Chapter 5 - Net Capital Requirements Flashcards
SEC Rule 15c3-1
Net capital rule – the most important financial responsibility rule
Prescribes minimum liquidity standards for BDs, to ensure BDs maintain sufficient liquid assets to promptly satisfy claims of customers, plus a cushion of liquid assets in excess of liabilities to cover potential market and credit risks
Prevents a BD from becoming over-leveraged
The key ratio is: Aggregate indebtedness / Net capital
Not all debts/liabilities or all equity are included – only liquid amounts
Aggregate indebtedness
In general, includes liabilities that are not secured by a specific asset of the BD. Secured liabilities (secured with BD assets, not customer assets) are usually excluded.
Free credit balance
Amounts owed to customers on demand
Amounts included in AI
- Loans or other liabilities not secured with a BD asset (i.e. collateralized with customer securities)
- Customer and non-customer free credit balances (money owed to them on demand)
- Credit balances in both customer and non-customer accounts containing short positions
- Accounts payable in course of business (including taxes payable)
- Fails to receive in customers’ accounts
- Fails to receive for BD’s account where security has since been resold (aka, FTR with no satisfactory offset) (note an offsetting FTD or borrowed security is considered a satisfactory offset)
- Securities loaned for customers’ accounts (not securities loaned for firm account, since that’s collateralized by firm securities)
- 15% of securities borrowed
Amounts excluded from AI
- 85% of securities borrowed
- Securities loaned for firm’s account (because the cash collateral is collateralized by the securities)
- FTR for firm’s account (except when the offsetting security has been resold, i.e. FTR for firm’s account with no satisfactory offset)
- FTR for firm’s account offset by FTD
- FTR for firm’s account offset by stock borrowed
- Firm short trading account
- Short security differences over 30 calendar days old
- Subordination agreements
- Adequately secured fixed liabilities
- Liabilities on open contractual commitments
- Deferred tax liabilities
Subordination agreements
Loans in which the lender has agreed to accept a lower payment priority than other creditors
Common source of regulatory capital for BDs
2 types of subordination agreements
Subordinated loan agreement (SLA)
Secured demand note (SDN)
SLA
Subordinated loan agreement – investor loans cash (not securities) to a BD and the terms such as interest rate, loan amount, and maturity date are known
SDN
Secured demand note – investor provides promissory note in which the investor agrees to provide funds on demand during the term of the note. Investor also must provide cash or securities as collateral, deposited with the firm. Investor is considered the beneficial owner of these securities but cannot sell them during the term of the note.
Securities must be fully paid and non-exempt (publicly offered/sold without registration under SEA). Also must be in bearer form or registered in the name of the BD (which allows the BDs to use the securities for hypothecation or short sales).
Investor has right to substitute
Investee does not have the right to keep dividends on collateralized securities
How to use subordination agreements to increase regulatory capital
Agreement must be approved by FINRA prior to being effective
FINRA requires a disclosure notice to the investor:
- No SIPC or private company insurance protection
- No priority in payment over other lenders
- No restrictions on use of investor’s funds/securities
- Firm can force sale of securities pledged as collateral
Adequately secured fixed liabilities
Liability is secured by assets used in the course of the BD’s business. Sole recourse of the creditor must be against the asset backing the liability. Ex. Mortgage loan on HQ building is not AI, but real estate investment (not used in course of business) is AI
Liabilities on open contractual commitments
Underwriters of new issues of securities will often commit to purchasing some amount; this is not included in AI
Calculating AI
Total liabilities included in AI
Then, AI is reduced by the lesser of amount on deposit in Reserve Account or amount required to be on deposit by 15c3-3
Summary of net capital requirements
Must meet greatest of:
1. In general, net capital must be at least 1/15 of AI (no greater than 15:1 ratio AI:NC). If in first year as BD – must be at least 1/8
2. Must also meet the minimum dollar requirement (i.e. BD must maintain larger of 1/15 AI or minimum dollar requirement at all times) depending on type of business
3. If greater than other minimums, market maker requirement, depending on number and per share price of market made stocks
Minimum dollar requirement
In addition to 1/15 rule, BDs are also subject to minimum dollar amounts:
OTC derivatives dealer $20m
Prime broker $1.5m
Self-clearing broker-dealer that acts as an executing broker in a prime brokerage relationship $1m
Block positioner $1m
General securities firm (carries customer accounts/holds securities) $250k
Brokers broker $150k
Carries accounts but doesn’t hold funds/securities $100k (includes introducing BDs acting as market makers)
Introducing BD that receives customer securities for immediate delivery to clearing broker $50k
Introducing BD that acts as a selling group member in a firm commitment underwriting $50k
Introducing BD on fully disclosed basis and doesn’t receive customer funds/securities $5k
BD only executing riskless principal transactions $5k
Sale of redeemable shares of investment companies (mutual funds) on other than a subscription way basis $25k
Dealer (proprietary account >10 trades a year) $100k
(k)(2)(i) firms $100k
Review table in book
Prime broker
Performs centralized clearing and account maintenance functions for customers who execute transactions through several other BDs
Definition of receiving and holding funds
Payment is made directly in the name of the BD
Payment is not promptly forwarded/transmitted to another party
Promptly = noon of next business day
Limitations on introducing firms with regard to net capital amounts
A $5k or $50k introducing BD cannot participate in a firm commitment underwriting (best-efforts or all-or-none underwriting only). $100k introducing BDs can do firm commitment. A $50k introducing BD may act as a selling group member (no liability) in a firm commitment underwriting.
Introducing BDs also may only do 10 or fewer trades per year for their own accounts, i.e. cannot act as dealer/market maker (if more than that, bumps them to $100k requirement)
OTC derivatives dealer
Any dealer that limits its securities activity to engaging as a counterparty in transactions in eligible OTC derivative instruments with derivatives counterparties
OTC derivative instrument
Important financial management tool employed by many companies to manage risk (interest rate, exchange rate) or lower funding costs
Market maker net capital requirements
In addition to minimum requirements, a market maker must maintain a minimum for each stock for which it makes a market:
$2500 for each stock selling over $5 a share
$1000 for each stock selling $5 or less a share
Capped at $1m
Alternative net capital requirement
Typically used by larger BDs instead of standard net capital rule
Calculated as greater of $250k or 2% aggregate debit items as calculated under 15c3-3 (and when calculating 3-3 reserve, take 3% haircut on ADI instead of 1%)
If a firm using the alternative method intends to withdraw excess capital, firm’s remaining net capital must be at least 5% of ADI (must obtain FINRA approval for withdrawal of >10% of NC)
If firm engages in credit derivative transactions, it must maintain tentative net capital of $1B, and net capital of $500m. Must notify the SEC if TNC falls below $5B.
Debt-equity requirement for net capital
A BD’s equity must be at least 30% of its debt-equity total, which prevents a BD from deriving too much of its net capital from subordinated loans or SDNs
Debt-equity total = B/S equity + current month net income + +unrealized profits (AOCI) + amount of satisfactory subordination agreements
If equity falls below 30% (i.e. debt >70%) for >90 days, BD is in violation of net capital rule
Criteria for subordinated loan to be included as equity in debt-equity requirement
- Lender must be a partner/stockholder
- Loan must have had an initial term of at least 3 years and must have at least 12 months remaining
- Loan may not have any provisions for accelerated maturity (allowing lender to call early)
Moment-to-moment capital compliance
BD must always have sufficient capital, i.e. if a BD partakes in a large transaction that puts its current capital level too low, it must ensure capital is sufficient
Additional net capital requirement for reverse repo agreements
additional net capital requirement if the underlying collateral rises to more than 105% of the contract price. i.e. if collateral rises from $80m to $84m that triggers additional NC
A broker-dealer is required to maintain additional net capital based on the type of security that’s the subject of the reverse repurchase agreement. If the market value of securities in a reverse repurchase agreement increases by a certain percentage above the contract value, additional capital is required. The amount of the increase depends on whether the collateral is direct U.S. government obligations, agency securities, or other securities.
block positioner
refers to a firm that buys and sells large quantities of equity securities using its own capital
(k)(2)(i) firms
firms which carry no margin accounts, promptly transmit all customer funds and deliver all securities, does not otherwise hold funds or securities for, or owe money or securities to, customers and effects all financial transactions for customers through one or more bank accounts maintained exclusively for this purpose
must maintain a minimum net capital of $100,000
Rules for short securities differences in the AI calculation (trick question)
Unresolved short securities differences do not become part of a broker-dealer’s aggregate indebtedness after 30 days. The broker-dealer is required to establish a reserve to replace the missing securities. Replacement is required within 45 calendar days of the inventory.
Net capital requirements for mutual fund agents
A firm that offers mutual fund shares can transact using a subscription method (older approach, with an application) that has a net capital requirement of $5,000. If the firm wants to operate on other than a subscription way basis, the net capital requirement is $25,000
