On February 6, 2024, the US Securities and Exchange Commission (SEC) adopted new Rules 3a5-4 and 3a44-2 (the Final Rules) under the Securities Exchange Act of 1934 (the Exchange Act) to further define what it means to be engaged in the business of dealing in securities and government securities. The Final Rules principally could capture certain proprietary trading firms, some private funds, and other market participants whose trading activities the SEC views as de facto market making but who have historically viewed themselves as traders within the so-called dealer-trader distinction.
The Final Rules will present an array of challenges for market participants that may be captured by the new definitional framework. This is especially the case for market participants that have had no direct exposure to the prescriptive requirements applicable to broker-dealers. These challenges, discussed in more detail in this report, are exacerbated by the relatively short window of time until the Final Rules’ anticipated compliance date of around May 2025.
While the Final Rules will apply to market participants who act as dealers with respect to any type of security (e.g., equities, fixed income, digital assets), the most significant impact may be on participants in the government securities markets, which may be the SEC’s primary goal. Indeed, the Final Rules are the second of three rules that will fundamentally restructure the US Treasury securities (Treasury) markets.
The consequences of being a dealer are significant. Dealers generally must register with the SEC, become members of a self-regulatory organization (SRO) such as the Financial Industry Regulatory Authority, Inc. (FINRA), and comply with a litany of SEC and SRO rules and requirements, including certain financial responsibility and risk management rules, transaction and other reporting requirements, operational integrity rules, and books and records requirements.
The SEC has long interpreted the dealer definition to apply to market participants who act as de facto market makers, i.e., market participants who professionals or the public look to for liquidity. Yet the SEC and its staff have also for decades recognized the so-called “dealer-trader distinction,” an analytical framework for assessing when a person’s securities transactions do not rise to the level of being engaged in the business of dealing in securities as part of a regular business.
Under the Final Rules, a person would be deemed to be engaged in buying and selling securities for their own account as a part of a regular business—and therefore within the definition of “dealer”—if such person is engaged in a “regular pattern of buying and selling [government] securities that has the effect of providing liquidity to other market participants” under either of two qualitative standards, subject to certain exclusions.
According to the SEC, the Final Rules are intended to retain the dealer-trader distinction for those market participants that only provide liquidity on an incidental basis while bringing within the dealer definition those that provide liquidity as part of a regular business.