On February 6, 2024, in a 3–2 vote along party lines, the U.S. Securities and Exchange Commission (SEC) adopted rules that further define what constitutes “dealer” or “government securities dealer” activity for purposes of the Securities Exchange Act of 1934 (Exchange Act).1 The adopted rules generally require any person that engages in a regular pattern of buying and selling securities (or government securities) that has the effect of providing liquidity to other market participants to have to register as a dealer pursuant to Section 15(b) of the Exchange Act (or as a government securities dealer pursuant to Section 15C of the Exchange Act).
Specifically, new Rules 3a5-4 and 3a44-2 under the Exchange Act (the Rules) further define what it means to trade securities or government securities for one’s own account “as part of a regular business” in a manner that would require a person to register as a “dealer” or a “government securities dealer,” respectively, absent an exception or exemption (other than the so-called “trader” exception) from such definitions.
According to the SEC, the Rules are intended to capture “entities engaging in de facto market making activity”2; however, the Rules are written significantly more broadly than what one would generally consider to be de facto market making. In particular:
- No Exclusion for Investment Advisers and Private Funds — The SEC made clear that registered investment advisers and private funds are not excluded from dealer registration if engaged in activity covered under the Rules.
- Master Fund and Multistrategy Funds — Firms organized with a master fund or multistrategy fund structure will need to carefully evaluate whether their trading activity across different strategies may cause the fund to be engaged in dealer activity under the Rules.
- Quantitative and Statistical Arbitrage Trading Strategies — Many quantitative and statistical arbitrage strategies (or similar strategies, particularly those that are latency-sensitive) with relatively short holding periods may cause the persons or funds carrying out such trading to be subject to the Rules.
- Investment Advisers and Client Accounts — An investment adviser trading on behalf of its clients’ accounts would not be subject to the Rules “unless the investment adviser itself is the account holder or the account is held for the benefit of the investment adviser”; however, any client account of an investment adviser remains subject to the Rules and must be separately evaluated as a potential dealer. The Adopting Release is silent as to whether an investment adviser that has some interest in an advisory account (e.g., 10% ownership in a client fund) will be viewed as an account holder for purposes of the Rules.
- Regularly Expressing Trading Interest on Both Sides of the Market — SEC guidance regarding the first qualitative standard under the Rules provides that a person does not need to (i) “continuously” express trading interest or (ii) “simultaneously” express trading interest on both sides of the market to be captured under the Rules.
As a result, buying and selling activity in the same security — even where a firm only expresses trading interest periodically on one side of the market at a given time — could still be deemed dealer activity under the Rules. The “regularity” of expressing trading interest also depends on the depth and liquidity of the underlying security.
- DeFi and Automated Market Makers — The Rules apply to persons trading any type of security including those trading crypto asset securities and, in particular, automated market makers and decentralized finance (DeFi) protocols. The Adopting Release is devoid of guidance on the practical application of the Rules to DeFi protocols and automated market makers, notwithstanding important differences in how such systems operate.
- Key Changes From the Proposed Rules — As adopted, the Rules reflect a number of changes from the proposal, including (i) eliminating one of the qualitative standards;3 (ii) eliminating the quantitative threshold that would have caused persons trading certain volumes in the U.S. Treasury market to automatically be deemed government securities dealers; and (iii) a simplified “anti-evasion” provision in lieu of a complex account aggregation framework.4
Section 3(a)(5) of the Exchange Act generally defines the term “dealer” to mean “any person engaged in the business of buying and selling securities ... for such person’s own account through a broker or otherwise” but excludes “a person that buys or sells securities … for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business.”5 This statutory exclusion from the “dealer” definition is often referred to as the “trader” exception.
The operative concept in the definitions of “dealer” and “government securities dealer” that distinguishes the regulated entity from the unregulated trader is that the dealer is engaged in buying and selling securities for its own account “as part of a regular business.” Accordingly, the Rules are designed to further define what “as part of a regular business” means by providing two qualitative standards intended to more precisely identify activities of certain market participants who assume dealerlike roles. Specifically, the Rules identify persons whose trading activity in the market “has the effect of providing liquidity” to other market participants.
Summary of the Rules
Under the Rules, a person is engaged in buying and selling securities (or government securities) for its own account “as a part of a regular business” if that person engages in a “regular pattern” of buying and selling securities (or government securities) that has the effect of providing liquidity to other market participants by
- Regularly expressing trading interest6 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 capturing any incentives offered by trading venues to liquidity-supply trading interest.
The Rules also provide that there shall be no presumption that a person is not a dealer (or government securities dealer) solely because that person does not satisfy these qualitative standards.
Exclusions From the Rules; Intersection of the Rules With Other Exceptions and Exemptions
The Rules exclude three specific categories of persons — meaning that if a person meets one of the qualitative standards but falls within an exclusion, such person’s trading activity would not deemed to be “part of a regular business” under the Rules. The exclusions are for a person that
- has or controls total assets of less than $50 million,
- is an investment company registered under the Investment Company Act of 1940, or
- is a central bank, sovereign entity, or international financial institution.
Because there is no presumption under the Rules that a person is not a dealer (or government securities dealer) if they do not meet one of the qualitative standards, market participants still need to analyze their activity under prior SEC guidance and precedent, and applicable case law, to determine whether the activities may otherwise implicate the dealer and/or government securities dealer definitions.
The Rules do not change other available statutory or regulatory exceptions or exemptions from the dealer definitions or registration provisions that may be available to a particular person.
In response to concerns expressed by commenters, the SEC stated that activity should be analyzed on an entity-by-entity basis rather than aggregating accounts across entities that are controlled or under common control with another entity. However, the SEC also adopted an anti-evasion provision to deter the establishment of multiple legal entities or accounts to evade regulation under the Rules. The Rules prohibit persons from evading the registration requirements by
- engaging in activities indirectly that would satisfy one of the qualitative standards or
- disaggregating accounts.
The first anti-evasion prong is targeted at activity that includes using another person or entity to indirectly engage in activity that would meet one of the qualitative standards. The second prong is targeted at activity that includes spreading activity “across entities or accounts such that the level of activity is the same, with no real change with respect to liquidity provision.”7 The SEC stated that this is intended to address market participants that disaggregate or structure their activity to evade the Rules, while also recognizing that there may be structures that have no such evasive intent or purpose (e.g., where there are information barriers to prevent sharing of information and/or other criteria demonstrating noncoordination of buying and selling between accounts or entities).
Definition of “Own Account”
The SEC defined the term “own account” to determine which accounts must be considered for purposes of evaluating whether a person meets the criteria described above. Specifically, a person’s “own account” is defined to mean any account
- held in the name of that person or
- held for the benefit of that person.
The commission adopted a one-year compliance date from the “Effective Date” of the Rules for all persons that engage in activities that meet the dealer registration requirements under the Rules. The effective date is 60 days after publication of the Rules in the Federal Register, which should be in approximately mid-April. Accordingly, the final date for firms to register as a dealer or government securities dealer as a result of the Rules should be mid-April 2025.
However, the one-year compliance period only applies to market participants engaged in activities covered by the Rules prior to the compliance date.
Implications of Dealer Status
Any person deemed to be acting as a dealer under the Rules, absent an available exception, exemption, or “no-action” position, must register with the SEC and become a member of a national securities exchange and/or the Financial Industry Regulatory Authority (FINRA) and comply with applicable SEC and exchange/FINRA rules within one year of the effective date. Such persons will be subject to greater regulatory scrutiny and compliance costs as they will be subject to additional SEC regulations applicable to broker-dealers (e.g., net capital requirements, increased recordkeeping, risk management), self-regulatory organization rules (e.g., trade reporting, self-reporting of rule violations), and increased examinations and enforcement investigations.
Compliance with certain of these rules may prove challenging for some firms based on their current business model. For example, the SEC generally requires all registered broker-dealers to comply with its net capital rule (Rule 15c3-1 under the Exchange Act). The SEC’s net capital rule, as well as certain FINRA rules, imposes substantial limitations/restrictions on the ability to withdraw capital from such broker-dealer, and FINRA or an exchange could impose limits/restrictions on the amount of leverage used by a broker-dealer. This could restrict liquidity for investors in a private investment/hedge fund that seeks to trade principally through a wholly owned subsidiary that is a registered broker-dealer.
There is also a narrow exemption from FINRA membership for certain broker-dealers that trade only on an exchange of which they are a member or meet the requirements of recently amended Rule 15b9-1.8 However, these exemptions effectively prohibit a firm from being able to trade securities over-the-counter.
1 Securities Exchange Act Release No. 99477 (Feb. 6, 2024) (Adopting Release), https://www.sec.gov/files/rules/final/2024/34-99477.pdf Federal Register publication pending.
2 Adopting Release at 18.
3 Specifically, the SEC eliminated the proposed qualitative factor that would have captured persons engaging in liquidity provision by routinely making roughly comparable purchases and sales of the same or substantially similar securities in a day.
4 For more information on the proposed rule, please see this Sidley Update here: https://www.sidley.com/en/insights/newsupdates/2022/04/sec-proposes-significant-expansion-of-firms-that-must-register-as-dealers.
5 15 U.S.C. 78c(a)(5)(A) and (B). Similarly, Section 3(a)(44) of the Exchange Act provides, in relevant part, that the term “government securities dealer” means “any person engaged in the business of buying and selling government securities for his own account, through a broker or otherwise” but does not include “any person insofar as he buys or sells such securities for his own account, either individually or in some fiduciary capacity, but not as part of a regular business.” 15 U.S.C. 78c(a)(44).
6 While not defining “trading interest” under the Rules, the SEC states in the Adopting Release that “trading interest” means (i) an “order” as defined in Rule 3b-16(c) under the Exchange Act or (ii) any nonfirm indication of a willingness to buy or sell a security that identifies the security and at least one of the following: quantity, direction (buy or sell), or price.
7 Adopting Release at 91.
8 For more information on the Rule 15b9-1 exemption, please see this Sidley Update here https://www.sidley.com/en/insights/newsupdates/2023/08/us-sec-adopts-amendments-to-expand-finra-oversight-of-proprietary-trading-firms.
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