ECN and ATS

What an ATS Is

Under Rule 300(a) of Regulation ATS, an alternative trading system is any organization, association, person, group of persons, or system that 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 within the meaning of Rule 3b-16, and that does not meet either of two conditions. It does not set rules governing the conduct of subscribers other than the conduct of those subscribers' trading on the system, and it does not discipline subscribers other than by exclusion from trading.

Rule 3b-16(a) treats an organization, association, or group of persons as providing that market place or those facilities if it brings together the orders for securities of multiple buyers and sellers, and 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 the orders agree to the terms of a trade. Under Rule 3b-16(c), an order is 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.

Under Rule 3b-16(b), an organization is not considered to provide that market place solely because it routes orders to a national securities exchange, a market operated by a national securities association, or a broker-dealer for execution. Rule 3b-16(b)(2) adds a second exclusion for allowing persons to enter orders for execution against the bids and offers of a single dealer, subject to conditions the rule sets.

Subscribers, Not Members

Rule 300(b) defines a subscriber as any person that has entered into a contractual agreement with an ATS to access it for the purpose of effecting transactions in securities or submitting, disseminating, or displaying orders on it, including a customer, member, user, or participant in an ATS. A subscriber does not include a national securities exchange or national securities association.

National securities exchanges are categorized as self-regulatory organizations, known as SROs, meaning they have rules of conduct that apply to their members. National securities exchanges must be registered with the Securities and Exchange Commission, known as the SEC. An ATS is not an SRO.

What an ATS Trades

An ATS may trade listed stocks, as exchanges do. An ATS may also trade unlisted stocks, often called over-the-counter equity securities, or fixed income securities, such as bonds, which typically trade in over-the-counter markets.

Regulation ATS

Regulation ATS is codified at Rules 300 through 304. Rule 300 is headed Definitions. Rule 301 is headed Requirements for alternative trading systems. Rule 302 is headed Recordkeeping requirements for alternative trading systems, Rule 303 is headed Record preservation requirements for alternative trading systems, and Rule 304 is headed NMS Stock ATSs.

The SEC regulates ATSs under Regulation ATS. An ATS that does not fall within an exception in Rule 301(a) must register as a broker-dealer under Rule 301(b)(1). SEC regulations generally require ATSs to be operated by member firms of the Financial Industry Regulatory Authority, known as FINRA. ATSs are also subject to applicable securities laws and regulations.

The Exchange Exemption: Rule 3a1-1

Rule 3a1-1(a) lists the organizations that are exempt from the definition of the term exchange under section 3(a)(1) of the Securities Exchange Act of 1934. They include an organization operated by a national securities association and an organization in compliance with Regulation ATS, Rules 300 through 304. Under Rule 3a1-1(b), the exemption is not available if the organization reached the trading volume thresholds the rule sets during three of the preceding four calendar quarters and the SEC determines, after notice and an opportunity to respond, that the exemption would not be necessary or appropriate in the public interest or consistent with the protection of investors.

Registration and Notice: Rule 301

Under Rule 301(a), an ATS shall comply with the requirements in Rule 301(b) unless it is registered as an exchange under section 6 of the Securities Exchange Act of 1934, is exempted by the SEC from registration as an exchange based on the limited volume of transactions effected, or is operated by a national securities association. An ATS is also not required to comply if it is registered as a broker-dealer or is a bank and limits its securities activities to the instruments the rule lists, which include government securities and commercial paper. A fifth exception applies to an ATS that is exempted, conditionally or unconditionally, by SEC order, after application, from one or more of the requirements of Rule 301(b) or Rule 304.

Under Rule 301(b)(1), the ATS shall register as a broker-dealer under section 15 of the Securities Exchange Act of 1934. Under Rule 301(b)(2), the ATS shall file an initial operation report on Form ATS, in accordance with the instructions on the form, before commencing operation as an alternative trading system, and shall file an amendment on Form ATS before implementing a material change to the operation of the alternative trading system.

The headings of the remaining paragraphs of Rule 301(b) are Order display and execution access; Fees; Fair access; Capacity, integrity, and security of automated systems; Examinations, inspections, and investigations; Recordkeeping; Reporting; Written procedures to ensure the confidential treatment of trading information; and Name.

Order Display and Fees: Rule 301(b)(3) and (b)(4)

Rule 301(b)(3) applies to an ATS with respect to any NMS stock in which the ATS displays subscriber orders to any person other than ATS employees and reaches the average daily trading volume threshold the rule sets during at least four of the preceding six calendar months. In Regulation NMS, an NMS stock is any NMS security other than an option.

An ATS covered by Rule 301(b)(3) shall provide to a national securities exchange or national securities association the prices and sizes of the orders at the highest buy price and the lowest sell price for the NMS stock, displayed to more than one person in the ATS, for inclusion in the quotation data that the exchange or association makes available to vendors under Rule 602. It shall also provide to any broker-dealer that has access to that exchange or association the ability to effect a transaction with those displayed orders that is equivalent to the ability of the broker-dealer to effect a transaction with other orders displayed on the exchange or by the association, at the price of the highest priced buy order or lowest priced sell order displayed, for the lesser of the cumulative size of the priced orders entered at that price or the size of the execution the broker-dealer seeks.

Under Rule 301(b)(4), the ATS shall not charge any fee to broker-dealers that access it through a national securities exchange or national securities association that is inconsistent with the equivalent access required by Rule 301(b)(3). A further restriction on fees charged to members applies where the exchange or association has established rules on standards of equivalent access.

Fair Access: Rule 301(b)(5)

An ATS must comply with the fair access requirements of Rule 301(b)(5)(ii) if it reaches the volume thresholds the rule sets during at least four of the preceding six calendar months. The thresholds apply separately to NMS stocks, to equity securities that are not NMS stocks and for which transactions are reported to a self-regulatory organization, to municipal securities, and to corporate debt securities.

An ATS subject to those requirements shall establish written standards for granting access to trading on its system, and shall not unreasonably prohibit or limit any person in respect to access to the services it offers by applying those standards in an unfair or discriminatory manner. It shall make and keep records of all grants of access, including for all subscribers the reasons for granting access, and of all denials or limitations of access and the reasons for each applicant. It shall also report the information required on Form ATS-R regarding grants, denials, and limitations of access.

Under Rule 301(b)(5)(iii), an ATS is not required to comply with those requirements if it matches customer orders for a security with other customer orders, the customers' orders are not displayed to any person other than employees of the ATS, and the orders are executed at a price for the security disseminated by an effective transaction reporting plan, or derived from such prices.

Examinations and Confidential Trading Information

Under Rule 301(b)(7), the ATS shall permit the examination and inspection of its premises, systems, and records, and cooperate with the examination, inspection, or investigation of subscribers, whether the examination is conducted by the SEC or by a self-regulatory organization of which the subscriber is a member.

Under Rule 301(b)(10), the ATS shall establish adequate written safeguards and written procedures to protect subscribers' confidential trading information. Those safeguards and procedures shall include limiting access to the confidential trading information of subscribers to the employees of the ATS who are operating the system or responsible for its compliance with applicable rules, and implementing standards controlling employees of the ATS trading for their own accounts. The ATS shall also adopt and implement adequate written oversight procedures to ensure that the safeguards and procedures are followed.

Name: Rule 301(b)(11)

Under Rule 301(b)(11), the ATS shall not use in its name the word exchange, or derivations of the word exchange, such as the term stock market.

NMS Stock ATSs and Form ATS-N

Rule 300(k) defines an NMS Stock ATS as an alternative trading system that trades NMS stocks. Under Rule 304(a), unless it is not required to comply with Regulation ATS under Rule 301(a), an NMS Stock ATS must comply with Rules 300 through 304, except Rule 301(b)(2)(i) through (vii), to be exempt under Rule 3a1-1(a)(2). Rule 301(b)(2)(i) and (ii) are the Form ATS initial operation report and amendment requirements. An NMS Stock ATS files Form ATS-N instead.

No exemption is available to an NMS Stock ATS under Rule 3a1-1(a)(2) unless it files an initial Form ATS-N and the initial Form ATS-N is effective. The SEC may declare an initial Form ATS-N ineffective by order. An NMS Stock ATS must file a Form ATS-N in accordance with the instructions on the form.

Form ATS-N requires NMS Stock ATSs to disclose their manner of operations, the broker-dealer operator, and the ATS-related activities of the broker-dealer operator and its affiliates. An NMS Stock ATS shall amend its Form ATS-N before implementing a material change to its operations, shall amend it promptly to correct information that was materially inaccurate or incomplete when filed, and shall give notice of its cessation of operations on Form ATS-N before it ceases to operate as an NMS Stock ATS.

The SEC makes public, by posting on its website, each effective initial Form ATS-N, as amended, each Form ATS-N amendment to an effective Form ATS-N, each notice of cessation, and certain orders, including an order of ineffectiveness and an order suspending, limiting, or revoking the exemption for an NMS Stock ATS from the definition of an exchange. Each NMS Stock ATS shall make public, by posting on its website, a direct hyperlink to the SEC's website that contains those documents. The SEC publishes the disclosures, along with a regularly updated list of ATSs.

Lit Markets and Dark Pools

Traditional exchanges are considered lit markets. Quotation information is publicly displayed, and every market participant can take part in trading on both sides, buy or sell, by acting on the publicly available trading information.

Dark pool is a term often used to refer to an ATS that is not lit. A dark pool does not broadcast pre-trade data, meaning the presence, price and size of buy and sell orders, the way traditional exchanges do. Executed trades are reported, as covered below. Dark pools were designed, in general, to handle large trades for institutional investors anonymously, and most retail investors will not directly interact with dark pools. Institutional investors, such as insurance companies, mutual funds, and pension funds, are the main users.

A dark pool has no publicly available order book, and dark pools do not contribute to the public price discovery process until after trades are executed. Dark pools use public exchange prices as benchmarks.

Order Protection: Rule 611

Rule 611, the order protection rule, requires a trading center to establish, maintain, and enforce written policies and procedures reasonably designed to prevent trade-throughs on that trading center of protected quotations in NMS stocks that do not fall within an exception set forth in the rule. A trading center shall also regularly surveil to ascertain the effectiveness of those policies and procedures and shall take prompt action to remedy deficiencies.

Rule 600 lists an alternative trading system among the trading centers. Rule 600 defines a trade-through as the purchase or sale of an NMS stock during regular trading hours, either as principal or agent, at a price that is lower than a protected bid or higher than a protected offer.

Oversight and Trade Reporting

The SEC and FINRA are both actively involved in the regulation of dark pools. All off-exchange, off-ATS activity must take place at a registered broker-dealer, and remains subject to SEC and FINRA oversight.

All trade data for listed stock transactions occurring on ATSs, including dark pools, must be submitted to a FINRA Trade Reporting Facility, and is published on the consolidated tape along with trades occurring on exchanges. The consolidated tape is an electronic system that provides real-time trade data for listed securities. Firms must report trades in unlisted stocks to the FINRA OTC Reporting Facility, where OTC means over-the-counter, and trades in fixed income securities to the FINRA Trade Reporting and Compliance Engine, known as TRACE. Dark pools need to report information about trades that occur.

ATS and Single-Dealer Platform

A single-dealer platform, known as an SDP, is an electronic trading platform operated by a broker-dealer where the firm itself acts as the principal counterparty for every transaction. On an ATS, subscribers' orders to buy and sell are matched with one another by the ATS. On an SDP, the broker-dealer operating the SDP is always the counterparty to any trade that occurs on that platform.

What an ECN Is

Rule 600 of Regulation NMS defines an electronic communications network, for the purposes of Rule 602(b)(5), as any electronic system that widely disseminates to third parties orders entered in it by an exchange market maker or an over-the-counter market maker, and permits those orders to be executed against in whole or in part.

The definition excludes two kinds of system. The first is any system that crosses multiple orders at one or more specified times at a single price set by the system, by algorithm or by any derivative pricing mechanism, and does not allow orders to be crossed or executed against directly by participants outside of those times. The second is any system operated by, or on behalf of, an over-the-counter market maker or exchange market maker that executes customer orders primarily against the account of that market maker as principal, other than riskless principal.

ECNs and Quotation Rules: Rule 602(b)(5)

Under Rule 602(b)(5)(i), the entry of any priced order for an NMS security by an exchange market maker or over-the-counter market maker in that security into an ECN that widely disseminates the order is deemed to be a bid or offer under Rule 602. That bid or offer is communicated to the market maker's exchange or association for at least the minimum quotation size that the rules of the exchange or association require if the priced order is for the account of a market maker, or the actual size of the order up to the minimum quotation size required if the priced order is for the account of a customer. The entry is also deemed a communication of a bid or offer to a vendor for display on a display device.

Under Rule 602(b)(5)(ii), a market maker that has entered a priced order into an ECN that widely disseminates the order is deemed to be in compliance with Rule 602(b)(5)(i)(A) if the ECN meets one of two conditions.

Under the first condition, the ECN provides to a national securities exchange or national securities association, or to an exclusive processor acting on behalf of one or more exchanges or associations, the prices and sizes of the orders at the highest buy price and the lowest sell price for the security entered in, and widely disseminated by, the ECN by exchange market makers and over-the-counter market makers, and those prices and sizes are included in the quotation data made available to vendors. The ECN also provides to any broker or dealer the ability to effect a transaction with a priced order widely disseminated by the ECN and entered by an exchange market maker or over-the-counter market maker, equivalent to the ability of any broker or dealer to effect a transaction with an exchange market maker or over-the-counter market maker under the rules of the exchange or association to which the ECN supplies the bids and offers, at the price of the highest priced buy order or lowest priced sell order, or better, for the lesser of the cumulative size of those priced orders entered at that price by exchange market makers or over-the-counter market makers or the size of the execution the broker or dealer seeks.

Under the second condition, the ECN is an alternative trading system that displays orders and provides the ability to effect transactions with those orders under Rule 301(b)(3), and is otherwise in compliance with Regulation ATS, Rules 300 through 303.

How Orders Reach ECNs and ATSs

A broker may route an order, especially a limit order, to an ECN that automatically matches buy and sell orders at specified prices. A broker must evaluate the orders it receives from all customers in the aggregate and periodically assess which competing markets, market makers, or ECNs offer the most favorable terms of execution. Some brokers offer active traders the ability to direct orders to the market maker or ECN of their choice.

Rule 5310 requires that, in any transaction for or with a customer or a customer of another broker-dealer, a member and persons associated with a member use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. The factors considered in determining whether a member has used reasonable diligence include the character of the market for the security, the size and type of transaction, the number of markets checked, accessibility of the quotation, and the terms and conditions of the order which result in the transaction, as communicated to the member and persons associated with the member.

Exam Relevance

The Securities Industry Essentials examination content outline lists the third market and the fourth market under Topic 1.2.1, Types of Markets, within Topic 1.2, Market Structure, in Section 1, Knowledge of Capital Markets. The same topic lists the secondary market, with electronic, over-the-counter and physical named in parentheses. The list of rules that follows Topic 3.3.3 includes FINRA Rule 5310, Best Execution and Interpositioning. Candidates should check the current outline before the examination.

Common Misunderstandings

An ATS is a stock exchange. Unlike exchanges, ATSs do not have members, they have subscribers, and an ATS does not set rules governing subscriber conduct beyond trading on the system or discipline subscribers other than by exclusion from trading.

An ATS trades only listed stocks. An ATS may trade listed stocks, unlisted stocks, often called over-the-counter equity securities, or fixed income securities such as bonds.

An ATS has no regulatory obligations. An ATS is not a self-regulatory organization, but it is subject to Regulation ATS, and an ATS that does not fall within an exception in Rule 301(a) must register as a broker-dealer.

A dark pool is unregulated. The SEC and FINRA are both actively involved in the regulation of dark pools, SEC regulations generally require ATSs to be operated by FINRA member firms, and trade data for listed stock transactions on ATSs, including dark pools, must be submitted to a FINRA Trade Reporting Facility.

A dark pool does not report its trades. Dark pools need to report information about trades that occur, even though they are not required to publish quotations.

An ATS can discipline subscribers the way an exchange can. Under Rule 300(a), an ATS does not discipline subscribers other than by exclusion from trading.

Every system that matches orders electronically is an ECN. Rule 600 defines the term for the purposes of Rule 602(b)(5) and excludes a system that crosses orders at a single price at specified times, and a system operated by a market maker that executes customer orders primarily against the market maker's own account as principal, other than riskless principal.

An ECN can never be an ATS. Rule 602(b)(5)(ii)(B) addresses an ECN that is an alternative trading system.

An NMS Stock ATS files Form ATS like every other ATS. Under Rule 304(a), an NMS Stock ATS is excepted from Rule 301(b)(2)(i) through (vii) and files Form ATS-N.

A single-dealer platform is an ATS. On an SDP, the broker-dealer operating the platform is always the counterparty to any trade.

An investor decides where every order executes. A broker may route an order to an ECN, and a broker must evaluate which competing markets, market makers, or ECNs offer the most favorable terms of execution.

Key Points to Retain

An ATS is an electronic execution venue that acts much like a stock exchange, with subscribers instead of members and without the self-regulatory role of an exchange.

Under Rule 300(a), an ATS does not set rules governing subscriber conduct beyond trading on the system and does not discipline subscribers other than by exclusion from trading.

An ATS is regulated under Regulation ATS, and SEC regulations generally require ATSs to be operated by FINRA member firms.

Under Rule 3a1-1(a)(2), an organization in compliance with Regulation ATS is exempt from the definition of exchange.

Under Rule 301(b), an ATS registers as a broker-dealer and files Form ATS before commencing operation and before implementing a material change.

An NMS Stock ATS trades NMS stocks and files Form ATS-N.

A dark pool is an ATS that does not broadcast pre-trade data, meaning the presence, price and size of buy and sell orders, and its executed trades must be reported.

Rule 600 defines an ECN, for the purposes of Rule 602(b)(5), as an electronic system that widely disseminates to third parties orders entered in it by an exchange market maker or an over-the-counter market maker, and permits those orders to be executed against in whole or in part. An ECN automatically matches buy and sell orders at specified prices.

Under Rule 5310, a member must use reasonable diligence to ascertain the best market for the subject security so that the resultant price to the customer is as favorable as possible under prevailing market conditions.