Alternative Trading Systems

The Securities Exchange Act of 1934 requires SROs to maintain and enforce rules designed to keep trading in over-the-counter securities fair and honest.

The specific section of "the Act" states: Provisions governing the form and content of quotations relating to securities sold otherwise than on a national securities exchange which may be distributed or published by any member or person associated with a member, and the persons to whom such quotations may be supplied. Such rules relating to quotations shall be designed to produce fair and informative quotation; to prevent fictitious or misleading quotations, and to promote orderly procedures for collecting, distributing, and publishing quotations.

There are exchange rules designed to achieve the above goals. But, then there are "securities sold otherwise than on a national securities exchange," known as NMS securities. The SEC's Regulation NMS is concerned about access to timely market information on securities sold through other facilities, such as Electronic Communications Networks or ECNs. An ECN facilitates the electronic trading of securities that trade virtually everywhere. If they are a "linked ECN," they can report trades through the NASDAQ system. But if they are an "unlinked ECN," they need an alternative system to display quotes, compare trades, and report transactions to the market everything but route and execute orders.

To satisfy the need for ECNs and other non-exchange trading facilities to display buying and selling interest and report transactions to the market, FINRA created the Alternative Display Facility or ADF. As its name suggests, this is a display-only facility, meaning that orders are not routed and executed through the ADF the way they are on NYSE or NASDAQ Quotes are displayed through the ADF, but trades are not automatically routed for execution.

Rather, trades are routed and executed because broker-dealers are required to set up ADF Trading Centers that link to all other ADF Trading Centers and to any FINRA member who requests access. To set up an ADF Trading Center a member firm must set up an electronic system that provides electronic access to other members, meaning they must accept electronic orders from other members for execution, orders that do not require any voice communications. The ADF Trading Centers are referred to as Alternative Trading Systems (ATS).

Many firms see the quotes displayed through the ADF and enter orders through vari¬ous Alternative Trading Systems. But, firms can enter quotes to buy and sell securities through the Alternative Display Facility only if they are a Registered Reporting ADF Market Maker or a Registered Reporting ADF ECN (Electronic Communications Network).
The ADF Trading Center must provide other registered broker-dealers access to the system and allow them to, in turn, provide access to their customers.

FINRA defines indirect access as:
"The ability to route an order through a FINRA member, subscriber broker-dealer, or customer broker-dealer of an ADF Trading Center that are not an affiliate of the ADF Trading Center, for execution against the ADF Trading Center's best bid or offer subject to applicable FINRA rules and the federal securities laws, including SEC Regulation NMS"

The ADF Trading Center cannot determine or influence the prices charged by its customer broker-dealers who provide indirect access to the system to their customers, nor can they try to discourage or prevent indirect access from being provided. An ADF Trading Center must provide a level and cost of access to its quotations in an NMS stock displayed in that ADF at substantially equivalent levels to what SRO trading facilities provide and charge for that same stock. To be an ATS, the facility must demonstrate it has sufficient technology to update its quotes and immediately respond to orders for execution at the individual alternative trading system's best bid or offer.

Broker-dealers can only be denied access to the Alternative Display Facility as an ATS for failing to meet the requirements of the system and only through a carefully prescribed process
Automated trading centers must adopt reasonable standards that limit when their quotations can change from automated quotations to manual quotations, and vice versa, to specifically define circumstances that promote fair and efficient access to their automated quotations and are consistent with the maintenance of fair and orderly markets. What would be inconsistent with such a goal? How about a broker-dealer who waits for a lot of action on a thinly traded stock to suddenly become overloaded and starts executing orders manually and in a manner that customers are not able to follow? That would be a lack of transparency, what the regulators want to avoid.

Being able to enter automated quotations is critical. So is keeping the trading system up and running. As FINRA rules stipulate: in the event that an ADF Trading Center experiences three unexcused system outages during a period of five business days, the ADF Trading Center may be suspended from quoting in the ADF in all or certain issues for a period of twenty business days.


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