The US Securities and Exchange Commission (SEC) has proposed a sweeping expansion in how it defines securities exchanges to capture digital asset platforms, request-for-quote platforms, indication-of-interest platforms (IOI), and other messaging platforms.
In what has become a common tactic at the SEC under Chair Gary Gensler, on January 26, 2022, the SEC proposed sweeping and wide-ranging changes to the rules governing the way that securities exchanges are defined, while only providing a 30-day comment period (the Proposal). The Proposal, which as of the date of this LawFlash has not been published in the Federal Register, comes in at an astounding 654 pages.
In summary, the Proposal would (1) expand the definition of an exchange in Section 3(a)(1) of the Securities Exchange Act of 1934 (Exchange Act) by amending Exchange Act Rule 3b-16 in a way that would include systems that offer the use of non-firm trading interest and communication protocols to bring together buyers and sellers of securities; (2) repropose amendments from 2020 that would expand Regulation ATS for alternative trading systems (ATSs) that trade government securities, NMS stock, and other securities; and (3) extend Regulation SCI to ATSs that trade government securities.
Given the breadth of the Proposal, this LawFlash focuses solely on the proposed changes to Exchange Act Rule 3b-16 that would bring so-called Communication Protocol Systems within the regulatory framework applicable to securities exchanges. We anticipate addressing the other portions of the Proposal in separate LawFlashes.
Section 3(a)(1) of the Exchange Act defines an “exchange” as follows:
[A]ny organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides 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 as that term is generally understood, and includes the market place and the market facilities maintained by such exchange.
Persons meeting the definition of an exchange are required by Exchange Act Section 5 to register with the SEC under Exchange Act Section 6. As self-regulatory organizations (SROs), exchanges registered under Section 6 are subject to a panoply of requirements in Sections 5, 6, and 19 of the Exchange Act.
In light of technological advances that resulted in market participants using non-exchange facilities to effect transactions, the SEC in 1998 adopted Rule 3a1-1, Rule 3b-16, and Regulation ATS under the Exchange Act to provide a new framework for regulating venues that, in the SEC’s view, were the equivalent of exchanges.[1]
As explained by the SEC in the Proposal, Rule 3b-16 was adopted to further define terms used in the definition of an exchange to capture some of these exchange equivalents operating at the time of the rule’s adoption. As currently in effect, paragraph (a) of Rule 3b-16 brings within the definition of “exchange” an organization, association, or group of persons that
The current version of Rule 3b-16 is dependent on whether a system brings together orders. Rule 3b-16(c) defines an order to mean “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.”
Rule 3b-16 currently also requires that a system bring together the orders of multiple buyers and sellers. As explained in the Regulation ATS Adopting Release, a system “brings together” orders if it “displays, or otherwise represents, trading interests entered on the system to system users.”[3] A system must also bring together orders of “multiple buyers and multiple sellers.” Systems designed for the purpose of executing orders against a single counterparty, such as a single dealer operating a system, would not be considered to have multiple buyers and multiple sellers and therefore would not come within the meaning of an exchange.
As explained by the SEC, it adopted Rule 3b-16 to more accurately describe the range of markets that performed exchange functions as those were understood at that time. The SEC stated that most ATSs operating at the time of Rule 3b-16’s adoption met the criteria discussed above in that they offered the use of orders and algorithms that matched orders and allowed broker-dealers to place and execute orders on the systems, and the systems functioned as limit order books where orders were executed according to time, price, and size priority.
Just as technological advancements prompted the framework for Regulation ATS and Rule 3b-16, the use of what the SEC refers to as Communication Protocol Systems has prompted the SEC to seek amendments to Rule 3b-16 to bring these systems within the exchange and Regulation ATS regulatory framework. Although the SEC does not specifically define a Communication Protocol System, it does state that it would include “a system that offers protocols and the use of non-firm trading interest to bring together buyers and sellers of securities.”[4] The SEC further describes these systems as using various technologies and connectivity, generally offering the use of non-firm trading interest and established protocols to prompt and guide buyers and sellers to communicate, negotiate, and agree to the terms of the trade without relying solely on the use of orders.[5] According to the SEC, the following are examples of Communication Protocol Systems:
In the Proposal, the SEC further stated that Communication Protocol Systems perform similar marketplace functions as registered exchanges and ATSs, and have become venues for investors to discover prices, find a counterparty, and agree upon the terms of a trade. The SEC stated that Communication Protocol Systems do not fall within the definition of “exchange,” and as a result, market participants using these systems cannot avail themselves of the same investor protections, fair and orderly market principles, and SEC oversight that apply to today’s registered exchanges or ATSs. In light of this, the revisions to Rule 3b-16 discussed below are meant to bring these systems within the meaning of an exchange.
The SEC further expressed its belief that it is important for any system that falls within the criteria of Rule 3b-16(a) to be subject to the exchange regulatory framework, notwithstanding how thinly traded or novel a security may be, and participants on such systems should be able to avail themselves of the same benefits that participants on registered exchanges or ATSs receive. Accordingly, the SEC stated that the proposed amendments to Rule 3b-16(a) do not change the SEC’s interpretation of the statutory definition of “exchange” as applying to all securities.
The SEC would bring Communication Protocol Systems within the meaning of an exchange by amending Rule 3b-16 to include non-firm indications of a willingness to buy or sell a security, in addition to orders, within the interpretation provided for in the rule. The proposed amendments would also define “trading interest,” and add “communication protocols” as an established method that an organization, association, or group of persons can provide to bring together buyers and sellers of securities.
More specifically, Rule 3b-16 would be revised as follows:
(a) an organization, association, or group of persons shall be considered to constitute, maintain, or provide “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,” as those terms are used in section 3(a)(1) of the Act, (15 U.S.C. 78c(a)(1)), if such organization, association, or group of persons:
(1) Brings together the orders for securities of multiple buyers and sellers of securities using trading interest; and
(2) Uses Makes available established, non-discretionary methods (whether by providing a trading facility or communication protocols or by setting rules) under which such orders buyers and sellers can interact with each other, and the buyers and sellers entering such orders and agree to the terms of a trade.
Trading Interest: Proposed paragraph (e) of Rule 3b-16 would then define a “trading interest to mean
an order as the term is defined under paragraph (c) of this section or any non-firm indication 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 did not articulate how a willingness to buy or sell would be evidenced, or the features that would make an IOI non-firm.
Multiple Buyers and Sellers: The SEC is deleting the reference to multiple buyers and sellers because it believes that the term “multiple” could be misconstrued to mean that RFQ systems, for example, do not meet the criteria of Rule 3b-16(a) because a transaction request typically involves one buyer and multiple sellers or one seller and multiple buyers.
Makes Available Established, Non-Discretionary Methods: The SEC is also replacing the phrase “uses established, non-discretionary methods” with the phrase “makes available established, non-discretionary methods.” According to the SEC, this change is designed to capture established, non-discretionary methods that an organization, association, or group of persons may provide, whether directly or indirectly, for buyers and sellers to interact and agree upon terms of a trade. The SEC further expressed its belief that the term “makes available” would be applicable to Communication Protocol Systems because such systems take a more passive role in providing to their participants the means and protocols to interact, negotiate, and come to an agreement.
Importantly, the SEC also expressed the view that the term “makes available” is intended to make clear that, in the event that a party other than the organization, association, or group of persons performs a function of the exchange, the function performed by that party would still be captured for purposes of determining the scope of the exchange under Exchange Act Rule 3b-16. Further, the SEC stated that using the term “makes available” will help ensure that the investor protection and fair and orderly markets provisions of the exchange regulatory framework apply to all the activities that consist of the system that meets the criteria of Rule 3b-16(a), notwithstanding whether those activities are performed by a party other than the organization that is providing the marketplace.
Non-Discretionary: The SEC is not proposing to delete the term “non-discretionary” from Rule 3b-16(a)(2), but explained that the term “non-discretionary” should not be misconstrued to mean that a system does not meet the definition of “exchange” if it permits buyers or sellers using the system to exercise discretion with regard to the use of the system. The SEC clarified that under current Rule 3b-16(a)(2), the phrase “uses established, non-discretionary methods” applies to the organization, association, or group of persons that provides the means—the trading facility or rules—under which orders interact. Thus, an organization that meets the definition of “exchange” does not exercise any discretion in the matching of buyers and sellers or their orders, and buyers and sellers participating on an exchange can use their own discretion in finding and selecting a counterparty.
Communication Protocols: The proposed amendments add “communication protocols” as an established method that an organization, association, or group of persons can provide to bring together buyers and sellers of securities. In the SEC’s view, systems that bring together buyers and sellers of securities may function as exchange marketplaces of securities without orders or a trading facility for orders to interact. The SEC then stated that communication protocols, which can be applied to various technologies and connectivity, generally use non-firm trading interests as opposed to orders to prompt and guide buyers and sellers to communicate, negotiate, and agree to the terms of the trade. The SEC uses the example of an entity that makes available a chat feature, which requires certain information to be included in a chat message (e.g., price, quantity) and sets parameters and structure designed for participants to communicate about buying or selling securities, as a system that would have established communication protocols.
The SEC further stated that protocols that a system offers may take many forms and could include
The SEC stated that the examples above are not exhaustive, and the determination of whether the system meets Rule 3b-16(a)(2) would depend on the particular facts and circumstances of each system, but that the SEC would take an expansive view of what would constitute “communication protocols” under this prong of Rule 3b-16(a).
Bulletin Boards: The SEC expressed its continuing belief that systems that passively display trading interest—such as systems referred to in the industry as bulletin boards—but do not provide means for buyers and sellers to contact each other and agree to the terms of the trade on the system would not be encompassed by Rule 3b-16(a) as proposed to be amended. By way of example, the SEC stated that it does not believe that a system that unilaterally displays trading interest without offering a trading facility or communication protocols to bring together buyers and sellers would be considered to be making available established, non-discretionary methods.
Systems That Do Not Match or Provide Protocols: The SEC also expressed that a system that displays trading interest and provides only connectivity among participants without providing a trading facility to match orders or providing protocols for participants to communicate and interact would not meet the criteria of Rule 3b-16(a) because such system would not be considered to be making available established, non-discretionary methods. By way of example, 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 communication protocols prong of the proposed rule because such providers are not specifically designed to bring together buyers and seller of securities or provide procedures or parameters for buyers and sellers of securities to interact.
If adopted as proposed, the proposed changes would require that a Communication Protocol System either register as a national securities exchange or register as a broker-dealer and comply with the requirements of Regulation ATS. The SEC stated its expectation that most Communication Protocol Systems would prefer to be regulated as broker-dealers and be subject to Regulation ATS rather than exchange registration, but explained the implications under both options.
Exchange Registration: A Communication Protocol System that chooses to register as a national securities exchange would be required to do so pursuant to Sections 5 and 6 of the Exchange Act and must comply with the myriad of obligations applicable to such entities, including
Regulation ATS Exemption; Broker-Dealer Registration: A Communication Protocol System may choose to operate as an ATS pursuant to Regulation ATS, which exempts an ATS from the definition of “exchange” on the condition that the ATS be in compliance with the requirements of Regulation ATS and subject to
The proposed changes to Rule 3b-16 have the potential to capture a number of systems and platforms that may otherwise have never contemplated being captured under the regulatory framework applicable to exchanges.
Non-Firm IOIs: In the Proposal, the SEC did not go into great detail on when an IOI would be considered firm. In the Regulation ATS Adopting Release, however, the SEC emphasized that, for purposes of the definition of an “order,” a willingness to buy or sell a security must be firm, and it stated that it would look at what actually takes place between a buyer and seller interacting in a particular system to determine whether the IOI is “firm” or not.[6] The SEC further stated that the label put on an order (such as firm or not firm) is not dispositive; that an IOI will be considered firm if it can be executed without further agreement of the person entering the IOI; and that the IOI will be considered firm if the person’s assent to execution is always granted and otherwise operates as a formality.[7] In the Regulation ATS Adopting Release, the SEC then clarified that “a system that displays bona fide, non-firm indications of interest – including but not limited to, indications of interest to buy or sell a particular security without either prices or quantities associated with those indications – will not be displaying ‘orders’ and therefore would not fall within Rule 3b-16.”[8] It is unclear whether similar interpretive guidance regarding non-firm IOIs will make its way onto the Proposal’s new framework.
Order Messaging Platforms: Over the years, the staff of the SEC has issued a number of no-action letters to order messaging platforms that permits such platforms to operate without having to register as broker-dealers under Section 15(b) of the Exchange Act.[9] These platforms often provide electronic messaging capabilities and order transmission capabilities that would appear to come within what the SEC now contemplates as Communication Protocol Systems. It is unclear whether the SEC will ultimately have to withdraw these letters in the event that it adopts the changes to Rule 3b-16 as proposed.
Digital Asset Platforms: In the Proposal, the SEC reiterated that the definition of “exchange” applies to all securities, no matter how thinly traded or novel. Although the SEC made no specific mention of digital assets in the release—and did not analyze the economic implications of the proposed changes to Rule 3b-16 as they apply specifically to digital assets—the implication is that this new framework will capture digital asset platform providers. It is not unheard of for the SEC to subsequently apply a rule to an asset class that was not mentioned in the rulemaking—it recently did so in the context of Rule 15c2-11 and its application to fixed-income transactions. That said, it is unclear whether digital asset platforms could come within an exemption to Rule 3b-16, and in particular, the proposal to exclude issuer platforms.
Cross-Border Application: The proposed changes to Rule 3b-16 also cause uncertainty regarding the cross-border application of the exchange registration obligations given that “orders” no longer serve as a litmus test for exchange status. Although the SEC has not explicitly outlined the circumstances under which non-US exchanges have to register with the SEC, it has stated that “an exchange or contract market would be required to register under Section 5 of the Exchange Act if it provides direct electronic access to persons located in the U.S.”[10] While the SEC has not specified exactly what it means by direct electronic access, in some guidance, this concept can be construed to include not only the explicit grant by an exchange to a person to directly connect to the exchange, but also such things as “pass-through” linkages where a non-member customer of an exchange can enjoy electronic trading capabilities that are equivalent to the trading privileges of a member of the foreign market.[11] In further describing this “pass-through” capability, the Concept Release states:
From the broker-dealer’s and customer’s perspectives, this type of “pass‑through” service enables investors to send orders through the electronic interface without the broker-dealer having prior knowledge of each order or manually interpositioning itself in the trading process. As a result, orders routed electronically by a customer remain under the customer’s control until the moment of execution. This is in contrast to traditional brokerage activities involving orders that are routed from a customer to a foreign market member (or its affiliate) and from the member to the exchange. From the perspective of the foreign market, orders sent by a broker-dealer customer through a member’s electronic interface may be indistinguishable from orders placed directly by the member.[12]
Thus, foreign exchanges that provide capabilities for transacting in a manner that fell short of having “orders” may have to reconsider their operations to the extent they have a US presence, or use services providers located in the United States, given the SEC’s view that the proposed changes to Rule 3b-16 could capture all persons involved in providing exchange services in the United States.
JOBS Act Platforms: Section 201(c) of the JOBS Act[13] added new paragraph (b) to Section 4 of the Securities Act. In relevant part, that section states:
(1) With respect to securities offered and sold in compliance with Rule 506 of Regulation D under [the Securities Act], no person who meets the conditions set forth in paragraph (2) shall be subject to registration as a broker or dealer pursuant to section 15(a)(1) of this title, solely because— (A) that person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitation, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through other means.
The inclusion of Communication Protocol Systems within the framework applicable to exchanges could mean that the JOBS Act platforms described above could be subject to exchange registration. While it is unlikely that Congress intended such a result, the SEC’s expansive view could undo Congress’s legislative intent.[14]
The SEC has been engaged in a busy rulemaking season. While the SEC’s volume has been impressive, the speed at which it is issuing proposals and the truncated time limits for comment it is providing mean that the SEC and market participants may not have an opportunity to meaningfully consider the impact that the proposed rules will have.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Boston
Katherine Dobson Buckley
Doneld G. Shelkey
Chicago
Michael M. Philipp
New York
Thomas V. D’Ambrosio
R. Alec Dawson
Sheryl L. Orr
Etienne D. Shanon
Rebekah Raber
Philadelphia
Christine M. Lombardo
Washington, DC
Ron N. Dreben
Amy Natterson Kroll
Steven W. Stone
Kyle D. Whitehead
[1] See Securities Exchange Act Release No. 40,760 (Dec. 8, 1998), 63 Fed. Reg. 70,844 (Dec. 22, 1998) (Regulation ATS Adopting Release).
[2] A system currently has to meet both parts of Rule 3b-16(a) to be deemed an exchange.
[3] Id. at 70,849.
[4] Proposal 5 n.5.
[5] Proposal 18-19.
[6] Regulation ATS Adopting Release, 63 Fed. Reg. at 70,850.
[7] Id.
[8] Id.
[9] See, e.g., Neptune Networks Ltd., SEC No-Action Letter (Mar. 4, 2020); S3 Matching Technologies LP, SEC No-Action Letter (July 19, 2012); GlobalTec Solutions, LLP, SEC No-Action Letter (Dec. 28, 2005); Swiss American Securities, Inc., and Streetline, Inc., SEC Staff No-Action Letter (May 28, 2002); Prescient Markets, Inc., SEC No-Action Letter (Apr. 2, 2001); Broker-to-Broker Networks, Inc., SEC No-Action Letter (Dec. 1, 2000); Evare, LLC, SEC No-Action Letter (Nov. 30, 1998); Vedder, Price, Kaufman & Kammholz, SEC No-Action Letter (May 21, 1997); Charles Schwab & Co., SEC Staff No-Action Letter (Nov. 27, 1996).
[10] See Exchange Act Release No. 60,194 (June 30, 2009), 74 Fed. Reg. 32,200, 32,204 (July 7, 2009) (2009 SEC Order).
[11] Regulation of Exchanges Concept Release, Exchange Act Release No. 38,672 (May 23, 1997), 62 Fed. Reg. 30,485, 30,521 (June 4, 1997) (Concept Release).
[12] Id.
[13] The JOBS Act stands for the Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).
[14] For a further discussion on these platforms, see SEC Division of Trading and Markets, Frequently Asked Questions About the Exemption from Broker-Dealer Registration in Title II of the JOBS Act (Feb. 5, 2013).