PTFs, as the name implies, invest money for the principals, who then
benefit directly from the trading gains. This is similar to many
registered dealers. Similarly, private fund advisers, including their
affiliates that operate as general partners of private funds, typically
have a compensation arrangement by which they receive a significant
portion of gains (often 20 percent). In both cases, these compensation
arrangements may incentivize aggressive trading.
    Certain hedge funds, on the other hand, may satisfy either the
qualitative or the quantitative standards of the Proposed Rules, or
both. The remainder of this section discusses whether current hedge
fund activity may meet the standards, and describes regulations that
currently apply to registered hedge fund advisers. The qualitative
standards could potentially capture certain hedge fund trading
strategies, such as those that may involve automated or high-frequency
buying and selling of substantially similar securities in the same day.
It is also possible that a large hedge fund could trade sufficient
volumes of U.S. Treasury securities to satisfy the quantitative
standard. The extent to which hedge funds may satisfy these standards
is uncertain. Hedge funds do not report their transactions, so they are
not currently identifiable in CAT data or in TRACE data (beyond the
subset of U.S. Treasury TRACE discussed previously).\228\ Structured
data are not available that would indicate how many hedge funds would
satisfy the qualitative standards, but some hedge fund strategies would
likely do so. We observe at least one hedge fund (number suppressed in
Table 1 above) that surpassed the quantitative standard's threshold of
$25 billion in U.S. Treasuries in July 2021. Additional hedge funds may
meet the quantitative threshold beyond those we observe--for instance,
hedge funds who trade outside of covered ATSs and so only appear in
TRACE anonymously, or hedge funds that trade with other non-FINRA
members (such as banks) and so do not appear in TRACE at all.
---------------------------------------------------------------------------

    \228\ See supra note 169. Regarding CAT data availability, hedge
funds are currently not identifiable because CAT Firm Designated ID
(``FDID'') numbers do not map to broker-dealers' customers. Starting
in July 2022, CAT data will identify broker-dealers' customers,
including hedge funds.
---------------------------------------------------------------------------

    One hedge fund strategy that stands out is the Treasury basis
trade,\229\ as one study estimated that approximately 65 percent of
hedge funds' total Treasury exposure was tied to the basis trade before
March, 2020.\230\ A hedge fund's basis trade is not likely to satisfy
the qualitative standards of the Proposed Rules, because a futures
contract and a Treasury of similar maturity would not qualify as
substantially similar securities since the futures contract is not a
security. Also, since transactions associated with repurchase
agreements would not count toward the Proposed Rules' quantitative
standard, most hedge funds' basis trading would likely not satisfy that
standard. A large-volume

basis trading hedge fund could hypothetically be captured by the
quantitative standard, but a recent study suggests that few, if any,
basis trades involve enough Treasury trading volume to meet the
threshold of $25 billion per month in four out of the past six calendar
months.\231\ In 2019, when the basis trade was more attractive than at
present, the study reported that the aggregate basis trade of the 44
largest participants held a long Treasury position of about $400-$500
billion (an average of only about $9-$11 billion per large basis
trader). Furthermore, the basic strategy of the basis trade involves
holding Treasury securities to the earlier of: (i) Maturity; or (ii) a
time when the basis trade is no longer attractive.
---------------------------------------------------------------------------

    \229\ In a long Treasury basis trade, participants take a long
position in Treasury securities and a short position in Treasury
futures, and then profit from the eventual convergence of cash and
futures prices toward the delivery date. Hedge funds typically post
the Treasury securities as collateral for repo funding.
    \230\ See Barth, Daniel, and R. Jay Kahn, ``Hedge Funds and the
Treasury Cash-Futures Disconnect,'' OFR Working Paper 21-01 (Apr. 1,
2021).
    \231\ See id.
---------------------------------------------------------------------------

    As described above in Section III.A, the Commission is mindful that
registered private fund advisers are currently regulated under the
Advisers Act, and that advisers' requirements under the Advisers Act
affect the activities of private funds. This regulatory regime includes
anti-fraud measures applicable to all advisers and requires that many
private fund advisers register with the Commission. The Advisers Act
establishes reporting and recordkeeping requirements for registered
advisers to private funds for investment protection and systemic risk
purposes. Specifically, Section 204(a) of the Advisers Act requires
registered investment advisers to keep certain books and records
(records of the advised private funds are considered records of the
adviser for these purposes), and Section 206 subjects registered
investment advisers to several anti-fraud provisions, including
antifraud liability with respect to current and prospective clients.
Registered investment advisers also have fiduciary duties, which
comprise a duty of care and a duty of loyalty.\232\ Certain registered
investment advisers must also submit annual and, for certain large
advisers to certain large hedge funds, quarterly reports to the
Commission,\233\ and they are subject to Commission examinations.
---------------------------------------------------------------------------

    \232\ See Commission Interpretation Regarding Standard of
Conduct for Investment Advisers, Investment Advisers Act Release No.
5248 (June 5, 2019) 84 FR 33669 (July 12, 2019), at 24-25.
    \233\ These reports are submitted through Form PF, which was
adopted in 2011 as required by the Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010. Pub. L. 111-203, 124 Stat. 1376
(2010). See Reporting by Investment Advisers to Private Funds and
Certain Commodity Pool Operators and Commodity Trading Advisors on
Form PF, Advisers Act Release No. 3308 (Oct. 31, 2011), 76 FR 71128
(Nov. 16, 2011) at section I.
---------------------------------------------------------------------------

    Differences between the regulatory regime that applies to
registered advisers to private funds and the one that applies to
securities dealers include leverage constraints, and reporting.
Registered dealers' leverage is limited by net capital requirements,
which must be maintained at all times, even intraday, while private
funds have no formal leverage constraints. Private funds also do not
report their securities transactions. Their fixed-income transactions
do not appear in TRACE, or may appear anonymously as part of the
reporting obligation of broker-dealers. Transactions in fixed-income
securities other than municipal securities and U.S. Treasury securities
are reported to TRACE and publicly disseminated (transactions in U.S.
Treasury securities are reported to regulatory TRACE but not publicly
disseminated), so markets have more post-trade transparency with
regards to registered dealers than with regards to private funds.
Private funds' transactions in national market system (``NMS'') stocks,
OTC equities, and listed options already appear in CAT, but some
additional information is only available for firms that report directly
to CAT. For example, currently, when a PTF sends orders to a broker-
dealer, CAT will include the timestamp indicating when the order was
received by the broker-dealer, but not the timestamps indicating when
the order was originated or routed by the PTF. Additionally, if the PTF
originates a larger order and splits it into smaller orders for routing
to the broker-dealer, CAT will only include the smaller orders as they
are received by the broker-dealer, but CAT will not include the larger
order as originated. Regulators may be able to obtain more complete
data on private funds' pre- and post-trade securities trading activity
through examinations, but such information is more readily available
for registered dealers.
c. Number of Affected Parties
    The precise number of affected parties is uncertain, since existing
data does not provide a clear picture of all market participants'
activities. For instance, we do not know how many PTFs routinely
express trading interests that are at or near the best available prices
on both sides of the market. Nevertheless, the discussion in this
section seeks to provide some idea, based on available data, of the
Proposed Rules' scope. First, we provide data on the number of entities
that may satisfy the first qualitative factor by ``routinely making
roughly comparable purchases and sales of the same or substantially
similar securities in a day.'' The analysis requires us to assume a
particular functional form for this qualitative standard, but we do not
mean to imply that the standard would be defined this way in practice.
For the highest-volume U.S. Treasury security in July 2021 (the 10-year
on-the-run note, with 15 percent of total U.S. Treasury volume), we
compute a buy-sell volume imbalance for each firm and for each trading
day as [verbar]B-S[verbar]/(B+S), where B is the firm's daily buy
volume and S is the firm's daily sell volume. A low buy-sell imbalance
indicates purchases and sales in more similar dollar amounts. We then
repeat the analysis for the highest-volume security in equity markets
in October 2021 (the SPDR S&P 500 ETF, or ``SPY'', with 6.1 percent of
the total volume of NMS stocks \234\).
---------------------------------------------------------------------------

    \234\ For SPY volume, we use data from Intraday Indicators
Aggregate Market Liquidity--WRDS. We rely on CBOE statistics for the
total dollar volume of NMS stocks. See U.S. Equities Market Volume
Summary, CBOE, available at https://www.cboe.com/us/equities/market_share/.
---------------------------------------------------------------------------

    For the U.S. Treasury market, Table 3 shows the number of non-FINRA
member firms, by firm type, that had a ``low'' buy-sell volume
imbalance--below 10 percent or, alternatively, below 20 percent--for at
least 14 of the 21 trading days in July 2021. Twenty non-FINRA member
firms had a buy-sell volume imbalance of less than 20 percent in at
least 14 of 21 trading days and 15 non-FINRA member firms had a buy-
sell volume imbalance of less than 10 percent in at least 14 of 21
trading days. All of these firms were PTFs.\235\
---------------------------------------------------------------------------

    \235\ See supra note 218.

  Table 3--Count of Non-FINRA Member Firms by Type for the Treasury CUSIP With the Highest Volume in July 2021
----------------------------------------------------------------------------------------------------------------
                                                                                # Firms with at least 14 of 21
                                                                                days of buy-sell volume
                          Total # firms                              Firm type          imbalance less than
                                                                                -------------------------------
                                                                                10%             20%
----------------------------------------------------------------------------------------------------------------
Asset Manager...................................................               *               0               0
Dealer..........................................................              74               0               0
Hedge Fund......................................................              29               0               0
Other...........................................................               *               0               0
PTF.............................................................              34              15              20
Sum of *s.......................................................               6               0               0
                                                                 -----------------------------------------------
    Total.......................................................             143              15              20
----------------------------------------------------------------------------------------------------------------
Notes: 1. Buy-sell volume imbalance = [verbar]B-S[verbar]/B+S, where B is firm's daily buy volume and S is
  firm's daily sell volume. 2. The Treasury CUSIP with the highest volume in July 2021 is for 10-year on-the-run
  Treasury note. In July 2021, the total volume for this CUSIP was about 15 percent of the total volume for all
  Treasury securities. 3. * Suppressed; at least 1 firm of each type exists in the data (all suppressed numbers
  in the first column are greater than zero).

    A comparison of these 15 or 20 firms with the list of 46 firms (see
Table 1) that had total monthly Treasury-trading volume of more than
$10 billion \236\ in July 2021 revealed considerable overlap between
first qualitative standard and the qualitative standard: 17 of the 20
non-FINRA member PTFs with frequent buy-sell volume imbalance of less
than 20 percent in Table 3 also had monthly volume greater than $10
billion in Table 1; 14 of the 15 non-FINRA member PTFs with frequent
buy-sell volume imbalance of less than 10 percent in Table 3 also had
monthly volume greater than $10 billion in Table 1.
---------------------------------------------------------------------------

    \236\ As discussed above, we believe that the $10 billion
threshold in our analysis, which is limited to the subsection of
TRACE where we can verify traders' identities, corresponds to the
Proposed Rules' quantitative threshold of $25 billion.
---------------------------------------------------------------------------

    The analysis for the equity market relied on CAT data. While PTFs
and private funds do not directly report to CAT, their trades in NMS
stocks, OTC equity securities, and listed options are reported to CAT
by registered broker-dealers with whom they interact as customers
(e.g., by trading through a registered broker-dealer or with a
registered broker-dealer, including with an ATS). Specifically, for the
original receipt or origination of an order, registered broker-dealers
report to CAT the Firm Designated ID (``FDID''), which is then assigned
to various other CAT order events in the order lifecycle. These CAT
FDIDs uniquely identify trading accounts of registered broker-dealers
and can represent firm or customer accounts. Firm trading accounts
include market-making accounts and other proprietary accounts of the
registered broker-dealer. Customer accounts include mainly
institutional customer accounts and individual customer accounts, but
they also include customer average-price accounts and employee accounts
where an employee of the registered broker-dealer is exercising
discretion over multiple customer accounts.
    Because the activity of all market participants is captured in CAT
FDID customer accounts and because the Proposed Rules do not cover
persons with total assets of less than $50 million, in our analysis of
SPY we focused on CAT FDID institutional customer accounts.
Specifically, we computed buy-sell dollar volume imbalance for each CAT
FDID institutional customer account and each trading day in October
2021. As in our analysis of Treasuries, we defined buy-sell volume
imbalance as [verbar]B-S[verbar]/(B+S), where B is the firm's daily buy
volume and S is the firm's daily sell volume. We also computed the
total (i.e., buy plus sell) dollar volume in SPY for each CAT FDID
institutional customer account and each trading day in October 2021.
    Table 4 shows the number of CAT FDID institutional customer
accounts that had both (i) a ``low'' buy-sell dollar volume imbalance
in SPY and (ii) total buy plus sell dollar volume in SPY above a de
minimis threshold, in at least 14 of 21 trading days in October 2021.
We again define ``low'' to mean less than 10 percent or less than 20
percent. We include the de minimis threshold to remove small entities
that are the most likely to be excluded from the Proposed Rules for
having less than $50 million in assets.\237\ Table 4 shows results for
two alternate de minimis thresholds: $10,000 per day or $100,000 per
day. In addition to the number of CAT FDID institutional customer
accounts that satisfied these criteria, Table 4 also shows the combined
dollar volume of these accounts as percent of total SPY dollar volume
in October 2021.
---------------------------------------------------------------------------

    \237\ We did not discuss a de minimis threshold in the previous
analysis for the U.S. Treasury market (see supra Table 3), because
imposing a volume threshold even as high as $1 million did not
affect the count of firms that had low-imbalance and above de
minimis trading on each of 14 out of 21 days.

 Table 4--Number of CAT FDID Institutional Customer Accounts With at Least 14 of 21 Trading Days in October 2021
           With the Specified Buy-Sell Dollar Volume Imbalance and Buy Plus Sell Dollar Volume in SPY
----------------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------
Buy-sell dollar volume imbalance less than......             10%             20%             10%             20%
                                                 ---------------------------------------------------------------
                                                                                AND
                                                 ---------------------------------------------------------------
Total buy plus sell dollar volume more than.....         $10,000         $10,000        $100,000        $100,000
# CAT FDID institutional customer accounts......              44              61              41              57

Combined dollar volume of these accounts as                  3.3             6.3             3.3             6.3
 percent of total SPY dollar volume in October
 2021...........................................
----------------------------------------------------------------------------------------------------------------
Notes: 1. Buy-sell volume imbalance = [verbar]B-S[verbar]/B+S, where B is firm's daily buy volume and S is
  firm's daily sell volume. 2. There were a total of 21,115 CAT FDID institutional customer accounts that traded
  SPY in October 2021. A CAT FDID ``institutional customer account'' is an institutional account as defined in
  FINRA rule 4512I. See supra note [26] for further details.

    The results in Table 4 indicate that between 41 and 61 CAT FDID
institutional customer accounts (depending on the thresholds used) had
both low buy-sell dollar volume imbalance in SPY and above de minimis
total dollar volume in SPY in at least 14 of 21 trading days in October
2021, and the combined dollar volume of these accounts represented
between 3.3 percent and 6.3 percent of total SPY dollar volume in
October 2021. If the entities behind these accounts are not excluded or
otherwise exempted, such trading activity could satisfy the qualitative
standard of ``routinely making roughly comparable purchases and sales
of the same or substantially similar securities in a day.''
    The precise number of affected parties is highly uncertain, due to
several shortcomings. The U.S. Treasury market analysis has the
following caveats. First, we only analyze the buy-sell imbalance within
a single CUSIP, though firms could potentially satisfy the standard
based on other CUSIPs or on a combination of CUSIPs (the qualitative
standard includes trading in either the ``same'' or ``substantially
similar'' securities). Second, we do not observe the universe of U.S.
Treasury trading. Third, this analysis imposes quantitative cutoffs in
place of the qualitative standard, which is ``roughly comparable
purchases and sales.'' Due to the first two shortcomings, the actual
number of parties affected by this qualitative standard may be higher
than the 15 or 20 firms we estimate here. The third shortcoming
introduces additional uncertainty, since we do not know whether the
cutoffs assumed in the analysis--buy-sell imbalance less than 10
percent or 20 percent in at least 14 of 21 trading days--would align
with the qualitative standard in all cases.
    There are also caveats to the equity market analysis, as follows.
First, there is currently no one-to-one correspondence between CAT FDID
accounts and firms (although such information will be available
starting in July 2022). Some market participants may have several CAT
FDID institutional customer accounts, and some CAT FDID institutional
customer accounts may represent more than one customer. Therefore, the
number of CAT FDID institutional customer accounts that satisfy various
thresholds in Table 4 does not necessarily equal the number of market
participants that would satisfy the qualitative standard of ``routinely
making roughly comparable purchases and sales of the same or
substantially similar securities in a day.'' Furthermore, some of the
CAT FDID institutional customer accounts that satisfy various
thresholds in Table 4 may represent investments companies registered
under the Investment Act, which are excluded from the Proposed Rules.
    Despite these caveats, we believe that the results in Tables 3 and
4 provide useful indications about the scope of the Proposed Rules in
the markets for U.S. Treasury securities and NMS stocks.
3. Externalities
    When market participants who effectively provide liquidity do not
comply with existing dealer regulations, including rules specifically
designed to limit risk-taking and to deter manipulative or fraudulent
behavior, the probability of behaviors that are financially risky,
manipulative, or fraudulent increases. As described below, such
behavior on the part of one firm may create negatively externalities on
other firms. Although all liquidity providers are subject to Exchange
Act Section 17(a), Section 10(b), and 17 CFR 240.10b-10 (Rule 10b-10
thereunder), liquidity providers that are not registered as dealers
currently have more regulatory allowance to accept operational or
financial risk. For example, net capital requirements limit the
leverage that dealers are allowed to take on, while PTFs and private
funds have no regulatory leverage constraints. We estimate that
qualifying hedge funds are more leveraged than registered dealers. As
of the second quarter of 2021, registered investment advisers reported
that qualifying hedge funds had $1.4 trillion in assets that could be
liquidated within a day, $3.4 trillion in assets that could be
liquidated within a year, and $3.6 trillion in secured debts, so that
qualifying hedge funds' aggregate secured debt obligations appear much
higher than their aggregate liquid assets.\238\ In contrast, the Net
Capital Rule requires dealers to have highly liquid assets in excess of
unsubordinated debt.\239\ We are unable to estimate PTFs' leverage due
to data limitations. PTFs and private funds also may not have the same
obligations as dealers to implement operational risk controls.\240\ In
addition, PTFs are not subject to any examination or reporting
requirements, and neither PTFs nor private funds are required to report
securities transactions.
---------------------------------------------------------------------------

    \238\ Using data from ``Private Fund Statistics'' (see supra
note 228), we estimate qualifying hedge funds' net capitalization as
highly liquid assets minus secured debt. Dollar values of liquid
assets are from Table 49 (portfolio liquidity for qualifying hedge
funds as a percent of aggregate net asset value) and Table 4 (net
asset value), and the value of secured debt is from Table 51
(borrowings of qualifying hedge funds).
    \239\ See supra notes 76 and 205.
    \240\ See supra note 206 and accompanying text.
---------------------------------------------------------------------------

    Even though all market participants face incentives to remain
solvent and profitable, certain market participants may not bear all
the costs of their failure. Therefore, they may not have sufficient
incentive to ensure their ability to weather adverse shocks. When
entities have leverage, for example, creditors may bear some of the
costs of failure. As another example, entities that perform a
significant share of liquidity provision may disrupt market trading if
they fail, thus imposing costs on other entities.
    These incentives, or lack of incentives, create externalities that
market forces alone cannot resolve. A market participant who is unable
to meet its obligations may harm its creditors, other financial
institutions related to its creditors, its trading counterparties, and
other participants in securities markets including investors. Although
creditors can seek to estimate a borrower's probability of failure and
price the credit extension accordingly, large losses can potentially
propagate through the financial system--especially when indirect
exposures are not well understood and financial firms misread their
total exposure. Instability in securities markets may appear when a
failed liquidity provider exits the market or when a stressed liquidity
provider temporarily reduces its

activity, thereby reducing market liquidity for all traders until other
liquidity providers can fill the gap. During the U.S. Treasury market
volatility in March 2020, PTFs (most of whom are not registered as
dealers) appeared to especially pull back from market-making activity,
possibly because ``their lower capitalization relative to dealers may
[have left] them with less capacity to absorb adverse shocks.'' \241\
Other research also shows that, in equity markets, the presence of
high-frequency traders can further reduce market liquidity during
periods of extreme volatility (high frequency is one of the primary
features of PTF activity, according to the 2015 Joint Staff
Report).\242\ Instability may also appear when a struggling market
participant rapidly exits a large position in one or more securities,
leading to volume and price spikes that can quickly push market prices
away from fundamental values and can overwhelm exchanges and clearing
houses. The associated volatility may heighten the inventory and
operational risks of market participants throughout the securities
markets. The failure of a large market participant can potentially
propagate instability across securities markets if the failed entity
actively trades many different asset classes simultaneously.
---------------------------------------------------------------------------

    \241\ See 2021 IAWG Joint Staff Report at 13. Initially, PTFs
increased trading activity, but they pulled back from market making
several days later when volatility reached very high levels. (``In
the first week of March, a large share of the increased trading
volume came from PTFs, and on March 9, PTFs' share of trading on
electronic IDB platforms was just over 60 percent, a typical level.
But as heavy net investor sales continued, the balance of activity
in the interdealer market shifted . . . PTFs' total share of
activity fell to a low of 45 percent on March 16. Dealers' total
volumes on electronic IDB platforms also declined, but less sharply
than PTFs' volumes.'')
    \242\ See Brogaard, Jonathan, Allen Carrion, Thibaut Moyaert,
Ryan Riordan, Andriy Shkilko, Konstantin Sokolov, 2018, High
Frequency Trading and Extreme Price Movements, Journal of Financial
Economics 128(2), 253-265.
---------------------------------------------------------------------------

    As discussed above, the Commission and the SROs have established
rules designed to address the externalities related to financial
stress, by promoting registered dealers' financially responsibility and
operational capability. Specifically, the rules seek to minimize the
disruptions that can occur from losses related to operational risk. One
risk is that a firm may not be able to find offsetting trades, and so
accumulates an unexpectedly large position that must be rapidly
liquidated at a loss. Another risk is that errors in trading algorithms
or other systems (including human errors) lead to an unexpectedly large
position that must be rapidly liquidated at a loss.\243\ Since, as
discussed above, losses on the part of one market participant can harm
others, dealer regulations are designed to mitigate the magnitude of
these externalities and to reduce the probability that they occur at
all. However, these regulations do not currently apply to market
participants that are not registered as dealers. We do not have
sufficient oversight to understand what risk-management controls PTFs
may have in place, how much leverage they use, or how liquid their
assets are. Private funds' risk-taking may be constrained by their
advisers' fiduciary duties, but, as described above, we believe that
the average hedge fund is more leveraged than the Net Capital Rule
would allow (although we acknowledge the uncertainty around our
estimate).
---------------------------------------------------------------------------

    \243\ In 2012, an algorithm error at a single trader temporarily
affected the prices of 150 stock tickers, causing some to increase
or decrease more than 30 percent versus the day's opening. See
Knight Capital Americas LLC, Exchange Act Release No. 70694 (Oct.
16, 2013) (settled matter). Another firm, after a change in code and
in routing logic, erroneously allowed millions of orders with a
notional value of approximately $116 billion to be sent between 2010
and 2014. Latour Trading LLC, Exchange Act Release No. 76029 (Sept.
30, 2015) (settled matter).
---------------------------------------------------------------------------

    The potential for market manipulation or fraud constitutes other
negative externalities, since such behavior may distort market prices
or give the perpetrator unfair advantages over other market
participants. Several elements of the dealer regulatory regime address
these risks, but some important elements do not currently apply to
market participants that are not registered as dealers, including
financial reporting, examinations, and other regulations that
facilitate examinations. Financial statement reporting, transaction
reporting (to TRACE \244\ or CAT \245\), and examinations help the
Commission detect manipulation or fraud and determine whether firms are
in compliance with applicable regulations. Books and records
requirements facilitate examinations by ensuring that data entries are
defined, recorded, and preserved in a consistent manger across all
dealers. PTFs do not submit financial reports to regulators or report
their transactions, are not subject to examinations, and have no
regulatory books and records guidelines. Private funds also do not
report transactions to TRACE or directly to CAT, but registered private
fund advisers are subject to regular reporting requirements \246\ and
to books and records rules. In addition, the Commission has examination
authority with respect to registered private fund advisers.
---------------------------------------------------------------------------

    \244\ Registered dealers report their transactions in fixed-
income securities (other than municipal bonds) to TRACE.
Unregistered traders' fixed-income transactions only appear in TRACE
in two cases: (i) When they trade with a FINRA member, the FINRA
member reports the transaction to TRACE but keeps the counterparty
anonymous; or (ii) when they trade government securities on an ATS
that is a FINRA member, the ATS reports the transaction to TRACE
along with the identity of the counterparties.
    \245\ As discussed above, CAT also includes the transactions of
firms that are not registered as dealers, but certain other
information is only available for firms that report directly to CAT.
    \246\ See supra note 233 and accompanying text.
---------------------------------------------------------------------------

    Private information that market participants who are not registered
as dealers do not report to regulators also creates an impediment to
regulators' ability to study markets in a structured way, to detect and
respond to market events, or to inform investors. For regulators, the
gap between what information registered dealers report and what
information other market participants report varies by type of
participant, but may include annual or quarterly reporting, and
transactions reports. For investors, the gap consists of transactions
reports for fixed-income securities other than U.S. Treasury and
municipal securities, which reports are made publicly available. As
discussed previously, large private fund advisers file regular reports
to the Commission on Form PF, and the Commission also has authority to
examine private fund advisers. However, private funds do not report
their securities transactions to TRACE. Private funds' fixed-income
transactions may appear in TRACE with the private fund identified, if
the trade occurs on certain ATSs; the transactions may appear in TRACE
with the private fund anonymous, if the trade occurs outside certain
ATSs but with another FINRA member firm; or the transactions may not
appear in TRACE at all if the private fund trades with a non-FINRA
member firm. PTFs do submit financial reports to regulators, do not
report transactions, and are not subject to examinations, so regulators
have very little insight into their activities. Private funds also do
not report their securities transactions directly to CAT. As discussed
previously, their trades in NMS stocks, OTC equities, and listed
options are indirectly reported to CAT by other counterparties, but CAT
does not contain certain other information on firms who do not report
directly.
    Information limitations in the market for U.S. Treasury securities
became especially apparent during the instability of March 2020. The
IAWG noted in its 2021 IAWG Joint Staff Report on November 8, 2021,
that ``In March 2020 . . . there was a [particular]

need for timely information on the positions and transactions of
institutions other than dealers.'' \247\ Wider TRACE reporting would
have provided more of such information. Similar information limitations
exist in the markets for other fixed-income securities. Unregistered
market participants' transactions in NMS stocks, OTC equities, and
listed options are reported to CAT by other (registered) parties, but
their identities in the data remain anonymous and some pre-trade data
are not reported at all--e.g., time stamps and indications that a large
order has been broken into several smaller orders. Investors who rely
on publicly disseminated TRACE also are impacted by the unreported or
the anonymity of important market participants' trading activities.
---------------------------------------------------------------------------

    \247\ See supra note 5.
---------------------------------------------------------------------------

4. Competition Among Liquidity Providers
    An analysis of the cash U.S. Treasury market for July 2021 \248\
finds that liquidity provision in the market is reasonably
competitive.\249\ Table 5 below categorizes firms as potential
liquidity providers in three ways and displays two measures of market
concentration. In column 1, potential liquidity providers include only
dealers. In column 2, the list of liquidity providers also includes
PTFs. In column 3, the list of liquidity providers further includes
hedge funds.\250\ The first measure of concentration displayed in each
column is the volume share of the 5 highest-volume firms. The second
concentration measure is the Herfindahl-Hirschman index (HHI), which is
equal to the sum of squared market shares. An index of 1 would indicate
a completely concentrated market with a single liquidity provider. The
inverse of the HHI provides some intuition by giving the number of
equally sized competitors that would lead to such a HHI. For example, a
market with 5 equally sized competitors would have a HHI of \1/5\ or
0.2. The first column of Table 5 shows that 500 dealers were active in
the U.S. Treasury market in July, 2021, and that the 5 highest-volume
of these accounted for 43 percent of the group's total volume. The HHI
of liquidity provision in this column is 0.054, or comparable to the
competitive environment that would exist if there were 18 equally sized
liquidity providers. If we also consider PTFs (limited to the PTFs that
we can identify in TRACE) to be liquidity providers (column 2), then
545 liquidity providers were active in July 2021 and the 5 highest-
volume firms accounted for 34 percent of the group's total. The HHI in
this case is 0.04, which is comparable to the competitive environment
that would exist among 25 equally sized firms. If we further consider
hedge funds (again, limited to the hedge funds that we can identify in
TRACE) to be liquidity providers (column 3), then 586 liquidity
providers were active in the U.S. Treasury market in July, 2021, and
the 5 highest-volume firms accounted for one-third of the group's total
volume. In this third column, the HHI is 0.039, which is comparable to
the competitive environment that would exist among 26 equally sized
firms. The minimal difference between the numbers in row 2, columns 2-
3, does not suggest that hedge funds do not provide significant
liquidity in the U.S. Treasury market. The minimal difference only
means that the hedge funds that we can identify in TRACE do not appear
to provide significant liquidity in the U.S. Treasury market.
---------------------------------------------------------------------------

    \248\ See supra notes 217, 218, and 219, and accompanying text.
    \249\ A Federal Reserve analysis from 2020 finds that activity
on electronic interdealer platforms is slightly more concentrated,
with an HHI of 0.082. See supra note 2.
    \250\ Firms are classified based on an understanding of the
individual firms' businesses. See supra note 218.

                Table 5--Competition Among Liquidity Providers in the Treasury Market, July 2021
                             [The largest 5 firms in this table overall are dealers]
----------------------------------------------------------------------------------------------------------------
                                                                                Liquidity
                                                                     Liquidity       Liquidity      providers:
                                                                    providers:      providers:       dealers +
                                                                      dealers        dealers +     PTFs + hedge
                                                                                PTFs            funds
----------------------------------------------------------------------------------------------------------------
No. of liquidity providers......................................             500             545             586
Share of entire TRACE Sample....................................           52.1%           68.7%           69.4%
Top-5 volume share (within group)...............................           42.6%           33.6%           33.3%
HHI.............................................................           0.054           0.040           0.039
comparable to N equal-size competitors..........................              18              25              26
----------------------------------------------------------------------------------------------------------------

    The Commission also understands that a large number of firms
provide liquidity provision in the markets for corporate bonds and for
equities (not necessarily the same firms), and that intermediation
activity is reasonably competitive in both markets. Research has
documented that, as of the first quarter of 2020, about 600 dealers
intermediated in the market for corporate bonds, but that the top 10
dealers controlled approximately 70 percent of the volume.\251\ Another
analysis by the Commission \252\ found that of the 3,972 broker-dealers
that filed Form X-17a-5 (FOCUS report) in 2016, 430 of them were also
members of U.S. equities exchanges, and that the largest 20 broker-
dealers controlled approximately 75 percent of the total assets of all
broker-dealers.
---------------------------------------------------------------------------

    \251\ O'Hara, Maureen, and Alex Zhou, Anatomy of a Liquidity
Crisis: Corporate Bonds in the Covid-19 Liquidity Crisis, May 2020,
working paper.
    \252\ Transaction Fee Pilot for NMS Stocks, Exchange Act Release
No. 82873 (Mar. 14, 2018), 83 FR 13008 (Mar. 26, 2018).
---------------------------------------------------------------------------

    The current competitive landscape among liquidity providers is also
shaped by the difference in regulatory treatment between registered
dealers and unregistered market participants that the Commission
believes perform dealer-like roles in the markets. The additional
requirements to which registered dealers are subject may result in
higher compliance for registered dealers, which could incentivize less-
regulated firms such as PTFs to gain market share, or to continue to
gain market share, from more-regulated dealers. These dynamics may
especially apply to the electronic interdealer segment of the Treasury
market, where PTFs now account for a majority of trading activity (as
of 2019).\253\
---------------------------------------------------------------------------

    \253\ See supra note 2.

---------------------------------------------------------------------------

C. Economic Effects, Including Impact on Efficiency, Competition, and
Capital Formation

    As described above in Section II, the Commission believes that the
Proposed Rules would support the stability and transparency of U.S.
Treasury and other securities markets by closing the regulatory gap
that currently exists and ensuring consistent regulatory oversight of
persons engaging in the type of activities described in the Proposed
Rules. As described in Section II, the Commission believes that the
Proposed Rules would support the stability and transparency of U.S.
Treasury and other securities markets by closing the regulatory gap
that currently exists and ensuring consistent regulatory oversight of
persons engaging in the type of activities described in the Proposed
Rules. Specifically, the rules would result in increasing the share of
liquidity provision undertaken by persons who are subject to dealer
rules related to financial risk-taking, reporting, deceptive practices,
and examinations. As discussed above, these benefits would all be
associated with PTFs registering as dealers, but private funds'
potential dealer registration would also bring benefits related to net
capital requirements and transaction reporting. If registered private
fund advisers were to register as dealers, the benefits of transaction
reporting would apply, but the marginal benefits of other reporting
requirements, net capital requirements, books and records rules, and
examinations might be very small, since the regulatory regime that
applies to registered private fund advisers already contains similar
provisions to the rules that apply to dealers.
    Costs of the Proposed Rules include registration and membership
fees, costs of record-keeping and reporting, and costs associated with
net capital requirements. Additionally, the Proposed Rules may
influence patterns of market participation, which may in turn affect
competition among liquidity providers, market efficiency, and capital
formation.
1. Benefits
    The Proposed Rules seek to mitigate the externalities, discussed in
the baseline, that may arise when market participants who effectively
provide liquidity experience financial stress, engage in manipulative
or fraudulent behavior, or whose operations are not subject to
regulatory oversight. To the extent that unregistered market
participants engage in activities that satisfy the qualitative or
quantitative standards of the Proposed Rules, requiring them to
register as dealers would promote stability in U.S. securities markets
and would help protect investors. Specifically, the Proposed Rules
would bring liquidity providers that are not registered as dealers into
compliance with dealer regulations related to financial risk-taking,
reporting, and examinations. As previously discussed, we believe that
PTFs would be the most affected parties, though potentially some
private funds may be affected. Registered private fund advisers may
also be affected under limited circumstances.
    Regulations on Financial Risk-Taking: Registered dealers are
subject to net capital requirements (Exchange Act Rule 15c3-1) and to
various risk management rules that promote operational integrity.\254\
Unregistered PTFs and private funds do not have net capital
requirements, and they may not have the same risk-management
requirements. The Net Capital Rule requires dealers to maintain
sufficient liquid resources to meet all liabilities at all times,\255\
thus limiting their probability of financial failure by constraining
leverage and creating incentives against excessive risk-taking,\256\
and also helping protect creditors. These provisions help reduce the
externalities related to defaults and disorderly trading, which may
arise due to firms' financial stress. As discussed in Section III, the
Proposed Rules would require registration of persons whose trading
activity contributes significantly to market liquidity or to price
discovery. Such persons have the ability to significantly impact the
markets, so placing these regulatory safeguards around their risk-
taking would benefit investors and support capital formation by
promoting stable markets. These benefits would be largest for PTFs and
private funds, who are currently under no regulations related to risk-
taking, but they could also apply to registered private fund
advisers.\257\
---------------------------------------------------------------------------

    \254\ See supra notes 205 and 206 and accompanying text.
    \255\ See supra note 76.
    \256\ See also Capital, Margin, and Segregation Requirements for
Security-Based Swap Dealers and Major Security-Based Swap
Participants and Capital and Segregation Requirements for Broker-
Dealers, Exchange Act Release No. 86175 (June 21, 2019), 84 FR 43872
(Aug. 22, 2019).
    \257\ Registered private fund advisers are currently regulated
in their capacity as advisers, and the current adviser regulation
contains provisions related to financial risk-taking. However, the
Proposed Rules could also apply to advisers that trade with their
own proprietary capital. The adviser's proprietary trading is not
currently regulated, so the benefits of registering such an adviser
would be comparable to the full benefit of registering a PTF.
---------------------------------------------------------------------------

    Regulations on Reporting: Registered dealers must file annual
reports with the Commission that include audited financial
statements.\258\ They also report their transactions of NMS stocks, OTC
equities, and listed options directly to CAT,\259\ and registered
dealers who have selected FINRA as their SRO report their transactions
in fixed-income securities (other than municipal securities) to
TRACE.\260\ Unregistered PTFs do not report any of this information to
regulators. Private fund advisers report certain information on the
private funds they manage to the Commission annually (and, for certain
large advisers of certain large hedge funds, each quarter), but they do
not report transactions.
---------------------------------------------------------------------------

    \258\ See supra note 77.
    \259\ Unregistered market participants' transactions in NMS
stocks, OTC equities, and listed options are reported to CAT by
other (registered) parties, but, as described above, certain
information is only available for entities that report directly to
CAT.
    \260\ Unregistered market participants' transactions in U.S.
Treasury securities may appear in TRACE under certain conditions,
but they usually appear with the unregistered counterparty's
identity kept anonymous. See supra note 217.
---------------------------------------------------------------------------

    Reporting requirements, particularly requirements to report
transactions directly, enable regulators to conduct market research
that informs their efforts to detect or respond to market events, to
inform investors, to ensure that dealers' activities are in compliance
with regulation, and research has also shown that transaction reporting
can improve market efficiency and liquidity.\261\ Transaction reporting
in general enhances the ability of the Commission and SROs to more
efficiently and in a more timely manner monitor trading, which should
further enhance the ability of the Commission and SRO staff to
effectively enforce SRO rules and the Federal securities laws, rules,
and regulations.\262\ This enhanced ability of the Commission and SROs
staff to enforce the Federal securities laws, rules, and regulations
should help ensure the efficiency and stability of the markets, and
promote investor confidence in the fairness of the securities markets,
which may in turn promote capital formation.\263\ TRACE for fixed-
income securities other than municipal securities and U.S. Treasury

securities are made publicly available to investors, so this
transaction reporting to non-regulatory TRACE particularly informs
investors. The absence of reporting requirements for consequential
market participants thus creates negative externalities for investors.
The Proposed Rules are designed to target persons whose activities can
significantly impact markets or who otherwise trade large volumes of
U.S. Treasuries Securities; requiring such persons to further inform
regulators of their activities further promotes market stability,
investor protection, and capital formation. To the extent that
registered dealers were to select an SRO other than FINRA, the benefits
related to fixed-income transaction reporting would not appear.\264\
---------------------------------------------------------------------------

    \261\ See Bessembinder, Hendrik, William Maxwell, and Kumar
Venkataraman, 2006, ``Market Transparency, Liquidity Externalities,
and Institutional Trading Costs in Corporate Bonds,'' Journal of
Financial Economics 82(2), 251-288; and Edwards, Amy K., Lawrence E.
Harris, and Michael S. Piwowar, 2007, ``Corporate Bond Market
Transaction Costs and Transparency,'' The Journal of Finance 62(3),
1421-1451.
    \262\ See Consolidated Audit Trail, Exchange Act Release No.
62174 (May 26, 2010), 75 FR 32556 (June 8, 2010).
    \263\ Id.
    \264\ See supra note 77.
---------------------------------------------------------------------------

    Regulations on Deceptive Practices: Registered dealers are subject
to the anti-manipulation and antifraud provisions of Sections 10(b) and
17(a) of the Exchange Act, but they are also subject to the specific
anti-manipulative and other anti-fraud rules promulgated under Section
15(c) of the Exchange Act.\265\ Neither unregistered PTFs nor private
funds are subject to Section 15(c)(1) and related rules, but registered
private fund advisers are subject to antifraud provisions under Section
206 of the Advisers Act. The persons whom the Proposed Rules would
require to register would be those with the ability to significantly
impact markets, including by manipulation or fraud. Therefore,
subjecting them (particularly the PTFs) to the anti-fraud rules that
apply to registered dealers, would contribute to fair and orderly
markets and to investor protection.
---------------------------------------------------------------------------

    \265\ See supra note 80.
---------------------------------------------------------------------------

    Regulations related to Examinations: Registered dealers are subject
to examinations by the Commission and by the relevant SRO, and they are
also required to comply with certain books and records
requirements.\266\ PTFs that are not registered as dealers are not
subject to examinations or to books and records rules, but the
Commission has examination authority with respect to private fund
advisers, and registered private fund advisers are subject to
recordkeeping requirements. Examinations help regulators detect
manipulative or fraudulent activities, as well as verify more generally
that persons are in compliance with all relevant regulations. Books and
records requirements facilitate examinations by ensuring that data
entries are defined, recorded, and preserved in a consistent manner
across all dealers. The Proposed Rules would allow regulators to
examine firms that currently are not registered, including PTFs, who
are not currently subject to examinations, but whose activity
contributes significantly to market liquidity or to price discovery.
Therefore, since examinations help ensure compliance with other rules,
this benefit of the Proposed Rules supports all the other benefits
discussed above.
---------------------------------------------------------------------------

    \266\ See supra note 79.
---------------------------------------------------------------------------

    Some entities who would satisfy the Proposed Rules' qualitative or
quantitative standards might nevertheless avoid the registration
requirement by exiting a liquidity-providing strategy. If unregistered
entities were to exit and bid-ask spreads were to meaningfully widen,
other (registered) dealers might step in to replace the lost activity.
This scenario would result in an effective transfer of dealer activity
from unregistered market participants to registered dealers, and so
would preserve the benefits (and costs) of the Proposed Rules.
2. Costs Associated With Becoming a Registered Dealer
    The Proposed Rules would impose costs on certain market
participants, including costs of registering with the Commission and
with an SRO, recordkeeping and reporting costs, direct costs that may
stem from meeting net capital requirements (i.e., continuously
monitoring capitalization), and self-evaluation as to whether one is a
dealer or not.\267\
---------------------------------------------------------------------------

    \267\ Registered dealers would be subject to requirements, such
as Exchange Act Rule 15c3-1 and 17 CFR 240.17a-1, 240.17a-3,
240.17a-4, and 240.17-a5 (Exchange Act Rules 17a-1, 17a-3, 17a-4,
and 17-a5).
---------------------------------------------------------------------------

    The initial registration costs would include the costs associated
with filing Form BD and Form ID, SRO membership application fees, and
any related legal or consulting costs that may be needed to (e.g.,
ensure compliance with rules), including drafting policies and
procedures as may be required. The ongoing costs would include the
costs associated with amending Form BD, ongoing fees associated with
SRO membership, and any legal work relating to SRO membership.
    The Commission estimates compliance costs of approximately $600,000
initially and $265,000 annually thereafter to register as a broker-
dealer with the Commission, become a member of an SRO, and comply with
the associated dealer regulations.\268\ The costs include personnel
hours, outside legal services, building and maintaining books and
records systems, obtaining or maintaining employee licensure, and
direct costs associated with calculating net capital to comply with the
Net Capital Rule. The compliance costs associated with net capital,
reporting, and recordkeeping requirements would depend on the business
structure of a registered dealer (i.e., the capital structure of a
dealer and the scope of a dealer's activities).\269\ For example, these
costs may be lower for private funds, since their advisers are already
subject to requirements concerning books and records, examinations, and
internal control systems. In general, the costs would also vary
significantly depending on the types of securities a broker-dealer
holds, the level of net capital a broker-dealer maintains, and whether
a broker-dealer carries customer accounts, carries for other broker-
dealers, is a registered investment adviser, is affiliated with an
investment adviser, or transacts in a principal capacity.\270\
---------------------------------------------------------------------------

    \268\ Exchange Act Release No. 76324 (Oct. 30, 2015), 80 FR
71388, 71509 (Nov. 16, 2015) (``Regulation Crowdfunding Adopting
Release'') estimates the costs of registering as a dealer, becoming
a member of a national securities association, and complying with
the associated regulation would be approximately $520,000 initially
and $230,000 annually thereafter. Most of these costs involve
personnel hours and legal services (currently, the direct costs of
FINRA registration range between $7,500 and $60,000). Since the cost
of legal services and nominal wages paid to administrative and
financial operations employees have approximately risen with the
consumer price index since 2015, we adjust these estimates for
inflation of 15.33 percent between October 2015 and September 2021,
based on the Consumer Price Index for All Urban Consumers (CPI-U) as
recorded by the Bureau of Labor Statistics. See Consumer Price
Index, U.S. Bureau of Labor Statistics, available at https://www.bls.gov/cpi/data.htm. We therefore estimate the costs to be
approximately $600,000 initially and $265,000 annually thereafter.
We recognize that these costs may vary significantly across
registrants, depending on facts and circumstances.
    \269\ 2022 ATS Proposing Release at 15629.
    \270\ Id.
---------------------------------------------------------------------------

    For dealers that select an SRO other than FINRA (i.e., an
exchange), we believe that the initial and ongoing costs would be less
than $600,000 initially and less than $265,000 annually thereafter.
Dealers that select FINRA as their SRO would incur the costs of
reporting their fixed-income transactions (other than municipal
securities) to TRACE.\271\ Dealers that

trade NMS stocks, OTC equities, or listed options would incur the costs
of reporting their transactions in these securities to CAT.\272\ As
discussed in the CAT Notice and in the CAT Approval Order, the costs of
CAT reporting may vary significantly across broker-dealer firms
depending on the size and scope of their activities (e.g., the number
of CAT-reportable order events that the firm has and whether the firm
needs to report customer information).\273\ In these releases, the
Commission estimated that the one-time implementation costs related to
CAT reporting could range from $849,000 for small firms that did not
previously report to the Order Audit Trail System (OATS) to $7,231,000
for many large firms.\274\ The Commission also estimated that the
ongoing annual costs of CAT reporting could range from $443,000 for
small firms to $4,756,000 for many large firms.\275\ We adopt these
estimates and adjust them for inflation between November 2016 and
September 2021.\276\ This adjustment yields a per-firm cost estimate of
approximately $965,000 to $8,218,000 for one-time implementation plus
ongoing costs of approximately $503,000 to $5,405,000 annually.
---------------------------------------------------------------------------

    \271\ TRACE fees include system fees of between $20 and $260 per
month plus transaction reporting fees, which are one of: (i) $0.475
per trade for trades with par value up to $200,000, (ii) $2.375 per
million dollars par value for trades with par value more than
$200,000 but less than $1 million, or (iii) $2.375 per trade for
trades with par value of at least $1 million or $1.50 per trade for
agency pass-through MBS that are traded TBA or SBA-backed ABS that
are traded TBA. See FINRA Rule 7730 (Trade Reporting and Compliance
Engine), available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/7730.
    \272\ See Joint Industry Plan; Order Approving the National
Market System Plan Governing the Consolidated Audit Trail, Exchange
Act Release No. 79318 (Nov. 15, 2016), 81 FR 84696 (Nov. 23, 2016)
(``CAT Approval Order''). See also See Joint Industry Plan; Notice
of Filing of a National Market System Plan Regarding Consolidated
Equity Market Data, Exchange Act Release No. 77724 (Apr. 27, 2016),
81 FR 30614 (May 17, 2016) (``CAT Notice'').
    \273\ See CAT Notice, 81 FR 30712-30726 and CAT Approval Order,
81 FR 84857-84862.
    \274\ See CAT Notice, 81 FR 30725-30726 and CAT Approval Order,
81 FR 84861-84862. The Commission also estimated that small firms
that previously reported to OATS would incur lower one-time
implementation costs related to CAT reporting--$424,000. However, we
believe that this lower estimate for related implementation costs is
not applicable to firms that would be covered by the Proposed Rules,
because firms that would be required to register as dealers and
start reporting to CAT as a result of the Proposed Rules are
unlikely to have prior experience of reporting to OATS.
    \275\ See id.
    \276\ The estimates are adjusted for an inflation rate of 13.66
percent based on the Bureau of Labor Statistics data on CPI-U
between November 2016 and September 2021. See supra note 268.
---------------------------------------------------------------------------

    The wide range of these estimates indicates significant uncertainty
about the costs related to CAT reporting that individual firms that
trade equities or options may have to incur if they are required to
register as dealers as a result of the Proposed Rules. We make two
related observations. First, firms that would start reporting to CAT as
a result of the Proposed Rules are likely to have a relatively large
number of CAT-reportable order events, since the Proposed Rules are
targeting significant liquidity-providers. Therefore, for these firms,
the costs of CAT reporting are likely to be higher than the lower
bounds of $965,000 for implementation costs and $503,000 for ongoing
annual costs.\277\ Second, firms that would be required to report to
CAT as a result of the Proposed Rules do not carry customer accounts
and would therefore not need to report any customer information to CAT.
Thus, for these firms, the costs of CAT reporting are likely to be
lower than the upper bounds of $8,218,000 for implementation costs and
$5,405,000 for ongoing annual costs.\278\
---------------------------------------------------------------------------

    \277\ It is also possible that a firm would satisfy the
quantitative or the qualitative standards of the Proposed Rules by
transacting in asset other than those that are reported to CAT. Such
a firm would still be required to register as a dealer and report
any transactions it may have in NMS stocks, OTC equities, and listed
options. However, such a firm could have a relatively low number of
CAT-reportable order events and hence relatively low costs of CAT
reporting.
    \278\ In the CAT Approval Order, the Commission discussed its
belief that the requirement of the CAT NMS Plan to report customer
information represents a significant source of CAT reporting costs.
See CAT Approval Order, 81 FR 84868-84869. Furthermore, in the CAT
Notice, the Commission estimated CAT reporting costs for 14
electronic liquidity providers (``ELPs''), which are large
registered broker-dealers that do not carry customer accounts and
are not FINRA members. See CAT Notice, 81 FR 30724-30726. The
Commission estimated that for these ELPs the one-time implementation
costs related to CAT reporting would be $3,876,000 and the annual
ongoing costs of CAT reporting would be $3,226,000. When adjusted to
inflation between November 2016 and September 2021 (see supra note
265), these estimates become approximately $4,405,000 for the one-
time implementation costs and approximately $3,667,000 for the
annual ongoing costs of CAT reporting. Because the ELPs do not carry
customer accounts and operate as liquidity providers in the markets
for equities and options, their estimated costs of CAT reporting may
be applicable to some of the larger firms that would be required to
report to CAT as a result of the Proposed Rules.
---------------------------------------------------------------------------

    The Commission recognizes that the costs associated with obtaining
and maintaining SRO membership and reporting transactions may vary
significantly depending on entity characteristics, activity
characteristics, and the degree of the firm's reliance on outside legal
or consulting advice. For example, the costs of FINRA membership \279\
depend on, among other things, the number of associated persons being
registered, the scope of brokerage activities, revenue,\280\ the number
of registered persons, the number of branch offices, and trading
volume. TRACE and CAT reporting costs also vary depending on security
type, order size, and trading venue, among other factors. Entities with
a smaller number of registered persons, fewer brokerage activities,
smaller trading volume, and smaller revenue would face lower direct
costs.
---------------------------------------------------------------------------

    \279\ See Schedule of Registration and Exam Fees, FINRA,
available at https://www.finra.org/registration-exams-ce/classic-crd/fee-schedule#examfees, for the schedule of FINRA registration
fees.
    \280\ FINRA imposes a Gross Income Assessment as follows: (1)
$1,200 on a Member Firm's annual gross revenue up to $1 million; (2)
a charge of 0.1215 percent on a Member Firm's annual gross revenue
between $1 million and $25 million; (3) a charge of 0.2599 percent
on a Member Firm's annual gross revenue between $25 million and $50
million; (4) a charge of 0.0518 percent on a Member Firm's annual
gross revenue between $50 million and $100 million; (5) a charge of
0.0365 percent on a Member Firm's annual gross revenue between $100
million and $5 billion; (6) a charge of 0.0397 percent on a Member
Firm's annual gross revenue between $5 and $25 billion; and (7) a
charge of 0.0855 percent on a Member Firm's annual gross revenue
greater than $25 billion. When a firm's annual gross revenue exceeds
$25 million, the maximum of the current year's revenue and average
of the last three years' revenue is used as the basis for the income
assessment. See also Regulatory Notice 09-68: SEC Approves Changes
to the Personnel Assessment and Gross Income Assessment Fees, FINRA
(effective Jan. 1, 2010), available at https://www.finra.org/rules-guidance/notices/09-68.
---------------------------------------------------------------------------

    In addition to the monitoring costs incurred to comply with the Net
Capital Rule, described above, newly registered dealers who previously
held less capital than what is required would have to increase their
capitalization either by raising equity or by scaling back trading
activities. However, since higher levels of net capital reduce a firm's
probability of default, these direct costs of net capital requirements
may be partially offset by reductions in the firm's cost of capital.
    Market participants may also incur costs related to self-evaluation
regarding whether the qualitative standards describe their activities.
Since the quantitative standard is based on monthly Treasury-trading
volume, which is easy to define and measure, we do not believe any
market participants would incur additional costs to assess whether this
standard would require them to register.
    Some currently unregistered market participants may be affiliated
with other firms that are currently registered dealers, and in such
cases, the unregistered firm may seek to avoid the direct costs
described above by shifting trading volume to its affiliated dealer.
Other entities that are captured by the Proposed Rules may restructure
their legal organization to isolate the activity that triggered the
rules into a separate entity. Such activity shifting and legal
reorganizations may incur costs, such as the costs of changing computer
systems or paying attorney fees. To the extent that the securities-
dealing activity ends

up being conducted by an entity that registers with the Commission, all
the benefits of Proposed Rules still apply.
    In response to a related initiative in 2010,\281\ at least one PTF
expressed its opinion to the Commission that the costs of PTF
registration are not justified because equity markets worked well
during the autumn of 2008 (then the most-recent financial crisis) and
because the PTF believed that PTFs in general help market integrity by
providing liquidity during difficult situations.\282\ However, the 2021
IAWG Joint Staff Report showed that, during the U.S. Treasury market
volatility of March 2021, PTFs' share of market intermediation fell
considerably more than did dealers' share.\283\ These results suggest
that PTFs may not, or may no longer, promote market stability in all
securities markets in ways that registered dealers do not. Accordingly,
we believe that the benefits of registering PTFs who are also
significant market participants justify the costs.
---------------------------------------------------------------------------

    \281\ See 2010 Equity Market Structure Concept Release.
    \282\ See Letter from Berkowitz, Trager & Trager, LLC (Apr. 21,
2010).
    \283\ See supra note 241 for further discussion of changes in
trading activity of PTFs during the U.S. Treasury market volatility
of March 2020.
---------------------------------------------------------------------------

    PTFs, since they do not have clients or customers, would bear the
costs of registration themselves. Private funds, however, may either
bear the costs themselves or the costs may be borne by their investment
adviser. If the funds bear the costs, these costs would be passed on to
the funds' investors.
3. Other Effects, Including Impact on Efficiency, Competition, and
Capital Formation
    The Proposed Rules may produce several indirect benefits or costs,
based on the extent to which they encourage or discourage participation
in securities markets. The Proposed Rules could either increase or
decrease market participation due to three possible effects. First,
fairer and more stable markets could encourage greater market
participation. Second, registration and compliance costs could lead
some currently unregistered liquidity providers to decrease their
activity or even exit the market. If they do so, other firms may or may
not increase their own activity to compensate. Third, large-volume and
small-volume market participants may choose to differentially increase
or decrease their market participation, so that the Proposed Rules may
affect market concentration. Changes in patterns of market
participation could affect market efficiency, market competition, and
capital formation.
a. Effects on Efficiency
    The Proposed Rules could affect market efficiency--i.e., price
discovery, or the speed with which new information or developments
impact the market price of a security--depending on whether the net
effect on market participation is positive or negative. Other things
equal, markets with greater participation are more liquid. The net
effect on market efficiency is uncertain. On the one hand, improved
investor confidence might lead to greater market participation that
improves market efficiency for two reasons. First, new market
participants may have additional information, in which case the orders
they submit based on this information would aid price discovery.
Second, higher trading volumes would mean that prices would react
faster to changes in securities' fundamental values.
    On the other hand, if important and informed market participants,
such as PTFs or hedge funds, permanently reduce their market activity
or their pursuit of certain investment strategies, market efficiency
may decline in the markets for some securities.
b. Effects on Competition
    The net effect that the Proposed Rules may have on competition is
uncertain. On the one hand, the Proposed Rules would promote
competition by standardizing the regulatory treatment of--i.e.,
leveling the playing field for--all firms engaged in the activities
that meet the proposed standards described above.\284\ For instance,
the Proposed Rules would require all firms that conduct these
activities to incur the costs of complying with the same rules
regarding registration, net capital requirements, books and records,
and other requirements; whereas currently, only those who are
registered bear these costs.
---------------------------------------------------------------------------

    \284\ Although the analysis discussed in the baseline showed
that registered dealers have much greater market share in the U.S.
Treasury market (see supra Table 1 and note 217), PTFs are the
largest participants in the automated interdealer Treasury market
(see supra note 2).
---------------------------------------------------------------------------

    On the other hand, other effects on competition among liquidity
providers \285\ depend on the extent to which the rules encourage or
discourage market participation by affected parties. The indirect
benefits to all market participants--particularly the additional risk-
mitigating provisions and the Commission's increased ability to detect
manipulation or fraud--may encourage some market participants to
increase their liquidity-providing activities. However, the direct
costs that the Proposed Rules would impose on currently unregistered
firms who currently engage in covered activities may cause them to
scale back these activities.\286\ For example, if a hedge fund strategy
were to fall under the Proposed Rules, the fund engaged in that
activity might exit the strategy altogether in order to avoid
registration. Some research on high-frequency trading has shown that
firms engaged in this activity improve competition across trading
venues, by arbitraging cross-venue differences in security prices,\287\
which suggests that their withdrawal may have a negative impact on
competition. Furthermore, in response to a similar initiative in 2010,
commenters stated that registering PTFs as dealers would negatively
impact competition among liquidity providers by creating barriers to
entry.\288\
---------------------------------------------------------------------------

    \285\ As previously described, the qualitative standards of the
Proposed Rules apply to persons whose activities have ``the effect
of providing liquidity.'' See Section III.B.
    \286\ See also Capital, Margin, and Segregation Requirements for
Security-Based Swap Dealers and Major Security-Based Swap
Participants and Capital Requirements for Broker-Dealers, Exchange
Act Release No. 68071 (Oct. 18, 2012), 77 FR 70213 (Nov. 23 2012).
    \287\ See supra note 216.
    \288\ See Letter from Alston Trading, LLC, RGM Advisors, LLC,
Hudson River Trading, LLC, and Quantlab Financial, LLC (Apr. 23,
2010).
---------------------------------------------------------------------------

    Any net effect on competition would likely be small because, as
discussed in the baseline for competition above (including Table 5 for
the U.S. Treasury market), we understand that liquidity provision in
securities markets is reasonably competitive even among currently
registered dealers. The precise magnitude of the effect in competition
is also uncertain, and would depend on whether the benefits would
accrue more to currently registered dealers with large or with small
volumes and on whether the costs are more burdensome to currently
unregistered firms with large or with small volumes. We believe the
benefits would apply to all market participants alike. The quantitative
factor in proposed Rule 3a44-2 would apply only to firms with Treasury-
trading volume above the threshold. However, the qualitative factors
may also apply to small-volume firms, and some costs may be greater for
these firms on two points. First, FINRA's Gross Income Assessment \289\
generally declines as a percentage of revenue for larger firms. Second,
fees associated with reporting to TRACE \290\ are smaller per dollar
par value for larger trades.
---------------------------------------------------------------------------

    \289\ See supra note 280.
    \290\ See supra note 271.

---------------------------------------------------------------------------

c. Effects on Capital Formation
    The Proposed Rules' effect on capital formation may depend on any
net change in market participation (aggregate trading volume) that
results from the rules, and on any decrease or increase in competition
among liquidity providers. Other things equal, higher volumes and more
competition improve liquidity. In turn, greater liquidity increases
asset prices, reduces borrowing costs, and promotes capital formation.
    The likely effect on aggregate market participation is uncertain.
On the one hand, we believe the increased regulatory burdens would fall
on relatively few firms while the benefits of fairer and more stable
markets would extend broadly to all market participants--since the
baseline risk of an institution's failure would also propagate broadly
by reducing market liquidity, increasing price volatility, or imposing
losses on creditors. In the U.S. Treasury market, for example, we
estimate that no more than 46 firms have dollar trading volumes that
surpass the $25 billion threshold in the quantitative standard of
proposed Rule 3a44-2, as discussed in the baseline. The actual number
of affected firms may be lower, since some of these 46 may be exempt
financial institutions,\291\ and still others may be affiliated with
other firms that are dealers, in which case the corporate parent could
potentially avoid the costs of the rule by shifting certain activities
to the registered dealer affiliate.
---------------------------------------------------------------------------

    \291\ See supra notes 9 and 29.
---------------------------------------------------------------------------

    On the other hand, the Proposed Rules may cause some market
participants to scale back or exit certain liquidity-providing
strategies in order to avoid registration; or, even if they do not,
compliance costs including net capital requirements might lead them to
scale back some activities. If such reductions in liquidity provision
occur, we cannot be certain that other market participants would arise
to replace the lost liquidity. Even if other participants do eventually
arise, lost liquidity can lead to mispricing in the short run.
    Changes in aggregate trading volume may also affect market
liquidity in other ways. If the Proposed Rules increase investors'
confidence in the stability and fairness of markets, they may increase
their participation. Increased trading volume theoretically enhances
market liquidity because of the following two ways in which high volume
benefits dealers.\292\ First, dealers who trade a lot can spread their
fixed costs over more trades. Second, dealers' risk is smaller when
high volume makes it easier to adjust or lay off net positions. These
benefits make liquidity provision more profitable, which results in
narrower bid-ask spreads if dealers compete with one another for
orders.
---------------------------------------------------------------------------

    \292\ See Larry Harris, ``Trading and Exchanges: Market
Microstructure for Practitioners,'' Oxford University Press, 2003.
---------------------------------------------------------------------------

    Effects on market competition can also influence market liquidity.
If the Proposed Rules enhance competition, bid-ask spreads may
decrease; if the Proposed Rules weaken competition, bid-ask spreads may
increase. As discussed above, the net effect that the Proposed Rules
would have on competition is uncertain.

D. Reasonable Alternatives

    The Commission considered several alternatives to the Proposed
Rules: (1) Raise or lower the quantitative factor; (2) replace
qualitative standards with quantitative standards; (3) remove the
exclusion for registered investment companies; (4) remove the exclusion
from aggregation for registered investment adviser client accounts
where the advisers only have investment discretion; (5) exclude
registered investment advisers; (6) exclude private funds; and (7)
require private funds and private fund advisers to report transactions.
1. Alternative Thresholds for the Quantitative Factor
    The quantitative factor would require registration of all entities
with monthly trading volume above $25 billion during four out of the
past six calendar months. A threshold lower than $25 billion would
increase the costs of the Proposed Rules (by requiring many more
entities to register as dealers), but would only somewhat increase the
benefits (since additional registrants would not represent very much
aggregate trading volume). A threshold higher than $25 billion would
decrease both the benefits and the costs of the Proposed Rules (by
requiring registration of fewer firms but failing to capture a
significant portion of aggregate trading volume).
    Figure 2 shows the wide range of alternative thresholds that the
Commission considered in an analysis \293\ of U.S. Treasury-market
transactions reported to TRACE during July 2021.\294\ As described in
the baseline, since the subset of TRACE data where we can verify the
identity of the traders (``identified TRACE'') is approximately 42
percent of all non-FINRA members' transactions in TRACE (many non-FINRA
members only appear anonymously, also as described above), we believe
that the thresholds in Figure 2 (based on identified TRACE) are
approximately 42 percent of the equivalent threshold in the overall
U.S. Treasury market. Therefore, the threshold of $10 billion in Figure
2 corresponds with the Proposed Rules' quantitative threshold of $25
billion.\295\ Within identified TRACE, this figure shows the percentage
of firms (dashed line) and the percentage of volume that would be
captured by various quantitative thresholds. A threshold of $10 billion
would capture 26 percent of the firms and 96 percent of the volume in
the identified TRACE data. Larger thresholds include many fewer firms
but also considerably less trading volume--e.g., moving from a
threshold of $10 billion to $50 billion would capture 32 fewer firms
(18 percent of the 174 firms in the analysis) but also 15 percent less
of the aggregate non-FINRA member trading volume in TRACE. Smaller
thresholds include more firms but not very much additional volume--
moving from a threshold of $10 billion to $5 billion would capture 8
more firms (5 percent of the 174 firms in the analysis) but only 1
percent more of the aggregate non-FINRA member trading volume in TRACE.
The threshold that maximizes the Proposed Rule's benefits (by including
firms responsible for a large percentage of trading volume) while
minimizing costs (by limiting the number of firms that will be required
to register) appears to be somewhere around $10 billion.
---------------------------------------------------------------------------

    \293\ See supra note 217 and accompanying text.
    \294\ The analysis also back-tested the thresholds to July 2019
and found that the results based on July 2021 data are qualitatively
representative.
    \295\ We assume that all entities in identified TRACE are
proportionally represented in the anonymous TRACE data. If firms
engaging in dealer activities are overrepresented in identified
TRACE, then the Proposed Rules' quantitative threshold of $25
billion would correspond to a threshold in Figure 2 of higher than
$10 billion.

---------------------------------------------------------------------------

[GRAPHIC] [TIFF OMITTED] TP18AP22.037

2. Provide Only Quantitative Factors
    The Proposed Rules list several factors that will guide the
Commission in determining whether securities market participants are
dealers. With the exception of paragraph (a)(4) in proposed Rule 3a44-
2--dollar volume of cash Treasury trading--all factors are qualitative.
Alternatively, the Commission could replace the qualitative factors
with quantitative ``bright-line'' thresholds, above or below which
firms would be required to register as dealers. Particularly, the first
qualitative factor (``routinely mak[es] roughly comparable purchases
and sales of the same or substantially similar securities in a day'')
could express a range of buy-sell balance, and firms could be required
to register if their securities-trading activity features a buy-sell
balance within that range.
    The alternative rule could define buy-sell balance as the absolute
value of (buy-sell)/(buy + sell), so that the measure would always fall
between 0 (as when buy = sell) and 1 (as when a firm only buys or only
sells). The buy-sell balance could then be calculated each day for each
individual security (CUSIP), for each market participant. Any market
participant with a buy-sell balance for a security that is below a
quantitative threshold for a certain number of days per month could be
required to register as a government securities dealer or as a dealer.
For example, a firm whose buy-sell balance for CUSIP 78462F103 (SPDR
S&P 500 ETF) that is below 0.2 for 13 days in a month could be required
to register as a dealer, regardless of its buy-sell balance in other
securities. The Proposed Rules could also have a de minimis cutoff, so
that no market participant that trades less than, say, $1 million per
month could be required to register. The de minimis could help ensure
that small, individual investors would not be required to register.
    Table 6 below shows the number of market participants who would be
required to register under a few iterations of this alternative rule,
based on the buy-sell balance of the highest-volume securities in the
U.S. Treasury market (10-yr on-the-run note) and the equity market
(SPDR S&P 00 ETF). The first row of data show that, if the rule were
based on having a buy-sell balance of less than 0.2 (a 60-40 split or
more even) for at least 14 days in a month, with a daily de minimis
threshold of $10,000, then the firms behind 61 CAT FDID institutional
customer accounts would have to register as dealers based on their
trading of SPY, and 20 firms (not necessarily the same ones) would have
to register as government securities dealers based on their trading of
the 10-yr on-the-run Treasury note. It is possible that additional
firms would meet the proposed dealer definition based on their trading
of other securities, but the securities in Table 6 are by far the
largest in their respective classes (equities and Treasuries).

                 Table 6--Number of Market Participants Satisfying Quantitative Buy-Sell Balance
----------------------------------------------------------------------------------------------------------------
                                                                                10-yr note (on-the-
     De minimis volume  (applied daily)      (buy-sell)/(buy + sell)           SPY                  run)
----------------------------------------------------------------------------------------------------------------
$10,000....................................                     <0.2                    61                    20
                                                                <0.1                    44                    15
$100,000...................................                     <0.2                    57                    20

                                                                <0.1                    41                    15
----------------------------------------------------------------------------------------------------------------
This table shows the number of firms that would be required to register based on the buy-sell balance of their
  trades of SPY (SPDR S&P 500 ETF, the highest-volume equity security) or the 10-yr on-the-run Treasury note
  (the highest-volume Treasury security). Specifically, the rule would require registration of firms with a buy-
  sell balance below a certain threshold for either of these securities, for 14 days in a month. The firms that
  satisfy the buy-sell balance factor based on SPY (column 1) are not necessarily the same as those that satisfy
  the factor based on the 10-yr note (column 2). Equity data is for October 2021, and market participants are
  identified by CAT FDID institutional customer accounts. CAT FDID institutional customer account is not
  synonymous with firm; a firm may have multiple CAT FDIDs, and multiple firms may also share a single CAT FDID.
  Furthermore, some of the CAT FDID customer accounts may represent investment companies registered under the
  Investment Company Act, which are not covered by the Proposed Rules. Treasury data is for July 2021.

    We considered including ``similar securities'' in rule text and
interpreting ``similar securities'' as including different CUSIPs that
share similar characteristics--e.g., same issuer or same maturity.
However, such an approach may be too broad, and may include a wide
variety of arbitrage strategies or relative value strategies. For
example, firms may trade securities with the same issuer and similar
maturity when they arbitrage between on-the-run Treasuries against off-
the-run Treasuries, or they may trade securities of similar issuers and
similar characteristics when they take a long position in one company's
equity offset by a short position in a close competitor. Since we do
not view such strategies as descriptive of being a dealer, this
alternative to the Proposed Rules defines the buy-sell balance within
CUSIP only.
    Using quantitative factors instead of qualitative factors could
provide firms with additional certainty as to whether they should
register as dealers. However, we believe that a rule that relies solely
on quantitative factors would be less capable of distinguishing firms
that are liquidity providers from those that are not because at present
we do not have a reliable quantitative framework for defining liquidity
provision. Therefore, this alternative would likely require
registration of some firms that are not liquidity providers or market-
makers, thus burdening these firms with all of the registration costs
described above without doing much to enhance market stability or
improve regulators' insight into market activity (since such firms do
not play central market roles); and the alternative may also miss some
firms that do provide liquidity, thus allowing them to continue
operating without registering, as in the baseline.
3. Remove Exclusion for Registered Investment Companies
    The Proposed Rules explicitly exclude registered investment
companies. An alternative would be to remove this exclusion, as it is
possible that these entities might satisfy the criteria and,
collectively or individually, might be important liquidity providers in
securities markets. Requiring them to register as dealers might further
standardize the books and records practices of market liquidity
providers and, to the extent that registered investment companies were
to choose FINRA as their SRO, their registration might contribute
toward the completeness of fixed-income transaction reporting in TRACE.
For non-municipal securities, additional TRACE reporting would enhance
market stability by supporting regulators' ability to research,
understand, and respond to market events; for non-government and non-
municipal securities, additional TRACE reporting would also better
inform investors. If, instead of registering as dealer, registered
investment companies were to cease the activities that satisfy the
Proposed Rules' standards, these benefits would not materialize.
    This alternative would also lead to significant costs and
uncertainty. Registered investment companies have different business
models and serve different market purposes than PTFs or hedge funds,
and the regulatory regime that has evolved around liquidity providers
might be inadequate or inappropriate for registered investment
companies. As one example, it is unclear how registered investment
companies would comply with net capital requirements, or how they would
define net capital. Moreover, the benefits of the proposals as applied
to registered investment companies would be significantly lower than
for PTFs because registered investment companies are subject to an
extensive regulatory framework based on the Investment Company Act and
associated rules.\296\
---------------------------------------------------------------------------

    \296\ See supra notes 104-114 and accompanying text.
---------------------------------------------------------------------------

    We believe that affected parties will not have sufficient
incentives to evade the proposal by registering as a registered
investment company, because the requirements to be a registered
investment company are sufficiently similar to the proposal. For
example, registered investment companies must be securities issuers,
they are significantly constrained in their ability to borrow, and they
are subject to limitations on their derivatives positions. We
understand that leverage and derivatives are integral parts of the
types of trading strategies that would satisfy the Proposed Rules'
standards. Moreover, registered investment companies are required to
disclose details regarding their portfolio holdings. We acknowledge
that the costs and benefits of applying the Proposed Rules to
registered investment companies may differ from applying them to other
market participants, and we request comment on the costs and benefits
of excluding registered investment companies.
4. Remove the Exclusion From Aggregation for Registered Investment
Adviser Client Accounts Where the Advisers Only Have Investment
Discretion
    A registered investment adviser may have client accounts (including
private funds and separately managed accounts) that are not registered
as dealers but whose activity individually or collectively satisfies
the Proposed Rules' activity standards. The Proposed Rules would not
attribute the activities of those accounts to the registered investment
adviser if the adviser's control over the accounts simply involves
investment discretion. The Proposed Rules would require the registered
investment adviser to aggregate client accounts if it exercises certain
control rights over the accounts (voting rights, capital contributions,
or rights to amounts upon dissolution).\297\ Alternatively, the rule
could require registered investment advisers to

aggregate client accounts over which the adviser only has investment
discretion, so that all advisers would need to aggregate all of their
(non-dealer) discretionary accounts in order to determine whether their
activities fall under the Proposed Rules.
---------------------------------------------------------------------------

    \297\ See text in proposed Rules 3a5-4(b)(2)(ii)(B) and 3a44-
2(b)(2)(ii)(B).
---------------------------------------------------------------------------

    This alternative would strengthen the benefits described above by
applying more broadly the leverage constraints and transaction
reporting requirements of the dealer regulations. If advisers or their
funds were to avoid registration by reducing or ceasing certain trading
activities, the marginal benefits of this alternative could still
materialize if registered dealers then increased their own activities
to compensate. This alternative would further promote market stability
by ensuring that liquidity-providing activities are conducted by
entities that maintain minimum levels of net capital. The alternative
would result in a greater number of liquidity-providing transactions
being directly reported to TRACE (to the extent that new dealer
registrants choose FINRA as their SRO) or to CAT, which would enhance
market stability by supporting regulators' ability to research,
understand, and respond to market events. For non-government and non-
municipal fixed-income securities, additional TRACE reporting would
also better inform investors since FINRA disseminates those data
publicly. The benefits of TRACE reporting would not appear for new
dealer registrants choosing another SRO, such as a stock exchange.
    However, this alternative would also carry disadvantages, including
greater regulatory costs and possible negative effects on market
liquidity, efficiency, and competition. Regulatory costs, including
those associated with registration, reporting, and maintaining net
capital, would increase for any new dealer registrants, but self-
assessment costs would also increase for advisers that must continually
determine their obligations under the Proposed Rules. If advisers or
their accounts were to avoid registration by reducing or ceasing
certain trading activities, and if registered dealers did not then
increase their own activities to compensate, then market efficiency and
liquidity may decline. Also, aggregating all discretionary accounts for
the purposes of determining an adviser's obligations under the Proposed
Rules may reduce efficiency by creating incentives against economies of
scale associated with large advisers. Finally, competition among
liquidity providers may decline, but we believe that liquidity
provision in U.S. security markets would remain reasonably competitive.
    Relative to the Proposed Rules, this alternative would primarily
apply dealer regulations to smaller private funds or separately managed
accounts (via their advisers), since larger funds and their advisers
are more likely to be covered under the Proposed Rules. These benefits
of new leverage constraints and additional transaction reporting would
be small for such funds, while the funds would still bear all the
registration and compliance costs described above. Therefore, we
believe the additional benefits of this alternative would not justify
the additional costs.
5. Exclude Registered Investment Advisers
    The Proposed Rules do not aggregate registered investment advisers'
client accounts (including private funds or separately managed
accounts) and attribute their activity to the adviser, as long as the
adviser's control over the accounts is limited to investment
discretion. Accounts over which the adviser's control rights include
voting rights, capital contributions, or the rights to amounts upon
dissolution would be aggregated and attributed to the adviser in
determining whether the Proposed Rules would require the adviser to
register as a dealer.\298\ Registered investment advisers can also
trigger application of the Proposed Rules due to their own proprietary
trading. Alternatively, the Commission could propose an exclusion for
all registered investment advisers.
---------------------------------------------------------------------------

    \298\ See text in proposed Rules 3a5-4(b)(2)(ii)(B) and 3a44-
2(b)(2)(ii)(B).
---------------------------------------------------------------------------

    The additional exclusion would reduce the benefits described above,
since it would limit the Proposed Rules' ability to raise the share of
liquidity provision conducted by firms that are subject to the dealer
rule. The Proposed Rule would do so by: (i) Inducing additional
liquidity providers to register as dealers; or (ii) inducing liquidity
providers who do not wish to register as dealers to cease their
liquidity-providing strategies. If registered investment advisers
categorically were excluded, it is likely that fewer of them would
register and that fewer of them would register client accounts in order
to avoid aggregating those accounts' activities. Although registered
advisers would still be subject to the existing regulations described
above, including conduct rules, books and records requirements,
reporting requirements, and examinations, their exclusion would
undermine the Proposed Rules' benefits related to net capital
requirements and to transaction reporting.
    This alternative would also reduce the costs, since fewer entities
would be subject to the dealer regime and fewer entities would be
induced to exit certain trading strategies in order to avoid the dealer
regime. The potential negative effects on market liquidity, efficiency,
and competition would therefore be smaller under this alternative.
    However, a blanket exclusion may exclude, now or in the future, a
large adviser whose client accounts, if aggregated, would meet the
standards of the Proposed Rules and provide significant liquidity in
the securities markets. Also, we are concerned that this alternative
rule might lead a PTF to seek to register as an investment adviser
rather than as a dealer, in order to escape the requirements to report
transactions and maintain net capital. The regulations that apply to
registered investment companies place greater restrictions on leverage
and derivatives positions than do the regulations that apply to
registered investment advisers, so it would be unlikely that PTFs would
seek to register as investment companies. Due to the way in which this
alternative compromises the Proposed Rules' benefits related to net
capital requirements and transaction reporting, and due also to the
possibility for regulatory arbitrage, we believe the benefits of this
alternative do not justify the costs.
6. Exclude Private Funds
    The Proposed Rules do not exclude private funds, since we believe
some private funds--particularly some hedge funds--engage in activities
that have the effect of providing liquidity in securities market. The
Commission could explicitly exclude private funds in order to avoid
deterring certain fund strategies that may not be indicative of
securities dealing. This exclusion would potentially reduce some of the
benefits that would accrue if the Proposed Rules were to capture
liquidity-providing activities--either because funds who satisfy the
qualitative or quantitative standards register, or else because funds
who satisfy the standards exit certain strategies to avoid registration
and other (registered) dealers then arise to replace the lost activity.
Excluding private funds would also reduce the costs of lost liquidity
and reduced market efficiency that could materialize if affected
private funds exit certain strategies without being replaced.
    However, the Commission believes that some private funds
effectively provide liquidity in securities markets, and the Proposed
Rules' intent is to

apply dealer regulation to these activities. Excluding these funds
would guarantee that the dealer regime would fail to capture this type
of securities dealing activity. Furthermore, a blanket exclusion for
hedge funds may provide an opportunity for regulatory arbitrage. For
example, PTFs may seek to restructure themselves as private funds, thus
preempting the intended benefits of the Proposed Rules. This may be
particularly true given the similarity in incentive structures
mentioned above.
    Despite the high degree of uncertainty around private funds and the
possible negative effects of requiring some private funds to register
as dealers, the Commission believes that not excluding them is more
likely to meet the Proposed Rules' objectives than excluding them. We
therefore believe the costs of excluding private funds are justified by
the potential benefits.
7. Transaction Reporting Regime for Private Funds and Private Fund
Advisers
    As described above, private funds and private fund advisers not
registered as dealers are not subject to the requirement to report
transactions to TRACE. Alternatively, the Commission could require
private funds or private fund advisers who meet the rule's activity
standards to report to TRACE, without requiring them to comply with the
other aspects of dealer regulations. However, this alternative would
not require private funds or private fund advisers to comply with net
capital requirements, or with the operational risk-management
provisions of the dealer regime. Therefore, this alternative would fail
to address all of the potential for negative externalities that may
stem from market participants' financial stress, as discussed in the
baseline. It would also entail greater complexity in the need to
specify how alternative entities would become subject to TRACE
reporting.
    This alternative would reduce key benefits of the proposal, but it
would also reduce some of the costs related to registration, compliance
with requirements other than transaction reporting to TRACE, and self-
evaluation. We do not believe the reduced costs justify the reduced
benefits.

E. Requests for Comment

    The Commission requests comment on all aspects of this initial
economic analysis, including whether the analysis has: (1) Identified
all benefits and costs, including all effects on efficiency,
competition, and capital formation; (2) given due consideration to each
benefit and cost, including each effect on efficiency, competition, and
capital formation; and (3) identified and considered reasonable
alternatives to the proposed new rules and rule amendments. We request
and encourage any interested person to submit comments regarding the
Proposed Rules, our analysis of the potential effects of the Proposed
Rules and proposed amendments, and other matters that may have an
effect on the Proposed Rules. We request that commenters identify
sources of data and information as well as provide data and information
to assist us in analyzing the economic consequences of the Proposed
Rules and proposed amendments. We also are interested in comments on
the qualitative benefits and costs we have identified and any benefits
and costs we may have overlooked. In addition to our general request
for comments on the economic analysis associated with the Proposed
Rules and proposed amendments, we request specific comment on certain
aspects of the proposal:
Baseline
    57. Are firms that are not registered as dealers or as government
securities dealers important participants in securities market? If so,
in which markets and in what ways? Do commenters agree that such firms
have emerged as de facto liquidity providers?
    58. The quantitative factor in proposed Rule 3a44-2 would identify
as government securities dealers persons that trade more than $25
billion of Treasury securities monthly, during four out of the past six
calendar months. Do you agree that approximately 46 firms would be
government securities dealers based on this standard? Responses should
provide empirical support, if possible.
    59. One of the rules' qualitative factors would identify as dealers
and government securities dealers persons that ``routinely [make]
roughly comparable purchases and sales of the same or substantially
similar securities in a day.'' Approximately how many firms would be
dealers or government securities dealers based on this factor?
Responses should provide empirical support, if possible.
    60. Do you agree that PTFs have emerged as de facto liquidity
providers in the market for U.S. Treasury securities? To what extent do
PTFs also provide liquidity in other securities markets?
    61. Do you agree with the Commission's description of the potential
market disruptions that may follow the failure of one or more market
participants that are not registered as dealers--i.e., the potential
negative effects on creditors, counterparties, market liquidity, and
market volatility? Why or why not?
    62. Do you agree with the Commission's description of the
externality that arises due to the possibility of manipulative or
fraudulent behavior? Why or why not?
    63. Do you agree with the Commission's statement that the lack of
regulatory insight into the practices and transactions of unregistered
market participants negatively impacts markets by constraining
regulators' ability to understand and respond to significant market
events? Why or why not?
Economic Effects, Including Impact of Efficiency, Competition, and
Capital Formation
    64. Do you agree that the Proposed Rules would promote investor
protection and orderly markets by increasing the financial stability
and resiliency of individual liquidity providers in securities markets,
particularly those liquidity providers that are not registered with the
Commission? Why or why not?
    65. Do you agree that the Proposed Rules would promote investor
protection and orderly markets by better informing regulators through
more comprehensive transaction reporting, annual filings by newly
registered dealers, and examinations?
    66. Do you agree that the Proposed Rules would deter manipulation
or fraud behavior, by improving the Commission's ability to detect it?
Why or why not?
    67. Do you agree with the Commission's description of the direct
costs incurred by new registrants--e.g., costs of registering, costs of
SRO membership, costs of reporting, etc.? Why or why not?
    68. Do you agree that the Proposed Rules would have offsetting
positive and negative effects on market participation, market
liquidity, price efficiency, competition among liquidity providers, and
capital formation? Are the overall effects on each of these likely to
be positive or negative? Please explain.
    69. How will firms that register as dealers in response to the
Proposed Rules bring themselves into compliance with the net capital
requirements? Please provide details regarding how the new dealers will
implement and manage their compliance.
    70. Do you expect market participants, especially those captured by
the Proposed Rules, to alter their legal structures? What changes are
they

likely to make and what effects will those changes have?
    71. Do you expect some market participants, whom the Proposed Rules
would otherwise require to register as dealers, to reduce or exit
certain activities in order to avoid the requirement to register? What
types of entities would do so, and which activities would be affected?
Reasonable Alternatives
    72. What benefits or costs would result from setting the threshold
on the quantitative factor higher or lower than $25 billion monthly
volume during four out of the past six calendar months?
    73. What benefits or costs would result from limiting the
quantitative threshold by incorporating other characteristics of
trading activity, such as turnover or balance of buys and sells? For
instance, an alternative quantitative standard could require firms to
register as dealers if they met BOTH a dollar volume threshold and a
turnover threshold; another alternative standard could require firms to
register if they meet BOTH a buy-volume threshold and a sell-volume
threshold.
    74. What benefits or costs would result from replacing the
qualitative factors with quantitative ``bright-line'' thresholds?
    75. What benefits and costs would result from removing the
exclusion for registered investment companies? How would these benefits
and costs differ from the benefits and costs described above?
    76. What benefits or costs would result from removing the exclusion
for registered investment advisers that only have investment discretion
over client funds?
    77. What benefits or costs would result from excluding private
funds?
    78. Are there other reasonable alternatives to the Proposed Rules
that the Commission has not addressed? Commenters should describe any
additional alternatives, along with the benefits and costs relative to
the Proposed Rules.

VI. Paperwork Reduction Act

    The Proposed Rules would define terms and do not in and of
themselves contain ``collection of information'' requirements within
the meaning of the Paperwork Reduction Act of 1995 (``PRA'').\299\
However, the new definitions may affect the number of respondents that
meet the ``collection of information'' requirements in other Commission
rules. The Commission believes the Proposed Rules may affect the number
of respondents for 14 Commission rules with existing collections of
information. The potential changes in burden under the Office of
Management and Budget (``OMB'') Control Numbers corresponding to the
existing collections of information are explained in more detail below.
An agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless the agency displays a
currently valid control number. If the new definitions in the Proposed
Rules are adopted, the Commission will submit change requests to OMB to
update the number of respondents for these 14 other rules. The titles
of these existing collections of information are:
---------------------------------------------------------------------------

    \299\ 44 U.S.C. 3501 et seq.

------------------------------------------------------------------------
                                                            OMB control
               Rule                      Rule title             No.
------------------------------------------------------------------------
17 CFR 240.15b1-1 (Rule 15b1-1)     Application for            3235-0012
 and Form BD.                        registration of
                                     brokers or dealers.
17 CFR 240.15Ca1-1 (Rule 15Ca1-1)   Notice of government
 and Form BD.                        securities broker-
                                     dealer activities.
17 CFR 240.15Ca2-1 (Rule 15Ca2-1)   Application for
 and Form BD.                        registration of
                                     government
                                     securities brokers
                                     or government
                                     securities dealers.
17 CFR 240.15b3-1 (Rule 15b3-1)...  Amendments to
                                     application.
17 CFR 240.15b6-1 (Rule 15b6-1)     Withdrawal from            3235-0018
 and Form BDW.                       registration.
17 CFR 240.15Cc1-1 (Rule 15Cc1-1)   Withdrawal from
 and Form BDW.                       registration of
                                     government
                                     securities brokers
                                     or government
                                     securities dealers.
17 CFR 240.15c2-7 (Rule 15c2-7)...  Identification of          3235-0479
                                     quotations.
Rule 15c3-1.......................  Net capital                3235-0200
                                     requirements for
                                     brokers and dealers.
Rule 15c3-5.......................  Risk management            3235-0673
                                     controls for
                                     brokers or dealers
                                     with market access.
Rule 17a-3........................  Records to be made         3235-0033
                                     by certain exchange
                                     members, brokers,
                                     and dealers.
Rule 17a-4........................  Records to be              3235-0279
                                     preserved by
                                     certain members,
                                     brokers, and
                                     dealers.
Rule 17a-5........................  Reports to be made         3235-0123
                                     by certain exchange
                                     members, brokers
                                     and dealers.
17 CFR 240.17a-11 (Rule 17a-11)...  Notification               3235-0085
                                     provisions for
                                     brokers and dealers.
17 CFR 242.613 (Rule 613).........  Consolidated audit         3235-0671
                                     trail.
------------------------------------------------------------------------

A. Summary of Collection of Information

    The Proposed Rules create burdens under the PRA by adding
additional respondents to some of the 10 existing collections of
information noted above. The Proposed Rules would not create any new
collections of information. The collections of information applicable
to the additional respondents \300\ are summarized in the table below.
---------------------------------------------------------------------------

    \300\ See Section VI.C for a description of the categories of
respondents.

------------------------------------------------------------------------
     Collection of information                     Burden
------------------------------------------------------------------------
Rule 15b1-1 and Form BD...........  Register as a dealer (required by
                                     Section 15 of the Exchange Act).
Rule 15Ca1-1 and Form BD..........  Notification requirement that a
                                     dealer is acting as a government
                                     securities dealer.
Rule 15Ca2-1 and Form BD \301\....  Register as a government securities
                                     dealer (required by Section 15C of
                                     the Exchange Act).
Rule 15b3-1.......................  Comply with requirements to amend
                                     Form BD.
Rule 15b6-1 and Form BDW..........  File a notice of withdrawal using
                                     Form BDW.
Rule 15Cc1-1 and Form BDW \302\...  File a notice of withdrawal using
                                     Form BDW.
Rule 15c2-7.......................  Enumerates certain criteria that
                                     broker-dealers must meet to furnish
                                     a quotation for a security to an
                                     inter-dealer quotation system.

Rule 15c3-1.......................  Comply with notification and record-
                                     keeping obligations concerning
                                     capital requirements set for
                                     brokers-dealers.
Rule 15c3-5.......................  Comply with requirements to
                                     establish and maintain risk
                                     management and supervisory
                                     procedures.
Rule 17a-3........................  Comply with requirements to make and
                                     keep certain business records.
Rule 17a-4........................  Comply with requirements to keep
                                     certain records.
Rule 17a-5........................  Comply with requirements to make,
                                     keep, and report certain records.
Rule 17a-11.......................  Comply with notification
                                     requirements concerning broker-
                                     dealers that are experiencing
                                     certain financial or operational
                                     difficulties.
Rule 613..........................  Comply with requirements to report
                                     certain information.
------------------------------------------------------------------------

B. Proposed Use of Information
---------------------------------------------------------------------------

    \301\ Financial institutions that are government securities
dealers not exempt under 17 CFR part 401 must use Form G-FIN to
notify their appropriate regulatory agency of their status as a
government securities dealer. See 17 CFR 449.1.
    \302\ Financial institutions that are government securities
dealers must use Form G-FINW to notify their appropriate regulatory
agency that they have ceased to function as a government securities
broker or dealer. See 17 CFR 449.2.
---------------------------------------------------------------------------

    The existing information collections affected by the Proposed Rules
are used as described below:
1. Rules 15b1-1, 15Ca-1, 15Ca2-1, and 15b3-1 and Form BD
    Section 15(a)(1) of the Exchange Act provides that it is unlawful
for broker-dealers to solicit or effect transactions in most securities
unless they are registered as broker-dealers with the Commission
pursuant to Section 15(b) of the Exchange Act. In addition, Section
15C(a)(1) of the Exchange Act provides that it is unlawful for
government securities broker-dealers, other than registered broker-
dealers and certain financial institutions, to solicit or effect
transactions in government securities unless they are registered as
government securities broker-dealers with the Commission pursuant to
Section 15C(a)(2) of the Exchange Act. To implement these provisions,
the Commission adopted Rules 15b1-1, 15Ca-1, and 15Ca2-1 and Form BD.
In addition, Rule 15b3-1 requires a broker-dealer to file amendments to
Form BD only when information originally reported in Form BD changes or
becomes inaccurate.
    The Commission uses the information disclosed by applicants in Form
BD: (1) To determine whether the applicant meets the standards for
registration set forth in the provisions of the Exchange Act; (2) to
develop a central information resource where members of the public may
obtain relevant, up-to-date information about broker-dealers and
government securities broker-dealers, and where the Commission, other
regulators, and SROs may obtain information for investigatory purposes
in connection with securities litigation; and (3) to develop
statistical information about broker-dealers and government securities
broker-dealers. Without the information disclosed in Form BD, the
Commission could not effectively implement policy objectives of the
Exchange Act with respect to its investor protection function.
2. Rules 15b6-1 and 15Cc-1 and Form BDW
    Section 15(b)(5) of the Exchange Act provides that any broker-
dealer may, upon such terms and conditions as the Commission deems
necessary or appropriate in the public interest or for the protection
of investors, withdraw from registration by filing a written notice of
withdrawal with the Commission. In addition, Section 15C(c)(1)(B) of
the Exchange Act provides that any government securities broker or
government securities dealer may, upon such terms and conditions as the
Commission may deem necessary in the public interest or for the
protection of investors, withdraw from registration by filing a written
notice of withdrawal with the Commission. To implement the foregoing
statutory provisions of the Exchange Act, the Commission has
promulgated Rules 15b6-1 and 15Cc1-1, as well as Form BDW, the uniform
request for broker-dealer withdrawal.
    The Commission uses the information disclosed by applicants in Form
BDW, as required by Rules 15b6-1 and 15Cc1-1 to: (1) Determine whether
it is in the public interest to permit broker-dealers and notice-
registered broker-dealers to withdraw from registration; (2) develop
central information resources where the Commission and other government
agencies and SROs may obtain information for investigatory purposes in
connection with securities litigation; and (3) to develop statistical
information about broker-dealers, notice-registered broker-dealers, and
government securities broker-dealers. Without Form BDW, the Commission,
SROs, state regulators, the Commodity Futures Trading Commission, and
the public would be without an important source of information
regarding broker-dealers and notice-registered broker-dealers that are
seeking to withdraw from registration.
3. Rule 15c2-7
    The information required by Rule 15c2-7 is necessary for the
Commission's mandate under the Exchange Act to prevent fraud,
manipulation and deceptive acts and practices. When Rule 15c2-7 was
adopted, the information it required was critical to the Commission's
role in monitoring broker-dealers and protecting the integrity of over
the counter markets. It was through the disclosures required by Rule
15c2-7 that inter-dealer quotation systems would reflect the demand for
and market activity related to the securities quoted on these systems.
4. Rule 15c3-1
    Rule 15c3-1 is intended to help ensure that broker-dealers maintain
at all times sufficient liquid resources to meet all liabilities by
requiring that broker-dealers maintain a minimum amount of net capital.
A broker-dealer's minimum net capital requirement is the greater of:
(1) A fixed minimum amount set forth in Rule 15c3-1 based on the types
of business that the broker-dealer conducts; or (2) a financial ratio.
Exchange Act Section 15(c)(3) and Rule 15c3-1 promulgated thereunder
prohibit a broker-dealer from effecting transactions in securities
while not in compliance with its minimum net capital requirement.
    Various provisions of Rule 15c3-1 require that broker-dealers
provide written notification to the Commission and/or their designated
examining authority (``DEA'') under certain circumstances. For example,
a broker-dealer must send notice to the Commission if it withdraws more
than 10 percent or 20 percent of its excess net capital. In addition, a
broker-dealer electing to compute its net capital using the alternative