More SEC Rules on Alternatives Transparency Are Coming

The SEC this week voted to propose rules to enhance operational transparency and regulatory oversight of alternative trading systems—and the activities of brokers using them. 

Retirement specialist financial advisers in the defined contribution (DC) marketplace and investment consultants for defined benefit (DB) plans have in recent years viewed alternative investments with curiosity—motivated by a variety of interests but often to hedge against significant 2008-style losses or to boost portfolio yields in a difficult interest-rate environment.

DC specialists will know alternative strategies are not exactly an intuitive fit for retirement plan investment menus—but they do present an opportunity to diversify retirement portfolios, especially when folded into asset-allocation solutions such as target-date funds. Built into a 40-Act structure, named for the Investment Company Act of 1940, alternatives can be effectively liquefied and packaged for tax-qualified DC plans covered by the Employee Retirement Income Security Act (ERISA) and Securities and Exchange Commission (SEC) regulations.

Against this background the SEC on Wednesday dropped notice of pending regulations that could potentially expand transparency and access to alternative investments. The rulemaking seeks to eliminate “dark pools” of assets that are used commonly in the alternatives world—given the interest in many alternatives managers in keeping their trading strategies secret, at least for short periods of time, to prevent copy-cats and other potential problems. Specifically, the SEC wants to add to reporting requirements for alternative trading systems (ATSs) that trade stocks listed on a national securities exchange, often called “NMS stocks.”

SEC Chair Mary Jo White says the proposed changes, as currently envisioned, would represent a “critical step forward in delivering greater transparency to investors and enhancing equity market structure,” adding that investors and other market participants need “more and better information about how alternative trading systems work.”

White says the proposal would require an NMS stock ATS to file detailed disclosures on newly proposed Form ATS-N about its operations and the activities of its broker/dealer operator and its affiliates. These disclosures would include information regarding trading by the broker/dealer operator and its affiliates on the ATS, the types of orders and market data used on the ATS, and the ATS’ execution and priority procedures.

NEXT: Additional requirements suggested  

In announcing its intentions, the SEC makes no bones about tying this effort to other federal regulatory initiatives to identify and quash conflicts of interest and basic fairness issues up and down the financial markets. 

One ERISA compliance specialist tells PLANADVISER the new rules would likely have less of an impact within 401(k) plans, which still do not generally offer the sort of investment options that would utilize these alternative trading systems: “Defined benefit plans, however, might. So this may be a defined benefit plan sponsor area of interest. Also, it would seem that there would be no downside to what the SEC is proposing, since I am assuming they feel there is a lack of transparency and oversight right now in these areas. For example, those securities that trade via 'dark pools.' Lastly, the companies that operate these alternative trading systems will all say the additional regulation will cost them more money to comply with. The reality is it may also result in significantly more business by further legitimatizing their trading platforms.”

Beyond the new reporting requirements, the SEC says the proposal would make Form ATS-N disclosures publicly available on the Commission’s website, which could allow market participants to better evaluate whether to do business with an ATS, as well as to be better informed when evaluating order handling decisions made by their broker.

Importantly, the SEC says the proposals also would provide a process for the Commission to qualify NMS stock ATSs for certain reporting exemptions under which they currently operate, and to review disclosures made on Form ATS-N. This would provide a process for the Commission to declare Form ATS-N filings effective or ineffective, as well as provide a process to review amendments, the SEC says.  

The SEC says Form ATS-N would require an NMS Stock ATS to disclose the activities of its broker/dealer operator, and the broker/dealer operator’s affiliates, “including operation of non-ATS trading centers and other NMS Stock ATSs; products or services offered to subscribers; arrangements with unaffiliated trading centers; trading activities on the NMS Stock ATS; use of smart order routers (or similar functionality) or algorithms to send or receive subscriber orders; shared employees that service the operations of the NMS Stock ATS and any other business unit or affiliate of the broker-dealer operator; service providers to the NMS Stock ATS; differences in the availability of services, functionalities, or procedures available to subscribers, as compared to the broker-dealer operator, and its affiliates; and safeguards and procedures established to protect confidential trading information.”

With respect to the “manner of operations” of an NMS Stock ATS, the SEC will seek information regarding “treatment of subscribers; types of orders; connectivity, order entry, and co-location; segmentation of order flow and notice of segmentation provided to any persons; display of orders and other trading interest; trading services, including rules and procedures governing priority, pricing methodologies, allocation, matching, and execution; procedures governing trading during a suspension, system disruption or malfunction; opening, reopening, and closing processes, and after hours procedures; outbound routing; use of market data; fees; procedures regarding trade reporting and clearance and settlement; order display and execution access; fair access standards; and market quality statistics published or provided by the NMS Stock ATS to one or more subscribers.”

NEXT: Where’s it all going? 

If approved for publication by the Commission—a likely outcome given the SEC’s current makeup and existing commitment to conflict of interest mitigation—the proposed amendments will be published on the Commission’s website and in the Federal Register. The comment period for the proposed amendments will be 60 days after publication in the Federal Register.

By way of background, the SEC explains this move is a follow up on 1998 regulations, through which the Commission adopted Regulation ATS, which established a new regulatory framework designed to encourage market innovation, while ensuring basic investor protections. It gave securities markets a choice to register as a national securities exchange, or operate as an alternative trading system, which would be required to register as a broker/dealer and comply with Regulation ATS.

THe SEC says that, since the adoption of Regulation ATS, the equity markets have evolved substantially and ATSs have become a significant source of liquidity in NMS stocks, accounting for approximately 15% of volume in NMS stocks. “ATSs that trade NMS stocks generally operate with complexity and sophistication similar to registered national securities exchanges, which applicable laws and regulations require to be transparent trading venues,” SEC adds.

Looking at the SEC and beyond, this is just the latest move attempting to bring more clarity to the alternative investment industry, which is coming under increasing scrutiny. In 2010, the SEC approved a rule mandating hedge fund and private equity managers to register with the agency and be subject to surprise examinations. The Government Accountability Office (GAO) in 2011 stated that hedge funds and private equity investments pose a number of risks and challenges beyond those posed by traditional investments. More recently, a participant in retirement plans sponsored by Intel Corporation filed a lawsuit claiming its custom target-date funds were too heavily invested in private equity and hedge fund investments, making the funds too risky.