Broker-dealers must meet certain financial requirements in order to register. Those requirements are often summarized as net capital. You don’t need the detailed calculation here - think of net capital as a measure of the firm’s financial strength. Regulators don’t want underfunded firms handling customer securities transactions. If something goes wrong in a customer’s account and the broker-dealer is liable, the firm needs enough financial resources to make the customer whole.
Broker-dealers also need capital simply to process customer trades. For example, during the Gamestop short squeeze in early 2021, some firms needed additional funding to meet clearing and settlement-related demands. If a broker-dealer runs out of funds, it may not be able to operate properly.
Broker-dealers are registered with and regulated by both the Securities and Exchange Commission (SEC)* and the state administrators. Both the Securities Exchange Act of 1934 (the SEC-enforced federal law governing broker-dealers) and the Uniform Securities Act (USA) include specific financial requirements for broker-dealers. Sometimes those requirements differ.
*Broker-dealers that operate in one state only are not subject to SEC registration or regulation. In order to be subject to federal laws, interstate commerce (doing business in more than one state) is required.
So what happens if a broker-dealer faces two different financial requirements? For example, what if the SEC requires a minimum net capital level of $35,000, while a state administrator requires $50,000? The National Securities Market Improvement Act (NSMIA) of 1996 addresses this conflict. It establishes that federal law (and the SEC rules enforcing it) takes priority over state law in this area.
As a result, even if a state’s net capital requirement is higher than the SEC’s, state administrators cannot require broker-dealers to maintain net capital above the federal minimum. In practice, this makes the SEC and the Securities Exchange Act of 1934 the final authority on a broker-dealer’s net capital requirements. Since this is a state-based exam, the specific dollar amounts are typically not tested on the Series 63.
Brokerage firms are required to provide SIPC insurance to all customers. The Securities Investor Protection Corporation (SIPC) is an industry-funded nonprofit organization that provides insurance to brokerage firm customers if a broker-dealer goes bankrupt. If a brokerage firm becomes insolvent, SIPC works to help customers recover the assets in their accounts.
Broker-dealers hold (or arrange for the holding of) customer assets, so problems can arise if the firm fails. For example, the firm might not have properly segregated or tracked customer securities and cash. SIPC insurance is designed to address that kind of broker-dealer failure.
SIPC insurance covers customers up to $500,000 of securities and cash per registration, but no more than $250,000 in cash. If a customer has a margin account, only the customer’s equity is covered. In other words, any amount owed to the broker-dealer must be deducted from the customer’s assets before SIPC coverage is applied. If a customer’s claim exceeds SIPC limits, the customer becomes a general creditor of the broker-dealer.
Coverage is determined by separate registration. A separate registration generally means a different ownership capacity. For example, an individual account and a joint account with a spouse are two separate registrations, so they receive two separate SIPC coverages. However, an individual cash account and an individual margin account are both under the same individual registration, so SIPC provides only one coverage for the two accounts.
When a customer opens an account, the broker-dealer must provide confirmation of SIPC coverage. The broker-dealer must also provide annual confirmations of SIPC coverage to each customer.
SIPC insurance covers broker-dealer failure, not market risk. If an investor loses money because an investment declines in value, SIPC does not cover that loss.
In addition to net capital requirements, broker-dealers may be required by state administrators to post surety bonds.
A surety bond functions like insurance against certain broker-dealer failures to meet obligations to customers. Generally, surety bonds cover losses related to theft, misuse of customer funds, and unfulfilled commitments. For example, if an agent embezzles funds from a customer account, mistakenly sells a security when the customer requested a purchase, or promises product features that don’t exist, a surety bond can help ensure the customer is reimbursed when required.
Depending on the state, broker-dealers that exercise discretion or maintain custody of customer funds may be required to post a surety bond. Discretion means the broker-dealer makes investment decisions on the customer’s behalf, which requires power of attorney. Custody means holding customer funds or securities on the customer’s behalf. If you keep an account at the brokerage firm that executes your trades, that broker-dealer has custody of your assets. Some broker-dealers only execute transaction requests, while customer funds and securities are held at another institution (such as a bank). We’ll discuss custody in more depth later.
Like insurance, surety bonds typically involve ongoing premiums and fees paid to the organization providing the bond (often an insurance company or bank).
A broker-dealer can also satisfy the requirement by posting the required amount in cash or securities. For example, if Washington’s state administrator requires a $100,000 surety bond, the broker-dealer could post $100,000 of cash or securities as collateral instead of paying ongoing premiums. The state administrator cannot require a specific method of compliance. All of the following are eligible means to complying:
The following video summarizes the key points covered in this chapter, plus some details from the previous chapter:
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