Private funds are poring over the Securities and Exchange Commission’s new rules broadening the definition of a securities “dealer,” fearing more firms than predicted will be hit with steep compliance costs for heavy trading in US Treasuries and stocks.
The SEC adopted rules this week to boost oversight over proprietary traders and other firms that are responsible for significant liquidity in securities markets but operate without regulation as dealers. Such firms have taken an increased role with advancements in electronic trading, particularly in the $26 trillion Treasury market, the agency said.
The SEC predicted its new rules, which would impose more compliance and scrutiny for those affected, would have a modest reach, catching fewer than 45 firms—mainly proprietary trading companies. About 16 private funds, which include hedge funds, may be subject to the requirements, the agency estimates. That’s significantly less than under the rules the SEC initially proposed, following pushback from the private funds industry.
But it’s too soon to say just how sweeping the agency’s new rules will be, securities lawyers caution—and the ultimate impact may be higher.
“There’s still concern in the industry with who will be captured once we parse through the details of this,” said Richard Kerr, a K&L Gates LLP partner and co-lead of the firm’s financial services industry group.
The reach of the agency’s latest rules could ultimately determine whether private fund trade groups like the Managed Funds Association file a challenge in court. MFA has already brought a lawsuit over separate fee disclosure rules affecting private funds that the SEC adopted in August.
The rules could also spark changes in some funds’ trading activities to avoid being tagged a dealer.
Dealers generally have to register with the SEC and join the Financial Industry Regulatory Authority, a securities industry self-regulatory group. They’re also subject to trading reporting obligations, net capital requirements, and other rules.
“The costs will likely be immense, both upfront and long-term,” Val Dahiya, a Morrison & Foerster LLP partner who previously worked at the SEC and FINRA, said of the compliance costs.
‘Grossly Underestimated’
MFA said in a statement it’s still assessing how the final rules will affect its members.
Republican SEC Commissioner Mark Uyeda, dissenting from the rule’s adoption, said there are still ambiguities about who is a “dealer.” That’s part of the reason agency watchers worry the SEC “may have grossly underestimated the number” of affected funds, said Morgan, Lewis & Bockius LLP partner and former SEC attorney Ignacio Sandoval.
“I’m concerned that it’s going to give the industry a false sense of assurance, especially given that certain terms in the rule are going to be subject to interpretation,” Sandoval said.
Uyeda highlighted as lacking clarity the rules’ use of the term “regular” when describing behavior patterns that warrants dealer status.
The rules will take effect 60 days after publication in the Federal Register, and the compliance date will be one year later. During that time, firms likely will have numerous conversations with SEC staff to gauge whether they must comply.
Those kinds of assessments have their own costs.
“The reality is that while it may only ultimately require some small number of industry participants to register, it will require a much broader community of participants to consider the requirements of this rule in light of their own trading activity, and make determinations whether it requires them to register as a dealer,” Kerr said.
Pared-Back Rules
Private funds have lobbied hard against the rules, which the SEC proposed in 2022. In response, the SEC abandoned some of the most contentious parts of its initial proposal, including one that would’ve required firms trading $25 billion of securities a month to register as a dealer.
It also scrapped a test that said regularly buying and selling “substantially similar” securities triggers dealer status.
The “substantially similar” test in particular would have left firms “at the mercy of regulators and enforcement staff in interpreting what that means,” Sandoval said.
In the end, the SEC settled on dealer standards that look more like traditional market-making behavior, some attorneys said.
One asks whether a firm regularly provides liquidity to market participants by expressing interest in trading at, or near, the best available prices on both sides of the market. Another looks at whether firms earn revenue primarily from capturing bid-ask spreads—the difference between what a buyer offers to pay and a seller is willing to accept for a particular security. Firms managing $50 million or less in assets are exempt.
“It was a step in the right direction, that the SEC tried to further tailor the rule prior to adoption to address so many of the comments that were raised,” said Morrison & Foerster’s Dahiya.
SEC staff predict the new rules could affect up to 43 entities. While that includes some private funds, the number is far fewer than under the proposal, which some industry participants suggested would have captured hundreds of hedge funds.
Sweeping Efforts
The SEC is working across multiple fronts to police market participants who act like securities dealers.
The agency continues to press an expansive definition of “dealer” in court, including in recent lawsuits against penny stock flippers, critics say. One case against a Florida man who ran a small trading firm out of his home is on appeal at the US Court of Appeals for the Eleventh Circuit.
During arguments in December, James Sallah of Sallah Astarita & Cox LLC—an attorney for the defendant and a former SEC senior counsel—warned that the agency’s approach goes against decades of precedent. The SEC in court maintains there is nothing radical about its legal position.
Trading and Markets Project Inc., a group that advocates for investment companies, also participated in the oral argument at the 11th Circuit, expressing concern about the agency’s position.
On the regulatory side, the SEC has been pushing for even more sunlight on trading in US Treasuries—the world’s largest government bond market. That market in recent years has experienced significant disruptions, including a sharp drop in prices during the Covid-19 pandemic when investors rushed to sell Treasuries for cash.
Proprietary traders and other firms not registered as dealers increasingly account for a larger volume of trading activity in that market, the SEC said in its rules this week.
In addition to those rules, the agency in December adopted a policy to move most trading in Treasuries to a central clearinghouse that assumes responsibility for the transactions.
The SEC has also proposed bringing more alternative trading systems that trade Treasuries under the agency’s regulatory umbrella in order to provide more oversight.
“In combination, those three rules are fundamentally restructuring the Treasury markets,” Sandoval said.
