During the depths of the 2008 financial crisis, when it justifiably felt as if our E TRADE Financial Corporation (NASDAQ:ETFC) ntire financial system was on the verge of imploding, I was working as a licensed broker at Charles Schwab Corp (NYSE:SCHW). This was at a time when it seemed like major financial institutions were going broke or being swallowed whole by peers every other week.
As such, I fielded my fair share of frantic phone calls from clients who were downright terrified of losing their retirement accounts and life savings. Among the more frequent queries was this: “Is my account safe and insured?”
At the heart of that question lies the single biggest misconception that investors have regarding their brokerage and bank accounts. Let’s set the record straight about how these two account types are fundamentally different.
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With bank accounts, consumers are very well aware that banks immediately take their funds and use those dollars to make loans to other people and businesses, subject to regulatory reserve requirements, among other things. After all, that’s the business that banks are in.
That loan is exactly what puts your money at risk in a bank account, which is why the FDIC exists in the first place. Consumers know that their money isn’t actually sitting in an account somewhere — it’s being loaned out. In the event that those loans go bad and the bank becomes insolvent, the FDIC steps in to cover losses up to $250,000 per individual.
This perception is precisely what leads investors to wonder whether their brokerage accounts are also at risk when times are tough. It’s simply how we’re accustomed to thinking about our financial accounts. Everyone knows what a “run on the bank” is.
… is not like the other
In contrast, brokerage accounts are entirely different. Client brokerage accounts are segregated from firm assets as required by federal law. Your broker isn’t taking your idle cash and lending it out to others and technically putting it at risk. In the case of brokerage accounts, your money truly is sitting in a separate account with your name on it.
However, there have been rare instances when brokers aren’t playing by the rules, such as MF Global’s collapse a few years ago. This is where the Securities Investor Protection Corporation, or SIPC, comes into play. The SIPC covers losses of up to $500,000, including up to $250,000 for cash claims.