Regulatory Requirements of Broker-Dealers

FINRA member broker-dealers must have principals, also known as supervisors. For most firms, one of these principals must be registered as a Series 27 - Financial and Operations Principal (FINOP). A "FINOP" principal can supervise the following activities:

•    Back office operations
•    Preparation and maintenance of a member firm's books and records.
•    Compliance with financial responsibility rules that apply to self-clearing broker-dealers and market makers.

A principal with a Series 27 registration is responsible for filing regular FOCUS (Financial and Operational Combined Uniform Single) reports. FOCUS reports show items including amounts the firm owes to customers and other parties, as well as amounts owed to the firm. Securities borrowed for short sales, and securities that were failed to receive are also indicated. Also, the current values of securities owned by the firm are listed.

The SEC establishes broker-dealer net capital requirements under the Securities Exchange Act of 1934 and the rules issued under the Act. Whether a firm has a customer who is slow to pay when buying or slow to deliver when selling, the firm's own capital may be required to settle the transaction.

Member firms who underwrite securities frequently perform firm commitment underwriting in which they promise to buy shares that investors do not subscribe to. Not to mention that broker dealers are businesses that have all the typical general operating expenses that other professional service firms do.

FINRA-member broker-dealers are required to provide, on request, information about its financial condition to its customers. As the rules state:

[(a) A member shall make available to inspection by any bone-fide regular customer upon request, the information relative to such member's financial condition as disclosed in its most recent balance sheet prepared either in accordance with such member's usual practice or as required by any state or federal securities laws, or any rule or regulation thereunder.
(b) As used in paragraph (a) of this Rule, the term "customer" means any person who in the regular course of such member's business, has cash or securities in the possession of such member.]


Broker-dealers becoming insolvent can have a significant negative impact on the markets, so the SEC requires broker-dealers to constantly monitor and report their financial condition. What's critically important here is the liquid net worth of the firm.

Like any business, broker-dealers have assets that can be readily sold and those that can't. Therefore, when calculating their net capital, member firms exclude their illiquid assets. These assets that are not easily sold for their full value are also called non-allowable assets for purposes of calculating net capital. Illiquid or "non-allowable" assets include equity in real estate, exchange memberships, furniture and fixtures, and intangible assets such as goodwill or prepaid expenses. Notice that while these assets have value, the value is either too hard to determine or would involve selling, say, $5,000 worth of office furniture for a few hundred dollars.

The firm also owns securities. While securities do have a discernible market value, that value is often volatile. Some securities trade so infrequently that determining any market value can be difficult. So, if the regulators don't want broker-dealers counting intangible assets, it's not surprising they also don't want member firms counting their securities at 100% of today's market value.

Rather, the typical reduction in value called taking a haircut for common stock is 15 %. If the stock trades in a limited trading market, the haircut/reduction in value is 40%. And, if the security has no ready market, the regulators require broker-dealers to treat them as worthless a 100% haircut is taken.

The regulators even require an extra haircut if a security would make up too much of a firm's net capital, called an undue concentration. If a non-exempt security's value is more than 10% of the firm's tentative net capital, the firm must take an additional haircut at the same rate by which the position exceeds the 10 % threshold on the security's value.

And, if a customer has a fail to deliver after selling stock, the firm must set up a fail to deliver account on its books in the amount of the sales proceeds for the trans¬action. Believe it or not, at this point the position is still an allowable asset.

However, the longer the fail-to-deliver drags on, the bigger the required haircut. On the fifth business day following settlement the fail-to-deliver must be aged for purposes of computing net capital. The position would now be marked to the market with a 15% haircut taken on that. Even though the asset has been aged, it is still an allow¬able asset. It just needs to get itself an extra-short haircut to be counted in the firm's net capital.

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