"Is my brokerage account safe?"

Last month's FDIC takeover of unstable Silicon Valley Bank, and the subsequent shutdowns/shoring up of other banks, have made bank depositors wary. In recent articles, Mark and Matt have addressed depositor concerns, explaining what transpired with the troubled banks and why, even if other banks were to fail, most bank depositors aren't in danger of losing money. But what about brokerage firms? Could follow-on effects from the forces troubling the banking industry put brokerage businesses at risk? It's a natural question to ask. When destabilizing things start to happen in the financial world, everyone gets nervous!

However, it's important to remember that the business model of a bank and the business model of a brokerage firm differ.

Banks and brokers

• The banking model: Banks take deposits and, in turn, use those deposits to make loans. Banks earn money on the loans and pay some of those earnings to depositors as interest. (Interest is somewhat like a "rental" fee paid to depositors for the use of their money.)

When too many depositors demand their money back immediately, a bank can find itself in an "illiquid" situation. The bank may not be able to meet depositor demand.

• The brokerage model: Investors determine how their money will be deployed, and brokerage firms implement those choices. Typically, clients purchase investments such as stocks or mutual funds.

If many customers suddenly opt to sell their holdings and close their accounts, the brokerage firm wouldn't suffer a liquidity crisis. The broker would sell underlying investments, and the proceeds would be returned to the clients.

The liquidating investors would get their money back, and the financial health of the broker wouldn't be affected directly. (However, a decline in a broker's customer base would affect future earnings due to a loss of client fees.)

It's also worth pointing out that securities regulations prohibit brokerages from mingling investor funds with a firm's operating capital and accounts. Therefore, by law, the money returned to investors must come from investor accounts (and their underlying holdings), not from the brokerage firm's financial resources.

Schwab's two hats

One thing that's made some people wary about how banking-industry problems might affect brokerage firms is that Charles Schwab operates both kinds of businesses (a paywalled New York Times article that's free via Google). As you probably know, Schwab is one of SMI's recommended brokers, but there is also a Charles Schwab Bank — the 10th-largest bank in the U.S.

Although Schwab's two businesses are separate, they are closely connected. Schwab (the broker) deposits the cash held in investors' sweep accounts with Schwab (the banker). And while that money remains in sweep accounts, it is FDIC-insured because Charles Schwab Bank is an FDIC-insured institution.

Of course, sweep accounts aren't intended to be long-term investment options. They're temporary holding places for cash that'll be deployed elsewhere in short order. Most savvy investors keep relatively little money in sweep accounts on an extended basis, especially since sweep accounts pay very little compared to money-market funds.

Indeed, with Schwab's own money funds (from Schwab, the broker) paying more than 4%, investors have been moving cash from their sweep accounts and into better-yielding Schwab MMFs.

"Clients aren't moving bank deposits out of Schwab," noted Schwab CEO Walt Bettinger in an interview with The Wall Street Journal. "All they're doing is realigning their investments, as they should."

What if a brokerage firm did run into trouble?

To protect investors in the unlikely event that a brokerage firm was to fail, Congress created the Securities Investor Protection Corporation (SIPC) in 1970. Any brokerage firm registered with the Securities and Exchange Commission must be a member.

SIPC insurance protects the "custody function" of a brokerage firm. It doesn't protect investors from investment losses from market downturns or interest rate changes — otherwise, the SIPC would be very busy!

From the SIPC website:

SIPC protection is not the same as protection for your cash at [an FDIC-insured] banking institution because SIPC does not protect the value of any security.... Instead, in a liquidation, SIPC replaces missing stocks and other securities when it is possible to do so.

In other words, if any assets were missing because of a brokerage failure, the SPIC would attempt to restore those assets — deploying up to $500,000 per investor account to rebuild portfolios. The SIPC insurance limit for uninvested cash holdings is $250,000, but money-market funds — which are mutual funds invested in "cash" assets — are protected under the $500,000 limit.

To further assuage investor concerns about safety, many brokerage firms carry "excess of SIPC" coverage from other insurers.

Fidelity, an SMI-recommended broker, has additional coverage through Lloyd's of London, with no per-customer dollar limit on coverage of securities. Uninvested cash is covered up to $1.9 million. "This is the maximum excess of SIPC protection currently available in the brokerage industry," according to Fidelity. Schwab, too, offers "excess" coverage in the event SIPC protections are exhausted. "The combined total of our SIPC coverage and our 'excess SIPC' coverage means Schwab provides protection up to a combined return of $149.5 million per customer, up to $1.15 million of which may be in cash," says the Schwab website. (TD Ameritrade, which Schwab owns, has even more robust protections in place.) E-Trade offers "excess of SIPC" coverage via Morgan Stanley (which owns E-Trade). According to the Morgan Stanley site, "Excess Coverage provides additional protection up to the full net equity value of each account, including unlimited coverage for uninvested cash." Vanguard, too, offers additional protection. The company's current "Brokerage Account Agreement" document (PDF) provides sparse details, however, saying only that "Vanguard Brokerage maintains additional coverage through an insurer that supplements SIPC coverage."

Acting as matchmaker

In addition to its role as an insurer, the Securities Investor Protection Corporation stands ready to serve another crucial role: matchmaker. If a brokerage firm was at risk of failing, the SIPC would try to find another firm willing to take on the failing business's clients — similar to how the FDIC tries to find a healthy bank to assume the accounts of customers of a failed bank.

If the SIPC failed to find a match — and if investor assets had been compromised — only then would the SIPC's insurance function come into play. If that insurance proved insufficient for some clients, the "excess" coverage from other insurers would kick in.

A high level of protection

So, is your brokerage account safe? Yes, to the highest degree possible. It is protected by regulations that segregate brokerage accounts from investor accounts. It is further protected by SIPC insurance and other SIPC functions. And finally, it is covered by supplemental insurance running well into the millions of dollars.

Although it is theoretically possible that all of those backstops and protections could fail, the risk is so remote that it is not worth losing sleep over.

*Image used with permission. *