After the most recent crisis, investors are undoubtedly concerned about potential insolvency issues that may arise with their investment custodian.  Some of my clients have articulated this concern, and have asked whether it makes more sense to consolidate investment assets at one brokerage firm, or segregate accounts by institution as a form of makeshift diversification.  Some articles have been written on the matter, but I find that there is a lack of general understanding in/around the safeguards that have been created specifically to protect investors who hold assets at regulated brokerage firms.

In arguably all cases, when a brokerage firm ceases to continue as a going-concern, customer assets are safe and able to be transferred to another registered brokerage firm.  Here’s how:

  1. Brokerage firms are required to keep customers’ assets (both securities and cash) segregated from their own: the SEC’s Rule 15c3-3—the “Customer Protection Rule”—requires customers’ cash to be placed in a special, separate “reserve” account. Fully paid customer securities must be kept separate from firm and customer margin securities.
  2. Brokerage firms are required to meet net capital requirements to both demonstrate financial worthiness and to reduce the likelihood of insolvency (this allow allows them to be member to the Securities Investor Protection Corp (SIPC): the SEC’s Rule 15c3-1—the “Net Capital Rule”—requires brokerage firms to maintain certain levels of their own liquid assets. The minimum net capital a firm must have on hand depends on its size and business.
  3. The SIPC protects customer securities accounts up to $500,000, which would come into play in rare cases of where customer assets are missing because of either theft or fraud.

A note on ‘clearing’ versus ‘carrying’ firms

It’s helpful to differentiate between clearing and carrying firms.  When you open an account with a carrying brokerage firm, the firm not only handles your orders to buy and sell securities but it also custodies the securities in the account (inclusive of cash).  Because these firms generally hold assets for a a large number of customers, they are required to carry a much higher level of net capital than clearing firms, which limit their activities to clearing and settling trade commitments.

A historical note

Historically, brokerage firms that have faced financial insolvency have handled the calamity in different ways.  Some have been able to find a buyer to stave off indebtedness.  Bear Stearns, for example, was bought by J.P. Morgan in 2008.  Other firms self-liquidate, as did Drexel Burnham Lambert in 1990.  When a brokerage firm self-liquidates, securities regulators, including the SEC and FINRA, work with the firm to make sure that customer accounts are protected and that customer assets are transferred in an orderly fashion to one or more SIPC-protected brokerage firms.

In short, “Is it safer to use multiple brokerage firms to custody my investments?”

No.

Investors’ assets are separate from the brokerage firm and solely belong to the customer.  A brokerage firm’s failure should not result in loss of customer assets.  If in an extremely unlikely circumstance a client’s assets are lost (i.e., theft or fraud), account holders would be protected by SIPC up to the limits discussed above.  To protect yourself against theft and fraud, choose a well-know brokerage firm that is regulated by the SEC, member to FINRA/SIPC, and that publishes audited financials and statement of Financial Condition by a reputable audit firm.   You may also wish to review FINRA BrokerCheck, a free tool offered to help investors research the background of both FINRA-registered broker-dealers and investment advisor firms.  Lastly, many brokerage firms actually carry  “excess SIPC”  insurance that provide additional protection beyond SIPC’s limits through private carriers.  Maximum amounts may vary by firm, but you may wish to seek out a brokerage firm that carries these additional limits.

While there’s no way to completely remove institutional risk from your investment portfolio, I believe that the benefits that arise from account consolidation should outweigh fears of broker malfeasance; especially when you have hired an investment advisor to craft, implement, and manage a comprehensive investment strategy across your varied investment accounts.

I hope this information was helpful.  Please do not hesitate to let me know if you have any questions.

Best regards,

Jason M. Gilbert, CPA/PFS, CFF
T: 516-665-7800
E: [email protected]