Study guide
SEA Rule 15c3-3, the customer protection rule, exists so that if a broker-dealer fails, customer cash and securities are already segregated and can be returned quickly. The rule has two engines: possession or control of customer securities, and the reserve formula that locks up net customer cash in a special bank account.
Possession or Control of Customer Securities
A carrying broker-dealer must promptly obtain and thereafter maintain physical possession or control of all fully paid securities and excess margin securities of customers. Fully paid securities are those in cash accounts or margin accounts with no related debit; excess margin securities are the portion of a margin customer's securities with market value above 140 percent of the customer's debit balance. The firm may hold these securities itself, in physical possession, or at a control location, a place from which the firm can retrieve them without the consent of any other party. Good control locations include a clearing corporation or depository such as DTC, a special custody account at a bank meeting the rule's conditions, securities in transit between offices for a limited time, and securities out for transfer with the transfer agent for a limited period. Non-control locations are places where someone else has a claim: securities loaned to another broker-dealer, securities pledged as collateral at a bank, securities held by a foreign custodian not meeting the conditions, or fails to receive, where the firm bought securities for a customer but the seller has not delivered. Each business day the firm must determine, from its stock record, whether it has enough securities in control locations to satisfy customer requirements. If not, the rule prescribes deadlines to reduce securities to possession or control: for example, the firm must take prompt steps to recall loaned securities, retrieve pledged collateral, and buy in aged fails to receive that remain open beyond the rule's timeframes, commonly more than 30 calendar days. Imagine Harborview Clearing shows customers long 10,000 shares of a stock but only 9,000 in control locations because 1,000 are out on loan; Harborview must recall the loan or otherwise cure the deficit within the prescribed time.
The Customer Reserve Formula: Exhibit A
The reserve formula in Exhibit A to Rule 15c3-3 compares what the firm owes customers, credits, against what customers owe the firm, debits. Credits include free credit balances, which are funds customers could demand at any time, plus monies borrowed against customer securities, monies payable against customer securities loaned, customer securities failed to receive, credit balances in firm accounts attributable to customer transactions, and market value of short security count differences and certain aged items. Debits include margin debit balances owed by customers, securities borrowed to effect customer short sales or deliveries, customer fails to deliver, and required margin deposited at clearing organizations for customer transactions. The formula includes conservatism features: aged fails to deliver lose debit treatment as they age, and firms electing the alternative net capital method must reduce total debits by 3 percent. Concentrated single-customer margin debits can also require reductions under the formula's notes, a safeguard against one customer dominating the debit side. If credits exceed debits, the excess must be on deposit in the special reserve bank account. Work through Harborview Clearing's weekly computation as of Friday's close. Credits: free credit balances of $9,000,000, payables against customer securities loaned of $2,000,000, and other customer-related credits of $1,400,000, totaling $12,400,000. Debits before adjustment total $11,300,000, and because Harborview uses the alternative method it multiplies by 97 percent, giving $10,961,000. The reserve requirement is $12,400,000 minus $10,961,000, or $1,439,000. With $1,000,000 already on deposit, Harborview must deposit an additional $439,000. Firms computing monthly, permitted only when credits stay at or below $1,000,000, must hold 105 percent of the excess.
PAB Accounts and Carrying Agreements
Customer protection extends, in modified form, to broker-dealers whose accounts another firm carries. A PAB account, short for Proprietary Accounts of Broker-Dealers, is an account a carrying firm maintains for another broker-dealer's proprietary trading. The carrying firm must perform a separate PAB reserve computation, parallel to the customer computation, and maintain a separate special reserve account for PAB account holders. The mechanics mirror Exhibit A: the carrying firm tallies credits it owes to broker-dealer account holders against related debits and deposits any excess. One notable difference is flexibility on the securities side: the carrying firm must obtain and maintain possession or control of PAB securities unless it gives the account holder written notice that the securities may be used in the ordinary course of business, which gives the parties a contractual path that does not exist for customer securities. Why does this matter? Before PAB protections were added, an introducing firm's proprietary assets at its clearing firm sat relatively unprotected in a liquidation. The relationship between introducing and carrying firms is governed by FINRA Rule 4311, which requires a written carrying agreement approved by FINRA before it takes effect. The agreement must allocate responsibility for functions such as opening and approving accounts, extending credit, receiving and delivering funds and securities, safeguarding assets, preparing confirmations and statements, and accepting orders. Allocation does not let the carrying firm ignore red flags, and the introducing firm remains responsible to its own customers for functions allocated to it. The carrying firm must also notify its examining authority of its carrying arrangements and furnish introducing firms with certain exception reports so the introducing firm can supervise its business.
The Special Reserve Bank Account
Reserve deposits go into an account titled Special Reserve Bank Account for the Exclusive Benefit of Customers, held at a bank, separate from any other firm account. The title matters: it puts the world on notice that these assets belong to customers, not to the firm or the bank. The firm must obtain a written notification from the bank acknowledging that the account assets are not subject to any right of setoff or lien for the bank's own claims against the broker-dealer. Deposits must be cash or qualified securities, meaning securities issued or guaranteed as to principal and interest by the United States government; qualified securities are valued at market. The rule limits where cash can sit: cash deposited at an affiliated bank does not count toward the reserve, and cash at any single unaffiliated bank counts only to the extent it does not exceed 15 percent of that bank's equity capital, forcing diversification away from concentrated bank risk. Computations are weekly as of the close of the last business day of the week, with any required deposit made by one hour after the opening of banking business on the second following business day; for a Friday computation, that typically means Tuesday morning. Monthly computation is available only to firms whose credits stay at or below $1,000,000, and those firms must reserve 105 percent of the excess. Withdrawals are permitted only after a computation showing the remaining balance still meets the requirement. If a firm fails to make a required deposit, it must immediately notify the SEC and its designated examining authority, and operating without an adequate reserve is among the most serious violations a carrying firm can commit.
Exemptions, Hypothecation, and Related Protections
Paragraph (k) of Rule 15c3-3 exempts firms that do not hold customer property. The (k)(1) exemption covers firms whose business is limited to certain mutual fund and variable annuity transactions where customer checks are payable to the issuer and securities are promptly transmitted. The (k)(2)(i) exemption covers firms that carry no margin accounts, promptly transmit all customer funds and deliver all securities, do not otherwise hold customer funds or securities, and effect financial transactions through a bank account designated as a Special Account for the Exclusive Benefit of Customers. The (k)(2)(ii) exemption, the most common, covers introducing firms that clear on a fully disclosed basis through a carrying firm and promptly transmit any customer funds and securities they receive. Related to prompt transmission, Rule 15c2-4 requires that money received in contingency offerings be promptly deposited into a separate bank account or escrow until the contingency occurs, and if it fails, funds are returned. The hypothecation rules, 8c-1 and 15c2-1, restrict pledging customer securities: a firm may not commingle customer securities with its own under the same pledge, may not commingle securities of different customers as collateral without each customer's written consent, and may not pledge customer securities for more than customers in aggregate owe the firm. Rule 15c3-3(h) requires the firm to buy in short security differences unresolved for more than 45 calendar days after the quarterly count discovers them. FINRA Rule 2150 prohibits improper use of customer funds or securities, prohibits guaranteeing customers against loss, and permits sharing in a customer account only with prior written authorization and in proportion to the person's contribution. Finally, Regulation S-P requires privacy notices, opt-out rights before sharing nonpublic personal information with unaffiliated third parties, safeguards policies, and, under amendments adopted in 2024, incident response programs with customer breach notification.
Key terms
- Fully paid securities
- — Customer securities in cash accounts or margin accounts carrying no debit balance, which the carrying firm must keep in its possession or control.
- Excess margin securities
- — The portion of a margin customer's securities whose market value exceeds 140 percent of the customer's debit balance; treated like fully paid securities for possession or control.
- Control location
- — A location, such as a clearing depository or qualifying bank custody account, from which the broker-dealer can obtain customer securities without the consent of any other party.
- Free credit balance
- — Funds in a customer account payable to the customer on demand; a principal credit item in the reserve formula.
- Reserve formula
- — The Exhibit A computation comparing customer-related credits to customer-related debits; any excess of credits must be deposited in the special reserve bank account.
- PAB account
- — A proprietary account of a broker-dealer carried by another broker-dealer, protected by a separate reserve computation and special reserve account under Rule 15c3-3.
- Carrying agreement
- — The FINRA Rule 4311 written contract allocating functions such as account approval, credit extension, custody, and confirmations between an introducing firm and its carrying firm.
- Special reserve bank account
- — The segregated bank account for the exclusive benefit of customers holding cash or qualified securities equal to the reserve requirement, free of any bank lien or setoff.
- Qualified security
- — A security issued or guaranteed as to principal and interest by the United States government, eligible for deposit in the special reserve account at market value.
- (k)(2)(ii) exemption
- — The Rule 15c3-3 exemption for introducing firms that clear fully disclosed through a carrying firm and promptly transmit any customer funds and securities they receive.
- Hypothecation
- — Pledging securities as loan collateral; Rules 8c-1 and 15c2-1 bar commingling customer securities with firm securities, commingling customers without written consent, and pledging customer securities beyond what customers owe.
- Guaranteeing against loss
- — Promising a customer protection from loss in an account or transaction, prohibited by FINRA Rule 2150; account sharing is allowed only with written authorization and proportionate to contribution.
Exam tips
- Anchor the 140 percent test: excess margin securities are those above 140 percent of the debit balance, and only fully paid and excess margin securities must be in possession or control.
- In reserve formula questions, classify each item as a credit or debit first; free credit balances, payables on customer securities loaned, and fails to receive are credits, while margin debits, securities borrowed for customers, and fails to deliver are debits.
- Remember the computation calendar: weekly as of Friday with the deposit due one hour after bank opening on the second business day, monthly only if credits do not exceed $1,000,000, and monthly firms reserve 105 percent.
- Match each (k) exemption to its business model, and remember (k)(2)(ii) firms lose the exemption if they hold customer funds or securities instead of promptly transmitting them.
- Alternative-method firms reduce reserve formula debits by 3 percent; watch for this adjustment in any computational question.