored by the Fed, the Treasury Department, and the Commodity Futures Trading Commission, SEC Commissioner Elad L. Roisman noted that between July and December, 57% of the trading in U.S. Treasury Securities occurred on ATS’s. The SEC separately, in its September 28 press release announcing the proposed amendment, states that the average DAILY trading volume for the period was some $835 billion. In recognition of the increasingly critical importance of trading in government securities, the SEC has proposed an amendment to Regulation ATS and a related proposal concerning the cybersecurity of the affected trading venues.

Regulation SCI

In tandem with proposing to extend Regulation ATS to trading in government securities, the SEC also proposed to amend Regulation SCI (“System Compliance and Integrity”) to make it applicable to large ATS’s trading government securities, namely those that carry 5% or more of the average daily dollar volume traded during at least four of the last six months. Regulation SCI was adopted by the SEC on November 19, 2014. It arose after two-plus decades of growing concern at the SEC about the ever-increasing complexity of the technology used to operate America’s capital markets, and was particularly responding to a series of disruptions: these began the May 2010 “Flash Crash;” followed by the February 2011 hack of NASDAQ; then on to the March 2012 shut-down of the BATS public offering due to a “bug,” the May 2012 delayed trading of Facebook in its IPO, the August 2012 computer malfunction in Knight Capital Group, Inc.’s trading system (leading to the forced bail-out of Knight by Jeffries & Co.), Superstorm Sandy in October 2012, and the August 2013 three-plus hour halt to all trading on NASDAQ when it was unable to process quotes on its listed securities. Regulation SCI establishes the following five ongoing obligations for all SEC-supervised trading platforms:

1. Adopt policies and procedures to ensure adequate “capacity, integrity, availability, and security” to maintain operations of fair and orderly markets

2. Adopt policies and procedures that ensure compliance with the 34 Act and SEC regulations

3. Take prompt corrective action in case of disruption, non-compliance, and/or intrusion, AND notify the SEC

4. Submit quarterly reports to the SEC noting any completed, ongoing, or planned material system change

5. Conduct an annual compliance audit, submit it to senior platform management, and along with any management comments, also to the SEC

Regulation SCI applies to national securities exchanges (NYSE, NASDAQ, and others), certain large volume ATS’s, registered clearing agencies, certain exempt clearing agencies, FINRA, the Municipal Securities Rule Making Board (“MSRB”), and certain “plan processors” (pricing and reporting systems involved in the National Market System). Interestingly, the commentary that discussed the adoption of Regulation SCI as it applied to ATS’s spoke in terms of application depending on the volume of STOCKS traded on the ATS; clearly bond, let alone government securities, trading was not the focus of Regulation SCI. The SEC’s September 28, 2020, proposed amendment to Regulation SCI shows how that focus has broadened.

Regulation ATS Amendments

Under the existing exemption for trading in government securities on an ATS, the ATS must be operated by either a registered broker/dealer, a registered government securities broker or dealer, or a bank. Banks are not subject to the regulatory jurisdiction of the SEC. Moreover, exempt ATS’s are not required to report trading activity to any central data collection point; hence, oversight of trading activity is not systematized. The proposal would require a bank operating an ATS either to register with the SEC as a broker/dealer (and be subject to SEC supervision along-side that of the bank’s prudential banking regulators – federal and state) or transfer ownership of the ATS to either a government securities broker or dealer or a registered broker/dealer, perhaps one affiliated with the bank. Regulation ATS would subject government securities ATS’s to SEC inspection, examination, and investigation, as well as similar oversight from applicable self-regulatory organizations (FINRA, MSRB, etc.).

Commissioner Roisman, in his September 29 address, suggested the establishment of minimum capital requirements for the most active participants in trading government securities, if those participants are not registered with the SEC and already subject to such requirements. This step would reduce the risks now borne by the ATS operator in case of default. Commissioner Roisman also raised the question of whether more of the trading in government securities should be subject to required central clearing, to increase market transparency and thereby reduce the risk of surprise counter-party default. On another front, exempt ATS’s are not now required to make any public filing about their ownership, contact information, and business. That would change under the proposal. An operator of a government securities ATS would have to file a Form ATS-G with the SEC, where it would be posted on the SEC website; a copy would also have to be posted on the operator’s own website.

That form is substantially similar to (although in areas different from) the Form ATS-N filed by ATS’s that trade other than just government securities. Form ATS-G will disclose both the scope of the ATS operator’s activities and the methods of operations, including order entry methods, available order types, and execution protocols. One significant way the Form ATS-G differs from the ATS-N is required disclosure concerning interactions or functionality with related markets (e.g., futures, swaps, currencies, etc.). Form ATS-G would have to be amended, and the amended version filed upon any significant change in the information to be disclosed. In addition, the SEC may, after notice and a hearing, declare a Form ATS-G ineffective, which could lead to the ATS having to suspend or even cease operations.

Fair Access

In addition, government securities ATS’s that would be subject to Regulation SCI (based on the average daily dollar trading volume during the prior six months) will also be subject to the SEC’s Fair Access Rule. The Fair Access Rule was adopted by the SEC on June 29, 2005, in connection with the adoption by the SEC of its Regulation NMS (“National Market System”) and requires two things:

1. Written standards setting forth any conditions to be met in order to gain access to a trading venue

2. No unreasonable prohibition or limitation of access, or discriminatory application of those standards to inhibit access

The Regulation ATS amendment clarifies that the application of the Fair Access Rule is determined based on the volume of shares traded of equity securities and on the dollar volume of debt securities. One can see this additional scope of the Fair Access Rule as a rather logical extension of rules aimed at maintaining fair and orderly trading platforms in U.S. capital markets so that trading in government securities is treated the same as for trading platforms for equity and non-government securities.

Related Concept Release, the 2020 Election, and Concluding Observations

The SEC also issued a concept release on September 28, 2020, seeking public comment on a proposed framework for the adoption of regulatory policy regarding fixed-income securities (both corporate and municipal) electronic trading platforms, a long-stated goal of the SEC and a strong recommendation of the SEC’s Fixed Income Advisory Committee. That concept release, which may – depending upon comments received – be substantially reworked, is, although beyond the scope of this writing, deserving of close attention by anyone involved in this area of the U.S. capital markets. It must also be noted that the 2020 Presidential Election will result in changes at the SEC. Its Chair, Jay Clayton, appointed by President Trump, has already announced his departure as of the end of the year. The new Chair will, in all likelihood, not be appointed and confirmed until the Inauguration of President-Elect Biden.

Quite a number of recent SEC proposed regulatory actions have been approved by a 3-2 vote of the five Commissioners (see, e.g., the revised definition of “Accredited Investor,” permitting the direct listing of securities on an exchange, the proposed exemption from registration as a broker/dealer of certain finders, and the “rationalization” of exemption from registration of offerings, to name a few) with the two Democrat Commissioners dissenting. The disagreements among the Commissioners have generally been differing views on the ease of access to the capital markets versus investor protection. This author believes that the proposed ATS and SCI amendments discussed here are generally supported by all of the Commissioners so that any changes wrought by the election are unlikely to affect the amendments or lead to any effort to revise or withdraw them. The amendments are scheduled to become effective 60 days after publication in the Federal Register.