Broker-Dealer Regulation: Capital Requirements and Financial Responsibility

Welcome to the third installment of our series of articles for stock brokers willing to tap into the world of stock broker-dealer regulations. In part three, we’ll talk about what’s required of stock brokerages in terms of capital and their financial responsibility.

Without further ado, let’s dive in.

Net capital rule

All brokers and dealers registered with the SEC under Section 15(b) of the Securities Exchange Act of 1934 (we’ve discussed it in the previous installment of our series) must comply with this rule to ensure uniform net capital standards across the board. This liquidity standard applies to almost all registered broker-dealers, except broker-dealer’s holding companies or unregulated subsidiaries or affiliates.

The goal of this regulation is to ensure that registered broker-dealers always hold a sufficient amount of readily available assets for two purposes:

1. To promptly meet their obligations, i.e. customer claims, debts to creditors, and obligations to other broker-dealers.
2. To act as a safety net of liquid assets in excess of liabilities to provide a buffer against potential market, credit, and other risks that might require asset liquidation.

To fulfill this objective, the regulation employs a liquidity assessment. This assessment requires broker-dealers to maintain either a specific minimum monetary value or a specified percentage of their net capital. This requirement is calculated concerning two key metrics: aggregate indebtedness, which encompasses all of the broker-dealer’s liabilities, or customer-related receivables, representing funds owed to the broker-dealer by its customers, as determined by the reserve requirements laid out in Rule 15c3-3. Consequently, the net capital rule plays a pivotal role in bolstering investor and customer confidence in the financial stability and integrity of broker-dealers and the broader securities market.

If you’d like to know how broker-dealers calculate their net capital, follow this link.

Customer protection rule

This rule restricts how broker-dealers can use customer securities and funds. It has two parts: the first enforces broker-dealers to promptly obtain and maintain the physical possession or control of all fully paid and excess margin customer securities, and the second introduces the segregation of customer assets.

Physical possession or control of all fully paid and excess margin customer securities

We can break down this part of the rule the following way:

The physical possession part means that a broker-dealer needs to physically hold the securities in a place where it can be identified as belonging to the customer and not the broker-dealer.

Control stands for securities being held by a broker-dealer at certain specified locations, for example, a clearing agency or a bank.

Fully paid securities are securities in a customer’s account that have been completely paid for, while excess margin securities are those that have a value above the total loan value on margin.

Lastly, broker-dealers are required to conduct daily computations to determine if they comply with the possession or control requirements, and if they determine that they are not in possession or control of certain securities, they are required to initiate procedures to get possession or control of them.

Segregation of customer assets

This part of the rule requires broker-dealers to keep customer securities and funds completely separate from their own. This means that customers’ assets are not commingled with a firm’s assets. This separation ensures that the assets are protected and can be returned to the customers if the broker-dealer faces financial difficulties or goes bankrupt.

Regulatory reporting and auditing

In terms of reporting, broker-dealers must submit

1. Regular reports to regulators detailing the status of customer account segregation
2. Reserve computation records to show they have enough funds to repay customers
3. Documents to demonstrate their compliance with the SEC’s financial responsibility rules.

When it comes to auditing, an independent auditor comes on the stage to review accounting systems, practices, and the related policies and procedures of the broker-dealers annually. If any discrepancies are found, they must be resolved, and in some cases may lead to disciplinary actions. Auditors’ reports must cover whether a broker-dealer maintained proper reserves and if their controls around these requirements are efficient and conducted according to regulatory standards.

Conclusion

The above rules intend to maintain transparency and integrity in the operations of broker-dealers while strengthening investor confidence. Adherence to these procedures also allows the SEC and other regulatory bodies to monitor and maintain the financial stability of the securities industry.

Stay tuned for more as we continue to unveil the secrets of broker-dealer regulation in our upcoming articles. The next installment will cover KYC and AML regulations.