In my previous article, I described the most important financial intermediaries you may engage with if you own securities (stocks, bonds, ETFs and mutual funds). The role of safeguarding financial securities is filled by a custodian. Whenever securities trade, we engage the help of brokers or dealers, middlemen who match buyers with sellers in capital markets. Finally, we learned that clearing firms help settle transactions, including confirming trade details and facilitating the exchange of cash for securities. Large firms may perform all these functions, and I will refer to these do-all firms as “brokerage firms”.
In this article, I will address the question: Are my securities safe at my brokerage firm? You may already know about FDIC insurance, which protects cash up to certain limits, against bank failures. Silicon Valley Bank and First Republic are recent examples. But in my experience, few people know the risks involved in holding financial securities at a custodian or the protections in place to mitigate these risks.
Here are the biggest risks, along with examples from recent history and explanations of what protections exist for investors.
Risk 1: Brokerage firm mismanagement
Brokerage firms can and do fail. When this happens, the Securities Investor Protection Corporation (“SIPC”) steps in.
SIPC is a nonprofit organization the U.S. Congress created in 1970. Its primary functions are twofold. First, when a brokerage firm fails, SIPC arranges the transfer of client accounts to a new firm and either facilitates the sale of the failed firm or manages its liquidation. Let’s call this SIPC’s “liquidation oversight” function. Second, SIPC provides asset protection, up to $500,000 for securities and cash including a $250,000 limit for cash only, “held by a customer at a financially troubled SIPC-member brokerage firm”. I’ll call this the “insurance coverage” function. (Customers with multiple accounts may receive more than $500,000 of protection depending on “separate capacity”, which you can learn more about here). Let’s turn to a real-world example to see how SIPC protections operate.
When the U.S. housing market collapsed in 2008, Lehman Brothers, a large U.S. financial services firm, suffered massive losses due to its large exposure to subprime mortgages. Its collapse is the largest bankruptcy in U.S. history.
SIPC immediately began the liquidation of Lehman Brother’s brokerage business. While the entire process took fourteen years to complete, most brokerage clients had access to their money within a few weeks of liquidation. This amounted to a total of $106 billion among 111,000 customer claims. Impressively, they did all this without the use of either government or SIPC funds(!). How was this possible?
It’s important to understand that brokerage firms are not banks. Unlike banks, where customer deposits are bank assets, SIPC-member brokerage firms are required by the SEC’s Customer Protection Rule to segregate client assets from firm assets. What this means for clients is that in the event of a firm’s failure, client accounts are protected against claims of the firm’s creditors. So the failure of Lehman Brothers’ investment bank did not impact brokerage firm clients’ interests in their cash and securities. This protection is so strong and the liquidation process so efficient that most of Lehman Brothers’ clients had access to their money within a few weeks after the largest bankruptcy in U.S. history.
If SIPC were able to make clients whole without having to use any of its own funds, when does the SIPC insurance coverage function come into play? The answer: When client shares or cash is unaccounted for.
Risk 2: Brokerage firm fraud
The first point to make here is that this type of fraud is rare. The securities industry in the United States is highly regulated, which makes perpetrating a massive fraud difficult. Specifically, the rule to segregate client assets from firm assets is designed to protect client investments from the potential risky bets that banks may make with their own money. But fraud can occur, oftentimes in conjunction with bad investment decisions, and this is where SIPC insurance coverage is important. Let’s look at a real-world example of fraud.
MF Global was a large financial derivatives and commodities broker. The firm failed in 2011 when its positions in sovereign debt declined in value during the European debt crisis. Prior to its failure, MF Global broke the law by using customer funds to try to hide its losses. Before MF Global claimed bankruptcy, approximately $1.6 billion in customer funds went missing.
SIPC initiated proceedings against MF Global and was eventually able to satisfy 100% of client claims. (See the article here for details). The case was complicated, filled with complex financial instruments, international wires, and heated Congressional testimony. And while SIPC was able to restore misappropriated funds to client accounts through the liquidation process, one can imagine that they might have had to use insurance funds to make clients whole. So how does SIPC’s cash and securities insurance work?
SIPC insurance does not protect against the decline in value of client securities. Investors assume the risk that the stocks, bonds or other securities they purchase may fluctuate in price. SIPC protects only the custody function of the broker dealer. If a brokerage firm fails and an investor owned 10,000 shares of Apple stock, SIPC would transfer their 10,000 shares to a new firm. If in the interim the value of Apple declined by 20%, SIPC insurance would not cover that loss. However, if the failed brokerage firm could not account for all of the client’s shares, SIPC would cover that loss, within certain limits.
So how reliable has SIPC protection been in the past? According to SIPC “no fewer than 99 percent of [eligible investors] get their investments back.” Source. That is a very high recovery rate. And what if you were one of the unlucky few investors?
Many custodians also purchase their own excess SIPC protection which covers potential losses in excess of SIPC limits. You can find more information about excess SIPC protection at Sensible Financial’s custodians here: Fidelity, Schwab, Altruist.
In conclusion
There are few guarantees in this world. Risk is a part of life. However, when it comes to the safety of client assets at SIPC-member brokerage firms, the protections are substantial. The Securities Investor Protection Corporation has overseen the liquidation of the largest brokerage firms in U.S. history. While fraud is difficult to perpetrate, SIPC insurance can help make affected clients whole. Since its founding in 1970, SIPC has recovered $143.8 billion for an estimated 773,000 investors. No fewer than 99% of eligible investors lost money. Additional protections, such as firms’ excess SIPC policies, further reduce the likelihood of loss in the event of a brokerage firm collapse.