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News May 21 & 28, 2012 Issue

No-Action Relief Adds Certain Derivatives to Net Capital Calculation

For more than a decade, the net capital calculation has been missing an important player in the derivatives markets.

Security futures were prohibited in the U.S. trading markets when the net capital rule began using a new pricing model to account for derivatives. Although the prohibition was repealed three years later, the repeal did nothing to affect the net capital calculation. Broker-dealers with security futures positions could not use them to offset other derivatives positions and craft a more accurate assessment of a firmís true exposure to the markets.

All that changed earlier this month. FINRA and the Chicago Board Options Exchange (CBOE) successfully petitioned the SEC for relief to include security futures contracts for purposes of the net capital calculation.


In 1997, the SEC adopted amendments to the net capital rule, Rule 15c3-1 under the Securities Exchange Act. The amendments permitted broker-dealers to employ "theoretical option pricing models" when calculating net capital for listed options and related positions that hedge those options.

Specifically, the amendments allow broker-dealers to group long and short positions in listed options into "portfolio types," and then within that portfolio type, to offset gains and losses at the same valuation point.

The U.S. prohibited the trading of securities futures products until the enactment of the Commodity Futures Modernization Act of 2000 (CFMA). The CFMA established a framework of joint regulation of securities futures by the SEC and CFTC and repealed the prohibition.

More than a decade later, the absence of now commonly used security futures in the net capital calculation was being keenly felt in the industry. Broker-dealers took their case to FINRA and the CBOE, who in turn took it to the SEC.

The rationale.

Allowing security futures contracts in the option pricing models for the net capital calculation would more accurately measure the risk in a broker-dealerís portfolio, said FINRA and the CBOE. Further, it would provide a more accurate measure of the amount of net capital the broker-dealer should maintain with respect to the portfolio.

They said that broker-dealers using a theoretical options pricing model should be allowed to treat security futures on an individual stock as a position in the underlying instrument.

If security futures contracts had not been prohibited at the time of the 1997 amendments to the net capital rule, "CBOE and FINRA would have supported including security futures contracts," they asserted.

The SECís Division of Trading and Markets was receptive to the request.

The catch.

Subject to a technical condition related to the ruleís minimum charge calculation for a security futures contract, the SEC granted the relief on May 4.

Division associate director Michael Macchiaroli noted that while broker-dealers may treat a U.S.-listed security futures contract on an individual stock as a position in the "underlying instrument" for purposes of the net capital rule, the underlying instrument "shall not be deemed to include securities options, futures contracts, options on a futures contract, qualified stock baskets, or unlisted instruments."