FINRA to Broker-Dealers: Are You Liquid Enough?

Risk and financial reporting managers at clearing firms and large broker-dealers could soon have to recode their back office systems and establish new procedures.  Why? To quickly inform the Financial Industry Regulatory Authority (FINRA) whether they have a liquidity problem and report a lot more information about their financing deals.

The self-regulatory agency for broker-dealers has requested comments by March 18 on proposed amendments to FINRA Rule 4521 which would require some of its largest members to notify FINRA within 48 hours whether they have less access to money to fund their operations through secured or unsecured financing transactions. Those include repurchase agreements, securities loans and bank loans.

FINRA’s proposed amendments to Rule 4521 will also include broker-dealers with large customer and counterparty exposures file a supplemental liquidity schedule along with their monthly FOCUS Reports. Those reports include information on revenues, net income, assets and liabilities. Broker-dealers would now also need to report data related to specific financing transactions and other sources or uses of liquidity including the terms of repurchase and reverse repurchase agreements, securities borrowed and securities lent, bank loans and other credit facilities, total available collateral, margin loans, deposits at clearing organizations and cash and securities received and delivered on securities transactions not cleared through a central clearing counterparty.

“Broker-dealers will need to allocate personnel and systems resources to comply with the new filing requirements, particularly when it comes to their first filings,” recommends Mark Attar, a partner with the law firm of Schiff Hardin in Washington, D.C. Broker-dealers, he says will incur one-time initial compliance costs related to changing back-office systems and establishing new procedures for notification. Ongoing costs will also be incurred from systems testing and data collection.

Smaller to mid-sized broker-dealers falling under FINRA’s parameters will likely have higher relative costs than the largest ones. Attar predicts that those broker-dealers might ask FINRA to increase the thresholds for when the warning would be triggered or the size of the firm affected.

The amendments to FINRA Rule 4521, if adopted, would apply to carrying or clearing firms that have more than US$25 million in total credits and firms with at least US$1 billion aggregate amount outstanding in repurchase agreements, securities loan contracts and bank loans. By FINRA’s estimates, about 110 firms would be subject to the new requirements. About half of those firms would be subsidiaries or bank-holding companies.

Liquidity risk arises when broker-dealers are unable to meet their expected and unexpected cash flow and collateral needs without harming their daily operations or their firms’ financial conditions. Such a scenario can occur when a broker-dealer uses short-term borrowings to fund longer-term less liquid assets and loses access to its sources of short-term funding. Liquidity risk contributed to the collapse of brokerages such as Lehman Brothers and MF Global.

The proposed notification requirements and supplemental liquidity schedule, if adopted, would give FINRA and the SEC even more clout to actively monitor a broker-dealer’s liquidity and protect investors during periods of economic stress. Broker-dealers are currently subject to FINRA and the SEC’s rules requring them to notify regulators when certain operational thresholds related to net capital, segregation of customer assets, and books and records are violated.

Should that occur, the SEC or self-regulatory agency can more actively monitor the broker-dealer’s financial and operational conditions. In a worst-case scenario, a broker-dealer could be asked to curtail some of its operations or shut down completely. In 2015, FINRA also issued guidance to broker-dealers on best practice for liquidity management following a review of how broker-dealers manage their liquidity needs in a stressed environment.

In its request for comments on its proposed amendments to Rule 4241, FINRA says that it doesn’t expect broker-dealers to have any trouble meeting its new information requirements. After all, the data should already be readily available. Securities finance operations managers at broker-dealers tell FinOps Report that, although the data is available in multiple securities finance back-office systems, they will have to figure out how to consolidate the information and report it in a structured format.

Closer Tabs

Likely to be far more difficult for broker-dealers, Attar acknowledges, will be keeping track of FINRA’s criteria for “adverse liquidity events” that trigger notification. Those include the early termination of a counterparty of its financing agreement with the broker-dealer, a counterparty indicating it will no longer provide financing and a significant increase in the level of collateral required by a large counterparty.

For example, broker-dealers must report the loss of access to funding through repo agreements where the loss — excluding funding collateralized by US Treasury securities or collaeralized securities issued by a US government agency or government sponsored enterprise in the aggregate across all counterparties — represents 20 percent or more of the highest amount borrowed through such contracts within a 35 rolling calendar day period. The same thresholds and timing applies to bank loans.

“Many broker-dealers, particularly the largest ones, maintain extensive systems and techniques for identifying, assessing, monitoring and controlling liquidity risk,” says Attar, “However, under the proposed rules, firms will need to develop new processes and reporting metrics specifically designed for regulatory reporting purposes.” Bottom line: it will also be important for broker-dealers to maintain open lines of communication between their risk management, compliance and regulatory reporting functions.

Liquidity managers at broker-dealers do notify their risk management and compliance directors when concerned about liquidity risk. However, the thresholds used might not always match those FINRA wants. Hence, broker-dealers may have to readjust their rules to meet FINRA’s new metrics. Regulatory reporting managers also will need to be in the loop for the first time.

FINRA’s proposed new liquidity monitoring requirements could be just the tip of the iceberg for risk managers, compliance managers and regulatory managers. “Will the imposition of reporting requirements as to liquidity eventually result in the adoption by FINRA of substantive liquidity requirements?” asks Steven Lofchie, a partner with the law firm of Cadawalder, Wickerham & Taft in a new client communique. “Once an information requirement is adopted, will the Securities and Exchange Commission and FINRA be satisfied with firms using their own judgment as to an acceptable level of liquidity?”

Attar predicts that the SEC’s Division of Trading and Markets might recommend that the regulatory agency amend its net capital rule to require stress testing. The SEC might also amend its Rule 17a-11 to add more notification requirements related to a broker-dealer’s overall financial condition. Last but not least, the SEC might even decide to adopt a proposal it issued in 2012 to require dealers trading in security-based swaps to adopt new liquidity management policies based on specific stress test prameters. Such a new requirement, Attar believes, could eventually be applied to carrying and clearing brokers as well as large introducing brokers.