61. Whether a non­intermediary participant, such as an institutional investor, is subject to prudential or other controls is currently a matter for each jurisdiction's regulatory regime. The more difficult issue of the potential for a PTS system to offer direct participation by retail customers was noted by the Working Party, but was considered to be a rare occurrence at this stage in the development of PTSs.

62. Regulatory Issues for Consideration:

Access to the system should apply in a fair and non-discriminatory manner. The regulator and participants should be informed by a PTS of the criteria and procedures that will govern the grant or denial of access to a PTS of each specific category of participant.

In order to ensure financial soundness and integrity of PTSs there should be compliance by participants that are regulated intermediaries with the prudential controls established by the regulator, relevant SRO or PTS sponsor. Participants should comply with the system's rules, any applicable code of business conduct, and national securities laws.

PROVISION OF INFORMATION IN RELATION TO INDICATIONS OF INTEREST, QUOTATIONS, OR ORDERS TO PURCHASE OR SELL SECURITIES ­ PRE­TRADE INFORMATION

63. The focus of the Working Party's deliberations is on PTSs which provide for matching, crossing or execution of transactions. This excludes those systems that only make available historical information about completed transactions and are not designed to induce orders.

64. A PTS that offers some facility for the matching, crossing or execution of transactions will display information on its system in relation to indications of interest, details of quotes, or buy and sell orders. As noted above, PTSs may provide access to specific categories of participants defined according to some objectively established criteria ("similarly situated participants"). Participants seek access to the PTS and in doing so may be deemed to have accepted the types and manner in which the PTS provides its services on a commercial basis. At a minimum, the system should provide pre-trade transaction information on the same basis to all similarly situated participants. This is designed to ensure an equitable distribution of information to similarly situated participants in the PTS system.

65. Some Working Party members considered that the provision of information on a differential basis to specific categories of participants in a PTS may create an in-equitable distribution of information and unfair trading advantages for particular categories of system participants. These Working Party members considered that, in principle, information should be provided to all PTS participants on the same basis and that any departure from this principle should only occur where there was a reasonable basis for the provision of differential information to categories of participants. This would involve the regulator making some assessment of whether the categorization of participants and the type of information provided to each category was reasonable and did not result in any unfair trading or other advantages to any one category of PTS participant.

66. Regulatory Issues for Consideration:

To enhance investor protection, market liquidity, price discovery and efforts of intermediaries to provide best execution the PTS should provide, at a minimum, information in relation to indications of interest, quotations, or orders to purchase, sell or exchange securities on the same basis to all similarly situated market participants. There should be a reasonable basis of any categorization of participants for the purposes of access to pre­trade transaction information. Any differential access to such information should not unfairly disadvantage specific categories of participant, especially where such participants are unable to adequately assess for themselves the commercial risks involved in participation in the PTS.

ORDER ROUTING

67. The specific regulatory issues in relation to order routing on a PTS may depend on whether orders are transmitted to an organized regulated market or to other alternative trade execution and matching systems.

68. The focus of the Working Party's deliberations is on PTSs which provide for the matching, crossing or execution of transactions. This definition excludes systems that merely automate the collection and transmission of orders by regulated intermediaries to a regulated market and that do not provide any facilities for automatic matching, crossing or execution of those orders (internal order routing systems). These systems in many ways make more efficient the current activities of members of the regulated exchanges and raise less significant issues since such systems will be the subject to the current rules and oversight of the regulated market or self-regulatory organization. The relevant exchange or SRO, however, may need to ensure that the implementation of automated order routing does not lead to procedural mismatching that may undermine the orderly conduct of the regulated market. The definition of PTS also excludes exchange trading and other systems.

69. PTSs that do provide for matching, crossing or execution of transactions linked to a regulated market or to other alternative trade matching and execution systems raise additional regulatory issues. A key concern is that PTSs will lead to market fragmentation with adverse consequences for the depth and liquidity, and therefore, price discovery, transaction costs and efficiency of trading. Fragmentation can be defined as the dispersion of order flow and can occur between market centres for inter­listed securities, in the procedures of the market (i.e. crossing rules), among dealers in a dealer market or between different trading systems.

70. The development of PTSs has the possibility to further disperse buying and selling orders between competing trading centres and reduce the opportunities for order interaction in a central auction process. The hearings into the Rules of the Toronto Stock Exchange and Instinet Canada Limited by the Ontario Securities Commission indicated that these concerns arise even where the PTS is linked to a regulated market and not only where orders are routed to alternative matching or execution systems.

71. There may be both benefits and costs in fragmented versus central markets. In part this is due to the two types of competition in the securities markets:  (i) between buyers and sellers of a security; and (ii) among providers of dealer or trading services. Accordingly, competition between trading centres or systems appears more conducive to innovation in services, reduction in commissions and greater flexibility for investors. In some cases it is argued that fragmentation has directly increased the liquidity in some markets due to spillover effects.¹⁶ Such competition may, however, raise issues about the ability to adhere to time and price priority trading rules, as well as to claims of "free riding" of alternative trading systems on the price discovery and regulatory functions performed by the primary regulated markets.¹⁷

72. These matters raise difficult issues about the advantages of the two types of competition and how the benefits of competition between market centres and systems can be achieved without undermining the important price discovery and regulatory functions of the primary regulated markets. Various jurisdictions approach the achievement of this difficult balance in different ways. At a minimum, it is important that regulators and participants have sufficient information to be able to assess the implications of PTSs' order routing procedures. In addition where the PTSs' order routing procedures are linked to a regulated market they should be assessed to ensure that they are consistent with the integrity of the market as a whole and do not result in a disturbance to the orderly conduct of the regulated market.

73. Regulatory Issues for Consideration:

Order routing procedures should be clearly disclosed to participants and the regulator, applied fairly to all similarly situated participants, and not involve any breaches of relevant national laws relating, among others, to client precedence, front running or other abusive market conduct.

The specific regulatory issues in relation to order routing on a PTS may depend on whether orders are transmitted to an organized regulated market or to other alternative trade execution and matching systems. If orders are transmitted to an organized market, the specific regulatory issues in relation to order routing on a PTS should be addressed to ensure fairness, efficiency and integrity of the market as a whole. The relevant regulated market's order routing, displacement, crossing and other rules should be taken into account in order to avoid any disturbance to the conduct of an orderly market that may be caused by procedural mismatching between the PTS and regulated markets.

EXECUTION OF TRANSACTIONS

74. The order execution algorithm is the set of rules that determines the processing and matching of orders entered into the system. A wide variety of order execution algorithms are possible. The order execution algorithm can be a simple time and price system or have more complex features to deal with specific types of transactions, such as block or crossed trades. It can also be designed to enforce speculative position limits, credit limits, price limits, circuit breakers or other market control features. The more complex the system the more importance needs to be attached to appropriate design to prevent market abuses.¹⁸ Automated systems have certain advantages in that the execution algorithm can be specified to ensure compliance with regulatory requirements and the system can generate an automatic audit trail to enable the detection of any abuses. The order execution algorithm should be disclosed to the regulator and system participants prior to the operation of the system and be fairly applied to similar types of system participants.

75. Some members were of the view that the same order algorithm that applies in a regulated market should apply to that of the PTS. The consistency of execution algorithms between the regulated market and PTS will be more of an issue where the two markets are closely inter­linked. Working Party members agreed that there will be a need to ensure that any mismatching in execution procedures does not cause a problem for the orderly conduct of the regulated market.

76. Regulatory Issues for Consideration:

The order execution algorithm is the set of rules that determines the processing and matching of orders entered into the system. A wide variety of order execution algorithms are possible. The order execution algorithm should be disclosed to the regulator and system participants prior to the operation of the system and be fairly applied to similarly situated system participants.

Where the exchange and PTS are linked in some way, the execution algorithm of the PTS should be assessed to avoid any procedural mismatching between the PTS and regulated market that may effect the orderly conduct of the regulated market.

POST­TRADE REPORTING AND PUBLICATION

77. The issue of transparency, post­trade reporting and publication of transaction information and the implications for market efficiency, integrity and fairness has been the subject of other work by the Working Party. The Working Party is still considering issues related to the establishment of international agreed minimum standards of transparency. The IOSCO Discussion Paper on transparency provides an analysis of the arguments relating to inter­exchange competition and the ability of some markets to free­ride off other markets with general detrimental effects.¹⁹ In that IOSCO Discussion Paper one issue relates to the ability of a less transparent market being able to gain the benefits of the price discovery process without sharing in the costs of that transparency. This, it is sometimes argued, provides an unfair competitive advantage to the former market and is potentially harmful to the overall price discovery process.

78. This issue arises in the context of the relationship between the primary regulated markets and PTSs in that many of these systems may passively price on the basis of the price discovery process in the primary market. This is an example of potential free-riding by the PTSs on the costs borne by the regulated markets. It raises the general issue of whether there should be common minimum transparency requirements applicable to both the primary regulated markets and PTSs.

79. Working Party members considered that, as a minimum, there should be equitable distribution of information to participants in the same category and that any such categorization of PTS participants should be objective and based on reasonable grounds. Regulators should be able to specify participants access to information in accordance with their regulatory requirements. The nature of any agreed minimum international standards for post­trade publication is the subject of other work in the context of the debate about transparency generally. Working Party members are inclined to the view that where the same or related securities are traded the same post trade publication standards should apply to both the regulated markets and PTSs. It was agreed by all Working Party members that post trade information should be made available to the market where the regulator considers that it is necessary for the operation of a fair market generally.

80. Regulatory Issues for Consideration:

In order to enhance investor protection, address market fragmentation issues and enhance regulatory monitoring, information on completed transactions on a PTS should be provided on the same basis to all similarly situated PTS participants and reported in accordance with national requirements to the regulator. Where the information is considered by the regulator to be necessary for the protection of investors or the availability of a fair market, it should be made available to the market as a whole.

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¹⁶ SIB in its recent discussion Paper on UK equity markets notes that the creation of the American Depositary Receipt market has arguably increased American investor interest in the UK equity market.

¹⁷ These issues are discussed in the Ontario Commission Staff Submission (Appendix A, p. 10) to the Ontario Securities Commission Hearings into Instinet Canada Limited, the SIB's Discussion Paper on the Regulation of the United Kingdom Equity Markets (1994, Ch. 6 Exchanges and Market Service Providers), and the Report by the SEC's Division of Market Regulation ­ Market 2000:  An Examination of Current Equity Market Developments (1994, Study III Market Fragmentation, Competition and Regulation).

¹⁸ See the discussion in Corcoran, A. and Lawton, J. (1993) "Regulatory Oversight and Automated Trading Design:  Elements of Consideration", Journal of Futures Markets, Vol. 13, No. 2, pp. 218­219.

¹⁹ This is also an issue raised by the SIB in its Discussion Paper on UK Markets (p. 33) and by the SEC Division of Market Regulation in its Market 2000 Report (Study III, pp. III­2 ­ III­7 and Study IV Transparency).