Statement on Further Definition of “As a Part of a Regular Business” in the Definition of Dealer
Feb. 6, 2024
Thank you, Chair Gensler. Thank you to the staff for your presentation.
Today’s action is problematic. The Commission’s effort to classify nearly any person who buys and sells securities as a “dealer” under the Securities Exchange Act of 1934 (the Exchange Act) extends beyond its statutory authority. The lack of any limiting principle creates the potential for arbitrary and capricious government action. Further, today’s action may reduce liquidity in the Treasury markets, make them more volatile, reduce the number of liquidity providers, and increase debt costs to taxpayers.
The Exchange Act limits who is a “dealer” by requiring that the trading from one’s own account be “as a part of a regular business.”[1] The final rules fail at their attempt to clarify what “part of a regular business” means.[2] Instead, they proclaim that “no presumption shall arise that a person is not a dealer within the meaning of [the Exchange Act] solely because that person does not satisfy [the standards set forth in the rules].”[3] In other words, complying with the rules provides no assurance on dealer status, whether in the Treasury market or beyond.[4]
Today’s action codifies the Commission’s view that the “dealer” definition is practically limitless. The public should be concerned about the immense scope of this claimed jurisdiction. The rule of law means that the government should define ex ante which activities are lawful and which are not. Without such definition, governmental authority can be arbitrary and even tyrannical. Government can favor some entities, while disfavoring others.
This rulemaking targets proprietary trading funds (PTFs), private funds, and others who make money by buying low and selling high in the Treasury market, while creating additional regulatory confusion for other markets, including crypto asset securities. Indeed, following Form PF, the adoption of private fund adviser rules, securities lending disclosure, and short position and short activity reporting, this action feels like another salvo in the Commission’s war on private funds.
The Commission claims that advancements in electronic trading across securities markets resulted in PTFs and others providing more liquidity to the Treasury markets,[5] a traditional dealer activity.[6] While that may be true, it does not legally transform traders into dealers. Broadly speaking, any market participant can be a liquidity provider, and it makes no sense to use liquidity provision as the basis for legally distinguishing between dealers and traders.[7]
The role of PTFs and private funds has grown partly because outstanding public debt has massively increased. In January 2024, total outstanding public debt was $34.1 trillion, with $27 trillion held by the public.[8] Four years ago, those amounts were $23.2 trillion and $17.1 trillion, respectively. Yet primary dealer balance sheets have stayed flat and are constrained by the supplemental leverage ratio. If the banks and dealers cannot provide additional liquidity, where will it come from? Nearly omitted from the Commission’s analysis is that PTFs and private funds provide positive externalities to the Treasury markets through increased liquidity, more competition, and tighter spreads.
The Commission suggests the benefits of imposing dealer regulations on PTFs and others include: (1) these entities will be less likely to discontinue trading in turbulent markets;[9] (2) regulators would have more information about their activities;[10] and (3) the playing field would be leveled.[11]
Overlooked is the fact that dealer regulations are designed to protect customers, not to address whether PTFs and others might stop trading during market turmoil. For example, the net capital rule[12] protects customers during a wind-down but is costly and inappropriate for firms that lack customers.[13] Unsurprisingly, the Commission cannot convincingly demonstrate any gains in investor protection as a result.[14]
Ironically, today’s action promotes the very outcome that it seeks to avoid. Increasing costs on non-dealer liquidity provision will generally result in less liquidity and/or higher transaction costs.
As justification, the Commission provides two examples: the March 2020 Covid lockdown and the 1982 failure of Drysdale Government Securities.[15] It is telling that the most specific example is from forty years ago. As for March 2020, the unprecedented global shutdown resulted in a loss of liquidity for all asset classes. The PTFs decline in liquidity provision in March 2020 appears anomalous. By contrast, in the March 2023 market stress, the PTFs increased their activity in the Treasury market and provided a greater share of liquidity.[16] Treasury Under Secretary for Domestic Finance Nellie Liang noted that this “higher share is more consistent with past behavior, such as during the October 15, 2014 event.”[17] Yet the Adopting Release fails to credit PTFs with providing increased liquidity during times of Treasury market stress, including in 2014 and 2023.
There are already tools that constrain and monitor risk taking by PTFs. When PTFs trade through a bank or broker-dealer, Federal Reserve Regulations T, U, and X limit the principal traders’ risk by imposing margin requirements. If they trade through a broker-dealer, FINRA Rule 4210 may apply specific margin requirements. If they trade directly, the Market Access Rule requires a sponsoring broker-dealer to establish, document, and maintain a system of controls and supervision designed to limit the risks of the principal traders’ activities.[18]
The argument about leveling the playing field entails a fundamental economic fallacy. When a business engages in an economic activity, it weighs the incremental benefits against incremental costs. Even if current registered dealers have fixed regulatory costs associated with other activities, they can remain competitive in the Treasury markets with PTFs and private funds, because their marginal regulatory costs are not tightly linked to that activity per se. However, increasing the regulatory costs for PTFs and private funds will lead them to supply less liquidity to the Treasury market and some firms may exit. Suggesting that there is an intrinsic public benefit tied to increasing the costs of the lesser regulated liquidity providers is misguided.
The argument that the Commission needs more information on PTF transactions is similarly weak. The SEC already has access to substantial data. Most PTF trades occur on interdealer broker platforms.[19] “[B]roker-dealers and ATSs report transactions in U.S. government securities to TRACE” and “TRACE data include the identities of unregistered entities.”[20] For non-Treasury transactions, the Consolidated Audit Trail “generally includes all principal traders’ orders in NMS securities, OTC equities, and listed options because they are reported by other registered parties.”[21] Finally, “[p]rincipal traders with high volumes or with large portfolios may also have to report to the Commission on Form 13F or Form 13H.”[22]
The final rules exclude investment companies registered under the Investment Company Act, but not private funds or collective investment trusts.[23] The Commission largely relies on the same rationale described in the proposing release for not excluding private funds, including the comprehensive regulatory framework and extensive oversight of registered investment companies.[24] Yet, the Commission has not considered the aggregate effects of the various rules proposed and/or adopted for private funds since the proposing release.[25] The lack of such analysis makes the final rules arbitrary and capricious.
Today’s action follows other Commission actions increasing the number of persons required to register with FINRA.[26] By sweeping more persons into FINRA, it starts to become a de facto federal securities regulator. As such, consideration ought to be given on whether FINRA is now a state actor.[27]
Under the Commission’s approach, any person can be a “dealer” if they buy and sell securities as part of a regular business. The final rules modification from “routine” to “regular” provides no further clarity to market participants. The ambiguity is highlighted by recent litigation over the dealer definition, when the Commission argued that the “Exchange Act does not define what it means to be ‘engaged in the business’ of buying and selling securities, but [this entity] is a business: it has offices, employees, keeps accounting records, and carries on for a profit. And its business model is to buy and sell securities.”[28]
Historically, dealers had customers. The Exchange Act’s definitions of “broker” and “dealer” generally reference how customer securities transactions are effectuated. “Brokers,” acting as agents, trade “for the account of” the customer.[29] “Dealers” take the opposite side of a customer’s trades in their “own account.”[30] The Commission selectively cherry-picks one 1930s treatise to support its view that a dealer can have no customers,[31] while ignoring a contemporaneous treatise stating “a dealer sells to and buys from a client whereas a broker buys and sells for the account of the client.”[32]
Until recently, the Commission has enforced dealer registration in a manner consistent with the idea that “broker” and “dealer” relate to customer orders. That view has apparently changed through regulation by enforcement. [33] As a result, persons are now subject to Commission enforcement, even though they have been operating under the same business model for a long time with the understanding that they were not dealers.
The Commission has filed a number of cases on dealer registration,[34] including a recent settlement with Aryeh Goldstein.[35] Mr. Goldstein loaned money to publicly-traded companies through convertible debt agreements.[36] Goldstein could convert unpaid debt and interest into discounted stock after waiting six to twelve months, as required under Rule 144.[37] Staff guidance on the Commission’s website since 2008 suggested that individuals who buy and sell securities for themselves are not considered dealers and lists a number of factors for consideration.[38] Mr. Goldstein and his firm did not appear to hold themselves out as dealers, did not have customers, nor did they advertise themselves as such.[39] The Commission’s rulemaking could have addressed this regulatory ambiguity, but did not.
Given the negative consequences of the final rules, combined with the continued ambiguity on who is a dealer, I am unable to support. Many of the anticipated costs are fixed and small firms will be most disadvantaged. A number of the Commission’s findings supporting the final rules are speculative and lack sufficient data or evidence in the administrative record.[40]
While the Commission recognizes that “a decrease in the activities of liquidity-providing entities and their investors would harm market liquidity” and that the harms to the Treasury markets may be more pronounced than others,[41] it theorizes that if that were to occur and bid-ask spreads widen, other registered dealers might increase their own trading to offset the gap. Wishful thinking is not a strategy when it comes to the most important market in the world.
I thank the staff in the Divisions of Trading and Markets and Economic and Risk Analysis as well as the Office of General Counsel for their efforts.
[1] Section 3(a)(5) of the Exchange Act.
[2] 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 (“Adopting Release”), Release No. 34-99477, (Feb 6, 2024), available at: https://www.sec.gov/files/rules/final/2024/34-99477.pdf.
[3] Paragraph (d) of the final rules, Adopting Release at 245.
[4] Furthermore, that provision’s use of a triple negative represents poor regulatory text drafting. Cf. 17 C.F.R. 230.421(d) (“no multiple negatives” is allowed in the Commission’s plain English rules for prospectuses).
[5] Adopting Release at 3-4.
[6] As discussed in the economic analysis section of the Proposing Release, non-dealer firms, such as PTFs, do not constitute a large part of the overall market. Specifically, the non-dealer firms constitute only 19% of the overall Treasury market. On the other hand, PTFs do constitute a substantial proportion of the interdealer markets, “accounting for 61 percent of the volume on automated interdealer broker platforms and 48 percent of the interdealer broker volume overall.” See Proposing Release: Further Definition of “As a Part of a Regular Business” in the Definition of Dealer and Government Securities Dealer (Proposing Release), Release No. 34-94524, File No. S7-12-22, at 23080, available at https://www.federalregister.gov/documents/2022/04/18/2022-06960/further-definition-of-as-a-part-of-a-regular-business-in-the-definition-of-dealer-and-government
[7] One might argue that if a person is offering to execute orders near each side of what might be determined to be the current market price, then one is a dealer because one is selling immediacy of execution and making money from the bid-ask spread. But all market participants make money by buying low and selling high, and by entering the market in their efforts to do so, they increase liquidity. For instance, if a trader has an algorithm that can reasonably predict the equilibrium market value at any point in time, then it would buy when the price is below that point and sell when the price is above that point, as long as the spread covered the transaction cost. In its efforts to buy low and sell high, the trader may be on both sides of the market, and others might perceive the trader as selling immediacy of execution—but the trader is engaging in the market transactions solely based on its perception of value. The efficiency of connectivity and electronic markets has rendered the resulting spreads from this type of trading activity tighter, but that does not magically transform that activity into dealer activity. Indirectly, the Adopting Release’s Economic Analysis seems to recognize this when, in an effort to determine what entities would be covered by this new definition of dealer, it stated that “the calculation of intraday spreads does not distinguish between trades that capture the bid-ask spread and trades that profit from intraday price movements.” Perhaps if you can’t empirically distinguish between those two activities, then they are not actually different. And perhaps that is why the Adopting Release immediately added that “[a]lthough we rely on a practical definition of dealing for the purpose of this analysis, we stress that the determination of whether an entity is engaged in regular dealing activity depends on the facts and circumstances.” Adopting Release at 116-117.
[8] See FiscalData, Debt to the Penny, at Treasury.gov, available at https://fiscaldata.treasury.gov/datasets/debt-to-the-penny/debt-to-the-penny
[9] For example, see Adopting Release at 93 stating that “[t]he financial responsibility and operational integrity of these significant liquidity providers, in turn, will support the resilience of securities markets”
[10] See, e.g., id. at 143-145. In particular, the Adopting Release states: “The information would enable regulators to better analyze markets—including reconstructing markets and detecting abusive trading behaviors—respond to market events and inform investors.”
[11] See, e.g., id. at 136, where it states: “The regulatory consistency under the final rules is expected to benefit currently registered dealers by ensuring that all of their competitors, including currently unregistered market participants, are subject to common regulatory requirements.”
[12] 17 CFR §240.15c3-1.
[13] For example, one comment letter observes: "By way of example, the SEC’s Net Capital Rule is designed to ensure that a broker-dealer holds, at all times, more than one dollar of highly liquid assets for each dollar of liabilities (i.e., money owed to customers and counterparties), excluding liabilities that are subordinated to all other creditors by contractual agreement. If a broker-dealer fails, it should be in a position to meet all unsubordinated obligations to its customers and counterparties and generate resources sufficient to wind down its operations in an orderly manner. Certainly, an assurance that a broker-dealer can meet its customer obligations (and cannot use customer funds to satisfy its own liabilities) is vital to the protection of customers and to the orderly functioning of the retail marketplace. Requiring a trading firm to maintain net capital when it has no customers to protect is simply nonsensical – yet the Proposal would presumably require just that. Imposing capital requirements that are intended to benefit customers, not traders without customers, does not help investors or the market, and serves no purpose other than as an unnecessary barrier to entry and impediment to liquidity." See Comment Letter of Joanna Mallers, Secretary, FIA Principal Traders Group, (May 27, 2022), at 9, available at https://www.sec.gov/comments/s7-12-22/s71222-20129717-296007.pdf
[14] For example, PTFs and other market participants are already subject to Section 17(a) of the Securities Act of 1933 and section 10(b) of the Exchange Act. No attempt is made by the Commission to quantify the additional benefits and corresponding costs resulting from registration as a dealer. Without examining such effects, the Commission does not have a rational basis for extending the dealer regime to PTFs and private funds.
[15] Adopting Release at 129-131.
[16] Remarks by Under Secretary for Domestic Finance Nellie Liang at the 2023 Treasury Market Conference (Jan. 30, 2024) (underlining added), available at https://home.treasury.gov/news/press-releases/jy1917
[17] Id., underlining added.
[18] Adopting Release at 107-08. Such risks can include financial, regulatory, operational, or legal risks.
[19] The Adopting Release states “A Federal Reserve staff analysis concluded that PTFs were particularly active in the interdealer segment of the U.S. Treasury market in 2019, accounting for 61% of the volume on automated interdealer broker platforms and 48% of the interdealer broker volume overall.” Adopting Release at 105.
[20] Adopting Release at 110. For an ATS, TRACE reporting when the trades occur on an ATS covered by FINRA Rule 6730.07, which “generally” includes “the ATSs with higher volume.” Id.
[21] Adopting Release at 108.
[22] Adopting Release at 110.
[23] Collective investment trusts are often used as investment options in defined contribution plans (e.g., 401(k) plans).
[24] Adopting Release at 194-97.
[25] See, e.g., Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Investment Advisers Act Release No. 6383 (Aug. 23, 2023), 88 FR 63206 (Sept. 14, 2023); Form PF; Event Reporting for Large Hedge Fund Advisers and Private Equity Fund Advisers; Requirements for Large Private Equity Fund Adviser Reporting, Investment Advisers Act Release No. 6297 (May 3, 2023), 88 FR 38146 (June 12, 2023); Amendments to Form PF to Require Current Reporting for Large Hedge Fund Advisers and Amend Reporting Requirements for Large Private Equity Fund Advisers, Advisers Act Release No. 6297 (May 3, 2023) [88 FR 38146 (June 12, 2023)], available at https://www.govinfo.gov/content/pkg/FR-2023-06-12/pdf/2023-09775.pdf. While the Adopting Release did provide some very modest analysis of the “overlap between the compliance period for the final amendments”, it did not conduct a thorough economic analysis of the impact on potential costs and benefits of the current rule in combination with these newly adopted rules, even though that is the world upon which these new rules will be imposed, and even though this was also not covered in the economic analysis provided in the Proposing Release. See Adopting Release at 97-100, and 168-170.
[26] See Exemption for Certain Exchange Members, 88 FR 61850 (Sept. 7, 2023).
[27] See Alpine Securities Corp. v. FINRA, No. 23-5129, 2023 WL 4703307 (D.C. Cir. July 5, 2023) (Walker, J., concurring).
[28] See Plaintiff Securities and Exchange Commission’s Memorandum of Law in Opposition to Defendants’ Motion to Dismiss, SEC v, LG Capital Funding, LLC, U.S. District Court, (EDNY), Civil Action No. 22-cv-3353-WFK-JRC (filed Oct. 27, 2022) at 9-10. The Commission has made similar arguments in other court filings related to violations of Section 15(a).
[29] 15 U.S.C. § 78c(a)(4).
[30] 15 U.S.C. § 78c(a)(5).
[31] See Adopting Release at 23, n. 57.
[32] Hodges, Charles, Wall Street Treatise (1930). See also C.H. Meyer, Law of Stock Brokers and Stock Exchanges § 43-a. at 34 (1933), (What “distinguishe[s]” the “dealer ... from a broker” is that the dealer “sells to his customers ... securities which he had purchased for his own account elsewhere,” or “buys from his customer securities for his own account with a view to disposing them elsewhere.”)
[33] If an activity is viewed as concerning by the Commission, particularly where a long-standing approach has influenced market practices, the appropriate course of action is to pursue rulemaking or guidance subject to public comment and accompanied by an economic analysis rather than through enforcement. Cf. CFTC v. EOX Holdings, LLC, No. 22-20622, Jan. 8, 2024 (5th Cir.) (holding that defendants lacked fair notice of the CFTC’s unprecedented interpretation of a 39-year old rule).
[34] See SEC v. Actus Fund Management, LLC, No. 1:23-cv-111233 (D. Mass.); SEC v. Almagarby, No. 21-13755 (11th Cir.); SEC v. Keener, No. 22-14237 (11th Cir.), SEC v. LG Capital Funding, LLC, No. 1:22-cv-03353 (E.D.N.Y), SEC v. Carebourne Capital L.P., No. 21-cv-02114 (D. Minn.), SEC v. Morningview Financial, LLC, 1:22-cv-08142 (S.D.N.Y), SEC v. Fife, No. 1:20-cv-05227 (N.D. Ill.), SEC v. Fierro, No. 3:20-cv-02104 (D.N.J.), SEC v. GPL Ventures LLC, No. 1:21-cv-06814 (S.D.N.Y.), SEC v. River North Equity LLC, No. 1:19-cv-01711 (N.D. Ill.), and SEC v. Long, No. 1:23-cv-14260 (N.D. Ill).
[35] SEC v. Aryeh Goldstein, Adar Bays, LLC, and Adar Alef, LLC, Litigation Release No. 25930 (Jan. 23, 2024), available at https://www.sec.gov/litigation/litreleases/lr-25930.
[36] Complaint ¶ 1.
[37] Id.
[38] Commission Guide to Broker Dealer Registration (April 2008), available at https://www.sec.gov/about/reports-publications/investor-publications/guide-broker-dealer-registration.
[39] The Complaint says that they “grew their business by word-of-mouth” and makes no mention of websites and/or advertising. Complaint ¶ 14. The entities involved, Adar Bays, LLC and Adar Alef, LLC were owned and controlled by Goldstein, the sole managing member. Complaint ¶ 10-11. Goldstein and his entities “traded in their own account on their own behalf.” Complaint ¶ 15. Shockingly, Goldstein and his entities were forced to “surrender for cancellation its remaining stock and its remaining conversion rights under convertible notes issued since 2014”, which goes beyond any disgorgement principle and could be viewed as a method of punishment in addition to any penalty imposed. See SEC v. Aryeh Goldstein, Adar Bays, LLC, and Adar Alef, LLC, Litigation Release No. 25930 (Jan. 23, 2024), available at https://www.sec.gov/litigation/litreleases/lr-25930.
[40] Specifically, and in sum, I have concerns with the Adopting Releases conclusions that the final rules will promote, support or increase:
- orderly markets and investor protection by addressing negative externalities that may arise when a liquidity provider experiences financial failure,
- financial responsibility and operational integrity of liquidity providers in securities markets by subjecting them to the net capital rule and to other Commission and SRO rules and oversight,
- market stability and resiliency, and
- liquidity and efficiency during times of market stress.
See, e.g., Adopting Release at 96.
[41] Adopting Release at 189.