Customer Reserve Formula

A firm's proprietary trading account holds securities positions the firm owns for its own account, separate from anything held for customers. How are these proprietary positions treated for net capital purposes, compared to how customer credit balances are treated under the customer reserve formula?

1. A.The firm's own proprietary positions are subject to haircuts in the net capital computation just like other allowable securities, while the reserve formula is a completely separate computation that looks only at customer-related credit and debit items, not at the firm's own trading positions.Correct. Proprietary positions are haircut in net capital; the reserve formula is a separate, customer-only computation.
2. B.Proprietary positions are excluded from both computations entirely, since neither net capital nor the reserve formula considers assets the firm holds for itself.Wrong. Proprietary positions are included in the net capital computation and subject to haircuts.
3. C.Proprietary positions are counted in the reserve formula as a customer debit item, since the firm effectively owes itself for holding them.Wrong. The reserve formula does not include the firm's own proprietary positions as a customer item.
4. D.Proprietary positions receive the same treatment in both computations, since both net capital and the reserve formula apply an identical haircut methodology.Wrong. The reserve formula does not apply a haircut methodology to proprietary positions at all; it is a separate customer-focused computation.

Why: The firm's own proprietary positions are subject to haircuts in the net capital computation just like other allowable securities, while the reserve formula is a completely separate computation that looks only at customer-related credit and debit items, not at the firm's own trading positions.

Pemberton Securities carries customer accounts and performs the customer reserve formula computation required by the SEC customer protection rule. Conceptually, what does that computation compare, and what follows from the result?

1. A.The firm's total assets against its total liabilities, to confirm that the firm is solvent.Wrong. Solvency is a balance sheet question, and this computation is indifferent to the firm's overall net worth.
2. B.The firm's net capital against the minimum its business activities require.Wrong. That is the separate net capital test, which measures the firm's own liquidity rather than what it owes customers.
3. C.Total customer credits against total customer debits, with any excess of credits deposited in a special reserve bank account.Correct. The computation isolates the customer balance and requires any surplus to be set aside where the firm cannot use it.
4. D.Securities the firm holds in segregation against the securities customers have fully paid for.Wrong. That comparison describes the possession and control obligation, which runs alongside this computation rather than being it.

Why: The customer protection rule has two limbs. One requires the firm to have possession or control of fully paid and excess margin securities. The other requires the reserve formula computation, which totals the credits the firm owes customers, chiefly free credit balances and the proceeds of customer securities the firm has used, against the debits customers owe the firm, chiefly margin loans. Where credits exceed debits, the difference must sit on deposit in a special reserve bank account for the exclusive benefit of customers, cash the firm may not lend, pledge or deploy in its own business. The formula is therefore a test of whether one set of customers is financing the firm or other customers, not a test of the firm's own solvency.

A firm's customer reserve computation, used to determine how much cash and qualified securities must be set aside to protect customer funds, is prepared entirely by an outside accounting firm each period. No one inside the firm reviews the outside firm's work product, methodology, or underlying data before it's relied upon. What is the concern with this arrangement?

1. A.There is no concern, since an outside accounting firm is inherently more qualified to prepare this kind of computation than internal staff would be.Wrong. Assumed outside expertise does not substitute for the firm's own internal review of the resulting computation.
2. B.The concern is limited to whether the outside accounting firm is registered as a broker-dealer itself.Wrong. This invents an irrelevant registration requirement for a firm performing an accounting computation service.
3. C.Outsourcing preparation of the reserve computation does not relieve the firm of responsibility for its accuracy, and without any internal review of the outside firm's methodology, data, and results, the firm has no way to catch an error in a calculation that directly determines how well customer funds are actually protected.Correct. The firm remains responsible for the computation's accuracy and needs its own review process to catch errors in a calculation this consequential.
4. D.The concern is that the computation should be prepared internally during some periods and externally during others, to create a natural cross-check.Wrong. This proposes an alternating arrangement rather than addressing the actual missing internal review of the outside preparer's work.

Why: Outsourcing preparation of the reserve computation does not relieve the firm of responsibility for its accuracy, and without any internal review of the outside firm's methodology, data, and results, the firm has no way to catch an error in a calculation that directly determines how well customer funds are actually protected.

In preparing the customer reserve computation, a principal allows a customer's debit balance in one account to be netted against that same customer's credit balance in a completely separate, unrelated account, without any documented cross-guarantee or netting agreement authorizing that treatment between the two accounts. What is the concern?

1. A.There is no concern, since both accounts belong to the same customer, which is itself sufficient basis to net the balances against each other.Wrong. Common ownership alone does not establish the documented basis the computation requires to net separate accounts together.
2. B.The concern is limited to whether the customer was notified in writing that her two accounts were being netted against each other for this purpose.Wrong. Customer notice alone does not establish the documented basis the computation itself requires.
3. C.The concern is that the two accounts should have been merged into a single account number to avoid any need for netting in the first place.Wrong. This proposes an unrelated structural fix rather than addressing the actual documentation gap in the netting itself.
4. D.Netting balances between separate accounts for reserve computation purposes requires a proper documented basis authorizing that treatment; without it, the computation may understate what the firm actually needs to set aside, since the two accounts are not automatically treated as a single combined position just because they belong to the same customer.Correct. A proper documented basis is required to net separate accounts together; common ownership alone is not enough.

Why: Netting balances between separate accounts for reserve computation purposes requires a proper documented basis authorizing that treatment; without it, the computation may understate what the firm actually needs to set aside, since the two accounts are not automatically treated as a single combined position just because they belong to the same customer.