Chapter 5 - Net Capital Requirements

Question 1

SEC Rule 15c3-1

Answer 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

Question 2

Aggregate indebtedness

Answer 2

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.

Question 3

Free credit balance

Answer 3

Amounts owed to customers on demand

Question 4

Amounts included in AI

Answer 4

• 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

Question 5

Amounts excluded from AI

Answer 5

• 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

Question 6

Subordination agreements

Answer 6

Loans in which the lender has agreed to accept a lower payment priority than other creditors

Common source of regulatory capital for BDs

Question 7

2 types of subordination agreements

Answer 7

Subordinated loan agreement (SLA)
Secured demand note (SDN)

Question 8

SLA

Answer 8

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

Question 9

SDN

Answer 9

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

Question 10

How to use subordination agreements to increase regulatory capital

Answer 10

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

Question 11

Adequately secured fixed liabilities

Answer 11

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

Question 12

Liabilities on open contractual commitments

Answer 12

Underwriters of new issues of securities will often commit to purchasing some amount; this is not included in AI

Question 13

Calculating AI

Answer 13

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

Question 14

Summary of net capital requirements

Answer 14

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

Question 15

Minimum dollar requirement

Answer 15

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

Question 16

Prime broker

Answer 16

Performs centralized clearing and account maintenance functions for customers who execute transactions through several other BDs

Question 17

Definition of receiving and holding funds

Answer 17

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

Question 18

Limitations on introducing firms with regard to net capital amounts

Answer 18

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)

Question 19

OTC derivatives dealer

Answer 19

Any dealer that limits its securities activity to engaging as a counterparty in transactions in eligible OTC derivative instruments with derivatives counterparties

Question 20

OTC derivative instrument

Answer 20

Important financial management tool employed by many companies to manage risk (interest rate, exchange rate) or lower funding costs

Question 21

Market maker net capital requirements

Answer 21

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

Question 22

Alternative net capital requirement

Answer 22

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.

Question 23

Debt-equity requirement for net capital

Answer 23

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

Question 24

Criteria for subordinated loan to be included as equity in debt-equity requirement

Answer 24

1. Lender must be a partner/stockholder
2. Loan must have had an initial term of at least 3 years and must have at least 12 months remaining
3. Loan may not have any provisions for accelerated maturity (allowing lender to call early)

Question 25

Moment-to-moment capital compliance

Answer 25

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

Question 26

Additional net capital requirement for reverse repo agreements

Answer 26

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.

Question 27

block positioner

Answer 27

refers to a firm that buys and sells large quantities of equity securities using its own capital

Question 28

(k)(2)(i) firms

Answer 28

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

Question 29

Rules for short securities differences in the AI calculation (trick question)

Answer 29

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.

Question 30

Net capital requirements for mutual fund agents

Answer 30

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