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Capital-Markets Activities Manual
Activities: Regulatory Compliance
Source: Federal Reserve System
(The complete Activities
Manual (pdf format) can be downloaded from the Federal Reserve's web
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
PRINCIPLES OF SUPERVISION
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
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.
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
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 SECURITIES ACTIVITIES
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.
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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