Net Capital Computations & Minimum Net Capital Requirements (security Firms in USA)

To run a net capital computation a member firm starts by figuring its net worth.

Net worth = all assets - all liabilities. 

Then, because many firms are capitalized by taking out subordinated loans, if the subordinated loan has been approved by the regulators, the firm then adds it to their net worth. At this point they have their total available capital.

Of course, we aren't going to let them count everything, or at full value. Therefore, the firm would then reduce that "total available capital" by subtracting out the illiquid or non-allowable assets we looked at. Remember, if the asset is not something sell-able for a fair or certain price, it is non-allowable. After subtracting the non-Allowable assets such as equity in real estate or prepaid expenses the firm has arrived at their tentative net capital.
And the formula is:  

Tentative Net capital = (Net Worth + Subordinated Debt) - Non-allowable assets

Now, the firm must apply the various "haircuts" we looked at. Finally, fails to deliver are aged, at which point the firm's net capital has been computed. And, the formula would look like this:

Tentative net capital Haircuts Net Capital = Net Worth + Subordinated Debt – Total available capital "Non-allowable assets"

Now ... How much net capital is a firm required to have?
That depends on its activities.
  • Carrying and clearing firms who accept funds and securities from customers. The minimum net capital for these firms is $250,000. 
  • Introducing firms. The minimum net capital for is either $5,000 or $50,000, depending on their activities. 
  • An introducing firm that neither receives customer assets directly or indirectly nor holds customer assets can operate with just $5,000 of net capital. 
  • An introducing broker or dealer who introduces transactions and accounts to a carrying member firm and who receives but does not hold customer assets can operate with a minimum net capital of $50,000. Also, although such a firm could participate in a syndicate performing a firm commitment underwriting, they could not enter into a commitment to purchase shares themselves on a principal basis.
  • Firms who engage in the sale of redeemable shares of registered investment companies (open-end funds, UITs), including interests in separate accounts (variable annuities, variable life insurance) can operate with minimum net capital of $25,000. These brokers or dealers "must promptly transmit all funds and promptly deliver all securities received in connection with [their] activities as a broker or dealer, and may not otherwise hold funds or securities for, or owe money or securities to, customers."
  • Firms who act as dealers must maintain net capital of $100,000. A dealer is essentially a firm trading their own account as a principal.
So, If the member is completely responsible for customer assets, its minimum net capital is $250,000. The less responsible the firm is for customer assets, the lower their minimum net capital requirement.

With an open-end mutual fund, shareholder records are maintained by the transfer agent, so if the member firm does not hold customer assets or owe them money/securities, their required net capital is not extremely high. And, of course, the lowest minimum net capital requirement of just $5,000 makes sense if the firm is just signing up customers but letting a carrying firm handle all the customers' assets.

SEC (U.S. Securities and Exchange Commission) rules define a firm as a "dealer" if it either writes options not trading on a registered national securities exchange like the CBOE or engages in more than 10 transactions in any calendar year for its own account.

So, a "dealer" could be so determined based on a small number of transactions on a principal basis (for its own account).

A market maker, on the other hand, publishes BID and OFFER prices and engages in many transactions in securities all through the trading session. Market makers provide the markets with liquidity and, not surprisingly, their minimum net capital requirement is much higher than firms merely introducing accounts or helping customers buy and sell mutual funds.

A market maker's net capital requirement is also based on the number of securities in which it makes a market. For stocks trading above $5, the requirement is $2,500 for each stock. For stocks trading at $5 or below, the requirement is $1,000.

A "market maker" for purposes of these rules is defined as "a dealer who regularly publishes bona fide, competitive bid and offer quotations in a recognized inter-dealer quotation system; or (ii) furnishes bona-fide competitive bid and offer quotations on request; and, (iii) is ready, willing and able to effect transactions in reasonable quantities at his quoted prices with other brokers or dealers."

FINRA (US Financial Industry Regulatory Authority) reserves the right to increase a firm's required net capital to protect investors. As the rules state, "FINRA may, with respect to a carrying or clearing member or all carrying or clearing members, prescribe greater net capital or net worth requirements than those otherwise applicable, including more stringent treatment of items in computing net capital or net worth, or require such member to restore or increase its net capital or net worth.

The big idea about net capital is if a firm is not meeting its minimum requirement, to protect investors and the securities markets overall, several restrictions apply. Unless FINRA says otherwise, such a firm is required to suspend all business operations during any period in which it is not meeting its requirements.

And, unless FINRA permits it, no equity capital may be withdrawn from the owners and investors of the firm within one year of contributing it. Carrying or clearing members not meeting their minimum net capital requirement "shall not, without the prior written approval of FINRA, withdraw capital, pay a dividend or effect a similar distribution that would reduce such member's equity, or make any unsecured advance or loan to a stockholder, partner, sole proprietor, employee or affiliate, where such withdrawals, payments, reductions, advances or loans in the aggregate, in any 35 rolling calendar day period, on a net basis, exceeds 10% of its excess net capital."

Carrying or clearing members also are not allowed to expand their business operations if their net capital is deficient for 15 consecutive business days. Expanding a member's business would include hiring registered representatives, initiating market making activities in new securities, or opening branch offices, among other things. If their net capital gets too low, carrying or clearing firms are not only prevented from expanding their business but also told to reduce their business activities by FINRA until their net capital is back in line. The rules here define a "business reduction” as "reducing or eliminating parts of a member's business to reduce the amount of cap¬ital required," which includes:
  • closing one or more branch offices
  • collecting unsecured or partially secured loans, advances, or other receivables
  • accepting no new customer accounts
  • restricting the payment of salaries or other sums to partners, officers, directors, shareholders, or associated persons of the member
  • accepting only unsolicited customer orders
  • reducing the size or modifying the composition of its inventory and reducing or ceasing market making

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