Dealer, No Dealer?<a href="#_ftn1" name="_ftnref1" title="">[1]</a> : Statement on Further Definition of “As a Part of a Regular Business” in the Definition of Dealer and Government Securities Dealer in Connection with Certain Liquidity Providers

Thank you, Mr. Chair. I cannot support the final rule. Even though streamlined substantially,[2] it perpetuates the proposal’s fundamental flaw. The rule defines dealer in a way that is inconsistent with the statutory framework within which it sits and will distort market behavior and degrade market quality.

This rule turns traders, many of whom are customers, into dealers. Doing so runs counter to the statute, as the Commission and market participants have read it for decades. The Exchange Act defines a dealer as a person that is “engaged in the business of buying and selling securities” for its “own account through a broker or otherwise,” but—importantly—excludes “a person that buys or sells securities . . . for [its] own account, either individually or in a fiduciary capacity, but not as a part of a regular business.”[3] Nearly any firm in the financial markets that trades securities as a principal does so “as part of a regular business.” Recognizing the breadth of this language read out of context, the Commission has long appropriately interpreted this provision in a way that distinguishes between market participants that operate a dealing business and those that operate an investing and trading business.[4] To this end, the Commission and Commission staff repeatedly have issued guidance on what we have called the dealer-trader distinction.[5]

The rule the Commission is considering today obliterates this distinction by extending the definition of “dealer” to market participants that run investing and trading businesses, not dealing businesses. Rather than looking to whether the “regular business” of the firm bears the hallmarks of dealing activity,[6] today’s rule would capture any person whose “regular business” involves trading activity for its own account that provides liquidity on a more than “incidental” basis.[7] Although the Commission and its staff have previously stated that liquidity provision may be indicative of dealing activity, it has not to my knowledge ever before stated categorically that liquidity provision alone by a person trading for its own account constitutes dealing activity or that trading activity becomes dealing activity merely because it has the effect of providing liquidity.[8]

And for good reason: Once liquidity provision—not in the form of a service provided to market participants but as an effect of one’s trading activity—turns a person into a dealer, the dealer-trader distinction becomes unintelligible. The rule itself demonstrates this: The statutory trader exception is no longer sufficient to exclude registered investment companies from the dealer definition; the final rule is so broad that the Commission has determined that it needed to expressly exclude these investment funds. The express regulatory exclusion for investment companies suggests that the Commission believes that the statutory exception for traders is insufficient to exclude entities that almost no one has conceived could be dealers, that likely could not operate under broker-dealer regulations, and for which Congress has established an entirely different statutory framework. Such a narrow reading of the statutory exception is clearly a misreading of the statute. The upheaval wrought by the rule’s singular focus on liquidity provision creates uncertainty about dealer status for many market participants who rely on the trader exception.[9] Perhaps recognizing this, the Commission only briefly touches on the dealer-trader distinction in the release, conveniently avoids proffering any explanation for departing from the prior understanding of that exception, and instead asserts that the rule is “intended to reflect the longstanding [dealer-trader] distinction.”[10]

The express regulatory exclusion avoids creating absurd results for registered investment companies, but the rule still produces absurdities. The adopting release acknowledges that the market participants that will be forced to register under the final rule may not have any characteristics of dealers under the current rule.[11] Instead, simply executing any of a number of common trading, investing, and risk management strategies could turn a market participant into a dealer if doing so happens to provide significant liquidity to the market. Not only will these entities be subject to a dealer regulatory regime that does not make sense for them,[12] but they will lose the protections now afforded to them as customers.[13]

In addition to harming the market participants who find themselves transformed into dealers, this rule harms the broader market. It penalizes liquidity provision, which means there will be less of it. The penalty comes in the form of a costly and ill-fitting regulatory regime for liquidity-providing market participants. For playing this important role, principal trading firms, private funds, and other market participants swept up by the rule will now have to “register with the Commission and become members of an SRO; [and] comply with Commission and SRO rules, including certain financial responsibility and risk management rules, transaction and other reporting requirements, operational integrity rules, and books and records requirements.”[14] They also have to become members of the Securities Investor Protection Corporation (“SIPC”). When serving the markets comes with such onerous and unsuitable regulatory requirements, some market participants will decide to stop the activities that give rise to the positive liquidity provision externality. The Commission is attempting to solve the problem of inadequate liquidity provision in times of crisis by reducing liquidity provision ex ante. How this advances the Commission’s objective of shoring up liquidity provision is beyond me.[15]

The Commission casts this rule as part of an effort to protect competition,[16] but the rule will drive competitors out of the markets. By penalizing trading and investing strategies that have the effect of providing liquidity to the markets, the rule will dampen liquidity provision. The extra costs will cause firms to consolidate so that they can spread the fixed costs of the dealer regulatory regime over more activity. Small and mid-size participants that enhance the diversity and robustness of the ranks of liquidity providers will disappear, and liquidity providers will become more concentrated and more homogenous, which will make both these firms and the market more fragile.

The Commission contends that this rule is necessary to give us “more comprehensive regulatory oversight of securities markets.”[17] The SEC commonly falls back on this justification for rulemaking, but being an effective regulator does not require comprehensive surveillance and a prescriptive regulatory regime governing the activities of every market participant. In any case, we already have lots of data to conduct regulatory oversight: the Consolidated Audit Trail’s comprehensive monitoring of the equity and options markets, the ever-expanding Form PF to collect granular private fund data, the Trade Reporting and Compliance Engine (“TRACE”), large trader reporting, data arising from mandatory proprietary trader registration with FINRA, and the list goes on.[18] A regulator’s temptation may be to put every corner of the market under a regulatory spotlight and into a regulatory straitjacket, but a clear-eyed view takes into account the costs of such “comprehensive oversight” to the healthy, dynamic functioning of the market and the investors and issuers that participate in it.

In addition to these fundamental flaws, the new rule comes with other problems, including serious implementation challenges. The rule is ambiguous in scope, which almost certainly will bring in firms the Commission has given no thought to including.[19] These firms will incur significant costs in registering as dealers or changing their businesses so they do not have to register. The implementation period is too short, particularly given the involvement of both FINRA and SIPC.[20] The likely interactions with other rules are unpredictable. And, not surprisingly, the rule reflects little thought regarding its practical application in the crypto markets.[21]

Thank you to the staff in the Division of Trading and Markets, the Division of Economic and Risk Analysis, and the Office of General Counsel for your work on this release. You continue to impress me with your diligence and concern for the well-being of our markets. I know that the work will not stop with today’s adoption, but will continue through implementation, so thank you in advance for that.

I have a number of questions:

1. For DERA, the economic analysis acknowledges that the rule’s consequences are difficult to predict.[22]
   1. What metrics do we plan to use to measure the positive and negative consequences of this rule in a retrospective review several years from now?
   2. What could we see that would suggest the rule was a success?
   3. Will we be able to measure whether the rule has harmed liquidity provision?
2. The decision not to scope out private funds and pension funds is puzzling given the ill-fitting nature of dealer rules on funds.
   1. What is the logic for excluding registered investment companies, but not private funds and pension funds, which are also pooled investment vehicles?
   2. How many private funds and pension funds do you anticipate will be pulled into dealer registration by these new amendments?
   3. Will a private fund or pension fund that has to register as a dealer under the rule face any unique challenges? For example, a private fund’s liquidity rights for investors could conflict with the net capital rule, or assessing applicability of the rule that pursues multiple independent trading strategies might have to coordinate trading in violation of the fund’s policies and procedures.
   4. How will the relationship of a private fund or a pension fund with its broker-dealers change so as to diminish customer protections if the fund has to register as a dealer?
3. The Release explains that a crypto automated market maker might have to register as a dealer under the final rules. How can a software protocol register as a dealer?
4. What will the Commission do to work with FINRA and SIPC to ensure that all new dealers swept up by the rule will be able to be onboarded within the one-year compliance period?
5. The final rule does not exclude investment advisers, as some commenters had hoped.
   1. Why would it make sense for an investment adviser, which is already subject to a regulatory framework, to register as a dealer, and would doing so present any challenges to carrying out the adviser’s fiduciary duties?
   2. If an adviser provides seed capital for a strategy that triggers the new dealer definition, would the adviser have to register? If so, why does that make sense?