Aggregate Indebtedness and Alternative Standard

The net capital of a firm is based on its aggregate indebtedness, which the SEC (U.S. Securities and Exchange Commission) defines as:

"the total money liabilities of a broker or dealer arising in connection with any transaction whatsoever."

Aggregate Indebtedness includes: "money borrowed, money payable against securities loaned, securities failed to receive, the market value of securities borrowed to the extent to which no equivalent value is paid or credited, customers and non-customers free credit balances, credit balances in customers' and non-customers accounts having short positions in securities."

Firms using the aggregate indebtedness standard must not allow their aggregate indebtedness to exceed 1500 percent of their net capital if they are an established firm, or 800 percent of net capital for the first 12 months after commencing business as a broker or dealer.

Firms electing to use the alternative standard for computing net capital must notify their designated examining authority (FINRA, or the exchange) of their intention to use the alternative standard.

These firms must not allow their net capital to drop below the greater of $250,000 or two percent of "aggregate debt items."

Notice that the aggregate indebtedness standard involves comparing  Indebtedness to net capital, while the alternative standard goes the other way - net capital is compared to the firm's indebtedness. Point is, however the firm measures it, their net capital is extremely important to FINRA, the SEC, and the markets overall.

The SEC defines a free credit balance as:
"Liabilities of a broker or dealer to customers which are subject to immediate cash payment to customers on demand, whether resulting from sales of securities, dividends, interest, deposits, or otherwise."

Why is a customer's "free credit balance" a form of indebtedness to the firm?
Because that cash has been put to work by the firm and is owed to the customer upon demand. In other words, it's just like at a bank, where the money in someone's savings account has been put to work by the bank and is owed to the customer upon demand. In fact, that's why they call them "demand deposit accounts" at the bank.

Broker-dealers must follow stringent requirements when investing a customer's unused cash. As SEC rules require, sweep programs must be explained clearly to brokerage customers. Investors can leave their un-invested cash in their brokerage accounts. Or, they can have the cash swept into a money market mutual fund, which receives SIPC protection. Or, they can choose to have it swept into a bank account, where it receives FDIC insurance. The latter is called a "bank sweep program," for obvious reasons.

Some broker-dealers have the cash swept into multiple bank accounts. That way, rather than stopping at $250,000 of protection per-customer, these sweep programs provide up to $500,000 in protection.

Whatever the customer chooses, it is his responsibility to monitor his cash position to be sure it does not exceed either Securities Investor Protection Corporation (SIPC) or Federal Deposit Insurance Corporation (FDIC) coverage.

Broker-dealers earn interest on bank sweep accounts, much more than they credit to the customers. In fact, many well-known firms earn hundreds of millions of dollars each year just on the spread between what they earn and what they pay on un-invested customer cash.

If that seems unfair, there is a simple solution for customers—put the cash back into stocks, bonds, mutual funds, etc. The broker-dealer makes money either way: the interest on the unused cash, or the commissions on the trades.

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