Customer Protection

The customer protection rule safeguards customer securities and cash. The net-capital rule addresses the firm's financial resources; neither requirement replaces the other. Proper custody and reserves support customer recovery, but do not guarantee a particular liquidation result. Return or distribution of customer property is distinct from capped advances by the Securities Investor Protection Corporation (SIPC).

The Two Pillars

The customer protection rule has two operational pillars that work in parallel:

The rule's own short name for this account is the Customer Reserve Bank Account, and the matching account for other broker-dealers' proprietary accounts is the Proprietary Accounts of Broker-Dealers (PAB) Reserve Bank Account.

Where both obligations apply, satisfying one does not excuse failure of the other. Assess any applicable exemption or custody exception under its actual conditions.

Shared teams and combined internal records can address multiple duties when the necessary information and processes are present. A funded reserve calculation alone does not establish securities custody. The two-pillar distinction does not itself require separate internal attestations.

Think of it this way: Required custody securities need physical possession or qualifying control. Customer cash needs the reserve calculation and required bank balance. The reserve bank holds deposits for customers' exclusive benefit and cannot use them as security for loans to the firm or claim them. Check each applicable duty under its own conditions.

Pillar 1: Possession or Control of Customer Securities

The ordinary requirement is to obtain and maintain physical possession or control of fully paid securities and excess margin securities carried for customers. A qualifying securities loan can meet the specified custody exception; generic customer permission alone is insufficient.

Qualifying Securities Loans

Enter the written loan agreement at or before the loan. A separate term schedule or schedules must address compensation and the parties' rights and liabilities, and the lender must receive the actual borrowed-securities schedule at borrowing.

The agreement itself must contain the prominent qualified Securities Investor Protection Act (SIPA) warning: SIPA may not protect the securities-loan transaction, and delivered collateral may be the only recourse if the member fails to return the securities.

Provide full eligible collateral upon execution when the loan occurs then, or by the close of the business day of a later loan. Mark the loan at least daily and deliver additional eligible collateral by the next business day's close after the specified end-of-day shortfall.

These custody-exception conditions do not remove independent customer-borrowing duties, including applicable advance FINRA notice and pre-borrow customer determinations and disclosures.

Defining Excess Margin Securities

"Excess margin securities" = securities with market value exceeding 140% of the customer's debit balance.

Real-world example: Customer has $100,000 of stock and a $50,000 margin loan. 140% of $50,000 = $70,000. The first $70,000 of stock by value is regular margin collateral the firm may use. The remaining $30,000 is excess margin and must be segregated under possession or control.

Acceptable Control Locations

Examples of qualifying possession or control locations include:

• A qualifying clearing/depository location, such as the Depository Trust Company (DTC), with records identifying customer entitlements
• A qualifying bank custodian that acknowledges in writing that the securities are free of its claims or those of persons claiming through it, with delivery not requiring payment of money or value
• The firm's own vault (with proper recordkeeping and segregation)
• A qualifying omnibus account at another carrying firm, with instructions to maintain the customer securities free of the carrying firm's charges, liens and claims

Securities Not in Good Control

If required custody securities are not in good control, apply the relevant control-deficiency procedure and its deadlines. Depending on the facts, corrective steps can include:

• Buy-in the failing position
• Borrow the security to cure the deficiency
• Otherwise resolve the position

Temporary lags solely from normal operations can qualify when the firm takes timely good-faith steps to establish prompt control. They are not a general waiver. Do not infer that every deficiency requires an immediate buy-in.

Normally determine custody quantities as of the preceding business day's close, no later than the next business day. Inactive margin accounts can be computed at least weekly. When the ordinary control-reduction procedure applies, its specific triggers and deadlines include:

For a syndicate short position, the 30-day period starts when the underwriter's participation in the distribution ends. Apply the distinct long-sale provisions where they cover the position. These control-deficiency procedures do not require automatic recall of every qualifying securities loan.

Covered customer long sales use a different clock. If the firm has not obtained the sold securities from the customer within 10 business days after settlement, immediately thereafter close the customer transaction by purchasing securities of like kind and quantity. These covered positions are excluded from the 30-calendar-day allocated-short procedure.

The long-sale procedure excludes qualifying broker-dealer omnibus credit accounts. Its operation is suspended for sell orders in exempted securities, such as U.S. government and municipal obligations.

Exam Tip: Gotchas

• Excess margin = market value above 140% of the debit balance. Common exam trap: students remember "140%" but apply it to the wrong base. The 140% applies to the debit balance, not to the market value. The 40% above the debit is the buffer the firm gets to use as margin collateral.
• Ordinary custody shares are not available for unilateral firm use. A generic asset-use clause does not establish a qualifying securities loan. A loan meeting the written-agreement, schedule, qualified-notice and collateral conditions can meet the custody exception; independent borrowing safeguards still apply.

Pillar 2: The Customer Reserve Formula

The Reserve Formula (set out in the rule's Exhibit A) computes the dollar amount the firm must keep in the Special Reserve Bank Account. The math is a credit-side / debit-side balancing exercise:

Credits (What the Firm Owes Customers)

• Free credit balances in customer accounts (uninvested cash payable on demand)
• Credit balances in customer accounts (settled funds)
• Monies payable against customers' securities loaned, with the formula's applicable adjustments
• Other customer-related credits per Exhibit A

Debits (What Customers Owe the Firm or the Firm's Customer-Related Receivables)

• Customer debit balances (margin loans)
• Specified securities borrows for customer short sales or to make delivery on customers' failed-to-deliver positions
• Other customer-related debits per Exhibit A

The Net Result

If credits exceed debits, the Reserve Account must hold at least the excess, so the firm deposits any shortfall. The balance is not frozen there: the firm may withdraw to the extent the amount left is not less than the amount then required, and it must record the computation behind the withdrawal on the day it withdraws.

The deposit must consist of:

• Cash, or
• Qualified securities (securities issued by the United States or guaranteed by it as to principal and interest)

Reserve-bank documentation is required. Obtain and preserve the bank's written notification of exclusive-benefit holding and separation from other accounts. Maintain the written contract prohibiting direct or indirect use of the deposits as security for bank loans to the firm, and rights, charges, liens or claims in favor of the bank or persons claiming through it.

Think of it this way: The reserve formula treats the customer-related side of the balance sheet as a self-contained ledger. If the firm owes customers (in aggregate) more than customers owe the firm, the difference must be parked at a bank in an account held for the exclusive benefit of customers, separate from the firm's other accounts. The firm may use customer credits only for the purposes the formula's debit items specify, so it cannot use customer free credit balances to fund proprietary trading or pay firm operating expenses.

Computation Frequency: Weekly, Daily, or Monthly

The reserve formula is computed and the deposit reconciled on a frequency that depends on the firm's size:

The monthly customer route has a weekly-transition requirement when aggregate indebtedness exceeds 800% of net capital at a required computation. That route requires four successive weekly computations without an aggregate-indebtedness excess before the firm can return to monthly computation; the other eligibility conditions still apply.

The $500 Million Daily Threshold

The SEC adopted a daily reserve computation requirement for the largest carrying firms. The threshold is:

• Average total credits of $500 million or more: the arithmetic mean of combined customer and PAB total credits in the 12 most recently filed month-end FOCUS reports
• Comply with mandatory daily computation no later than six months after reaching the defined threshold
• To elect weekly computation after falling below the threshold, give the designated examining authority written notice at least 60 calendar days beforehand; falling below it alone does not end daily computation

Daily computation requires workflows that refresh data, reconcile and compute every business day. Firms below the mandatory threshold may have other permitted frequencies or voluntary daily arrangements; do not assume every below-threshold firm computes weekly.

Exam Tip: Gotchas

• The daily threshold uses a defined 12-report combined-credit average. Combine customer and PAB credits, apply the six-month compliance transition and check the written-notice conditions for electing weekly computation after falling below the threshold.
• The weekly deposit is due on the second following business day. Computation is as of the close of the last business day of the week (usually Friday); the deposit is due no later than one hour after banking opens on the second following business day (usually Tuesday). The exam may probe whether the deposit deadline is "the next business day" (it is not).

The PAB Reserve Account

The rule requires a separate Proprietary Accounts of Broker-Dealers (PAB) Reserve Computation for the firm's PAB account business. PAB credits and debits are computed under the same Exhibit A formula but for the proprietary accounts of other broker-dealers carried by the firm.

• PAB customers are other BDs whose assets the firm holds for them as proprietary positions
• The PAB rule extends customer-protection logic to inter-firm carrying relationships
• A separate special reserve bank account is required for PAB

The PAB reserve uses the same formula but addresses other broker-dealers' proprietary accounts. Its securities-use conditions differ from ordinary retail customer custody: before using PAB securities in the ordinary course of business, provide the account holder written notice and an opportunity to object. Do not treat the two account categories as identical in every respect.

A separate monthly PAB route applies under its own conditions. A firm that neither carries customer accounts as defined by the rule nor conducts a proprietary trading business may compute PAB reserves monthly rather than weekly. Assess other applicable frequency requirements before selecting the route.

If a required monthly PAB computation calls for an additional deposit, switch to weekly PAB computations until four successive weekly computations require no additional deposit.

Exam Tip: Gotchas

• The PAB reserve is SEPARATE from the customer reserve. Each is computed separately and kept in its own account. The one crossover runs a single way: a PAB deposit requirement may be satisfied to the extent of any excess debit in the customer computation of the same date, but a customer deposit requirement cannot be satisfied with excess debits from the PAB computation.

When a Firm Is Exempt from Customer Protection

A firm can claim an exemption only when its actual activities meet the applicable conditions. Examples include:

Fully Disclosed Introducing Firm

Clear all customer transactions on a fully disclosed basis through a clearing firm. Promptly transmit all customer funds and securities to that firm, which carries all customer accounts and maintains the customary required clearing books and records.

Limited-Business Route

Dealer transactions are limited to purchases, sales and redemptions of redeemable registered investment-company securities or insurance separate-account interests. Brokerage activity is limited to their sale and redemption, qualifying federally insured savings-and-loan share solicitation, and sales to fund immediate reinvestment in redeemable registered investment-company securities.

Promptly transmit funds and deliver securities; otherwise neither hold customer assets nor owe customers money or securities. Specific allowances cover a sole proprietor's occasional own-account trades through another registered broker-dealer and a qualifying insurance company's insurance business.

No-Margin Special-Account Route

Carry no margin accounts, promptly transmit customer funds and deliver securities, and otherwise neither hold customer assets nor owe customers money or securities. Effect all financial transactions with customers through bank accounts designated as special accounts for the exclusive benefit of the firm's customers.

SEC Relief

Written application can support an exemption if the SEC finds comparable customer safeguards and that applying the rule is unnecessary in the public interest or for investor protection. Follow any specified terms and conditions.

A firm label or absence of one account type does not establish an exemption. Temporary receipt for permitted prompt transmission is different from ongoing custody outside the claimed conditions. Examine actual activities and the annual reporting requirements; do not infer a false filing solely from receipt of customer assets.

What Should You Check on Exam Day?

• Can you state the percentage of the debit balance used to define excess margin securities, and which securities fall below that threshold?
• Do you know the average total credits threshold that shifts a carrying firm from weekly to daily reserve formula computation?
• Can you state the weekly reserve formula's computation and deposit deadlines, computed as of which day and deposited by which day?
• Can you distinguish the customer reserve computation from the PAB reserve computation, and say which way excess debits may cross between them?