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Trading and Capital-Markets Activities Manual

Trading Activities: Regulatory Compliance
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

The trading activities and related instruments discussed in this manual are covered by various securities, commodities, or banking laws and regulations. Trading and other activities relating to securities are regulated under a variety of statutes, including the Securities Act of 1933, Securities Exchange Act of 1934, and Government Securities Act of 1986. In addition to regulation by the Securities and Exchange Commission (SEC) and U.S. Treasury Department, various self-regulatory organizations (SROs) are responsible for oversight of securities broker-dealers. The SROs include the Municipal Securities Rulemaking Board (MSRB), the National Association of Securities Dealers (NASD), and exchanges such as the New York Stock Exchange (NYSE). 

Bank activities in the trading of securities are subject to further regulation from the various banking regulators. One of the more important statutory provisions governing securities activities of banks was the Banking Act of 1933 (the Glass-Steagall Act), which provided that member banks could purchase only certain limited types of securities (referred to as ''eligible securities'') and prohibited member banks from affiliating with entities that were engaged principally in the business of underwriting or issuing ineligible securities. Under the provisions of the Gramm-Leach-Bliley Act (GLB Act) enacted in 1999, financial holding companies are permitted to establish broker-dealer subsidiaries engaged in underwriting, dealing, and market making in securities, without the restrictions applicable to section 20 subsidiaries. The GLB Act provisions also permit financial subsidiaries of banks to engage in comparable activities, subject to certain bank capital limitations and deductions. Permissible equity trading activities of foreign and Edge corporation subsidiaries of U.S. banks are governed under the Board's Regulation K. 

Activities involving instruments other than securities also may be subject to a variety of regulatory provisions. Commodities futures and options are regulated primarily by the Commodity Futures Trading Commission (CFTC), with the activities of futures commission merchants (FCMs) subject to regulation by the CFTC as well as the rules of the National Futures Association (an SRO) and various exchanges on which trading is conducted. Most over-the-counter derivative instruments (for example, foreign-exchange contracts, forward rate agreements, and interest-rate swaps) are exempt from general CFTC regulation, either by statute in the case of foreign exchange or under CFTC regulatory exemptions in the case of other types of swaps and related transactions. While these instruments are not themselves subject to regulation, the activities of regulated entities in these instruments are subject to oversight by the banking or other regulators. 

In addition to laws and regulations issued by the regulatory authorities, industry trade groups such as the International Swaps Dealers Association or the Public Securities Association (PSA) have developed industry guidelines or standards in some areas. Additionally, organizations such as the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA) issue opinions and standards that relate to a financial institution's trading activities and financial disclosure.1 

Increasingly, securities trading activities of banking organizations are being conducted in separately incorporated, non-bank entities owned, directly or indirectly, by bank holding companies. The Board has permitted some banking organizations to engage in securities underwriting and dealing-most importantly, in corporate debt and equity-that previously was restricted largely to securities firms. The subsidiaries in which these securities activities are conducted are commonly referred to as ''section 20'' subsidiaries, after section 20 of the Glass-Steagall Act. Before the Board's approval of limited underwriting activities relating to corporate debt and equity securities, banking organizations were restricted to underwriting and dealing in bank-eligible securities, such as government securities, general municipal obligations, and money market instruments. 

Section 20 companies also are registered broker-dealers, as are many other bank holding company or bank subsidiaries. As such, they fall under the regulatory authority of securities regulators. The GLB Act requires banking regulators to rely to the greatest extent possible on the functional regulator of securities firms. Only under certain specified circumstances may a banking regulator conduct an examination of a broker-dealer. Thus, bank examiners need to become familiar with the regulatory environment in which securities broker-dealers have traditionally operated. This section will focus on that goal, deferring to existing material in the following manuals: Commercial Bank Examination Manual, Merchant and Investment Bank Examination Manual, and Bank Holding Company Supervision Manual. 

1. For example, FASB's Statement No. 80 outlines accounting requirements relating to futures contracts, while Practice Bulletin 4 of the AICPA addresses accounting issues concerning debt-for-equity swaps involving LDC obligations.


The main principles of securities regulation employed by the SEC are the protection of investors (especially the small and unsophisticated) and maintenance of the integrity and liquidity of the capital markets. These are not unlike the goals of banking regulators, who seek to protect small depositors and promote a stable banking system. However, securities and banking regulators differ in how they apply these goals to an institution encountering problems. Securities capital-adequacy rules are liquidity-based and designed to ensure that a troubled broker-dealer can promptly pay off all customers in the event of liquidation. Banking regulators face a different set of constraints when dealing with troubled banks and are less inclined to rely as quickly on the liquidation process. 


Securities broker-dealers generally must register with the SEC before conducting business. While broker-dealer activities undertaken by a bank itself generally are exempt from registration requirements, bank subsidiaries and bank holding companies or subsidiaries that are broker-dealers must register with the SEC. Registered securities broker-dealers also are registered with the NASD or another SRO, such as an exchange, and are required to have their sales and supervisory personnel pass written examinations.

Broker-dealers that engage in transactions involving municipal or government securities generally are registered with the SEC, but are subject to somewhat different requirements than the general registration requirements. When the bank itself acts as a government securities broker-dealer, the bank is required to notify its appropriate bank regulatory authority that it is acting in that capacity. 


Registered securities broker-dealers are subject to minimum net capital requirements pursuant to SEC Rule 15c3-1 or the U.S. Treasury's rules for government securities dealers (17 CFR 402). Requirements in excess of the minimum are also established by NYSE, NASD, and other SROs. If any of these minimums are breached, the firm is subject to harsh restrictions on its operations. Net capital is generally defined as the broker-dealer's net worth plus subordinated borrowings, minus non-liquid (non-allowable) assets, certain operational deductions, and required deductions (''haircuts'') from the market value of securities inventory and commitments. The level of the haircut depends on the type and duration of the security; the greater the duration and risk (or volatility), the greater the haircut. 


Various credit and concentration restrictions are imposed on a securities broker-dealer if the dealer is unduly concentrated in a given issue. Additionally, the Federal Reserve's Regulation T imposes limits on the amount of credit which may be extended by broker-dealers to customers purchasing securities. This restriction varies with the type of security. 


Regulatory Examinations 

All securities broker-dealers are required to publish annual financial statements audited by independent accountants. The SEC has the authority to conduct examinations, including examinations for compliance with sales-practice and customer securities custody-protection rules, recordkeeping and internal controls, and regulatory reporting. In most cases, the SEC delegates this examination responsibility to the NYSE or the appropriate SRO. The NASD also conducts all examinations of firms, except banks, that engage strictly in municipal or government securities trading. In the case of banks, bank regulators are responsible for the examination.

Regulatory Reporting 

Securities broker-dealers are required to file a monthly Financial and Operational Combined Uniform Single (FOCUS) report with their examining authority. This report contains financial statements and computations for the net capital rule, segregated funds held on behalf of commodity futures customers, and a reserve account designed to protect customer balances.2 Government securities dealers file a somewhat similar report, the G-405 or ''FOG'' report, unless they are banks. Bank dealers file their normal call reports. If the broker-dealer is a bank-affiliated section 20 company, it will also file a monthly Y-20 report. This report consists of a balance sheet and income statement and is used to ensure compliance with the Federal Reserve's restrictions on the amount of ''ineligible'' revenue a section 20 company may have. Although FOCUS and FOG reports are generally confidential, securities broker-dealers will often make them available to large customers for credit reasons. 

U.S. commercial banks and branches and agencies of foreign banks are required to file call reports with the appropriate federal bank regulatory agency. The call report includes schedules that detail various off-balance-sheet instruments and information on the institutions' trading-account securities. 


Foreign-owned securities firms in the United States are subject to the same rules as domestically owned firms. In general, offshore activities conducted by U.S. broker-dealers that are located entirely outside of U.S. jurisdiction and do not involve U.S. persons are not subject to U.S. securities regulation. Moreover, for FOCUS and FOG reporting purposes, the securities broker-dealer is not required to consolidate foreign (or domestic) subsidiaries unless the assets and liabilities have been guaranteed by the parent. 

2. SEC Rule 15c3-3 restricts the use of customers' funds and fully paid securities for proprietary transactions. 

Regulatory Compliance 

Examination Objectives 

The overall objective is to determine if the institution's trading activities are in compliance with applicable laws, regulations, and supervisory guidelines. Specified senior management, as well as the regulatory reporting area of the bank, must be thoroughly familiar with regulatory requirements. Whenever possible, the bank examiner uses the examination results of the securities regulators and FOCUS/FOG reports to help assess the firm's overall compliance record. 

1. To determine if the institution's internal controls and audit program address the regulatory compliance aspect of its various trading activities. 

2. To determine if the bank has in place risk-management procedures and controls that provide management with accurate and timely information on all trading positions and their potential impact on the institution's financial and regulatory position. 

3. To ascertain whether the institution's personnel involved in trading activities are aware of and knowledgeable about laws, regulations, and supervisory and other standards applicable to these activities.

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