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The Powers That Be are taking action to prepare for the next crisis.
These actions include:
1) New rules that allow funds to lock in your money for up to
10 days in the event of a crisis.
2) FDIC regulations that permit the FDIC to FREEZE bank
accounts at major banks when a meltdown hits.
3) Proposing the banning of physical cash.
All of these boil down to one key phrase: custody risk.
Custody risk is a legal phrase used to convey “what do you really
own when you buy an investment.”
In today’s financial world, virtually no one has the actual physical share
certificates of the stocks they own or other assets held by their various
accounts/ trusts/ etc. Instead, their shares and other assets are
electronically “parked” at their brokerage firm or some other financial
institution.
Custody risk assesses what happens to those shares or other assets in the
event that the brokerage firm goes under due to insolvency, negligence or
fraudulent action. It is essentially a legal framework through which you
maintain ownership even if the entity holding your shares or assets for you
(the custodian) goes out of business.
This is a HUGE issue that is boiling just beneath the surface of the
financial system. The SEC recently performed a study of some
400-investment advisor firms. As the SEC itself stated in its report approximately
one-third of them (over 140) failed to meet custody rule requirements.
The issues here are too myriad to list, but some of them include:
1) A lack of awareness by advisors concerning the custody rule
(read: the advisor isn’t even sure of whether he or she has custody of their
clients’ accounts)
2) Failure by the advisor to have the assets or securities
placed with a qualified custodian firm (a qualified financial firm)
3) Failure by the advisor to have an independent accountant
audit the firm’s holdings (so who is keeping track of what your assets are
actually worth or where they are for that matter)?
4) Failure to provide GAAP approved audits of client accounts
(read: the balance sheets of the clients funds they provided did not meet
Generally Accepted Auditing Standards or GAAP).
My point with all of this is that most investment professionals don’t even
consider these issues. Again roughly ONE THIRD of the advisory firms
the SEC examined failed to meet custody rule requirements.
In simple terms: these folks were not keeping track of where the assets
were, weren’t providing their clients with timely updates of where the assets
where, failed to pass special exams concerning issues of custody rule AND
failed to have independent audits of their clients’ funds performed.
In other words… they didn’t really know where their clients funds
were, how big or how small they were… in fact, many of them didn’t even
realize that they themselves were legal custodians
of their clients’ funds.
Custody risk goes beyond investment advisors. Indeed, these issues are
endemic to the financial system today.
Let’s say the financial firm which is actually keeping custody of your
assets (your stock shares, money market account, etc.) goes belly-up. What
happens then? How quickly can you access your accounts? How soon can they be
transferred out of the firm to another custodian?
You see where I’m going with this.
Even if an appropriate legal framework is in place to eliminate the risk
of loss of value of the securities held by the custodian in the event of its
failure, it can take weeks or even months to transfer the securities to a new
custodian. During that time, you cannot close out open positions…
they are effectively frozen.
In the case of MF Global, some investors were locked out of their accounts
and couldn’t trade their positions for weeks. As a
result many of them incurred massive losses (imagine owning stocks and not
being able to sell them during a crash).
I bring all of this is up because custody risk is one of the
biggest, most important issues to consider if you want to maintain your
wealth when the next round of systemic risk hits. Remember from the case of
Cyprus… once things get bad, they do so in a hurry.
Indeed, we know that custody risk is a major concern for the Big Banks
because they are pushing to outlaw physical cash.
Why?
Because when you demand your cash from a bank, you are demanding that they
relinquish custody. This means they have to come up with the actual money as
opposed to digital currency that floats around the financial system.
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