United States: SEC Finalizes "Dealer" Regulation – Uncertain Impact To Cryptoasset Market Participants

What You Need To Know

• The U.S. Securities and Exchange Commission (SEC) has finalized rulemaking intended to clarify a category of de facto market makers who should be considered to be a dealer subject to registration under the Exchange Act.
• The final rules put forth two qualitative factors as nonexclusive criteria establishing dealer status for persons providing liquidity in securities markets:
  • Regularly expressing trading interest at or near the best prices on both market sides for the same security.
  • Earning revenue primarily from capturing bid-ask spreads or trading venue liquidity incentives.
• Anyone who meets the definition of "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 close analysis of the facts and circumstances of specific DeFi products, services, or activities may be required.
• These new regulations will take effect 60 days after their publication and entities will have until approximately April 2025 for full compliance.

On February 6, the United States Securities and Exchange Commission (SEC) voted 3-2 to adopt Rules 3a5-4 and 3a44-2 under the Securities Exchange Act of 1934 ("Exchange Act"), as a final regulation to further clarify the definition of "dealer" (the Final Rules).¹

Trading securities for one's own account, on a "principal" basis, is generally not considered an activity regulated under the Securities Act of 1933 or the Exchange Act. However, under authority provided by the Exchange Act, the SEC has sought to oversee and regulate dealers who are significant enough to a securities market that their activities may impact market integrity and investor protection. Anyone who is a dealer under the Exchange Act is prohibited from effecting transactions in securities unless they are registered with the SEC and members of a self-regulatory organization, such as the Financial Industry Regulatory Authority ("FINRA").

The SEC's authority to regulate securities dealers stems from section 3(a)(5) of the Exchange Act, which defines the term "dealer" to mean "any person engaged in the business of buying and selling securities" but then carves out from the definition anyone who does so "for such person's own account, either individually or in a fiduciary capacity, but not as a part of a regular business." The SEC has long attempted to articulate the contours of a "dealer-trader distinction" on the basis of the activities and relationships of a given entity. The Final Rules arguably mark an extension of a trend set by 2002 and 2012 SEC guidance that has increasingly scrutinized market making as dealer activity. In his statement announcing the Final Rules, SEC Chair Gensler highlighted the insolvencies of major government securities trading firms in the 1980s that precipitated this regulatory trend.

The Final Rules state that a person is buying and selling securities "as part of a regular business" within the meaning of the Exchange Act definition of "dealer" if that person (1) engages in a regular pattern of buying and selling 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 the liquidity provision criteria (1) above:

• The "expressing trading interest" factor: Regularly expressing trading interest that is at or near the best available prices on both sides of the market for the same security, and that is communicated and represented in a way that makes it accessible to other market participants; or
• The "primary revenue" factor 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.

The SEC has positioned these factors as criteria establishing de facto market making activity, which is a subset of dealer indicia identified by past SEC guidance. Hence, the preamble to the Final Rules makes clear that satisfying either one of these two factors is sufficient but not necessary for the determination of dealer status. Notably, the Final Rules' exclusion of any person that has or controls total assets of less than $50 million only applies to the "de facto market making" activities outlined in the Final Rules.² In other words, the SEC has indicated that they may view a person to be a dealer even if the person does not satisfy the criteria in the Final Rules and does not meet the $50M total assets threshold. In her dissenting statement, SEC Commissioner Hester M. Peirce argued the rulemaking "obliterates [the dealer-trader] distinction by extending the definition of "dealer" to market participants that run investing and trading businesses, not dealing businesses."

During the notice and comment period of the SEC's rulemaking, several commenters raised concerns with how these criteria would impact the users and developers operating in blockchain-based decentralized finance markets ("DeFi"). Commenters noted some of the conceptual fissures and legal uncertainties that emerge from applying rules for human intermediaries to the peer-to-peer activities afforded by decentralized exchanges and automated market maker applications using autonomous code to effect critical operations. In many respects, the Final Rules do not satisfactorily address how the 1934 concept of a dealer is tractable in the DeFi space. The SEC has also declined to provide clarity, other than by enforcement actions, regarding which crypto assets are securities. "Rather than engage seriously with these questions," Commissioner Peirce observes, "the Commission hints that 'certain persons engaging in crypto asset securities transactions may be operating as dealers' already." As such, the language adopted in the Final Rules may require a close 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 dealer.

The Final Rules will become effective 60 days following the date of publication of the adopting release 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 the SEC's new regulations, anyone acting as a market maker in securities with $50 million in total assets may be required to register as a dealer with the SEC and FINRA.
• The factors constituting dealer status under the Final Rules include: (i) "regularly expressing trading interest" on both sides of a market in securities, or (ii) earning revenue primarily from capturing bid-ask spreads or liquidity provider incentives.
• The application and effect of these new regulations to DeFi markets is unclear. We will continue to monitor developments, including additional guidance (and enforcement) from the SEC.

Footnotes

1.Rule 3a5-4 concerns the definition for dealers in securities, while Rule 3a44-2 concerns the definition for dealers in government securities. The rules for government securities are substantially similar to those affecting non-governmental securities.

2.Other entities that are exempt from the rules are central banks, sovereign entities, and international financial institutions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.