Governments walk a tricky line when regulating tech: Come down too hard and stifle the very innovation that brings savings to consumers; regulate too lightly and consumers bear unintended consequences.

The fixed-income industry has electronified patchily over the past 20 years compared to other, more fungible asset classes. But innovation in protocols and platforms is rapid enough that it has long worried the US Securities and Exchange Commission (SEC), which earlier this year put out a proposal to bring some big changes to the regulation of trading venues in Treasuries and beyond.

Market participants, however, feel the regulator has tipped too far toward the stricter end of the regulatory continuum with this proposal, which contemplates amendments to Regulation Alternative Trading Systems (Reg ATS). These amendments, if finalized as proposed, would impose heavier compliance and disclosure obligations on platforms that trade Treasuries. And they would also touch on equity venues, cryptocurrency platforms, and incumbent fixed-income venues that are already heavily regulated.

The proposal was published at the end of January and the deadline for comment closed on April 18. However, the SEC bowed to public pressure last week and reopened the Reg ATS amendments, along with two other proposals. So the industry now has another 30 days to submit comments.

So far, most of the comments on the SEC’s website are from crypto enthusiasts concerned that heavy regulation could stifle the infant asset class. The other commenters tend to be established market operators like MarketAxess, Tradeweb, and Bloomberg, large non-operator vendors like Broadridge, and trade associations. There are few from smaller fintechs, providers of tools such as execution management systems (EMSs), order-routing technologies, communications and messaging systems, workflow tools and so on. But this is a community that could take arguably the heaviest blow from these amendments.

As written, the proposal contemplates sweeping them into the scope of Reg ATS, which would subject them for the first time to enhanced disclosures and other obligations. Virtually any third party supporting a transaction in a security, even tangentially, will have to register with the SEC if these amendments are finalized.

While few commenters deny that the SEC is right to look more closely at updating the regulation around Treasuries, this dramatic expansion of the trading perimeter has caused deep concern within the vendor community.

“Most major venues are already regulated in some way, but this is a more all-encompassing approach to oversee the market, which has evolved tremendously over the last 10 years. The proposal did go a few steps further than folks expected in terms of what would be included,” says Kevin McPartland, head of market structure and technology research at consultancy Coalition Greenwich.

“There’s a lot of talk about whether an EMS would have to register as an ATS, for instance, and I think that caught the industry off guard. I suspect there will be a lot of debate around this in the coming weeks and months as they look to pass the final rule.”

Among other measures, the proposal removes the carve-out from Reg ATS that Treasuries ATSs currently enjoy, and expands Regulation Systems Compliance and Integrity (Reg SCI, the SEC’s operational resilience regulation) to cover these systems, expanding their disclosure obligations. The proposal also tries to lower the threshold for what constitutes an ATS by expanding the definition of “exchange” to include so-called communication protocol systems (CPSs). The SEC never explicitly defines CPSs, but says they are systems that “offer the use of protocols and non-firm trading interest to bring together buyers and sellers of securities,” systems where buyers and sellers can communicate, negotiate, and agree to the terms of a trade.

The SEC also gives some non-exhaustive examples of what a CPS might do. It could provide request-for-quote (RFQ) protocols, stream axes, or be a conditional order system, for instance.

Industry participants say they are worried about the amendments to the exchange definition and the vagueness around what a CPS is, as it seems to draw in a broad range of messaging systems. Many letters, including those from Broadridge, Symphony, and Virtu Financial, called for clarity about what exactly a CPS is.

Even without knowing the precise definition, others say, it’s unlikely that regulation is appropriate for these systems. These are not liquidity centers whose failure would take offline liquidity in significant markets. EMSs and other comparable trading tools do not perform the functions of an exchange, but merely offer workflow or tools with the aim of bringing efficiencies to market infrastructure.

Bloomberg’s global head of regulatory affairs Gregory Babyak, and its regulatory analyst and market structure strategist Gary Stone, wrote the company’s comment letter submitted under the first round of notice and comment on this proposal. They say that even were the SEC to explicitly define a CPS, that still would not explain why these systems should be treated like exchanges. “They do not hold firm liquidity. They do not match or cross orders,” their submission says.

Shifting sands

To understand how the definition changes under the new amendments, consider the example of an EMS. Under the Exchange Act as it is now—SEC Rule 3b-16(a), to be exact—an EMS would fail the exchange litmus test and would therefore not have to register with the SEC.

Currently, under 3b-16(a), a business is considered an exchange if it brings together the orders of multiple buyers and sellers, and if it uses “established, non-discretionary methods”—setting rules for how orders interact or how they provide a trading facility. If a business counts as an exchange, it must register as such under the Exchange Act, or as a broker-dealer under Reg ATS. The latter comes with a lighter compliance burden, with exchange regulation reserved for the likes of systemically important trading venues and clearinghouses, and self-regulatory organizations (SROs) like the New York Stock Exchange (Nyse). EMSs do not bring together multiple buyers and sellers, nor do they make available established, non-discretionary methods for orders to interact.

The proposal, however, amends the wording of 3b-16(a) to define an exchange as something that no longer must set rules, but merely has to make available some kind of service for trading, the parameters of which the user can define for itself. It also deletes “multiple” buyers and sellers, replacing it with the concept that an exchange brings together “trading interest.” That could be firm or non-firm trading interest—really any interest submitted to a system.

“When the SEC proposed to change the definition of ‘exchange,’ the commission deleted the concept of ‘multiple’ and changed the interpretation of ‘makes available non-discretionary interactions.’ And suddenly, the regulatory perimeter, which was targeted—just the exchanges and those providing exchange-like functions that were deemed ATSs—now was no longer targeted but rather included more entities,” says a source at a vendor that would be affected by this proposal.

These amended definitions would certainly draw in EMSs by expanding the trading perimeter and deleting the word “multiple.”

Greenwich’s McPartland says an EMS could be caught because a buy-side user would use it to aggregate streaming prices.

“If you’re a hedge fund or an asset manager, and you have direct connections with your major brokers who are streaming you constant prices, you are using your EMS as an aggregator. The SEC has written this proposal as if to say, ‘OK, well now you effectively have a liquidity venue because you are using this platform to pull these prices together,’” McPartland says.

But this is a fundamentally different function to those performed by regulated fixed-income trading platforms like Bloomberg, MarketAxess, and Tradeweb, he adds.

“The EMSs, especially in fixed income, are not acting as counterparties to trades; they’re just pulling data into a single user interface that allows the trading desk to interact with that liquidity. That doesn’t fit the definitions of what exchanges or ATSs are, and a lot of industry responses are saying that this goes beyond the spirit of the rule,” McPartland says.

If the amendments are finalized as proposed, scores of previously unregistered businesses would get swept up into the definition of exchange and would have to register with the SEC. (The commission says that, due to the lighter burden under Reg ATS, it would expect them to register as broker-dealers rather than exchanges.) Indeed, some comment letters speculate that the SEC did not realize that these amendments would affect quite so many vendor businesses: The proposal estimates the number of CPSs at only 22.

“The SEC says they anticipate the changes will only create 22 communication protocol systems, so we don’t think the commission intended to scoop them up. There is a mismatch in expectations,” the vendor source says. “We don’t know where the number comes from, because the way the commission wrote the rule, EMSs and other trading and investing solutions appear to be in scope.”

Commenters say that there is no need to regulate CPSs: As third parties that provide software and services to heavily regulated financial institutions, they are already under scrutiny during vendor due diligence processes and operational resilience standards.

Large exchanges, too, already play a role in policing vendors, says Kelvin To, president of DataBoiler Technologies. The SROs can exert authority through their contracts with any party, including CPSs that subscribe to their market data.

“There is no necessity for the SEC to directly manage ATSs or CPSs when SROs have substantially more resources, including surveillance systems and other tools to guard against misbehaviors,” To says.

Some commenters, including Virtu Financial, said in their letters that the definition of an exchange is a keystone of regulation and market structure in the US, and by changing it, the commission is coming dangerously close to exceeding its statutory authority.

The vendor source agrees. “The definition of ‘exchange’ is a settled, foundational aspect of regulation. It should be left alone. The RFQ systems, which are sending requests, and the order routing systems, which are sending orders against firm or semi-firm quotes, are just communications. The SEC should not regulate communications as if they were risky exchange functions,” they say.

Wide net

Messaging systems vendor Symphony is worried that it could be drawn into the scope of Reg ATS. Symphony’s general counsel, Corinna Mitchell, wrote in the company’s submission about the comment period that it wants clarity around whether it would have to register with the SEC.

“Symphony believes that a technology provider that does not establish any protocols with respect to securities transactions, but rather provides modular and open software architecture whereby financial industry participants can communicate with each other should not be deemed to be acting as an ‘exchange,’” Mitchell writes.

Symphony CEO Brad Levy tells WatersTechnology that the SEC should more specifically define CPSs, and that regulating companies like his would not be appropriate.

“There’s enough ambiguity [in the proposal] that loads of technologies that are innovative and good, including ours, will be drawn in. Would that make sense? Probably not. It will limit the ability to leverage a lot of these technologies, whether it’s the phone, the collaboration and communication stack, or an EMS platform,” Levy says. ”We’re not a broker, we just get things from here to there.”

Back in 2021, Symphony had to suspend Sparc, a workflow tool for interest rate and cross-currency swaps, in which traders could use a single platform for RFQ negotiations. Swaps regulator the Commodity Futures Trading Commission (CFTC) ruled that Sparc should have been registered as a swaps execution facility (Sef), and fined Symphony $100,000.

EMS provider FlexTrade did not respond to requests for comment on this article, nor has the vendor yet submitted a comment letter on the most recent Reg ATS amendment proposal. However, it did respond to a prior 2020 proposal that heavily informed the 2022 one.

In that letter, FlexTrade CEO Vijay Kedia wrote that third-party software vendors do not act in the capacity of an exchange or an ATS, citing Rule 3b-16 (a): FlexTrade’s EMS does not bring together orders for securities of multiple buyers and sellers.

“As a technology platform, we are enabling the buy-side user to access bilateral liquidity, but there is no anonymity. Every dealer knows the identity of each buy-side firm, so that when a user sends an RFQ via the EMS, this occurs on a fully disclosed basis,” he wrote. “By contrast, when a buy-side firm uses a fixed-income venue/ATS such as MarketAxess or Tradeweb to send an RFQ to five dealers, the ATS knows who the buy-side firm is, and it will hide the firm’s identity.”

MarketAxess general counsel Scott Pintoff reiterated this contradiction in his firm’s filing to the 2022 proposal. Pintoff wrote that the CPS caught in Reg ATS would include those that, like FlexTrade, offer fully disclosed trading protocols like RFQ. But these new ATSs would also have to comply with SEC rules that require broker-dealers to implement risk management controls. These can’t be properly applied by platforms operating on a disclosed basis, Pintoff said.

“To implement the financial risk management controls required by [the risk management control rules], CPSs operating on a disclosed basis would have to interpose their perspective on appropriate credit limits between a dealer and its clients despite the fact that it is not a party to the trade and will have no financial exposure to the customer,” Pintoff wrote, asking for clarification of how these rules would work alongside the proposal.

Walking the line

But there are those that say the SEC’s proposal is a well-thought-out and appropriate response to automation of markets, in fixed income and in other asset classes. These commenters also note that there is a “regulatory gap”—an unfair emphasis on heavily regulating exchanges and ATSs, while other kinds of systems that perform similar functions have escaped these obligations.

The current rules were written when the trading landscape looked very different, and are based on an equities paradigm, these commenters say.

“I do sympathize with what the SEC is trying to do here. They want to put a better regulatory framework around how fixed income is traded and where it is traded. This is not like the equity markets 20 years ago, when we were trading on exchanges and order books. In hindsight, that feels straightforward compared to the diverse nature of the US bond markets,” Greenwich’s McPartland says.

McPartland adds that Greenwich’s own data shows that about 40% of investment-grade corporate bonds are traded electronically now. “That’s a sizable part of the market,” he says.

Other regulators are also clarifying their stance on these rapidly digitizing markets. The European Securities Markets Authority (Esma) published a draft opinion within two days of the Reg ATS proposal clarifying its own stance on the trading perimeter in the EU, with similar concerns expressed by tech providers and market participants in the bloc.

Nasdaq’s Reg ATS comment letter says that ATSs and other market centers have been able to “capitalize on regulatory flexibility and flourish in ways that exchanges cannot regulate.” And since market activity is shifting increasingly toward these non-ATS market centers, the time is ripe to put them under more scrutiny.

Nasdaq agrees with the commission that CPS perform similar functions as exchanges and ATSs, and that they should be regulated to promote safe and competitive markets.

Non-partisan think tank Better Markets says the proposal is “appropriate and necessary” and drawing CPSs—especially RFQ systems—into regulatory scope will help the SEC’s framework keep pace with electronifying markets.

“Communication protocol systems are clearly performing the same core market functions that exchanges and ATSs perform, notwithstanding the variations in platform design—they bring together buyers and sellers of securities on their platforms,” the letter says. “It is within the commission’s administrative discretion, and indeed its duty, to ensure entities operating as exchanges, regardless of their variations, by connecting buyers and sellers of securities are subject to the requirements of the Exchange Act.”