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Federal Register / Vol. 86, No. 149 / Friday, August 6, 2021 / Notices
for at least 90 days of public comment.219
The Commission agrees with the commenters who point out the differences between the capital standard of Exchange Act rule 18a1 i.e., the net liquid assets test and the Basel capital standard applicable to Covered Entities, and who therefore believe thatat a minimumadditional conditions are necessary to achieve comparable regulatory outcomes.220 As the Commission explained when proposing the additional capital condition, the net liquid assets test is designed to promote liquidity.221 In particular, Exchange Act rule 18a1 allows an SBS Entity to engage in activities that are part of conducting a securities business e.g., taking securities into inventory but in a manner that places the firm in the position of holding at all times more than one dollar of highly liquid assets for each dollar of unsubordinated liabilities e.g., money owed to customers, counterparties, and creditors.222 For example, Exchange Act rule 18a1 allows securities positions to count as allowable net capital, subject to standardized or internal model-based haircuts. The rule, 219 SIFMA

5/3/2021 Letter at 1920.
Americans for Financial Reform Education Fund Letter at 12; Better Markets Letter at 78.
221 See UK Substituted Compliance Notice and Proposed Order, 86 FR at 18387 explaining the differences between Exchange Act rule 18a1 and the Basel capital standard.
222 See, e.g., Exchange Act Release No. 8024 Jan.
18, 1967, 32 FR 856 Jan. 25, 1967 Rule 15c3
1 17 CFR 240.15c31 was adopted to provide safeguards for public investors by setting standards of financial responsibility to be met by brokers and 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.

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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.223 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 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.224 The final step in computing net capital is to take prescribed 223 See
17 CFR 240.15c31c2.
highly liquid assets under Exchange Act rule 18a1 are otherwise known as allowable assets because they are not deducted when computing net capital. See Exchange Act Release No. 87005 Sept. 19, 2019, 84 FR 68673, 68673
74, 6867780 Dec. 19, 2019 Books and Records Adopting Releasethe 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. See Books and Records Adopting Release, 84 FR at 6867374, 6867780.
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. See Books and Records Adopting Release, 84 FR at 6867374, 6867780. 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.
224 The
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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 the UK 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 UK margin requirements, Covered Entities will be required to post initial margin to counterparties unless an exception applies.225 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.226 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 Entity bears 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. 227 Under the Basel capital standard, a Covered Entity can count initial margin posted 225 Exchange Act rule 18a3 does not require SBS
Entities to post initial margin though it does not prohibit the practice.
226 See Capital and Margin Adopting Release, 84
FR at 4388788.
227 See Capital and Margin Adopting Release, 84
FR at 43887.

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