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July 15, 1987

Federal Reserve Bank of Cleveland

ISSN 042H

ECONOMIC
COMMENTARY
Throughout most of its U.S. history,
operation of the securities market has
been directed by private associations
with very little government regulation
or interference.
This situation changed after the
Crash of 1929, when an estimated $50
billion stock market loss triggered the
Great Depression and ended the
government's hands-off attitude.
Since the Depression, Congress has
enacted a number of measures, including the Securities Act of 1933 and the
Securities Exchange Act of 1934, that
have been designed to stabilize the
stock market and to protect investors.
Continuing in this tradition, Congress in 1970 passed the Securities
Investor Protection Act (SIPA) and
established the Securities Investor Protection Corporation (SIP C) as an
industry-funded, nonprofit, membership corporation that offers limited protection to investors.
As of year-end 1986, SIPC had 11,305
members, including all firms registered
as broker-dealers with the Securities
and Exchange Commission (SEC) and
all members of the national securities
exchanges.
In this Economic Commentary, we
shall outline briefly the events that led
to the establishment of SIPC, placing
an emphasis on the mechanics of securities trading in 1970. We shall then
proceed to an analysis of the rationale
for such an insurance mechanism by
discussing the role that SIPC might be
expected to play in response to disrup-

tions in the securities industry. Finally,
a comparison with other financial insurance programs leads to an assessment
of SIPC's exposure to loss.

Jerome S. Fons is an economist at the Federal
Reserve Bank of Cleveland. The author would like
to thank Mark Sniderman, Walker Todd, and
James B. Thomson for their helpful comments.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

1. U.S. v. Morgan, 118 F.Supp. 91 (S.D.N.Y.
1953).

Background
In the wake of the Great Depression,
the securities industry settled into a
new, highly regulated environment.
The public's indifference towards private financial instruments helped to
slow growth in the industry. Despite
the rapid increase in the amount of
U.S. Treasury obligations associated
with the financing of the Second World
War, the dominance of the Federal
Reserve and commercial banks over the
securities market served to limit opportunities for broker-dealers to expand.
The only noteworthy attention
received by the securities industry in
the postwar years resulted from charges
of price-fixing against a few powerful
underwriters.' For nearly 30 years thereafter, there were no significant disruptions in the industry.
Interest in the securities markets, as
measured by equity trading on the New
York Stock Exchange (NYSE), resumed
at a slow pace in the period following
the Second World War. Average daily
volume on the Big Board stood at
1,422,000 shares in 1945, at 1,980,000
shares in 1950, at 2,578,000 shares in
1955, and at 3,042,000 shares in 1960.
The increased trade in securities was
accompanied by several isolated failures
of small dealers and brokers. The first
post-Depression failure, in 1960, was
allegedly the result of a "partner's illegalities." In 1963, a second failure, a by-

1276

A Critical
Look at SIPC
by Jerome S_ Fans

product of the "Great Salad Oil Scandal," found the New York Stock Exchange paying $9.5 million in reimbursements to the failed firm's customers.
To maintain confidence in the financial markets, the New York Stock
Exchange subsequently established a
fund, with initial assets of $10 million
and a $15 million line of credit, to compensate customers of failed firms for
losses that resulted from theft or fraud.
The other exchanges followed the
NYSE's lead and also established customer protection funds. The exchanges,
however, were under no legal obligation
to settle any claims.
By 1965, the average daily volume on
the New York Stock Exchange rose to
6,176,000 shares; by 1968, it reached
12,971,000 shares. The dramatic growth
in trading volume over this period led
to what was referred to as the "paperwork crunch." At that time, securities
transactions were processed by hand.
Brokerage firms maintained a "cage"
in which cash and certificates were
physically stored and exchanged, sometimes leading to settlement mismatches
as trading volume grew." The level of
so-called "fails-to-deliver" incidents, in
which a firm fails to deliver securities
within five business days (then a
rather common occurrence), exceeded
$4 billion at the end of 1968.
Responding to the turmoil caused by
the increased trading volume and lack
of automation, the major exchanges
initiated "trading holidays" on Wednesdays throughout the second half of

2. Firms in New York (and the Federal Reserve
Bank of New York) still have cages-certificates
of deposit (CDs) and banker's acceptances (BIAs)
are traded for physical delivery.

1968. The New York Stock Exchange
also established the Central Certificate
Service, the forerunner of the Depository
Trust Company of New York today. The
Certificate Service replaced a sorting
center that had responsibility for the
processing and actual delivery of securities. The Central Certificate Service
was an intermediate stage of the evolution from the physical transference of
securities to electronic bookkeeping,
which rendered the cages obsolete.
A few small-firm failures in 1969 were
covered adequately by the assets of the
NYSE's trust fund. Several larger failures and amalgamations throughout
1970, however, forced the NYSE to replenish the customer protection fund
from its general fund, calling into question the ability of the NYSE's general
trust fund to withstand further failures
by its members. Many of the failures of
that era involved violations of the
exchange's net capital requirements;
members were required to maintain
"net capital" in excess of 5 percent of
their liabilities.
In June 1970, Congressional hearings
were initiated to investigate the history
and adequacy of the NYSE's and the
other exchanges' funds. Supported by
recommendations from industry representatives, the Congressional subcommittee found that risks to the financial
system arising from a loss of public confidence in the existing broker-dealer
network were large enough to warrant
public-sector involvement. Thus, in
December 1970, the Securities Investor
Protection Act became law, establishing SIPC, an industry-wide replacement
for the troubled funds previously created
by each of the separate exchanges. The
Act was amended in 1978 to streamline
procedural shortcomings in the settlement of customers' claims and to
increase coverage limits.
Not a Regulator
SIPC is not a regulatory agency;
instead, it is subject to SEC and Congressional oversight. It has a board of
seven directors who serve three-year
terms. The directors include one representative each from the Board of Gov-

3. If accounts are held by one customer in separate capacities, coverage limits apply separately to
each account.

ernors of the Federal Reserve System
and from the Department of the Treasury, three individuals associated with
different aspects of the securities industry, and two individuals (one of whom
serves as the chairman) not associated
with the securities industry. The latter
five individuals are appointed by the
President of the United States and confirmed by the U.S. Senate.
SIPC was created to promote investor
confidence in the securities industry by
insuring customers of failed brokerdealers against losses due to missing
cash and securities. Currently, the protection limit for a customer against loss
totals $500,000. This limit includes
$100,000 of protection against claims
for cash.' Of course, securities on hand
that are identifiable as fully-paid-for
property of customers need no protection and are returned to customers.
The term "customer" is intended to
refer to individuals or firms with
claims on the broker-dealer arising out
of ordinary business dealings. Such
dealings include purchases or sales of
securities or the safekeeping of securities and any cash balances maintained
for purchases or sales. Providers of capital, noncustomer creditors, or persons
with claims subordinated to those of
the firm's general creditors are not
considered customers. The failed firm's
general partners, officers, directors,
owners of at least 5 percent of the
firm's equity, and participants in at
least 5 percent of the firm's net profits
are excluded from customer protection.
A "failed firm" is defined as one that
is declared bankrupt, that is forced into
liquidation or receivership by any
agency of the United States (or any
state), that is in violation of the Securities Exchange Act or the rules of the
firm's self-regulatory agency, or that is
unable to establish its compliance with
applicable laws and rules. Faulty
record keeping, often accompanied by
fraud, appears to be one of the most
prominent factors leading to the demise
of members of SIPC. Poor record keeping also often causes some delay in the
settlement of customers' claims. By
year-end 1986, 53 of the 197 proceedings ever initiated under SIPA

4. Many of SIPC's larger members also maintain
private insurance to raise per-customer coverage
limits to several million dollars. This increased
coverage applies only to Slf'Cvtype claims (that is

remained unsettled because of so-called
problem claims and/or litigation. Criminal action has been taken in 66 cases.
A failed firm is brought to SIPC's
attention by the SEC or the relevant
self-regulatory agency (such as the
NYSE, the American Stock Exchange
[AMEX], or the National Association of
Securities Dealers [NASD]). In most
cases, unless the failed firm is merged
into an ongoing firm that agrees to
assume the losses of customers, the
failed firm simply is liquidated. Most
liquidations are not performed directly
by SIPC, but rather under the direction
of a SIPC-appointed or court-appointed
trustee. The difference on the filing
date between the market value of the
securities or cash claims of customers
(less securities or cash owed by customers) and the value of the failed
firm's holdings is satisfied out of the
SIPC fund.
This procedure differs from an ordinary bankruptcy proceeding because
SIPC stands ready to pay customers in
full at once; in bankruptcy proceedings,
claimants of failed firms must stand in
line for a pro rata distribution as trusteeship or receivership proceeds. Although
SIPC protection covers most types of
securities (including stocks, bonds,
notes, and CDs), commodity contracts
and commodity options are not covered.'
The Securities Investor Protection
Act specifies that the resources of the
SIPC fund shall be maintained at a
minimum of $150 million, an amount
reached in 1977; bylaws passed in 1985
raise the minimum to $250 million.
SIPC is authorized to assess premiums
on its members. These premiums are
traditionally calculated as an adjustable percentage of each member's gross
revenues from commissions, underwriting, and trading activity. The premiums are not specifically adjusted for
each firm and are collected by a
member's self-regulatory organization
or, if none exists, by SIPC.
The assessment rates are adjusted
periodically by SIPC directors, depending upon the condition of the fund and
upon the amount of expected customer
settlements. If fund resources fall

for customers' missing securities) and is separate
from fidelity insurance, which is designed to protect against fraud or other illegal activities.

Figure 1

Figure 2

Millions of dollars

Millions of dollars

400r----------------------.

400

70
Customers' distributions

300

from SIPC

60

50

200

100

IO

o
1971

1986

SOURCE: Securities Investor Protection
Corporation.

below the statutory minimum, the
assessment rate is adjusted to replenish the fund. Beyond this minimum
level, SIPC's board of directors has
considerable leeway in setting the
assessment. Because of the fund's relatively high value (around $380 million
at year-end 1986), annual assessments
were set in 1986 at a token $100 per
member. The fund currently holds only
cash and U.S. Government securities.
Interest on the fund's holdings contributes significantly to its growth.
In addition to its customer protection
fund, SIPC has at its disposal two
sources of external financing. Through
a consortium of banks, it has arranged
a $500 million revolving line of credit.
SIPC also has the authority to borrow
up to $1 billion from the SEC (which,
in turn, would have to obligate itself to
the United States Treasury in order to
obtain the funds).
Customer Settlements
The size of SIPC' s reserve fund is a
result of past assessments and payout
experience. A time-series plot of the
year-end levels of the fund is presented
in figure 1. Figure 2 shows SIPC's
payout experience, based on the 138
proceedings completed as of year-end
1986. The distributions ascribed to
1985 and 1986 are somewhat understated, however, reflecting the fact that
several proceedings were uncompleted.
The fund balance is superimposed in
figure 2 to show that episodes of high
payouts cause subsequent reductions in
the fund level. The worst year was
1981. Only 10 firms failed that year,

1971

1986

SOURCE: Securities Investor Protection
Corporation.

but the largest failure cost more than
$26 million. Customer settlements for
the year exceeded $63 million.
As a proportion of the fund's assets,
however, its third full year of operation
(1973), in which 30 firms failed, posed
the biggest threat to SIPC. The distributions during the year of over $31 million represented almost 56 percent of
the fund's 1972 year-end balance.
Although 40 firms failed during 1972,
SIPC distributed only $7 million to
their customers.
At SIPC's inception, customers were
protected against missing securities
worth up to $50,000 and had coverage
for cash claims up to $20,000. In 1978,
these respective limits were increased
to $100,000 and $40,000. In 1980, they
were raised to the present $500,000/
$100,000 levels. It is possible, therefore,
that historic payout levels might have
been somewhat higher had the current
protection limits been in force.
The relatively large number of proceedings in SIPC's early years has been
offset somewhat by the small number
of yearly failures over the past decade.
The 197 member failures experienced
over SIPC's 16-year history represents
just under one percent of the 22,600
broker-dealers ever affiliated with the
corporation. Perhaps the most important factor in SIPC's recent experience
is that no member firm of substantial
size has failed within the past 10 years.
The absence of large-firm failures may
have created a certain amount of complacency about the adequacy of SIPC's
resources.

Rationale for SIPC
Broker-dealers are commonly thought
of as financial intermediaries, providing ultimate savers (households, businesses and government) with access to
various investment opportunities.
Brokers bring together buyers and
sellers of securities; dealers actually
take positions, risking their own capita!
by purchasing securities. Though
many dealer activities, notably securities underwriting, involve significant
risk-taking, other activities closely
resemble the deposit-taking function of
commercial banks.
It could be argued that SIPC's role in
supporting public confidence in the
securities industry helps provide broad
and deep securities markets byassuring maximum dispersion of ownership.
The increased specialization in the
allocation of risk is thought to lower
the cost of physical investment and to
increase overall economic efficiency. If
the smooth functioning of the securities markets indeed is necessary for
public benefit, then there may be cause
for public-sector involvement in the
settlement of claims on broker-dealers,
perhaps to the point of government
assistance if an industry insurance
fund became insolvent.
Unfortunately, the issue of public
necessity is not addressed easily.
Opponents of government financial
assistance to SIPC might argue that
the benefits of increased investor (customer) safety accrue mainly to the
securities firms themselves. In this
view, the presumed inadequacy of SIPC
resources to cope with the liabilities
thrust upon it due to the wrongdoing of

1968. The New York Stock Exchange
also established the Central Certificate
Service, the forerunner of the Depository
Trust Company of New York today. The
Certificate Service replaced a sorting
center that had responsibility for the
processing and actual delivery of securities. The Central Certificate Service
was an intermediate stage of the evolution from the physical transference of
securities to electronic bookkeeping,
which rendered the cages obsolete.
A few small-firm failures in 1969 were
covered adequately by the assets of the
NYSE's trust fund. Several larger failures and amalgamations throughout
1970, however, forced the NYSE to replenish the customer protection fund
from its general fund, calling into question the ability of the NYSE's general
trust fund to withstand further failures
by its members. Many of the failures of
that era involved violations of the
exchange's net capital requirements;
members were required to maintain
"net capital" in excess of 5 percent of
their liabilities.
In June 1970, Congressional hearings
were initiated to investigate the history
and adequacy of the NYSE's and the
other exchanges' funds. Supported by
recommendations from industry representatives, the Congressional subcommittee found that risks to the financial
system arising from a loss of public confidence in the existing broker-dealer
network were large enough to warrant
public-sector involvement. Thus, in
December 1970, the Securities Investor
Protection Act became law, establishing SIPC, an industry-wide replacement
for the troubled funds previously created
by each of the separate exchanges. The
Act was amended in 1978 to streamline
procedural shortcomings in the settlement of customers' claims and to
increase coverage limits.
Not a Regulator
SIPC is not a regulatory agency;
instead, it is subject to SEC and Congressional oversight. It has a board of
seven directors who serve three-year
terms. The directors include one representative each from the Board of Gov-

3. If accounts are held by one customer in separate capacities, coverage limits apply separately to
each account.

ernors of the Federal Reserve System
and from the Department of the Treasury, three individuals associated with
different aspects of the securities industry, and two individuals (one of whom
serves as the chairman) not associated
with the securities industry. The latter
five individuals are appointed by the
President of the United States and confirmed by the U.S. Senate.
SIPC was created to promote investor
confidence in the securities industry by
insuring customers of failed brokerdealers against losses due to missing
cash and securities. Currently, the protection limit for a customer against loss
totals $500,000. This limit includes
$100,000 of protection against claims
for cash.' Of course, securities on hand
that are identifiable as fully-paid-for
property of customers need no protection and are returned to customers.
The term "customer" is intended to
refer to individuals or firms with
claims on the broker-dealer arising out
of ordinary business dealings. Such
dealings include purchases or sales of
securities or the safekeeping of securities and any cash balances maintained
for purchases or sales. Providers of capital, noncustomer creditors, or persons
with claims subordinated to those of
the firm's general creditors are not
considered customers. The failed firm's
general partners, officers, directors,
owners of at least 5 percent of the
firm's equity, and participants in at
least 5 percent of the firm's net profits
are excluded from customer protection.
A "failed firm" is defined as one that
is declared bankrupt, that is forced into
liquidation or receivership by any
agency of the United States (or any
state), that is in violation of the Securities Exchange Act or the rules of the
firm's self-regulatory agency, or that is
unable to establish its compliance with
applicable laws and rules. Faulty
record keeping, often accompanied by
fraud, appears to be one of the most
prominent factors leading to the demise
of members of SIPC. Poor record keeping also often causes some delay in the
settlement of customers' claims. By
year-end 1986, 53 of the 197 proceedings ever initiated under SIPA

4. Many of SIPC's larger members also maintain
private insurance to raise per-customer coverage
limits to several million dollars. This increased
coverage applies only to Slf'Cvtype claims (that is

remained unsettled because of so-called
problem claims and/or litigation. Criminal action has been taken in 66 cases.
A failed firm is brought to SIPC's
attention by the SEC or the relevant
self-regulatory agency (such as the
NYSE, the American Stock Exchange
[AMEX], or the National Association of
Securities Dealers [NASD]). In most
cases, unless the failed firm is merged
into an ongoing firm that agrees to
assume the losses of customers, the
failed firm simply is liquidated. Most
liquidations are not performed directly
by SIPC, but rather under the direction
of a SIPC-appointed or court-appointed
trustee. The difference on the filing
date between the market value of the
securities or cash claims of customers
(less securities or cash owed by customers) and the value of the failed
firm's holdings is satisfied out of the
SIPC fund.
This procedure differs from an ordinary bankruptcy proceeding because
SIPC stands ready to pay customers in
full at once; in bankruptcy proceedings,
claimants of failed firms must stand in
line for a pro rata distribution as trusteeship or receivership proceeds. Although
SIPC protection covers most types of
securities (including stocks, bonds,
notes, and CDs), commodity contracts
and commodity options are not covered.'
The Securities Investor Protection
Act specifies that the resources of the
SIPC fund shall be maintained at a
minimum of $150 million, an amount
reached in 1977; bylaws passed in 1985
raise the minimum to $250 million.
SIPC is authorized to assess premiums
on its members. These premiums are
traditionally calculated as an adjustable percentage of each member's gross
revenues from commissions, underwriting, and trading activity. The premiums are not specifically adjusted for
each firm and are collected by a
member's self-regulatory organization
or, if none exists, by SIPC.
The assessment rates are adjusted
periodically by SIPC directors, depending upon the condition of the fund and
upon the amount of expected customer
settlements. If fund resources fall

for customers' missing securities) and is separate
from fidelity insurance, which is designed to protect against fraud or other illegal activities.

Figure 1

Figure 2

Millions of dollars

Millions of dollars

400r----------------------.

400

70
Customers' distributions

300

from SIPC

60

50

200

100

IO

o
1971

1986

SOURCE: Securities Investor Protection
Corporation.

below the statutory minimum, the
assessment rate is adjusted to replenish the fund. Beyond this minimum
level, SIPC's board of directors has
considerable leeway in setting the
assessment. Because of the fund's relatively high value (around $380 million
at year-end 1986), annual assessments
were set in 1986 at a token $100 per
member. The fund currently holds only
cash and U.S. Government securities.
Interest on the fund's holdings contributes significantly to its growth.
In addition to its customer protection
fund, SIPC has at its disposal two
sources of external financing. Through
a consortium of banks, it has arranged
a $500 million revolving line of credit.
SIPC also has the authority to borrow
up to $1 billion from the SEC (which,
in turn, would have to obligate itself to
the United States Treasury in order to
obtain the funds).
Customer Settlements
The size of SIPC' s reserve fund is a
result of past assessments and payout
experience. A time-series plot of the
year-end levels of the fund is presented
in figure 1. Figure 2 shows SIPC's
payout experience, based on the 138
proceedings completed as of year-end
1986. The distributions ascribed to
1985 and 1986 are somewhat understated, however, reflecting the fact that
several proceedings were uncompleted.
The fund balance is superimposed in
figure 2 to show that episodes of high
payouts cause subsequent reductions in
the fund level. The worst year was
1981. Only 10 firms failed that year,

1971

1986

SOURCE: Securities Investor Protection
Corporation.

but the largest failure cost more than
$26 million. Customer settlements for
the year exceeded $63 million.
As a proportion of the fund's assets,
however, its third full year of operation
(1973), in which 30 firms failed, posed
the biggest threat to SIPC. The distributions during the year of over $31 million represented almost 56 percent of
the fund's 1972 year-end balance.
Although 40 firms failed during 1972,
SIPC distributed only $7 million to
their customers.
At SIPC's inception, customers were
protected against missing securities
worth up to $50,000 and had coverage
for cash claims up to $20,000. In 1978,
these respective limits were increased
to $100,000 and $40,000. In 1980, they
were raised to the present $500,000/
$100,000 levels. It is possible, therefore,
that historic payout levels might have
been somewhat higher had the current
protection limits been in force.
The relatively large number of proceedings in SIPC's early years has been
offset somewhat by the small number
of yearly failures over the past decade.
The 197 member failures experienced
over SIPC's 16-year history represents
just under one percent of the 22,600
broker-dealers ever affiliated with the
corporation. Perhaps the most important factor in SIPC's recent experience
is that no member firm of substantial
size has failed within the past 10 years.
The absence of large-firm failures may
have created a certain amount of complacency about the adequacy of SIPC's
resources.

Rationale for SIPC
Broker-dealers are commonly thought
of as financial intermediaries, providing ultimate savers (households, businesses and government) with access to
various investment opportunities.
Brokers bring together buyers and
sellers of securities; dealers actually
take positions, risking their own capita!
by purchasing securities. Though
many dealer activities, notably securities underwriting, involve significant
risk-taking, other activities closely
resemble the deposit-taking function of
commercial banks.
It could be argued that SIPC's role in
supporting public confidence in the
securities industry helps provide broad
and deep securities markets byassuring maximum dispersion of ownership.
The increased specialization in the
allocation of risk is thought to lower
the cost of physical investment and to
increase overall economic efficiency. If
the smooth functioning of the securities markets indeed is necessary for
public benefit, then there may be cause
for public-sector involvement in the
settlement of claims on broker-dealers,
perhaps to the point of government
assistance if an industry insurance
fund became insolvent.
Unfortunately, the issue of public
necessity is not addressed easily.
Opponents of government financial
assistance to SIPC might argue that
the benefits of increased investor (customer) safety accrue mainly to the
securities firms themselves. In this
view, the presumed inadequacy of SIPC
resources to cope with the liabilities
thrust upon it due to the wrongdoing of

any single large member, let alone the
liabilities from more than one large
member, would constitute at least prima
facie evidence that premium collections
have been too small or that protection
limits have been too great. It is to the
securities industry's advantage, after
all, to minimize disruptions associated
with a loss of public confidence, which
could be potentially manifested as
"runs" on securities dealers.
Government involvement might be
justified if one could show that disruptions would inevitably lead to a severe
bear market instead of simply being
limited to certificate withdrawals.
Though causation is difficult to determine, past experience suggests that
broker-dealer failures may actually be
associated with bear markets.'
Drawing the argument to a conclusion, opponents of public assistance to
SIPC might say that the maintenance
of investor confidence is best accomplished by establishing strict rules of
conduct and by extensive self-policing.
Industry-funded insurance schemes,
such as SIPC, would be expected to
operate with a minimum of publicsector involvement or support. Thus,
government assistance to SIPC might
be desirable and convenient, at least
from the perspective of the member
firms, but it is not always necessary
from the perspective of the broad public
interest.
The position in favor of extensive
self-regulation partly reflects the spirit
of the Securities Exchange Act of 1934.
Specifically, the SEA stresses selfregulation on the part of the securities
industry. Because the exchanges and
NASD already had sufficient supervisory capability, the SEC was created to
provide regulatory oversight. Beyond
reducing redundancy, this system also
served to protect the Treasury's exposure to loss in the industry.
Among the dangers associated with
an investor protection plan is that
uninformed investors might mistakenly
think that coverage extends to the market value of their securities, thereby
encouraging insufficient investor scrutiny of broker-dealers and reckless
behavior on the part of the firms. This
is a variant of the moral hazard argument used against insurance protection
in general, and against deposit insurance protection in particular. Moreover,
this type of protection may allow inefficient firms to survive longer than would
be the case with unfettered markets.

SIPC and Federal Deposit
Insurance
The insurance provided by SIPC differs
in many respects from that provided to
commercial bank or savings and loan
(S&L) depositors either by the Federal
Deposit Insurance Corporation (FDIC)
or by the Federal Savings and Loan
Insurance Corporation (FSLIC).
First, the FDIC and FSLIC either
have regulatory powers themselves or
have affiliated authorities, such as the
Federal Home Loan Bank Board, that
have such powers and that maintain
close supervision of their members.
SIPC, on the other hand, must rely on
the SEC or its members' self-regulatory
organizations for supervision and regulatory control.
Second, when a bank or thrift institution fails, the federal deposit insurer
typically acts as the receiver, supervising the liquidation or, possibly, the
merger of the failed firm with a healthy
one, often with financial assistance
from the insurance fund. Such failures
usually occur, for instance, when an
institution's loan portfolio has an
excess of problem loans, when it faces
severe liquidity problems, or through
management fraud or neglect.
More importantly, federal deposit
insurance funds guarantee (currently
up to a stated maximum coverage of
$100,000 per account) the full value of
insured deposits in the event of a
covered institution's insolvency. The
determination of the insurer's residual
liability usually is straightforward
because banks and S&Ls carry deposit
liabilities, and most assets on their
books, at par value. The protection
afforded by SIPC, on the other hand, is
offered simply against missing securities owed to the customers of a failed
broker-dealer. The value of a customer's claim, however, is determined by
current market prices, which change as
often as market conditions change.
SIPC coverage does not protect customers from changes in the market value
of their securities after a member
firm's failure.
Furthermore, the deposit insurance
premium charged to an insured institution is computed as a percentage of its
total deposit base, unlike the revenuebased (or flat-rate) premium charged to
SIPC members. The FDIC, for instance,

5. SIPe's 1985 annual report cites its origin in
the difficult years of 1968-70, when "the paperwork crunch, brought on by unexpectedly high
volume, was followed by a very severe decline in
stock prices."

charges members a rebatable onetwelfth of one percent of total deposits.
Finally, the federal deposit insurance
funds claim to be backed by the full
faith and credit of the federal government. SIPC has to avoid making this
particular claim."
Fund Exposure
One of the difficulties encountered in
comparing SIPC-type coverage and
deposit insurance is in determining the
insurer's exposure to risk. The value of
total insured deposits approximates the
level of a federal deposit insurance
fund's exposure. In practice, however,
many general creditors of depository
institutions have been granted de facto
100 percent insurance in recent years,
so that the true exposure of the deposit
insurance funds is somewhat greater
than the total of insured deposits. SIPC,
on the other hand, rarely extends its
coverage to noncustomers, as determined either by itself or by a court.
The total exposure of a financial
insurance mechanism, however, is only
one determinant of the adequacy of its
resources. On an actuarial basis, it is
necessary for the present value of future
premiums to at least equal the present
value of expected future claims. The
role of the insurance fund is to allow
for deviations from expected payouts.
An insurance system faced with a
claims stream with a high variance will
need a larger fund than a system facing
a less volatile payout stream.
Ideally, the insurer's revenues rise
when the industry experiences strong
growth-and
is therefore most able to
finance the fund's needs-and fall during difficult periods. This pro-cyclical
premium strategy minimizes the overall burden of the insurance mechanism.
The revenue-based premium of SIPC
members, though perhaps unrelated to
the risk involved, has fallen precipitously just as the industry is experiencing
enormous growth and increased risk.
Furthermore, not all financial insurance mechanisms are designed to protect against the same type of risk. A
bank depositor may depend on the
backing of an insurance mechanism
because the use of deposited funds is
completely relinquished. In the absence
of insurance, the depositor would be
subject to the underlying risk of the
institution's assets.
6. We should note, however, that Congress has
not yet made a legally binding commitment to
provide the necessary funds to fully guarantee
the ailing FSLlC.

On the other hand, a broker-dealer
fully complying with existing securities
regulations does not subject the customer to the type of risk SIPC insures.
The qualitative differences between
risks limit the insight provided by
direct comparisons with deposit insurance. For illustrative purposes only,
however, we provide here a comparison
between SIPC's potential exposure and
that of the FDIC.
Since 1950, the FDIC's fund balance
has ranged between 1.15 and 1.50 percent of total insured deposits. An analogous figure for SIPC is not readily
available, since there are no published
estimates of the aggregate value of
securities holdings for customers by all
SIPC members. A proxy for this figure
that may serve as an upper bound to
the insurance fund's exposure can be
constructed from data maintained by
the Depository Trust Company (DTC)
and the Federal Reserve System.
The Depository Trust Company is a
participant-owned corporation that
serves as a securities depository for a
major portion of the financial industry.
DTC is regulated by the SEC, the New
York State Banking Department, and
the Federal Reserve. DTC holds actual
securities and issues its own bookentry receipts for them. Exchanges of
DTC receipts facilitate the change of
ownership of securities. DTC also provides securities registration, or ownership information, to publicly traded
firms and to others. DTC traditionally
accepted only corporate bonds and
shares of stock for deposit. Since 1981,
however, its opera tions have been
expanded to include municipal bonds.
DTC maintains records of the value
of securities on deposit for its 357
broker-dealer participants. Similar
records are kept for banks (DTC's largest participant group) and for clearing
agencies. Presented in figure 3 are the
year-end balances (at market value) of
all corporate and municipal securities
held at DTC for nonbank brokerdealers. Because this aggregation does
not distinguish between securities held
for a broker-dealer's own account and
securities held for its customers, or
between the portion of customers'
securities that are insured and those
that exceed insurance limits, the
aggregation may overestimate SIPC's
exposure by an unknown amount.
Also shown in figure 3 are the yearend positions in U.S. Treasury securities and Federal Agency obligations
(most notably, mortgage-related securities) for the nonbank, non broker-dealers
designated as primary dealers by the

Figure 3
Nonbank dealer positions
billions of dollars

SIPC fund balance
millions of dollars

600.---------------------------,1,200
1,100
1,000
900
800
700
600
500
400
300
200
100

Municipals and corporates
plus agencies and treasuries

300
200
100
1975

1981 through 1986 in figure 4. In terms
of year-end levels, this six-year period
witnessed a quadrupling of the combined outstanding volume of these conBillions of dollars
tracts to more than $460 billion, raising
450~----------------------~
SIPC's potential exposure to over $1
trillion. Of course, these figures would
be somewhat greater if we included the
remaining SIPC members. Combining
Repurchase agreements
plus reverse repurchase
the estimates and assumptions assoagreements
ciated with these securities agreements
with the estimates and assumptions
previously advanced, it then appears
that SIPC's fund currently represents
coverage for only 0.03 percent of its
total potential exposure."
100
The implications of the repurchase
and reverse repurchase agreements rul50
ing for SIPC go beyond the absolute
1986 increase in exposure to the higher risks
1981
associated with these financial contracts. Poor record keeping and fraud
SOURCE: See text.
has led to several failures of unregulated government securities firms in
are "customers" entitled to SIPC prothe past.? Congress responded to these
tection. Although SIPC may appeal this conditions by imposing tighter regularuling, estimates of its current level of
tions on all government securities
exposure should be adjusted for the
firms, though several provisions of the
level of repurchase and reverse repurGovernment Securities Act of 1986
chase activity of its members.
have yet to be implemented.
Weekly averages of the level of repurThe recent emergence of a whole new
chase and reverse repurchase agreegeneration of financial instruments
ments, in terms of the value of securimay have further broadened the scope
ties used as collateral, are available for
of SIPC's liabilities. Many of these new
the nonbank primary dealers from the
instruments are of the so-called assetFederal Reserve Bank of New York.
backed variety, and cover such items as
The annual average levels of the two
types of agreements are presented for
Figure 4

1980

1985

o

SOURCE: See text.

Federal Reserve Bank of New York.
Although there were only 21 firms with
this particular designation (as of June
1986), they are among the largest
securities dealers. Primary dealers
facilitate the implementation of monetary policy through open-market operations in government securities and help
to underwrite the huge borrowing
needs of the federal government. Just
as with DTC's data, we cannot distinguish between holdings for customers
and positions taken for the primary
dealers' own trading accounts.
Estimates of non primary brokerdealer positions in government securities currently are not available. Several
recent failures of previously unregulated government securities dealers led
Congress to enact the Government
Securities Act of 1986, covering participants in this market.' As a result, a
large number of government securities
dealers will be required to register with
the SEC. At present, however, there is
no way of knowing just how many
firms will choose the registration
option that automatically would make
them members of SIPC, and that would
automatically increase the risk-level of
its insurance fund.
The past can provide a clue about the
potential increase in risk. The data at
our disposal indicate an almost
eighteen-fold increase in the potential
exposure of SIPC over an ll-year
period during which the SIPC insurance fund balance only quadrupled. It
should be noted that this period partially covered the planned buildup of
the SIPC fund to its old statutory min-

imum of $150 million. On the basis of
our estimates and assumptions, the
level of the SIPC fund at year-end 1986
represents only 0.06 percent of its
potential exposure.
Of special importance to this analysis
is the implication of last year's ruling
on the status of counterparties with
whom member firms have engaged in
repurchase and reverse repurchase
agreements. SIPC had considered such
counterparties general creditors
because repurchase and reverse repurchase agreements often are used by
broker-dealers as financing vehicles for
their securities inventories. In a typical
repurchase agreement, the brokerdealer sells selected securities to a
counterparty with an obligation to buy
(or repurchase) them at a later date at a
specified (higher) price. In essence, the
firm obtains a loan from the counterparty. The typical reverse repurchase
agreement has the broker-dealer purchase selected securities, hold them for
a short period, and then resell them to
the counterparty. This practice can be
interpreted as a short-term loan by the
firm to the counterparty.
Last year, however, a U.S. District
court in New Jersey held that these
agreements constitute contracts for the
sale and resale of securities. This
means that repurchase and reverse
repurchase agreement counterparties

7. See EJ. Stevens, "Seeking Safety," Economic
Commentary, Federal Reserve Bank of Cleveland,
April 15,
1987.

8. This and the earlier estimate should not be
interpreted as the author's appraisal of SIPC's
actual exposure. In the absence of detailed information, these figures are offered only to stirnulate discussion on this issue.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

9. Notably ESM Government Securities, Inc.; E.].
Stevens, op cit, lists all of them.

automobile receivables and credit card
payment obligations as well as
"stripped" securities, often applied to
mortgages and other debt instruments.
In most cases, these instruments are
obligations of the institution performing the securitization or stripping, and
lack the full backing of the underlying
issuer. Although these securities were
not included in our estimates of SIPC's
exposure, they too must be considered
in any discussion of the fund's adequacy and risks.
Conclusion
Several issues connected with SIPC are
worth considering. First, the nominal
level of its members' annual assessment
may result in the slow depletion of its
insurance fund-especially
in view of
the corporation's payout experience.
Second, considering the current size
of the securities industry and the
nature of some of SIPC's new exposures, the statutory $250 million minimum level of its insurance fund is
probably too low.
Third, in the event of severe losses in
the securities industry, it is quite possible that SIPC would be unable to
meet its insurance obligations. In that
event, the federal government most
likely would step in to assist investors,
even possibly shifting some of the
financial burden to taxpayers.
The urgency of addressing these
problems, however, rests on certain
assumptions about the proper role of
investor protection and the extent of
appropriate government involvement in
it. These are issues that sooner or later
must be addressed by the securities
industry and our nation's legislators.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Address Correction
Requested:
Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
PO. Box 6387,
Cleveland, OH 44101.

On the other hand, a broker-dealer
fully complying with existing securities
regulations does not subject the customer to the type of risk SIPC insures.
The qualitative differences between
risks limit the insight provided by
direct comparisons with deposit insurance. For illustrative purposes only,
however, we provide here a comparison
between SIPC's potential exposure and
that of the FDIC.
Since 1950, the FDIC's fund balance
has ranged between 1.15 and 1.50 percent of total insured deposits. An analogous figure for SIPC is not readily
available, since there are no published
estimates of the aggregate value of
securities holdings for customers by all
SIPC members. A proxy for this figure
that may serve as an upper bound to
the insurance fund's exposure can be
constructed from data maintained by
the Depository Trust Company (DTC)
and the Federal Reserve System.
The Depository Trust Company is a
participant-owned corporation that
serves as a securities depository for a
major portion of the financial industry.
DTC is regulated by the SEC, the New
York State Banking Department, and
the Federal Reserve. DTC holds actual
securities and issues its own bookentry receipts for them. Exchanges of
DTC receipts facilitate the change of
ownership of securities. DTC also provides securities registration, or ownership information, to publicly traded
firms and to others. DTC traditionally
accepted only corporate bonds and
shares of stock for deposit. Since 1981,
however, its opera tions have been
expanded to include municipal bonds.
DTC maintains records of the value
of securities on deposit for its 357
broker-dealer participants. Similar
records are kept for banks (DTC's largest participant group) and for clearing
agencies. Presented in figure 3 are the
year-end balances (at market value) of
all corporate and municipal securities
held at DTC for nonbank brokerdealers. Because this aggregation does
not distinguish between securities held
for a broker-dealer's own account and
securities held for its customers, or
between the portion of customers'
securities that are insured and those
that exceed insurance limits, the
aggregation may overestimate SIPC's
exposure by an unknown amount.
Also shown in figure 3 are the yearend positions in U.S. Treasury securities and Federal Agency obligations
(most notably, mortgage-related securities) for the nonbank, non broker-dealers
designated as primary dealers by the

Figure 3
Nonbank dealer positions
billions of dollars

SIPC fund balance
millions of dollars

600.---------------------------,1,200
1,100
1,000
900
800
700
600
500
400
300
200
100

Municipals and corporates
plus agencies and treasuries

300
200
100
1975

1981 through 1986 in figure 4. In terms
of year-end levels, this six-year period
witnessed a quadrupling of the combined outstanding volume of these conBillions of dollars
tracts to more than $460 billion, raising
450~----------------------~
SIPC's potential exposure to over $1
trillion. Of course, these figures would
be somewhat greater if we included the
remaining SIPC members. Combining
Repurchase agreements
plus reverse repurchase
the estimates and assumptions assoagreements
ciated with these securities agreements
with the estimates and assumptions
previously advanced, it then appears
that SIPC's fund currently represents
coverage for only 0.03 percent of its
total potential exposure."
100
The implications of the repurchase
and reverse repurchase agreements rul50
ing for SIPC go beyond the absolute
1986 increase in exposure to the higher risks
1981
associated with these financial contracts. Poor record keeping and fraud
SOURCE: See text.
has led to several failures of unregulated government securities firms in
are "customers" entitled to SIPC prothe past.? Congress responded to these
tection. Although SIPC may appeal this conditions by imposing tighter regularuling, estimates of its current level of
tions on all government securities
exposure should be adjusted for the
firms, though several provisions of the
level of repurchase and reverse repurGovernment Securities Act of 1986
chase activity of its members.
have yet to be implemented.
Weekly averages of the level of repurThe recent emergence of a whole new
chase and reverse repurchase agreegeneration of financial instruments
ments, in terms of the value of securimay have further broadened the scope
ties used as collateral, are available for
of SIPC's liabilities. Many of these new
the nonbank primary dealers from the
instruments are of the so-called assetFederal Reserve Bank of New York.
backed variety, and cover such items as
The annual average levels of the two
types of agreements are presented for
Figure 4

1980

1985

o

SOURCE: See text.

Federal Reserve Bank of New York.
Although there were only 21 firms with
this particular designation (as of June
1986), they are among the largest
securities dealers. Primary dealers
facilitate the implementation of monetary policy through open-market operations in government securities and help
to underwrite the huge borrowing
needs of the federal government. Just
as with DTC's data, we cannot distinguish between holdings for customers
and positions taken for the primary
dealers' own trading accounts.
Estimates of non primary brokerdealer positions in government securities currently are not available. Several
recent failures of previously unregulated government securities dealers led
Congress to enact the Government
Securities Act of 1986, covering participants in this market.' As a result, a
large number of government securities
dealers will be required to register with
the SEC. At present, however, there is
no way of knowing just how many
firms will choose the registration
option that automatically would make
them members of SIPC, and that would
automatically increase the risk-level of
its insurance fund.
The past can provide a clue about the
potential increase in risk. The data at
our disposal indicate an almost
eighteen-fold increase in the potential
exposure of SIPC over an ll-year
period during which the SIPC insurance fund balance only quadrupled. It
should be noted that this period partially covered the planned buildup of
the SIPC fund to its old statutory min-

imum of $150 million. On the basis of
our estimates and assumptions, the
level of the SIPC fund at year-end 1986
represents only 0.06 percent of its
potential exposure.
Of special importance to this analysis
is the implication of last year's ruling
on the status of counterparties with
whom member firms have engaged in
repurchase and reverse repurchase
agreements. SIPC had considered such
counterparties general creditors
because repurchase and reverse repurchase agreements often are used by
broker-dealers as financing vehicles for
their securities inventories. In a typical
repurchase agreement, the brokerdealer sells selected securities to a
counterparty with an obligation to buy
(or repurchase) them at a later date at a
specified (higher) price. In essence, the
firm obtains a loan from the counterparty. The typical reverse repurchase
agreement has the broker-dealer purchase selected securities, hold them for
a short period, and then resell them to
the counterparty. This practice can be
interpreted as a short-term loan by the
firm to the counterparty.
Last year, however, a U.S. District
court in New Jersey held that these
agreements constitute contracts for the
sale and resale of securities. This
means that repurchase and reverse
repurchase agreement counterparties

7. See EJ. Stevens, "Seeking Safety," Economic
Commentary, Federal Reserve Bank of Cleveland,
April 15,
1987.

8. This and the earlier estimate should not be
interpreted as the author's appraisal of SIPC's
actual exposure. In the absence of detailed information, these figures are offered only to stirnulate discussion on this issue.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

9. Notably ESM Government Securities, Inc.; E.].
Stevens, op cit, lists all of them.

automobile receivables and credit card
payment obligations as well as
"stripped" securities, often applied to
mortgages and other debt instruments.
In most cases, these instruments are
obligations of the institution performing the securitization or stripping, and
lack the full backing of the underlying
issuer. Although these securities were
not included in our estimates of SIPC's
exposure, they too must be considered
in any discussion of the fund's adequacy and risks.
Conclusion
Several issues connected with SIPC are
worth considering. First, the nominal
level of its members' annual assessment
may result in the slow depletion of its
insurance fund-especially
in view of
the corporation's payout experience.
Second, considering the current size
of the securities industry and the
nature of some of SIPC's new exposures, the statutory $250 million minimum level of its insurance fund is
probably too low.
Third, in the event of severe losses in
the securities industry, it is quite possible that SIPC would be unable to
meet its insurance obligations. In that
event, the federal government most
likely would step in to assist investors,
even possibly shifting some of the
financial burden to taxpayers.
The urgency of addressing these
problems, however, rests on certain
assumptions about the proper role of
investor protection and the extent of
appropriate government involvement in
it. These are issues that sooner or later
must be addressed by the securities
industry and our nation's legislators.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Address Correction
Requested:
Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
PO. Box 6387,
Cleveland, OH 44101.