Customer Protection: Reserves and Custody of Securities

The customer protection rule is the customer-asset-segregation rule. The net-capital rule protects the firm; the customer protection rule protects the customer's specific assets. The rule sits at the heart of SIPC's customer-protection mandate: if the firm's possession-or-control discipline holds and the reserve account is properly funded, customer claims should be satisfiable in liquidation without dipping into SIPC funds.

The Two Pillars

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

Both pillars apply continuously. A firm that satisfies one but fails the other has a customer-protection violation.

Think of it this way: The customer hands the firm two things, securities and cash. The customer protection rule puts each of those things in its own protected category. Securities get the possession-or-control pillar (they must be in a depository, custodian bank, or the firm's vault, not pledged to firm creditors). Cash gets the reserve-account pillar (the firm computes how much customer money it owes and parks that amount at a bank where firm creditors cannot reach it).

Pillar 1: Possession or Control of Customer Securities

The firm must take physical possession or control of all fully paid securities and excess margin securities held for customers.

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

The firm satisfies possession or control by holding securities at one of these locations:

• A registered securities depository (e.g., DTC, DTCC)
• A bank custodian that has segregated the position for customers
• The firm's own vault (with proper recordkeeping and segregation)
• An omnibus account at another carrying firm (in a clearing-broker relationship)

Securities Not in Good Control

If a security is not in a good control location (for example, a fail-to-receive), the firm must take prompt action to bring it into compliance:

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

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.
• Customers' fully paid securities are the firm's RESPONSIBILITY to possess or control. They are NOT the firm's property and cannot be hypothecated or used for the firm's business. The "customer protection" framing is literal: those positions are off-limits even if the customer signs a generic "the firm may use my assets" provision.

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)
• Securities loaned to other firms against customer collateral
• 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)
• Securities borrowed for customer fails
• Other customer-related debits per Exhibit A

The Net Result

If credits exceed debits, the firm must deposit the excess into the Reserve Account.

The deposit must consist of:

• Cash, or
• Qualified securities (U.S. Treasury obligations or other permitted instruments)

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 where firm creditors cannot reach it. The firm cannot use customer free credit balances to fund proprietary trading or pay firm operating expenses unless the reserve formula's "debit cushion" already covers those credits.

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 $500 Million Daily Threshold

The SEC adopted the daily reserve computation requirement in 2024 with an effective date of June 30, 2026. The threshold is:

• Average total credits (combining customer and PAB credits) of $500 million or more, computed using FOCUS data
• The SEC estimates approximately 49 firms cross this threshold

Daily computation requires significant operational scaling. Firms above the threshold must build systems that re-compute the formula every business day.

Exam Tip: Gotchas

• Crossing the $500 million average total credits threshold flips a firm from weekly to daily reserve-formula computations. The threshold is computed across both customer AND PAB credits using FOCUS data. Daily computation is a structural operational change, not just a paperwork change.
• The weekly deposit follows a Friday / Tuesday cadence. Computation as of close of business Friday; deposit due by Tuesday following. The exam may probe whether the deposit deadline is "the next business day" (it is not) or "Tuesday" (it is).

The Customer PAB 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

Think of it this way: The PAB rule recognizes that one BD carrying another BD's proprietary positions creates a customer-like relationship. The carrying firm holds the carried firm's assets, so those assets need the same segregation discipline that retail customer assets get. The mechanism is identical (Exhibit A formula, special reserve account) but the population is different (other BDs, not retail customers).

Exam Tip: Gotchas

• The PAB reserve is SEPARATE from the customer reserve. A firm cannot net a PAB credit against a customer debit. Each computation stands on its own; each requires its own deposit if credits exceed debits.

When a Firm Is Exempt from Customer Protection

A small subset of BDs operate under an exemption from the customer protection rule:

• Firms that do not carry customer accounts and do not hold customer funds or securities can claim an exemption
• Pure introducing firms with no customer asset custody fall into this category
• The exemption is reflected in the firm's annual audit report (the Exemption Report instead of the Compliance Report)

A firm that claims the exemption but in fact holds customer assets has both a customer-protection substantive violation and a misrepresentation in its audit filing.