Free Credit Balances

The free credit balances rule is a disclosure rule that pairs with the customer protection 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, with the reserve account providing the customer-protection backstop. The free credit balances rule forces the firm to tell each customer this fact in writing, in plain language, every quarter.

What Free Credit Balances Are

A free credit balance is customer cash held by the BD that is not subject to a possessory lien, meaning it is not collateralizing a margin debt or otherwise pledged.

• 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 firm cannot defer payment, condition it on additional trades, or invoke set-off rights for unrelated obligations.

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 for firm purposes (within the limits of the reserve formula). The free credit balances rule's job is to make this clear to the customer.

The Quarterly Disclosure Requirement

Firms holding free credit balances must provide each customer with written notice at least quarterly disclosing three points:

The disclosure can ride on the customer's normal account statement. Most firms include a standard free-credit-balance disclosure block in the quarterly statement. The "at least quarterly" language sets a minimum; firms that send monthly statements can satisfy the rule with the monthly disclosure.

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"
• "Your funds may be used in our business, subject to applicable regulations"
• 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 in the firm's business, provided the firm meets its customer-reserve obligation. The quarterly disclosure makes this explicit so customers understand their cash is not sitting in a vault.
• 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 aggregate credits exceed aggregate debits, the firm deposits the excess into the Special Reserve Bank Account at a bank
4. The cash in the reserve account is the customer-protection backstop if the firm fails

The free-credit-balance disclosure tells customers the firm may use their cash. The customer protection rule ensures that customer cash, in the aggregate, is backstopped by a reserve at a bank. The two rules work together: the free credit balances rule is the customer-facing disclosure; the customer protection rule is the operational segregation.

Exam Tip: Gotchas

• A firm that delivers the free-credit-balance disclosure but fails to include free credit balances in the customer reserve formula has TWO violations, not one. Disclosure does not cure the operational segregation requirement. The customer must be told AND the cash must be backstopped.

Firm's Use of Free Credit Balances

The firm may use free credit balances in the ordinary course of its business, subject to:

• The customer-reserve requirement (aggregate credits backstopped at the bank)
• Possession-or-control discipline for any securities purchased with those funds
• 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 firm parks $10 million at a bank in the special reserve account. 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 bank deposit 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 segregates the aggregate net credit the customer side of the book represents.