Sometime in 1998, Division of Trading and Markets Director Rich Lindsey gave an unusual assignment to Associate Director Belinda Blaine. He asked her to “set a group of lawyers to work on defining what an exchange was.” By then, the proliferation of electronic trading venues had made Chairman Arthur Levitt truly concerned about fragmentation of the markets and hoping to create a consistent regulatory regime for ECNs which, unlike public exchanges, were private and available only to subscribers. Lindsey knew that comprehensive rulemaking was also required because the Order Handling Rules contained a loophole that enabled any company to set up an exchange and trade its own shares without regulation. Along with closing that loophole with what he called “a light regulatory system 39, ” Lindsey decided that the new rules should define legally just what an exchange was. About a month later, Blaine returned with two thick binders and told Lindsey “this is everything that’s even been written about what an exchange is. “Great,” replied Lindsey, while pushing the binders back across the table, “now tell me what an exchange is.” 39 In the end Lindsey got his answer, which was written into the final version of Regulation Alternative Trading Systems, or “Reg ATS.”
The idea was nothing new. In the late 1980s, Congress took up, and then dropped, legislation aimed at reforming “fragmented” markets. In 1991, Congressman Ed Markey wrote to SEC Chairman Breeden. “Some market participants have argued that proprietary electronic trading systems represent a natural and logical extension of the National Market System,” Markey stated, “while others have maintained that such systems will lead to the demise of the NMS and a ‘Balkanization’ of the securities markets into separate institutional and retail markets—with the result that fewer orders will be interacting in the national market to produce the best price.” Markey’s question for Breeden was essentially why it had dealt with fragmentation through no-action letters, rulemaking, and encouraging linkages, rather than through more comprehensive regulations. 40
By May 1997, the SEC was ready to undertake this more comprehensive approach, issuing a concept release soliciting input on how securities regulation should be tailored to suit technological change; particularly how to deal with the rise of the ECNs. The SEC was ready to nudge the markets a bit more firmly toward centralization. In December 1998, the SEC proposed a new set of rules and rule amendments known collectively as “Regulation ATS.” It was adopted in 1999. In addition to coining a new term—“Alternative Trading System”—Reg ATS restored clarity to the line between an exchange and a broker-dealer that technology had blurred by exempting alternative trading systems from registration as exchanges if they simply routed orders to an existing exchange. If an ECN exercised self-regulatory authority over its members or customers, Reg ATS determined, that ECN would have to register as an exchange. 41 Reg ATS contained one other very important provision at the behest of Chairman Levitt. Levitt, who had been chairman of the AMEX, knew that because they were mutually owned by members heavily invested in the status quo, the specialist exchanges were unable to innovate in any way that threatened the floor. Reg ATS specifically allowed exchanges to privatize, offering them at least a pathway into an electronic future if they wanted to take it. 42
The new clarity created by Reg ATS, combined with continued competition, spurred a series of strategic moves by the ECNs and exchanges. In 1999, Island ECN applied to become a national securities exchange. In the early 2000s, a number of ECNs followed Island’s lead and sought registration as exchanges. Other ECNs began to merge in order to gain market clout. By the early 2000s, both the NYSE and NASDAQ were in need of financing with which to compete. NASDAQ went first to the well, going public in 2001.
The NYSE had been insulated for a time by Rule 390, but in 1999, losing market share and under heavy pressure from the SEC, it repealed the Rule with “a tremendous amount of cajoling,” as Annette Nazareth, then Senior Counsel to Chairman Arthur Levitt, put it. 43 By the time of Reg ATS, the NASDAQ was emerging from a period of vulnerability and was able to more effectively compete in the new institutional and regulatory landscape. The NYSE, on the other hand, had just taken the first step.
(38) Regulation and Market Structure from ATS to NMS, June 1, 2018, 11.
(39) Regulation and Market Structure from ATS to NMS, June 1, 2018, 11.
(40) See Letter to SEC Chairman Richard Breeden from U.S. Representative Edward Markey Concerning National Market System, May 16, 1991.
(41) SEC Release: Regulation of Exchanges and Alternative Trading Systems, December 8, 1998.
(42) Regulation and Market Structure from ATS to NMS, June 1, 2018, 11-12.
(43) November 4, 2005 Interview with Annette Nazareth, 25.
