Wednesday, April 22, 2015


So I'm reading the Securities and Exchange Commission's (SEC) 2011 "Study on Investment Advisers and Broker-Dealers." After 2008 so many shady deals and self-serving transactions were discovered on the part of Wall Street that one of the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was for the SEC to produce a study on how broker-dealers (traders) and investment advisers operated.

The goal of the study is help guide Congress as it works to protect the American consumer from traders and advisers who might be inclined to put their interests ahead of their clients. Before discussing what caught my eye in the 2011 SEC study a little history explaining why traders and advisers need to be regulated is in order here.

What's presented below offers us some jargon free historical perspective, and is drawn from a post I did on the topic more than 3 years ago.

Once upon a time there was a big problem on Wall Street. But it wasn't 1929. It was 1968. And the problem would persist until 1970. More than 40 years ago broker-dealers who over saw individual investment portfolios decided that it would be a good idea to use the assets in client accounts as collateral for their personal business deals.

So, for example, if you had $500,000 invested with a Wall Street firm they would use your assets (mostly securities) as collateral for their own investment purposes.

The idea was that they would put up your assets as collateral, take out a loan, invest that money, make a quick killing, and then return the asset before anyone knew what happened. Shear brilliance, wouldn't you say?

Anyways, in part because of the increased number of trades being made at the time, major market players - but especially the broker-dealers - found it difficult to keep track of all the transactions (it was before computers and automation dominated the day). No one really knew who had what. This was OK by many broker-dealers because they didn't really want their clients (or the Feds) to know what they were up to (proprietary information, you know).

Because market players weren't offering up their own assets as collateral they made big bets. Needles to say, they were also reckless. As the brilliant schemes of broker-dealers began to collapse, a large number of their client's assets (i.e. securities) were seized and sold. After the dust settled it was discovered that big chunks of customer accounts - many of whose assets were stuffed with fully paid securities - had disappeared.

Wow. As Yogi Berra might have said, it could be déjà vu all over again.

Banks who had granted loans to broker-dealers had cashed in the collateral. Broker-dealer clients lost millions. Many Wall Street firms who had either participated or winked and nodded at the activities crashed too.

In fact, more than a dozen New York Stock Exchange firms failed (many because their "back offices" couldn't keep up). Losses exceeded $100 million. To stop the bleeding of public confidence swift action was taken to prop up the securities industry. Funds were pooled from industry survivors to help compensate clients who had been cheated. But this was just the beginning.

To protect the public Congress enacted the Securities Investment Protection Act (SIPA) in 1970 which, generally speaking, is the cornerstone of Rule 15c3-3 for the Securities Exchange Commission (SEC).

Among the changes that Rule 15c3-3 did was:

Segregate Accounts: SIPA mandated that fully paid off securities in a customer's account be kept separate from client assets that have been used as collateral, or that have not been fully paid off (i.e. purchased on margin).
Reserve Requirement / Net Capital Rule: SIPA mandated that accounts have enough liquid assets on hand. This meant implementing a requirement that broker-dealers had to tabulate how much a client's portfolio was worth in the market, and then limited how much could be borrowed against those assets (about 8-15 times the total value; this is the "net capital" rule).
Securities Investor Protection Corporation (SIPC): SIPC is a federally mandated, member-funded, corporation that protects securities investors if their broker-dealer cheats them or goes under. In many ways, SIPC is an insurance program for holders of securities.

Well, guess what? Because of deregulation (especially with reference to reserve requirements in 2004), much of what SIPA was supposed to do was undermined. To be sure, SIPA is still there. But the spirit of the law was - and has been - turned into a cruel joke. This is what makes the SEC's 2011 study so interesting.

What caught my eye in the SEC's 2011 study is very simple. Here it is, from page 165 in the conclusion:

Retail customers should not have to parse through legal distinctions to determine whether the advice they receive was provided in accordance with their expectations. Instead, retail customers should be protected uniformly when receiving personalized investment advice or recommendations about securities regardless of whether they choose to work with an investment adviser or a broker-dealer. 

In plain English, the above is SEC-speak for, "you as a client shouldn't have to worry that your broker-dealer or investment adviser might actually be using your account for their own benefit; nor should you have to worry if they're taking your money and using it to purchase the toxic instruments and financial crap that other, bigger, clients are trying to dump on to other portfolios."

Yeah, that's right. Even after 2008 the SEC is still concerned that broker-dealers and financial advisers - hiding behind legal walls created and maintained by Congress - might be ripping off unsuspecting clients who know little about how market structures, or how market players operate. And, yes, those unsuspecting clients include people like you and me.

Worse, what they're doing is happening on a colossal level.

- Mark

The SEC's 2011 study ...

1 comment:

Cxgllc said...

Informative post.Thanks for sharing.

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