Given the recent reports of bank failures, there is a growing concern among individuals regarding the safety of their investments in the event of a brokerage company collapse.
It’s understandable why this question would arise since both banking and brokerage industries primarily deal with holding people’s money. Hence, it’s certainly reasonable to ask whether their investments are secure.
The first thing to know is that even though banks and brokerage firms seem to be in a similar business, they are regulated very differently.
When it comes to banks, client assets and excess funds show up on the bank’s balance sheet. In contrast, brokerage firms are required by the Securities and Exchange Commission to deposit customer funds into a separate account, which is distinct from the firm’s own money. This separation of client and firm assets means that if a brokerage firm becomes insolvent, client assets typically do not get mixed in with the firm’s assets and exposed to the claims of creditors.
FINRA, which is one of the brokerage regulators, has a piece that says, “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. For example, registered brokerage firms must keep their customers’ securities and cash segregated from their own so that, even if a firm fails, its customers’ assets will be safe.”
An important component of the segregation of client assets is the registration of securities. Most of the common investment types are held in “street name” at the Depository Trust Company (DTC). This is a central clearing house for trades and custody of securities. This is why switching firms is such an easy process. The Depository Trust Company simply changes ownership records through the Automated Customer Account Transfer Service (ACAT) when clients transfer their investments to another firm. As a result, the only change that really occurs when investments registered in street name are transferred from one firm to another is a new logo and color change on the client’s statement.
This ease of transference isn’t just a convenience, it also gives you some protection. According to FINRA, “The street name system is designed to withstand even a brokerage firm meltdown. When a firm faces liquidation, regulators, including the SEC and FINRA, work to ensure that customers’ securities are transferred to another firm. Keeping investments in street names can actually make the process easier because all of the documentation will be in one centralized account.”
In the event of a brokerage firm’s liquidation, the firm immediately comes under the guidance of the Securities Investor Protection Corporation (SIPC), provided that the brokerage firm was a member of SIPC. The SIPC, a non-profit organization established by Congress in 1970, oversees the liquidation of brokerage firms and protects customers from losses resulting from the failure of the brokerage firm.
The first step the SIPC takes during liquidation is to reregister all covered securities to a new brokerage firm. If customer assets are missing, the SIPC provides up to $500,000 of protection on securities, including up to $250,000 in cash. This coverage isn’t just a per person limit, as it depends on what the SIPC calls “separate capacity.” For example, an individual account, joint account, corporate account, trust account, individual retirement account, Roth individual retirement account, executor’s account, and guardian’s account are all separate capacities. If an individual has an IRA and a joint account, their coverage amount is a million dollars since these accounts are held in separate capacity. However, two IRA accounts held by the same client are combined for coverage purposes.
In addition to SIPC membership, most larger firms maintain additional coverage above the SIPC limits. For instance, LPL Financial, a primary custodian, has the normal SIPC coverage and an additional 750 million in aggregate coverage through a private insurer.
It’s important to note that the SIPC only steps in when a firm is liquidating to return securities or the value of those securities up to the limits. The SIPC does not protect against the loss of market value, bad investment advice, investment scams, or complaints about a brokerage firm’s actions. Therefore, it’s crucial to ensure that the firm your financial advisor uses doesn’t custody their investments (like Madoff), and the firm is a member of the SIPC.
So if you were getting uneasy about all this upheaval and turmoil, I hope this makes you feel a little better.