With the announcement that Altruist will acquire Shareholder Services Group (“SSG”) and move client accounts to their platform, we’ve received lots of questions from clients. (Sensible Financial has advisory relationships with Fidelity, Schwab and SSG). Some of those questions include:

• Will my investments at Altruist be safe?

• What are the risks of having my assets there versus a more well-known company such as Fidelity or Schwab?

• What protections are there to minimize the risk of fraud or to protect us if one of our financial institutions fails?

We tend not to think about this kind of risk until some triggering event. Prior to the high-profile failures of banks in 2023, including Silicon Valley Bank and First Republic, people generally believed their money was ‘safe’ in a bank. Isn’t that why we store our money there? But we learned that banks are riskier than you think.

Similarly, not many people think about the safety of their assets at institutions like Fidelity or E-trade until something happens unexpectedly. When I started writing this article, I began with the risks involved in holding securities at a custodian. I then realized many people probably don’t know what a custodian is. For that matter, most people probably do not know the difference between a broker-dealer or a clearing firm. How strange, I thought, that millions of Americans trust their life savings to these institutions, but probably have no idea who they are working with and what those companies do. How can we talk about risk if we do not even know the parties involved?

In this article I will identify the most important financial intermediaries that you may work with, describe what these firms do and in a follow-up article identify the potential risks involved.

Understanding financial intermediaries

From the average investor’s perspective, the buying and selling of securities (stocks and bonds) appears straightforward. Say for example you want to buy 100 shares of Apple. You log in to a website (or instruct your advisor) to place a trade. Shortly thereafter you are the proud owner of 0.0000006% of the largest company in the world. But this seemingly simple transaction takes no fewer than three parties, or financial intermediaries, to accomplish. I will use the hypothetical example of Bill to illustrate the roles these intermediaries play in buying and taking ownership of a stock from start to finish.

Bill has read interesting articles about GameGo and decides to purchase 10,000 shares. He calls up his broker, Dependability, to place a trade. Dependability finds a seller, Jane, who offers to sell her GameGo shares to Bill.

The first financial intermediary we encounter is Dependability, our fictional broker. If you have ever purchased or sold a security, then you have worked with a broker. Charles Schwab, Fidelity, Vanguard and E-trade are all examples of brokers (actually broker-dealers but more on that below).

What does a broker do? A broker is an agent that helps clients fulfill their orders. They act as middlemen, finding buyers for clients looking to sell and sellers for clients looking to buy. Another type of middleman is a dealer. A dealer differs from a broker in that it can buy and sell securities from its own account. Many large financial institutions can act in either capacity. These companies are broker-dealers.

Once Bill and Jane agree on a price, they need to complete the transaction. Bill wants to give Jane money in exchange for her shares. Jane wants to receive money in exchange for her shares. How can they safely perform this exchange?

While you’ve probably never heard of them, clearing firms perform an essential function in financial markets. These firms stand in between the buyer and the seller, ensuring that trades “settle”. Settlement refers to the transfer of securities and funds between the buyer and the seller. Broker-dealers exist to solve the problem, ‘Who can I sell my shares to/buy shares from?’ Clearing firms solve the problem, ‘How can I be sure I get paid for my shares/receive shares for my payment?’

Bill and Jane are strangers. Neither fully trusts the other to deliver what they said they would. Each needs assurance that the other can and will fulfill their promise. Clearing firms provide this assurance. They take on counterparty risk, i.e. the risk that a party to a financial transaction will break their promise, in exchange for a small fee usually paid by the broker-dealer.

Clearing firms come in two flavors: independent clearing firms and self-clearing brokers. The former are independent firms that charge fees to broker-dealer clients for their services. The latter are subsidiaries that large broker-dealers establish to handle clearing. The largest broker-dealers are all self-clearing, including Fidelity, Schwab and Vanguard. Altruist formerly used Apex Clearing (one of the largest clearing firms) until last year, when it also began self-clearing.

The clearing firm confirms the details of the trade, creates a record of the transaction for regulatory compliance reasons and sends Bill his 10,000 GameGo shares and Jane her cash. Now that Bill is the proud fractional owner of GameGo, he needs somewhere to safely keep his shares.

At one time, stock ownership was recorded in physical form as stock certificates. Similarly, bearer bonds were paper bonds with detachable coupons which could be redeemed to collect interest payments. Digitization has changed all that. Most stock and bond ownership is recorded electronically, not only streamlining the process of buying, selling and transferring shares but also significantly increasing safety. In the not-too-distant past, owners of stock assumed the risk that they might lose or misplace their certificates. To guard against this risk, people stored certificates in safes and safety deposit boxes along with other valuables.

Today the role of safeguarding digital shares is handled by a custodian. Think of a custodian as a very large safe in which clients store their electronic certificates. In addition to safekeeping assets, custodians produce tax documents, collect and distribute dividends and interest, and provide recordkeeping and reporting services.  The largest financial custodians in the US as of this writing are Bank of New York Mellon (over $46T), State Street Corporation (~$42T), J.P. Morgan (~$34T), Citibank (~$27T).

When a custodian also functions as a clearing firm, it’s known as a self-clearing custodian. All the broker-dealers Sensible Financial works with have their own self-clearing custodian subsidiary.  Fidelity custodies through their clearing firm National Financial Services, Schwab through Schwab Advisor Services and Altruist through Altruist Clearing.

So, if you work with Sensible Financial, it’s likely that your primary financial institution is your broker-dealer, clearing firm and custodian all in one. This firm performs many important functions including connecting buyers with sellers, ensuring the proper exchange of securities for cash and vice versa, and safeguarding your electronic ownership records.

With a better understanding of all the roles that these financial intermediaries play, I will next turn to the risks involved with working with these firms, the steps you can take to reduce these risks and the protection (insurance) that exists to reduce the risk of loss when firms fail, or frauds occur. Stay tuned for my next article.

Photo by Maria Teneva on Unsplash