APPENDIX: Registered Broker-Dealer: Measurement of Credit Losses on Financial Instruments

APPENDIX

Implementing ASC 326: Financial assets that should be considered and that are unique to registered brokers and dealers

Commissions receivable that are due from the clearing broker for introducing brokers:  Typical business practices in the securities industry and the commodities markets are that such receivables are usually remitted on a monthly or quarterly basis.  The broker should maintain awareness of the credit-worthiness of the clearing broker.   The regulatory community constantly maintains its awareness of the liquidity of clearing brokers and FCMs.  As a result, failures of these organizations have not been frequent but still need to be evaluated. 

Private placement fees receivable:  Broker-dealers that engage in obtaining financing or arranging mergers and acquisitions often require an initial nonrefundable deposit and monthly payments as work progresses in order to limit exposure to credit losses.  If final success fees are not collected at closing then the broker must closely follow the credit-worthiness of the customer. Broker-dealers should consider historical loss information of the customer and pool for periods in which they cannot make reasonable and supportable estimates of future credit losses. Any adjustments to historical experience should consider relevant qualitative and quantitative factors related to (a) the economic environment in which the broker-dealer operates and (b) specific attributes of the customer, sector and industry.

Fees receivable for brokering trades on trading floors or at financial markets:  Often commissions for these brokers are invoiced monthly to customers and are unsecured.  Information about regulated broker-dealers may be available and should be utilized.   However, credit information from other market participants such as funds and commercial entities will be more difficult to come by. Similar to the above, in evaluating the allowance for credit losses from these entities, broker-dealers should look to historical loss information of these entities when estimates of future credit losses cannot be made. Broker-dealers should consider environmental factors including trends in the economy, the aging of receivables and collection history and industry factors relevant to these entities when making this assessment.

Unsecured customer receivables: Generally, the securities industry and commodities market registrants closely monitor customer accounts to reduce the exposure to unsecured customer receivables.  Although controls are usually in place to ensure that unsecured customer receivables are rectified timely and kept to a minimum, credit losses can still occur.  Size, age, and historical or expected credit loss patterns can be important factors in developing estimates of credit losses when there are significant unsecured receivables.

Customer receivables that are secured: A customer account may be extended credit to trade in margin if there are sufficient securities in custody that will cover the risk of loss.  These receivables may be eligible for the practical expedient of financial assets secured by collateral maintenance provisions as long as the customer has the intent and ability to provide additional collateral.

Securities lending: A receivable is created when one broker-dealer borrows securities from another and provides cash as collateral.  The asset is referred to as “stock borrowed”. Since the stock and cash move in opposite directions, one can understand that the cash a broker receives when it lends stock results in a liability called “stock loaned.” At its essence, securities lending represents financing transactions that serves the interests of each party. Securities lending is generally collateralized by cash, although securities or letters of credit may also be used as collateral. The nature of these transactions is generally governed by Regulation T and SEC Rule 15c3-3.

If repayment is expected substantially through the operation or sale of collateral and the borrower is experiencing financial difficulty, the broker-dealer should consider the method of repayment. When repayment will be from the operation of the collateral, a broker-dealer would generally use the present value of expected cash flows from the operation of the collateral as the fair value. When a broker-dealer expects to sell the collateral so it can be repaid, it should deduct the costs to sell from the fair value of the collateral measured as of the measurement date. In connection with the sale of collateral, a broker-dealer should consider the costs to sell collateral. Costs to sell are incremental direct costs to transact a sale, that is, the costs that result directly from and are essential to a sale transaction and that would not have been incurred by the entity had the decision to sell not been made. These would typically include legal fees, administration fees, and brokerage fees – costs that would not have been incurred had the broker-dealer not sold the collateral.

When a broker-dealer determines that foreclosure of the collateral is probable, ASC 326-20 requires that the broker-dealer measure initial expected credit losses based on the difference between the current fair value of the collateral (i.e., the fair value as of the measurement date) and the amortized cost basis of the financial asset. As a practical expedient before foreclosure is probable, a broker-dealer can use the collateral’s fair value at the reporting date to estimate the asset’s expected credit losses.

Repurchase agreements: A repurchase agreement accounted for as a collateralized borrowing (repo agreement) refers to a transaction in which a seller-borrower of securities sells those securities to a buyer-lender with an agreement to repurchase them at a stated price plus interest at a specified date or in specified circumstances. A repurchase agreement accounted for as a collateralized borrowing is a repo that does not qualify for sale accounting under US GAAP (i.e., FASB ASC 860, Transfers and Servicing.)

The practices for estimating credit losses for collateral dependent financial assets, described above, would also apply to repurchase agreements. It is important when applying the practical expedient to consider whether or not the repurchase agreement is subject to a tri-party arrangement as well as the counterparty’s ability to continue to adjust collateral. A tri-party agreement provides for collateral to be in the custody of a third party, usually a major financial institution.  Broker-dealers should consider if the fair value of collateral asset equals or exceeds the amortized cost basis of the financial asset as well as assess the counterparty’s credit (a risk which can be mitigated in a tri-party arrangement).  In the absence of a third party to serve as custodian of the collateral, additional qualitative information about the counterparty should be evaluated by the seller-borrower. 

In addition, both repurchase and securities lending agreements are typically subject to master netting arrangements. If there is a legal right to offset the associated assets and liabilities with one counterparty as discussed in ASC 210-20, Offsetting, a broker-dealer may be able to estimate the allowance for credit losses based on net exposure to the counterparty.

Due from clearing organizations: Receivables from clearing organizations may include amounts receivable for securities failed to deliver; amounts receivable from clearing organizations relating to open transactions, margin deposits used as performance bonds for open trades, and good-faith funds on deposit regardless of activity. In addition, the net receivable or payable arising from unsettled trades would be reflected in either the receivable or payable line item on the statement of financial condition. If a broker-dealer clears transactions on behalf of correspondents, or has its transactions cleared through other correspondents, there may be balances in the omnibus accounts with one or more of the correspondents. Balances included in this category may be reported separately on the statement of financial condition as due from or due to correspondent brokers.

When assessing the various asset balances from clearing organizations, an important consideration is whether or not these balances are recorded at fair value through the income statement and therefore out of scope of CECL. Funds on deposit would therefore be subject to the CECL model and require consideration for expected credit losses. 

Fail-to-deliver: A broker-dealer that sells securities, either for its own account or a customer's account, but does not deliver the securities on the settlement date to the other broker-dealer representing his or her customer, should record the fail-to-deliver as an amount due from the other broker-dealer. A fail-to-deliver asset should be measured at the selling price of the security, including any accrued interest in the case of a fixed income security. Fail-to-deliver receivables are collected upon delivery of the securities by the selling broker-dealer. Broker-dealers would have exposure if the contract value exceeds the market value for a fail-to-deliver. Fail-to-deliver receivables would be considered a financial asset at amortized cost and would be within the scope of CECL.

Interest receivable: A broker-dealer that makes an accounting policy election to present the accrued interest receivable balance within another statement of financial position line item should disclose the amount of accrued interest and shall disclose in which line item on the statement of financial position that amount is presented. Broker-dealers must make the following disclosures about their accounting policy elections related to accrued interest:

• If a broker-dealer elects to not measure an allowance on accrued interest, it must disclose what time periods it considers to be timely by class of financing receivable or major security type.
• If a broker-dealer elects to write off accrued interest by reversing interest income, it must disclose the amount of accrued interest reversed through interest income by portfolio segment or major security type.
• If a broker-dealer elects to present accrued interest within another line item on the balance sheet, it must disclose the line item on the balance sheet where the amount of accrued interest is presented.

Click here to return to the article - Registered Broker-Dealer: Measurement of Credit Losses on Financial Instruments