Alternative order

What Is Alternative Trading System (ATS)?

An Alternative Trading System (ATS) is a U.S. Securities and Exchange Commission (SEC) regulated trading venue that operates outside of traditional national securities exchanges. It utilizes a computerized system, such as an electronic communication network (ECN), to match buy and sell orders for various financial instruments, including equity securities. ATSs are a key component of modern market structure, offering market participants an alternative to lit exchanges for executing trades. An "alternative order," in this context, refers to a buy or sell order placed or executed within such a system, often to achieve specific trading objectives like minimizing market impact or finding additional liquidity. ATSs can be operated by a broker-dealer and must comply with specific regulatory obligations, including those set forth by the Financial Industry Regulatory Authority (FINRA).¹⁰

History and Origin

The development and adoption of Alternative Trading Systems are closely tied to the evolution of electronic trading and the push for greater competition in financial markets. Historically, most securities trading occurred on centralized exchanges. However, technological advancements in the late 20th century enabled the creation of electronic platforms that could match orders efficiently. The concept of an ATS gained significant traction with the passage of Regulation ATS by the SEC in 1998. This regulation provided a framework for how non-exchange trading systems should operate, bringing them under SEC oversight without requiring them to register as full-fledged exchanges, provided they met certain conditions. This regulatory clarity spurred the growth of ATSs, and by 2012, they accounted for a substantial portion of U.S. equity trading volume. The increasing prevalence of ATSs has contributed to what is known as market fragmentation, as trading activity disperses across numerous venues.

Key Takeaways

• Alternative Trading Systems (ATSs) are SEC-regulated venues for trading securities that function as an alternative to traditional exchanges.
• They primarily use electronic systems to match buy and sell orders.
• ATSs offer advantages such as the potential for lower trading costs and reduced market impact for large orders.
• Their growth has contributed to market fragmentation, leading to considerations about price discovery and overall market quality.
• ATSs are subject to specific regulatory oversight from both the SEC and FINRA.⁹

Interpreting the Alternative Trading System

Understanding Alternative Trading Systems involves recognizing their role within the broader financial ecosystem. Unlike traditional exchanges where bid and ask prices are publicly displayed on an order book, many ATSs, particularly "dark pools," do not display pre-trade quotes, offering what is known as "undisplayed liquidity." This characteristic can be particularly attractive to institutional investors looking to execute large orders without publicly revealing their intentions and potentially moving the market against them. However, the lack of pre-trade transparency in some ATSs raises questions about how it affects public price discovery and the ability of all market participants to achieve best execution. Regulators continuously assess the impact of these systems on market fairness and efficiency.

Hypothetical Example

Consider an institutional investor, such as a large pension fund, that needs to buy a significant block of shares in Company XYZ. If they were to place this order directly on a traditional public exchange, the sheer size of their order could signal their interest to the market, potentially causing the stock's price to rise before their order is fully executed, leading to higher average purchase costs.

Instead, the pension fund's broker-dealer might route this "alternative order" to an Alternative Trading System. Within the ATS, the order would be matched with a corresponding sell order from another institutional investor looking to offload a large block of Company XYZ shares, often at the prevailing midpoint of the national bid-ask spread. Because the ATS does not publicly display the order before execution, the transaction can occur with minimal impact on the broader market price, allowing both parties to achieve their trading objectives more efficiently than they might on a public exchange.

Practical Applications

Alternative Trading Systems are utilized in various facets of modern finance. Their primary application lies in facilitating large block trades for institutional investors who seek to minimize market impact, which is the effect a large order can have on a security's price. Many ATSs also serve as venues for over-the-counter (OTC) equity trading. For instance, FINRA, the Financial Industry Regulatory Authority, publishes delayed OTC trading information reported by ATSs and member firms to enhance transparency in these markets.⁸,⁷

Another significant application of ATSs is their role in supporting algorithmic trading and high-frequency trading (HFT). HFT firms often act as market makers within ATSs, providing liquidity and profiting from the tiny price discrepancies (or arbitrage opportunities) that arise across different trading venues. The ability of ATSs to offer rapid execution and discreet order matching makes them integral to these sophisticated trading strategies. In 2013, FINRA even proposed rules to enhance the transparency of volume information reported by ATSs, highlighting their growing importance in market operations.⁶

Limitations and Criticisms

Despite their benefits, Alternative Trading Systems face several limitations and criticisms. A primary concern revolves around market transparency. Because many ATSs, particularly dark pools, do not publicly display pre-trade quotes, critics argue that they can detract from public price discovery and create an uneven playing field.⁵,⁴ Retail investors, who primarily trade on lit exchanges, may not have access to the same liquidity or pricing opportunities available within these private venues.

Another criticism is the potential for conflicts of interest for broker-dealers operating ATSs, particularly if they engage in proprietary trading within their own systems. Some argue that this could allow an ATS operator to gain an informational advantage over its clients. Regulatory bodies, including the SEC, have expressed concerns about market fragmentation and the potential for regulatory arbitrage, where firms might exploit differences in rules between various trading venues.³ A 2013 SEC staff review highlighted that while market quality has generally improved, the benefits have accrued disproportionately to the largest stocks, and increased fragmentation may harm the market depth of smaller company stocks.²

Alternative Trading System (ATS) vs. Dark Pool

The terms Alternative Trading System (ATS) and dark pool are often used interchangeably, leading to confusion, but there is a distinct difference. An Alternative Trading System (ATS) is a broad regulatory classification under U.S. securities law for any non-exchange trading venue that brings together buyers and sellers of securities. All ATSs must register with the SEC as a broker-dealer and comply with specific regulations, including those outlined in Regulation NMS.

A dark pool is a type of ATS characterized by its lack of pre-trade transparency. Unlike traditional exchanges or some other ATSs that display their order book and quotes to the public, dark pools do not make this information public before a trade is executed. This "dark" nature allows institutional investors to place large orders without impacting market prices, as neither the size nor the identity of the trading parties is revealed until after the transaction is completed. Therefore, while all dark pools are ATSs, not all ATSs are dark pools; some ATSs may offer varying degrees of pre-trade transparency.

FAQs

Who can use an Alternative Trading System (ATS)?

While ATSs facilitate a significant portion of securities trading, they are primarily designed for and used by institutional investors, such as hedge funds, pension funds, and large asset managers. Retail investors typically access these venues indirectly through their broker-dealers, who may route orders to ATSs for best execution.

Why do Alternative Trading Systems (ATSs) exist?

ATSs exist to provide alternative venues for securities trading outside of traditional exchanges. They often offer benefits like reduced transaction costs, the ability to execute large orders with minimal market impact (especially for dark pools), and customized trading functionalities. Their rise reflects the evolution of market structure towards greater electronic trading and competition.

Are Alternative Trading Systems (ATSs) regulated?

Yes, Alternative Trading Systems are regulated. In the United States, they are overseen by the SEC under Regulation ATS and must register as broker-dealers. They are also subject to oversight by FINRA, which sets rules and monitors trading activity to ensure compliance and market integrity.¹

Do Alternative Trading Systems (ATSs) contribute to market fragmentation?

Yes, the proliferation of Alternative Trading Systems has significantly contributed to market fragmentation. With trading activity dispersed across numerous exchanges, ATSs, and over-the-counter (OTC) venues, liquidity for a given security can be spread across many locations rather than concentrated on a single exchange. While competition can have benefits, fragmentation can also complicate price discovery and the process of achieving best execution for orders.