7 February 2024

SEC's new 'dealer' rule: What compliance teams need to know

The SEC recently adopted rules 3a5-4 and 3a44-2 that aim to capture proprietary trading firms, hedge funds, and potentially other entities that actively provide liquidity in securities markets but are not registered as broker-dealers. The rules could have significant implications for firms in these spaces.

MBK Search has compiled this explainer on the changes and what firms demonstrate to be compliant.

Defining Dealer Activity

The new rules establish two non-exclusive factors for determining when an entity is engaged in a “regular pattern of buying and selling securities” as part of a business rather than on a limited basis:

Regularly expressing trading interest at favorable prices on both sides of the market for the same security in a way accessible to others. This attempts to reflect technological changes in market making.

This attempts to reflect technological changes in market making. The rule clarifies that “regularly” depends on factors like market depth and liquidity – in highly liquid markets like US Treasuries, it likely means high frequency intraday and daily expressions of interest. However, in less liquid markets, it may accommodate interruptions.

Beyond traditional firm quotes, expressions could include streaming quotes, RFQs, orders, or any non-firm indications of a willingness to transact that identify the security plus price, quantity or direction.

This captures varied market mechanisms but still requires consistent evidence of readiness to trade on both sides for the same security at favorable prices accessible to others.

Primarily earning revenue from capturing bid-ask spreads or exchange incentives offered to liquidity providers rather than market price appreciation.

The rule explains this includes buying at the bid price and selling at the ask price to capture the spread, as well as earning incentives like exchange rebates frequently provided for liquidity supplying limit orders.

The revenue calculation looks at total revenue including spreads and incentives – the rule does not require overall profitability.

Though no bright line test, the SEC states earning a majority of revenue from spreads/incentives means a firm likely buys and sells securities as a regular business. This distinguishes dealers from regular traders focused on longer term price appreciation.

Assessing Impact

Firms will need to carefully analyze if their trading strategies involve consistently expressing interest or earning spreads, requiring dealer registration absent an exclusion.

1. Self-Evaluation of Trading Activity

Firms will need to carefully evaluate whether their trading strategies involve consistently expressing interest at favorable prices on both sides of the market for the same securities, or primarily earning revenue from capturing bid-ask spreads/incentives. If so, they will have to register as a dealer absent an exclusion.

2. Policies and Procedures

Registered firms should document detailed policies and procedures outlining how they will comply with applicable SEC and SRO regulations for registered dealers. This includes risk management controls, recordkeeping rules, reporting obligations, and other dealer requirements.

3. Periodic Compliance Reviews

Registered entities will likely need to demonstrate compliance by performing periodic reviews of trading activity, revenue sources, risk management systems, books and records, transaction reporting, and other areas. Any deficiencies must be reported and remediated.

4. Financial Tracking and Reporting

Firms will need to implement mechanisms to track revenue sources, trading volumes/frequency, bid-ask spread capture, and other metrics to assess if they cross thresholds requiring registration. Registered entities must comply with financial reporting rules like submitting FOCUS reports.

The SEC estimates the rules could impact up to 31 liquidity providing firms not currently registered and 12 hedge funds using high frequency trading strategies. These entities will face significantly increased compliance costs and oversight. However, the rules also aim to level the playing field between registered broker-dealers and unregistered firms providing similar liquidity services.

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