We all hold assets (stocks, ETF, cash, ...) with our brokers and custodians. Given those institutions are the recipients of our savings a natural question to ask is: How safely are those assets stored? This question is even more important for savvy businesses and corporations CFOs who use cash management products to optimize the yield on their organization idle cash.
Multiple lines of defense
As with any type of protection, more layers are better than a single one. As mentioned on the FINRA (Financial Industry Regulatory Authority) website* : “In virtually all cases, when a brokerage firm ceases to operate, customer assets are safe and typically are transferred in an orderly fashion to another registered brokerage firm. Multiple layers of protection safeguard investor assets.”
Here are the several layers of protection which are in place to safeguard assets:
1) Regulation: First of all, it is important to note that broker dealers and custodians are heavily regulated by a government body such as the SEC as well as by FINRA. This means broker dealers and custodians are subject to regular inspections and audits as well as strict rules and regulation.
2) Rules: Secondly some rules have been put in place to further protect customers:
a. Asset segregation: With the “Net Capital Rule” Brokers and custodians are required by law to keep their customers' securities and cash segregated from their own. In this case, even if a firm fails, its customers' assets will remain safe.
b. Capital buffer: The “Customer Protection Rule" requires brokerage firms to maintain certain levels of their own liquid assets and the minimum net capital a firm must keep at all times depends on its size and business. This provides a cushion in an adverse scenario.
3) Insurance: Finally all broker dealers and custodians are members of the Securities Investor Protection Corp (SIPC), which protects customer securities accounts up to $500,000. The SIPC protection comes into play in the unlikely event of a firm failure where customer assets are missing because of theft or fraud.
SIPC vs. FDIC
As the FDIC provides protection in case of a bank failure the SIPC protects customer assets in brokerage accounts in the event of theft or fraud. The table below (provided by FINRA) shows the major differences between FDIC and SIPC:
The proof is in the pudding
We can look at prior instances of broker dealer failure to get a better understanding about the outcome during the unlikely adverse cases. A prominent example is MF Global, one of the largest bankruptcies in US history, which committed fraud by taking segregated client assets and using them to fund their own losses. Nonetheless and despite the fraud, none of MF Global’s clients lost any capital and that was even without having to use the SIPC insurance (thanks to capital requirement protection).
Taking a step back, the SIPC insurance has actually been very seldomly used over the 50yrs it has been put in place. And even in those instances when it had to be deployed there are very few cases where customers have lost money due to their brokerage firm going out of business.
When we look at the data the SIPC reports that 99% of eligible investors retrieved their asset in full in the 327 cases of liquidation that it has handled since inception**. Of the more than 770,400 individual entity claims completed or substantially completed as of December 31, 2020, 355 remained unsatisfied for claims of cash and securities whose value was greater than the limits of protection afforded by SIPC. These claims total $49.7 million and represent less than 0.06% of all claims made.
As described in this piece historical data clearly shows that not only failure of a broker dealer and custodian are extremely rare events but also that in those unlikely cases nearly all (99%) customers recovered all their assets and, for those who didn’t, the loss was very small (0.06% of all claims made).
Nothing is certain in life (beside death and taxes). However hard data and the multiple layers of regulation highlight the fact that your assets held at your broker and custodian are very safe.
(*) The Financial Industry Regulatory Authority (FINRA) is a private American corporation that acts as a self-regulatory organization which regulates member brokerage firms and exchange markets, If a Brokerage Firm Closes Its Doors
(**) SIPC, 2020 Annual Report
Ben Verschuere (Chief Investment Officer)
Treasure Investment Management, LLC
Disclaimer: The views and opinions in this piece are just the author's own, offered to the public at large and not to any one particular investor.