Who Needs Customers, Anyway? New SEC Rules Turn Traders Into Dealers

The SEC's New Rules 

On February 6, 2024, the SEC published a release (the "Adopting Release") adopting new rules further defining certain terms used in the statutory definitions of "dealer" and "government securities dealer" under, respectively, Sections 3(a)(5) and 3(a)(44) of the Securities Exchange Act of 1934 ("Exchange Act"). These statutory provisions essentially define a "dealer" or "government securities dealer" as any person engaged in the business of buying and selling securities or government securities for such person's own account, but exclude "a person that buys or sells securities [or government securities] … for such person's own account, either individually or in a fiduciary capacity, but not as a part of a regular business." This longstanding exclusion—known as the dealer/trader distinction—has historically been relied upon by market participants, including hedge funds, to avoid registering with the SEC as dealers. The new rules significantly narrow the statutory exclusion and will likely require numerous entities to register as dealers; become members of a self-regulatory organization ("SRO") such as the Financial Industry Regulatory Authority ("FINRA); comply with federal and SRO broker-dealer requirements (including net capital and other financial responsibility, recordkeeping, and books and records rules); and become members of the Securities Investor Protection Corporation, or SIPC, for the first time. 

"Dealer" Status under New Rule 3a5-4

As adopted, Rule 3a5-4 provides that a person will be deemed to be engaged in dealer activity "as part of a regular business" if it "engages in a regular pattern of buying and selling securities that has the effect of providing liquidity to other market participants" in one of the following two ways: 

• "Regularly expressing trading interests that is at or near the best available prices on both sides of the market for the same security and that is communicated and represented in a way that makes it accessible to other market participants"; or
• "Earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trade interest."

The SEC considers an entity engaging in either of the above activities to be "providing liquidity" as part of its regular business and that providing such liquidity is not merely incidental to their trading activity. Notably, the SEC had proposed that "routinely making roughly comparable purchases and sales of the same or substantially similar securities in a day" would also be considered to be routinely providing liquidity for purposes of the rule, but the final rule deleted that measure.

Further, the new rule excepts persons that have or "control" total assets of less than $50 million, investment companies registered under the Investment Company Act of 1940, central banks, sovereign entities, and international financial institutions from the operation of the new rule. For purposes of these exceptions: (i) a "central bank" is defined as "a reserve bank or monetary authority of a central government (including the Board of Governors of the Federal Reserve System or any of the Federal Reserve Banks) and the Bank of International Settlements"; (ii) the term "international financial institutions" includes a laundry list of specified entities plus "any other entity that provides financing for national or regional development in which the U.S. Government is a shareholder or contributing member"; and (iii) a "sovereign entity" means "a central government (including the U.S. Government), or an agency, department or ministry of a central government." 

As noted above, a "dealer" buys and sells securities for its "own account." For purposes of the new rule, the term "own account" means any account: (i) held in the name of that person; or (ii) held for the benefit of that person. The SEC had originally proposed that term to also include accounts "held in the name of a person over whom that person exercises control or with whom that person is under common control," but that part of the proposed definition was not adopted in the final version. That requirement would have required entities to aggregate affiliate transactions and holdings with their own to determine if they meet the $50 million threshold for application of the new rules.

Finally, the rule makes clear that a person that would otherwise be subject to the rule cannot evade the registration requirement by engaging in those activities indirectly as opposed to directly, and explicitly prohibits persons from disaggregating accounts in an attempt to evade its coverage. This latter anti-evasion proscription is intended to prevent entities from creating multiple legal entities or accounts to evade the registration requirements.

"Government Securities Dealer" Status Under New Rule 3a44-2 

New Rule 3a44-2 includes the same two qualitative tests for determining government securities dealer status, the exceptions and the definitions described above for Rule 3a5-4. The final rule not only narrowed the qualitative criteria that constitutes a regular pattern of providing liquidity, but the SEC also dropped its proposal to include an additional quantitative, bright-line test for government securities dealer status (i.e., it had proposed that if, during four of the last six calendar months, the entity engaged in buying and selling more than $25 billion of trading volume in government securities, the entity would have to register as a government securities dealer). 

Entities Not Excluded From the Rules

The new rules do not exclude registered investment advisers (which are already subject to federal regulation) or private funds from the final rules. Further, the SEC did not exclude certain types of securities, including crypto asset securities, from the application of the rules, on the basis that the rules are based on the trading activities of liquidity providers, not the type of security being traded. The SEC also rejected commenters' suggestion to exclude proprietary trading firms from application of the rules because they have no "customers," finding that position had no basis in the statutory language. Also not explicitly excluded are governmental plans, including public pensions, or state and city administrators managing state and city pension funds, on the basis that the modifications to the qualitative standards in and deletion of the quantitative standard from the final rules should make the rules not applicable to those persons, but ambiguity persists. And, while "sovereign entities" are exempt from the rule, certain sovereign wealth funds (assuming they meet the qualitative criteria in the rules) may not be.

The Commission's Economic Analysis

Court challenges to SEC rules often focus on shortcomings in the agency's cost/benefit analysis in support of the rules. In fact, with respect to these new rules, commenters had asserted that the SEC's economic analysis in its Proposing Release did not adequately address the economic implications of the rules, and the economic analysis in the Adopting Release appears to be similarly speculative. With respect to the costs of the new rules, the SEC estimates that total initial costs of registering as a dealer with the SEC will be at least $1.8 - $5.7 million, with annual costs thereafter in the $1.2 - $4.6 million range or more. These costs would be in addition to the millions of dollars in collective costs that will be incurred by firms subject to these new rules to also comply with the panoply of other new rules recently, or soon-to-be, adopted by the Commission, such as increased reporting obligations relating to Form PF, short position reporting, and securities loan reporting, among others. 

The SEC's economic analysis on the new rules spends quite a lot of text explaining why the SEC cannot estimate the number of affected entities. While it estimates that 31 of the 231 proprietary trading firms, which it says have emerged as de facto market makers, particularly in the U.S. Treasury markets, would be subject to registration as government securities dealers under the new rules, it also admits that it does not have sufficient information to be able to estimate the number of firms trading securities other than treasuries that would have to register as dealers under the new rules. (It characterizes its own reliance on a private fund's use of high frequency trading ("HFT") strategies as a proxy for meeting the qualitative standard in the new rule as "imperfect.") The SEC counters commenters' estimates that hundreds of hedge funds could be affected by the new rules by stating that the changes to the final rule (e.g., removing one of the proposed qualitative factors and the quantitative factor, which had only applied to government securities dealers) reduces the number of entities that will be required to register as dealers, but provides no estimate of the rules' actual impact on market participants.    

Impact on the Market

The SEC's stated rationale for the new rules was that they will improve market transparency, although commenters noted that the SEC already has tools that accomplish that goal, including several comprehensive trade reporting systems (e.g., CAT, TRACE, and large trader reporting); and the new rules could actually negatively impact liquidity. 

As argued by Commissioner Peirce in her dissenting statement, the new rules are likely to drive competitors out of the market—by imposing the high cost of registration and regulatory compliance on liquidity providers, the new rules are likely to result in consolidation of larger firms and the departure of smaller ones. Having fewer liquidity providers likely will increase volatility, particularly in times of market stress, and the Adopting Release admits that "[s]tudies on HFT firms are mixed on whether affected firms' activities may improve or worsen market liquidity" and that "the final rules could have the effect of reducing liquidity." She further notes that, because the new rules do not exclude certain types of market participants pension plans and private funds or registered investment advisers, potential conflicts of interest may arise if those entities are required to register as dealers that owe duties to the markets generally as opposed to the fiduciary duties they owe to their respective participants, shareholders and clients. This and other open questions will have to be addressed by the SEC staff during implementation. 

Existing Guidance Still Valid

The new rules make clear that there is no presumption that a person is not a dealer or government securities dealer if it does not meet the qualitative criteria in the proposed rules. In this regard, the new rules should not impact the continued viability of previously issued guidance relating to dealer status. Consequently, persons not only will need to take the new rules into account when determining whether they are a dealer, but they also will need to review prior SEC guidance regarding other factors the SEC will consider in its analysis. For instance, in recent years there have been a number of SEC enforcement actions against proprietary trading firms for acting, in the SEC's view, as unregistered dealers, despite the fact that the activities of those firms may not be covered by the new rules.

Short Implementation Period 

The compliance date for the new rules is one year from the effective date of the final rules. This means that, starting 60 days after publication of the Adopting Release in the Federal Register, entities that meet the definition of dealer or government securities dealer in the new rules will need to be registered dealers no later than one year thereafter. The SEC asserts that FINRA has committed to expedite the registration process for applicants.