We’re going to focus on Schwab here since they’re our custodian. (If you weren’t aware, Schwab purchased TD Ameritrade back in 2019 and everything will officially become Schwab this year after Labor Day.) However, all of this would apply to other big brokerage firms like Fidelity or Vanguard.
Schwab And Other Custodians Don’t Work Like Banks
One crucial distinction between a brokerage firm like Schwab and a bank is the way each accounts for its deposits. Banks accept deposits from customers, which are categorized as liabilities on the bank’s balance sheet. These deposits are considered demand deposits, meaning customers can withdraw their funds on demand or access them through checks, debit cards, and other means.
As you know, banks are insured by the FDIC, which provides deposit insurance coverage of up to $250,000 per depositor, per insured bank. I went into more detail on FDIC coverage in the blog last week.
In contrast, brokerage firms like Schwab primarily hold customer deposits as assets, not deposits, on their balance sheets. Any funds held by customers in a brokerage account are classified as customer assets rather than Schwab’s liabilities.
However, brokerage firms may offer cash sweep options, such as money market funds. Some of these do not have the same regulatory protections as bank deposits, while others, ironically, are FDIC insured since they may be offered through an FDIC bank such as Schwab Bank, which is kind of confusing! So, money market funds at a brokerage firm can be either FDIC insured or insured through SIPC, which we’ll cover momentarily.
What About Investments at Schwab?
Schwab, like other brokerage firms, acts as a custodian for various investment products, including mutual funds and exchange-traded funds (ETFs). However, it is important to note that these funds and ETFs have separate custodians. This separation ensures that the assets of the funds are held independently, mitigating the risk of commingling, and enhancing investor protection.
For instance, if you wanted to purchase DFAU, Dimensional’s U.S. Core Equity ETF, your funds would eventually wind up at that ETFs’ custodian, Citibank. The custodian, Citibank in this case, keeps a separate account for the Dimensional for these funds that are separate from Citibank’s assets on their balance sheet.
So, you can see the layers of protection with third-party custodians here.
But what happens if you’ve purchased one of Schwab’s funds or ETFs? Let’s say that, instead of DFAU, you want to purchase SCHB, Schwab’s U.S. Broad Market ETF. Well, in this case, the custodian for SCHB is State Street, not Schwab.
So, Schwab isn’t even the custodian for its own funds – and that’s not a bad thing. When the fund manager and the custodian are one and the same, that’s when shenanigans can start to happen, as Bernie Madoff showed us.
In the unlikely event of Schwab’s bankruptcy, the mutual funds and ETFs held by investors would remain separate from the firm’s assets and would not be subject to claims from any of Schwab’s creditors. The custodian responsible for safeguarding these investment vehicles would continue to hold them on behalf of the investors. This separation helps protect the interests of mutual fund and ETF investors from the potential fallout of the brokerage firm’s financial troubles.
Okay, so if you have your investments as Schwab, you could feel safe that, if Schwab went bankrupt, your investments would still be safe. Now, there’s no telling if your investments’ values wouldn’t go down. If a huge custodian like Schwab went bankrupt, there’s probably some bad things going on in the economy.
SIPC and FDIC Insurance Differences
Where banks benefit from FDIC insurance coverage, brokerage firms have a different form of protection for their customers. The Securities Investor Protection Corporation (SIPC) is a non-profit organization established by Congress – and funded by its member firms – to protect customers of failed brokerage firms. SIPC provides limited coverage to investors in the case of a brokerage firm’s insolvency.
SIPC insurance protects against the loss of cash and securities held by customers, up to $500,000 per customer, including a maximum of $250,000 for cash claims. However, it’s crucial to understand that SIPC protection does not guarantee the value of investments or safeguard against market fluctuations. It is primarily designed to cover instances of fraud or theft within the brokerage firm.
However, Schwab and other large custodians also carry “excess SIPC” insurance protection that would protect and aggregate claim amount of up to $600 million. So, there’s even more coverage available beyond what SIPC typically insures.
In contrast, FDIC insurance covers bank deposits up to $250,000 per depositor, per insured bank. It guarantees the return of principal and accrued interest on qualifying deposits, regardless of the bank’s financial condition.
Should You Worry About Schwab Going Bankrupt?
While all the recent bank failures are concerning, understanding how brokerage firms are structured very differently from banks can give us some peace of mind. Unlike banks, brokerage firms primarily hold their clients’ money as separate assets rather than liabilities on their balance sheets. These assets would not be subject to the claims of any creditor in the unlikely event that Schwab (or any other brokerage firm) went bankrupt.
While anything is possible, losing your money should your brokerage firm go bankrupt is a low-probability event, simply based on how these firms are set up.
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