Commentary

Tim Quast
Traders Magazine Online News

We're All HFTs Now

In this guest commentary, author Tim Quast looks back at the history of HFT and how the market has evolved to where many firms now fit the definition of high-frequency trader.

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March 1, 1999

Alternative Trading Systems

By Sam Scott Miller and Lauren Mullen

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  • Alternative Trading Systems

On Dec. 8, 1998, the Securities and Exchange Commission adopted a new regulatory scheme for alternative trading systems (ATS).

The new scheme requires an ATS either to register as a national securities exchange or as a broker dealer and comply with new requirements under Regulation ATS.

The agency has revised its interpretation of the term exchange to apply to ATSs through new rule 3b-16. Previously, the agency relied on the definition in the Securities Exchange Act of 1934 to identify those entities subject to exchange regulation.

Over the past 30 years, the SEC has examined how to apply the term "exchange" to systems that have been variously called proprietary trading systems (PTSs), broker-dealer trading systems, and most recently, ATSs.

In 1990, the SEC excluded PTSs from exchange treatment in its Delta release. In 1995, the SEC adopted rule 17a-23, which treated these systems as broker dealers and imposed certain recordkeeping and notice obligations on PTSs.

Many market participants thought rule 17a-23 ended the debate on regulating these systems. In 1997, however, the SEC questioned its historic treatment of PTSs as broker dealers, ultimately adopting the new regulatory scheme.

New Interpretation

New Securities Exchange Act rule 3b-16 expands the concept of an exchange to mean any "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."

The new interpretation is intended to capture systems that centralize orders, either by the display or the processing and execution of orders. Orders include "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," and are executable without further meaningful negotiation.

An exchange-run system must deal with multiple buyers and sellers in contrast to systems operated by a single dealer who acts as a counterparty to all trades. Similarly, systems that do not provide for order interaction, such as those that route orders to order-execution facilities, will not qualify as exchanges. In addition, exchanges must use "established, non-discretionary methods" for order interaction.

These methods include rules governing trading conduct and trading facilities that standardize the manner of order interaction, such as computer algorithms. Most importantly, the system operator cannot exercise discretion in working orders.

Regulation ATS

An ATS includes any system that qualifies as an exchange and does not exercise self-regulatory functions. Regulation ATS applies to any ATS that chooses broker-dealer registration over exchange registration, although certain systems are not required to comply with Regulation ATS. These include, among others, those registered, or exempt from registration, as national securities exchanges, and systems operated by national securities associations

The requirements of Regulation ATS are designed to ensure that adequate information about ATSs is available. They are also designed to protect confidential subscriber trading information, and to ensure cooperation in investigations of ATSs and their subscribers.