Division of Trading and Markets Broker-Dealer Risk Office
The Division of Trading and Market’s Broker Dealer Risk Office (BDRO) conducts ongoing prudential supervision of broker-dealers registered with the Commission that calculate net capital under the alternative method in Appendix E of Rule 15c3-1 or Appendix F of Rule 15c3-1 under the Securities Exchange Act of 1934 (Exchange Act), or that are owned by a holding company supervised by the Commission pursuant to Section 17(i) of the Exchange Act. This program of prudential supervision was created to provide an enhanced oversight program that augments the Commission’s other supervisory programs for U.S. registered broker-dealers. In addition, BDRO monitors broker-dealers subject to the recordkeeping and reporting requirements under Section 17(h) of the Exchange Act (Risk Assessment Program).
The Commission has learned through its longstanding experience that even broker-dealers that are well-capitalized and in compliance with applicable financial responsibility and customer protection rules are affected by the financial difficulties of affiliate entities and may thus be placed at risk in several ways. The financial distress of an affiliate, including the holding company, may affect the registered broker-dealer either directly, if affiliates seek to withdraw capital from or effectively transfer liabilities to the registered broker-dealer, or indirectly, if the registered broker-dealer receives financing from an affiliate or relies on the affiliate in order to access the capital markets. Notably, the use of derivatives and complex structured and securitized products often occurs outside the registered broker-dealer, sometimes in unregulated entities, which adds to the risk inherent in complex holding companies.
Accordingly, BDRO reviews risks arising from broker-dealer affiliates and risk management controls within the broker-dealer and its holding company. In addition, the BDRO Inspections Group augments BDRO’s monitoring efforts with on-site testing of relevant controls. Based on its technical expertise in market developments and risk management, BDRO also assists the Commission in intra-agency projects and interagency regulatory efforts.
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Broker-dealers that wish to use the ANC computation must file an application with and obtain authorization from the Commission, as well as maintain an “early warning” level of at least $5 billion in tentative net capital1 and minimum levels of at least $1 billion in tentative net capital and at least $500 million in net capital. The application, among other things, must describe the broker-dealer’s Value-at-Risk (VaR) model or models, including how the model or models meet the requirements of Appendix E, and the broker-dealer’s internal risk management controls, including how those controls satisfy the requirements of Exchange Act Rule 15c3-4. The application must also include sample risk reports that are provided to the persons at the ultimate holding company who are responsible for managing group-wide risk.
Prior to Commission action on an application, SEC staff conduct a thorough assessment of the firm’s financial position, the adequacy of the firm’s internal risk management controls, and the statistical models the firm will use for internal risk management and regulatory capital purposes, through both the review of documents and on-site testing. If the Commission approves the broker-dealer’s use of the ANC computation, BDRO supervises the broker-dealer’s use of the approved mathematical models, risk management, and financial controls. BDRO reviews monthly, quarterly, and annual filings containing financial, risk management, and operational data for ANC firms. BDRO staff also meet regularly with senior risk managers to review business unit risk taking and risk controls, aggregate risk metrics and the independent risk control function, and control processes supporting risk management. In addition, BDRO staff meet regularly with each ANC firm to review financial, internal audit, and price verification results, the management of the firm’s balance sheet, and, in particular, the liquidity of the balance sheet. The BDRO Inspections Group augments BDRO’s monitoring efforts with testing of the ANC firms’ controls.
For a more detailed description of the ANC Program, see Broker-Dealers Using the Alternative Net Capital Computation under Appendix E to Rule 15c3-1.
OTC derivatives dealers that wish to use VaR models to calculate capital charges for market risk and to take alternative charges for credit risk in accordance with Appendix F to Rule 15c3–1 must, like ANC firms, file an application with and obtain authorization from the Commission. The application, among other things, must describe the OTC derivatives dealer’s VaR model or models, including the manner in which the model or models meet the requirements specified in Appendix F, and the dealer’s internal risk management controls system (as required under Exchange Act Rule 15c3–4). The OTC derivatives dealer must also describe in the application any non-marketable securities that it wishes to include in its VaR calculation.
Prior to Commission action on an application, BDRO staff will conduct a review to determine whether the dealer has met the requirements set forth in Appendix F, among other rules, relating to its VaR model and internal risk management control systems. In addition, an OTC derivatives dealer must file an application with the Commission before making any material changes to its VaR model or internal risk management control systems and receive authorization before implementing any such changes.
In its supervisory role, BDRO staff review filings of OTC derivatives dealers and meet periodically with each firm to discuss market and credit risk exposures, finances and earnings, and specific positions and their associated revenue.
The Supervised Investment Bank Holding Company (SIBHC) Program permits the Commission to monitor on a group-wide basis an investment bank holding company (IBHC) that has elected this regulatory framework. In addition, the SIBHC framework is intended to provide a basis for non-U.S. financial regulators to treat the Commission as the principal U.S. consolidated, home-country supervisor for SIBHCs and their affiliates (including broker-dealers).
An IBHC that meets specified criteria may elect to become a SIBHC and be subject to supervision on a group-wide basis by filing a notice of intention with the Commission. Pursuant to Exchange Act Section 17(i) and the rules thereunder, an IBHC is eligible to be an SIBHC if it is not affiliated with certain types of banks and has a subsidiary broker-dealer with a substantial presence in the securities markets. A SIBHC must meet requirements regarding its group-wide internal risk management control system, recordkeeping, and periodic reporting (including reporting of consolidated computations of allowable capital and risk allowances). The SIBHC Program is not intended to duplicate regulation of banks, insurance companies, or futures commission merchants by other regulatory agencies.
The Risk Assessment Program was established under the Market Reform Act of 1990 following the collapse of Drexel Burnham Lambert Group, Inc. (Drexel), the holding company parent of Drexel Burnham Lambert, Inc. (DBL), a registered broker-dealer. Drexel’s collapse demonstrated that broker-dealers could encounter serious financial difficulty due to the loss of market confidence, loss of access to the capital markets, or failure of the registered broker-dealer’s affiliates or the holding company itself.
Broker-dealers and municipal securities dealers belonging to holding companies generally are subject to the Risk Assessment rules unless they meet an exemption.2 The exemptions cover, for example, (1) broker-dealers that do not carry or clear customer assets, including limited purpose mutual fund broker-dealers; (2) introducing broker-dealers that clear all transactions with and for customers on a fully disclosed basis with a clearing broker; (3) broker-dealers that clear customer trades but do not hold funds or securities for customers except to facilitate transactions and only for the time necessary to complete the transaction; (4) broker-dealers maintaining capital, including subordinated debt, of less than $20 million and who do not clear or carry customer accounts; and (5) broker-dealers that maintain less than $250,000 in total capital.
Broker-dealers subject to the Risk Assessment rules must keep records and file with the Commission information including the holding company organizational chart, risk management policy information, consolidating and consolidated financial statements, securities and other financial product position data of material associated persons, and other categories of financial and securities related information, as specified in Rules 17h-1T and 17h-2T and Form 17-H.
BDRO staff review filings under the Risk Assessment Program relating to reporting broker-dealers or their material affiliates to analyze the activities and relationships of the broker-dealer and associated entities. Staff analyze financial dependencies and unregulated business activities which could potentially affect the net capital, liquidity, financing or profitability of the broker-dealer, as well as sources of funding for the broker-dealer and the parent.
The BDRO Inspections Group focuses on the financial and operational condition of the ANC Firms, subjecting their relevant controls to on-site testing. Ongoing BDRO monitoring activities are informed and enhanced by the results of timely and focused reviews of controls conducted by the BDRO Inspections Group and designed to target identified risks. Projects focus on the portfolio of controls around a particular business -- for example credit or equity trading – and may encompass the marking of positions, computation of risk exposure measures, transaction flow, permissioning, and computation of regulatory capital. Almost all projects are implemented across multiple firms. Conducting similar work at multiple firms within a short time interval enables the staff to develop a comprehensive understanding of the relevant business and control issues, and allows for more useful feedback to the firms.
In addition to its monitoring and inspections functions, BDRO provides technical expertise on market and risk management developments and emerging financial issues, assisting the Commission with its work in various domestic and international regulatory groups, including the President’s Working Group, Senior Supervisors Group, Joint Forum, International Organization of Securities Commissions, and Financial Stability Forum.
BDRO cooperates and collaborates with the Federal Reserve Board, Federal Reserve Banks, and the United Kingdom’s Financial Services Authority (FSA) regarding the financial condition, internal controls, capital, liquidity, and funding sources of the firms it supervises and their holding companies, and regarding other regulatory and supervisory issues of mutual interest. In addition, BDRO cooperates, shares information, and coordinates its supervision with self-regulatory organizations to which ANC firms belong, such as Financial Industry Regulatory Authority (FINRA), as well as the functional regulators of affiliates of ANC firms.
1 “Tentative net capital” is defined in Exchange Act Rule 15c3-1(c)(15) as net capital before deductions for market and credit risk.
2 There are currently seven provisions exempting categories of broker-dealers from the Risk Assessment rules. They are found under Rules 17h-1T(d) and 17h-2T(b) under the Exchange Act.