“Dealers” Must be Dealt With: The SEC’s New Rules Sweep Securities Participants

In a financial world where every move seems to echo with the clink of coins and the rustle of bills, a seismic shift has rocked the securities market. On February 6, 2024, the U.S. Securities and Exchange Commission (“SEC”) adopted two new rules with a 3-2 vote along party lines. (SEC; Sidley). These rules aim to further define what it means to be a “dealer” and “government securities dealer” under the Securities Exchange Act of 1934. Id. The regulatory scheme requires implicated market participants to register with the SEC as “dealers” and conform to various regulatory requirements. Id. Despite the SEC’s good-faith attempt to curtail de facto market makers and promote fairness among market participants, the new rules have been met with harsh criticisms due to their various impracticalities. (Fluhr, et al., DLA Piper; SEC).

The SEC’s new rules, Rules 3a5-4 and 3a44-2, seemingly broaden, yet clarify, the definitions of “dealer” and “government securities dealer” activity. (SEC; Sidley). Historically, the Securities Exchange Act has long distinguished between “traders” and “dealers.” (Aaron, et al., The National Law Review). An individual trading for their own account and not as part of a regular business, was a “trader,” and any individual trading as part of their business was a “dealer.” Id. However, the new rules now blur this distinction. Id. Specifically, the rules aim to provide a more precise understanding of what it means for a dealer to engage in activities “as part of a regular business.” (Sidley). According to these rules, an individual engages in activities “as part of a regular business” if they exhibit a regular pattern of purchasing or selling securities that enhance market liquidity in one of two qualitative ways:

·       (1) if they regularly express trading interests at or near the best prices on both sides of the market for the same security, ensuring accessibility to other market participants; or

·       (2) if they primarily generate income by exploiting bid-ask spreads — either through buying at the bid and selling at the offer or by utilizing incentives from trading platforms for providing liquidity (e.g., market makers). Id.; (Fluhr, et al., DLA Piper).

If a market participant falls into either qualitative category, they are considered a “dealer” absent a relevant exclusion. (Aaron, et al., The National Law Review).

The SEC’s rules carve out three notable exclusions for: (1) participants who have or control less than $50 million in assets, (2) participants who have a registered investment company under the Investment Company Act of 1940, and (3) central banks, sovereign entities, or international financial institutions. (Sidley). If an individual or entity meets one of the qualitative standards but falls within an exclusion, its trading activity will not be considered as “part of a regular business.” Id. Otherwise, those that meet the “dealer” definition are subject to various heightened requirements. (Aaron, et al., The National Law Review; SEC).

According to the new rules, participants who are deemed to be “dealers” must register with the SEC as broker-dealers, become a member of a self-regulatory organization (“SRO”), and adhere to securities laws and regulatory duties. Id. These participants will face heightened regulatory scrutiny and increased compliance expenses because they will need to comply with additional SEC regulations pertaining to broker-dealers (e.g., enhanced recordkeeping and risk management), as well as SRO rules (e.g., trade reporting and self-disclosure of rule violations). (Sidley). Moreover, participants can expect more frequent examinations and enforcement probes. Id. On a broader scale, the SEC’s rules aim to target specific market participants, including cryptocurrency (or “crypto”) vehicles. (Hamilton, CoinDesk).

The new rules may pose a serious impact in the crypto asset industry—particularly in decentralized finance (“DeFi”). Id. DeFi is an automated process by which crypto asset securities are traded through blockchain technology to reduce banking intermediaries. (Sharma, Investopedia). DeFi market participants argue that the new rules are “unworkable” because DeFi products are simply software and do not have a controlling body like dealers. (Wynn, The Block). This begs the question: How can software register as a dealer, let alone keep records? (Fluhr, et al., DLA Piper; Aaron, et al., The National Law Review). Other DeFi advocates stress that the rules might stifle innovation within the digital asset ecosystem. Id. Generally, crypto investors cite qualms with the rule due to a seeming undercurrent in which the SEC continues to overregulate the crypto market industry. (Lewis, JD Supra).

Regardless of the impending impact on DeFi and crypto, the SEC cites important reasons for adopting the new rules. (Aaron, et al., The National Law Review; SEC). The Commission emphasizes that by implementing the new rules, individuals and entities (especially large-volume proprietary trading firms) will refrain from engaging in de facto market making, because otherwise they would be required to register as dealers. Id.; (Fluhr, et al., DLA Piper). Underlying the SEC’s rationale is that registration and regulatory requirements should apply on a level playing field—equally to all dealers. (SEC). SEC Commissioner, Caroline Crenshaw, agrees that allowing de facto market makers to act as dealers leaves investors and markets without financial risk protections and reporting requirements. (Crenshaw, SEC). The SEC’s reasoning for adopting the rules has been met with some harsh critics. (Fluhr, et al., DLA Piper).

In addition to DeFi participants’ outcry, SEC commissioners have voiced their objections to the new regulatory scheme. Id. SEC Commissioners, Hester Pierce and Mark Uyeda, objected to the rule, arguing that the definition of “dealer” has historically only implicated individuals trading securities in a fiduciary capacity. Id. Pierce asserts that the new rule is too far sweeping, turning traders who are customers into “dealers.” Id.; (Lewis, JD Supra). Moreover, the rule for penalizing small and midsize liquidity providers by requiring them to bear the cost of registration and compliance, suggesting such providers may withdraw or consolidate liquidity. Id.

It is clear that the new SEC rules will likely impact DeFi and proprietary trading firms. (Fluhr, et al., DLA Piper). Practically speaking, the implications of the rules could be far reaching. For example, many now “dealers” will need to hire personnel who can oversee compliance with the SEC’s regulatory requirements, including trade reporting and recordkeeping. (Lewis, JD Supra). Additionally, individuals or firms will have to spend several months preparing applications to become a member of a SRO, which likely requires management and personnel to satisfy licensing requirements—requiring months of study. Id. Thus, compliance appears to be burdensome, despite the SEC’s aim to prevent de facto market makers and promote fairness. (SEC). With the compliance date of the new rules looming, any direct impact remains largely unknown. However, market participants who have voiced their objections will likely fight tooth and nail to prevent compliance, even by initiating litigation. (Lewis, JD Supra; Mulholland, Chief Investment Officer). Above all, the SEC remains resolute that “dealers” must be dealt with.