Every broker or dealer conducting a general securities business registered with the Securities and Exchange Commission (Commission) must comply with SEC Rule 15c3-1, the Net Capital Rule. The Net Capital Rule is designed to ensure that broker-dealers will have adequate liquid assets to meet their obligations to investors and liabilities to other creditors. The rule is complex and specifically addresses the liquidity, market, and counterparty credit risks associated with the proprietary positions of the broker-dealer. In the May 1992 edition of The Business Lawyer the author published an overview of the rule entitled “The Net Capital Rule,” which concluded by observing that the Commission needed to update the rule to take into account the growth in derivative instruments. Since then the Commission has made multiple amendments to the rule that do just that, culminating with the recent amendments governing swap transactions mandated by Dodd-Frank. This article updates the 1992 article by taking the reader through those rule changes, including the Commission’s evolutionary recognition of quantitative models to measure the risk associated with derivative positions.
A broker-dealer conducting a securities business that is required to register with the Securities and Exchange Commission (“SEC” or “Commission”) under section 15(b) of the Securities Exchange Act of 1934 (“Exchange Act”)1 must comply with Exchange Act Rule 15c3-1, the Net Capital Rule. The Net Capital Rule sets forth a liquid asset test that seeks to ensure that a broker-dealer approaching financial distress will be able to finance its own liquidation expenses. In a 1992 The Business Lawyer article, the author published an overview of the rule.2 That article concluded with a section that summarized the future challenges facing the Net Capital Rule. The challenges described in that section pointed to the difficulty presented to the Commission in keeping up with the fast-paced development of the over-the-counter (“OTC”) derivatives markets.3
Much has happened since that time in the securities industry, the derivatives markets, and with the rule. The SEC has now provided for the use of quantitative models in the rule for both listed and OTC derivatives. It had a brief stint as a holding company supervisor, under which it applied a notice requirement based on the Basel Committee on Banking Supervision (“Basel Committee”) capital framework for holding companies of large securities firms not already under supervision of a domestic or international banking authority.4 More recently, it was required to rework the rule to conform with the statutory mandate of Title VII—Wall Street Transparency and Accountability of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).5 In the past firms had been able to engineer OTC derivatives transactions in a manner that avoided application of the Net Capital Rule. Title VII gives direct jurisdiction to U.S. regulators of OTC derivatives dealing with U.S. persons and requires that those transactions be subject to U.S. regulatory capital requirements.
This article will bridge the gap between the 1992 article and the present. It will take the reader through a brief summary of where the Net Capital Rule was then, what happened in the meantime, and conclude with a special focus on where it ended up.
As covered more explicitly in the 1992 article, the objective of the Net Capital Rule is to provide for a base of liquid assets from which the broker-dealer can fund its liquidation expenses should it fail. The Net Capital Rule is part of a broader set of SEC rules known as the “financial responsibility rules.”6 The goal of the financial responsibility rules is to promote the self-liquidation of securities firms that are in danger of failing. Those rules include books and record requirements,7 audit requirements,8 securities count requirements,9 customer property segregation requirements,10 and the Net Capital Rule.
The role of the Net Capital Rule (Rule 15c3-1) is distinguished from that of the Customer Protection Rule (Rule 15c3-3) in that Rule 15c3-3 works toward making sure that customer assets are available in a distribution. Rule 15c3-1 tries to provide for a funding base to pay liquidation expenses. In a formal or informal liquidation, expenses such as clerical salaries, rent, and systems support must be paid. The goal of the Net Capital Rule is to have the firm that failed to pay the expenses involved in unwinding its affairs.
Like most financial regulatory capital rules, the Net Capital Rule compares a minimum requirement against a computation of what regulatory capital the firm has. Paragraph (a) of the Rule sets forth the minimum requirements. The definition of the term “net capital” in paragraph (c)(2), along with the incorporation of the Rule’s appendices, sets forth the amount of “net capital” a securities firm has, in comparison to its requirement under paragraph (a).
Since the 1992 article, the Commission amended the minimum requirements under paragraph (a).11 Paragraph (a)(1) sets forth the “aggregate indebtedness method” of determining a securities firm’s minimum net capital requirement. It requires firms to maintain net capital of the greater of 6 2/3 percent of its “aggregate indebtedness,” as that term is defined in paragraph (c)(1), and a prescribed minimum dollar amount that varies depending on the nature of the business.12 Instead of the aggregate indebtedness method, firms can elect the “alternative method” under paragraph (a)(1)(ii), under which firms must maintain net capital of the greater of 2 percent of “aggregate debit items” or $250,000. Aggregate debit items are amounts representing situations where the firm is financing customer activities. The most common example is when the firm lends money to a customer to purchase securities in a margin account. Aggregate debit items are calculated in connection with the firm’s Formula for Determination of Customer and PAB Account Reserve Requirements of Brokers and Dealers under § 240.15c3-3 (“Reserve Formula”) as prescribed in Rule 15c3-3a.
Prior to the amendments in 1992, firms that did not compute the Reserve Formula because they did not handle customer property were not allowed to elect the alternative method. Under the amendments, the Commission allowed those firms to elect the alternative method but required them to accept a minimum dollar threshold of $250,000. As a result of this change, generally most firms that have the $250,000 minimum choose to operate under the alternative method.
Paragraph (c)(2) defines the term “net capital,” which is the basis of the calculation of how much net capital the firm has, as compared to its minimum requirements in paragraph (a). This definition and the appendices take up the bulk of the rule. Generally, as spelled out in the 1992 article,13 the calculation of net capital begins at net worth as determined under generally accepted accounting principles. Net worth is adjusted by deducting a large variety of charges for unsecured counterparty credit risk and market risk in proprietary positions.
In 1992 market risk deductions for listed options were not portfolio based, but rather reflected particular fundamental option strategies. The rule did not include specific provisions governing swaps, but the rule was interpreted to generally presume counterparty default on transactions that were not centrally cleared.14 In 1993, the Commission published a concept release that posed a series of questions for comment relating to how the rule should be amended to take into account the risk of listed and unlisted derivatives.15 With respect to OTC derivatives, the questions were general, but the release offered helpful guidance as to how the rule was being interpreted at that time. The release includes a discussion of the various risks associated with OTC derivative products, but the risk of counterparty default is emphasized throughout the document. With respect to listed options, the release introduced the consideration of the use of quantitative models to measure market risk, including the one that is used in the rule today.
Beginning with listed options, the remainder of this article goes through the incremental changes made by the SEC to the rule to specify capital requirements for derivative transactions. Following listed options, the article covers the SEC’s acceptance of the use of approved internal quantitative risk models, first with OTC derivatives dealers and later with full-service brokerage firms. The article ends with the recent amendments to the rule for swap transactions.
The 1992 article discussed the market risk charges for listed options. At the time the charges were designed to reflect specific option strategies. The charges for cleared option market maker accounts were based on the theory that option market makers could more readily liquidate listed option positions because of their participation on the floor of the exchange. The charges for securities firms that were not option market makers presumed that they would have to exercise the option rather than close it out on the exchange floor. The primary difference between the two approaches lies in the “time value” of the option. The time value is the portion of the option price that is attributable to potential changes in the price of the underlying security over the remaining time to the option’s expiration. To illustrate the difference, presume a market maker purchased a long option to buy a security at $50 when the market price was also $50, with a month remaining to expiration. The price of the option would reflect some value, for this example $2, representing the possibility of the security rising over $50 over the next month. The rule presumed for market makers that they could sell that option on the exchange floor and realize the $2 profit in our example. The rule presumed that firms that were not on the floor would have to exercise the option and, in this example, would not get the benefit of the $2 of time value.
The premise for the distinction may have been valid at the time of the origination of the option markets in 1975, but over time, the ability of securities firms that are not option market makers to liquidate listed option positions on the exchange has been demonstrated. In 1994, the Commission proposed for comment revised market risk deductions that not only eliminated that distinction, but also marked the first time that the SEC implemented the use of quantitative models in the Net Capital Rule.16
Although the Commission acknowledged the landmark options pricing model introduced by Fischer Black and Myron Scholes (“Black-Scholes model”),17 it selected for use in the rule a binomial pricing model developed by John Cox, Stephen Ross, and Mark Rubenstein (“Cox-Rubenstein model” or “binomial model”).18 While the Black-Scholes model was useful in predicting the future price of an European option19 at the time of expiration, the Cox-Rubenstein model replicates periodic upward and downward movements in the value of the option until the option’s expiration. In the proposing release, the Commission acknowledged the benefits of the Cox-Rubenstein model in not only incorporating dividend yields into its formula, but also its ability to predict the prices of American-styled options.20
The other benefit of the model was that it was employed at the time by Options Clearing Corporation (“OCC”) to develop its Theoretical Intermarket Margining System to measure market risk associated with the OCC’s participant’s positions and to establish clearance margin requirements related to them.21 In addition to the fact that OCC is a self-regulatory authority supervised by the Commission, all of the listed options in the United States clear through it.
Concurrent with the proposing release, the Division of Market Regulation (“Division”)22 issued a no-action letter that allowed firms to compute option deductions under the proposal immediately.23 The Division had experience with the proposed deductions as they had been the subject of a study and pilot program administered by the Chicago Board of Options Exchange, Inc. and the OCC.24
In February 1997, the SEC adopted the proposed rule largely in the form in which it was proposed.25 The adopting release did set forth specific particular indexes as “high capitalization diversified” and “non high capitalization diversified indexes.”26 It also announced the Commission’s intention to issue a release to provide generic guidelines for adding and deleting indexes to the list.27 The SEC has yet to issue that release.
Under the amendments, each day the broker-dealer provides to OCC the following information:
OCC applies the above information to the binomial model and computes theoretical gains and losses at ten equidistant points along a range of percentages of the market prices of the underlying instruments that are generally borrowed from the haircuts in the rule.29 The percentages are:
For example, for an option on an equity security, the gains and losses are computed at the following intervals upward and downward from the market price of the underlying security:
-15%, -12%, -9%, -6%, -3%, +3%, +6%, +9%, +12%, +15%.
The broker-dealer applies these theoretical gains and losses to its options position in the given underlying instrument and the largest computed theoretical loss becomes the capital charge for that class of options position.
In computing the theoretical gains and losses, the amendments allow for some offsetting between positions in related underlying instruments. While generally offsetting positions in the same security, index, or currency net at each valuation point, the amendments also allow for partial offsetting between index options, futures, and futures options and portfolios of underlying securities (“Qualified Stock Baskets”)33 that meet certain criteria.
The chart below summarizes the offsets that are recognized at each valuation point for specific hedges involving index options, futures, and futures options. The difference in the offset percentages take into account the liquidity and execution risk in different markets.34
|Index Position||Hedge||Offset at Each Valuation Point|
|Option, future, or futures option on broad-based high capitalization index||“Qualifying Basket” of securities underlying the index position not less than 90% of the capitalization of the index||95%|
|Option, future, or futures option on narrow-based high capitalization index||“Qualifying Basket” of securities underlying the index position not less than 100% of the capitalization of the index||95%|
|Option, future, or futures option on broad-based high capitalization index||Different option, future, or futures option on broad-based high capitalization index in same product group||90%|
|Option, future, or futures option on broad-based non-high capitalization index||Different option, future, or futures option on broad-based non-high capitalization index in same product group||75%|
|Option, future, or futures option on broad-based non-high capitalization index||Basket of securities||None|
The SEC also adopted minimum charges that apply to each portfolio type. The minimum for each portfolio type is the largest of three tests. The first test is based on a calculation done for each contract. For products other than foreign currencies, the minimum charge is one quarter point times the multiplier35 for each equity and index option contract and each related instrument within the option’s class or product group.36 For options, futures, and futures options on major market foreign currencies,37 the minimum charge is $25 for each position, but the minimum charge for futures and futures options is adjusted for contract size differentials and in the case of long positions in options and options on futures contracts, it cannot exceed the market value of contract.38
The second test applies to stock baskets offset by high capitalization indexes. The minimum for those positions is 5 percent of the market value of the securities in the basket.39
The third test applies to stock baskets offset by non-high capitalization indexes. The minimum for those positions is 7½ percent of the market value of the securities in the basket.40
Some commentators on the proposal stated that the Commission should allow for the use of models designed by the firm for use in measuring risk for both listed and OTC options under the rule.41 The Commission stated in the release that: “[t]he staff of the Division is preparing a separate release which will propose for comment further amendments to the Net Capital Rule to permit the use of proprietary models to value listed options.”42 While the SEC has yet to propose alternatives to the use of the Cox-Rubenstein model for listed options, it did adopt a separate regime for OTC options.
In 1997 the Commission issued both a concept release and a simultaneous proposal to allow the use of approved proprietary quantitative models for broker-dealers that limited their business to OTC derivatives and related hedges (“OTC Derivatives Dealer Proposal”).43 The releases followed a period of dialogue with international financial regulators and also the largest OTC derivatives dealers operating in the United States. In the years preceding the releases, the Commission, through its membership in the International Organization of Securities Commissions, was involved with the Basel Committee. In December 1995, the Basel Committee amended its regulatory capital or Basel Accord to incorporate market risk capital requirements and approved the use of proprietary Value at Risk (“VaR”)44 models to determine bank capital requirements for market risk (“Market Risk Amendments”).45 The Market Risk Amendments also recommended a number of quantitative and qualitative conditions that should apply to a bank’s use of models to ensure that VaR models are prudently used.
As the Basel Accord is only an internationally accepted standard, it must be adopted by each jurisdiction to become enforceable. In 1996, the Board of Governors of the Federal Reserve System (“Fed”), the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation adopted rules that were designed to implement the Market Risk Amendments for U.S. banks and bank holding companies.46
While the Commission staff was meeting with international banking regulators, it was also conducting a dialogue with the largest U.S. derivatives dealers. These dealers formed a group known as Derivatives Policy Group47 and created a Framework for Voluntary Oversight (“Framework”).48 The Framework called for the use of quantitative statistical models to measure risk exposure to capital. It allowed firms to use their own models under certain agreed-upon general criteria but also called for calculations based on assumptions provided by SEC staff. Those calculations were done to give the SEC staff a baseline for comparison among firms whose individual models and assumptions would vary. The Framework also called for standards for risk management, governance, reporting, and independent verification.
While the Framework provided the SEC staff with experience both in the application of proprietary models and OTC derivatives activities, it did not provide for regulatory oversight of those activities. Much of those activities were conducted in affiliates not regulated by the Commission either under the Rule 15a-649 exemption available to foreign securities firms transacting with U.S. persons or because the activities were not deemed to be transactions in securities requiring registration in the United States as a securities firm.
In the OTC Derivatives Dealer Proposal, the Commission acknowledged that it:
has been told that few swaps and other types of OTC derivative instruments are booked in registered broker-dealers because of the way these transactions are treated under the Net Capital Rule. There are two reasons for this. First, the current Net Capital Rule requires a firm to subtract most unsecured receivables from its net worth when calculating its net capital. For example, for an interest rate swap, the rule requires that the current value of the next net interest payment due from a counterparty be deducted from the firm’s net worth in calculating its net capital. Also, any unrealized gains on the swap would have to be deducted. Second, the rule does not allow broker-dealers to take into account positions that offset their OTC derivatives positions to the same extent as banks or foreign dealers using VaR models. This treatment of OTC derivatives transactions often requires broker-dealers to reserve more capital with respect to these transactions than banks or foreign broker-dealers have to reserve.50
To address this concern, the Commission created a separate class of registered broker-dealer (“OTC Derivatives Dealer”)51 that, as long as it limited its business to OTC derivatives and related hedges,52 would be able to apply to the Commission for permission to use new Appendix F of Rule 15c3-1 to compute market and counterparty credit risk charges that are generally consistent with the Basel Accord.53 Although the OTC Derivatives Dealer Proposal allowed for lower market and counterparty credit risk charges, it did require the dealer to maintain a higher minimum net capital of $20 million and a higher tentative net capital of $100 million.54
For market risk, under paragraph (a)(1)(ii) of Appendix F, an OTC Derivatives Dealer could use an alternative method of computing market risk capital charges for equity instruments and OTC options and use VaR models for its other proprietary positions. Under the alternative method, an OTC Derivatives Dealer would be permitted to use its own theoretical pricing model as long as it contains the minimum pricing factors set forth in Appendix A discussed above.
In order to obtain approval to use its own VaR model for market risk charges, the OTC Derivatives Dealer must meet certain conditions. First, an OTC Derivatives Dealer’s VaR model must be integrated into its daily risk management process.55 Second, an OTC Derivatives Dealer’s risk management processes must provide for appropriate stress tests.56 Third, an OTC Derivatives Dealer’s VaR model and risk management systems must be subject to periodic independent reviews performed by internal audit staff and annual reviews conducted by an independent public accountant.57 Fourth, OTC Derivatives Dealers would be required to conduct “back testing,” which compares its VaR-based profit and loss projections against actual trading results.58
The OTC Derivatives Dealer is required to compare actual net trading profit or loss for its most recent 250 business days with the corresponding daily VaR measures.59 In addition, once each quarter, the OTC Derivatives Dealer must identify the number of business days for which the actual daily net trading loss exceeded the corresponding daily VaR measure.60 The number of these exceptions would determine the multiplication factor the OTC Derivatives Dealer is required to use to compute market risk charges for the following quarter.61 The factor continues to apply until the next quarter’s back-testing results are obtained, unless the Commission determines that a different adjustment or other action is appropriate.62
The multiplication factors range from three to four depending on the number of back-testing exceptions.63 The multiplication factor is intended to cover the additional risks that would be present in an OTC Derivatives Dealer’s portfolio, including legal, liquidity, and operational risk, or the risk of human error or deficiencies in the firm’s operating systems, including its VaR model.64
For counterparty credit risk, Appendix F includes a two-part charge computed on a counterparty basis. First, for each counterparty, OTC Derivatives Dealers must take a capital charge equal to the “net replacement value in the account of the counterparty” (“net replacement value”)65 multiplied by 8 percent, and further multiplied by a counterparty factor.66 As originally adopted, the counterparty factor was based on the counterparty’s rating by at least two nationally recognized statistical rating organizations (“NRSROs”).67 The counterparty factors ranged from 20 percent for counterparties that are highly rated to 100 percent for counterparties with ratings among the lowest rating categories.68 A charge of 100 percent of the net replacement value was assessed for counter-parties that are in bankruptcy or whose bonds were in default.69
The second part of the credit risk charge consisted of a concentration charge that would apply when the net replacement value in the account of any one counterparty exceeded 25 percent of the OTC Derivatives Dealer’s tentative net capital.70 The original concentration charge was also based on the counter-party’s rating. For counterparties that were highly rated, the concentration charge was 5 percent of the amount of the net replacement value in excess of 25 percent of the OTC Derivatives Dealer’s tentative net capital.71 The concentration charge increased with respect to the OTC Derivatives Dealer’s exposure to lower rated counterparties to 20 percent or 50 percent depending on the rating.72
As originally adopted, if a counterparty was not rated by a rating organization, an OTC Derivatives Dealer was permitted to use its own ratings of the counter-party to calculate its credit risk charge.73 If the OTC Derivatives Dealer planned to use internal ratings, however, it had to demonstrate that its ratings criteria and due diligence procedures, including procedures for the initial analysis and ongoing review of the counterparty, were equivalent to those used by NRSROs.74
Following the Dodd-Frank prohibition on reliance on credit ratings,75 the Commission amended Appendix F to remove the references to NRSRO credit ratings and now requires an OTC Derivatives Dealer, as part of its initial application, to request Commission approval to use internal credit ratings.76
The OTC Derivatives Dealer Proposal also included a charge to limit overallcounterparty credit risk exposure to all counterparties. If the aggregate net replacement values of all counterparties exceeded 300 percent of the OTC Derivatives Dealer’s tentative net capital, the OTC Derivatives Dealer would have had to deduct 100 percent of the excess from its net worth.77 Commenters on the proposal suggested that the charge would have to be dropped in order for the proposal to be viable.78 The rule as adopted does not contain this provision.79
The OTC Derivatives Dealer structure provided firms with a means to conduct those activities in an SEC registered broker-dealer, but it also provided the Commission staff oversight experience of OTC derivatives activities without risking exposure to customers of a full-service brokerage firm and to the Securities Investor Protection Corporation (“SIPC”). As explained in the 1992 article, Rule 15c3-1 is a part of a regulatory scheme designed to promote self-liquidation of financially distressed securities firms without the need for the appointment of a SIPC trustee.80 By limiting the activities to exclude a general securities business, the Commission was able to exclude firms that registered as OTC derivatives dealers from SIPC membership.81 In addition to SIPC membership, the Commission also exempted OTC derivatives from membership in the Financial Industry Regulatory Authority (“FINRA”)82 and compliance with Exchange Act Rules 15c3-3, 15c2-1, 8c-1, and Regulation T.
Use of proprietary quantitative models is only allowed following an extensive review and examination process by the SEC staff.83 Among other things, that examination emphasizes compliance with Exchange Act Rule 15c3-4.84 Rule 15c3-4 sets forth risk management governance standards that are largely similar to those agreed to by the Derivatives Products Group.
As a procedural matter, firms that are interested in using models in an OTC Derivatives Dealers must start the process by delivering a draft application for the SEC staff to use as a basis for their examination. The staff will conduct an extensive examination of the firm’s risk management and other practices and provide the firm with comments and other items that need to be addressed before the application will be accepted in its final form.
Following the experience that the Commission staff gained with OTC Derivatives Dealers, the Commission was ready to allow VaR models to be used to compute market and credit risk charges in full-service broker-dealers that are SIPC members. Rule 15c3-1 was amended in 2004 to allow firms whose holding company is supervised by either the SEC or by a recognized “principal regulator”85 and meets other conditions to apply to be able to use VaR based capital charges.86
Up until this time the SEC had never supervised a holding company of a securities firm. The SEC’s entrance into holding company supervision was primarily driven by the European Union’s (hereinafter “EU’s”) Financial Conglomerates Directive (“Directive”)87 in 2002, which required financial firms doing business in Europe to “be subject to equivalent and appropriate supplementary supervisory arrangements which achieve objectives and results similar to those pursued by the provisions of this Directive.”88 A number of U.S. securities firms were not subject to holding company supervision at the time and securities firms located in the EU stated that they would either be subject to additional capital charges or required to form a sub-holding company in the EU.89 To address this, the Commission created its Consolidated Supervised Entity (“CSE”) program.
Under the CSE program, large independent securities firms such as Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bears Stearns could voluntarily subject their holding companies to SEC oversight in return for being allowed to calculate market and credit risk charges using VaR in their SEC registered full-service broker-dealer subsidiaries.90
The program came under scrutiny amid the financial crisis in 2008, during which Lehman Brothers failed, Bear Stearns and Merrill Lynch were purchased by banks, and Goldman Sachs and Morgan Stanley became financial holding companies supervised by the Fed. Unfortunately, much of the criticism was founded on misunderstandings of the program.91
The program was designed to deal with the Directive; it was not designed to replace, copy, or supplement Fed supervision. As such, it adopted the Basel Accord as accepted in Europe and did not incorporate the leverage or other constraints that the Fed required of U.S. financial holding companies.92 The supposition that this program allowed the holding companies of these firms to increase their leverage is false, as they were not subject to any regulation prior to their voluntary SEC CSE oversight.
Following the financial crisis, the SEC was no longer a holding company supervisor as the firms it supervised either liquidated, merged, or became financial holding companies. Section 618 of Dodd-Frank addressed firms that would be impacted by the Financial Conglomerates Directive in the future by allowing: “[A] securities holding company that is required by a foreign regulator or provision of foreign law to be subject to comprehensive consolidated supervision may register with” the Fed and become subject to Fed supervision.93
While the SEC no longer supervises holding companies,94 the sections of the rule that pertain to the CSE program remain in the rule. Appendix G of Rule 15c3-1, which pertains to holding company supervision, is no longer in force. The provisions in the Net Capital Rule that allow for a broker-dealer to apply to the SEC to use VaR to compute market and credit risk charges under Appendix E of the rule continue to be available and are generally referred to as Alternative Net Capital.
It is important to note that in order for a broker-dealer to be eligible to apply for VaR based capital charges under Appendix E, it must maintain tentative net capital of not less than $5 billion and net capital of not less than $1 billion, but also notify the SEC if its tentative net capital95 is less than $6 billion.96
In addition to maintaining higher levels of minimum and tentative net capital, broker-dealers that seek to apply VaR based capital charges in Appendix E must also comply with Rule 15c3-4.97 Appendix E operates for full-service broker-dealers that use VaR based capital charges in a similar way to how Appendix F is applied by OTC Derivatives Dealers. Both have application requirements and qualitative and quantitative criteria for modeling.
While Appendix E bears some resemblance to Appendix F, it is important to note the differences between OTC Derivatives Dealers and broker-dealers that apply to use the Alternative Net Capital (“ANC”) treatment. First, as mentioned above, OTC Derivatives Dealers are not members of SIPC or FINRA, are not subject to Rule 15c3-3, and apply Fed margin rule Regulation U instead of Regulation T.
The market risk charges in Appendix E are generally the same as those in Appendix F except that Appendix E allows the broker-dealer to apply to the Commission to use “scenario analysis” as an alternative to VaR to compute market risk deductions.98 The proposing release describes scenario analysis as “the identification of the potential impact on the profit or loss on a position of various extreme events that affect the pricing of the position in the portfolio.”99 As of the date of publication of this article, no broker-dealer has applied and been approved by the SEC to use scenario analysis.
The credit risk charges in Appendix E are generally the same as those in Appendix F, with some notable differences, one of which is the use of the term “credit equivalent amount” instead of “net replacement value.” In the proposing release the Commission reiterated its interest in the Basel Committee and specifically references the New Basel Accord, which was released for public comment in April 2003.100 The New Basel Accord built upon the original Accord and expanded the methods upon which banks could compute credit risk deductions. Generally, among other things, the new credit risk approach required firms to take into account both “loss given default” and “exposure at default” and generally recognized that a bank’s loss as the result of a counter-party default could be greater than the amount of current exposure because of factors such as the decline in the market value of collateral that the bank had received.101
Another difference with Appendix F is that Appendix E requires firms to take a “portfolio concentration” charge.102 That charge is directed at the total current credit exposure to all counterparties.103
As mentioned above, the OTC Derivatives Dealer Proposal defines “net replacement value in the account of a counterparty” to mean “the aggregate value of all receivables due from that counterparty (which would be computed by marking the value of such receivables to market daily), including the effect of legally enforceable netting agreements and the application of liquid collateral.”104 Under paragraph (c)(4)(i) of Appendix E, the credit equivalent amount is the “maximum potential exposure” multiplied by one unless the Commission determines that another factor is appropriate. The term “maximum potential exposure” is defined to be:
the VaR of the counterparty’s positions with the broker or dealer, after applying netting agreements with the counterparty meeting the requirements of paragraph (c)(4)(iv) of this appendix E, taking into account the value of collateral from the counterparty held by the broker or dealer in accordance with paragraph (c)(4)(v) of this appendix E, and taking into account the current replacement value of the counterparty’s positions with the broker or dealer105
Similar to the way that the market risk deduction works, the multiplication factor under paragraph (c)(4)(i) of Appendix E is adjusted over time depending on back-testing results under paragraph (d)(1)(v) of Appendix E. Under the rule, the broker or dealer is required to propose, as part of its application, a schedule of multiplication factors for approval by the Commission. The schedule must be based on back-testing exceptions and, going forward on a quarterly basis, the broker-dealer must apply its back-testing results to the approved schedule to determine the relevant multiplier.106
To conduct the back testing, the broker-dealer must, for at least eighty counterparties with widely varying types and sizes of positions with the firm, compare the ten-business-day change in its current exposure to the counterparty based on its positions held at the beginning of the ten-business-day period with the corresponding ten-business-day maximum potential exposure for the counterparty generated by the VaR model.107
At the end of each quarter, the broker or dealer must identify the number of back-testing exceptions of the VaR model.108 Under paragraph (d)(1)(v)(B) of Appendix E a back-testing exception is defined as “the number of ten-business day periods in the past 250 business days, or other period as may be appropriate for the first year of its use, for which the change in current exposure to a counterparty exceeds the corresponding maximum potential exposure.”109
Although the application and examination processes are generally similar in practice, the application requirements in (a)(1) of Appendix E are more specific. Both (a)(1)(viii) and (ix) require undertakings by the holding companies of the broker-dealer. Firms that are considering applying for Appendix E can sometimes be alarmed by these undertakings.
Dodd-Frank gave the Commodity Futures Trading Commission (“CFTC”) and the SEC broad rulemaking authority over the U.S. swap markets.110 The SEC was granted authority over “security-based swaps,”111 such as swaps on equity securities and credit default swaps on specific bonds. The CFTC was generally granted authority over other swaps,112 such as interest rate swaps and indexed credit default swaps. Both agencies received jurisdiction over “mixed swaps.”113
Dodd-Frank section 731 amended the Commodity Exchange Act by adding section 6s(e)(1)(B),114 which explicitly granted the CFTC specific authority to promulgate capital rules for swap dealers but swap dealers that are banks are excluded from that jurisdiction. Section 731 added section 6s(e)(1)(A),115 which allowed bank regulators to continue to maintain the authority to set capital standards for banks that are also swap dealers.
Section 764 amended the Exchange Act in a similar fashion by adding section 15F(e)(1)(B),116 granting the SEC specific authority to promulgate capital rules for security-based swap dealers (“SBSD”) that are not banks. Dodd-Frank section 764 added Exchange Act section 15F(e)(1)(A),117 which specifically allowed bank regulators to continue to regulate the capital requirements of SBSDs that are also banks.
On June 21, 2019, the SEC adopted its capital requirements governing security-based swaps and other swaps.118 Both the proposing119 and adopting releases are large documents that are primarily dedicated toward establishing capital, segregation, and margin requirements for SBSDs under Dodd-Frank. It should be noted that the framework for the SBSD capital rule, Rule 18a-1,120 and the segregation rule, Rule 18a-4,121 is largely based on Exchange Act Rules 15c3-1 and 15c3-3.
Broker-dealers whose dealing in securities-based swaps exceed the thresholds of Exchange Act Rule 3a71-2122 must also register as SBSDs. While the rules adopted for SBSDs generally track the rules applicable for broker-dealers, some distinctions were created. One distinction is that the Commission adopted a separate additional minimum capital requirement applicable to broker-dealers that are also registered as SBSDs.123 Those firms must maintain the greater of $20 million or the total of the amount computed under Rule 15c3-1(a)(1) (i.e., the amount computed under aggregate indebtedness or alternative methods) plus a percentage of its “risk margin amount” as defined under paragraph (c)(17).124 The rule includes a mechanism to increase the percentages in paragraph (a)(10)(i)(A) over time and starts with 2 percent of the risk margin amount and then rises to 4 percent after three years and then to 8 percent after five years.125 The increases to 4 and 8 percent must be approved by the Commission before going into effect.126
Paragraph (a)(10)(ii) also requires broker-dealers that are also registered as SBSDs but not using model-based market and credit risk charges to comply with its internal risk management control systems rule, Rule 15c3-4. Previously, only broker-dealers that had obtained model approval under Appendices E or F were required to comply with Rule 15c3-4.127
Although the proposing and adopting releases focus on SBSDs, the SEC also amended Rule 15c3-1 to prescribe market risk and credit risk deductions for all swaps entered into by broker-dealers, which are applicable whether the broker-dealer is also registered as an SBSD or not.128 As discussed below, the rule, as amended, separates capital charges for the counterparty credit risk of default from charges related to market price movements. The rule also separates the market risk capital charges by security-based and other swaps. The market risk charges for security-based swaps are located where the capital charges for securities products are found, in the main body of Rule 15c3-1 and Appendix A. Non-security-based swaps are under the CFTC’s jurisdiction and market risk charges for those swaps are located in Appendix B, where charges for commodity futures and other CFTC regulated products are found.
The credit risk charges for all swap products are divided in to two categories: 1. charges related to the failure to collect variation margin129 and 2. charges related to not collecting initial margin.130 Generally, the broker-dealer must take a capital charge to the extent it does not collect variation margin under paragraph (c)(2)(iv).131
The charges related to initial margin are linked to applicable margin requirements. Paragraph (c)(2)(xii) requires the broker-dealer to take a capital charge for under-margined accounts. The charges are based on the uncollected amount of margin collateral required by a “clearing agency, Examining Authority, the Commission, derivatives clearing organization or the Commodity Futures Trading Commission.”132 Note that taking a capital charge under (c)(2)(xii) does not relieve the broker-dealer of its obligation to collect the required margin. Note also that a single cleared swap transaction may be covered by margin requirements of more than one of the organizations on the list.
For broker-dealers that are also SBSDs but not approved to apply models under Appendix E, the counterparty credit risk deductions for uncleared security-based swaps are in paragraph (c)(xv)(A). Paragraph (c)(xv)(A) requires a deduction of “the initial margin amount calculated pursuant to § 240.18a-3(c)(1)(i)(B) for the account of a counterparty at the broker or dealer that is subject to a margin exception set forth in § 240.18a-3(c)(1)(iii), less the margin value of collateral held in the account.”133 Broker-dealers that are also SBSDs must take a capital charge in lieu of collecting the amount of margin it would have been required to collect if the exception were not in place.
Broker-dealers that are not also SBSDs are not subject to Rule 18a-3 and the margin exceptions are not applicable. Stand-alone broker-dealers are subject to the margin rules of the Examining Authority,134 which for most firms is FINRA. As of the date of this writing, FINRA had adopted an interim margin rule for credit default swaps135 but had not yet proposed a margin rule for equity or total return swaps. Under existing paragraph (c)(2)(xii), stand-alone broker-dealers are already required to take a capital charge in “the amount of cash required in each customer’s or non-customer’s account to meet the maintenance margin requirements of the Examining Authority for the broker or dealer, after application of calls for margin, marks to the market or other required deposits which are outstanding 5 business days or less.”136 Those firms will be required to take capital charges under paragraph (c)(2)(xii) for any margin they fail to collect under margin rules of FINRA or other Examining Authorities.137 Again, taking the capital charge does not alleviate the obligation to collect the required margin.
Credit risk charges for non-securities-based swaps are covered in paragraph (c)(xv)(B), which bases the charges on the CFTC’s swap margin rule. If the broker-dealer is subject to the CFTC margin rule (i.e., is a CFTC registered swap dealer) and its counterparty is afforded an exception from the rule, the broker-dealer must take a capital charge in lieu of collecting the amount of margin it would have been required to collect if the exception was not in place.138
As the Commission notes in the Swaps Adopting Release, uncleared security-based swap customers may elect under section 3E(f) of the Exchange Act to have the initial margin that they post held in an independent account at a third-party custodian.139 Paragraph (c)(2)(xv)(C) sets forth the criteria under which the broker-dealer can establish those accounts and treat the collateral as received by the broker-dealer for purposes of computing the capital deduction. Generally, the criteria require that the custodian be a bank unaffiliated with the counter-party, or if the collateral consists of foreign securities or currencies, a supervised foreign bank, or depository or clearing organization.140 The criteria also call for a legally enforceable agreement retained by the broker-dealer that provides the broker-dealer the right to access the collateral to satisfy the counterparty’s obligations to the broker-dealer related to the swap transactions.141
Note also that the swap may be transacted with a counterparty that either desires or is required to collect margin from the broker-dealer. In the Swaps Adopting Release, the Commission states that “if a stand-alone broker-dealer . . . delivers initial margin to a counterparty, it must take a deduction from net worth in the amount of the posted collateral.”142 The Swaps Adopting Release cites paragraph (c)(2)(iv) as a reference.143
The Swaps Adopting Release also provides an interpretation that enables the broker-dealer to avoid capital charges for providing initial margin.144 Under the interpretation, an affiliate of the broker-dealer would lend the broker-dealer the initial margin and agree that it waives repayment by the broker-dealer until the margin is returned and will accept the returned margin collateral as repayment of the loan.
The market risk capital charge for cleared security-based swaps is provided in paragraph (c)(2)(vi)(O) and the market risk capital charge for cleared swaps is provided for in paragraph (b)(1) of Appendix B. The charges are very similar. Both are based on the margin requirement of the clearing organization and both allow for reduction of the charges if the cleared security-based or other swap references an equity security or equity security index. The hedging allowance determination is provided for in Appendix A of Rule 15c3-1. Note that while Appendix A is entitled Options, it is not necessary that an option hedge the swap in order for hedging benefit to apply.
An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time.145 For example, a commercial firm with floating rate debt obligations may seek to set its interest cost over time. To address this, the firm can enter into an interest rate swap under which the counterparty agrees to pay the firm periodically adjustable variable rate interest payments based on a $100 million notional amount over thirty years. In return, the firm can agree to pay the counterparty payments based on a fixed interest rate applied over the thirty-year period. While adjusting the nature of the interest rate risk, it is important to acknowledge that it also introduces additional counterparty credit risk—the risk that the swap counterparty may default.
The fixed rates offered in the swap market are known as the “swap rate.” The market swap rate is published by market data services and generally tracks the U.S. treasury yield curve.146 Under the Net Capital Rule, each side of the interest rate swap is converted into a synthetic U.S. government bond position based on the notional amount of the swap and the interest rates against which payments are calculated.147 Specifically, Rule 15c3-1b(b)(2)(ii)(3) applies the haircut percentages in the rule that apply to U.S. securities, using the maturity of the swap and the notional amount. The charges can be offset by “comparable long or short positions in the reference asset or interest rate,” but a minimum charge of 1/8 of 1 percent is applicable to swaps with a maturity of three months or more.148
A credit default swap basically insures the buyer against the default of a debt obligation that the buyer presumably holds. It is an instrument in which the buyer makes a series of payments to the seller and, in return, the seller is obligated to make a payment to the buyer if a credit event occurs with respect to one or more entities referenced in the contract or with respect to certain types of obligations of the entity or entities referenced in the contract.149 Upon the occurrence of a specified event of default, the purchaser of the credit default swap receives the notional value of the swap contract less the current market value of the referenced obligation. The purchaser must pay the seller periodic (typically quarterly) payments over the term of the contract and possibly an additional upfront amount. The cumulative amount of annual payments can be expressed as a “spread” in basis points.150 The spread at which a credit default swap trades is based on the market’s estimation of the risk that the debt obligation referenced in the contract will suffer a credit event (as defined in the contract) that triggers the credit seller’s payment obligation as well as the market’s assessment of the size of that payment. The greater the estimated risk that a credit event will occur (or the greater the expected payment contingent upon a credit event occurring), the higher the spread will be (i.e., the cost of buying the protection).151
A credit default swap that references a single debt security or a narrow-based index is a security-based swap.152 The capital charges for those swaps is found at paragraph (c)(2)(vi)(P)(1). The charge for an unhedged short security-based credit default swap is provided for in a grid in paragraph (c)(2)(vi)(P)(1)(i):
|Length of Time to Maturity of Credit Default Swap Contract||Basis Point Spread|
|100 or less||101–300||301–400||401–500||501–699||700 or more|
|Less than 12 months||1.00%||2.00%||5.00%||7.50%||10.00%||15.00%|
|12 months but less than 24 months||1.50%||3.50%||7.50%||10.00%||12.50%||17.50%|
|24 months but less than 36 months||2.00%||5.00%||10.00%||12.50%||15.00%||20.00%|
|36 months but less than 48 months||3.00%||6.00%||12.50%||15.00%||17.50%||22.50%|
|48 months but less than 60 months||4.00%||7.00%||15.00%||17.50%||20.00%||25.00%|
|60 months but less than 72 months||5.50%||8.50%||17.50%||20.00%||22.50%||27.50%|
|72 months but less than 84 months||7.00%||10.00%||20.00%||22.50%||25.00%||30.00%|
|84 months but less than 120 months||8.50%||15.00%||22.50%||25.00%||27.50%||40.00%|
|120 months and longer||10.00%||20.00%||25.00%||27.50%||30.00%||50.00%|
This grid is based on the margin requirement in FINRA’s credit default swap margin rule, Rule 4240.1(a).
Credit default swaps that are based on a broad-based index are “swaps” generally under the CFTC’s jurisdiction.153 The capital charges for unhedged uncleared short credit default swaps that reference a broad-based index is in a similar grid found at Rule 15c3-1b(b)(2)(i)(A).
|Length of Time to Maturity of Credit Default Swap Contract||Basis Point Spread|
|100 or less||101–300||301–400||401–500||501–699||700 or more|
|Less than 12 months||0.67%||1.33%||3.33%||5.00%||6.67%||10.00%|
|12 months but less than 24 months||1.00%||2.33%||5.00%||6.67%||8.33%||11.67%|
|24 months but less than 36 months||1.33%||3.33%||6.67%||8.33%||10.00%||13.33%|
|36 months but less than 48 months||2.00%||4.00%||8.33%||10.00%||11.67%||15.00%|
|48 months but less than 60 months||2.67%||4.67%||10.00%||11.67%||13.33%||16.67%|
|60 months but less than 72 months||3.67%||5.67%||11.67%||13.33%||15.00%||18.33%|
|72 months but less than 84 months||4.67%||6.67%||13.33%||15.00%||16.67%||20.00%|
|84 months but less than 120 months||5.67%||10.00%||15.00%||16.67%||18.33%||26.67%|
|120 months and longer||6.67%||13.33%||16.67%||18.33%||20.00%||33.33%|
The charges in the grid for unhedged uncleared short credit default swaps that reference a broad-based index are 33 percent lower than the charges in the grid for unhedged short security-based credit default swaps. The proposing and adopting releases do not offer an explanation for that difference—presumably it takes into account the broader diversification offered by a broad-based index.
Outside of the 33 percent distinction, the other charges for credit default swaps are less dependent on whether the swap is a security-based swap. The capital charges for long uncleared credit default swaps is 50 percent of the applicable percentage in the relevant grid.154 If the broker-dealer hedges long securities positions with long credit default swaps, its haircut on the securities under paragraph (c)(2)(vi) or (vii) is cut in half.155 If the broker-dealer hedges short securities positions with short credit default swaps, there is no charge on the short credit default swap, but the broker-dealer incurs the full haircut on the short securities under paragraph (c)(2)(vi) or (vii).156
The capital charges for long credit default swaps hedged with similar short credit default swaps is dependent on whether the swaps are security-based. For security-based credit default swaps, a combined position of long and short swaps that meet the specified pairing criteria in the rule are subject to a charge of 50 percent of the applicable percentage of the higher maturity category of the two swaps in the grid in paragraph (c)(2)(vi)(P)(1)(i).157 Offsetting long and short uncleared credit default swaps that reference broad-based indexes are not subject to a capital charge. Rule 15c3-1b(b)(2)(i)(C) only requires a charge on the “excess long or short position” as if that excess was an unhedged long or short position.
A total return swap is designed to put the buyer in the position of having market exposure to a reference security without actually owning it. The seller pays the buyer appreciation and any interest or income on the referenced security and the buyer pays the seller any depreciation or loss on the referenced security plus a variable interest rate.158 The market risk charge for uncleared securities-based total return swaps is the capital charge on the referenced security.159 If the swap is hedged by a comparable long or short position in the reference security, the broker-dealer may reduce its capital charge by an amount equal to any reduction recognized for a comparable long or short position in the reference security under paragraph (c)(2)(vi). For example, if the total return swap referenced a debt instrument, the broker-dealer could reduce the charge by offsetting it against a position in the underlying debt instrument in paragraphs (c)(2)(vi) (A), (B), (C), (E), or (F). If the total return swap references equity securities, the broker-dealer may also reduce the charge by applying an offset available in Appendix A. Again, note that Appendix A is entitled Options, but it is not necessary that an option hedge the swap in order for hedging benefit under that appendix to apply.
The Net Capital Rule has withstood the test of time by evolving to meet the growing complexity of the securities business. It has grown from a one-page rule adopted in 1942160 with a single simple percentage to one that now is several hundred pages long, including seven appendices, with sophisticated quantitative measures. It has weathered crises, most notably the Paperwork Crunch in the late 1960s and the 2008 financial crisis, not without criticism and subsequent adjustment.
The Paperwork Crunch drew congressional attention and resulted in the adoption of the Uniform Net Capital Rule in 1975,161 applicable to all registered broker-dealers in the United States, including exchange members. Prior to 1975 exchange members complied with the capital rules of their exchanges instead of the SEC’s Net Capital Rule and exchanges varied in their application of it.162
Much of the criticism coming out the financial crisis in 2008 related to the voluntary supervision of certain broker-dealer holding companies, including Lehman Brothers Holdings, Inc.163 While the trustee for the SIPC liquidation of Lehman Brothers, Inc. found that “[a]s the Trustee’s review of the LBI experience shows, once an entity the size and scope of Lehman as a whole has already become highly leveraged and enmeshed in risky transactions, the CSE program gave the SEC seemingly ample but in practice imperfect and unwieldy tools—and limited resources—for effecting immediate change,”164 the report points to risky transactions in affiliates of Lehman’s broker-dealers as to the cause of the demise: “Probably only forceful intervention by late 2006 or early 2007, or greater separation of the broker-dealer from entities engaging in risky proprietary transactions, would have prevented a salvage operation for the broker-dealer.”165 Outside of the CSE holding company oversight provisions, the report contains no criticisms or recommendations related to the Net Capital Rule or other financial responsibility rules.
The article correctly refers to the twelve-to-one leverage ratio or “aggregate indebtedness method” that is still in the rule in paragraph (a)(1) today. It goes on to suggest that the aggregate indebtedness method was replaced by the rule changes that gave rise to the Consolidated Supervised Entities program, resulting in much higher leverage at the largest independent brokerage firms. Id. In fact, most large brokerage firms do not use the aggregate indebtedness method because they elect the so-called alternative method in Rule 15c3-1(a)(2), which requires minimum net capital to exceed 2 percent of aggregate debit items in the Reserve Formula. Strangely, the alternative method which the firms now use was adopted in 1975, when Lee Pickard was the Director of the Division of Market Regulation. See Adoption of Uniform Net Capital Rule and an Alternative Net Capital Requirement for Certain Brokers and Dealers, Exchange Act Release No. 11,497, 40 Fed. Reg. 29795 (July 16, 1975) [hereinafter Adoption of Uniform Net Capital Rule Release]; Annual Report of the SEC for the Fiscal Year Ended June 30, 1975 at v, https://www.sec.gov/about/annual_report/1975.pdf.