SEC Permits BDs to Provide Equities Collateral for Stock Borrowings

The SEC Division of Trading and Markets ("Division") issued an Order and a related no-action letter regarding the collateral that broker-dealers may pledge when borrowing customer securities.  

The Order and no action letter responded to long time industry requests to allow broker-dealers to provide equities collateral for borrowings of equity securities. The Division stated that the relief should reduce the costs to borrow securities by expanding permissible types of collateral and thus should benefit market liquidity.   

Under the terms of the Order, "broker-dealers that borrow fully-paid or excess margin equity securities from certain types of institutional investors" may "pledge a basket of Russell 1000 and/or S&P 500 equity securities ('Eligible Equity Collateral')." The Order states that "the issuers of Eligible Equity Collateral are U.S. companies with the largest public share and market capitalization." By this Order the SEC designated "this highly liquid collateral as permissible" for the purposes of Exchange Act Rule 15c3-3 ("Customer protection-reserves and custody of securities") stating it "is consistent with the rule’s objectives, which are designed to ensure that securities borrowings from customers remain fully collateralized."

Under the Order, the SEC provided key definitions and the conditions for pledging eligible equity collateral. "Eligible Equity Collateral" is defined as including a diversified basket of long customer margin securities or proprietary account of broker-dealer ("PAB") securities that are included in the Russell 1000 and/or S&P 500 indices. (Unleveraged exchange-traded funds composed of these indices also qualify). A lender that meets the definition of "Qualified Institutional Securities Lender" includes (i) a Qualified Institutional Buyer ("QIB") under Securities Act Rule 144A ("Private resales of securities to institutions"); (ii) an entity owning and investing at least $100 million on a discretionary basis in unaffiliated issuers; or (iii) a principal lender represented by a bank agent lender that has at least $100 million in outstanding securities loans.

To utilize this exemption, broker-dealers must adhere to the following conditions:

• Over-Collateralization Requirements: In addition to the standard 100% minimum collateralization requirement set forth in Rule 15c3-3, broker-dealers must provide excess collateral based on the currency denomination of the borrowed securities:
  • +1% (101% total) if the borrowed securities are denominated in Euros, British pounds, Swiss francs, Canadian dollars, or Japanese yen.
  • +5% (105% total) if denominated in any other currency.
• Custody: The pledged Eligible Equity Collateral must be held at a bank or a broker-dealer.
• Diversification Standards: The broker-dealer and the lender must agree to "maintain concentration and diversification standards" with respect to the pledged collateral "to their reasonable satisfaction."
• Cure Periods: If a lender ceases to qualify as a Qualified Institutional Securities Lender, or if a pledged security ceases to qualify as Eligible Equity Collateral, a five-business-day grace period applies. By the end of the fifth business day, the broker-dealer must either substitute the collateral with other Rule 15c3-3 compliant collateral or return the borrowed securities.

At the same time as the Order was issued, the staff also issued a related no-action letter that reiterated many of the terms of the Order, and added some additional conditions.

On Eligible Collateral Requirements, the Division reiterated that (i) the pledged equity securities must be Russell 1000 or S&P 500 equity securities, (ii) the broker-dealer must comply with the Order, and (iii) that if a pledged security ceases to qualify as eligible equity collateral (e.g., it is removed from the Russell 1000 or S&P 500), the broker-dealer has five business days to either substitute it with qualifying collateral or close out the stock borrow.

On Permitted Purposes for the Borrow, the Division said the equity security borrowed (or received as collateral) must be used specifically to: (i) cover a customer or PAB short sale; (ii) make delivery on a customer or PAB fail to deliver; or (iii) allocate to a customer or PAB account.

On Strict Allocation and Internal Controls, the Division said that (i) the broker-dealer must develop, build, and utilize daily written internal controls to perform a separate "equity for equity allocation;" (ii) the controls must ensure there is absolutely no cross-over between the customer Reserve Formula and the PAB Reserve Formula regarding these allocations (i.e. no commingling); (iii) the broker-dealer must be able to evidence that the pledged equity security allocates to a customer or PAB long position; and (iv) the internal controls and accompanying documentation governing these allocations must be made available to SEC staff and the broker-dealer's Designated Examining Authority ("DEA") upon request.

On Reserve Formula Computations and Accounting, the Division requires broker dealers to perform daily customer and PAB Reserve Formula computations and mark-to-market all non-cash items daily. The Division requires the broker dealer to apply the following specific treatments: (i) the broker-dealer may include a debit under Item 11 of the customer or PAB Reserve Formula for the market value of the equity security borrowed (or the collateral received); and (ii) when a security is pledged as collateral for a borrow (or loaned out), the broker-dealer must include a credit under Item 3 of the respective Reserve Formula for the market value of the security pledged or loaned that allocates to a customer or PAB long position.