Executive Summary
The SEC Division of Trading and Markets has issued a no-action letter permitting broker-dealers, under specified conditions, to:
- Pledge customer margin equity securities as collateral to borrow securities used for:
- Customer short sales; and
- Customer fails to deliver; and
- Take a debit under Item 11 of the Rule 15c3-3 Reserve Formula equal to the market value of the borrowed securities.
This relief represents a significant shift from existing practice, which generally restricts Item 11 debits to borrowings collateralized by cash, qualified securities, or letters of credit.
Regulatory Background
Rule 15c3-3 Customer Protection Rule
- Rule 15c3-3 requires broker-dealers to maintain possession or control of customer securities and maintain a reserve account computed under the Reserve Formula (Rule 15c3-3a).
Item 11 (Debit):
- Permits a debit for securities borrowed to cover customer shorts or fails—but only where borrowings are secured by specified collateral (historically cash, qualified securities, or letters of credit).
Prior to the relief, equity securities were not permissible collateral for this purpose.
Relief Granted
The SEC Division of Trading and Markets’ staff stated it will not recommend enforcement action if a broker-dealer pledges customer margin equity securities as collateral to borrow equity securities and includes a debit under Item 11 equal to the market value of the borrowed securities, provided specified conditions are met.
The relief applies to both Customer Reserve Formula and PAB (Proprietary Accounts of Broker-Dealers) Reserve Formula (on analogous terms).
Key Conditions for Relief
The principal requirements include:
1. Eligible Equity Collateral
- Must consist of highly liquid equity securities, specifically:
- Securities in the Russell 1000 or S&P 500.
2. Qualified Institutional Securities Lenders
Collateral may only be provided when borrowing from sophisticated lenders, including:
- QIBs (Rule 144A);
- Entities with ≥ $100 million discretionary investments; and
- Agent lenders (banks) with ≥ $100 million in securities lending activity.
Broker-dealers may rely on reasonable representations regarding lender status.
3. Collateralization Requirements
- Additional margin required for cross-currency transactions:
- +1% for major currencies (EUR, GBP, CHF, CAD, JPY)
- +5% for others
4. Custody Requirements:
Collateral must be held at a bank or a broker-dealer
5. Reserve Formula Mechanics
To rely on the relief:
- Debit (Item 11): Equal to market value of borrowed securities
- Credit (Item 3): Must reflect market value of securities pledged
- Firms: Must perform daily reserve computations and mark-to-market daily all relevant items
6. Internal Controls and Allocation Requirements
Broker-dealers must:
- Establish daily “equity-for-equity” allocation processes;
- Ensure only customer (or PAB) equity securities are used and there is no crossover between customer and PAB reserve computations;
- Maintain written, documented controls; and
- Provide documentation to the SEC or DEA upon request.
7. Substitution / Cure Periods
- If collateral ceases to qualify (e.g., falls out of index eligibility): broker-dealer has 5 business days to substitute eligible collateral or close out the borrow.
- Similar 5-day cure applies if a lender is later found not to qualify.
Operational Requirements
Firms relying on the relief must also conduct daily reserve calculations (even where not otherwise required); implement prompt remediation procedures for (1) incorrect collateral usage and (2) inclusion of proprietary securities; and maintain robust books and records supporting allocations and compliance.
Notably, this relief does not extend to Regulation SHO Rules 203 and 204, which are explicitly excluded.
Practical Considerations for Broker-Dealers
Firms considering reliance should:
- Evaluate systems capability for daily allocation and tracking.
- Review and enhance:
- Collateral eligibility controls; and
- Reserve formula processes.
- Confirm:
- Ability to segregate customer vs. PAB collateral flows.
- Implement:
- Governance and documentation frameworks sufficient for regulatory review.