SEC Net Capital and Customer Protection Rules Still Matter

An article by New York Institute of Finance instructor Stephen Zak, currently CFO of VTB Capital.

One need not look very hard to find brokerage firms that have experienced financial difficulty in the recent past: MF Global, Lehman Brothers and Bear Stearns are just a few. These noteworthy examples are complimented by the failure of many smaller broker dealers of which we have never heard.  All these cases show the importance of the net capital rules which allow for an orderly wind down of the firm’s business and a return of customer money and securities.

The Securities and Exchange Commission’s (SEC) uniform net capital rule (15c3-1) and customer protection rule (15c3-3) form the foundation of the securities industry’s financial responsibility framework.  The net capital rule focuses on liquidity and is designed to protect securities customers, counterparties and creditors by requiring that broker dealers have sufficient liquid assets on hand at all times to satisfy claims promptly.  The Customer Protection Rule (Rule 15c3-3) which compliments rule 15c3-1 is designed to ensure that customers’ funds and securities are properly safeguarded.  These rules both apply to the activities of registered broker dealers and unregistered affiliates.

The primary purpose of the Net Capital Rule is to ensure that registered broker dealers maintain at all times sufficient liquid assets to promptly satisfy their liabilities (claims of customers, creditors and other brokers) as well as to provide a cushion of liquid assets to cover potential market, credit and other risks should the broker be forced to liquidate.  The rule achieves this purpose by prescribing a liquidity test that requires the broker dealer to maintain the greater of a specified minimum dollar amount or a specified percentage of net capital in relation to aggregate indebtedness (which include most liabilities) or customer related receivables.

To comply with the SEC’s net capital rule, broker dealers must perform two computations: One determines the broker dealer’s net capital (liquid capital) and the other computation determines the broker dealer’s appropriate minimum net capital requirement.  This process of computing net capital is really about separating liquid and illiquid assets.  Starting with ownership equity, the firm deducts the value of all its illiquid assets as well as operational charges for delays in promptly settling securities transactions to arrive at a firm’s Tentative Net Capital. This figure is then reduced by “haircuts” on securities positions which are percentage deductions of a securities value based upon type and maturity.  It is only after deducting these “haircuts” that you arrive at the firm’s net capital.

This net capital position then gets compared with the firm’s net capital requirement which, as stated previously, is either based upon a minimum dollar amount, a percentage of Aggregate Indebtedness or a percentage of customer receivables. The resulting difference between Net capital and required net capital is called excess net capital.

Rule 15c3-3, adopted in 1972, provides regulatory safeguards regarding the custody and use of customers’ funds and securities in the conduct of the broker dealers business. It has two parts.  The first requires the broker dealer to promptly obtain possession or control of all fully paid for and excess margin securities.  The second part requires that a broker dealer segregate all customer cash that has not been used to finance transactions of other customers.

The reason that Brokerage firms and their employees need to go to great pains to ensure proper adherence to the rules (other than the incurring the wrath of regulators) is that they actually work.  In regards to the Lehman bankruptcy, while holding company creditors are still awaiting payment, on October 5, 2012 SIPC announces that 100% of customers’ property will be returned without the need for advances from the SIPC fund.  For MF Global the trustee anticipates satisfaction of 100% of all allowed securities customers claims. (Bear Stearns was purchased by JP Morgan so those clients were merely transferred).  In a nutshell the rules work if properly followed.

Given their importance, a working knowledge of the Rule 15c3-1  and 15c3-3 should be required of not only the individuals that are directly responsible for the preparation of the reports but also those that are more tangentially involved. It is those individuals who may also come across activities or transactions that need to be reflected in the computations.  A support staff that is well schooled in the basics of the rules provide an extra level of oversight and a elevation of the broker dealer’s internal control structure.

About New York Institute of Finance

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