The SEC recently adopted amendments to Rule 15c3-3, the so-called “customer protection rule.” SEC Rule 15c3-3 was adopted in 1972 at the direction of Congress to coordinate with the enactment of the U.S. Securities Investor Protection Act of 1970 (SIPA) with the goals of preventing failure of registered broker-dealers, restoring investor confidence in the capital markets, and upgrading the financial responsibility requirements for such broker-dealers. SEC Rule 15c3-3 became effective in early 1973.1 The new amendments are effective 60 days after publication of the SEC’s adopting release (the “Adopting Release”) in the Federal Register.2
Background:
SEC Rule 15c3-3 has two primary objectives: (i) the protection of “funds carried for the account of any customer” (or PAB account)3 through the customer (and PAB) reserve formula (and the reserve account deposit requirement) and (ii) the protection of “securities carried for the account of a customer” (or PAB account)4 through physical possession or control, or, as applicable, the customer (or PAB) reserve formula (and reserve account deposit requirement).5 Although under SEC Rule 15c3-3(b)(1) a carrying broker-dealer is required to promptly obtain, and thereafter maintain, a customer’s (or PAB account’s as applicable) “fully paid securities” and “excess margin securities”6 — effectively requiring the carrying firm to “lock up” or segregate those securities in the broker-dealer’s physical possession or control7 — such a broker-dealer is permitted to use, or rehypothecate, customers’ “margin securities,”8 but in doing so, SEC Rule 15c3-3 requires the broker-dealer to protect such customers’ rehypothecated margin securities through the addition of credits in the customer (or PAB as applicable) reserve formula to economically protect the customer in the event the broker-dealer is unable to get back those securities.9
Thus, the customer (and PAB) reserve formula serves to protect customers’ (or PAB accounts’) cash/funds carried by the broker-dealer as well as customers’ (or PAB accounts’) securities carried by the broker-dealer therefor as may be applicable.10
The customer and PAB account reserve formula is set forth as a combined reserve formula in Exhibit A to SEC Rule 15c3-3.11 The reserve “formula” comprises nine credit items and six debit items. A “credit” item, generally, represents an obligation of the broker-dealer to the customer (or PAB account) but not necessarily a cash liability of the broker-dealer payable to the customer.12 A “debit” item represents a permissible reduction to offset credit balances in the reserve formula, and thus to reduce the carrying broker-dealer’s reserve requirement, and which may or may not relate to a cash obligation of the customer to the broker-dealer.13
As noted, pursuant to SEC Rule 15c3-3(e)(2), a broker-dealer may use only credit item-amounts in the formula to fund debit-item amounts in the formula; that is, the broker-dealer may use credits only to fund customers’ securities activities, not to fund the broker-dealer’s own/proprietary activities (or activities of a non-customer). Pursuant to SEC Rule 15c3-3(e)(1), and item 16 of the formula, a broker-dealer is required to deposit the excess of total credits (sum of items 1 through 9) over total debits (sum of items 10 through 15) into a special reserve bank account as established pursuant to SEC Rule 15c3-3(e) and (f). Thus, debits reduce the amount of credit balances that a broker-dealer is required to deposit into, and “lock up” or segregate, in its special reserve bank account under the reserve formula.
Pursuant to SEC Rule 15c3-3(e)(3)(i), a carrying broker-dealer is required to compute its reserve not less than weekly — as of the close of the last business day of the week (generally, Friday).14 If there is a net credit balance arising from such computation, the broker-dealer is required to make a deposit of such net credit balance (with U.S. cash or “qualified securities”15) not later than 10 a.m. local time on the second following business day (after the required computation date —which will, again, generally, be Friday even if the broker-dealer actually computes the reserve on the next succeeding Monday morning).16 Thus, the carrying firm must, generally, make the required deposit on the following Tuesday (if not a bank holiday).
Under SEC Rule 15c3-3(e)(3)(iv), a broker-dealer is permitted to make more frequent reserve computations than its default computation under SEC Rule 15c3-3(e)(3)(i) (assumed for these purposes to be a weekly computation) but subject to the same two-business day deposit requirement as described above. A number of broker-dealers have for several years elected to voluntarily compute their reserve on a daily basis. As more fully discussed below, the new amendments will require certain firms to compute their reserve on a daily basis (daily will be the new default requirement) but will continue to allow firms to elect to voluntarily compute their reserve on a daily basis.
For carrying broker-dealers, the firm’s reserve requirement is also linked to its minimum net capital requirement under SEC Rule 15c3-1(a)(1). For a firm subject to the “basic” or aggregate indebtedness (AI) standard of SEC Rule 15c3-1(a)(1)(i) and (a)(2)(i), the firm’s minimum net capital is the greater of (i) $250,000 and (ii) 6-2/3% of its AI (12.5% of AI during the firm’s first 12 months of business as a broker-dealer). Most carrying firms, however, compute their net capital under the “alternative” standard of SEC Rule 15c3-1(a)(1)(ii) whereby the firm’s minimum net capital is the greater of (i) $250,000 and (ii) 2% of aggregate or total debit items as computed in accordance with the customer reserve formula.17
Under Note E(3) to the reserve formula, item 10 debit balances (debit balances in customers’ cash and margin accounts) must be reduced by 1% of their aggregate value for firms that compute their net capital under the basic or AI standard; as such, firms would carry item 10 debits in the reserve formula at 99% of their aggregate value but would carry all other debit items at 100% of their aggregate value.18 However, pursuant to SEC Rule 15c3-1(a)(1)(ii)(A), firms that compute their net capital under the alternative standard must reduce aggregate debit items in the reserve formula (all debit items, not just item 10 debits) by 3%. This means that a firm under the alternative standard may only carry debit items at 97% of their aggregate value, thereby creating an additional reserve “buffer” that all else being unchanged would result in an additional reserve deposit of cash and/or qualified securities in the firm’s reserve bank account.19
Impact of New Amendments to SEC Rule 15c3-3
(i) Amendment of SEC Rule 15c3-3(e)(3) — Daily Computation
SEC Rule 15c3-3 was amended to add new subsection (e)(3)(i)(B)(1) to require that any broker-dealer with “average total credits” equal to or greater than $500 million must compute its reserve daily (and must make any necessary reserve deposit by 10 a.m. local time on the second following business day after the required daily computation). Thus, for firms that carry this amount of credits, the new reserve computation default/requirement is daily and no longer weekly (but see the discussion herein about when a firm must beginning a daily reserve computation).
Average total credits means the sum of total credits in the customer reserve formula and the PAB reserve formula, as reported in the 12 most recently filed month-end20 FOCUS Reports (SEC Forms X-17A-5), divided by 12. The first 12-month determination must be made beginning with the June 30, 2024, FOCUS Report and ending with the July 31, 2025 FOCUS Report. If a firm meets the $500 million credit threshold based thereon, then it must commence computing its reserve on a daily basis no later than six months thereafter (i.e., beginning no later than December 31, 2025, although a firm could elect to voluntarily compute its reserve daily sooner with notice to FINRA; see below).
The SEC expects that 49 firms will be subject to the daily reserve requirement, which firms will, in the aggregate, carry about 99.3% of all customer and PAB credit items. Of those 49 firms, nine already compute, voluntarily, the customer and PAB reserve on a daily basis. Nearly all of these firms compute their net capital under the alternative standard.
In the event that a firm subsequently falls below the $500 million credit threshold, such firm could elect to switch to a weekly reserve computation provided that the firm gives its designated examining authority under the Exchange Act (generally, this will be FINRA, and that is hereafter assumed for these purposes) at least 60 days’ (calendar days’) notice, in writing, before effecting such switch in computation.21 But if the firm subsequently retriggers the $500 million credit threshold, the firm will still have six months to switch to a daily reserve computation (even though it had previously computed its reserve on a daily basis, perhaps, even with a recent period of time). The SEC expects that only about one or two firms will have average total credits that “hover” around the $500 million credit threshold (in the $450 million to $600 million range) and could be so affected by a switch.
Pursuant to SEC Rule 15c3-3(e)(3)(iv) and (v), a firm that does not trigger the $500 million credit threshold to be required to compute its reserve daily may, nonetheless, elect to voluntarily compute its reserve daily provided that the firm gives FINRA notice, in writing, of the firm’s election at least 30 calendar days before beginning such daily reserve computation. A firm that computes its net capital under the alternative standard (which will be nearly all carrying firms) may be inclined to voluntarily compute its reserve daily, again even if it is not required to do so, because there is a net capital (liquidity) benefit for the firm as more fully discussed below via a “debit reduction” in the reserve formula to do the more frequent computation. However, if such broker-dealer has notified FINRA of its election to voluntarily compute its reserve daily, such firm must continue to compute its reserve on a daily basis unless FINRA has approved a change back to weekly (or monthly as applicable) even if weekly (or monthly as applicable) is the firm’s default, or required, computation period under SEC Rule 15c3-3(e)(3)(i)(A) (or (e)(3)(i)(C) as applicable).
(ii) Net Capital/Liquidity Benefit to Compute Reserve Daily (for a Firm Computing Net Capital Under the Alternative Standard)
As noted above, carrying firms that compute their net capital under the alternative standard set forth in SEC Rule 15c3-1(a)(1)(ii) are required to reduce their total/aggregate debit items in the formula by 3% (i.e., to carry debits in the reserve formula at 97% of the aggregate value thereof). Under the new amendments, if a firm computes its reserve daily — whether it is required to do so or elects to voluntarily do so — the firm will be allowed to reduce the aforesaid debit reduction from 3% to 2%, a 1% reduction. This will reduce the “buffer” or excess the firm may need to deposit into its reserve bank account — potentially a significant amount — and, thus, should/will free up liquidity for the firm. That additional liquidity could be used to defray the cost of switching from a weekly reserve computation to a daily reserve computation but could also make more funds available for customer activities, such as making margin loans or borrowing securities for customers’ short sales.22
On the other hand, a so-called “transitory cash” issue could become more prevalent for a firm that computes reserve daily versus weekly. The issue is that when a firm moves to daily (including voluntarily before December 31, 2025) and can, then, take advantage of the added liquidity arising from the debit reduction in the formula from 3% to 2%, there is a risk that if the firm receives a large influx of credits on a computation day but after the daily cash sweep23 cutoff, the cash will get swept the next business day, but the firm will nonetheless have to potentially reserve that cash (if it results in a net credit balance) on the second following business day after the required computation — potentially well before when it would need to reserve under the weekly approach (where a weekly computation could potentially even remove, or substantially reduce, any added net credit balance arising intraweek by the Friday end-of-week computation if the customers’ cash is swept out before the required Friday computation). The daily firm could, thus, be subject to funding the (now intraweek) reserve deposit in question from its own balance sheet, although it could offset that via the 1% debit reduction creating additional liquidity.
But this transitory cash point has been an issue for years for the firms that currently do a voluntary daily reserve computation (although many of those firms may be very well capitalized and could easily absorb the additional deposit).
That said, the balance sheet impact is, arguably, very short-term in that if a firm is computing reserve daily, suppose the firm gets a large influx of free credit cash after its sweep cutoff on Monday (a regular business day) resulting in a net credit balance that must be reserved on Wednesday (the second following business day — by 10 a.m. local time). On Tuesday, all else being the same, the firm would, then, compute an excess reserve deposit and could withdraw the excess cash on deposit in its reserve bank account on Thursday (if a regular bank day). So the excess funds could be withdrawn quickly, although the firm, nonetheless, has to fund the deposit in the first instance. The SEC refused, at this time, to provide any “exemptive” or other relief on this point but did note that it will monitor to see whether relief in this area would be warranted.
However, mutual fund groups may allow sweep deposits by 6 p.m. ET as long as the firm receives the purchase order by 4 p.m. ET (and for sweeps, the purchase order is automatically set for each day), which may substantially reduce the transitory cash impact.
Under the new amendments, because a carrying firm that computes its reserve on a daily basis will be subject to a lower 2% debit reduction (versus the current 3% requirement) in aggregate debit value with respect to the customer reserve, that means that the firm will, in particular, be able to carry its item 10 debits (debits in its customers’ cash and margin accounts) at 98% versus 97% of the aggregate value thereof, that is, at a debit value 1% higher/greater than for a nondaily firm. That 1% differential — carrying the item 10 debit at a greater value — could, however, affect whether a firm has a concentrated debit balance under Note E(5) to the reserve formula that must be excluded from the reserve formula (i.e., subject to a 100% reduction) and should, presumably, be monitored.
In any event, if a carrying firm that computes its net capital under the alternative standard and is not required under the new amendments to compute its reserve daily, then such firm will continue to be subject to a 3% reduction in aggregate/total debits for the reserve formula if it continues to compute reserve on a weekly (or monthly as applicable) basis.
In addition, although a carrying firm that (i) computes its net capital under the basic standard and (ii) triggers the $500 million credit threshold would, also, be required to compute its reserve on a daily basis, such a firm would not be subject to the 1% debit reduction (from 3% to 2%) because such 1% debit reduction is applicable/available only to firms that compute their net capital under the alternative standard.24
(iii) Reason to Require Daily Reserve Computation — Mismatch
The primary reason for requiring “larger” carrying firms (i.e., those with “average total credits” of at least $500 million) is to reduce the risk of reserve “mismatch.” Such mismatch arises where the net credit balance of the firms exceeds the actual reserve balance in the firm’s special reserve bank account.25
With a carrying firm that computes its reserve on a weekly basis, suppose a firm receives a large deposit of free credit balances on Monday. If nothing else changes during the week (and assuming Friday is a regular business day, as are the following Monday and Tuesday), the firm would compute its reserve as of the close of business on Friday (end-of-week, but where the actual computation probably occurs on Monday), and if that results in a net credit balance, the firm would have until the next Tuesday after the required Friday computation (i.e., in the following week) to make the deposit into is special reserve bank account (by 10 a.m. local time). As such, there would be a mismatch between the amount of the firm’s customer obligations and what the firm has on deposit in its reserve bank account for over a week. Although under SEC Rule 15c3-3(e)(2) a carrying firm is not permitted to use credit balances in the customer reserve except to finance/fund debit balances therein (e.g., to fund customers’ margin debits (item 10)), given that cash is fungible, the aforesaid reserve mismatch increases “the likelihood of carrying broker-dealer inadvertently using customers’ or PAB account holders’ funds to finance any part of their business.”26 The SEC said that this (i) reduces the likelihood that a failing carrying firm can self-liquidate under SIPA and (ii) increases the risk of depletion of the insurance fund established by the Securities Investor Protection Corporation (“SIPC”) under SIPA.
If, on the other hand, the same carrying firm computes its reserve on a daily basis, although there is still a mismatch arising on Monday, then all else being the same, that mismatch would be eliminated on Wednesday of the same week when the firm is required to make its reserve deposit (assuming no applicable holidays). As such, requiring a daily reserve shortens the life of a reserve mismatch in the above example from eight days to two days (but also has the benefit of allowing the broker-dealer to more quickly withdraw any excess deposit from its reserve bank account).
At the $500 million level of credits, the SEC noted in the Adopting Release that the shortening of mismatch from a daily reserve computation would capture firms carrying about 99.3% of total credits and so it believes would substantially address the mismatch concern. In addition, the SEC noted that carrying firms above the $500 million credit threshold are more likely to carry PAB accounts, and these PAB accounts generally hold much greater amounts of total credits, so that mismatch is likely to pose a greater risk to proprietary accounts of other broker-dealers. This risk is exacerbated for PAB accounts because proprietary accounts of other broker-dealers are not entitled to advances under SIPA (from the SIPC insurance fund).27
(iv) Impact on Reserve Account Requirements for Security-Based Swaps
The SEC allows registered broker-dealers, including those registered as security-based swap dealers, to include credits arising from their security-based swap activities with security-based swap customers in its customer reserve computation pursuant to Exhibit A to SEC Rule 15c3-3 (versus having to separately compute under Exhibit B thereto) and to maintain the deposit required in a customer reserve account pursuant to SEC Rule 15c3-3(e), provided that the customer reserve formula computation would not include any debit items arising from security-based swap activities.28 As such, the SEC said in the Adopting Release that there would be no need to require a registered broker-dealer (including a broker-dealer registered as a security-based swap dealer) to a perform a security-based swap customer reserve computation on a daily basis as it would have “virtually no impact because credits related to security-based swap activity for security-based swap customers generally are being included in the customer reserve computation.” And because a stand-alone security-based swap dealer generally operates under an exemption from reserve computation requirements under SEC Rule 18a-4(f), the SEC concluded that there should be no need to impose a daily reserve computation requirement thereon.
(v) Impact of Certain FINRA Notification Requirement
FINRA Rule 1020(b) generally requires a FINRA member that operates under an exemption per SEC Rule 15c3-3(k) to obtain the prior approval of FINRA before it changes the way that it operates under SEC Rule 15c3-3. Because carrying firms are “fully computing” under SEC Rule 15c3-3 and thus do not operate under a (k) exemption thereunder, this notification/apply should not apply to a carrying firm that is required, or elects voluntarily, to compute its reserve on a daily basis.
FINRA Rule 1017(a)(5) and (b) requires that a FINRA member obtain the prior approval of FINRA by filing a “continuing membership application” (or CMA) before engaging in a “material change in business operations” as defined in FINRA Rule 1011(m). However, in light of the new notification requirements to FINRA (assumed to be a firm’s designated examining authority) already being specifically incorporated into SEC Rule 15c3-3(e)(3) with respect to the new daily reserve requirement, there should be no need to require a separate, or additional, notification/filing under FINRA Rule 1017.
(vi) Determination of New Systems and Personnel Requirements
The customer reserve formula is deceptively simple in appearance but complex to implement. Firms that will be subject to the $500 million credit threshold as well as firms that will elect to voluntarily compute reserve on a daily basis should start evaluating for new systems and personnel needs, the cost(s) associated therewith, and the timeline for testing any new systems requirements. As noted above, the 1% debit reduction will be available for firms that compute their reserve on a daily basis — either as a requirement or electively — to defray build-out/development costs.
(vii) Takeaways
- SEC Rule 15c3-3 and the customer (and PAB) reserve formula are complex and potentially become more complex when switching from a weekly (or monthly) computation to a daily computation. Because of “transitory cash” issues, a firm may need to expand upon existing, or establish new, credit facilities — potentially on a satisfactory subordinated loan basis that requires FINRA approval under SEC Rule 15c3-1d (Appendix D) — to be available to finance reserve deposits that could arise more frequently than under a weekly (or monthly) computation.
- Because the 1% debit reduction will increase liquidity, a firm should consider how best to deploy that liquidity and may need to amend, or revise, its liquidity risk management controls per SEC Rule 17a-3(a)(17) to take that into account.29
- Firms should consider the timing, cost, and scope of systems development and testing, including with respect to other recent SEC rules that affect the reserve formula.30 Firms should also reassess their current reserve computation methodologies to ensure full rule conformance with SEC Rule 15c3-3. To this end, firms should evaluate their systems and support infrastructure under the current weekly state for necessary/needed adaptations to the increased frequency that will be required for, or arise from, daily computations and, in particular, which should include (i) reviews on capabilities around utilizing third-party vendors versus internal systems, (ii) increasing awareness and control discipline for areas providing support to the daily computation process, and (iii) upgrading internal controls to manage the risk of noncompliance across functions involved in the daily reserve computation process.
- These evaluations are of great importance given that for a carrying firm, noncompliance with SEC Rule 15c3-3(e) (reserve) can easily result in a “material weakness” in “internal control over compliance,” as such terms are defined in SEC Rule 17a-5(d)(3)(iii) and (ii), respectively, which could result in notifications to the SEC, FINRA, and other applicable regulators under SEC Rule 17a-11(d), SEC Rule 15c3-3(i), and FINRA Rule 4530(b) (and adverse enforcement consequences) as well as reporting to the firm’s customers under SEC Rule 17a-5(c).
- Firms should review their current roster of reserve bank providers to ensure that banks are willing to take on daily reserve requirements. With the expansion of the number of firms required to compute, or electing to voluntarily compute, their reserve on a daily basis, some banks that currently accept firms with a daily reserve requirement may not want to expand their service roster because of the volatility arising from the expansion of daily withdrawals. Firms may need to expand their roster of special reserve banks to include U.S. bank branches of foreign banks but that may require SEC/FINRA approval.31
- The $500 million credit threshold is not based on a fiscal year computation but is a “rolling” computation over the preceding 12 months (based on the firm’s monthly FOCUS Reports).
1 SEC Rule 15c3-3 supplanted SEC Rules 8c-1 and 15c2-1, each adopted in 1940 (they are identical rules), as the primary customer protection rule applicable to broker-dealers registered under the U.S. Securities Exchange Act of 1934 (the “Exchange Act”), although broker-dealer are also subject to those other rules.
2 See SEC Release No. 34-102022. Page references herein to the Adopting Release are to this version of the SEC’s release.
3 See SEC Rule 15c3-3(a)(10) — such funds represent cash liabilities of the broker-dealer to a customer (or PAB account) in the form of “free credit balances” and/or “other credit balances” as defined in SEC Rule 15c3-3(a)(8) and (a)(9), respectively. The term “customer” is defined in SEC Rule 15c3-3(a)(1) to generally mean any person from whom, or on whose behalf, a registered broker-dealer has received or acquired or holds funds or securities for the account of such person but which term excludes the proprietary account of a registered broker-dealer or an unregistered foreign broker-dealer. The term “PAB account” is defined in SEC Rule 15c3-3(a)(16) to mean a proprietary securities account of a broker-dealer (including an unregistered foreign broker-dealer or a foreign bank acting in a broker-dealer capacity) other than with respect to a delivery-versus-payment or a receipt-versus-payment account and other than with respect to certain proprietary accounts of a registered or unregistered broker-dealer that have been subordinated to the claims of creditors of the carrying broker-dealer.
4 See SEC Rule 15c3-3(a)(2).
5 In addition, the SEC amended SEC Rule 15c3-3 in 2019 to add subsection (p) to provide comparable protections for security-based swap positions carried by a broker-dealer for the account of security-based swap customers: (i) protection of excess securities collateral carried for the security-based swap customer and (ii) reserve account protections.
6 See SEC Rules 15c3-3(a)(3) and (a)(5), respectively.
7 See SEC Rule 15c3-3(c) for what constitutes a good “control location” of a broker-dealer with respect to securities carried for the account of a customer (or PAB account) that are not in the carrying firm’s physical possession.
8 See SEC Rule 15c3-3(a)(4). These are customer (or PAB account) securities, held for the account of such customer (or PAB account), that collateralize such customer’s (or PAB account’s) margin debit balance (margin loan financing from the carrying broker-dealer) in accordance with applicable margin requirements but that have a market value that does not exceed 140% of the customer’s (or PAB account’s) “adjusted” margin debit balance. See SEC guidance at SEC Rule 15c3-3(a)(5)/01.
9 Per SEC guidance at: https://www.sec.gov/rules-regulations/staff-guidance/trading-markets-frequently-asked-questions-1 — at Q/A 7 — “Broker-dealers should treat securities carried for a PAB account as ‘customer’ securities for this purpose, including for determining which securities are fully paid and excess margin securities.”
10 Per the SEC’s original 1972 adopting release to SEC Rule 15c3-3 (SEC Release No. 34-9775), the SEC stated the intent and objective of the rule as being “the elimination of the use by broker-dealers of customer funds and securities to finance firm overhead and such firm activities as trading and underwriting through the separation of customer related activities from other broker-dealer operations.” Per SEC Release No. 34-21651, one objective of the rule was to “inhibit the unwarranted expansion of a broker-dealer’s business through the use of customers’ funds by prohibiting the use of those funds except for designated purposes”; the rule “forbid[s] brokers and dealers from using customer assets to finance any part of their businesses unrelated to servicing securities customers; e.g., a firm is virtually precluded from using customer funds to buy securities for its own account.” The SEC has informally referred to SEC Rule 15c3-3 as the “bedrock foundation” of customer protection under the federal securities laws, and noncompliance with either the rule’s (i) possession or control or (ii) reserve requirements is serious and can result in a “material weakness” in “internal control over compliance”; see further herein.
11 The security-based swap reserve formula is set forth, separately, in Exhibit B to SEC Rule 15c3-3.
12 Although an item 1 credit does relate to cash liabilities of the broker-dealer payable to a customer (via “free credit balances” (subject to “immediate” payment) and “other credit balances” (cash liabilities, but not necessarily subject to immediate payment, such as short sale proceeds that collateralize a customer’s short sale (margin) position, in each case, that are carried for the account of customers)), credits in the formula — and obligations of the carrying firm to its customers (PAB accounts) can arise in other ways, for example, item 2 credits (monies borrowed and collateralized by customers’ margin securities) and item 3 credits (monies payable against customers’ margin securities loaned) as well as item 4 credits (customers’ securities failed to receive) and item 5 credits (where the broker-dealer has an open short position with respect to a security sold by the firm, as principal, to a customer). With respect to these other credit items, the carrying firm does not necessarily have a cash liability to the customer (or PAB account) but does have an obligation to return or deliver securities to the customer (or PAB account).
13 An item 10 debit does represent a direct cash obligation of the customer to the broker-dealer (debit balances in customers’ cash and margin accounts), but item 11, for example, allows a broker-dealer to borrow securities against a pledge of customer funds to the securities lender for the purpose of making delivery of the borrowed securities to effectuate shorts sales by (other) customers as well as to make delivery on customers’ securities failed to deliver and, thus, does not establish a cash liability to customers. Although in a short sale, the customer who sells a security short has “borrowed” such securities from the broker-dealer for delivery on the settlement of the customer’s short sale (ignoring “short arranging” for these purposes), that does not create a debit balance, or cash obligation, in the customer’s account in a margin sense in that the customer owes back the borrowed securities, not cash. Rather, the inclusion of a debit in the formula allows the carrying firm to use customer funds to fund/finance customer activities as permitted under SEC Rule 15c3-3(e)(2).
14 Some broker-dealers carrying a limited amount of credit balances are permitted to compute their reserve on a monthly basis. See SEC Rule 15c3-3(e)(3)(i), (ii), and (iii).
15 Such as U.S. Treasury securities; see SEC Rule 15c3-3(a)(6). In certain cases, a broker-dealer may deposit foreign currencies if the firm has an offsetting customer credit balance in the same foreign currency — per guidance (as specified in the next footnote) at SEC Rule 15c3-3(e)(1)/07. Digital currencies, such as bitcoin or ethereum, are not eligible to meet a deposit.
16 See the SEA Rule 15c3-3 and Related Interpretations on the website of the Financial Industry Regulatory Authority, Inc. (FINRA) at SEC Rule 15c3-3(e)(1)/061. Withdrawals of excess amounts on deposit in the reserve bank account may be withdrawn in accordance with SEC Rule 15c3-3(g), also, by 10 a.m. local time on the second following business day following/after the most recent reserve computation that shows an excess in the reserve account.
17 The reason therefor is that the alternative standard — by freeing the net capital computation from an AI/leverage ratio/requirement — generally results in a lower minimum net capital requirement as further discussed herein.
18 Pursuant to Note 4 to the PAB reserve, the 1% reduction to item 10 debit items under Note E(3) does not apply to the PAB reserve computation. Similarly, there is a 3% reduction to aggregate (all) debit items under SEC Rule 15c3-1(a)(1)(ii)(A) (for firms that compute their net capital under the alternative standard) and that arises “in lieu of the 1% reduction” in Note E(3) (but where Note E(3), again, does not apply to the PAB reserve under Note 4 above); thus, the 3% reduction under the alternative standard, also, does not apply to the PAB reserve computation. See also footnote 159 to the Adopting Release, “The PAB reserve computation does not require either the 3% or the 1% debit reduction,” and page 55 of the Adopting Release, “Further, this amendment to Rule 15c3-1 applies only to a carrying broker-dealer’s customer reserve computation” (emphasis supplied).
19 The reduction in the value of aggregate debits is only for the purpose of the customer reserve formula but not for the purpose of the computation of the broker-dealer’s minimum net capital requirement under the alternative standard, which is based on 2% of (100%) aggregate debit items in the reserve formula. See page 55 of the Adopting Release: Because, as noted above, the amendment to Rule 15c3-1 applies only to the customer reserve computation, “[i]t does not amend or change the minimum net capital requirement for carrying broker-dealers under Rule 15c3-1 irrespective of whether they use the basis or alternative methods. Consequently, carrying broker-dealers electing the alternative method must continue to maintain the greater of $250,000 or 2% of aggregate debit items under Rule 15c3-1 and they remain subject to an early warning notification requirement under Rule 17a-11 if their net capital falls below 5% of aggregate debits items” (see SEC Rule 17a-11(b)(2)).
20 Carrying firms are required to prepare their FOCUS Reports on a monthly basis.
21 See SEC Rule 15c3-3(e)(3)(i)(B)(2). The Adopting Release suggests that the inclusion of the 60 days’ written notice before switching from a daily reserve computation to a weekly (monthly) reserve computation is designed/intended to guard against a carrying broker-dealer that might perform interim reserve computations “opportunistically” to “minimize require reserve deposits.” In addition, as noted herein, a firm is required to provide at least 30 calendar days’ written notice to FINRA before electing to voluntarily switch to a daily reserve computation. Such “speed bumps” are imposed on the ability of a carrying firm to switch from a daily to weekly, or a weekly to daily, reserve computation.
22 The alternative standard was added to SEC Rule 15c3-1 in 1975 via SEC Release No. 34-11497. As noted above, the SEC had observed that the alternative standard could, potentially, result in a lower minimum net capital requirement for a carrying firm than if net capital was computed under the basic standard, and, as such, the SEC adopted the 3% debit reduction in the customer reserve formula as a condition to using the alternative standard in order to create an additional reserve “buffer” or “cushion” that would, then, serve as available capital to satisfy customer claims in the event of the broker-dealer’s insolvency and, thus, to somewhat offset the fact that the basic standard may result in a higher minimum net capital requirement. In addition, the 3% reduction could be viewed as providing an additional cushion of secured debit items in the reserve formula — akin to carrying debit balances with a “haircut,” like a net capital “haircut” on a proprietary securities position — where such cushion would, then, be available to ensure that such debit items can be liquidated, and with the buffer, there should be enough cash to be available to satisfy customers’ claims against the carrying firm. The SEC concluded that lowering the debit reduction to 2% from 3% should not undermine this basic cushion given that the carrying broker-dealer would be required to more quickly deposit, and lock up, any net credit balance under the reserve into the firm’s special reserve bank account.
23 Pursuant to SEC Rules 15c3-3(j)(2)(i) and (j)(2)(ii), firms that sweep customers’ free credit balances to an appropriate sweep destination remove such credit balances from the firm’s balance sheet and, thus, for reserve (computation) purposes under SEC Rule 15c3-3(e).
24 As noted above, under Note E(3) to SEC Rule 15c3-3a (the reserve formula), firms that compute their net capital under the basic standard are subject only to a debit reduction (1%) on item 10 debits in its reserve formula (versus the new 2% deduction for firms under the alternative standard) and are allowed to carry all other debits in the formula at 100% of their aggregate value (so no reduction). Thus, these “basic firms” were never subject to the same level of reserve buffer or cushion as were firms that compute their net capital under the alternative standard (again because, as a general matter, basic firms are subject to a higher level of minimum net capital). That said, there is also no added economic “incentive” to encourage a “basic firm” that does not trigger the $500 million credit threshold to elect to voluntarily switch to computing the reserve on a daily basis to shorten “mismatch” as described herein. But as a practical matter, nearly all carrying firms compute their net capital under the alternative standard, so the “mismatch” risk is, presumably, de minimis for basic firms.
25 “Mismatch” is computed as a carrying firm’s “deposit” (the amount that such firm needs to deposit into its reserve bank account to close the “gap” between amount prescribed by the reserve computation and the actual reserve deposit in the firm’s reserve bank account) divided by its reserve account balance. If there is a positive percentage, then the firm’s special reserve bank account does not reflect the full “obligation” of the firm to its customers, thereby resulting in a reserve “mismatch.” In the Adopting Release, the SEC determined that the average reserve mismatch across carrying broker-dealers above the $500 million credit threshold was 15.7%; it was 6.4% for carrying broker-dealers below the $500 million credit threshold.
26 See page 110 of the Adopting Release.
27 See Section 78fff-3(a)(5) of SIPA. That said, the amount of advance available to “customers” under SIPA (which includes another broker-dealer) is limited to customer claims of $500,000 (with a limit of $250,000 for cash claims).
28 See Q/A 1 to SEC Frequently Asked Questions at https://www.sec.gov/rules-regulations/staff-guidance/trading-markets-frequently-asked-questions/faqs-financial.
29 Pursuant thereto, a firm, generally, must maintain a record documenting the credit, market, and liquidity risk management controls established and maintained by the broker or dealer to assist it in analyzing and managing the risks associated with its business activities. In this regard, firms should consider the formulation of transition plans and documentation changes necessary to switch to a daily reserve computation.
30 In particular, see the SEC’s 2023 release relating to “Standards for Covered Clearing Agencies for U.S. Treasury Securities and Application of the Broker-Dealer Customer Protection Rule With Respect to U.S. Treasury Securities” (SEC Release No. 34-99149), which added an item 15 debit to the reserve formula relating to (i) purchases and sales of U.S. Treasury securities and (ii) U.S. Treasury securities repurchase and reverse report agreements that, in each case, have been cleared, settled, and novated by a registered clearing agency (currently, only the Fixed Income Clearing Corporation).
31 See: https://www.sec.gov/divisions/marketreg/mr-noaction/2014/finra-022614-15c3.pdf
Attorney Advertising—Sidley Austin LLP is a global law firm. Our addresses and contact information can be found at www.sidley.com/en/locations/offices.
Sidley provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act upon this information without seeking advice from professional advisers. Sidley and Sidley Austin refer to Sidley Austin LLP and affiliated partnerships as explained at www.sidley.com/disclaimer.
© Sidley Austin LLP
