FLASH FRIDAY: Define “Exchange”

FLASH FRIDAY is a weekly content series looking at the past, present and future of capital markets trading and technology. FLASH FRIDAY is sponsored by Instinet, a Nomura company.

What is an exchange?

In capital markets parlance, the definition is a straightforward one: a place where stock trades are sent to meet the other side for execution. Go in a buy or sell order, come out a done deal. 

But as markets are always evolving, so too are definitions. Today’s stock market isn’t your father’s stock market, when the New York Stock Exchange and Nasdaq were a duopoly and stock trades were executed only on exchanges. The electronification of markets allowed stock trades to execute anywhere, at least theoretically, and alternative trading systems have over time captured about one-third market share from the incumbent exchanges.

The U.S. Securities and Exchange Commission has faced a balancing act. On one hand, regulators need to promote choice and competition in the marketplace for trade execution, which ATSs provide. But on the other hand, regulators need to ensure a level playing field, which means not regulating exchanges tightly while allowing ATSs to skate by without being subject to at least some of the same rules. 

The SEC has been seeking a more expansive definition of exchange for many years. From a 1999 Traders Magazine article:  

“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.”

To be sure, markets have changed substantially over the past 24 years, and the rule change that addressed gaps of 1998 isn’t sufficient for today. At least that’s the view of the SEC, which this past January proposed to expand the definition of exchange under Rule 3b-16 of the Exchange Act, to include trading systems that bring together “trading interest”, not just the firmer “orders”.  

Earlier this week, SIFMA, the industry group representing brokers, came out against the SEC proposal, saying it “the Commission is proposing to expand the definition of “exchange” in several significant respects, including to require “communication protocol systems”—a term the Commission does not define,” and the whole notion “needs a far more deliberate, nuanced evaluation and clearer articulation of a compelling policy rationale.”  

So what is an exchange? At least in the eyes of the SEC, the definition needs to be broadened — again.