Brokerage firms are required to keep sufficient capital on hand to cover all customer trades. If for whatever reason a firm doesn’t meet those capital requirements, it must immediately make moves to cover that shortfall in liquidity. Typically, any shortfalls in capital are very short-term in nature. However, in times of great financial stress, such as the Great Recession at the end of the last decade, some firms actually went under. The important thing to know is that even in the event of a firm bankruptcy, customer assets are protected.
Firm Capital Requirements
The Depository Trust & Clearing Corporation is the firm that actually processes brokerage trades. However, stock trades don’t settle until two days after they are made. If for some reason a brokerage firm can’t provide the money to pay for that trade two days later, the DTCC is on the hook to process the trade. During normal market operations, this isn’t usually a problem, as customer funds are paid two days after the trade and the transaction gets settled.
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However, in times of market volatility, the DTCC takes on a greater risk that customers (and brokerage firms) won’t be able to pay for their trades. In these instances, capital requirements for firms can go up dramatically.
For example, in early 2021, GameStop and some other stocks became tremendously volatile, in some cases moving 100% or more in a single day. Since this makes trading in these stocks inherently risky, brokerage firms are required to provide additional capital to cover those trades.
In this specific case, the NSCC — a subsidiary of the DTCC — required Robinhood to raise an additional $3 billion to cover trades in GameStop and other stocks during those periods of intense volatility. At the time, the firm didn’t have that cash on hand, so it was forced to raise additional capital from venture capitalists and others to satisfy its requirements.
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Customers are protected from firm insolvency in two primary ways. First, brokerage firms are required to segregate customer assets from firm assets. This means that even if a firm can’t cover its capital requirements, customer assets are to remain untouched. Second, all legitimate brokerage firms are members of the Securities Investor Protection Corporation, or SIPC. Customer assets at SIPC-member firms are insured from loss for up to $500,000, including a $250,000 limit for cash. SIPC insurance doesn’t protect against a decline in the value of securities held by customers, but rather against the failure of the customer’s brokerage firm.
In addition to standard SIPC insurance, many brokerage firms have supplemental insurance of $1 million or more to protect customers against the failure of a firm. The bottom line is that even when firms run out of capital, investors have some insurance, although it may take some time to be fully reimbursed. Even when Lehman Brothers spectacularly failed during the Great Recession, all of its customer assets were protected.
This article is part of GOBankingRates’ ‘Economy Explained’ series to help readers navigate the complexities of our financial system.
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