US Securities and Exchange Commission: Open Meeting
US Securities and Exchange Commission
Open Meeting
Tuesday, February 6, 2024
Topline
- The item was approved by a vote of 3-2, with Chair Gensler, Commissioner Crenshaw, and Commissioner Lizarraga voting yes and Commissioners Peirce and Uyeda in opposition.
ITEM 1: Special Purpose Acquisition Companies, Shell Companies, and Projections
The Commission considered whether to adopt new rules to further define the phrase “as a part of a regular business” as used in the statutory definitions of the terms “dealer” and “government securities dealer” under the Securities Exchange Act of 1934, in connection with certain liquidity providers.
Staff Discussion
Hoaxiang Zhu, Director, Division of Trading and Markets, SEC
Zhu said that the Division of Trading and Markets recommends that the Commission adopt the rules that identify certain activities that would cause those who engage in those activities to become “dealers” or “government securities dealers” as defined by the Exchange Act. Pursuantly, those engaging in those activities would need to register and comply with securities laws. Zhu cited technology changes and electronic trading in the past few decades which has led to certain market intermediaries becoming significant liquidity providers. Many of these intermediaries are not registered despite providing liquidity functions similar to those who do have to register. Zhu says that gap is particularly salient in the U.S. Treasuries market.
Zhu then said that the Division of Trading and Markets recommends that the Commission implements two qualitative factors that further define what it means to buy and sell securities “as part of a regular business.” First, regularly expressing interest in trading at or near the best available prices of a security on both sides of the market and communicating trading interest to other market participants. Second, earning revenue primarily from capturing bid-ask spread. Additionally, Zhu explained the Division of Trading and Markets recommends removing the bright-line quantitative test and recommends replacing the aggregation component with an anti-evasion provision. Zhu finished by saying that the rule will level the playing field and enhance regulatory oversight.
Shauna Sappington, Senior Special Counsel, Division of Trading and Markets, SEC
Sappington started by saying that the Division of Trading and Markets recommends the adoption of these rules. She said that these rules ensure that market participants who take on significant market making roles are appropriately registered. Sappington emphasized that the final rule is not the exclusive means of establishing whether a person is a dealer or government securities dealer, and that existing Commission interpretation and precedent will still apply. She said that the final rules set forth two qualitative factors that are designed to capture market participants who engage in a regular pattern of buying or selling of securities or government securities that has the effect of providing liquidity to other market participants. First, by regularly expressing trading interests that are at or near the best available prices on both sides of the market for the same security and that is communicated to other market participants. Second, 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 interest.
Sappington noted the final rule did not implement a proposed qualitative standard which would have captured roughly comparable purchases and sales of the same or similar securities in a day. Also noting that the final rule does not include a proposed quantitative standard that would have specified certain levels of activity in the U.S. Treasury market that would qualify them as buying and selling government securities as part of regular business, regardless of if qualitative factors were met. She said the definition of “own account” will be revised to mean accounts held in the name of, or for the benefit of that person. She also noted that the final rule includes an anti-evasion provision intended to deter establishing multiple legal entities to avoid regulations. Sappington said that the final rule will exclude those with total assets of $50 million because they are smaller market players who are less likely to engage in the significant liquidity provision the final rules are meant to address. Finally, she noted that the rules will also exclude registered investment companies, sovereign entities, central banks, and international financial institutions.
Jessica Wachter, Director, Division of Economic and Risk Analysis (DERA), SEC
Wachter emphasized the important market function that dealers provide of bridging gaps in orders and providing liquidity. She then said that dealers are particularly important in the market for U.S. Treasury securities where vast sums change hands daily. Wachter explained that the U.S. Treasury securities market is bifurcated into an interdealer market and a dealer to customer market. Wachter said that many firms acting as dealers are not registered as dealers, most of these funds are known as principal trading firms (PTFs) which are firms trading as a principal. Wachter said that the typical incentive of registering to access exchanges, but this is not the case with U.S. Treasury markets. She said the two-prong test would bring liquidity providers operating as dealers into the comprehensive regulatory regime including risk limits, reporting obligations, and oversight by FINRA. She says this rule will address an unevenness in the market where some are able to compete with lower costs. Wachter says that if there are decreases in treasury markets, her division does not believe they will be significant.
Commissioner Questions and Comments
Chair Gary Gensler
Gensler expressed his support for the final rule. He said that he thinks that it is important because it requires the firms that act like dealers to register with the Commission as dealers. Gensler said that historically dealer oversight has been a cornerstone of securities laws because when they register, they become subject to a variety of laws and responsibilities such as having a minimum amount of capital, reporting their books and records, and reporting data to regulators.
Gensler went on to say that as markets have evolved, some market dealers have not registered and that this is a gap in the system. He talked about how the types of trading changing over time: electronic and high-frequency traders are now participating in the treasury market and, as of 2019, PTFs represent 60% of the trading volume on inter-dealer trading platforms in the treasury markets. He says that over half of the volume on inter-dealer trading platforms being PTFs might be clue as to PTFs being dealers. Gensler said that these PTFs are acting as de facto market-makers and are buying securities and government securities “as part of a regular business” but a number of them have not registered as dealers. Gensler said that the rule will address this regulatory gap by further defining what it means to engaged in buying and sell securities and government securities “as part of a regular business.”
Commissioner Hester Peirce
Peirce started by saying that she does not support the final rule because of it has a fatal flaw and will distort market behavior and degrade market quality. She said this rule will turn traders into dealers which runs counter to the statute as it has been read for decades. Peirce said that recognizing the breadth of the provision the Commission has long interpreted it in a way that distinguishes between market participants who run a dealing business and those who operate an investment and trading business. She said that this rule could capture anyone who trades securities as part of their regular business. Peirce then said that liquidity provision alone does not constitute dealing activity and trading that has the side effect of liquidity provision does not constitute dealing. She said that this rule could create absurdities because it causes common trading strategies to turn a trader into a dealer.
Peirce said that this rule harms the broader market because many market participants will be swept up by the rules and must follow many regulatory requirements which will lead them to decide to stop serving the markets. She then said this rule will dampen liquidity provision and force liquidity providers to consolidate, ultimately making the market more fragile. Peirce then addressed the notion that the Commission needs more data to conduct oversight. She said that being an effective rule maker does not require having comprehensive surveillance. She then said that the rule has other problems such as serious implementation challenges because of the ambiguity of its scope and particularly that it has given little thought to crypto markets. Peirce mentioned that the economic analysis shows that the positive and negative consequences will be hard to predict.
She asked Wachter what metrics the Commission plans to use during a retrospective review in a few years. Wachter said that there are a number of academic studies in the release that can be replicated with new data. She also said that the state of competition can be looked at.
Peirce then asked if there was one thing to look at to see if this rule is successful what it would be. Wachter said that beyond everything she already mentioned, the aim of the rule is to bring firms into registration so you could look at the number of registrants would be another indicator of success.
Peirce then asked what the logic is for including registered investment companies but not private funds or pension funds. Sappington said that this would depend on the totality of the circumstances, a fund may be engaged in the business of buying and selling securities for its own account. She said that she does not believe that pension funds and many private funds would be captured by the rule.
Peirce asked if there would be any unique challenges for private and pension funds that would have to register. Zhu said that the legal status of a firm is not carved in stone; many firms are able to have a separate dealer entity that is registered. Randall Roy (Deputy Associate Director of the Division of Trading and Markets, SEC) said that the way that the rule is structured, if they register as a broker-dealer, there are different capital requirements for different tiers.
Peirce then talked about registering a separate entity as a dealer. She said that this seems to conflict with the actual rule, asking that if you can just carve out that activity doesn’t that takeaway from the purpose of making those that we want to register actually register. Zhu said that if a fund is acting as a dealer, we want to look at the nature of what they are doing, are they investing for long-term appreciation or convergence or dealing the bid ask spread.
Peirce then moved to talk about crypto-markets and about the release saying that Automated Market Makers (AMMs) would need to register as a dealer. She asked how software could register as a dealer. Zhu said that an AMM is more than just software. He explained that there is typically a pool of crypto assets and when you want to exchange one token for another, you would deposit one token and then a mathematical formula would determine the exchange rate. He said that the AMM would be making money based off the bid-ask spread, similar to broker-dealers. He said that they are not trying the technology with the rule but the people using it for dealing.
Peirce then asked what the Commission is doing to work with SIPC and FINRA to make sure that new registrants can comply with the one-year compliance period. Sappington said that, unless exempted, all new registrants are automatically SIPC members with no onboarding process. She then said that FINRA has agreed to expedite the process for new registrants.
Peirce talked about how investment advisers are not explicitly excluded from the rule, however there were modifications that made them less likely to be included in the rule. She asked why it would make sense to pull them in when they are subject to a separate registration and regulatory framework. She further asked if this would potentially lead to conflicts between their dealer obligations and fiduciary duties. Sappington said that they do think that the modifications will largely exclude them from the final rule. She said that investment advisers are investing on the behalf of clients and not for their “own account.” She then added that if an investment adviser is dealing or engaging in dealing activity, it is important that comply with the regulatory obligations.
Gensler took the opportunity to add to the responses from Peirce’s questioning. He first said that there is a de minimis exception for firms with less than $50 million in assets, regardless of whether they deal with crypto or not. Peirce said that she does think that this would be helpful but what is troubling her about the rule is that it is no longer about what you intended, it is the effects that pull you in, which in this case are positive effects of liquidity provision. She said that she thinks that the Commission is giving with one hand and taking away with the other.
Gensler said that he sees it differently because it is a consequential choice that you make to engage in dealing or providing liquidity. He also says that he does not think that it conflicts with fiduciary duties. He mentioned that he was a former partner of a major broker-dealer where there were fiduciary duties to each of the partners to maximize revenue and profits, while complying with securities laws. Peirce clarifies that the question that she was asking is about registered investment advisers having to register as dealers, she said this is not the same as Gensler’s situation where he had obligations to his own entity. She says in her scenario there is a fiduciary obligation to your advisory client and to customers in your dealer capacity. Gensler says that he thinks it is more straightforward because he does not think that the adviser, which is a management company, would be providing those services.
Commissioner Caroline Crenshaw
Crenshaw started by saying that the Commission has been granted broad authority over the security industry. She said that the dealer regulatory regime is a key component of the U.S. securities laws and dealers provide important market functions such as absorbing order imbalances and providing liquidity. She said that under the Exchange Act that the Commission has the authority to define the terms that are used in the statutory definition of “dealer.” She said that dealers are willing to help facilitate trading because they are willing to trade for their own account as principals when investors cannot immediately find other investors to trade with; dealers provide the service of immediate trading.
Crenshaw said that there is a clear loophole, market participants are engaging in activities like those performed by dealers without registering as dealers. She said this leaves investors and markets without important protections such as limitations on financial risk, reporting and disclosure, and other benefits. She said this rule will help close this loophole and level the playing field by bringing market participants performing similar functions into a common regulatory regime.
Commissioner Mark Uyeda
Uyeda said that he thinks that the rule is problematic and extends beyond the Commission’s statutory authority. He said that the rule may reduce liquidity in Treasury markets, make them more volatile, reduce the number of liquidity providers, and increase debt costs to taxpayers. He says that the rule does not clarify what “part of a regular business” means. He says that complying with rules provides no assurance. Uyeda says that the public should be concerned about the breadth of the Commission claimed jurisdiction. He says that this rule fails to define the unlawful conduct and allows for arbitrary government authority and allows for uneven enforcement.
Uyeda said there are already rules that monitor risks by PTFs, such as Federal Reserve regulations that apply when they trade through banks; specific margin requirements when they trade through a dealer; and if they trade directly themselves, the Commission’s market access rule applies. Uyeda says that is misguided to think that there is public benefit in increasing costs. He says that increases in cost will cause firms to provide less liquidity and some to exit. Uyeda also says that it is a weak argument to say that the Commission needs more data, because they already are receiving enough.
Uyeda said that the Commission has not considered the aggregate effect of this rule with existing laws and regulations. He also shares concerns about sweeping more people into FINRA’s regulatory orbit, making them appear as a de facto federal securities regulator.
Uyeda says that the Commission’s approach, any person can be a dealer if they buy and sell securities “as part of a regular business.” He says that the final rule modifies some of the provisions from “routine” to “regular” but that provides no further clarity. He says that there is much ambiguity surrounding this question. Uyeda said that he cannot support the final rule because it does not clarify ambiguity as to who is a dealer, it will impose fixed costs on small firms, and there is no evidence to substantiate its necessity.
Uyeda asked about one of the provisions in the rule that says, “at or near,” he asked what exactly “near” means when determining when an entity falls into the definition. Zhu said that the reason for this being generic is because different securities have different liquidity profiles and pricing. He said that what is “near” this is very fact specific and would apply differently to different securities.
Uyeda says that the failure to register is a non-scienter charge, so it does not matter whether you tried to figure out whether you should register. He asked whether everybody who would be brought into this regime would already be subject to the anti-fraud and anti-manipulation rules without being registered as a dealer. Sappington said yes.
Uyeda closed by saying he thinks that this rule would have been well-served by a re-proposal, he says that it is important to know what is below before jumping off the diving board.
Commissioner Jaime Lizárraga
Lizárraga expressed his support of the rule saying that it is important in strengthening market resiliency which will help reduce the harmful impact of unanticipated shocks. He says that the rule will provide greater protection and give investors greater confidence in capital markets and the financial system. He says that this rule will level the playing field. Lizárraga then cites the U.S. Treasury Secretary, Janet Yellin as describing the U.S. Treasury market as the “bedrock of our financial system.” He says that Yellin emphasized the need to strengthen the U.S. Treasury market due to recent episodes of stress. He cites 2023 annual report of the interagency Financial Stability Oversight Council urged regulators to strengthen resiliency through enhanced data transparency. He says the rule helps towards this goal.
Lizárraga said the increase of electronic trading has split Treasury markets between firms operating in accordance with regulatory standards and unregistered firms with substantial presence that do not. He says registered firms provide the market with key data and comply with financial responsibility and risk management rules. He says that the risk of failure of substantial market makers is real, and we have seen this. Lizárraga said that this rule could have prevented some firms leaving the market in recent years. He finished by expressing support for the rule saying that it will benefit the U.S.’s vital $24 trillion treasury market.
Vote
Chairman Gensler called the role. The item was approved 3-2. Peirce and Uyeda voted no.
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