The U.S. Securities and Exchange Commission (SEC) has recently made significant adjustments to its regulatory framework, introducing two pivotal rules, Rules 3a5-4 and 3a44-2, collectively known as the Final Rules.
ACA Group, a developer of compliance, risk and technology solutions, has delved into what this means.
These amendments could compel certain hedge funds and proprietary trading firms, particularly those contributing liquidity to the market, to register as broker-dealers and join the ranks of FINRA members. This move, as highlighted in the Adopting Release, responds to the influential role played by unregistered entities in liquidity provision, underlining the necessity for these changes.
Historically, the Exchange Act’s Section 3(a)(5) outlined a dealer as any entity engaged in the transaction of securities for its own account, either directly or through a broker, with certain exceptions. The Final Rules aim to clarify and extend the definition of “dealer” by introducing qualitative standards to determine whether an entity’s securities transactions form part of its regular business operations.
Qualitative standards redefine dealer status
These standards hinge on whether an entity, with at least $50m in assets, engages in securities or government securities transactions as a regular aspect of its business, meeting either the Trading Interest Factor or the Primary Revenue Factor.
The former pertains to regularly demonstrating trading interests at competitive market prices, accessible to other market participants, while the latter involves primarily earning revenue through bid-ask spreads or trading incentives.
It’s noteworthy that certain entities, such as registered investment companies and international financial institutions, remain outside the scope of these rules.
Limited impact but significant for high-frequency trading hedge funds
The SEC anticipates these regulations will affect a modest fraction of funds, particularly targeting hedge funds involved in algorithmic high-frequency trading. Such activities, characterized by frequent and balanced market participation or by profits derived from trading margins and incentives, are at the core of the Final Rules. Despite this narrow focus, the implications for those within scope are profound, necessitating registration as broker-dealers and adherence to comprehensive regulatory obligations.
In response to industry concerns, SEC Chairman Gensler has clarified that these rules principally target large, high-speed trading entities rather than hedge funds broadly.
Streamlined registration and compliance support
To facilitate compliance, FINRA has introduced a simplified application process, outlined in Regulatory Notice 23-19, allowing for expedited review for firms needing to register under these new criteria. The Final Rules are set to be enforced from April 29, 2024, with a grace period extending to April 29, 2025, for affected entities to complete their registration.
ACA Signature’s comprehensive compliance solutions
For broker-dealers navigating these regulatory waters, ACA Signature presents a bespoke compliance and advisory solution. Tailored to each firm’s specific needs, ACA Signature amalgamates compliance advisory, cutting-edge technology, managed services, and cybersecurity expertise to address regulatory demands efficiently and effectively. Firms are encouraged to consult with ACA to optimize their Governance, Risk, and Compliance (GRC) strategies, ensuring readiness and resilience in the face of regulatory evolution.
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