Is Your Money Safe With Your Broker?

Posted on May 13, 2011 at 6:05 PM PST by

When Lehman Brothers went bankrupt in September 2008, most investors faced a question they had never considered: Is my money safe with my broker? What happened to Lehman brokerage accounts, and what makes one broker like Fidelity safer than another?

To get to the bottom of this question, I caught up with Michael Hogan, CEO ofFOLIOfn Investments Inc.

When stock markets began, brokers physically traded share certificates of a company’s stock and had armed guards moving certificates between brokers and their vaults all day. In the 1960s there was a back-office crisis as trading volume went from 5 million shares daily to 15 million shares. The paperwork burden was overwhelming and brokers and stock exchanges came together to form the Depository Trust and Clearing Corporation (DTC).

Fast forward to our highly automated world—there are virtually no share certificates, but only records of how many shares are owned and by whom. The DTC is the heart of the system, and tracks the shares of all securities that all brokers have. After trading is done each day, the brokers settle between one another through the DTC. Your IBM stock held in your Schwab brokerage account is held in Schwab’s name, or “street name” at the DTC. If you sell 100 shares of IBM to someone at Merrill Lynch, that night, the DTC will transfer shares from Merrill to Schwab and cash from Schwab to Merrill. Schwab keeps track of which clients own how many shares. DTC is like a huge file back-up system for everyone’s stocks, bonds, and cash in brokerage accounts.

Anyone can pass a test and become a broker. But a “clearing broker” is part of the elite group plugged directly into the DTC system. There are hundreds of clearing brokers, and thousands of “introducing” brokers. All introducing brokers need to “clear” through a clearing broker.

Clearing brokers hold money and securities and need a multi-million-dollar IT infrastructure to process orders and keep accounts and the capital to deliver securities or pay for them. “The bar is high,” Hogan says. “Clearing brokers must demonstrate to regulators that they have the capability to be part of this highly regulated system. They must reconcile cash and securities on a nearly daily basis with the DTC and all other firms and are audited every week.”

The Securities Investor Protection Corporation (SIPC) restores cash and securities to investors with assets in the hands of bankrupt and otherwise financially troubled brokerage firms. SIPC provides up to $500,000 of protection for brokerage accounts and estimates that no fewer than 99 percent of persons who are eligible have been made whole in the failed brokerage firm cases that it has handled.

Brokers go broke because of bad management or fraud. Lehman went bankrupt because of bad management. SIPC and the DTC quickly restored investor accounts at another broker. As long as the records of the brokerage firm are accurate, and there was no fraud involved, you get your securities and cash back or moved to another broker within a month or two.

When fraud is involved, it is generally with introducing brokers who are able to cash your checks, and create a set of fake books. It is nearly impossible for clearing brokers to commit fraud. Hogan says, “The main way the system breaks down is when you deal with an introducing broker, and you’re told to deposit money with their firm. They steal it and circumvent the system and create statements with a color printer. You’re disconnected from reality and don’t have a cross-check.”

Hogan offers two pieces of advice if you don’t use a clearing broker. When introducing brokers, only make out your check to its clearing broker, and get access to the clearing broker’s website so you can see your account. While introducing brokers have their own branded websites and statements, you should have online access to the clearing broker. Check your balances frequently. In addition, make sure regulators have never sanctioned your broker.

As long as you have your securities and cash with a clearing broker that has been around for at least 10 years, is run by competent management with a strong financial statement and an unblemished regulatory record, your money is safe.


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