Liquid Lounge
Re: Buffett - Margin Account Danger?

Format for Printing

Format for printing

Request Reprints


By howardroark
January 18, 2005

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

While a margin account could involve more risk than a cash account in a case of broker failure, the difference isn't as big as you might think.

The Customer Protection Rule (15c3-3) of the '34 Act generally requires broker-dealers to segregate customer assets from firm assets, and prohibits them from borrowing or using customer assets without consent. Thus, in a cash account, your securities will generally be held otherwise unencumbered at the DTC. Absent fraud, no financial dealings of the broker-dealer can get between you and your priority claim on those assets. If the SIPC liquidates a broker due to capital inadequacy, customer assets are not part of the estates, and customers are not on par with financial and trade creditors. Their assets, held in trust, are distributed first.

On the other hand, in a margin account Brokers will often require your signed to borrow your securities, and they will often relend them to third parties. But even then, you don't simply become a mere creditor of your broker and/or the third party in the case of your broker's insolvency. Broker's are actually required to post collateral at least equal to the value of any securities they borrow from you. And they must fund that collateral by establishing a Reserve Account, where they instruct the bank that the assets containing the collateral are customer property and may not be used by the brokerage. The collateral in the reserve account is generally restricted to cash, short term Treasuries and bank LOCs. And the collateral must be marked to market to match changes in the value of securities. And, again, customers have priority rights to this Reserve Account in a liquidation, which absent fraud should theoretically equal 100% of customer assets.

The biggest risk that I can see, absent fraud, comes from the one-week lag before the Reserve Account has to be adequately funded with collateral. This lag seems to mean that a broker-dealer might become under-collateralized mid-week, or might even be able to postpone liquidation and create a worsening situation by continuing to borrow again more customer securities as it tries to meet its weekly Reserve Account requirements. I believe the latter is part of what actually happened in MJK Clearing, which I think is the biggest broker blow-up since the SIPC was created. But even in that case, which was really borderline fraud as opposed to mere derivative failure as there were numerous market-to-market issues, the customer were ultimately made whole. Note that this risk is much different from bank insolvency, because banks are permitted to access and borrow customer assets without posting liquid collateral in return.

If a broker-dealer does fail without sufficient assets for customers, the SIPC only covers $500K per customer ($100K of which may be cash). After that, many large brokers carry excess insurance. Historically, this has been largely third party coverage, but the only third party excess SIPC coverage I know about today are Lloyd's of London (Schwab and Merrill) and XL Capital (UBS), which are capped at I think $600 or $650 million in total. Most of the other large brokers have combined to form a captive insurance company called Capco. Its financial strength is pretty much opaque to customers, though numbers are provided to S&P who rates it. Here's a list of Capco members:

It is a little unsettling that most of the insurance industry has fled the excess SIPC market, considering that for years millions of premiums had been paid without a single claim dollar paid out. You wonder why the industry would run from insuring this risk given the numerous regulatory protections and the very strong claims history. So I'm sure you can't exactly rest easy, but it's a mistake to think your are simply another creditor subject to the financial and counter party risk of your broker, or worse -- the risks of your brokers various counter parties.

Become a Complete Fool
Join the best community on the web! Becoming a full member of the Fool Community is easy, takes just a minute, and is very inexpensive.