Trading Venue Perimeter: Whose Interest Being Protected Under ATS Reform? By Kelvin To, Founder And President, Data Boiler Technologies

Do market participants need better ability to evaluate potential conflicts of interest of multilateral trading venues? No. Market participants are not “Cops” to regulate trading venues, the Securities and Exchange Commission (SEC) is. The public relies on market regulators and Self-Regulatory Organizations (SROs) to assure that they are not scammed in the open market. Such a market is called the Exchange. Otherwise, civilians are left with reading all the “small print” (Form ATS, ATS-N, ATS-R, ATS-G and other enhanced disclosures) on their own and taking risk engaging with a trading partner or counterparties. These are called bilateral deals or multilateral trade agreements. The trade terms and corresponding recordkeeping are subject to privacy protection. Regulators should refrain from intervening legitimate private practices.

A broker-dealer able to offer multiple Alternative Trading Systems (ATSs) marketplaces is not a problem, whilst alleged exploitations or potential conflict of interest is. Those who point to a slew of settlement cases between ATS operators and regulators do have some merit. Per Steven and Steven’s empirical research, “Market makers are willing to reduce or eliminate execution advantage to exploit the information advantage.” Hence, raising additional concerns for “selective timing” to get in-and-out of market. It is not how a broker-dealer “claims” the trades were dealing with a customer or counter-party. Rather, as the trade data would reveal, with consistency, whether the firm was “in effect” acting in the best interest of the customer rather than treating the party as a counter-party (i.e. without fiduciary responsibility).

Regarding the evaluation of potential conflicts of interest, it is about defining the line between the permissible use of one’s “economy of scope/ scale” to discover new revenue streams and the potential prohibited action(s) that generates a spectrum of adverse effects inflicting damage onto others. The Commission may consult market participants for insights and/or have whistleblower programs. Yet, the responsibilities to conduct evaluations and draw the line remain with the regulators and SROs.

Given that an ATS must register as a broker-dealer and become a member of an SRO, and SROs must set standards of conduct for its members and administer examinations for compliance with these standards, then wouldn’t it be a supervisory fail if the SRO(s) failed to curb conflicts of interest activities or other alleged misconducts of the ATSs? Shouldn’t the SEC go after the SROs to mandate improvements of their standards of conduct and surveillance systems to enforce proper compliance by the ATSs? Tolerating the SROs from fulfilling their supervisory oversight responsibilities over ATSs, would that be something worth self-reflecting by the SEC? SROs have substantially more resources than the SEC to properly guard against ATSs’ misbehaviors. Shifting this burden to market participants is unfair and indeed implies that ATSs are more akin to broker-dealer functions.

We reviewed a recent settlement case between FINRA and Deutsche Bank Securities Inc. (DBSI) to see whether regulators have or not have sufficient basis to act or impose governmental costs at this time. DBSI did offer SuperX clients way to “opt out” of default routing practice. Prosecutors are required to consider if available evidence will lead to a conviction by the “beyond-a-reasonable-doubt” standard. The prosecutors’ argument in this particular incident is a moot point. Prosecuting from a prejudicial standpoint that alleged wrong doing is “tending to” impair other in a manner of conflict of interest requires in-depth analysis of market timing, consistency in orders routing method, and digging into other details.

Regulation ATS and other heightening of disclosures requirements largely focus on written standards and provided some scenarios that are likely to implicate a material change to ATS’s manner of operations. Market operators or investment firms that run ATSs do the best they can to figure out what to write (mostly through the supports of big law and consulting firms) and then certify in various form filings that ‘they are not doing anything wrong’. Then regulators can decide whether or not they agree with these “well-articulated” form filings and written policies and procedures. The proposed amendments have nothing with regards to monitoring the market timing and consistency of trades to detect which prohibited activities or conflict of interest acts.

The transactions in the DBSI case were between 2014 and 2019, whilst the firm closed the ATS – SuperX on September 24, 2021. The enforcement actions or disclosures neither prevent alleged wrongdoing, nor avoid a market failure. If there were ever any serious public harm, after-the-facts investigation would take years to conduct. Although there is a settlement, the $37 million fine is divided evenly between the SEC and the New York Attorney General. There seems to be not a single dollar allocated to any victim. When victims are not identified or they cannot count on timely salvages of losses, how can rules such as Regulation ATS and other disclosure requirements under the proposed rules amendments enhance investor protection?!

The SEC’s proposal concerning Investor Protections in Communication Protocol Systems (CPSs) and ATSs if adopted would bring more entities within scope to either register as an exchange or comply with Regulation ATS pursuant to Exchange Act Rule 3a1-1(a)(2). By scaling-up Fair Access and pushing CPSs to be regulated Exchanges or ATSs, the “push” may dissipate some of the benefits of regulated markets. The capital markets never lack competition. Indeed, we have more than enough markets but insufficient farmers and diversity to work in the field. Market participants are required to comprehend various order types and functions of different lit and dark venues. These middlemen (trading venues, TCA, liquidity sourcing, outsourced execution tools and smart order routers) do not care about eroding market efficiency. Instead they profit from an ever more fragmented market. We are concerned that when “everybody is a trading venue, nobody is a trading venue”. It increases costs to connect with additional venues for BestEx compliance when those additional venues may add little or no real benefit.

The current market environment is at Warring States period. It is an Animal Farm where every constituent wants to negotiate to be “more equal”. Smaller firms struggle to survive and merge away because of inequalities in markets. The number of FINRA registered firms has dropped from 4,000+ in 2014 to 3,435 at 2020-year end. The SEC should go after the SROs to turnaround that decline number of registered broker-dealers, or else face non-renewal of their Exchange license. The SROs should also be held accountable for improving the “standards of conduct” of their members, including ATSs.

Transparency does not always help advance the goals of the Commission. The larger firms may have wider “shoulders” to bear the burden through big law or consulting firms which smaller players cannot afford, yet this does not mean smaller firms have higher risk than their larger counterparts. Heighten disclosures in the beautified name of “improve transparency” may indeed be bad policies for an uneven playing field hurting the smaller players, increase costs to operate an ATS and deter new entrants into the ATS space.

Privacy of commercial transactions should be respected. Extending recordkeeping requirements to technology vendors / CPSs beyond FINRA registered firms, would give government regulatory agencies an overly invasive power over private information. These private records would otherwise be unobtainable unless under summons for suspicious illicit activities. Being nosey may create resentments, discomfort feelings, and civic concerns about massive government surveillance.