Free Credit Balances

The free-credit-balance notice is a disclosure requirement inside the customer protection rule, and it pairs with that rule's reserve framework. Free credit balances are not segregated cash sitting in a vault for each customer.

They are general firm liabilities that the firm may use only for the purposes the reserve formula's debit items specify, with the reserve account providing the customer-protection backstop. The notice requirement makes the firm tell each customer in writing, at least every three months, the amount it owes and that the amount is payable on demand.

What Free Credit Balances Are

A free credit balance is a liability of the BD to a customer that is subject to immediate cash payment on demand, whether it came from a sale of securities, dividends, interest, a deposit or otherwise.

• Customer deposits cash in the account
• Customer sells a security and the proceeds settle but are not yet reinvested
• Customer's account holds long positions paid in full plus a cash balance
• The cash sits as a general firm liability payable to the customer

Customers have the right to demand payment of free credit balances on request. The balance is subject to immediate cash payment on demand, so the firm cannot defer payment or condition it on additional trades.

Think of it this way: A free credit balance is a checking-account deposit at the BD. The customer can pull it whenever they want. While it is sitting there, the BD treats it as a general firm liability and may use the cash only for the purposes the reserve formula's debit items specify, such as financing other customers' margin loans. The notice's job is to tell the customer what the firm owes and that it can be demanded at any time.

The Quarterly Disclosure Requirement

Firms holding free credit balances must provide written notice with every statement and at least once every three months, stating:

The notice may appear in or accompany the account statement. A firm sending monthly statements includes the required notice with each one. Accurate additional explanation of permitted firm use is possible, but the current notice provision specifically requires the amount and demand right. The rule's next paragraph separately governs sweep programs, consent, and related disclosures.

Plain-Language Format

The disclosure must be written so the customer can understand it. Acceptable language includes:

• "Your free credit balance of $X is payable to you on demand"
• "As of this statement date, we owe you $X"
• A brief reference to the customer protection rule or SIPC for those who want to read more

Exam Tip: Gotchas

• Free credit balances are NOT segregated cash. They are general firm liabilities that may be used only for the purposes the reserve formula's debit items specify, with at least the net excess of credits over debits kept in the reserve account.
• The firm needs notice procedures before it uses the balances. It must have adequate procedures for sending each such customer the quarterly statement. That statement does not have to say the firm may use the funds; it must state the amount due and that it is payable on demand.
• The notice is "at least quarterly." The rule sets a floor, not a ceiling. Monthly statements satisfy the rule. The exam may probe whether annual disclosure is sufficient (it is not).

Interaction with the Customer Protection Rule

Free credit balances flow into the customer reserve formula on the credit side. So the customer-protection chain looks like this:

1. Customer leaves cash in the account → free credit balance accrues
2. The free credit balance is reported as a credit in the firm's reserve formula computation
3. If final credits exceed final debits, the difference determines the required customer reserve balance; any additional deposit depends on existing qualifying assets and the applicable deadline
4. The cash in the reserve account is the customer-protection backstop if the firm fails

The free-credit-balance notice tells customers what the firm owes them and that it is payable on demand. The reserve requirement requires at least the net amount the firm owes customers to be held in a reserve account at a bank. The two requirements work together: the notice is the customer-facing disclosure; the reserve requirement is the operational backstop.

Exam Tip: Gotchas

• Complete, timely disclosure does not cure a reserve-formula omission. On those facts, the firm has a reserve violation; it has not also failed the disclosure duty it satisfied.

Firm's Use of Free Credit Balances

The firm may use free credit balances only for the purposes the reserve formula's debit items specify. The formula is applied to customer accounts, so funding the firm's own inventory, repo book or payroll is outside those purposes. Use is also subject to:

• Adequate procedures for sending each such customer the quarterly notice
• The customer-reserve requirement (at least the net excess of customer credits over customer debits kept at the bank)
• Continued possession-or-control protection for customer-owned fully paid and excess margin securities; proprietary inventory does not automatically become customer property
• The customer's right to demand the balance at any time

Real-world example: A BD has $50 million of customer free credit balances and $40 million of customer debit balances (margin loans). The reserve formula nets to $10 million of customer credits. The special reserve account at a bank must hold at least $10 million, so the firm deposits whatever that account is short. The remaining $40 million of free credit balances is funding the firm's margin-loan book to customers. This is permissible because the reserve formula already netted those credits against the related debits; the reserve balance covers the residual.

The rule is structurally similar to fractional-reserve banking: the BD does not segregate every customer's cash one-for-one. It keeps at least the aggregate net credit the customer side of the book represents in the reserve account.

What Should You Check on Exam Day?

• Can you state the required amount and payment-on-demand disclosures?
• Do you know the minimum frequency for the free-credit-balance disclosure, and whether an annual disclosure satisfies the rule?
• Can you distinguish a reserve violation from a disclosure violation without assuming both occurred?
• Do you know why free credit balances are not segregated cash, and what right the customer retains over that balance regardless?