The Rule Proposal Would Clarify Which Market Participants Are Engaged in Buying and Selling Securities for Their Own Account "as Part of a Regular Business" and Are Subject to Dealer Registration Requirements

The U.S. Securities and Exchange Commission (SEC) recently proposed a new rule¹ (the Proposal) which could require a diverse range of market participants to register as dealers,² including a number of proprietary trading firms, hedge funds, digital asset market makers, and other businesses currently providing liquidity to securities markets. The Proposal further defines the statutory definitions of "dealer" and "government securities dealer," respectively, under the Securities Exchange Act of 1934 (the Exchange Act).

Exchange Act Section 3(a)(5) defines a "dealer" as any person engaged in the business of buying and selling securities for such person's own account, while Section 3(a)(44) similarly defines a "government securities dealer" as any person engaged in the business of buying and selling government securities for his own account. In each case, the definition excludes persons who do not sell securities, or government securities, as applicable, "as part of a regular business." The Proposal seeks to provide guidance around the phrase "as part of a regular business," as it is used in these two definitions.

The Proposal

The Proposal is intended to provide clearer standards to identify market participants that are engaged in buying and selling securities for their own account "as a part of a regular business" and that are, as a result, providing significant liquidity in securities markets. Drawing on existing guidance from the SEC and the courts, the Proposal sets out non-exclusive qualitative and quantitative standards to help identify when a market participant's activities would require them to register as a "dealer" under the Exchange Act.

Under the Proposal, "[a] person that is engaged in buying and selling securities for its own account is engaged in such activity 'as a part of a regular business' … if that person:

1. Engages in a routine pattern of buying and selling securities with the effect of providing liquidity to other market participants by:
   1. Routinely making roughly comparable purchases and sales of the same or substantially similar securities in a day; or
   2. Routinely expressing trading interests that are at or near the best available prices on both sides of the market and that are communicated and represented in a way that makes them accessible to other market participants; or
   3. 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 interests; and
2. Is not:
   1. A person that has or controls total assets of less than $50 million; or
   2. An investment company registered under the Investment Company Act of 1940."

Below, we discuss a variety of business models that may be affected by adoption of the Proposal.

Market Participants That May Be Affected by the Proposal

1. Proprietary Trading Firms

The Proposal states that the SEC intends to regulate as "dealers" proprietary trading firms (PTFs) that engage in significant market making activities and provide liquidity to securities markets. Changes in the structure of securities markets, including the proliferation of fully electronic trading venues and algorithmic or other automated trading strategies which allow parties to quickly execute trades, have enabled many PTFs to establish themselves as important market intermediaries and sources of liquidity. The Proposal is consistent with the SEC's longstanding practice of recognizing liquidity provision as an identifier of dealer status, and would bring a large number of currently unregulated PTFs within the SEC's regulatory oversight.

Crypto Note

Increasingly, PTFs and other market participants are expanding their portfolios to include digital assets. To determine whether they may be subject to the Proposal, market participants should carefully consider whether any digital assets in which they invest are securities for purposes of U.S. federal securities laws.

2. Hedge Funds

The SEC notes in the Proposal that many hedge funds use trading strategies that include routinely making roughly comparable purchases and sales of the same or substantially similar securities, or routinely trading to capture bid-ask spreads. Hedge funds employing such trading strategies may be subject to regulation as dealers under the Proposal.³ For purposes of the Proposal, "routinely" generally means both "repeatedly within a day" and "on a regular basis over time," for instance, on the majority of days in a calendar month.

Crypto Note

Funds focused on digital assets may raise additional unique considerations in connection with the Proposal.

• Due to the costs and administrative burden of rebalancing fund assets, traditional hedge funds are unlikely to become subject to regulation as dealers solely because of their fund rebalancing transactions. However, crypto funds are increasingly emerging that provide investors exposure to a diversified portfolio of digital assets, including funds focused on investments in high market-capitalization digital assets traded on major exchanges. Because of the high degree of liquidity of many digital assets and the relatively low administrative burden for conducting digital asset transactions, funds that increase the frequency of their asset rebalancing, could face the prospect of being regulated as dealers under the Proposal.
• High frequency trading strategies require hedge funds to engage in extremely frequent purchases and sales of securities, so that such funds are likely to be dealers under the Proposal. Digital asset exchanges are beginning to facilitate high frequency trading of digital assets on their platforms. Crypto funds duplicating high frequency trading strategies in digital assets are therefore similarly likely to be considered dealers under the Proposal.

3. Investment Platforms Providing Secondary Liquidity to Investors

Many businesses operate online platforms to facilitate offerings of securities by various affiliated funds. Some such businesses offer, or may wish to offer, liquidity to investors by creating a dedicated fund to engage in secondary purchases and sales of interests in the platform's other funds. These dedicated liquidity funds may be subject to regulation under the Proposal if they routinely engage in purchases and sales of securities which provide liquidity to other platform investors. However, if such a liquidity fund's trading strategy is focused on long-term investments in securities, as is typical in Nasdaq Private Market-facilitated transactions, for example, such liquidity funds are unlikely to be dealers under the Proposal.

4. Digital Asset Market Makers

Digital asset market makers that provide significant liquidity to digital asset markets may be dealers under the Proposal. Typically, a digital asset issuer loans the market maker quantities of the digital asset to enable the market maker to engage in purchases and sales of the asset in secondary transactions. Because the digital asset market maker's function is to routinely engage in purchases and sales of the asset on a day-to-day basis, the digital asset market maker would likely be deemed to be a dealer if the relevant digital asset is a security.

5. Underlying Asset Digitalization/Fractionalization Programs

Companies may issue digital assets representing total or fractional ownership interests in existing assets which they hold on a custodial basis, including in existing securities. Whether such companies constitute "dealers" under the Proposed Rule because of their purchases and sales of substantially similar securities depends upon the nature of the underlying assets and the frequency with which the company engages in such purchases and sales. If such companies only infrequently purchase new underlying assets and issue corresponding digital assets, such companies' activities may not have the effect of providing liquidity to other market participants, and as a result they may not be dealers under the Proposed Rule.

Next Steps for Market Participants

We believe it is likely that the Proposal will be adopted in substantially the form proposed. Accordingly, securities market participants engaging in trading activities similar to those described here, and that are not already registered as broker-dealers, should consult with legal counsel to determine whether it's feasible to structure their trading activities to avoid the dealer registration requirement. If restructuring such trading activities is not an option, market participants may have to undertake the significant cost and effort of registering as a dealer.

[1] Securities Exchange Act Release No. 34-94524 (March 28, 2022).

[2] The dealer registration process imposes substantial burdens on applicants. Generally, applicants are required to file a Form BD with the SEC and apply for membership with FINRA. Among other requirements, applicants must have at least two principals who have passed the Series 24 exam, and at least two others who have passed the Series 7 Exam or other general securities exam. Once registered, dealers are subject to significant net capital, customer protection, advertising, and other requirements under the Exchange Act and FINRA rules.

[3] The SEC has previously noted that many hedge funds rely on the “trader” exception to the Exchange Act’s broker-dealer registration requirement, and that the line between a trader, which requires no registration, and a dealer, which does, turns on the specific facts and circumstances. See Memorandum re Hedge Funds to Chair Richard C. Breeden from William H. Heyman, Director, Division of Market Regulation, and Marianne K. Smythe, Direction, Division of Investment Management (June 12, 1992) at p. 6. The Proposal also states that while it “would establish standards that identify when a person is acting as a dealer or government securities dealer, whether a person’s activities meet these standards would remain a facts and circumstances determination.” It notes that to the extent consistent with the Proposal, “existing Commission interpretations and precedent will continue to apply.” The likely implication of these statements is that hedge funds must continue to consider their specific facts and circumstances, including their trading patterns and strategies, in determining whether to register as dealer.