Prop stop: SEC plan to register prop trading threatens liquidity

Rule change may also be a crypto landgrab by SEC chairman Gensler, critics say

  • The SEC has proposed making non-bank proprietary trading firms register with it as dealers, and with Finra as broker-dealers.
  • The proposal is causing alarm among PTFs and dismay among cryptocurrency market participants, who see the move as a landgrab by chair Gary Gensler.
  • The move would potentially reduce liquidity in equity and fixed income markets – especially US Treasuries – discouraging smaller PTFs in particular from market participation.
  • Most larger PTFs are already registered with the SEC and would be unaffected by the move.

There’s high dudgeon in high-frequency trading circles, where a plan by the Securities and Exchange Commission to make more non-bank proprietary trading firms register as dealers – and with the Financial Industry Regulation Authority (Finra) as broker-dealers – is causing alarm.

The proposal could dampen liquidity in fixed income and equity markets, its critics argue – just as volatility is surging – driving some proprietary trading firms (PTFs) out of the market and deterring new and smaller players from entering. The larger and more active PTFs, such as DRW, Jump and Virtu, meanwhile, are already registered with the SEC and Finra, and will be unaffected.

SEC chairman Gary Gensler argues that registering prop traders will help “level the playing field” among firms and make markets more resilient.

But others say the rules could do the opposite – raising the barriers to entry for market newcomers and reducing incentives for some participants to provide liquidity. Compliance costs of registration are a further concern.

Some also fear the SEC is using its new registration proposal as a Trojan horse in a bid to become the primary US regulator of cryptocurrency trading, by extending its oversight of firms that are actively making markets in digital assets.

If the proposal is adopted in its current form, industry sources say almost every prop shop active in US financial markets – and certainly all significant firms – would have to register with the SEC as a dealer, and with self-regulatory organisation Finra as a broker-dealer, despite many of them having no clients in the traditional sense.

The SEC wants firms to register as dealers if they fit one of three criteria: they control more than $50 million in total assets and routinely make “comparable purchases” of “similar securities”; they routinely act on both sides of a trade, offering quotes at or near best price; or they earn revenues by regularly capturing the spread between the bid and the ask price, or “by capturing incentives offered by trading venues to supply liquidity”.

The proposal applies to all securities trading activity, but the SEC is considering specific guidelines aimed at the US Treasury market, where prop traders have become a dominant force in the past decade.

Any entity – apart from registered investment companies – that engages in trading more than $25 billion in Treasuries in four of the past six months must be registered as a dealer. In 2020, prop traders made up 61% of the trading activity on inter-dealer platforms in the market, according to a Federal Reserve study.

Gary Gensler
Photo: SEC
SEC’s Gensler talks of “levelling the playing field”

Graham Harper, head of public policy and market structure at DRW Holdings, says the market context of rising rates and tapering make the SEC’s stance especially galling.

“As written, this broad proposal is absolutely going to require people to rethink their footprint in the Treasury market. This is particularly concerning right now, given the well-covered concerns around market liquidity coupled with the Fed unwinding their balance sheet and the Treasury issuing record numbers of bonds,” Harper adds.

According to the SEC, 452 registered firms are active in Treasury markets, including all the larger players. Their Treasuries trading won’t be affected by the new rules. However, the SEC believes there are another 174 firms not registered, and their proposed threshold would capture 46 extra firms, of which 22 are principal trading firms and 20 are non-bank dealers.

Although many PTFs are already registered with the SEC and Finra, some avoid booking trades via a registered dealer platform for reasons of capital optimisation. There are practical reasons for prop shops to avoid signing up as dealers, which are subject to stringent net capital requirements that prop traders have so far managed to avoid in the 12 years since the Dodd-Frank legislation banned banks from trading on their own account.

Harper says the suggested rule “is very wide-reaching – it applies to everyone from asset managers to hedge funds, credit unions, proprietary trading firms and insurance companies. If you’re not a registered investment company and you trade in the Treasury market, you should be paying very close attention to this proposal and its implications”.

Joe Schifano, global head of regulatory affairs at trade surveillance technology firm Eventus, says that from “a regulator’s point of view”, the idea of all liquidity providers becoming dealers “makes a ton of sense”.

“I think the mature folks in the market anticipated that this could come some day and they’ll do what they need to do,” to comply with broker-dealer regulations, Schifano adds.

Cost-conscious

But being a broker-dealer is an expensive business.

The SEC proposal puts the cost of registering as a broker at anything from $965,000 to $8,218,000. Once you are up and running, doing all the paperwork will set you back between $503,000 and $5,400,000 per year, depending on the size of the business.

These costs are hardly outlandish for any established financial services business – but for a young hotshot with dreams of building a trading empire, a million dollars represents a sizeable obstacle. A future Ken Griffin, who began low-latency trading out of his Harvard dorm room in the late 1980s, might be deterred by the prospect of a million dollars in compliance costs.

Despite the SEC’s estimates, the reality is that for incumbent firms, the costs are hard to quantify and depend on the firm’s existing level of sophistication. Broker-dealers require complex risk management, capital adequacy and compliance infrastructure that prop traders are not legally obliged to have. They must retain records in case the SEC wants to examine them and must subject themselves to self-regulation by Finra.

The reality is that the major prop shops – such as Citadel Securities, Jane Street and Virtu – have registered broker-dealer platforms as “part of the family”, as Schifano puts it.

Securities and Exchange Commission
Photo: Andriy Blokhin/Alamy Stock Photo
Almost every prop shop active in US financial markets would have to register with the SEC as a dealer

Nevertheless, people from various corners of the market have noted that while being a PTF is a capital-light business, being a Finra-registered broker is more capital-intensive.

If the rule change passes, a banker at a European firm says, prop firms have some tough choices to make. Smaller ones could decide to stop trading certain asset classes.

“Does it result in some different strategies from some of those [PTF] firms? Do they take less risk? Those are the most obvious choices, right?” suggests the European banker. “Are you big enough that you have enough resource to go through with registration or do you pull back and look for other markets and strategies?”

Dealers are also wondering what the dealer definition proposal means for foreign affiliates of broker-dealers. Such entities tend to be overseen by the Commodity Futures Trading Commission (CFTC), rather than by the SEC and Finra, and would not welcome being forced into dual registration with both market regulators for the same activities.

One US market source jokes that it could be a good way to keep out foreign competition. But even so, they are not celebrating. “In my shoes, I should be arguing this is a great idea. ‘Put up more barriers?’ ‘Yes, we should. Excellent.’ But you should also make sure that if you’re going to make a rule, you need to demonstrate a reason for it and how the rule is going to make things better.”

Crypto landgrab

The dealer registration proposal comes in the midst of a turf war among US regulators over how digital assets are policed.

The CFTC is pushing to seize the mantle of top crypto watchdog in the US, and has an ally in the powerful House Agriculture Committee, which has proposed a bipartisan bill to codify the derivatives regulator’s authority over digital assets.

While Wall Street banks have been cautious about investing in crypto assets, the prop trading community has been far more bullish about the asset class, often through new legal entities that are not SEC-registered.

The SEC’s Gensler has already stated he believes cryptocurrencies should be regulated as securities – the SEC’s domain. If he gets his way, anyone trading a portfolio of more than $50 million in crypto assets, who is routinely buying similar tokens, making money through the spreads on two-way pricing, must fall under the SEC’s jurisdiction as well.

“It’s a landgrab by the SEC,” sighs one market source. “That’s the biggest point to be honest.”

This view holds that the proposal is a simple way of giving the SEC far-reaching powers over high-frequency crypto traders.

“He’s imposing marginal damage and capital inefficiency on existing participants in Treasuries and equities, but it’s a huge opportunity for him if crypto is classified as security,” says the source.

Iniquity for equity

There are fears that the dealer registration proposal could also have a negative impact on equity market liquidity.

A prime broker at a global bank says that if the SEC prop trader registration proposal is implemented, it “definitely could impact the amount of liquidity” offered by high-frequency traders.

“It could potentially take some of them out of the equation entirely,” he warns.

A reduction in liquidity provision could widen bid-ask spreads, especially for the most heavily traded securities in the equity market, such as technology stocks, explains the prime broker.

“I look at [prop traders] as providing a valuable service which keeps spreads tight.”

The crucial role played by prop traders in the US equity market became a talking point during the Gamestop saga in early 2021, when a short squeeze pitted retail traders against hedge funds. The furore over the halting of trading in Gamestop and 12 other equities by Robinhood put a spotlight on the way the brokerage firm was selling order flow to Citadel Securities, the most well-known and largest non-bank market-maker.

The SEC proposal explicitly refers to firms triggering dealer registration requirements if they are “capturing incentives offered by trading venues to liquidity-supplying trading interests”.

What is missing in the proposal, says the prime broker, is any indication that the fundamentally different motives of dealers and PTFs have been taken into account. Banks that run broker-dealers tend to offer multiple services – the strategy is to get a client to use your institution to do lots of different things in the hope that you make a profit on a net basis, even if some operations – UK corporate broking being an example – are run as a loss leader.

“Liquidity provision in and of itself is a great, noble thing, but no-one in the PTF world is doing it if they aren’t making money,” the prime broker points out. It’s a different proposition for broker-dealers that don’t need to make all their money on providing liquidity “because of a broader business initiative around it”, he adds.

“The prop trading firms are only going to do things that they make money doing. They’re not doing it for any other reason.”

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