Regulatory framework for introducing broker / carrying broker arrangements

Background

• The current arrangement types had their origins in 1995 when the TSE adopted amendments to its existing introducing broker / carrying broker rules

• Prior to the introduction of these amendments there was only one permitted IBCB arrangement – the current Type 1 arrangement

• Each arrangement developed in 1995 included combinations of some or all of the following activities:- Trade execution - Trade settlement *- Custody of cash * - Custody of securities *- Bookkeeping * - Financing of customer positions

Existing Arrangements

• Type 1 Arrangement– Assumes there is no need for the introducing broker

to handle client cash and securities– Carrying broker (CB):

• Executes, clears and settles all firm securities and financing trades and all client securities trades

• Provides day to day financing of margin lending to clients

• Monitors compliance with the client free credit balance segregation requirements

• Monitors client account credit and concentration risks

Existing Arrangements

• Type 1 Arrangement (con’t)– Carrying broker (con’t):

• Holds client positions in segregation and safekeeping, in accordance with SRO requirements and client instructions

• Prepares trading and client account related books and records

• Reports client account balances on Form 1• Assumes responsibility (not sole responsibility)

for complying with all regulatory requirements that apply to the functions they are performing for the introducing broker

Existing Arrangements

• Type 1 Arrangement (con’t)– Introducing broker (IB):

• Has lower minimum capital and insurance requirements because it is not handling client cash and securities

• Posts a comfort deposit with the carrying broker to cover client account losses for which it is ultimately responsible

• May only enter into one IBCB arrangement1 and may not fully service any portion of its business

1 An exception of made for arrangements involving futures contracts and futures contract options

Existing Arrangements

• Type 1 Arrangement (con’t)– Introducing broker (IB) (con’t):

• Retains responsibility for complying with all regulatory requirements that are otherwise the exclusive responsibility of a full service dealer as follows:

– Where performance of the function is not delegated to the CB, IB retains exclusive responsibility

– Where performance of the function is delegated to the CB, IB has responsibility to monitor to ensure delegated function is being properly informed and must act to correct if it becomes aware that the delegated function is not being properly performed

Existing Arrangements

• Type 2 Arrangement– Same features as the Type 1 Arrangement except:

• IB can handle client cash and securities on a limited basis - as a result, the IB minimum capital and insurance requirements are the same or similar to that for a full service dealer

• IB has the option of executing its own trades for those markets for which it is a participating organization

Existing Arrangements

• Type 3 and 4 Arrangements– Codification of arrangements that were referred to

as service arrangements prior to 1995– Same features as the Type 2 Arrangement except:

• IB provides day to day financing of margin lending to clients

• IB monitors client account credit and concentration risks

• IB reports client account balances on Form 1• IB can enter into multiple IBCB arrangements

and may fully service any portion of its business

Existing Arrangements

• Type 3 and 4 Arrangements (con’t)– Same features except (con’t):

• In the case of Type 4, IB executes all of its financing trades

Plain Language Rewrite

• As part of IIROC’s plain language rewrite project the introducing broker / carrying broker arrangement rules have been rewritten and recently published for public comment (Rules Notice 11-0061, February 11, 2011)

• Proposed new plain language Rule 2450, Acceptable Back Office Arrangements, includes the following proposed substantive revisions:– Specific definitions for the terms “clearing

arrangement” and “introducing broker / carrying broker arrangement”

– Specific restrictions on the multiple arrangements that a Type 3 or 4 IB may enter into

Plain Language Rewrite

• Proposed substantive revisions (con’t):– Clarification of the margin requirements to

provided by the carrying broker; this existing rule requires margin to be provided but is silent on how it is to be calculated

– Clarification of wording regarding carrying broker requirement to report any comfort deposits received as a liability

– Clarification of wording regarding introducing broker insurance requirements to make consistent with the current requirements set out in Rule 400

Plain Language Rewrite

• Proposed substantive revisions (con’t):– Clarification of the obligations of the IB and CB to

comply with IIROC rules an to ensure that clients are properly served

– Revision of cash handling requirements to prohibit the handling client cash in the form of money

– Make consistent the notification requirements when a CB wishes to use a portion of the IB comfort deposit

Plain Language Rewrite

• Proposed substantive revisions (con’t):– Executing foreign affiliate arrangements no longer

involves seeking an exemption– Specifically stating that clearing arrangements are

not introducing broker / carrying broker arrangement

– Streamlining of the IIROC approval process for introducing broker / carrying broker arrangements

– Specific exclusion of clearing arrangements, as defined, from requiring IIROC approval

Summary

Type 2 [Introduction Arrangement]CB:•Executes*, clears and settles all trades•Maintains custody of all client cash and securities•Prepares trading and client account related books and records•Provides day to day financing of margin lending to clients•Reports client account and other related balances on Form 1•Assumes responsibility for complying with applicable regulatory requirementsIB:•May not enter into multiple arrangements or fully service portions of its business•Retains non-financial client service and regulatory obligations to client•Retains responsibility for complying with all regulatory requirements

Type 3 [Service Arrangement]CB:•Executes*, clears and settles all trades•Maintains custody of all client cash and securities•Prepares trading and client account related books and records•Assumes responsibility for complying with applicable regulatory requirementsIB:•May enter into multiple arrangements or fully service portions of its business•Provides day to day financing of margin lending to clients•Reports client account and other related balances on Form 1•Retains non-financial client service and regulatory obligations to client•Retains responsibility for complying with all regulatory requirements