The SEC Expands the Definition of Dealer

The U.S. Securities and Exchange Commission (SEC) adopted two new rules, Rules 3a5-4 and 3a44-2 (Final Rules), that may require some hedge funds and proprietary trading firms that provide liquidity to other market participants to register as broker-dealers and become FINRA members. According to the Adopting Release, the Final Rules are required because of the “significant role of unregistered entities that act as liquidity providers.”

Under Section 3(a)(5) of the Exchange Act, a dealer includes “any person engaged in the business of buying and selling securities…for such person’s own account through a broker or otherwise” but excludes firms that buy or sell securities for their own account or as a fiduciary, but not as a part of a regular business. This exclusion is typically referred to as the “trader” exception. The Final Rules clarify what “part of a regular business” means and expands the definition of “dealer.”

The Final Rules expand the definition of “dealer” and “government securities dealer” by incorporating two qualitative standards to establish whether an entity buys or sells securities as part of its regular business. This qualification occurs if an entity owns or controls at least $50 million in total assets and trades in securities (or government securities) for its own account as part of its “regular business” and meets the Trading Interest Factor or Primary Revenue Factor.

• Trading Interest Factor: The entity regularly expresses trading interests that are 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.
• Primary Revenue Factor: The entity earns revenue primarily from capturing bid-ask spreads, buying at the bid and selling at the offer, or capturing any incentives offered by trading venues to a liquidity-supplying trading interest.

While the Final Rules exclude registered investment companies, central banks, sovereign entities, and international financial institutions, there is no exclusion for investment advisers and private funds.

Under the Adopting Release, however, an investment adviser trading on behalf of its clients' accounts would not be subject to the Final Rules “unless the investment adviser itself is the account holder or the account is held for the benefit of the investment adviser.” Specifically, the Adopting Release states that the trading interest expressed by investment advisers for purposes of their fiduciary duty to their clients, such as when investment advisers place orders or request quotations on behalf of their clients, would not be activity captured by the rules. Therefore, only an investment adviser that trades for their own (proprietary) account, and meets one or both of the standards outlined within the Adopting Release, may be subject to registration.

Private funds that are buying and selling for their “own account” in a way that meets the qualitative standards could be required to register as a dealer, even if the investment adviser managing the fund is not required to register.

Implications

In the Adopting Release, the SEC stated that it only expected a small subset of funds to likely be affected. Specifically, the staff described those hedge funds that engage in algorithmic high-frequency trading as potentially subject to the Final Rules since such trading can involve regularly expressing trading interests on both sides of the market (the Trading Interest Factor) or earning revenue from bid-ask spreads or incentives offered for liquidity-providing trades (the Primary Revenue Factor). The SEC staff project that up to 16 hedge funds could be subject to dealer registration, although the staff provided numerous caveats as to the accuracy of those estimates.

Due to concerns raised by the hedge fund industry following the Adopting Release, SEC Chairman Gensler emphasized that the Final Rules are intended to focus on big high-speed trading firms and not on hedge funds.

If an entity qualifies as a dealer, it must register with the SEC as a broker-dealer, become a member of FINRA, and comply with broker-dealer obligations under the Exchange Act and FINRA’s rules. To assist firms that are deemed to be a dealer and are required to register as a broker-dealer under Rule 15b9-1 and become FINRA members, FINRA issued Regulatory Notice 23-19 to announce the creation of a short form application process that will allow these firms to go through an expedited review process. Firms wishing to apply using the short form application must submit their application by May 9, 2024.

The Final Rules will be effective 60 days after publication in the Federal Register, which is April 29, 2024, and affected entities have one year after the effective date to register (April 29, 2025).

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