Timothy Fadek/Bloomberg NewsMembers of the Securities Investor Protection Corporation listened to investors last year who lost money with Bernard L. Madoff.The MF Global story still lingers as an insolvency matter, but now we hear rumblings that there will be no criminal charges. It may well be that no crimes were committed, but if this is so, it is time to seriously rethink how broker-dealers handle customer property.
In theory, customer property at a brokerage firm should be even more secure than money in a bank, because banks use fractional reserves, meaning that by design they have “used” a large part of the deposits, while customer property at a brokerage firm is supposed to be segregated in a special fund at a third-party custodian bank.
Somehow, it never works out that way.
Since the Great Depression, banks have overcome the inherent weakness of fractional reserves with insurance from the Federal Deposit Insurance Corporation. Brokerage accounts have insurance, too, but it’s limited. Most notably, the Securities Investor Protection Corporation insurance covers only securities, defined essentially as plain-vanilla investments (stocks, bonds, mutual funds). That leaves commodities and futures traders out in the cold.
The simple solution is to extend S.I.P.C. insurance to all types of investments. But is this also a simplistic solution?
Bank account insurance comes with bank regulation. This means the F.D.I.C. and either a state or federal bank regulator oversee the bank. And by bank here, we mean the actual subsidiary of the holding company that provides bank accounts.
Brokerage firms are regulated, to be sure, but it’s not quite the level of oversight that regulators have with depository banks. And the insurer, S.I.P.C., has no regulatory role at all.
Handing out insurance to brokerage firms without simultaneously ramping up the degree of oversight is a great way to prop up shaky brokerage firms at taxpayer expense. But that is probably not quite the point of providing insurance to brokerage accounts.