Recap: The Capital-Intensity Problem
In our previous post, we identified the critical challenge threatening the viability of Fully Paid Lending (FPL) programs: capital cost. While compliant with FINRA and SEC rules, a program collateralized with cash creates a massive balance sheet “gross-up.” For broker-dealers subject to bank capital rules, this balance sheet inflation is penalized by the Supplemental Leverage Ratio (SLR), creating a capital charge so large it can render the entire program unprofitable.
This dilemma has forced firms to find a new model: one that remains compliant with securities rules while being efficient under banking rules. The goal is to move the FPL transaction “off-balance-sheet” to solve the SLR problem. Fortunately, the solution is written directly into the regulation that created the problem.
The Solution: The “Other” Collateral Option in SEC Rule 15c3-3
The “Customer Protection Rule,” SEC Rule 15c3-3(b)(3) under the Securities Exchange Act, permits a broker to borrow fully-paid securities by posting collateral consisting of “cash or United States Treasury bills and Treasury notes.” This “or” is the key to the entire capital-light structure. By using U.S. Treasuries (non-cash collateral) instead of cash, the broker fundamentally changes the accounting and capital treatment of the transaction.
Under U.S. GAAP, a cash-collateralized loan is a secured borrowing that must be recorded on the balance sheet. In contrast, a loan of one security (the customer’s stock) in exchange for another security (the broker’s Treasury) is a security-for-security (S4S) transaction. S4S transactions are treated as off-balance-sheet activities, recorded merely as memo items.
Because the transaction no longer inflates the broker’s assets, it is no longer “seen” by the Supplemental Leverage Ratio calculation. This single change eliminates the primary capital charge, transforming the FPL program from a capital-intensive burden into a capital-light, scalable business.
The Trade-Off: Pricing the New “Capital-Light” Program
This solution, while elegant, comes with a significant economic trade-off. By removing cash from the transaction, the broker also removes the cash reinvestment spread. In the cash-collateral model, a broker’s primary profit source on “easy-to-borrow” securities was earning a market interest rate (e.g., OBFR) on the cash collateral that was higher than the rebate rate paid to the borrower.
In the new non-cash model, there is no cash to reinvest. The broker’s profit is now limited only to the intrinsic fee earned for lending the security itself. This means the program may no longer be profitable for “general collateral” (GC) securities, which have little or no intrinsic fee. The program must now be laser-focused on lending “hard-to-borrow” (HTB) securities, where the demand from short-sellers creates a high intrinsic fee.
This trade-off is ultimately positive. It simplifies the business model, reduces exposure to short-term interest rate risk, and focuses the program on its core purpose: sourcing in-demand securities for the market.
Deriving the Retail Payout from the Wholesale Rate
This new capital-light structure also clarifies and simplifies the pricing model for the retail customer. The pricing is no longer a complex blend of fees and opaque interest-on-cash spreads. It becomes a simple, transparent revenue-share derived from a single benchmark.
The process begins with the “wholesale rate.” This is the market-clearing fee (spread) that institutional counterparties (the “street”) are willing to pay to borrow a specific HTB security on a security-for-security basis. This rate (e.g., 3.00% per year for an in-demand stock) represents the total gross revenue pool for the transaction. The non-cash premium is computed as an adjustment to the cash collateralized spread. Collateral optimization services include adjusting these factors within their transfer pricing algorithms to correct inefficiencies in their collateral management programs.
The broker then offers the retail customer a percentage share of that transparent wholesale rate. For example, a 50/50 split means the customer receives a 1.50% payout (50% of the 3.00% gross fee). This “revenue-share” model is the ideal solution: it is easy to disclose, directly aligns the interests of the broker and the customer, and is built upon a capital-efficient foundation that ensures the FPL program can remain a viable and profitable product for years to come.