Understanding Custody - Segregated and Non-Segregated Accounts

November 3, 2011

Given events in the past regarding the implosion of broker/dealers (BDs) and futures commodities merchants (FCMs) from things ranging from ponzi-type frauds to leverage generated losses, participants in the financial markets (both investors and those who service them) should fully understand the nature and risks of their custody arrangements, as well as any protections that may apply in the case of the failure of either BDs or FCMs).

As the customer of a BD, a securities account custodied with a BD is insured by the Securities Investor Protection Corporation (SIPC) up to $500,000. SIPC insurance does not provide insurance to you or others from market losses, but instead provides customers of the brokerage firm the ability to reclaim their actual securities held at the broker/dealer. Of particular interest is the current debate concerning SIPC protection for investors in Stanford Financial Certificates of Deposit (Stanford CDs) in an offshore banking affiliate of Stanford later found to have engaged in ponzi-like conduct. While Stanford CDs were often custodied or sold through an affiliated United States based BD, SIPC is now debating whether SIPC insurance will apply to non-security and non-US products such as these. The protection afforded under SIPC's rules also generally does not extend to those who finance the operations of the BD, which may include ponzi-like activity. Those parties who are engaged in repurchase or swap transactions and have BDs as counterparties need to be aware of two things: (a) they will not be able to claim SIPC protection in the event of the default of the BD, and (b) since they are not "customers" of the BD, they instead become general creditors of the BD in the event of default. There is no SIPC equivalent for FCMs that customers may utilize to claim protection under similar circumstances.

Where things become muddled are when accounts in regulation neutral jurisdictions are used in a "non-segregated" manner to custody assets by way of introduction from a US affiliate. For example, the offshore affiliate of an FCM or BD introduced by the U.S. parent may offer the ability to employ higher trading leverage or receive higher overnight rates on free credit balances. However, the risk entailed in the participation in such arrangements is that assets are not "segregated," which means in their own account walled off from the risks of the trades of other customers of the firm. Investment advisers are generally required to use segregated accounts through what the SEC deems to be a "qualified custodian." However, "non-segregated" accounts outside the U.S. in the case of BDs or FCMs generally represent a pool of money that customers have agreed to commingle and hypothecate that is not with a "qualified custodian." That total "pool" represents an asset of the offshore affiliate. In the event of the bankruptcy or failure of the U.S. parent of that offshore affiliate, customers generally do not get their positions back but instead assume the role as general unsecured creditors.

In the case of parties engaged in swaps with regulated entities, the central premise to remember is that a swap is generally not considered a security. The collateral that backs up a swap is the regulated entity itself and the revenue it derives from its accounts, minus its other liabilities. As such, swap transactions have risks very much dependent upon the financial solvency of their counterparty. The failure of a regulated entity in a swap generally places the counterparty in the position of being an unsecured creditor, subject to the terms and conditions of the swap confirmation.

Understanding one's custody arrangements is clearly a sound practice for market participants of all kinds, especially in light of volatile markets.

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