SUMMARY
While investors often overlook the details of their custody relationships, the type of custodian employed has major implications for asset safety in times of crisis.
When considering the safety of our assets, our first thoughts are usually about the risks involved with particular investments. How much volatility might our equities suffer? Might the issuer of a certain bond default? However, the safety of such assets can also be affected by the type of custody relationship under which they are held either with a bank or a broker-dealer. Despite this, investors often pay little attention to the significant differences between these two types of custodians.
Not all accounts offered by broker-dealer custodians are equal when it comes to asset safety. Client assets held in margin accounts are not fully segregated, as a result, the broker-dealer may pledge those assets as collateral or use them for other client’s needs, such as covering short positions. While this is not true of broker-dealer cash accounts, where the client has paid in full for all assets held, the distinction does not matter in a worst-case scenario where the broker dealer fails.
Considerations for the safety of your custody of assets
If the broker-dealer fails, all the assets held in the broker-dealers custody are commingled together. This happens irrespective of whether the assets belong to client cash accounts or a client’s margin account. Clients with accounts in the U.S. have to wait for the Securities Investor Protection Corporation (SIPC) to manage an orderly recovery, which can be a lengthy process.
Based on the results of this assessment, a broker-dealer’s clients may only get back a pro rata share or distribution of their affected positions. Eventually, clients may be able to recover all of their assets, but there is no guarantee of this. Only once the assessment and recovery are complete would clients be able to transfer their assets to another custodian.
By contrast, bank custodians fully segregate client assets from their own assets: clients remain the main beneficial owners of their own assets. As a result, the bank cannot lend out (or hypothecate) client assets held in bank custody. In the event of a bank failing, the Federal Deposit Insurance Corporation (FDIC) would facilitate the return of client assets in custody.
The likeliest times for custodians to experience distress are during periods of intense financial and economic turbulence. While the financial system continued to function smoothly during the COVID-19 pandemic, the air of uncertainty has prompted investors to revisit the important differences between holding assets with a bank or broker-dealer custodian.
The differences between broker-dealer custodians and bank custodians
Although very important, asset safety is only one difference between broker-dealer and bank custodians. Broker-dealers are typically used by clients for their ability to generate ideas and place trades. By contrast, bank custody is a specialized service focused on the administration and reporting of client portfolios; bank custodians are agnostic as it relates to the generation of ideas or execution of trades. The table below highlights further considerations when comparing the two types of custody services, which can impact how you grow and preserve your wealth over time.
|
Broker-dealer custodian |
Bank custodian |
|---|---|---|
Trade execution |
Clients may be required to trade through the broker-dealers own desk |
Clients have the flexibility to trade through any third-party execution desk that makes a delivery versus payment (DVP) account available, allowing their trades to settle through their bank custodian |
Costs |
Typically no separate custody fee, as revenue is earned on trade commissions and mark-ups charged on trades done through the trading desk |
Separate custody fee for safekeeping client assets; client negotiates trade commissions and mark-ups charged on trading through the respective trading desks they use |
Borrowing (In the US) |
Margin lending (reg. T)1 |
Reg. U collateralized lending i.e. purpose vs non-purpose2 |
Service |
Typically, the focus is on advice and transactional needs |
Typically, there is a dedicated team of custody specialists working directly with clients or their intermediaries on administrative and reporting needs |
Regulators (In the US) |
The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) |
The Federal Reserve Board and the Office of the Comptroller of the Currency (OCC) |
Insurance (In the US) |
Securities Investor Protection Corporation (SIPC) for investments and cash |
Federal Deposit Insurance Corporation (FDIC) for on balance sheet cash deposits |
Often, investors don't understand the differences or nuances of their custody arrangements. As a client’s portfolio grows more complex, spanning multiple accounts and providers, understanding where assets are held is pivotal, and the need to centralize assets for safety benefits, enhanced reporting, and ease of administration become more pronounced.
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