21. In contrast the regulation of broker­dealers is more narrowly focused and is primarily designed to ensure that the interests of their clients are adequately protected, although regulators are increasingly concerned with the potential systemic effects of the failure of a major intermediary. This approach would not normally extend to the organizational aspects of the trading facility itself.

22. In the United States there are currently operational a number of proprietary trading systems that trade securities. The SEC's approach has been to determine whether it is appropriate to treat a PTS as a non­exchange or an exchange system. The non­exchange systems have been regarded as broker-dealers and banks (at least where trade execution is involved) and SEC staff issue a no­action letter with respect to the registration of those systems as exchanges where it is considered appropriate to do so.

23. As a condition of the no-action letters, the SEC staff have required the system sponsor to provide:  quarterly reports of trading activity in the system; the number and identity of the system participants and of prospective participants who have been denied access to the system; and at least 30 days advance notice of material changes to the system. The system sponsor is also required to reassure the regulator that there is adequate system security and additional capacity to cope with any expected increase in the volume of transactions. Finally, the SEC staff has added additional reporting requirements tailored to the specific characteristics of the system. The SEC's approach has developed incrementally on a case by case approach.

24. In one instance the SEC has recognized the affiliation between a non­exchange system sponsored by a registered broker­dealer (RMJ Options, Inc.) and an entity that operates as a registered clearing agency (Delta Government Options Corp.). Thus, the Delta system, which permits participants to trade options on government securities, operates subject to the regulatory protection applicable to registered clearing agencies as well as registered broker­dealers.

25. In addition, the SEC has recognized one PTS, AZX Inc., which operates as an exchange through a single­price auction format that aggregates supply and demand at a single point in time. The SEC granted AZX an exemption from exchange registration based on the limited volume of securities transactions contemplated to be executed through the system. That exemption was conditional upon requirements that the system, among other things:  (i) restrict traded securities to registered securities and government securities; (ii) adopt surveillance procedures to detect insider trading, manipulative abuses, and confidentiality violations; and (iii) disseminate transaction information to the SEC, to a vendor and to self­regulatory organizations. Finally, the SEC stated that should volume in the system rise to levels equivalent to the Cincinnati Stock Exchange, the SEC would commence a review to determine whether to rescind the exemption.

26. In 1989 the SEC requested comment on proposed Rule 15c2­10 that sought to impose a regulatory structure between that of an exchange and that of a broker­dealer. Under the Rule, a trading system would have been required to file with the Commission a plan describing its operation, make records available to the Commission on a regular basis and permit the Commission to examine and supervise the system to ensure compliance with the terms of the submitted plan and with federal securities laws.

27. The SEC's staff has examined the role PTSs play in the market, and the appropriate means of overseeing such systems, including proposed Rule 15c2­10, in the recently released report Market 2000:  an Examination of Current Equity Market Developments. In Market 2000, SEC staff concluded that its experience in overseeing these systems did not lead it to believe that the regulatory structure contained in proposed Rule 15c2­10 was appropriate for PTSs at this time. The staff concluded that regulatory treatment as broker-dealers continues to be appropriate given the nature of PTS activities, but that additional information should be provided to the SEC to monitor their activities. Accordingly, the staff recommended that the SEC adopt a record keeping and reporting rule to provide the SEC with better oversight of the aspects of automated trading systems without unduly burdening the systems. The SEC has recently proposed such a record keeping and reporting rule,⁶ and has withdrawn proposed Rule 15c2­10.⁷

28. In the UK a person carrying on investment business by making, or offering or agreeing to make arrangements with a view to a person who participates in the arrangements buying, selling, subscribing for or underwriting investments (paragraph 13 (b) of Schedule One to the Financial Services Act 1986), may seek to become authorized as a service company by the Securities and Investments Board ("SIB"). Alternatively, authorization as a broker­dealer may be sought by virtue of membership of a self­regulatory organization such as the Securities and Futures Authority. An organization may also apply to SIB for recognition as an investment exchange ("RIE"). SIB will grant such an application if it is content that the organization is capable of meeting the obligations imposed on RIEs by the Financial Services Act 1986, in which case it becomes an exempted person with respect to anything done in its capacity as such which constitutes investment business. In certain circumstances the obligation to apply for authorization may not apply if the arrangements are made by a person without a permanent place of business in the UK.⁸

29. Service company authorization is restricted to persons who carry on paragraph 13 (b) activities and where the participants are business or experienced investors. Service companies are not permitted to guarantee or ensure performance of transactions undertaken on their facilities.

30. A number of inter­connected factors are likely to influence the approach to regulation of PTSs in any particular jurisdiction including the history and structure of the legislative regime, attitudes towards the role of a central market place and fragmentation, the market microstructure (quote versus order driven markets), and approach to issues such as transparency. Many of these issues are the subject of other work by IOSCO and will only be mentioned in this context to the extent that they have a bearing on issues related to PTSs.

31. It would appear that an important factor in characterization of a PTS as an exchange or broker-dealer is whether the primary tool for enhancing market quality is a central market place in which order flow is centralized or a market structure which relies on the obligations of intermediaries to procure best execution for their clients. This factor is not sufficient by itself to explain the regulatory characterization of PTSs as either an exchange or broker­dealer in all jurisdictions.

32. It is because of these different emphases that it was not considered useful to pursue further an approach to the regulation of PTSs in terms of their institutional characterization as either a broker­dealer or as an exchange.

33. Rather, it was agreed that a more fruitful approach would be to develop a non­prescriptive analytical framework on the regulatory issues arising in relation to PTSs.

34. A number of approaches were examined. One approach was to seek to "unbundle" the provision of regulatory, trading, information and other services that have traditionally been combined in a traditional securities exchange. For example, the SIB's discussion document notes that the services provided by a securities exchange typically included all or most of the following services:

- publication of bid / offer quotations (quote­driven system);

- publication of public limit orders (order­driven system);

- publication of post­trade transaction details;

- publication of information concerning an issuer (company news);

- provision of a medium for dealing (e.g. floor, electronic dealing systems);

- provision of trade reporting facilities;

- provision of trade confirmation and matching facilities;

- provision of clearing and settlement facilities;

- infrastructure for surveillance and enforcement of market rules.⁹

35. As noted above, the underlying premise of those jurisdictions that treat PTSs as exchanges is that the provider of a trading facility should also be obliged to undertake certain regulatory functions or services.¹⁰ By seeking to separately identify the different types of regulatory services provided and "unbundle" these from the provision of the actual trading facility the analysis has the potential to identify:

- whether other parties could be contracted to perform some of the services usually undertaken by the self­regulatory organization;

- which regulatory services are required for all or any categories of PTSs; and

- the comparability of regulatory requirements between different types of trading systems and also different jurisdictions.¹¹

36. The attempt to "unbundle" the provision of regulatory services from the provision of a trading facility opens up a range of possible trading system-regulatory configurations. Some of the variations include:

- a system proprietor who provides the trading facility but does not supply any regulatory services;

- a system proprietor who contracts one or more independent parties to provide the facility infrastructure and / or various regulatory services;

- the provision of the trading facility to a single market with a variety of issuers and tradeables;

- individual issuers utilizing the trading facility to run markets in their own tradeables.

37. No doubt there are many other possibilities.¹² Concern was expressed by some members of the Working Party that if the "unbundling" approach was adopted as a regulatory approach rather than as merely an analytical tool then some of the important synergies, such as the availability of expert staff, arising from the joint regulation of the trading system and its operator, whether a traditional member based exchange or some other private organization, would be lost with adverse consequences for the level of investor protection. There were also reservations that regulatory functions may not be properly performed if third party service providers have substantial financial interests in the system and that the "contracting out" of regulatory functions could result in significant coordination problems.

38. A related approach is to base regulation on an examination of the various functions performed by any particular system and impose regulation relevant to the actual functions performed. This recognizes that a PTS may perform one or more of the functions associated with a traditional exchange and that it is necessary to tailor the regulation accordingly. This involves imposition of the relevant regulatory requirements on the system proprietor. This approach is consistent with the unbundling concept in that it recognizes that for each function it is necessary to examine which regulatory service is appropriate and how it is best delivered to ensure an adequate level of investor protection.

39. In this approach the first step is to identify the key functions and the regulatory objectives for each element at a general level before more detailed regulatory standards can be determined. These functions can be related directly to the nature of the activity undertaken on the system. One suggestion is that it is relatively easy to distinguish the core "market" functions of organizing liquidity through the interaction of the orders of a group of market participants as compared to the dealer function where the intermediary provides liquidity through the commitment of its own capital.¹³ This analytical approach was supported in comments received from one member of the IOSCO Consultative Committee. This approach, however, has the potential to re­introduce the difficulties in determining whether any function is properly characterized as a dealer or market under the securities laws of any particular jurisdiction. Also, there are difficulties applying this approach to some systems as the boundaries between once separate activities become blurred.

40. It has also been suggested that the core functions relating to the display of market information, order routing and trade execution can be assessed against the key regulatory issues identified by IOSCO Working Party No. 7 in its work on screen based trading for derivative products and that the Principles identified by Working Party No. 7 are applicable to all screen trading systems.

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⁶ Securities Exchange Act Release No. 33605 (February 9, 1994) (proposing Rule 17a­23 under the Securities Exchange Act of 1934 to establish record keeping and reporting requirements for brokers and dealers that operate automated trading systems (called "broker­dealer trading systems", or "BDTSs"). Registered broker­dealer sponsors of these systems would be required to maintain participant, volume and transaction records, and to report system activity periodically to the Commission. As proposed, the Rule would cover both PTSs and some automated trading systems operated by third market makers.

⁷ Securities Exchange Act Release No. 33621 (February 14, 1994).

⁸ Details of current approval requirements are set out in SIB (1994), Regulation of United Kingdom Equity Markets, Discussion Paper, February.

⁹ SIB (1994), p. 28.

¹⁰ Lee, R. (1992) "What is an Exchange" Discussion Paper, Capital Markets Forum, p. 33.

¹¹ As the traditional exchanges face increasing competition from other exchanges and alternative trading systems some are re­examining their core functions, whether they need to carry out all the functions traditionally engaged in, and more explicitly the costs of the regulatory services provided.

¹² For example, in the UK there is a separation of the self­regulatory organization ("SRO") from the Exchange. The SRO (and SIB in the case of service companies) is responsible for fitness and properness, prudential supervision and the conduct of the firm / client relationship. The Exchanges are responsible for maintaining an orderly market by regulating inter­professional conduct (e.g. broker / market maker, market maker / market maker), policing it for signs of manipulative activity and determining questions of market structure, listing criteria, etc. within an explicit regulatory framework. Another example is in Italy where CONSOB directly monitors the activities of exchange members. The exchange screen based trading system operates under an agreement between a private company and the Chamber of Commerce. There is no formal SRO structure in Italy, although there are currently steps in this direction.

¹³ Ketchum, R. (1993) "Electronic Trading Systems in a Global Environment ­ Local and Global Issues", Paper at 1993 IOSCO Annual Meeting, Workshop on Screen­Based Trading Systems and Quasi­Exchanges. Mexico City, Mexico, October 26.