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.
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.
A pure dealer buys from customers at a bid price that it sets and sells to customers at a higher ask price. It accumulates long and short inventory from this process. It makes money from the spread between the bid and ask prices but expects to lose a little money on average on its inventory. At the other extreme, a pure investor pays the bid/ask spread but expects to make money from holding its positions.
In practice, there is a continuum between dealers and investors. Dealers will manage and hedge their inventory in various ways, and perhaps bias their prices to steer it in a desired direction. Investors will use strategies to minimize transaction costs, and even to make money by buying securities experiencing selling pressure and selling securities amid buying pressure. The SEC’s justification for the new rule is that some proprietary trading firms and hedge funds have become so aggressive and successful in their trading that they have become de facto dealers.
It's hard to predict the effect of the rule. Perhaps the kind of aggressive trading the SEC has targeted will transition to organizations exempt from the rule, like public mutual funds, international financial firms and small high-frequency trading shops. Or maybe proprietary trading firms and hedge funds can wall off certain trading activities to a registered broker dealer subsidiary, without exposing all their trading to dealer rules. Maybe funds can restructure trading to avoid the rule.
Directionally, however, it’s clear the rule will make providing liquidity more expensive, meaning less market liquidity. The capital and disclosure requirements will make some trading strategies that depend on low or negative transaction costs uneconomic, meaning market prices will be less efficient. The rules will be very expensive for firms to implement, meaning lower returns for investors.
The SEC cites three offsetting advantages. The first is a “level playing field” for dealers. That makes little sense, as dealer profits are not an essential human right to be distributed equally. Registered dealers are complaining that innovators have found cheaper and better ways to sell liquidity, and they want to impose increased costs on those competitors.
The second advantage is more SEC insight into markets. This does make sense, but I’m wary of regulators looking for more information without clear Congressional authorization and a plan to use it. I fear regulators always want to know more, so they can find new things to do. On the other hand, it’s possible the SEC will use the additional information to root out fraud and manipulation, and to improve market efficiency and stability.
Finally, the SEC argues that forcing shadow dealers to hold more capital will stabilize markets, because they will be able to continue offering liquidity after taking losses in chaotic markets. Really? First, many shadow dealers may stop providing liquidity at any time. Second, the increased capital requirements will force dealers to stop dealing after losses. Third, dealers never willingly take losses for the benefit of the market — they tend to shut down losing businesses even if they have enough capital to continue.
On a higher level, this rule is another step in the chronic effort by regulators to extent authority over the entities created to mitigate the harm of past rules. Congress did not give the SEC a mandate to protect traders banded together in proprietary trading funds. The SEC is using its authority over dealers to sneak in the back doors of these entities, which will inevitably create new or modified entities to reduce the cost of regulation. This is regulatory creep that should be resisted, not because this is the worst rule in history, but because it is part of a process toxic to innovation, efficiency and freedom.
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