New SEC Rule Will Impair the World's Most Important Market

Never mind the dense 247 pages. Just the title of Securities and Exchange Commission’s new rule concerning trading of US Treasuries, deemed the world’s most important market, will make your eyes glaze over: “Further Definition of ‘As a Part of a Regular Business’ in the Definition of Dealer and Government Securities Dealer in Connection with Certain Liquidity Providers.” But regardless of what the SEC calls it, this is a classic example of regulatory creep.

First, a bit of history. The legislation creating the SEC as part of the New Deal gave it responsibility for protecting ordinary investors. The agency exercised this responsibility by forbidding or discouraging funds that took money from the public from charging performance fees, using leverage, taking concentrated positions, short selling, buying illiquid assets, keeping positions or strategies confidential or other techniques considered too risky.

However, the SEC allowed funds to charge high sales loads, and did not limit fees. And it allowed brokers to conspire to keep commissions high, and to kick some of the commissions back to fund managers. As a result, investors in public mutual funds lost money after fees, inflation and taxes until the invention of index funds and money-market funds - both initially opposed by the SEC. Another result was that hedge funds emerged to offer market-beating returns to wealthy investors, outside the rules for public funds. So, in the 21st century the SEC has expanded its regulation of hedge funds.

A world of Debt

The way these things go is that a regulator makes unwise rules, people find ways to avoid the harm of the rule and the regulator then applies the unwise rules to the innovations. It’s partly as a result of this creep that we have seen the rise of proprietary trading firms, or as the SEC refers to them “Certain Liquidity Providers,” and family offices to avoid hedge fund regulation. These entities take no cash from outsiders, investing only their own money.

The SEC cannot regulate proprietary trading funds using its investor protection mandate, so it relies upon its other major task, protecting markets. It has long regulated securities dealers, requiring them to hold large amounts of capital, disclose extensive information and abide by strict rules. The new rule reclassifies some proprietary trading funds as dealers.