On March 28, 2022, the US Securities and Exchange Commission (SEC) proposed rules (Proposing Release) that would require securities market participants that engage in dealer-like activities — such as a proprietary trading firm that engages in a routine pattern of buying and selling securities that has the effect of providing liquidity to other market participants — to register with the SEC, become a member of a self-regulatory organization (SRO), and comply with federal securities laws and regulatory obligations.
Congress defined “dealer” in the Securities Exchange Act of 1934 (Exchange Act) as a person engaged in the business of buying and selling securities for such person’s own account. The definition has historically excluded proprietary trading firms and others as “traders,” those persons that buy or sell securities for such persons’ own account but not as a part of a regular business. The Proposing Release seeks to eliminate this long-standing dealer/trader exclusion for many securities market participants.
Existing Regulatory Framework
A person must evaluate its securities activities to determine if those activities could constitute engaging in dealer activities, and whether an exception or exemption from dealer registration is available. Section 3(a)(5) of the Exchange Act defines the term “dealer” to mean “any person engaged in the business of buying and selling securities . . . for such person’s own account through a broker or otherwise,” but excludes “a person that buys or sells securities … for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business.” Similarly, Section 3(a)(44) of the Exchange Act defines “government securities dealer” to mean “any person engaged in the business of buying and selling government securities for his own account, through a broker or otherwise,” but excludes “any person insofar as he buys or sells such securities for his own account, either individually or in some fiduciary capacity, but not as a part of a regular business.”
The first inquiry in the analysis, therefore, is whether the person is “buying and selling securities” for its own account. The next inquiry is whether the person has “engaged in the business” of that activity “as part of a regular business.” If a person’s securities-related activities fall under the general definition of “dealer,” that person must register as a broker-dealer unless the person can meet the terms of an exception or exemption from the dealer definition.
Importantly, Congress recognized in Section 3(a)(5)(B) that a person who is buying securities for that person’s own account may not be a “dealer” if that person is not engaged in the activity as part of a regular business. The SEC has long recognized the exclusion as the dealer/trader distinction and has indicated in its informal guidance that certain indicia are relevant to drawing this distinction, including, among others, whether the firm is carrying an inventory, has regular clientele, quotes the market, buys and sells the same security simultaneously, engages in securities activities that are relatively minor as measured against its other business, holds itself out as willing to buy and sell particular securities on a continuous basis, or acts as a de facto market maker whereby market professionals or the public look to the firm for liquidity. SEC staff guidance also noted that the level of a firm’s activity with respect to securities is not a measure of whether the firm is “engaged in the business” of buying and selling securities.
If adopted, the proposed rules — Exchange Act Rule 3a5-4 and Exchange Rule 3a44-2 — would define the phrase “as part of a regular business” section of the “dealer” and “government securities dealer” definitions as being satisfied by meeting one of three qualitative standards. In addition to these qualitative standards, Rule 3a44-2 would also interpret the “as a part of a regular business” part of the “government securities dealer” definition as being satisfied by meeting a quantitative standard. Finally, these standards would be non-exhaustive and the rules would set out certain limited exceptions that would apply to each standard. We summarize these pertinent aspects of the proposed rules in greater detail below.
Qualitative Standards Under Both Rules. A firm would be deemed to be engaged in buying and selling securities for its own account “as a part of a regular business”, and therefore acting as a dealer or a government securities dealer, if it engages in a routine pattern of buying and selling securities that has the effect of providing liquidity to other market participants. The SEC sets forth three qualitative standards of activities that would be considered to have the effect of providing liquidity to other market participants:
- Routinely making roughly comparable purchases and sales of the same or substantially similar securities in a day;
- 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
- 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.
Quantitative Standard for Government Securities Dealers. A firm would also be deemed to be engaged in buying and selling securities for its own account “as a part of a regular business”, and therefore acting as a government securities dealer if it trades more than $25 billion in government securities in each of four out of the last six calendar months.
Non-Exhaustiveness of Standards. Both rules would include a provision stating that not meeting one of the listed standards does not create a presumption of not being a dealer. The SEC specifically clarified in the release that despite these standards, whether specific activities qualify would remain a facts-and-circumstances determination and that other patterns of buying and selling may have the effect of providing liquidity to market participants, and hence require registration. The SEC also stated that its existing interpretations and precedent will continue to apply, as long as they are consistent with the Proposing Release.
Exclusions. Both rules would exclude firms that:
- Have or control total assets of less than $50 million; or
- Are investment companies registered under the Investment Company Act of 1940.
Impact on Private Funds
Private funds often claim the dealer/trader exclusion from the definition of dealer. Indeed, SEC staff has provided no-action relief to hedge funds engaged in government securities premised on the dealer/trader exclusion. As the Proposing Release focuses on activity and effects rather than intent, label, or status, private funds and hedge funds relying on an exemption from registration provided in Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (Investment Company Act) that provide market liquidity on a regular basis and do not qualify for one of the noted exceptions or exemptions would need to comply with the requirements of the rule. Furthermore, the Proposing Release states that private funds are deliberately not excluded from the proposed definitions because private funds are not subject to the extensive regulatory framework of the Investment Company Act, and their disclosure obligations under Form PF do not reach the level of disclosure that the SEC relies on for dealer regulation and oversight purposes.
The Proposing Release would also pick up investment advisers registered under the Investment Advisers Act of 1940 (Advisers Act) with respect to trading for proprietary accounts or, under certain circumstances, because of aggregating trading in proprietary accounts with client accounts they control. However, a registered investment adviser would not necessarily be required to aggregate its own trading activities with the trading activities of its advised vehicles for these purposes. Client assets will be attributable to a registered investment (and the adviser will be required to aggregate its trading activities with those of the client) if the adviser is determined to “control” the client, whether as a result of the adviser’s right to vote or direct the vote of voting securities of the client, the adviser’s right to sell or direct the sale of voting securities of the client, or the adviser’s capital contributions to or rights to amounts upon dissolution of the client.
Impact on Decentralized Finance (DeFi)
The Proposing Release’s expanded definition of “dealer” to include persons and entities that use automated and algorithmic trading technology to execute trades and provide market liquidity could encompass persons acting as liquidity providers on digital asset exchanges and DeFi platforms to the extent they are dealing with securities. The Proposing Release clearly states that “dealer” would include persons that “employ passive market making strategies….” Moreover, Footnote 36 of the Proposing Release states that the “proposed Rule[s] … would apply to securities … including any digital asset that is a security or a government security within the meaning of the Exchange Act.”
As noted in this Latham post discussing the proposed Reg ATS amendments, the critical threshold question in analyzing whether a crypto platform, liquidity provider, or automated market maker is engaging in broker-dealer or exchange activity of course remains whether the digital assets that are being traded on it qualify as “securities.”
Request for Comment
The Proposing Release requests comment from the general public in 84 often-multipart questions on all aspects of the Proposing Release. The comment period will remain open until May 27, 2022, which would be 30 days after publication in the Federal Register. The Proposing Release provides market participants that would fall within the scope of the new definitions a one-year compliance period from the effective date of any final rules to become registered as broker-dealers.
 See Definition of Terms in and Specific Exemptions for Banks, Savings Associations, and Savings Banks Under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934, SEC Release No. 34-46745 (Oct. 30, 2002), 67 FR 67495, 67498-67500 (Nov. 5, 2002) (explaining that “a person that is buying securities for its own account may still not be a “dealer” because it is not “engaged in the business” of buying and selling securities for its own account as part of a regular business. This exclusion is often referred to as the dealer/trader distinction. A “trader” does not have to register as a broker-dealer.”).
 See e.g., Louis Dreyfus Corp., SEC No-Action Letter (July 23, 1987); Martin E. Lybecker, SEC No-Action Letter (July 13, 1986); see also Proposed Rule: Definition of Terms in and Specific Exemptions for Banks, Savings Associations, and Savings Banks Under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934, SEC Release No. 34-46745 (Oct. 30, 2002) available at https://www.sec.gov/rules/proposed/34-46745.htm.
 See United Trust Co. (Morris, Larson, King), SEC Denial of No-Action Request (Sept. 6, 1978) (“the level of a firm’s activity with respect to [securities] is not the measure of whether it is ‘engaged in the business’ of buying and selling [securities]”).
 The Proposing Release uses the term “routinely” to connote the frequency with which a person engages in day-trading of substantially similar securities. The frequency of activity rising to the level of “routinely” can be understood as a regularity of transactions that plays a significant role in price discovery and the provision of market liquidity, as opposed to merely occasional, isolated, or sporadic activity. Liquidity provision need not be continuous, however, like that of some traditional dealers.
 The broad term “trading interest” is used rather than “quotations” to reflect the prevalence of non-firm trading interest offered in the securities markets, and “to account for the varied ways in which developing technologies permit market participants to effectively make markets.” It is intended to capture traditional quoting engaged in by dealer liquidity providers, as well as new and developing quoting equivalents.
 The phrase “earn revenue” is used rather than, e.g., “profit from” to make clear that a trading strategy need not be profitable to bring it within the rule.
 The Proposing Release here relies on a definition of “trading venue” as set forth in a separate SEC release proposing Amendments Regarding the Definition of “Exchange” and Alternative Trading Systems (ATSs) That Trade U.S. Treasury and Agency Securities, National Market System (NMS) Stocks, and Other Securities: “a national securities exchange or national securities association that operates an SRO trading facility, an ATS, an exchange market maker, an OTC market maker, a futures or options market, or any other broker- or dealer-operated platform for executing trading interest internally by trading as principal or crossing orders as agent.” (See this Latham post for more information).