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FinOps FAQ: Introducing Broker/Carrying Broker Arrangements



One of the main roles of IIROC’s Financial and Operations Compliance department (FinOps) is to assess whether firms have enough capital for the type and scope of their business activities. FinOps monitors firms for compliance with IIROC financial rules to reduce the possibility of financial failure due to excessive leverage or risky business practices.


Frequently asked questions

 


  1. What is an Introducing Broker/Carrying Broker Arrangement?

  2. What trading related functions in combination are considered to be an Introducing Broker/Carrying Broker Arrangement?

  3. Is a Dealer Member allowed to be a full service broker for one segment of their business while introducing another segment of their business to a carrying broker?

  4. Can an introducing broker execute principal trades either through a different carrying broker or a jitney broker?

  5. Can security-lending/financing activities be carried out by the introducing broker under any of the four types of arrangements?

  6. Is a Type 4 introducing broker required to carry out its own security-lending/financing activities?

  7. Whose name (the introducing broker, the carrying broker or both) should be on contracts, statements and correspondence that relate to introduced customer accounts?

  8. Is there a standard disclosure statement that should be used?

  9. Is the introducing broker or the carrying broker responsible for customer free credit segregation?

  10. Does the carrying broker have to segregate any comfort deposit it has received from the introducing broker?

  11. What is the margin requirement to be provided by the Type 1 and 2 introducing broker in the event the carrying broker liens on the comfort deposit?

  12. Is the introducing broker or the carrying broker responsible for ensuring that customer securities are properly segregated?

  13. What responsibilities do the auditors of introducing brokers have with respect to the segregation of customer securities?

  14. Can the contracting parties modify a standard introducing agreement?

  15. Do carrying brokers have to provide introducing brokers with a security record and position listing securities held for their customers?

  16. Do auditors of Type 3 and 4 introducing brokers have to confirm their year-end security positions with their carrying broker?

  17. Do introducing brokers have to enter into a separate RRSP trust agreement with a trustee in order to provide RRSP accounts to their customers?

  18. Can an introducing broker/carrying broker arrangement be entered into with a foreign affiliate?

  19. What kind of Canadian Investor Protection Fund (“CIPF”) coverage would customers of a foreign affiliate have?

  20. What credit policies should an Introducing Broker have in place?

  21. What other reference sources are there on the IIROC web-site relating to Introducing Broker/Carrying Broker Arrangements?

 

1. What is an Introducing Broker/Carrying Broker Arrangement?

An Introducing Broker/Carrying Broker Arrangement is an agreement entered into between two Self Regulatory Organization (“SRO”) members that allow one firm (the “Introducing Broker”) to use the back office of another firm (the “Carrying Broker”) to perform certain trading related functions on its behalf.

Now that the MFDA has been recognized as a SRO, does this mean that MFDA Member firms can now enter into introducing broker/carrying broker arrangements with IIROC Dealer Members?

In addition to requiring that both the introducing broker and the carrying broker be members of a SRO, IIROC Rules 35.1(b) and 35.1(c) require both firms be members of a SRO that is a participating institution in the Canadian Investor Protection Fund. Currently, the only SRO that is a participating institution in the Canadian Investor Protection Fund is the Investment Industry Regulatory Organization of Canada. As a result, MFDA Member firms are not permitted at this time to enter into introducing broker/carrying broker arrangements with IIROC dealer members.

 

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2. What trading related functions in combination are considered to be an Introducing Broker/Carrying Broker Arrangement?

Certain combinations of functions provided by one Dealer Member to another constitute an Introducing Broker/Carrying Broker Arrangement, whereas other combinations of functions do not. The following are six main trading related functions that are performed:

Function #1 Function #2 Function #3 Function #4 Function #5 Function #6
Trade execution Trade settlement Custody of cash Custody of securities Bookkeeping Financing of customer positions


Functions or combinations of functions that do not constitute an Introducing Broker/Carrying Broker Arrangement include: 
 

Functions #1 and #2 This combination of functions is a “jitney” or “omnibus” arrangement and is not subject to the requirements of the Introducing Broker/Carrying Broker Arrangement rules, as set out in IIROC Rule 35.
Functions #2, #3 and #4 This combination of functions is a custodial arrangement and is not subject to the requirements of the Introducing Broker/Carrying Broker Arrangement rules, as set out in IIROC Rule 35. Of course this arrangement is subject to other requirements set out in the IIROC Rule Book relating to custody of customer cash and securities.
Functions #1, #2, and #5 This combination of functions is not subject to the requirements of IIROC Rule 35. The introducing broker/carrying broker requirements do not apply where cash and security custody is kept separate and assets are not commingled in any way with the service provider’s assets. This requires distinct segregation of securities by means of individual account FINS #s at the Canadian Depository for Securities Ltd. or other depository for securities of the servicee.
Functions #5 The preparation of books and records is not subject to the requirements of IIROC Rule 35. This function is typically performed by a service bureau with the Dealer Member retaining the responsibility to comply with the IIROC Rule Book requirements for bookkeeping.


Combinations of functions that do constitute an Introducing Broker/Carrying Broker Arrangement include:

 

Functions #1 through #6 This combination of functions is subject to the introducing and carrying broker rules and is classified as either a Type 1, 2 or 3 Arrangement pursuant to IIROC Rule 35.
Functions #1 through #5 This combination of functions is subject to the introducing and carrying broker rules where financing of customer positions is performed by the introducer and is classified as a Type 4 Arrangement pursuant to IIROC Rule 35.
Functions #2 through #6 This combination of functions is subject to the introducing and carrying broker rules where trade execution is performed by the introducer and is classified as either a Type 2 or 3 Arrangement pursuant to IIROC Rule 35.
Functions #2 through #5 This combination of functions is subject to the introducing and carrying broker rules where trade execution and financing of customer positions is performed by the introducer and is classified as a Type 4 Arrangement pursuant to IIROC Rule 35.

 

IIROC Rule 35 details four types of permissable Introducing Broker/Carrying Broker Arrangements. Why were four types of arrangements developed and what are the unique characteristics of each type?

When IIROC Rule 35 (formerly IDA By-law No. 35) went through its last major revision in 1997, four types of Introducing Broker/Carrying Broker Arrangements were introduced. The four types of arrangements were developed to give firms increased flexibility to use the excess back office capacity of other firms. The carrying broker is relied on most heavily to perform trading related functions on behalf of the introducing broker under an Introducing Type 1 Arrangement and least heavily under an Introducing Type 4 Arrangement. For details of the unique characteristics of each arrangement please refer to Member Regulation Notice MR096.

 

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3. Is a Dealer Member allowed to be a full service broker for one segment of their business while introducing another segment of their business to a carrying broker?

Yes, in the case of Dealer Members using either a Type 3 or 4 arrangement, a Dealer Member may introduce a segment of their business to a carrying broker as well as fully service another segment of their business. This ability is limited to Dealer Members using either a Type 3 or 4 arrangement as, under such arrangements, the introducing broker is responsible for reporting customer balances and security positions on its own books. Therefore, the combination of the Dealer Member fully servicing one segment of their business and using a Type 3 or 4 arrangement for another segment will result in all balances and security positions of the customer being reported on the books of the introducing broker.

Requiring all customer balances and security positions to be reported on the books of one Dealer Member is an important regulatory issue. If this was not a requirement, a situation could arise where customer assets might form part of a comfort deposit lodged with a carrying broker. As a result, brokers who enter into Type 1 or Type 2 arrangements for certain business segments are explicitly prohibited from acting as a full service broker for another business segment since under that situation customer balances and security positions would be reported on the books of the introducing broker and the carrying broker.

 

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4. Can a Dealer Member introduce customers to more than one carrying broker?

A broker can introduce customers to more than one carrying broker where:

  • The additional introducing broker/carrying broker arrangement relates to the trading of futures contracts and options [IIROC Rule 35.1(e)(ii)]; or
  • The Dealer Member is a Type 3 or 4 introducing broker and the Dealer Member has established a business case for entering into an additional Type 3 or 4 arrangement [IIROC Rule 35.1(e)(v)].

 

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5. Can an introducing broker execute a customer trade either through a different carrying broker or a jitney broker?

As stated in FAQ #5 above, there are two situations under which a Dealer Member may enter into more than one introducing broker/carrying broker arrangement. In the case of the first situation, the unique clearing and settlement issues relating to the trading of futures contracts and options necessitate allowing the introducing broker to enter into an additional introducing broker/carrying broker arrangement for this business segment. In the case of the second situation, a business case must be made before a Type 3 or 4 introducing broker would be permitted to deal with more than one carrying broker. As part of any business case developed it is envisaged that additional introduction agreements would only be entered into for unique business segments. As a result, the scenario above where an introducing broker would be permitted to execute a trade through a different carrying broker would not be permitted.

Use of a jitney broker by a Type 1 or 2 introducing broker to execute a customer trade would be prohibited as this would result in the Dealer Member providing “full service” to the customer, which is prohibited under IIROC Rule 35.1(e)(iii). A Type 3 or 4 introducing broker would be permitted to use a jitney broker to execute a trade provided that the introducing broker/carrying broker arrangement entered into with the carrying broker allows for this practice.

 

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6. Can an introducing broker execute principal trades either through a different carrying broker or a jitney broker?

Type 2, 3 or 4 introducing brokers may execute principal trades through an IIROC Dealer Member other than the carrying broker. Pursuant to IIROC Rule 35.1(e)(iv), Type 1 introducing brokers must introduce all principal trades to their carrying broker due to the lower required minimum capital and insurance coverage applicable to a Type 1 introducing broker.

 

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7. Can security-lending/financing activities be carried out by the introducing broker under any of the four types of arrangements?

Only under a Type 4 arrangement is the introducing broker permitted to undertake security-lending/financing activities. Under Type 1, 2 and 3 arrangements, lending and borrowing of securities is the responsibility of the carrying broker.

 

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8. Is a Type 4 introducing broker required to carry out its own security-lending/financing activities?

No. While IIROC Rule 35.5(e) stipulates that the introducing broker is required to carry out its own security lending/financing activities under a Type 4 arrangement, the introducing broker is not prohibited from having the carrying broker perform these activities on its behalf. This would be achieved through the execution of a master security lending agreement with the carrying broker. As the execution of this agreement would modify the nature of the introducing broker/carrying broker arrangement entered into, prior regulatory approval would be required.

 

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9. Whose name (the introducing broker, the carrying broker or both) should be on contracts, statements and correspondence that relate to introduced customer accounts?

Under a Type 1 or 2 arrangement, the name of both the introducing broker and the carrying broker must appear on all contracts, statements and correspondence relating to any introduced customer accounts. This is because under these arrangements both the introducing broker and the carrying broker have significant performance obligations to the introduced customers. Further, in order to ensure that the customer is aware of the individual roles and obligations of the introducing broker and the carrying broker, a disclosure statement detailing the roles and obligations of both brokers must be provided to the customer at the time they open an account as well as on an annual or ongoing basis thereafter.

Under a Type 3 and 4 arrangement, only the introducing broker's name must appear on all contracts, statements and correspondence relating to any introduced customer accounts. This is because under these arrangements the introducing broker retains the bulk of the performance obligations to the introduced customers. For the most part the carrying broker under these arrangements acts as a securities clearing, settlement and record keeping service bureau. However, as with the Type 1 and 2 arrangements, a disclosure statement detailing the roles and obligations of both Dealer Members must be provided to the customer at the time they open an account as well as on an annual or ongoing basis thereafter.

 

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10. IIs there a standard disclosure statement that should be used?

IIROC Rule 35 specifies the nature of information that must be disclosed to customers of the introducing broker. While there is no standard disclosure text that is required, IIROC has prepared suggested sample disclosure paragraphs which may be used. These sample disclosure paragraphs are available upon request from IIROC.

 

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11. Is the introducing broker or the carrying broker responsible for customer free credit segregation?

Since it is responsible for the security-lending/financing activities relating to the introduced customer account, the carrying broker is responsible for free credit segregation under Type 1, 2 and 3 arrangements. The introducing broker is responsible for free credit segregation under a Type 4 arrangement as it retains the responsibility for all security-lending/financing activities under this arrangement. If, as described in FAQ #9, the introducing broker chooses to have the carrying broker perform these activities on its behalf, the introducing broker as well as the carrying broker will be responsible for customer free credit segregation. 

Since it is responsible for the security-lending/financing activities relating to the introduced customer account, the carrying broker is responsible for free credit segregation under Type 1, 2 and 3 arrangements. The introducing broker is responsible for free credit segregation under a Type 4 arrangement as it retains the responsibility for all security-lending/financing activities under this arrangement. If, as described in FAQ #9, the introducing broker chooses to have the carrying broker perform these activities on its behalf, the introducing broker as well as the carrying broker will be responsible for customer free credit segregation. 

Since both the introducing broker and the carrying broker must be SRO members, they are both considered regulated entities for account margin purposes. Does this mean that account balances resulting from introduced transactions that arise on the books of the introducing broker or the carrying broker must be margined on a “value for value” basis?No, account balances resulting from introduced transactions are exempt from being margined on a “value for value” basis. This is because the introducing broker/carrying broker arrangement is a standard industry three party agreement, with the audit jurisdiction SRO being the third party to the agreement. However, where:

  • a comfort deposit is lodged with the carrying broker by the introducing broker; and
  • the carrying broker uses a portion of the deposit to cover any margin required on the introduced client accounts;
that portion would need to be reclassified by the introducing broker as a non-allowable asset.

 

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12. Does the carrying broker have to segregate any comfort deposit it has received from the introducing broker?

Yes, to extent the comfort deposit is not being used by the carrying broker to cover any margin required on the introduced client accounts (as discussed in FAQ #13 above), the comfort deposit must be segregated. If the comfort deposit is in the form of cash, the cash must be kept by the carrying broker in a separate bank account in trust for the introducing broker.

 

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13. What is the margin requirement to be provided by the Type 1 and 2 introducing broker in the event the carrying broker liens on the comfort deposit?

a) Client margin deficiency – The carrying broker is permitted to offset any margin required to be maintained against the loan value of any deposit made by the introducing broker to the extent of the risk adjusted capital of the introducing broker. The carrying broker must advise the introducing broker if any margin lien is placed on the comfort deposit. See IIROC Rules 35.2(c) and 35.3(c).
b) Unsecured accounts – The introducing broker is required to reclassify its comfort deposit as a non-allowable asset for those client accounts that are unsecured. See IIROC Rule 35.2(f) and 35.3(f).

 

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14. IIs the introducing broker or the carrying broker responsible for ensuring that customer securities are properly segregated?

Under IIROC Rule 35, since under all four types of arrangements the carrying broker is responsible for the clearing and settlement of security transactions, the carrying broker is also responsible for the segregation of customer securities. However, should the introducing broker become aware of problems with the segregation of its customers' securities, it has a fiduciary responsibility to ensure that these problems are corrected. Further, it is prudent, particularly for Type 3 and 4 introducing brokers, for the introducing broker to monitor the segregation process to ensure that their customers' securities are properly segregated. This can be accomplished by reviewing a sample of customer monthly statements.

 

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15. What responsibilities do the auditors of introducing brokers have with respect to the segregation of customer securities?

Since under all four types of arrangements the carrying broker has the responsibility to ensure proper segregation of customer securities, the introducing broker's auditor need not file a security segregation report as part of the annual filing of the Form 1. It is also not necessary for the auditor to obtain a comfort letter relating to segregation from the carrying broker's auditor. The testing of security segregation is to be performed by the carrying broker's auditor for all accounts of, including those accounts introduced to, the carrying broker.

 

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16. Can the contracting parties modify a standard introducing agreement?

While the clauses of the standard agreements may not be modified, additional provisions may be added to the agreements by way of schedules or appendices (which would also have to be approved by IIROC as part of the agreements), provided that these provisions do not override the standard provisions.  

In the case of a Type 3 arrangement, the introducing broker is responsible for the reporting and margining of customer account balances and the carrying broker is responsible for any necessary segregation of customer free credit balances. How does the carrying broker calculate the free credit segregation requirement when it doesn’t report elsewhere in its regulatory filings the free credit balances of introduced customer accounts?

In order to allow the carrying broker to properly calculate its free credit segregation requirement (including any requirement relating to carried customer accounts), Statement D of the Form 1 has been modified to accommodate Type 3 introducing arrangement free credit balances. No similar modification to Statement D was needed to accommodate free credit balances arising from Type 4 introducing arrangements, as the introducing broker is responsible for free credit segregation.

 

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17. Do carrying brokers have to provide introducing brokers with a security record and position listing securities held for their customers?

Carrying brokers must provide the introducing brokers with a listing of customer securities held and the quantities segregated for Type 3 and 4 introducers. Auditors of Type 3 and 4 introducing brokers must confirm with the carrying broker all securities held.

 

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18. Do auditors of Type 3 and 4 introducing brokers have to confirm their year-end security positions with their carrying broker?

Yes. IIROC has informed the panel auditors that at the year-end audit time and pursuant to IIROC Rule 300 they are required to confirm all securities held by the carrying broker for Type 3 and 4 introducing brokers. In order to facilitate this process, the carrying brokers are obligated to make available to the introducing brokers at least annually a listing similar to a security record and position report detailing all the securities held for the introducing broker on behalf of each customer.

 

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19. Do introducing brokers have to enter into a separate RRSP trust agreement with a trustee in order to provide RRSP accounts to their customers?

No, provided that the carrying broker’s agreement with the trustee allows for the use of an agent (the introducing broker) in addition to the carrying broker. All introducers, regardless of type, can use the trust arrangements of the carrying broker.

 

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20. Can an introducing broker/carrying broker arrangement be entered into with a foreign affiliate?

An arrangement may be entered into between a Dealer Member and a foreign affiliate whereby the Dealer Member carries the account of a foreign affiliate or its customers. To accommodate one of these arrangements one of the standard agreements, may be modified or a separate agreement may be developed to meet both foreign regulatory requirements and the requirements set out in IIROC Rule 35.6.

 

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21. What kind of Canadian Investor Protection Fund (“CIPF”) coverage would customers of a foreign affiliate have?

The CIPF protects customers of CIPF Members firms. Accounts of foreign affiliate customers that are carried by CIPF Members firms, in accordance with the requirements set out in IIROC Rule 35.6, are considered to be customers of CIPF Members firms and are therefore entitled to CIPF coverage.

 

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22. What credit policies should an Introducing Broker have in place?

Credit risk management is important for all Dealer Members, including introducing brokers. While carrying brokers impose their credit risk policies on client accounts introduced to them, introducers may implement even more stringent rules. For further details, see IIROC Notice 09-0171 dated June 11, 2009 (Best Practices for Credit Risk Management).

 

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23. What other reference sources are there on the IIROC web-site relating to Introducing Broker/Carrying Broker Arrangements?

 

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