SEC may lack legal clout to impose new dealer rule – Citadel

Adoption of quantitative dealer definition may require congressional changes to the US Securities Exchange Act

The US Securities and Exchange Commission (SEC) may be stepping outside its statutory authority in its attempt to make buy-side Treasury market participants register as dealers, a lobbyist for the hedge fund Citadel said last week.

A proposed rule would require participants to register as dealers if they have traded more than $25 billion of US Treasuries in four of the last six months, subjecting them to a range of additional regulatory requirements.

Aaron Friedman, deputy US head of government and regulatory policy at Citadel, said the country’s Securities Exchange Act did not support the definition of a dealer by purely quantitative measures.

The SEC's proposal for registration of dealers is aggressive

Darrell Duffie, Stanford University

“There is nothing in the Exchange Act that supports the SEC's proposition that trading volume in a particular asset, including government securities, is indicative of dealer status,” he said at the International Swaps and Derivatives Association’s trading forum in New York on September 21.

“If the SEC were to finalise this rule, absent congressional change of the Exchange Act, I think there are real statutory authority concerns.”

The US Securities Exchange Act defines a dealer as any person “engaged in the business of buying and selling securities … for [its] own account” as part of regular business. Where this activity is not part of regular business, firms fall within the “trader exception” and would not be considered dealers.

Friedman said the move to a quantitative threshold for the dealer definition would be unprecedented: “The SEC has never taken a position that large trading volumes in a particular asset make you a dealer.”

Shifting definitions

The rulemaking, which seeks to amend the definition of ‘dealer’ and ‘government securities dealer’, has attracted the ire of hedge funds and large asset managers. Some lawmakers are also vocal critics of the proposals.

Friedman was worried that the broker-dealer regulatory framework was incompatible with fund management.

Dealer registration would require firms to comply with higher capital requirements, annual reporting rules, trade reporting and subject firms to other restrictions, such as investing in initial public offerings.

Fund managers typically take risk with client money in the hope of making returns from market moves. In contrast, dealers buy and sell financial products in the hope of making a profit on the difference between the bid and the offer.

If the SEC were to finalise this rule, absent congressional change of the Exchange Act, I think there are real statutory authority concerns

Aaron Friedman, Citadel

Friedman warned that hedge funds and other asset managers could curtail trading government securities to avoid registration, likely harming market liquidity.

He noted that this change would come alongside record issuance of US government bonds: “The last thing you want to do is be harming Treasury market liquidity by making some of the biggest investors and Treasury draw back to their activity.”

“Of all of the SEC's 40 or so rulemakings, from a buy-side perspective, this is probably the most concerning,” said Friedman.

Speaking on the same panel, Stanford University’s Darrell Duffie echoed concerns around the proposed trading threshold for dealer designations: “The SEC's proposal for registration of dealers is aggressive.”

He noted that there were “many investors in the world” that would exceed the requirement and were not dealers in the “English language sense” of the word.

Analysis by the Alternative Investment Management Association suggests at least 50 hedge funds would be captured by the quantitative threshold.

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Duffie, who is leading industry discussions on adoption of all-to-all trading in the Treasury market, said he understood “where the SEC is coming from” on the rest of its proposal, which would make proprietary trading firms of all kinds register as broker-dealers.

“Maybe they'll think again and modify the activity requirement,” he added.

Proprietary trading firms have widely criticised the SEC’s proposal, suggesting the move could harm market liquidity, at a time when the agency is trying to strengthen the Treasury market by introducing mandatory clearing of cash Treasuries and repo transactions.

In a statement to Risk.net, Larry Weithers, global head of relative value trading at DRW, says: “Forcing all active traders in the market to register as dealers based solely on the amount of trading they do is a novel [criterion] for which there seems to be no easy-to-understand rationale.”

He adds that the rule would hurt liquidity by reducing competition and decreasing the diversity of participants in the market.

“Given other regulatory efforts to strengthen the resiliency of this market, it seems like [a] surprising time to be making claims about beneficial consequences of regulating trading firms as dealers, instead of simply regulating the products and markets themselves, and allowing firms to compete,” says Weithers.