Amex FRD Notice 03-03 - Market Maker Exemption From Net Capital Rule

It has recently come to the Exchange's attention that there is confusion surrounding the fact that the market maker exemption from the Securities and Exchange Commission's net capital rule, Rule 15c-3-1 (17 CFR 240.15c3-1) does not extend to market makers that are active in products other than options¹. Accordingly, the exemption does not extend to regular members acting as Registered Options Traders making markets in index warrants, currency warrants, securities listed pursuant to Section 107 of the Company Guide ("Other Securities", so called structured products), Trust Issued Receipts (i.e., HOLDRS), and derivative products (as defined in Article I, Section 3(d) of the Exchange Constitution) including Portfolio Depositary Receipts (e.g., SPDRs and DIAMONDs) and Index Fund Shares (e.g., iShares, including WEBs, and VIPERs). And the exemption does not extend to Options Principal Members and Limited Trading Permit Holders making markets in derivative products (i.e., Portfolio Depositary Receipts and Index Fund Shares).

Does Not Impact Market Maker Margin

The foregoing does not, however, impact whether a market maker's transactions qualify for market maker margin treatment. Accordingly, market makers that are active in products other than options continue to qualify for market maker margin on all of their market maker transactions.

Steps to be Taken by Market Makers that Have Wrongly Relied Upon the Market Maker Exemption from the Net Capital Rule

Any member organization or sole member that has relied upon the market maker exemption from the net capital rule but has not limited its market-making activities to options should either move immediately to comply with the net capital rule, modify its activity going forward such that it qualifies for the exemption, or contact the Exchange at the number set forth below to request additional time to come into compliance with the rule².

Going forward, the Exchange intends to review clearing statements of its market makers and take other steps as necessary to determine whether market makers are complying with the net capital rule as applicable. The Exchange expects that it would take enforcement action against member organizations and sole members that are found not to be in compliance where such member organizations and sole members did not notify the Exchange of such non-compliance as requested above.

Impact of Compliance with the Net Capital Rule on Market Makers that Formerly Utilized the Options Market Maker Exemption

A complete overview of the net capital rule and all other regulatory requirements applicable to market makers subject to the net capital rule is outside the scope of this notice. Accordingly, market makers that formerly considered themselves exempt from the net capital rule are urged to consult with an accountant that is knowledgeable about the net capital rule in order to ensure that they have a comprehensive understanding of the financial and other regulatory requirements with which they must comply³.

Market makers should, however, be aware of the following minimum requirements:

Capital
For purposes of the net capital rule, market makers are considered dealers and must maintain minimum net capital of $100,000⁴.

Filings
Market makers subject to the net capital rule will be required to file a monthly net capital computation with the Exchange's Financial Regulation Department on or before the 17th business day after each month-end. They are also required to file a quarterly FOCUS Report on or before the 17th business day after the end of each quarter. In addition, market makers that engage in more than occasional off-floor transactions, that are not directly related to their primary on-floor business, to the extent that the off-floor transactions are more than 25% of their total transactions will be required to file annually audited financial statements. Additional guidance on these requirements can be found at www.amextrader.com/dynamic/amexnotices.stm. (See Amex Notice 02-06 dated November 7, 2002 and Amex Notice 03-01 dated January 24, 2003.)

Haircuts and Undue Concentration
Market makers falling into the non-exempt category may take advantage of the favorable treatment provided under paragraph (c)(2)(vi)(N) of the rule for specialists, which treatment provides an exemption from the application of the rule's haircut and undue concentration deductions with respect to specialty and market maker securities⁵.

This exemption from the rule's haircut and undue concentration deductions will not apply to net capital calculations made for purposes of compliance with the notice provisions of paragraph (e) of the net capital rule⁶ and of Securities Exchange Rule 17a-11 ⁷. For example, market makers subject to the net capital rule but that are not required to deduct haircuts from net worth in computing net capital must, before withdrawing any equity capital, take into account all haircuts and undue concentration deductions that would be required but for the exemption required under paragraph (c)(2)(vi)(N). These market makers would be allowed to withdraw equity capital, however, so long as their tentative net capital, i.e., net capital before haircut and undue concentrations deductions, is equal to at least 25% of their total deductions and 120% of their required minimum net capital before haircuts.

All market makers covered by paragraph (c)(2)(vi)(N) must also include a separate calculation of haircuts that would otherwise be required in their monthly net capital computation required by paragraph (a)(11) of Securities Exchange Act Rule 17a-3 or otherwise made on any report required under Securities Exchange Act Rule 17a-5.

Under Section (a)(6) of the Net Capital Rule
Alternatively, market makers that elect to utilize section (a)(6) of the net capital rule may avoid haircuts, even for the limited purposes set forth above.

Section (a)(6) is available to a dealer who does not effect transactions with other than brokers or dealers, who does not carry customer accounts, who does not effect transactions in unlisted options, and whose market maker or specialist transactions are effected through and carried in a market maker or specialist account cleared by another broker or dealer as provided in paragraph (a)(6)(iv) of the net capital rule.

Non-qualifying Subordination Agreements
Market makers that are required to comply with the net capital rule that intend to rely upon existing subordination agreements are cautioned that they need to contact the Exchange at one of the numbers set forth below in order to ensure that such agreement meets the requirements of the net capital rule or to arrange for the approval thereof as appropriate ⁸.

¹ In general, the net capital rule requires all broker-dealers subject to the rule to maintain certain specified minimum levels of net capital. "Net capital," as that term is defined in subparagraph (c)(2) of the rule, is computed by adding to a broker-dealer's net worth, determined in accordance with generally accepted accounting principles, certain liabilities subordinated to the claims of creditors including customers and by deducting from net worth assets not readily convertible into cash and certain percentages (called "haircuts") of the market value of all proprietary positions held by the broker-dealer. The exemption for option market makers is set forth at 15c3-1(b) of the rule.

² Of course, member organizations or sole members that engage in hedging transactions in equities, ETFs, or other securities solely in connection with their option market making activities would continue to qualify for the option market maker exemption from the net capital rule.

³ In this regard it is highly recommended that the accountant be Series 27 licensed.

⁴ See 15c3-1(a)(2)(ii).

⁵ The haircut deductions found at subparagraph (c)(2)(vi) take into account market and credit risk. The undue concentration deduction found at subparagraph (c)(2)(vi)(M) of the net capital rule applies to all long or short proprietary securities positions of a single class or series of an issuer, the market value of which exceeds 10% of the broker-dealer's net capital before haircuts.

⁶ Paragraph (e) of the net capital rule requires a broker-dealer to notify the Commission of, and authorizes the Commission to restrict, for a period of up to 20 business days, any withdrawal by a broker-dealer of equity capital where such withdrawal, together with all other such withdrawals during the preceding 30 calendar day period, exceeds 30% of the broker-dealer's excess net capital. Paragraph (e) also prohibits a stockholder or partner from withdrawing equity capital of the broker-dealer if, among other reasons, the withdrawal would cause its net capital to be less than 120% of the minimum dollar amount required, or less than 25% of its total haircut and undue concentration deductions from net worth in computing net capital. In the case of a market maker subject to the net capital rule, the notice provisions of paragraph (e)(1) and the temporary restrictions on withdrawal of net capital of paragraph (e)(3) would be based upon tentative net capital rather than net capital.

⁷ Rule 17a-11 (17 CFR 240.17a-11) under the Exchange Act requires, among other matters, all broker-dealers subject to the net capital rule to notify the Commission in the event:

1. their net capital is less than the minimum required by the rule; or
2. their net capital falls below specified levels (commonly referred to as "early warning levels") set above the minimum requirements of the net capital rule.