SEC Proposed Definition of “Broker”: What Impact Does It Have on Investment Firms? | Marcum LLP

In March 2022, the Securities and Exchange Commission (“SEC”) proposed a new rule to update the definition of “dealer” under Section 3(a) of the Securities Exchange Act of 1934 (“Exchange Act “). The proposed rule is in response to increased trading volume and market liquidity from unregistered market participants. This has resulted in a significant increase in market activity by companies that are not regulated by the SEC. The rule proposed by the SEC aims to strengthen investor protection and ensure market stability.

The increase in activity in the unregistered market is likely attributable to advances in technology, including the use of algorithms, which are commonly used by proprietary trading firms. These firms focus on trading volume and speed in order to execute their strategies, especially in the US Treasury markets.

In the Proposed Ruling, the SEC provided the following chart to demonstrate this observed trend:

Source: TRACE data from July 2021 as presented in https://www.sec.gov/rules/proposed/2022/34-94524.pdf

As shown in the chart above, the SEC has observed that the trading volume of unregistered firms significantly exceeds the activity of regulated firms. The SEC believes this demonstrates the use of technology and the accelerated speed at which these companies execute transactions. The current definition of “dealers”, requiring registration, relates to those who buy and sell securities in the course of their “ordinary business”. Unregistered market participants (non-traders) have historically asserted that their activities are not a “regular business” in order to benefit from the exemption from registration. By expanding the definition of “dealer,” the proposed rules target market participants, such as investment managers and private funds, that have the effect of “providing liquidity” to markets. The draft rules add the following standards:

Qualitative standards:

  1. Regularly make roughly comparable purchases and sales of identical or substantially similar securities in one day;
  2. Regularly express trading interests that are at or near the best available prices on both sides of the market, which are communicated and represented in a way that makes them accessible to other market participants; and
  3. To earn revenue primarily by capturing bid-ask spreads, buying on the bid and selling on the bid, or capturing any incentive offered by trading platforms to trading interests providing liquidity.

Quantitative standard:

  1. One person, in each of the last four of the past six calendar months, has engaged in the buying and selling of more than $25 of government securities trading volume billing.
    1. The quantitative standard focuses only on government securities due to the SEC’s observed trend of high trading volume in the US Treasury market by non-FINRA firms.

Qualitative standards provide no clear line test. Firms will be required to exercise significant judgment in applying terms such as “usually” and “approximately comparable” used in these standards, as follows:

  1. Routine – more frequent than occasional but not necessarily continuous.
  2. Roughly comparable – buys and sells similar enough (i.e. dollar volume, stock volume, risk profile) to result in a nearly neutral position in the market.

The proposed rules also seek to update the definitions of “control” and “proper account” to provide a more substantive framework to be applied by parties who are primary beneficiaries of trading activity in the marketplace. . The revised definitions would deter individuals and businesses from reorganizing their legal entities to avoid being subject to the proposed rules.

Additionally, the SEC has placed particular emphasis on how registered investment advisers view a “shadow account structure” in which multiple legal entities under common control invest in similar assets.

There are also practical concerns about how registered investment advisers will or will not aggregate their clients’ trading activities, which will require careful analysis.

The compliance burden for businesses that must register as brokers due to the proposed rule will be significant. These requirements include, but are not limited to, the following:

  • Net capital requirements,
  • Anti-fraud rules,
  • Annual financial reports (audited financial statements),
  • Blocking of capital contributions (12 months),
  • Restrictions on new issues (IPO),
  • Direct reporting of trading information, and
  • Subject to reviews by the SEC and self-regulatory organizations (such as FINRA).

Market participants with controlled assets of less than $50 million would qualify for an exclusion from the proposed rule.

Comments were required to be filed with the SEC by May 27, 2022. Based on the comments posted on the SEC’s website (https://www.sec.gov/comments/s7-12-22/s71222.htm), the proposed rule elicited a significant amount of negative reaction, including these representative comments:

  • It is expected that a large number of businesses will need to be registered, especially private funds.
  • The rules are too vague.
  • The rules confer jurisdiction beyond the statutory authority of the SEC, including the original intent of the Exchange Act.
  • Negative consequences in the market, such as an immediate increase in sell positions when private funds sell off, creating pressure in the market.
  • Overall decrease in the volume of market transactions.
  • Decreased distinction between resellers and merchants.
  • Comment period too short.
  • Limited discussion of digital asset securities considerations.

Conclusion

The SEC’s draft rule expands the definition of what constitutes a “dealer,” based on a market trend that could put investors at risk, and offers a solution that offers increased regulation and oversight. The response from the investment community appears to be critical of the proposed rule due to potential unintended consequences, such as high costs, resource constraints, negative market reaction, and difficulties in interpretation and implementation. implementation of the rule in practice.

Source

  1. SEC Publication No. 34-94524; File number S7-12-22.