Customer Protection and Custody of Assets

Broker-dealers hold customer cash and securities, and several rules and protections exist to keep those assets safe. This section covers the key regulatory requirements and the safety net that protects customers if a firm fails.

What You'll Learn

• How the Customer Protection Rule shields customer assets from misuse
• What the Net Capital Rule requires of broker-dealers
• How FINRA prohibits the improper use of customer property
• What the Securities Investor Protection Corporation (SIPC) covers (and does not cover)

1. The Customer Protection Rule

The Customer Protection Rule is the primary SEC rule governing custody of customer assets. Its purpose is to prevent broker-dealers from using customer funds and securities to finance their own operations.

Two primary requirements:

1. Physical possession or control - the firm must maintain possession or control of all fully paid customer securities (securities the customer has paid for in full, not purchased on margin)
2. Special Reserve Bank Account - the firm must maintain a dedicated bank account for the exclusive benefit of customers, holding the net cash owed to customers

Key principles:

• Customer securities must be segregated from the firm's proprietary securities
• Customer cash must be kept in a separate reserve account; the firm cannot use it for proprietary trading or other business purposes
• If a broker-dealer fails, this segregation increases the likelihood that customer property will be returned

Exam Tip: Gotchas

• Fully paid and excess margin securities are the trigger. The firm must keep both fully paid and excess margin securities (value above 140% of the customer's debit balance) in its possession or control. Margin securities up to 140% of the debit balance may be pledged for the firm's own financing, but the firm cannot divert that collateral to cover its own trades; segregation from proprietary activity still applies.
• The Special Reserve Bank Account is untouchable. The firm cannot dip into it for any reason. If a question describes a firm borrowing from the reserve account, that is a violation.

2. The Net Capital Rule

The Net Capital Rule requires broker-dealers to maintain a minimum level of net capital (liquid assets minus liabilities) at all times.

• Net capital acts as a financial cushion, ensuring the firm can meet its obligations to customers even during market stress
• If a firm's net capital falls below the required minimum, it must stop doing business until the shortfall is corrected
• The rule is designed to protect customers by preventing firms from becoming insolvent while holding customer assets

Think of it this way: The Customer Protection Rule keeps customer money separate. The Net Capital Rule makes sure the firm itself stays financially healthy enough to operate. Together, they create a two-layer safeguard.

3. Improper Use of Customer Assets

FINRA reinforces customer protection by explicitly prohibiting:

• Using customer securities or funds for the firm's own benefit (unless the customer has given written authorization)
• Commingling (mixing) customer assets with firm assets
• Any other improper use of customer property

Exam Tip: Gotchas

• Segregation is the key word. Customer assets and firm assets must be kept completely separate. A firm using customer funds to cover its own trading losses violates both the Customer Protection Rule and FINRA's prohibition on improper use of customer assets.
• Commingling is always prohibited. There is no exception that allows a firm to mix customer and firm assets in the same account.

4. SIPC: Securities Investor Protection Corporation

The Securities Investor Protection Act of 1970 (SIPA) created the Securities Investor Protection Corporation (SIPC), a nonprofit membership corporation funded by member broker-dealers. SIPC provides a safety net when a broker-dealer fails financially.

Coverage limits:

• $500,000 per customer for securities and cash combined
• Within that $500,000 limit, $250,000 maximum for cash claims

What SIPC covers:

• Stocks, bonds, Treasury securities, mutual funds, and other registered securities missing from a customer's account when a broker-dealer fails
• Cash held in a brokerage account for the purpose of buying securities

What SIPC does NOT cover:

• Losses from a decline in market value of securities (SIPC protects against firm failure, not bad investments)
• Commodity futures contracts or forex trades
• Fixed annuity contracts that are not registered as securities
• Losses caused by a broker's bad investment advice

Separate capacity rule: Each "separate capacity" (individual account, joint account, IRA, etc.) is treated as a separate customer, each eligible for up to $500,000 in coverage.

Exam Tip: Gotchas

• SIPC is NOT insurance against market losses. If your stock drops 50% in value, SIPC does not reimburse you. It only protects against missing assets when a broker-dealer fails.
• $500,000 total, $250,000 cash sublimit. Two caps apply independently. A customer with $200,000 in securities and $400,000 in cash gets only $450,000 from SIPC ($200,000 securities + $250,000 cash), because the cash sublimit is the binding constraint, not the $500,000 overall cap.
• SIPC is funded by its member broker-dealers, not by the federal government. It is not a government agency.

Think of it this way: SIPC coverage is like a suitcase with a compartment. The whole suitcase holds up to $500,000, but the cash pocket inside maxes out at $250,000 (exactly half). Securities fill the main compartment; cash goes in the smaller pocket. Both limits apply independently.

What Should You Check on Exam Day?

• Can you explain the two main requirements of the Customer Protection Rule?
• Do you know what the Special Reserve Bank Account protects and why firms cannot borrow from it?
• Can you state the SIPC coverage limits for securities and cash combined?
• Do you know what losses SIPC does not cover, such as a decline in market value?
• Can you explain how the Net Capital Rule differs from the Customer Protection Rule?