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Federal Register / Vol. 86, No. 145 / Monday, August 2, 2021 / Notices
khammond on DSKJM1Z7X2PROD with NOTICES3

Act rule 18a1 allows securities positions to count as allowable net capital, subject to standardized or internal model-based haircuts. The rule, however, does not permit most unsecured receivables to count as allowable net capital. This aspect of the rule limits the ability of SBS Entities to engage in activities, such as uncollateralized lending, that generate unsecured receivables. The rule also does not permit fixed assets or other illiquid assets to count as allowable net capital, which creates disincentives for SBS Entities to own real estate and other fixed assets that cannot be readily converted into cash. For these reasons, Exchange Act rule 18a1 incentivizes SBS Entities to confine their business activities and devote capital to securitybased swap activities.
The net liquid assets test is imposed through how an SBS Entity is required to compute net capital pursuant to Exchange Act rule 18a1. The first step is to compute the SBS Entitys net worth under U.S. generally accepted accounting principles GAAP. Next, the SBS Entity must make certain adjustments to its net worth to calculate net capital, such as deducting illiquid assets and taking other capital charges and adding qualifying subordinated loans.236 The amount remaining after these deductions is defined as tentative net capital. Exchange Act rule 18a1
prescribes a minimum tentative net capital requirement of $100 million for SBS Entities approved to use models to calculate net capital. An SBS Entity that dealers. The basic concept of the rule is liquidity;
its object being to require a broker-dealer to have at all times sufficient liquid assets to cover his current indebtedness. footnotes omitted;
Exchange Act Release No. 10209 June 8, 1973, 38
FR 16774 June 26, 1973 Commission release of a letter from the Division of Market Regulation The purpose of the net capital rule is to require a broker or dealer to have at all times sufficient liquid assets to cover its current indebtedness. The need for liquidity has long been recognized as vital to the public interest and for the protection of investors and is predicated on the belief that accounts are not opened and maintained with broker-dealers in anticipation of relying upon suit, judgment and execution to collect claims but rather on a reasonable demand one can liquidate his cash or securities positions.; Exchange Act Release No.
15426 Dec. 21, 1978, 44 FR 1754 Jan. 8, 1979
The rule requires brokers or dealers to have sufficient cash or liquid assets to protect the cash or securities positions carried in their customers accounts. The thrust of the rule is to insure that a broker or dealer has sufficient liquid assets to cover current indebtedness.; Exchange Act Release No.
26402 Dec. 28, 1988, 54 FR 315 Jan. 5, 1989
The rules design is that broker-dealers maintain liquid assets in sufficient amounts to enable them to satisfy promptly their liabilities. The rule accomplishes this by requiring broker-dealers to maintain liquid assets in excess of their liabilities to protect against potential market and credit risks. footnote omitted.
236 See 17 CFR 240.15c31c2.

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is meeting its minimum tentative net capital requirement will be in the position where each dollar of unsubordinated liabilities is matched by more than a dollar of highly liquid assets.237 The final step in computing net capital is to take prescribed percentage deductions standardized haircuts or model-based deductions from the mark-to-market value of the SBS Entitys proprietary positions e.g., securities, money market instruments, and commodities that are included in its tentative net capital. The amount remaining is the firms net capital, which must exceed the greater of $20
million or a ratio amount.
In comparison, Covered Entities in France are subject to the Basel capital standard. The Basel capital standard counts as capital assets that Exchange Act rule 18a1 would exclude e.g., loans and most other types of uncollateralized receivables, furniture and fixtures, real estate. The Basel capital standard accommodates the business of banking: Making loans including extending unsecured credit and taking deposits. While the Covered Entities that will apply substituted compliance with respect to Exchange Act rule 18a1 will not be banks, the Basel capital standard allows them to count illiquid assets such as real estate and fixtures as capital. It also allows them to treat unsecured receivables related to activities beyond dealing in security-based swaps as capital notwithstanding the illiquidity of these assets.
Further, one critical example of the difference between the requirements of Exchange Act rule 18a1 and the Basel capital standard relates to the treatment of initial margin with respect to security-based swaps and swaps. Under the French margin requirements, 237 The highly liquid assets under Exchange Act rule 18a1 are otherwise known as allowable assets because they are not deducted when computing net capital. See Books and Records Adopting Release, 84 FR at 6867374, 6867780
the sections of the amended Part II of the FOCUS
Report setting forth the assets side of the balance sheet and the net capital computation. Illiquid assets otherwise known as non-allowable assets are deducted when computing net capital. Id.
Allowable assets include cash, certain unsecured receivables from broker-dealers and clearing organizations, reverse repurchase agreements, securities borrowed, fully secured customer margin loans, and proprietary securities, commodities, and swaps positions. Id. The term high quality liquid assets or HQLA are defined under the Basel capital standards liquidity coverage ratio LCR
and generally consist of cash and specific classes of liquid securities. See BCBS, LCR30 under the Basel capital standards, available at: https www.bis.org/
basel_framework/chapter/LCR/
30.htm?tldate=20191231&inforce=2019121.
Generally, cash and securities that qualify as HQLA
under the LCR would be allowable assets under Exchange Act rule 18a1.

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Covered Entities will be required to post initial margin to counterparties unless an exception applies.238 Under Exchange Act rule 18a1, an SBS Entity cannot count as capital the amount of initial margin posted to a counterparty unless it enters into a special loan agreement with an affiliate.239 The special loan agreement requires the affiliate to fund the initial margin amount and the agreement must be structured so that the affiliaterather than the SBS Entitybears the risk that the counterparty may default on the obligation to return the initial margin.
The reason for this restrictive approach to initial margin posted away is that it would not be available to the SBS
Entity for other purposes, and, therefore, the firms liquidity would be reduced. 240 Under the Basel capital standard, a Covered Entity can count initial margin posted away as capital without the need to enter into a special loan arrangement with an affiliate.
Consequently, because of the ability to include illiquid assets and margin posted away as capital, Covered Entities subject to the Basel capital standard may have less balance sheet liquidity than SBS Entities subject to Exchange Act rule 18a1.
For these reasons, the Commission disagrees with the commenter who stated that additional capital conditions were unnecessary and inconsistent with the Commissions substituted compliance framework.241 As discussed above, there are key differences between the net liquid assets test of Exchange Act rule 18a1 and the Basel capital standard applicable to Covered Entities.
Those differences in terms of the types of assets that count as regulatory capital and how regulatory capital is calculated lead to different regulatory outcomes.242
In particular, the net liquid assets test produces a regulatory outcome in which the SBS Entity has more than one dollar of highly liquid assets for each dollar of unsubordinated liabilities.243 The Basel capital standardwhile having measures designed to promote 238 Exchange Act rule 18a3 does not require SBS
Entities to post initial margin though it does not prohibit the practice.
239 See Capital and Margin Adopting Release, 84
FR at 4388788.
240 See id. at 43887.
241 SIFMA Letter II at 717.
242 See Better Markets Letter at 78 comparing the differences between Exchange Act rule 18a1
and the Basel capital standard and stating that not only are the Frances capital requirements different from the SECs in both form and substance, but the regulatory outcome is not comparable.
243 As discussed above, highly liquid assets under Exchange Act rule 18a1 are also known as allowable assets and generally are consistent the LCRs HQLA.

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