The Role of Alternative Trading Systems

An exchange and an alternative trading system do the same commercial job: they match orders. What separates them is regulatory authority over participants. A venue that matches orders but does not police the people using it, beyond their trading on the venue itself, registers as a broker-dealer rather than as an exchange, unless a scope exclusion takes it outside those requirements.

What Makes a Venue an Alternative Trading System?

An alternative trading system (ATS) is any organization, association, person, group of persons, or system that satisfies both prongs of the definition.

1. It constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities, or otherwise performs with respect to securities the functions commonly performed by a stock exchange, within the meaning of the exchange functions definition rule.
2. It does not set rules governing the conduct of subscribers other than the conduct of those subscribers' trading on the system, and does not discipline subscribers other than by exclusion from trading.

The second prong is the role boundary. A venue that matches orders but does not regulate its participants beyond their trading conduct is an ATS, and it registers as a broker-dealer rather than as an exchange, unless one of the scope exclusions in the lesson on requirements for alternative trading systems applies.

Exam Tip: Gotchas

• The second prong is stated as two things the venue must not do. Setting broader conduct rules or disciplining beyond exclusion from trading takes a venue outside the definition.
• Exclusion from trading is the one permitted sanction. A venue may still bar a subscriber and remain an alternative trading system.
• The first prong is not self-contained. It borrows its content from the exchange functions definition rule, which supplies the actual two-part test.

What Are the Functions Commonly Performed by a Stock Exchange?

An organization, association, or group of persons is considered to constitute, maintain, or provide a market place or facilities for bringing together purchasers and sellers of securities, or otherwise performing the functions commonly performed by a stock exchange, if it does both of the following.

1. Brings together the orders for securities of multiple buyers and sellers.
2. Uses established, non-discretionary methods, whether by providing a trading facility or by setting rules, under which those orders interact with each other and the buyers and sellers entering those orders agree to the terms of a trade.

For this purpose, an order means 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. The terms bid and offer carry their meanings under the national market system rules (Regulation NMS).

The SEC may conditionally or unconditionally exempt any organization, association, or group of persons from that definition.

Exam Tip: Gotchas

• Multiple buyers and sellers is part of the test, not a description. A system bringing together one buyer's orders with one dealer's does not satisfy the first element.
• The methods must be non-discretionary and must produce agreement on terms. A venue whose operator picks counterparties by judgment fails the second element.
• An indication counts only if it is firm. A soft expression of interest is not an order for this test.

Which Activities Do Not Make a Venue an Exchange?

An organization, association, or group of persons is not within that phrase solely because it engages in one or more of the listed activities.

• Routing orders to a national securities exchange, a market operated by a national securities association, or a broker-dealer for execution.
• Allowing persons to enter orders for execution against the bids and offers of a single dealer, together with either of the two branches below.

The first branch: as an incidental part of those activities, it matches orders that are not displayed to any person other than the dealer and its employees.

The second branch has three parts. In the course of acting as a market maker registered with a self-regulatory organization (SRO), it displays the limit orders of its own or another broker-dealer's customers.

It then matches customer orders with those displayed limit orders, and, as an incidental part of its market making activities, crosses or matches orders that are not displayed to any person other than the market maker and its employees.

Exam Tip: Gotchas

• The word solely carries the exclusion. A venue that routes orders and also runs a matching engine is not saved by the routing activity.
• The single-dealer branch is not free-standing. Allowing orders against one dealer's quotations counts only in combination with one of the two matching branches.
• Incidental limits the undisplayed matching only. The first branch requires the matching of undisplayed orders to be an incidental part of those activities, and in the second branch the qualifier attaches to crossing or matching undisplayed orders, not to matching customer orders with the displayed limit orders.

How Does an Electronic Communications Network Fit In?

Regulation NMS defines an electronic communications network (ECN), for the purposes of one paragraph of the quotation rule, as any electronic system that widely disseminates to third parties orders entered in it by an exchange market maker or OTC market maker, and permits those orders to be executed against in whole or in part.

The definition then excludes two systems.

• Any system that crosses multiple orders at one or more specified times at a single price set by the system, whether by algorithm or by any derivative pricing mechanism, and does not allow orders to be crossed or executed against directly by participants outside those times.
• Any system operated by, or on behalf of, an OTC market maker or exchange market maker that executes customer orders primarily against the account of that market maker as principal, other than riskless principal.

The same definition carries into the limit order display rule, which sets seven exceptions to the display duty. One of them covers an order delivered immediately upon receipt to a national securities exchange, to a national securities association-sponsored system, or to an electronic communications network that complies with the quotation rule's requirements for that order. That rule is covered in the unit on Regulation NMS.

An ATS and an ECN are not alternatives to each other. A FINRA member that is an ATS displaying orders in the alternative display facility is swept into the registered reporting ADF electronic communications network definition, which is covered in the lesson on the use of the alternative display facility.

The quotation rule treats the two as compatible outside the ADF as well. A market maker that enters a priced order into an ECN is deemed to meet its quotation duty where that ECN is an ATS that displays orders and provides the ability to trade with them under the Regulation ATS order display requirement, and otherwise complies with Regulation ATS.

Exam Tip: Gotchas

• The definition is expressly scoped to one paragraph of the quotation rule. It is not a general definition of the term across the securities laws.
• The orders that must be disseminated are a market maker's. The definition names orders entered by an exchange market maker or an OTC market maker.
• Riskless principal is carved out of the second exclusion. A system executing customer orders against the market maker's account on a riskless principal basis is not excluded on that ground.

What Should You Check on Exam Day?

• Test both prongs before calling a venue an alternative trading system, since a venue that disciplines subscribers beyond exclusion from trading fails the second.
• Confirm the venue brings together orders of multiple buyers and sellers using established, non-discretionary methods.
• Check whether the venue does anything beyond a listed activity that itself meets the two-part test, because the exclusions do not excuse that other activity.
• On the single-dealer exclusion, look for one of the two matching branches, since the dealer element alone does not carry it.
• Read an electronic communications network question against the two exclusions, especially the crossing system that prices at set times.