During times of financial stress, it is important to examine the risks associated with past recessions, including the possibility of brokerage firms filing for bankruptcy. Namely, what would happen to the assets of a brokerage account being held at a firm that goes bankrupt?
There are two main regulations that help protect client assets should a brokerage firm become insolvent: the Net Capital Rule and the Customer Protection Rule. The Net Capital Rule requires that brokerage firms maintain at least a 1:1 ratio of highly liquid assets, such as cash or treasury bills, to liabilities. This ensures that brokerage firms will be able to pay out their liabilities without touching clients’ assets held in brokerage accounts. The Customer Protection Rule mandates that firm assets and customer assets be held in separate accounts. Therefore, if a brokerage firm makes a bad investment, client assets can’t be used to pay the firm’s debts.
On top of these regulations, the vast majority of brokers are covered by the Securities Investor Protection Corporation (SIPC). SIPC covers $500,000 in securities, including up to $250,000 in cash, similar to the Federal Deposit Insurance Corporation (FDIC) coverage of up to $250,000 for bank accounts. An important difference however is that SIPC is a private company, whereas FDIC is backed by the federal government. SIPC provides insurance through the premiums it charges its member firms. SIPC also has a $2.5 billion line of credit with the US Treasury.
Lehman Brothers famously went bankrupt during the financial crisis of 2008 due to the falling value of their mortgage-backed securities. Although brokerage services were not a driving factor in Lehman Brothers’ bankruptcy, the accounts were still at risk. The collapse of Lehman Brothers was hardly unforeseen, and many investors withdrew assets in anticipation. After Lehman Brothers filed for bankruptcy, the bulk of retail investors had their accounts moved to Barclays in under a week. Clients with prime brokerage accounts (think hedge funds) were less fortunate. Although Barclays had originally agreed to take these accounts on as well, the bank suddenly backed out of the deal. Eventually, Barclays agreed to take these accounts, but only after years of delay during which clients had no access to or control over their assets.
Similarly, MF Global was a brokerage firm that was under significant pressure due to risky trades surrounding European debt in the early 2010s. In October of 2011, regulators discovered that MF Global used $1.6 billion of client funds to pay off debts that were incurred from firm trades: a violation of the Customer Protection Rule. MF Global quickly filed for bankruptcy and the process of liquidation began. The process of returning client assets was arduous and included multiple lawsuits, but by December of 2014 all assets had been returned.
Although clients of both firms were able to fully recover their assets, it came with costs in the form of opportunity. For retail clients of Lehman Brothers, the opportunity cost was negligible, but for clients of MF Global and clients with prime brokerage accounts at Lehman Brothers, the opportunity costs were significant. These clients were unable to open or close positions for years until their accounts were finally returned to them.
Holding your assets at a brokerage firm is not the only option. Banks offer an alternative to brokers for custody of securities and are less prone to delays in recovery. Assets held at a bank are held under your own name, as opposed to being held in “street name,” which is typical for brokerage firms. This increases the security of your assets as banks cannot commingle customer assets with bank assets, i.e. an MF Global violation would be difficult to execute at a bank. There are tradeoffs, banks typically charge higher fees for custodial services and while de minimis, transactions in securities must be executed at brokers that charge a commission.
As we know, risk is an inherent part of investing. During the Great Recession, we witnessed the bankruptcies of brokerage firms and the failure of banks alike. It was a very difficult and stressful time for many. While many firms took significant steps to fortify their businesses and legislators increased oversight and scrutiny, risk cannot be fully eliminated. We believe both the banks and brokers serving as custodians to Eagle Ridge clients to be “qualified custodians” as defined by the Securities and Exchange Commission and as such, are well suited to provide for the safekeeping of client assets.