The False Comfort of SIPC Insurance

Prospective clients often ask why they should trust Wealthfront to manage more than $500,000 of their assets if SIPC insurance only covers up to that amount. You might be surprised to learn SIPC insurance is quite irrelevant when it comes to asset protection.  In fact it has seldom been used over the 42 years it has been available. Simply put there are exceptionally few cases where investors have lost money due to a brokerage firm going out of business.

The Securities Investment Protection Corporation (SIPC) is a nonprofit, membership corporation, funded by its member securities broker-dealers that was created 42 years ago to restore funds to investors with assets in the hands of bankrupt and otherwise financially troubled brokerage firms. SIPC is to brokerage accounts what the FDIC is to bank accounts.

Before we dive into a lot of detail about the how and what of SIPC we want to surface these far more important considerations about your brokerage accounts, whether:

  • Your advisor keeps very little cash in your account
  • Your securities are held in street name at the DTC
  • Your advisor’s custodian pursues proprietary trading
  • Your account at the custodian is a cash account

They will begin to make more sense as we proceed.

So How Does SIPC Insurance Work?

When a brokerage firm is closed due to bankruptcy or other financial difficulties and client assets are missing, SIPC steps in to help return clients’ cash, stock and other securities. Keep in mind SIPC only steps in when a firm shuts down due to financial circumstances in which customer assets are missing.[i] In such circumstances SIPC provides up to $500,000 of protection on securities held per legal entity and up to $250,000 in cash in excess of what is not recovered, per legal entity. The following would qualify as separate legal entities, each subject to the $500,000 limit: your individual account, your trust, your IRA, your spouse’s individual account, trust and IRA, your joint account, as well as a custodial account for a child. Two IRA accounts held by the same client would be considered one legal entity and thus are combined for purposes of insurance coverage. The same combination occurs when a single client holds two individual taxable accounts.

Not all asset types are covered by SIPC. Among those assets typically not eligible for SIPC protection are commodity futures contracts, precious metals, as well as investment contracts (such as limited partnerships) and some fixed annuity contracts.

Wealthfront does not purchase non-eligible assets for its clients and thus all of your Wealthfront assets are protected by SIPC insurance.

And when it comes to cash, Wealthfront typically only keeps enough cash on hand in your account to pay your management fees for one year (approximately 0.25%). Even on a $5 million account, that translates to only $12,500, which is well under the $250,000 cash protection limit provided by SIPC.

To help you visualize this process let’s walk through a typical SIPC liquidation on a $5 million dollar client account:

  • Assume a brokerage firm fails, resulting in $5 billion of client claims on assets.
  • Assume 90% of the clients’ assets ($4.5 billion) are recovered. The actual historical recovery rate is 98.7% (Source: 2011 SIPC Annual Report) and in very few cases was only 90% recovered.
  • A client holding $5 million in SIPC eligible assets would receive $4.5 million from recovered assets and $500,000 from SIPC. The loss on a $5 million client account would be zero.

SIPC reports that 99.7% of eligible investors have been made whole in the 324 cases of failed brokerage firms that it has handled since its founding 42 years ago. Of the more than 625,200 individual entity claims completed or substantially completed as of December 31, 2011, 351 remained unsatisfied for claims of cash and securities whose value was greater than the limits of protection afforded by SIPC. These claims total $47.2 million and represent less than 0.06% of all claims made. The remaining claims in excess of SIPC limits were filed by clients of brokerage firms that did not carry “excess of SIPC” coverage.

“Excess of SIPC” Coverage

Because of SIPC’s coverage limits, many large brokerage firms purchase so-called “excess of SIPC” insurance, which insures their clients for any losses above and beyond the distributions they would receive in a liquidation proceeding, including payments from SIPC. In other words, this insurance is only paid out when all distributions from a brokerage firm liquidation are insufficient to satisfy a client’s claim in full. Claims for excess of SIPC insurance have been extremely rare because client asset recovery rates are so high. To the best of our knowledge there have been only 2 known cases of excess of SIPC insurance being invoked, which together totaled less than $1 million in claimed assets.

Wealthfront’s brokerage partner provides its clients with “excess of SIPC” coverage from Lloyd’s of London. The policy provides in aggregate up to $150 million in excess of SIPC coverage, subject to maximum limits of $37.5 million for any individual customer’s securities and $900,000 for any individual customer’s cash. This excess of SIPC coverage would only be used if SIPC coverage were exhausted which, as previously explained, is extremely rare.

To illustrate how excess-of-SIPC insurance works on a $6 million client account:

  • As per our previous example, assume a historically low recovery rate of 90% (again, the actual historical recovery rate is 98.7%).
  • A client with a $6 million account would receive $5.4 million from recovered assets and $500,000 from SIPC insurance. The $100,000 balance would be covered by excess of SIPC insurance.

Holding securities in “Street Name”

Both SIPC and excess of SIPC coverage are limited to securities held in “street name” in a brokerage account. Securities held by clients in street name are kept securely with the Depository Trust Company (DTC), separate and distinct from the assets of the securities firms. Regulated by the SEC and the Federal Reserve, the DTC is a national clearinghouse for settling trades and a custodian of securities.

All securities purchased by Wealthfront are held in street name at the DTC.

Say No to Proprietary Trading

Some brokerage firms make trades in the marketplace using their own capital. This practice is known as proprietary trading. When a firm that engages in proprietary trading makes a bad bet and doesn’t have the capital to pay for its losses, it either must declare bankruptcy or — even worse (not to mention illegal) — commit fraud by taking supposedly segregated client assets and using them to fund their losses. MF Global, the eighth largest bankruptcy in US history, was an example of a brokerage firm that committed fraud to fund its losses. Despite the fraud, none of MF Global’s clients lost any capital, even without SIPC insurance.

Wealthfront would never participate in proprietary trading, which we view as a significant risk mitigator.

Say No to Rehypothecation

There are two types of brokerage accounts that you, as an individual, can open, either for your own use or for use by your financial advisor. They are known as cash and margin accounts. A margin account allows you to borrow money to invest (i.e. “margin loans”), sell shares short or buy options or commodities. A cash account does not allow these activities. A cash account assures that your assets are fully paid for and may not be rehypothecated (used as collateral for a brokerage firm to borrow money). You may not realize it because it’s buried in the fine print of your account opening contact, but a margin account allows your brokerage firm to loan out the securities you hold in your account to other brokerage firms. The securities are usually loaned to other brokerage firms to enable a short sale.

A short sale is when you borrow shares to sell at one price with the hope of buying them back at a lower price and pocketing the difference. You would only engage in a short sale if you thought a particular security was likely to drop in value. To facilitate a short sale your broker/dealer (this can be part of a full-service brokerage firm or an independent firm that specializes just in buying and selling securities) will borrow shares you’ve sold short from another broker/dealer and deliver those shares to the buyer. When you buy the shares back and cover the short, those shares are delivered to the original lending broker and placed back in the customer’s margin account.

Problems can arise for margin account clients when their stock leaves the broker/dealer’s custody. That’s because if the lending broker/dealer fails, the borrowing broker/dealer may be unwilling to return the shares (even when the short is covered) until its own counter-claims against the failed broker/dealer are settled. Margin account customers whose shares have been lent out become unsecured creditors of the failed firm. A real problem arises when a margin account client must sell the shares that have been loaned out to meet a margin call, because the securities aren’t in the account. The only way to avoid this scenario is to limit the number of securities in your margin account or to not have a margin account altogether. Doing so makes those securities unavailable to the broker/dealer’s stock loan department to loan out.

Wealthfront prevents this problem because we only open cash accounts on our clients’ behalf so they never run into these challenges. 

An Educated Investor is a Better Protected Investor

As you can now see, SIPC insurance actually plays very little role in the extent to which your brokerage account is protected because it is seldom needed. As we have explained even brokerage firm bankruptcies represent little if any risk to your account. We understand that most people perceive that a large well-known brokerage firm offers lower risk, but in reality it actually doesn’t make much of a difference.

Disclosure: Neither SIPC nor the excess of SIPC insurance protects against loss of market value.

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