This post is a high level summary of net capital, a measure of liquidity and overall financial health for U.S. broker-dealers. After reading, you’ll learn the following:
- What is net capital and how is it calculated
- An example of net capital
- Why is it used
- Other frequently asked questions about net capital
What is net capital and how is it calculated?
Net capital is the net liquid assets of a U.S. broker-dealer, measured in dollars and starting with the U.S. GAAP definition of net worth (total assets minus total liabilities). From there, adjustments are made to net worth based on the perceived liquidity of the broker-dealer’s assets and securities inventory. The concept of net capital comes from Rule 15c3-1 of the Securities Exchange Act.
An example of net capital
Let’s say you were a registered broker-dealer with the SEC. Your net worth is $10,000. It’s comprised of Apple stock worth $5,000, cash of $2,000, and a used Jeep Grand Cherokee worth $3,000. Based on a prescribed set of deductions known as “haircuts”, you must deduct 15% of your Apple stock’s value and 100% of your Jeep to calculate net capital. The stock is considered liquid because it is listed on a stock exchange where it can be easily traded. While you can list your Jeep on Truecar.com, it probably won’t sell fast. Cash is cash, so no deduction there. From your $10,000 net worth, your net capital equals $10,000 – 750 – 3,000 = $6,250.
Now, let’s pretend you bought a put option on that Apple stock that would allow you to sell it at a higher price than the market. The deduction no longer becomes 15%, but is instead based on theoretical price scenarios and the gain or loss you would make at each price move. The deduction is known as a risk based haircut (RBH) because it’s based on the calculated market risk for your portfolio of Apple stock and an Apple put option. This methodology applies to other products like futures and ETFs whose market risk is based on the underlying security or basket of securities that the product is supposed to track.
Since different firms can have different theoretical price scenarios, RBH models must go through an approval process with regulators before being considered legit for net capital calculations. The most common model is provided by the Options Clearing Corporation (OCC). How they calculate the projected price moves is supposedly a black box, but it’s widely used and accepted as the industry standard. There are also technology vendors that provide automated solutions to calculate net capital. Dash Regulatory and Axiom are two examples of vendors that provide an automated solution.
Why is it used?
Net capital is used because it parses out illiquid assets from liquid assets on a firm’s balance sheet. Since broker-dealers are vital in providing liquidity to capital markets, it’s essential for regulators to know whether these key players are sufficiently capitalized to perform their financial duties.
Other frequently asked questions
Here are some frequently asked questions about net capital and Rule 15c3-1:
- When was Rule 15c3-1 created?
- The rule as we know it today was created in 1975 as part of an amendment to the original net capital rule.
- How were the haircut percentages determined?
- First, it’s important to note that the percentages are meant to be conservative. They reflect the perceived market risk of a security or portfolio of securities during periods of negative economic shock. U.S. government bonds have lower haircuts than common stock, which have lower haircuts than non-investment grade corporate bonds. Another way to think about it, using the Apple stock example, is that under a market stress scenario the Apple stock will be sold at 75% of its current price ($3,750).
- How often are firms required to calculate net capital?
- Rule 15c3-1 requires that firms monitor their net capital on a “moment-to-moment” basis. This language provides leeway for broker-dealers to calculate net capital as frequently as they are practically able to do so. Based on the technology solutions at the firm, this could mean as frequent as every minute or as infrequent as once a day.
- What are the penalties for violating Rule 15c3-1?
- Firms can be charged a fine and are not allowed to take on new positions until they meet net capital requirements again. The penalties can be high as $16 million on top of additional scrutiny from regulators as the firm addresses any process or control deficiencies.
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