Summary Overview

On February 6^th, 2024, the Securities and Exchange Commission (SEC or the Commission) adopted two rules, Exchange Act Rules 3a5-4 and 3a44-2 (the Final Rules), which require market participants who engage in dealer roles, in particular those who take on significant liquidity-providing roles, to (i) register with the SEC, (ii) become a member of a self-regulatory organization (SRO), and (iii) comply with federal securities laws and regulatory obligations.

The Final Rules were adopted by a 3-2 vote, with Chairman Gary Gensler and Commissioners Caroline Crenshaw and Jamie Lizárraga voting in favor of the rules and Commissioners Hester Peirce and Mark Uyeda voting against them.

The Final Rules will become effective 60 days after publication of the adopting release in the Federal Register, and the compliance date for the Final Rules will be one year after the effective date.

Key Provisions of the Rules

Prior to the adoption of the Final Rules, market participants relied on Section 3(a)(5) of the Exchange Act for the definition of “dealer,” which contained an important exclusion. The definition carved out any persons who buy and sell securities for their own account “not as a part of regular business.”  Investment funds, proprietary trading firms, and more recently, those involved in the crypto arena, relied on this exception to avoid registering with the SEC as a “dealer.”

The Final Rules have been adopted by the SEC to clarify the statutory definitions of “dealer” and “government securities dealer”, by narrowing the exception through the establishment of two qualitative standards that define “as a part of regular business.” This means that the scope of dealers has now expanded. Specifically, the Final Rules state that a person buying and selling securities “for its own account” is engaged in that activity “as a regular business” if that person engages in a regular pattern of buying and selling securities that has the effect of providing liquidity to other market participants by:

• “Regularly expressing trading interest 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 trading interest.”

The SEC believes that the identification, registration, and regulation of these market participants will provide regulators with a more comprehensive view of the markets, support stability and resiliency, and protect investors.

Exclusions

The Final Rules provide several exclusions for market participants that the SEC determined do not provide liquidity in a manner requiring dealer registration or are subject to a comparable regulatory structure that addresses the concerns of the Final Rules. Specifically excluded are (1) a person that has or controls assets of less than $50 million, (ii) an investment company registered under the Investment Company Act of 1940, and (iii) central banks, sovereign entities, and international financial institutions.

Potential implications for private funds, proprietary trading firms, and crypto firms

Notably, the rules will have significant implications for proprietary trading firms, private funds, and the crypto market. Specifically, the SEC estimates that approximately 43 entities, half of which are proprietary trading firms and private funds engaged in active trading in U.S. Treasury securities, may be required to register. Furthermore, private funds outside of those that are active in trading U.S. Treasury securities will also need to review their activities to determine whether they, too, are in scope. Lastly, the Final Rules apply to persons trading any type of security, including those trading crypto asset securities through automated market makers and decentralized finance (DeFi) protocols. Unfortunately, the Final Rules do not provide sufficient guidance to firms on making a determination as to whether dealer registration will be required.  In fact, with respect to entities trading crypto securities, when questioned by Commissioner Peirce as to whether an automated market maker or a decentralized exchange would need to register, SEC Trading and Markets Head Haoxiang Zhu responded that it would be determined on a case-by-case basis “[depending] on the facts and circumstances.”

In addition to the lack of clear guidance, any new person determined to be acting as a dealer under the Final 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). The person must also comply with SEC and FINRA rules within one year of the effective date. Firms will need to comply with net capital, recordkeeping, trade reporting, and risk management requirements, among others. The new rules are expected to impose significant costs that entities must consider if they wish to remain in this space and continue in an existing role.

Put Patomak’s Expertise to Work

Patomak’s expert team has decades of experience analyzing SEC rules and their implications for the market. In the ever-changing regulatory environment, Patomak stands well positioned to partner with your firm to help analyze dealer status, meet registrant requirements, reasonably manage costs and resources, and deploy a robust compliance framework. If you have any questions regarding the matters in this publication or would like to learn more about how Patomak can assist with your tailored needs, please reach out to Laura Magyar, Managing Director, at lmagyar@patomak.com.