An Introduction to Portfolio Margining

December 2006, Vol. 26 No. 11 Thomson/West An Introduction to Portfolio Margining By Kenneth M. Rosenzweig* IN THIS ISSUE: An Introduction to Portfolio Margining...1. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered, however it may not necessarily have been prepared by persons licensed to practice law in a particular jurisdiction. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional. For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, USA (978) 750-8400; fax (978) 646-8600 or West s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651)687-7551. Please outline the specific material involved, the number of copies you wish to distribute and the purpose or format of the use. For subscription information, please contact the publisher at: west.legalworkspublications@thomson.com Background The margin rules adopted by the Board of Governors of the Federal Reserve System (Fed) establish limits on the value of stock and other securities that are used as collateral in an initial transaction. 1 In broad terms, the Fed s Regulation T (Reg T) generally prohibits a broker-dealer from initially lending its customers more than 50% of the value of securities or from extending credit based on more than 50% of the value of securities collateral. 2 Reg T governs the amount of margin that must be obtained when a customer buys or sells a security, sells a security short, or removes funds or securities from a margin account. In other words, Reg T imposes margin requirements for new securities transactions and for withdrawals of cash or other collateral, but does not otherwise establish any requirements relating to the amount of margin that must be maintained in a customer s account after it has bought (or sold short) one or more securities. 3 Reg T nonetheless authorizes the securities self-regulatory organizations (i.e., the national securities exchanges and the National Association of Securities Dealers) to adopt rules governing the amount of margin that must be maintained for open positions. 4 New York Stock Exchange (NYSE) Rule 431 accordingly provides that NYSE-member broker-dealers must collect additional margin from their customers when, as a result of changes in market values, the equity in the customer s account falls below specified levels. Specifically, Rule 431 establishes a minimum 25% maintenance margin requirement for long positions and a 30% requirement for short positions, but also permits margin reductions for certain defined strategies, such as covered call writing or option spreads and straddles. Amendments to Reg T adopted by the Fed in 1998, however, permit broker-dealers to use exchange-approved portfolio margining programs to compute their customers initial and continuing margin requirements, in lieu of the amounts that would otherwise be required by Reg T, provided that the relevant exchange s portfolio margining rules have been approved by the Securities and Exchange Commission (SEC). 5 An exchange that adopts a portfolio margining program, therefore, will effectively combine in its margin rule the synthesized initial and maintenance margin requirements. 6 ARTICLE REPRINT

The goal of portfolio margining is to set levels of margin that more accurately reflect actual net risk. Customers benefit from portfolio margining because margin requirements calculated on the basis of net risk are generally lower than the amounts that would be required by strategy-based methodologies, thus providing more leverage in an account. Broker-dealers benefit because a highly correlated pair or group of positions is a better proxy for the risk associated with one or more of those leveraged positions than cash or other forms of collateral. The NYSE formally sought approval from the SEC for a portfolio margining pilot program in 2002. The SEC published the NYSE proposal for public comment in 2002 and 2004, before approving a two-year pilot program in July 2005. 7 As currently in effect, NYSE Rule 431 permits NYSE member firms to apply a risk-based margin requirement to eligible products including listed broad-based securities index options, index futures and futures options, and related exchange-traded funds as an alternative to strategy-based margin requirements. In July 2006, the SEC approved additional amendments to the pilot program that expand the scope of products eligible for portfolio margining to include equity (single stock) options and single stock futures, conform the associated customer disclosure requirements, and modify the NYSE s net capital requirements applicable to broker-dealers that maintain portfolio margin accounts. 8 Portfolio margining is not new it has been employed by The Options Clearing Corporation (OCC) to calculate margin requirements since 1996, followed by the introduction of the SPAN margining system for futures and futures options in 1998. Based in part on variations of the Black-Scholes and Cox-Ross-Rubinstein option pricing models and value-atrisk modeling, portfolio margining calculates a customer s margin requirement by shocking a portfolio of financial instruments at different points along a range representing potential percentage increases and decreases in the value of the instrument (or underlying instrument in the case of a derivative product). Projected gains and losses for each instrument in the portfolio are netted at each calculation point along the range to derive a potential portfolio-wide gain or loss for that calculation point, with the greatest potential loss point being used to determine the required margin. 9 The table that follows illustrates the beneficial effects of portfolio margining on a relatively straightforward portfolio of S&P 500 put and call options. 10 In addition to reflecting certain modeling assumptions (based on market movements within a range of -8% to +6%), this example assumes that the strike price for the puts is $21.00, the strike price for the calls is $15.35, and that the S&P 500 settled (closed) on the prior trading day at 1244.12. Position Standard Margin Portfolio Margin Margin Reduction Short 1000 SPX $18,073,800 $5,654,150 $12,419,650 SEP 1250 Calls (68.8%) Short 1000 SPX $18,661,800 $8,198,746 $10,463,054 SEP 1250 Puts (56.1%) Long 1000 SPX $3,635,000 $75,000 $3,560,000 SEP 1250 (97.9%) Put-Call Straddle Short 1000 SPX $18,661,800 $6,669,421 $11,992,379 SEP 1250 (64.3%) Put-Call Straddle Portfolio Margining Models NYSE Rule 431 currently provides that a broker-dealer offering portfolio margining to its customers must employ a methodology that has been approved by the SEC for use in calculating regulatory capital. 11 To this point, the SEC has approved only the use of the Theoretical Intermarket Margining System (TIMS), the risk-based algorithm developed by OCC. 12 This means that the SPAN margining system developed by the Chicago Mercantile Exchange (CME) and the internal risk models that are employed by a consolidated supervised entity (CSE) or over-the-counter derivatives dealer (so-called BD lite ) entity to calculate the risk of its proprietary positions for purpose of its calculating net capital requirements cannot be applied, at this time, to determine customer margin requirements. 13 Proposed amendments to Rule 431(g), however, would require a broker-dealer to develop a comprehensive risk analysis methodology and file that methodology with the broker-dealer s designated examining authority and the SEC prior to the implementation of portfolio margining. Thus, although not explicitly contemplated by Rule 431, it is possible that an internal risk model that was previously reviewed (and implicitly approved) as part of the approval of a CSE or BD lite could be approved for purposes of portfolio margining. The portfolio margin available to a broker-dealer s customers may not exceed 1,000 percent (a 10:1 ratio) of the broker-dealer s tentative net capital (i.e., net capital computed before application of the securities haircuts required by the SEC net capital rule) for more than three business days. A firm that is not in compliance with that requirement must cease opening new portfolio margining accounts, but is not required to restrict trading in existing accounts. 14 Margin Deficiencies NYSE Rule 431 requires that account equity be calculated and maintained separately for each portfolio margin account. Futures and Derivatives Law Report. 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Margin calls have to be met by the customer within three business days (T+3), but the broker-dealer is required to take a charge to its regulatory capital for the amount of any margin deficiency remaining after T+1. In addition, and unlike the practice with joint back office (JBO) accounts and certain other margin transactions, NYSE member organizations are not permitted to deduct portfolio margin call amounts from their regulatory capital in lieu of collecting the required margin from the customer. Eligible Instruments Qualifying customers are permitted to effect transactions in listed, broad-based U.S. index options, index warrants or listed single stock options in a portfolio margining account over-the-counter transactions in index or equity options do not currently qualify for portfolio margining treatment. In addition, transactions in the underlying securities can be effected in a portfolio margining account provided that a position in an offsetting listed, broad-based U.S. securities index option, index warrant or listed single stock option is already in the account or established in that account on the same day. 15 If a listed, broad-based U.S. index option, index warrant or listed single stock option position that was used to offset an underlying instrument expires or is closed out, the position must be replaced within ten business days; if the position is not replaced, the underlying instrument has to be transferred to a non-portfolio margining account, thus becoming subject to the normal margin requirement for that position. Eligible Customers Portfolio margining is currently available only to (i) individuals and entities (other than Individual Retirement Accounts) that have or establish, and thereafter maintain, at least $5 million in equity in a portfolio margining account; (ii) SEC-registered broker-dealers; and (iii) members of futures exchanges to the extent that listed index options hedge their positions in index futures. Any such customer must additionally be approved for options transactions, including uncovered short option positions, by the broker-dealer carrying the customer s account. The $5 million requirement can be met by combining all securities and futures accounts owned by the customer and carried by the broker-dealer (as broker-dealer and as futures commission merchant), provided that ownership is identical across all combined accounts. Account guarantees cannot be used as a means of satisfying portfolio margin requirements. If account equity falls below the $5 million minimum, additional equity must be deposited within three business days. However, and as discussed in greater detail below, the NYSE has proposed to largely eliminate the $5 million minimum equity requirement. Accounts which exceed that threshold, however, would be exempt from the special day trading restrictions imposed by Rule 431(f)(8)(B) 16 if the broker-dealer has the ability to monitor the special risks associated with intra-day trading. Broker-Dealer Requirements A broker-dealer must obtain approval from its designated examining authority, which for most large broker-dealers will be the NYSE. 17 NYSE member organizations also must provide written notification to and receive approval from the NYSE before offering portfolio margining to their customers. As such, member organizations will be required to establish written procedures for monitoring the risks associated with portfolio margining, including a methodology for assessing any potential risk to the member organization s capital. 18 Broker-dealers are additionally required to provide customers with a special risk disclosure statement, in the form specified in NYSE Rule 726(d), that identifies the special risks associated with portfolio margining, and obtain an acknowledgment from the customer that it has read and understood the disclosure statement. 19 Treatment of Futures and Futures Options By its terms, NYSE Rule 431 is applicable to stock index futures and futures options, such as the S&P 500 contracts traded on the CME, as well as to security futures products, the single stock futures and narrow-based index futures and futures options traded on OneChicago. These products cannot be included in a portfolio margining account, however, without regulatory relief from the Commodity Futures Trading Commission (CFTC). 20 The CFTC has thus far been unwilling to take such a step based, in part, on the incompatability of the rules that would apply to the insolvency of a combined broker-dealer/futures commission merchant. 21 Regulatory Capital Considerations As discussed in greater detail below, the NYSE has requested SEC approval of proposed amendments to Rule 431 that would, among other things, allow a broker-dealer to include swaps in their computation of the margin requirements for a portfolio margining customer. 22 Broker-dealers that are not CSEs have historically entered into swaps through an affiliate that is not a registered broker dealer. That is because the net capital rule effectively requires a broker-dealer to assign no value to the receivable from a swap counterparty, to deduct from net capital any amounts payable to such counterparty, and to discount ( haircut ) the broker-dealer s hedging position. 23 The net capital rule requires a broker-dealer to deduct accounts receivable from net capital if they are unsecured and, if they are partially secured, to the extent they are unsecured. 24 As proposed to be amended, however, Rule 431 would require that a separate account be established for each portfolio margining customer in which the broker-dealer would hold the customer s equities, options, futures, options on futures and swap positions. That account may not be fully secured for purposes of the net capital rule, however, if these non-securities instruments are not combined with equities and securities options in a customer s account. 25 Thus, absent amendments to the net capital rule, there is not. 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likely to be material net capital relief for a broker-dealer that is approved for portfolio margining under Rule 431(g), even though its customers margin requirement will have been reduced and the broker-dealer will have received the NYSE s approval of its procedures and guidelines for the monitoring of credit risk. 26 Additional problems are posed by the inclusion of futures in a portfolio margin account. A customer s portfolio margin account may be fully margined on the books of the brokerdealer, but the broker-dealer will nonetheless have to take a charge to capital to the extent that the margin requirements for the portfolio positions are less than would be required for the futures positions in isolation. 27 In like fashion, a broker-dealer that has taken the opposite side of a portfolio margining customer s position (e.g., by selling a call to the customer) will have to take a haircut on its principal position and on the long or short position it established to hedge its customer exposure, even though this undermines the use of portfolio margining to control risk to the broker-dealer. 28 Proposed Amendments The NYSE has submitted to the SEC proposed amendments to Rule 431 that would further expand the scope of products that are eligible for portfolio margining, eliminate the $5 million minimum equity requirement for certain market participants, establish a simplified mechanism for carrying futures positions in a portfolio margining account and make numerous other technical and clarifying amendments. 29 Specifically, the proposed amendments would broaden the list of eligible instruments to include any margin equity security, 30 as well as unlisted derivatives such as swaps, forwards and over-the-counter options. The NYSE proposal additionally would allow broker-dealers to carry debt instruments and other securities that are not eligible for portfolio margining in a portfolio margin account as long as the broker-dealer is able to apply strategy-based margin treatment to those ineligible positions. 31 The proposed amendments also would eliminate the $5 million minimum equity requirement for market participants (other than IRA accounts) that are not broker-dealers or members of a futures exchange except in cases where the portfolio margining calculation includes unlisted derivatives. 32 The special day-trading margin requirements contained in Rule 431(f) would continue to apply, however, to portfolio margin accounts that have less than $5 million in equity unless the trades are part of a hedge strategy (as defined). Finally, the proposed amendments would extend portfolio margining treatment to futures and futures option positions, but only to the extent that they were carried in a portfolio margin account, as opposed to a cross-margin account, as currently contemplated by Rule 431(g). The NYSE s intentions on this subject are unclear, however, since it is not within the power of the SEC to permit the commingling of customers futures and securities accounts (something that would require an amendment to the CEA or an exemptive order from the CFTC). 33 The NYSE proposal also appears to assume that the affected clearinghouses, including the OCC, CME and the National Securities Clearing Corporation (the clearinghouse for the NYSE, the American Stock Exchange and NASDAQ), will enter into contractual and other arrangements among themselves as necessary to ensure that the collateral that is held in a portfolio margining account at the customer level is cross-collateralized ( cross-margined ) at the clearinghouse level to support the broker-dealer s obligations to the affected clearing organizations. Although there are cross-margining agreements in place between OCC, CME and the Fixed Income Clearing Corporation, those agreements are bilateral (and not multilateral), are structured differently (involving either one or two pots of collateral), do not extend to equity securities, and have not been approved for customers other than market-makers and other market professionals. 34 Thus, even assuming CFTC action, much remains to be done before it will be possible for market participants to fully realize the benefits of portfolio margining. Notes * Kenneth M. Rosenzweig is a partner in the Financial Services Group at Katten Muchin Rosenman LLP, specializing in exchange-traded and over-the-counter instruments. E-mail: kenneth.rosenzweig@kattenlaw.com. Mr. Rosenzweig wishes to thank Morris Simkin and Alex Liker, a partner and associate in Katten s Financial Services Group, for their valuable assistance in the preparation of this article. 1 17 C.F.R. Parts 220, 221 and 224. 2 For this purpose, the securities must be traded on a national securities exchange (e.g., the New York Stock Exchange), or on NASDAQ, or be included in a list of eligible foreign securities published by the Fed. Regulation U applies comparable, but more limited, requirements to domestic entities other than broker-dealers. Specifically, Regulation U limits the extension of credit to finance the purchase or carrying by customers of publicly traded equity securities, but only where the extension of credit is secured, directly or indirectly, by margin stock. Regulation X effectively extends the provisions of Regulation U to extensions of credit by a non-united States lender to a United States borrower. 3 See 12 C.F.R. 220.3(c). 4 See 12 C.F.R. 220.1(b)(2). 5 See 12 C.F.R. 220.1(b)(3)(i). 6 Although the term portfolio margining systems is not defined in Reg T, the SEC has described such a system as follows: Portfolio margining establishes margin levels by assessing the market risk of a portfolio of positions in securities or commodities. Under a portfolio margining system, the amount of required margin is determined by analyzing the risk of each component position in a customer account (e.g., a class of options with the same expiration date) and by recognizing any risk offsets in an overall portfolio of positions (e.g., across options and futures on the same underlying instrument). So that adequate margin is deposited to cover extraordinary market events, one or more additional adjustments may be applied in calculating a customer s required margin. A portfolio margining system may also Futures and Derivatives Law Report. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered,

be used in conjunction with a risk-based margining system, which assesses margin based on the historical performance of individual instruments, rather than as a fixed percentage of current market value. Depending upon the risks attributable to one or more positions, the amount of required margin in a portfolio margining system may be greater than or less than the margin levels currently required for securities positions in a fixed-percentage, strategy-based margining system. Exchange Act Release No. Release No. 34-46292, 78 S.E.C. Docket 384, 2002 WL 1769439 (July 31, 2002). 7 Securities Exchange Act Release No.34-52031, 85 S.E.C. Docket 2785, 2005 WL 2778642 (July 14, 2005); Securities Exchange Act Release No. 4-50885, 84 S.E.C. Docket 1838, 2004 WL 3177123 (December 20, 2004); Securities Exchange Act Release No. 34-46576, 2002 WL 31189742 (October 1, 2002). 8 See Exchange Act Release No. 34-54125, 2006 WL 2986961 (July 11, 2006). 9 Projected prices are calculated based upon the closing price of the underlying asset for each day, plus and minus price moves at ten equidistant data points over a +6/-8% range for high capitalization indices and a +10/-10% range for non-high capitalization indices. The implied volatility curve specific to an option s underlying security and maturity is matched to the potential market scenarios in the calculation of projected prices for that option; interest rates reflect current swap rates; dividend amounts are input based on data from third-party sources. In general, the amount of initial and maintenance margin that is required with respect to a given, margined portfolio is equal to the greater of (i) the greatest loss amount among the valuation point calculations, subject to certain adjustments, and (ii) the sum of $.375 for each option, futures contract or other instrument in the portfolio times the multiplier for the relevant instrument (e.g., the index multiplier for options on the S&P 500 is $100). 10 Source: Fimat Preferred, LLC. http://www.fimatpreferred.com/ Portfolio_Margin/index.htm 11 See Securities Exchange Act Release No. 34-52031, 85 S.E.C. Docket 2785, 2005 WL 2778642 (July 14, 2005); 17 C.F.R. 240.15c3-1a. 12 OCC recently announced that it has replaced TIMS with System for Theoretical Analysis and Numerical Simulations (STANS), which uses Monte Carlo-based simulation techniques for risk estimation. 13 In broad terms, the CSE status offers a reduction in the net capital haircuts that would otherwise apply to swaps and other illiquid positions in exchange for SEC review and approval of the financial, operational and risk controls of the broker-dealer and its holding company. In essence, the CSE framework consists of an alternative net capital computation for broker-dealers that voluntarily elect to be supervised on a consolidated basis. CSE status is not automatic. A broker-dealer that has at least $1 billion in tentative net capital (in essence, net capital, increased by the balance sheet value of over-the-counter (OTC) derivatives, before the alternative CSE deductions) and $500 million in adjusted net capital must apply to the SEC before operating as a CSE. A broker-dealer that has been so approved computes market risk for its proprietary securities positions using value-at-risk or scenario analysis in lieu of the haircuts that would otherwise be required by SEC Rule 15c3-1(c)(2)(vi) and (vii) (15%, if the securities are readily marketable; 100% if not). The value-at-risk model must be an integral part of the firm s risk management; must be reviewed periodically; and capture liquidity, event and default risk for each position, but the SEC may authorize scenario analysis (the worst 10-day move over the last four years) for certain positions. All other positions remain subject to the ordinary Rule 15c3-1 haircuts. A CSE must also take a deduction for credit risk, equal to the sum of (i) a counterparty exposure charge, (ii) a counterparty concentration charge, and (iii) a portfolio concentration charge. See 17 C.F.R. 240.15c3-1e. There were six approved CSEs as of November 30, 2006. See http://www.cftc.gov/files/tm/fcm/tmfcmdata0610.pdf. BD lite was the SEC s initial response to complaints that the net capital haircuts in Rule 15c3-1 and related requirements for OTC derivatives were forcing broker-dealers to carry their OTC positions in non-regulated, special purpose companies which needed to be separately capitalized. (The BD lite rules were adopted in January 1999; the CSE rules were adopted in June 2004.) BD lite has not been widely embraced by the industry, however, because over-the-counter derivatives dealers (the formal name for BD lite entities) are permitted to engage in only certain types of securities transactions (including swaps, structured notes and other hybrid securities), cash management and ancillary portfolio management activities, but may not engage in forward purchases or sales of securities (with certain exceptions for government securities and margin stock), transactions in securities listed on an exchange or the NASD, or repurchase or reverse repurchase transactions (other than to finance securities positions). An overthe-counter derivatives dealer must maintain $100 million in tentative net capital and $20 million in net capital. Appendix F to Rule 15c3-1 (17 C.F.R. 240.15c3-1f) establishes net capital requirements that are analogous to those under the CSE system the dealer must take either (i) the regular net capital haircuts or (ii) market risk charges, based on an SEC-approved value-at-risk model, and credit risk charges based on replacement cost with a concentration charge overlay. Unlike transactions effected by a broker-dealer that is part of a CSE, transactions effected by an over-the-counter derivatives dealer are exempt from Reg T (because the over-the-counter derivatives dealer is not a brokerdealer subject to Reg T), but remain subject to Reg U. 14 See 17 C.F.R. 240.15c3-1(c)(15). 15 The term broad-based U.S. securities index option is not defined in Rule 431, but is apparently intended to refer to an option on an index that is not narrow-based (see 15 U.S.C.A. 78c(a)(55)(B)) and whose underlying securities are traded on a United States exchange or NASDAQ. 16 NYSE Rule 431(f)(8)(B) establishes a special 25% margin requirement for day traders in equity securities, plus a minimum account equity requirement of $25,000 for pattern day traders. A pattern day trader also may not trade in excess of its day trading buying power (in essence, four times the sum of the account equity minus the Rule 431 maintenance margin requirement). 17 See National Association of Securities Dealers Rule 2521 (member firm not required to comply with NASD margin rule if another self-regulatory organization is the designated examining authority for that member); Chicago Board Options Exchange (CBOE) Rule 12.11 (member organization that also is member of NYSE may elect to be bound by NYSE margin requirements). The CBOE has separately received approval for its own portfolio margining pilot program. See generally CBOE Regulatory Circular RG05-71 (August 31, 2005). Broker-dealers that are not NYSE members will, in most cases, be subject to the margin requirements of NASD Rule 2520, which to this point has not been amended to provide for portfolio margining. As of November 30, 2006, only two firms Fimat Preferred, LLC and Fimat USA, LLC had been approved by the NYSE. 18 See NYSE Information Memo 06-57 (August 2, 2006). 19 The NYSE has indicated that it intends to amend Rule 726(d): see Amendment No. 1 to SR-NYSE-2006-13 (filed September 13, 2006). 20 Among other things, the Commodity Exchange Act (CEA) and CFTC Regulations require that futures customer funds be held in a segregated futures customer funds account. Although there is a statutory exception from this rule for single stock futures and narrow-based index futures, the CFTC would need to grant. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered, Vol. 26 No. 11, 2007

regulatory approval to permit margin for broad-based index futures and futures options, such as the S&P 500 futures and options and futures traded on the CME, to be held in a securities account (or for securities margin to be held in a futures segregated funds account). There is some precedent for allowing futures margin to be held by a broker-dealer that is in compliance with the requirements of SEC Rule 15c3-3 (17 C.F.R. 240.15c3-3). CFTC Staff Letter 02-22, Comm. Fut. L. Rep. (CCH) 28,955 (July 11, 2001); see CFTC Staff Letter No. 06-20 (September 7, 2006). Although not explicitly stated in the staff letters, it is generally understood that these letters were issued in relation to TRAKRS (exchangetraded but non-traditional futures contracts designed to provide market exposure to various market-based indices of stocks, bonds, currencies, commodities and other financial instruments). 21 In the event of an FCM bankruptcy, futures customers would have claims against the pool of customer segregated funds accounts. See 11 U.S.C.A. 766, 17 C.F.R. 190.07-190.08. By contrast, securities customer accounts are insured under, and would ordinarily be liquidated in a proceeding under, the Securities Investor Protection Act of 1970. SEC rules require the segregation of the property of securities customers, but only to the extent that it exceeds the amounts owed by customers to the broker-dealer. If a customer has both a securities account and a futures account, the customer has a separate claim against each pool of funds. 22 See Release No. 34-53577, 2006 WL 1641791 (March 30, 2006) (SR-NYSE-2006-13); Amendment No. 1 to SR-NYSE-2006-13 (filed September 13, 2006). 23 See 17 C.F.R. 240.15c3-1(c)(2)(vi); Securities Industry Association (pub. avail. Nov. 21, 1991), NAFT WSB File No. 032392059. 24 See 17 C.F.R. 240.15c3-1(c)(2)(iv). 25 See 17 C.F.R. 240.15c3-1(c)(6) (defining customer by reference to funds and securities received, acquired or held by broker-dealer; other instruments not included). 26 The SEC staff apparently intends to recommend amendments to SEC Rules 15c3-1 and 15c3-3 to facilitate the use of crossmargining of certain customer accounts and reduce certain capital charges to better align the capital requirements with the risk associated with customer positions. See 71 Fed. Reg. 74303, 74319 (December 11, 2006). 27 See 17 C.F.R. 1.17(c)(5)(viii), 240.15c3-1b. 28 Under the SEC s alternative net capital requirement, net capital is required to be not less than 2% of the customer debit formula set forth in Appendix A to SEC Regulation 15c3-3 (17 C.F.R. 240.15c3-3a), with certain modifications. See 17 C.F.R. 240.15c3-1(a)(1)(ii). Portfolio margining will reduce the customer assets within the control of the broker-dealer as well as its risk exposure. Thus, the rationale for Appendix A Item 4 (customer securities failed to receive), Item 11 (stock borrowed to cover customer short sales), and Item 12 (fails to deliver of customer securities less than 30 days old), the 1% haircut for Items 11 and 12, and the 3% charge for customers cash and margin account debit balances in computing net capital is difficult to reconcile with the risk and credit control mechanism that are a condition to approval for portfolio margining under Rule 431. 29 See Release No. 34-53577 (March 30, 2006) (SR-NYSE-2006-13); Amendment No. 1 to SR-NYSE-2006-13 (filed September 13, 2006), http://apps.nyse.com/commdata/pub19b4.nsf/docs/ F38EAB43BF641B5E852571E8005C434D/$FILE/NYSE-2006-13%20A-1.pdf. At the time this article was prepared, the proposed amendments were pending SEC approval. The amendments were approved on a pilot basis by the SEC on December 12, 2006, with an effective date of April 2, 2007. The expanded pilot program is scheduled to expire on July 31, 2007. Release No. 34-54918 (December 12, 2006). 30 The term margin equity security is defined for this purpose by reference to Reg T, which in turn defines that to mean a margin security that is an equity security within the meaning of Section 3a(11) of the Exchange Act (15 U.S.C.A. 78c(a)(11). 12 C.F.R. 220.2. As a practical matter, this includes shares in open-end mutual funds, Rule 144 control and restricted stock, and foreign equity securities and options thereon. 31 Money market mutual fund shares may be included only if they are subject to the customary Rule 431 strategy-based margin requirements and the customer waives its right to redeem the shares without the broker-dealer s consent. 32 The minimum equity requirement and the requirements applicable to accounts with a margin deficiency are to be determined as of the close of business on a trading day, and not intra-day. An account that has a margin deficiency would be permitted to make new trades only as long as they are risk-reducing, the approach taken by the futures exchanges and clearinghouses under their portfolio margin rules. 33 Subject to a limited exception for securities futures products (i.e. single stock futures and futures on narrow-based indices), the customer funds segregation requirements of the CEA and CFTC regulations require that an FCM deposit customer funds (see 17 C.F.R. 1.3(gg)) only with a bank or trust company, a registered derivatives clearing organization or with another FCM. The segregation requirements additionally prohibit (again, with a limited exception for security futures products) the use of customer funds for any purpose other than to margin, guarantee or secure customers trades and positions. 7 U.S.C.A. 6d(a)(2); 17 C.F.R. 1.20(a), 1.22. In addition to the segregation rules, the CFTC would, at a minimum, need to grant relief from its rule that prohibits FCMs from agreeing not to collect the minimum margin required by an exchange. See 17 C.F.R. 1.56. 34 See, e.g., 56 Fed. Reg. 61404 (December 3, 1991) (CFTC Order approving expansion of CME-OCC cross-margining program); Memorandum Recommending Approval of the Chicago Mercantile Exchange s and the Intermarket Clearing Corporation s Proposals to Expand Their Cross-Margining Programs with The Options Clearing Corporation to Include the Cross-Exchange Net Margining of the Positions of Certain Market Professionals, Comm. Fut. L. Rep. (CCH) 25,190 (1991). Futures and Derivatives Law Report. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered,