Last year, the Securities and Exchange Commission (SEC) made a proposition to substantially expand the scope of what is defined as an “exchange.” This proposition could have the effect of broadening the SEC’s regulatory purview over a wider range of technologies vital to the securities markets. The proposal has been recently in the limelight as the SEC reopened the commentary period with a special focus on crypto asset securities and decentralized finance (DeFi) technologies. Yet, one mustn’t lose sight of the proposal’s original intent: To reconsider the rules surrounding fixed income markets and the platforms, technologies, and systems facilitating their trade.
A variety of products fall under the “fixed-income” banner, each with its unique features and trading mechanisms. Fixed income securities are often less standardized and interchangeable than equities, and they also trade less frequently. Historically, the trading practices for these products developed in a dealer-centric manner; a buyer or seller will usually contact multiple dealers, initiating manual, bilateral negotiations to accomplish a transaction. However, over the past two decades, segments of these markets have become more electronified, with new technologies fostering more efficient and cost-effective trading environments.
From a regulatory standpoint, some fixed-income platforms operate as alternative trading systems (ATS). But not all of them do, due to the specifics of fixed income trading practices and the SEC’s existing definition of an “exchange” crafted in 1998. The current definition generally focuses on firm, actionable orders for matching and trading, being catered primarily to the order-driven equity markets. This definition would change with the SEC’s recent proposal.
If the SEC’s proposal is accepted, the definition of an “exchange,” and by extension the range of the ATS regulatory oversight, would become broader across all types of securities. Two significant changes would be made: relaxing the restriction of bringing together firm orders by replacing “orders” with “trading interest,” which includes orders and non-firm indications of willingness to trade; and an addition of “communication protocols” as a triggering criterion for exchange status.
The SEC, in proceeding with this proposal, must cautiously deal with a number of complexities and challenges. Here are four critical issues:
- Slowing Electronification and Maturation of Markets: The SEC must deliberate whether the impending expansion of the ATS regulation would hamper the move towards further automation and enhanced efficiency in fixed income markets.
- Definition of ‘Communication Protocol’: The proposal does not provide a clear definition of the term “communication protocol system.” It’s imperative for the SEC to work on a clear definition and guidance, so that market participants understand the regulatory lines clearly.
- SEC Resources and Planning: The SEC estimates that the proposal might lead to 35 to 46 new ATS designations. The agency needs to ensure it has enough resources in place to administer the ATS program effectively.
- Compliance Timing: The SEC’s proposed timelines for compliance are considered short, therefore finding the right balance on compliance timelines is of paramount importance.
More details on this can be read in this Bloomberg Law Professional Perspective.
About the author: Jeffrey T. Dinwoodie is partner at Cravath, Swaine & Moore.
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