It discusses the important need for capital adequacy standards for securities firms taking positions as principal, carrying client (customer) accounts, and/or holding client property⁽³⁾. It sets forth a three-part conceptual framework against which capital adequacy standards for these firms can be measured. The framework would consist of the following:

1. A capital adequacy test that reflects liquidity, solvency, and the risks (market settlements, and other) faced by a securities firm;

2. A regulatory structure for the maintenance of a securities firm's books and records; and

3. A framework of regular reporting to, and examination by, a supervisory authority.

While this paper recognises that the segregation of client property is an important aspect of prudential supervision and investor protection, it is not covered herein as it is not strictly within the ambit of capital adequacy standards. Annex A briefly describes the client segregation approaches in some countries. Clients in some national markets are protected in the event of the failure of a particular securities firm through a compensation or insurance scheme. However, the existence of a customer insurance arrangement would still leave market participants concerned about their exposure to their customers or counterparties for uncompleted transactions entered into with a failed securities firm. Without adequate financial responsibility safeguards, compensation arrangements would become extremely costly⁽⁴⁾ To be effective, a compensation or insurance scheme should operate in tandem with strong financial responsibility requirements.

This paper also recognises that there are a wide variety of firms in securities markets worldwide, but in terms of regulation, there are two principal categories:

1. Securities firms, whose predominant activity is acting as agent or principal in securities or derivative products, and

2. Banks, whose securities activities generally are only one part of their total activities and have generally been a minor part of those activities.

This paper primarily focuses on the former, but many of the risks for a bank involved in the securities business would be similar. There are fundamental differences between the regulatory approach of many securities firm regulators and that of bank regulators. The differences are discussed briefly in Annex B.

The equity market crash in October 1987, focused attention on the growing interdependency of the world's securities markets. It highlighted the potential capital exposure of securities firms to developments in those markets and the need for all markets to have an adequate regulatory structure for the prudential supervision of securities firms. This, along with the increasing international competitiveness of the securities industry, has focused attention on different capital approaches in international markets. From the viewpoint of firms operating in those markets,; would be helpful to have requirements which are similar in approach. Accordingly, there is a need for some degree of convergence in the conceptual framework underlying the capital requirements imposed by different countries.

Footnotes:

3. Securities firms engage in a wide variety of other activities such as:(1) managing or participating in underwriting of public offerings of securities; (2)arranging for private placements of securities issues;(3) assisting and participating in mergers and acquisitions of companies;(4) lending and borrowing securities; (5)engaging in repurchase and reverse repurchase transactions; and (6) engaging in foreign currency and interest rate swap transactions. However, in some countries , certain financial activities may not be covered by the securities laws . For example, in one country, the securities laws are not applicable to firms dealing solely in foreign currency or interest rate swaps. Thus, these activities may be carried on in that country in unregulated affiliates of a securities firm. However, if these activities are carried on in the regulated securities firm, the capital adequacy standard of that country would apply. This paper does not deal with capital requirements for firms engaged solely in providing investment advice or managing investments.

4. Clearing house guarantee arrangements would also become extremely expensive in the absence of an adequate financial responsibility framework.