Study guide
The net capital rule, SEA 15c3-1, requires every broker-dealer to hold enough liquid capital to wind down in an orderly way and pay all customers and creditors. Together with margin, securities lending, and short-sale close-out rules, it defines how a FinOp manages the firm's capital and cash from moment to moment, because compliance is measured continuously, not just at month end.
Minimum Net Capital by Firm Type
Rule 15c3-1 sets dollar minimums that scale with the risk a firm poses to customers. A carrying firm, one that holds customer funds or securities, must maintain at least $250,000. A firm that carries customer accounts but qualifies under the (k)(2)(i) framework because it does not generally hold customer funds or securities has a $100,000 minimum, and $100,000 is also the general dealer minimum for firms trading for their own account, including firms that endorse or write over-the-counter options. An introducing firm that receives customer securities for prompt forwarding but does not hold them has a $50,000 minimum. The lowest tier, $5,000, applies to introducing firms that never receive or hold customer funds or securities, introducing all business fully disclosed to a carrying firm. Market makers have a position-based requirement: $2,500 for each security in which they make a market priced above $5 per share and $1,000 for each security at $5 or less, subject to a floor of $100,000 and a ceiling of $1,000,000. A firm's actual minimum is the greatest applicable figure, and FINRA membership agreements can impose higher requirements. Consider three invented firms. Brightwater Clearing carries retail accounts, so its floor is $250,000. Kestrel Trading runs a proprietary desk and makes markets in 90 stocks over $5, so its market maker figure is 90 times $2,500, or $225,000, which exceeds the $100,000 dealer minimum. Fernway Advisors introduces all accounts to Brightwater and never touches customer assets, so $5,000 applies. The dollar minimum, however, is only the starting point; the ratio tests in the next section usually govern.
Aggregate Indebtedness versus the Alternative Standard
Beyond the dollar minimum, a firm must satisfy one of two ratio standards. Under the basic aggregate indebtedness standard, aggregate indebtedness, which is essentially the firm's total unsubordinated liabilities with specified exclusions, may not exceed 1,500 percent of net capital, a 15 to 1 ratio. For a firm's first twelve months of business, the limit tightens to 800 percent, or 8 to 1. Equivalently, required net capital is one-fifteenth, or in year one one-eighth, of aggregate indebtedness, if that exceeds the dollar minimum. Watch the early warning line at 12 to 1, where Rule 17a-11 notification is triggered. Try the math on Fernway Advisors, in its first year with aggregate indebtedness of $600,000 and net capital of $70,000. The ratio is $600,000 divided by $70,000, about 8.57 to 1, which violates the first-year 8 to 1 limit even though it is comfortably below 15 to 1; Fernway needs at least $75,000 of net capital, one-eighth of $600,000. The alternative standard, elected mainly by carrying firms, ignores aggregate indebtedness entirely: the firm must maintain net capital of at least 2 percent of aggregate debit items computed under the Exhibit A reserve formula, subject to the $250,000 floor, with early warning at 5 percent of debits. A carrying firm with $100,000,000 of aggregate debits needs $2,000,000 of net capital and hits early warning below $5,000,000. Remember that alternative-method firms also reduce reserve formula debits by 3 percent. Compliance with whichever standard applies is a moment-to-moment obligation: a firm that dips below its requirement at any point during the day is in violation, must cease business requiring net capital, and must notify regulators the same day.
The Computation: From Net Worth to Net Capital
Net capital is computed in a fixed sequence. Start with GAAP net worth, total assets minus total liabilities. Make adjustments: add back liabilities subordinated under an approved Appendix D agreement, since they behave like capital, and add back certain deferred tax liabilities; deduct unrealized profit adjustments as required. Next subtract non-allowable assets, which are assets that cannot be readily converted to cash: fixed assets like furniture and leasehold improvements, prepaid expenses, most unsecured receivables, goodwill and other intangibles, and exchange memberships. What remains is tentative net capital. Finally subtract haircuts, percentage deductions from the market value of proprietary securities positions that cushion against price movement, plus other prescribed charges. The result is net capital, which is compared to the requirement. Work the numbers for Meridian Securities, a carrying firm. Net worth per the ledger is $1,200,000. Meridian adds back a $300,000 FINRA-approved subordinated loan, reaching $1,500,000. Non-allowable assets total $300,000: furniture and fixtures of $150,000, prepaid expenses of $50,000, and unsecured receivables of $100,000. Tentative net capital is therefore $1,200,000. Meridian's only proprietary position is $400,000 of marketable equities, taking a 15 percent haircut of $60,000, so net capital is $1,140,000. Against the $250,000 carrying minimum, Meridian has $890,000 of excess net capital. Its aggregate indebtedness of $900,000 produces a ratio of roughly 0.79 to 1, far below 15 to 1, and one-fifteenth of aggregate indebtedness is only $60,000, so the $250,000 dollar minimum governs. Early warning would not trigger unless net capital fell below $300,000, which is 120 percent of the minimum.
Haircuts and Other Charges
Haircuts scale with price risk and liquidity. Marketable equity securities generally take 15 percent of market value on the greater of the long or short side, with an additional charge on the lesser side to the extent it exceeds 25 percent of the greater side. United States government securities take much smaller haircuts on a schedule graduated by remaining maturity, from a fraction of one percent for short maturities to roughly 6 percent at the long end. Municipal securities and investment-grade nonconvertible debt have their own graduated schedules, generally between those extremes. Securities with no ready market, and most non-marketable positions, are haircut 100 percent, effectively non-allowable. The undue concentration charge adds another 15 percent on the portion of a single security position whose value exceeds 10 percent of the firm's tentative net capital, discouraging concentrated bets. Suppose Kestrel Trading has tentative net capital of $2,000,000 and holds $500,000 of one equity. Ten percent of tentative net capital is $200,000, so $300,000 is excess. The base haircut is 15 percent of $500,000, or $75,000, and the undue concentration charge is 15 percent of $300,000, or $45,000, for a total deduction of $120,000. Other charges follow the same logic of penalizing stale or risky items: fails to deliver outstanding five business days or more take haircut-based charges, unsecured or aged customer margin deficiencies are deducted, open contractual commitments such as underwriting positions take haircuts on the net commitment, and if the firm's fidelity bond deductible exceeds the amount FINRA Rule 4360 permits, the excess is deducted from net worth. Aged short security differences from the quarterly count also generate charges as they await buy-in.
Subordinations, Withdrawal Limits, and Business Curtailment
Appendix D to Rule 15c3-1 governs subordinated loan agreements, the approved route for treating borrowed money as capital. A subordination must run at least one year, be approved by the firm's examining authority before it counts, and subordinate the lender's claim to all other creditors. Two flavors exist: cash subordination agreements, where the lender hands over cash, and secured demand note agreements, where the lender delivers a demand note secured by marketable securities the firm can sell in liquidation; the collateral is haircut when counted. Temporary subordinations of up to 45 days are available for limited purposes such as underwritings. Capital quality is policed by the debt-equity requirement: total subordinated debt generally may not exceed 70 percent of the sum of subordinated debt plus equity for more than 90 days. A firm with $300,000 of equity and $700,000 of subordinated loans sits exactly at 70 percent; one more dollar of subordination without new equity breaches the standard. FINRA Rule 4110 gives FINRA authority over capital withdrawals and sale-of-assets transactions at carrying and clearing firms, and Rule 4120 imposes operational consequences near early warning: a firm may not expand its business when, for 15 consecutive business days, its ratio exceeds 10 to 1 or net capital is below 5 percent of aggregate debits or below 150 percent of its minimum, and it must reduce business when the figures reach 12 to 1, 4 percent, or 125 percent. Funding and cash management round out the function. Regulation T sets 50 percent initial margin and a payment deadline shortly after settlement, with extension requests filed under FINRA Rule 4230. FINRA Rule 4210 sets maintenance margin, generally 25 percent on long positions and 30 percent or prescribed dollar amounts on shorts, a $2,000 minimum equity, pattern day trader requirements including $25,000 minimum equity, and the special memorandum account that preserves buying power. Firms fund inventory through stock loan and repurchase agreements, both marked to market daily with collateral customarily around 102 percent, and Regulation SHO requires a locate before short sales under Rule 203 and close-out of fails under Rule 204, generally by market open the settlement day after settlement date for short sale fails, with longer periods for long sales and market makers.
Key terms
- Net capital
- — A broker-dealer's liquid capital: net worth adjusted for subordinated liabilities and other items, minus non-allowable assets and haircuts, required by SEA Rule 15c3-1 to exceed prescribed minimums at all times.
- Aggregate indebtedness
- — Generally the firm's total unsubordinated liabilities with specified exclusions; under the basic standard it may not exceed 1,500 percent of net capital, or 800 percent in the firm's first year.
- Alternative standard
- — The elective net capital standard requiring net capital of at least 2 percent of aggregate debit items from the reserve formula, with a $250,000 floor and early warning at 5 percent.
- Tentative net capital
- — Net worth after adjustments and after deducting non-allowable assets but before haircuts; also the base for measuring undue concentration.
- Non-allowable asset
- — An asset not readily convertible to cash, such as fixed assets, prepaid expenses, goodwill, and most unsecured receivables, deducted in full in the net capital computation.
- Haircut
- — A prescribed percentage deduction from the market value of proprietary securities positions, such as 15 percent on marketable equities, reflecting price and liquidity risk.
- Undue concentration
- — An additional 15 percent haircut on the portion of a single security position exceeding 10 percent of tentative net capital.
- Subordinated loan agreement
- — An Appendix D borrowing, approved by the examining authority, with the lender's claim subordinated to all other creditors, allowing the proceeds to count as capital; minimum term of one year.
- Secured demand note
- — A subordination in which the lender contributes a demand note collateralized by marketable securities rather than cash; the collateral value is subject to haircuts.
- Debt-equity requirement
- — The limit under which total subordinated debt generally may not exceed 70 percent of combined subordinated debt and equity for more than 90 days.
- Regulation T
- — The Federal Reserve rule governing broker-dealer extension of credit, setting 50 percent initial margin on most equity purchases and payment deadlines, with extensions requested under FINRA Rule 4230.
- Rule 204 close-out
- — The Regulation SHO requirement that a clearing participant close out a fail to deliver, generally by market open on the settlement day after settlement date for short sale fails, with extended periods for long sales and bona fide market making.
Exam tips
- Lock in the minimums ladder: $250,000 carrying, $100,000 for (k)(2)(i) firms and dealers, $50,000 for introducing firms that receive but do not hold securities, $5,000 for pure introducing firms, and $2,500 or $1,000 per security for market makers between a $100,000 floor and $1,000,000 cap.
- Practice the computation order until it is automatic: net worth, plus approved subordinations and permitted add-backs, minus non-allowable assets, equals tentative net capital, minus haircuts and other charges, equals net capital.
- Keep the ratio tests straight: 15 to 1 basic, 8 to 1 in year one, 12 to 1 early warning; alternative method is 2 percent of aggregate debits with 5 percent early warning; and net capital compliance is continuous, moment to moment.
- Expect a debt-equity question: subordinated debt above 70 percent of total capital for more than 90 days is a violation, so recompute the ratio after any proposed withdrawal or new loan.
- Associate FINRA 4120 thresholds with consequences: expansion is barred around 10 to 1, 5 percent of debits, or 150 percent of the minimum, and business reduction is required around 12 to 1, 4 percent, or 125 percent.