What you need to know
- The U.S. Securities and Exchange Commission (SEC) has completed rulemaking aimed at clarifying a category of de facto market makers that should be considered traders subject to registration under the Exchange Act.
- The final rules establish two qualitative factors as non-exclusive criteria establishing intermediary status for persons providing liquidity in the securities markets:
- Periodically express trading interest at or near the best prices on both sides of the market for the same value.
- Earn income primarily by capturing bid-ask spreads or trading venue liquidity incentives.
- Anyone who meets the definition of a "dealer" must register with the SEC and become a member of a self-regulatory organization, such as the Financial Industry Regulatory Authority (FINRA).
- The implications of these new regulations on cryptoasset markets are currently unclear. A detailed analysis of the facts and circumstances of specific DeFi products, services or activities may be necessary.
- These new regulations will come into effect 60 days after their publication and entities will have until approximately April 2025 to fully comply.
On February 6, the United States Securities and Exchange Commission (SEC) voted 3-2 in favor adopt Rules 3a5-4 and 3a44-2 of the Securities Exchange Act of 1934 (“Exchange Act”), as a final regulation to further clarify the definition of “broker” (the Final Rules).1
Trading securities for one's own account, on a “principal” basis, is generally not considered an activity regulated by the Securities Act of 1933 or the Exchange Act. However, under the authority granted by the Exchange Act, the SEC has sought to supervise and regulate traders who are important enough to a securities market that their activities could affect market integrity and investor protection. . Anyone who is a trader under the Exchange Act is prohibited from transacting securities unless they are registered with the SEC and are a member of a self-regulatory organization, such as the Financial Industry Regulatory Authority (“FINRA”).
The SEC's authority to regulate securities brokers arises from Section 3(a)(5) of the Exchange Act, which defines the term "broker" as "any person engaged in the business of buying and selling securities." but then excludes from the definition anyone who does so “on his own account, whether individually or in a fiduciary capacity, but not as part of a regular business.” The SEC has long attempted to articulate the contours of a “dealer-dealer distinction” based on the activities and relationships of a given entity. The Final Rules arguably mark an extension of a trend established by the 2002 and 2012 SEC guidelines that have increasingly examined market making as a dealer activity. In its statement In announcing the Final Rules, SEC Chairman Gensler highlighted the insolvencies of major government securities trading firms in the 1980s that precipitated this regulatory trend.
The Final Rules provide that a person is buying and selling securities “as part of a regular business” within the meaning of the Exchange Act's definition of “dealer” if that person (1) engages in a regular pattern of buying and selling of securities that has the effect of providing liquidity to other market participants and (2) has or controls at least $50 million in total assets. The Final Rules further establish two independent “qualitative factors” for what satisfies liquidity provision criterion (1) above:
- The “express commercial interest” factor: Periodically express a trading interest that is at or near the best prices available on both sides of the market for the same security, and that is communicated and represented in a manner that is accessible to other market participants; either
- The “primary income” factor: Earn income primarily by capturing bid-ask spreads, buying at bid and selling at bid, or by capturing any incentives offered by trading venues to trading interests that supply liquidity.
The SEC has positioned these factors as criteria that establish de facto market making activity, which is a subset of dealer indicia identified by prior SEC guidance. Therefore, the preamble to the Final Rules makes clear that satisfying either of these two factors is sufficient but not necessary to determine distributor status. In particular, the Final Rules' exclusion of any person who has or controls total assets of less than $50 million only applies to the “de facto market making” activities described in the Final Rules.2 In other words, the SEC has indicated that they can consider a person a trader even if the person does not meet the criteria in the Final Rules and does not meet the $50 million total assets threshold. In its dissenting statementSEC Commissioner Hester M. Peirce argued that the regulations “erase [the dealer-trader] distinction by extending the definition of “distributor” to market participants who conduct investment and trading businesses, not trading businesses.”
During the notice and comment period for the SEC rulemaking, several commenters expressed concerns about how these criteria would impact users and developers operating in blockchain-based decentralized financial ("DeFi") markets. Commenters pointed out some of the conceptual fissures and legal uncertainties that arise from applying rules for human intermediaries to the peer-to-peer activities offered by decentralized exchanges and automated market maker applications that use autonomous code to effect critical trades. In many respects, the Final Rules do not satisfactorily address how the 1934 dealer concept is manageable in the DeFi space. The SEC has also declined to provide clarity, other than through enforcement actions, regarding which crypto assets are securities. "Rather than seriously addressing these issues," Commissioner Peirce observes, "the Commission implies that 'certain persons engaged in cryptoasset securities transactions may already be operating as traders.'" As such, the language adopted in the Final Rules may require a detailed analysis of the facts and circumstances of specific DeFi products, services, or activities to reach a determination of whether someone would need to register as a distributor.
The Final Rules will take effect 60 days after the date of publication of the adoption authorization in the Federal Register. The compliance date for the Final Rules will be one year after the effective date: on or about April 7, 2025.
Key takeaways
- Under new SEC regulations, anyone acting as a market maker in securities with $50 million in total assets may be required to register as a broker with the SEC and FINRA.
- Factors that constitute broker status under the Final Rules include: (i) “regularly expressing trading interests” on both sides of a securities market, or (ii) deriving income primarily from capturing bid-ask spreads or incentives. of liquidity providers.
- The application and effect of these new regulations on DeFi markets is unclear. We will continue to monitor developments, including additional guidance (and enforcement) from the SEC.
[1]Rule 3a5-4 addresses the definition of securities dealers, while Rule 3a44-2 addresses the definition of government securities dealers. The rules for government securities are substantially similar to those affecting non-government securities.
[2]Other entities that are exempt from the rules are central banks, sovereign entities and international financial institutions.
