Saturday, December 22, 2007
Are You Covered if Your Broker Fails?
A COUPLE WEEKS AGO, WE ASKED Barron’s readers what would prompt them to switch online brokers or open an account with a new one. The overwhelming response—over three-quarters of those who took the time to write—was that the primary motivation would be to protect assets.
"What would happen to my account if my broker goes under?” howled a respondent. “I just don’t want to deal with that.”
Brokerages are required to carry insurance backed by the Securities Investor Protection Corp., a federally mandated entity funded by broker-dealers that covers up to $500,000 of stocks, options and bonds per account. Futures contracts, commodities and currencies are among the asset classes ineligible for SIPC coverage.
SIPC insurance has been mentioned many times in the midst of the recent credit crisis, but the details of its coverage still puzzle many. As a reader noted, “Not to pick on E*Trade, but if they go into bankruptcy, what happens to the money in people’s individual trading accounts? Are their stocks protected by SIPC but not their money-market funds? What happens if the account is $1 million? SIPC insurance doesn’t cover amounts that high, or does it? That concern and uncertainty is causing people to move their accounts out of E*Trade and into other firms.” (E*Trade’d sizable mortgage exposure prompted speculation about its financial health. The firm has since received an investment from hedge fund Citadel Investment Group.)
ACCORDING TO SIPC, customers of a failed brokerage firm get back all securities (such as stocks and bonds) that are registered in their name. The firm’s remaining customer assets (including cash or assets not covered by SIPC) are then divided, with the funds shared in proportion to the size of claims. If that still doesn’t cover the losses, then SIPC reserve funds are used, up to the $500,000 per-customer ceiling, which includes as much as $100,000 for claims of cash that were held in the client’s account.
The majority of the brokers we cover in Barron’s have a relationship with a clearing firm, which is where your assets are actually held. These firms work with the securities exchanges to confirm, deliver and settle trades. They’re also responsible for seeing that transactions are settled correctly in a reasonable amount of time.
Most brokerage executives we spoke with said that it would be difficult for a clearing firm to go bankrupt. If one of their member firms did something crazy, such as overextending margin or allowing a customer to trade a product he or she didn’t understand, it could affect the clearing corporation. But there would have to be a huge drop in the market, combined with a lot of trading on margin. In other words, a perfect storm is about the only thing that could cause a bankruptcy at a clearing firm.
Here’s how some electronic brokers arrange their coverage.
Mickie Siebert, CEO and founder of Siebertnet (http://www.siebertnet.com), says National Financial Services handles clearing at her firm and is ultimately responsible for customer assets. If Siebert’s firm went out of business, the customer’s assets would be kept segregated and safe at the clearer, she says. NFS has SIPC coverage in place and also provides, through an industry conglomerate called Capco, additional coverage with no cap.
A bankruptcy of OptionsHouse would have no direct financial impact on the assets of clients, says John Hass, the firm’s CEO (http://www.optionshouse.com). Options House clears through Penson Financial Services, which holds excess SIPC insurance of $200 million in aggregate for all customer accounts, subject to a maximum limit of $900,000 per customer for cash. Of course, Hass makes clear that his firm has another form of protection: “Options House has never had and does not currently have funds invested in subprime or other low-grade securities.”
Another Penson client, MB Trading, has access to SIPC coverage as well as insurance for $34.5 million in securities and $900,000 in cash through Lloyd’s of London, says MB’s executive vice president, David Lipsett (http://www.mbtrading.com).
ChoiceTrade (http://www.choicetrade.com) also clears through Penson, and its coverage is similar to that of Options House: $200 million in aggregate, subject to a maximum cash limit of $900,000 per customer, in excess of the base SIPC insurance, according to President Neville Golvala.
“Firstrade Securities has unlimited excess SIPC insurance, which covers all accounts up to the total equity in the account, including all cash balances,” says Vice President Peter Gschweng. Firstrade (http://www.firstrade.com) clears through Ridge Clearing & Outsourcing Solutions, which carries all its customer assets, so if something negative were to happen to Firstrade, these assets are protected, he says.
SIEBERT, A FORMER BANKING regulator in New York State, is concerned about claims of excess SIPC coverage as provided by the insurer Lloyd’s. That insurance is subject to a cap that doesn’t cover all the assets held by the clearer. A large firm, she says, could have a cap of $600 million for its excess coverage, but its total account assets might be more than 20 times that figure.
Fuad Ahmed, president of Just2Trade (http://www.just2trade.com) and LowTrades (http://www.lowtrades.com), says that firms must have real-time systems to analyze customers’ exposure. “It comes down to risk management and how the individual broker-dealer manages its potential risk exposure both through its own portfolio and through each client’s trades,” Ahmed says.
Adds Siebert, “Someone might think, ‘Gee, I only have $2 million in my account and it says each account is covered to $25 million, so I’m safe.’ But that is subject to the cap for the whole firm. The big firms would go through that kind of money so fast they wouldn’t know what hit them.”
“If my customers are going to lose their money, they want to lose it themselves. They don’t want to lose it on something they thought was safe,” says Siebert.
OUR 13TH ANNUAL REVIEW of online brokers is coming up. What’s most important to you these days as you consider opening—or moving additional money to—an online brokerage account? Let us know at firstname.lastname@example.org .
Published in Barron’s, December 17, 2007