SEC no-action letter relating to prime brokerage
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Prime Brokerage Anatomy™
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One of the sacred artefacts of US prime brokerage; deep lore that we foreigners ought not speak.
But.
In a nutshell, the SEC no-action letter relating to prime brokerage of January 25, 1994 confirms that a cash trade executed by a customer with an executing broker for give-up to a prime broker does not violate the “free-rider” rule in Regulation T.
Thus, once you have your BAU operational framework set up, Regulation T is not really something that should trouble the legal eagles, at least from a documentation perspective, prescribing as it does how the business should operate, not how it is documented.
In saying this, the no-action letter does have a rather succinct description of what prime brokerage, for the most part, is. Made somewhat succincter, the JC reads the gist as follows:
Prime brokerage is the process by which a registered broker-dealer clears and settles of securities trades for its customers. It involves three distinct parties: the prime broker, the executing broker, and the customer.
The prime broker is a registered broker-dealer that clears and finances the trades the customer has executed with an “executing broker” — another registered broker-dealer at the customer’s request.
Each executing broker receives a letter from the prime broker agreeing to clear and carry each trade placed with it by the customer, where the customer directs delivery of money or securities under the trade to be made to or by the prime broker, to an account the customer maintains with the prime broker.
Orders placed with the executing broker are effected through an account with the executing broker in the name of the prime broker for the benefit of the customer.
When a customer places an order with the executing broker it informs the prime broker who records the transaction in the customer’s prime brokerage account and in an account with the executing broker.
So, for the purposes of the proposal, you have three actions going on:
- Customer order to executing broker
- Trade settlement settlement of the customer order between the executing broker and the prime broker on the customer’s behalf, which the prime broker settles out of its own funds
- Margin loan: A resulting margin loan between prime broker and customer (in the amount paid by prime broker to executing broker to settle the trade.
Englishers should note that these transactions have a unusual quality of agency about them, the unintended consequences of which the SEC no-action letter is meant to ameliorate. In an English law arrangement, the trade settlement would be regarded as a principal trade from the get go — the practical difference between a delivery versus payment trade settlement done as agent and one done as principal being nil anyway.
Proposal
Regulation T provides that anyone investing on margin has to have an account open, and can borrow up to a maximum of 50% of the purchase price. At also prohibits someone cheekily trading in and out of a position before having to front up with any cash — the “free-rider” problem. All good stuff, as a result of the 1929 crash where many investors were as much as 10 times levered. Never again said the US authorities, until we’ve fully forgotten the lessons of 1929, which didn’t happen till 1999, and notwithstanding quite hearty reminders in 1987 and 1998. But Reg T has remained.
Okay: so much for background. Now the market practice of “give-ups” rather queered the pitch seeing as hedge funds like to flash the cash and trade across the street with lots of executing brokers, but only have one (or at any rate a few) prime brokers. This looks — if you put your paranoia glasses on and squint a bit — like a free-rider play in violation of Reg T. Would the executing broker trade by fouled up by Regulation T?
The prime broker committee, chaired by Bear Stearns (remember them?) sought clarity from the SEC that a normal PB settlement would not be. It proposed to treat the “trade settlement” transaction between the prime broker and executing broker as an inter-dealer (principal) trade even though theoretically executed as agent for the customer. The SEC granted it, in the no-action letter.
Terms
The SEC Enfrocement Division will not recommend that the Commission take enforcement action if, under such a prime broker arrangement, the executing broker and prime broker treat the customer account as if it were a broker-dealer credit account under Regulation T and:
1-3 The PB and EB
[...][Various matters relating to the regulatory status and set up of the prime broker itself]
4. The Customer
The customer must keep a minimum net equity with the prime broker of at least $500,000 in liquid assets )[1] and the customer is obliged to cure any passive breaches of that USD500,000 limit within a rather leisurely 5 business days, on pain of the PB publicly disowning its customer and DKing[2] all subsequent trades.
A prime broker may settle prime broker trades for customers
- whose accounts are managed by a registered investment adviser as long as the account has a minimum net equity of at least $100,000 in liquid assets.
- who keep a minimum net equity with the prime broker of at least $100,000 in liquid assets, if the account cross-guaranteed by another customer of the prime broker who itself has $500,000 in liquid assets in an account with the prime broker.
5. Documentation
To qualify for no-action relief the following contracts must be executed and available for inspection:
- The prime broker and executing broker must first have executed contract under which:
- each acknowledges and agrees to be bound by the terms of the no-action letter;
- the executing broker acknowledges its responsibility for credit sanctioning, KYC and locating shares to cover short sales and DK’d trades; and
- the prime broker is obliged to notify the executing broker if its customer prime brokerage contract terminates
- Both EB and PB must execute written contracts with their mutual customers consistent with the terms of the no-action letter.
- The EB must inform any firm clearing its trades that is intends to act as an executing broker]]
6. Records
The PB must keep separate records for all of its customers available for inspection
7. EB notifications
The customer and the executing broker must inform the prime broker by open[3] on the next business day of each contract amount, the security, number of shares, and whether it was a long or short sale or purchase. The parties must use a registered clearing agent to issue trade confirmations by open[4] on the next business day.
8. Settlement by PB
The prime broker must confirm and settle the transactions the customer placed with the executing broker and within the timeframes above, unless it DKs a trade, which it must do by close of business on T+1. (This is why the executing broker must undertake its own KYC and credit review.)
If, due to force majeure at the clearing agency, the prime broker receives a trade confirmation that was entered in a timely fashion after noon (eastern time) on T+1 the prime broker has until the close of business on T+1 of the day after receipt to DK the transaction.
9. Record of DKs
The PB must keep a record of all DKs over the past three years, with reasons. Where a PB DKs a trade that remains the EB’s trade.
10. Short sale regulations=
The EB must comply with all the applicable short sale provisions and, before executing any short sale must determine that the securities can be borrowed to deliver against the short sale.
11. 10b-10 confirmations
The EB must send 10b-10-compliant trade confirmations to the customer for each trade placed under the PB arrangement. It may send these care of the prime broker where the customer has instructed this in writing (but the PB cannot make that instruction a condition to acting, nor give favourable fees to clients who give such an instruction. The PB must in any case make the confirmations available free of charge.
The PB must send the customer 10b-10-compliant notifications of each trade placed with the executing broker pursuant to the prime broker arrangement, based on information provided by the customer.
12. EB records
The EB must keep records of the PB trades per rule 17a-3.
13. DK procedure
When the PB DKs a trade:
- The prime broker must give the customer a notice of cancellation.
- The EB must send a new 10b-10-compliant replacement confirmation.
See also
References
- ↑ Being cash or securities with “a ready market”: see the definition in 15-c3 of “ready market”, which amounts to a liquid public market: “... a recognized established securities market in which there exists independent bona fide offers to buy and sell so that a price reasonably related to the last sales price or current bona fide competitive bid and offer quotations can be determined for a particular security almost instantaneously ...”.
- ↑ Until the year of our Lord 2021, the JC laboured under the gentle misapprehension that “DK” stood for “drop-kick”. To an American, not being wise in the ways of rugby union, it turns out DK means she “does not know” — that is, rejects — the trade allegation. Strange but true.
- ↑ Technically, “morning”.
- ↑ Technically, “morning”.