On January 26, 2022, the SEC proposed rule changes that would greatly expand the scope of Regulation ATS, the regulatory regime that governs alternative trading systems (“ATSs”). The proposal focuses on four main changes:
- Expanding the definition of exchange to include “communication protocol systems;”
- Expanding Regulation ATS to cover “Government Securities ATSs;”
- Extending Regulation SCI to cover Government Securities ATSs; and
- Expanding requirements for ATSs that trade NMS stock and other securities.
While expanding Regulation ATS to Government Securities ATSs and layering on Regulation SCI requirements was the main headline, all existing ATS operators should carefully review the proposal, as its reach and effects go far beyond government securities.
The proposal also broadens the scope of the ATS regime from a centralized construct to one in which a communication protocol system would be viewed as an exchange, and required to register as a broker-dealer and file Form ATS, even if used or deployed by a third party without the involvement of the developer. We covered this aspect in our earlier client alert, including the potential effect on the crypto and DeFi space.
The other major takeaways include new requirements for NMS stock ATSs to file amendments and provide additional fee and operational disclosures, and new requirements under the fair access rule that will affect all ATSs.
Heightened Requirements for Government Securities ATSs
Currently, Government Securities ATSs are not subject to many provisions of Regulation ATS, including the fair access rule, order display rules, or fee restrictions. In addition, Government Securities ATSs need not file a public Form ATS-N, nor are they subject to the requirements of Regulation SCI. The proposal would eliminate these exemptions. As proposed, Government Securities ATSs would need to comply with the fair access rule (above specified volume thresholds), the requirement to file a public Form ATS-N, recordkeeping obligations, inspections, and reporting requirements, among others.
The proposal would also extend Regulation SCI to Government Securities ATS that meet specified volume thresholds. Regulation SCI currently applies to NMS stocks and supersedes certain system integrity provisions that exist within Regulation ATS for non-NMS Stock ATSs. Regulation SCI requires an “SCI entity” to, among other things, establish, maintain, and enforce written policies and procedures reasonably designed to ensure that their key automated systems have levels of capacity, integrity, resiliency, availability, and security adequate to maintain their operational capability; take appropriate corrective action when systems issues occur; provide certain notifications and reports to the SEC regarding systems problems and systems changes; inform members and participants about systems issues; conduct business continuity and disaster recovery testing; conduct annual reviews of their automated systems, including penetration testing; and make and keep certain books and records. Regulation SCI compliance will be an additional heavy-up for any Government Securities ATSs that hit the 5% SCI Entity threshold.
The proposal would also remove the exemption for a bank that trades government securities or repurchases/reverse repurchases. In support of removing this exemption for banks, the SEC notes the importance of SRO membership for ATSs, and because banks typically operate in reliance on exemptions from broker or dealer status, they are not required to become a member of FINRA. Accordingly, bank-operated ATSs trading only government securities would not be able to rely on the exemption from exchange registration provided by Regulation ATS. The SEC believes a bank in such a situation may adopt a registered affiliate structure for government securities operations by moving its ATS operations into a new or existing broker-dealer affiliate of the bank. For banks currently trading government securities pursuant to an exemption without a registered broker-dealer affiliate, they will need to either register a broker-dealer and ATS or cease the activity.
Amendments Applicable to NMS Stock ATSs and Other ATSs
Under the proposal, ATSs that trade NMS stocks would need to: (i) file an amendment to their existing disclosures in accordance with a revised Form ATS-N, which includes questions about interaction with related markets, liquidity providers, and activities the ATSs undertake to surveil and monitor their markets; and (ii) report changes to fee disclosures on Form ATS-N no later than the date on which they make a fee change. Additionally, any ATS subject to the fair access rule would need to ensure that it meets minimum requirements for reasonable written standards for granting, limiting, and denying access to ATS services that must be established, and applied, and among other things, justify why each standard is fair and not unreasonably discriminatory.
The proposal sets forth minimum requirements for reasonable written standards that must be established and applied by any ATS, including: (i) dates of adoption, effectiveness, and modification; (ii) any objective and quantitative criteria upon which each standard is based; (iii) identification of any differences in access to the services of the alternative trading system by an applicant and current participants; (iv) justification as to why each standard, including any differences in access to the services of the alternative trading system, is fair and not unreasonably discriminatory; and (v) information about any of the aforementioned standards for granting, limiting, or denying access to the alternative trading system services that are performed by a person other than the broker-dealer operator. Elements of these proposed changes appear based on the subjective standards to which exchanges are subject to show that their proposed rule changes are reasonable, equitable, and not unreasonably discriminatory. This standard has created significant challenges in the exchange space. Further ensconcing this approach in the ATS space will create additional burdens for ATSs and likely slow operational progress if they want to effect a change.
The fair access rule will also be amended so that for the purpose of calculating the average transaction volume for fair access thresholds, ATSs would be required to aggregate the trading volume for a security or category of securities for ATSs that are operated by a common broker-dealer, or ATSs that are operated by affiliated broker-dealers. For any ATSs operated by a common broker-dealer or broker-dealer affiliates, this will increase the likelihood of needing to comply with the fair access rule.
The proposal would also require ATSs to file both Form ATS and ATS-R electronically via EDGAR. Currently, filings are made to the SEC via paper, in triplicate. While ATS-N filings are made via EDGAR today, this is a curious perpetuation of use of what is objectively viewed as an antiquated, clunky, and difficult-to-navigate system. Some might even argue that paper-based filings are more efficient.
These amendments would subject Governments Securities ATSs to the review process currently applicable to NMS stock ATSs, where the SEC has 120 days to declare the Form ATS-N ineffective if it finds such action to be consistent with the public interest and protection of investors. This is another curious decision, based on the difficulties the agency had in clearing the original slog of ATS-N filings submitted in 2019, for which the SEC extended its own review period by 120 for some filers.
As part of the 654-page proposal, the SEC proffered 224 questions to the public for which it would like feedback. Comments are due 30 days after the proposal is published in the Federal Register, meaning the comment period could expire in early March. Given the sweeping changes proposed, it is likely the SEC will receive significant public feedback. We will continue to monitor any developments in this area, including potential final adoption.
 Under the proposal, a Government Securities ATS would be subject to the fair access rule if, during at least four of the preceding six calendar months: (1) it had 3% or more of the U.S. Treasury Securities average weekly dollar volume traded in the United States; or (2) it had 5% or more of the Agency Securities average daily dollar volume traded in the United States..
 Government Securities ATSs would not be subject to the order display and execution access provisions under Rule 301(b)(3) or the fees provision of Rule 301(b)(4) that are applicable only to NMS Stock ATSs.
 Under the proposal, the definition of “SCI ATS” would be revised to include those ATSs which, during at least four of the preceding six calendar months, had, with respect to U.S. Treasury Securities, 5% or more of the average weekly dollar volume traded in the United States; or had, with respect to Agency Securities, 5% or more of the average daily dollar volume traded in the United States (as provided by the SRO to which such transactions are reported).
Nicholas J. LosurdoPartner