Sunday, May 17, 2009

The mechanics of buying stocks

Most of us receive regular statements from our stockbrokers telling us what stocks we own. But what happens if your broker goes bankrupt; will you lose all your shares? For legal and practical reasons, few people have physical stock certificates today. So how do you prove that you own your stocks if your broker goes bust, or makes a mistake?

Here's what actually happens when a stock trades, and how you can protect yourself from losing your stocks:

How the ownership of a stock changes during a trade

When you buy stocks, you're actually triggering off a long chain of activity in the financial system. But your broker is probably the only party that you deal with. Here's what happens:

(click on the image to expand it)

1. When you instruct your broker to buy a stock, your broker will go out to look for people who are willing the sell the stock you want. This could be someone else who has told the broker that he wants to sell that stock; in which case the broker would simply "transfer" the stock to you at the agreed price. More likely, the broker would have to get in touch with other brokers to find the stocks you want. This can be through a stock exchange such as the NYSE, where all trades and their clearing prices are made known to the public. Or, it could be through a network of brokers who have come together to trade. Such networks are known as Alternative Trading Systems. In general, the SEC regulates where public listed stocks may be traded, with the objective of minimizing fraud and creating a fair market for all parties. Once a willing buyer and seller are found, they are matched and the trade takes place. So far, the actual stocks haven't been transferred to you yet. Rather, you just have a confirmation that the buy trade was carried out.

2. The next thing that happens is the settlement process. This is where the stocks you bought actually get "delivered" to you. In the past, all stocks were held in certificate form. If you owned 100 shares of Company X, you would have a stock certificate which said just that. This was an extremely important piece of paper, because it was like cash in the sense that if you lost it, you lost your stocks. The stock broker would literally get the stock certificate from the seller (or the seller's broker) and hand the certificates to you in exchange for a cash payment. Some people would keep their stock certificates in a bank vault, others would keep them with a custodian in a custodial account, and yet others would leave them with the broker so that they could be easily sold later on.

The paperless settlment process today
- Stocks are often held in the broker's accounts

However today, most countries operate a paperless stocks system, in which no paper certificates are transferred between sellers and buyers. Instead, ownership of a stock is recorded in the books of various parties in the financial system. When you buy a stock, there is no paper certificate that gets transferred to you. Rather, a book entry (or many book entries) is made to say that the stocks have been transferred from the seller's account to yours.

At the heart of the system is a depository institution (for example, the Depository Trust and Clearing Corporation (DTCC) in the United States, or the CDP in Singapore). All brokers open an account with the depository institution and "deposit their stocks" there. After a trade, the buying and selling brokers will notify the depository that the ownership of the stock that was traded should be changed. The depository institution will then updates its books to move the ownership of the stocks have from the selling broker to the buying broker. It also manages the transfer of payments between brokers, and minimizes counterparty risk through various guarantees and insurance schemes.

The depository institution may notify the company (whose stock was traded) about the change in ownership of stock. All listed companies keep track of their stock holders in a "register of stockholders". It lists all the people who own the company's stock, and allows the company to know who to send dividends to, and who to notify in the event there are corporate actions which require a shareholder vote. In many cases, the company will outsource the work of maintaining the shareholder register to a stock transfer agent, such as Computerserve. (The transfer agent can do other things too, like manage dividend distributions, issue share certificates, and more. Stock transfer agents are also known as share registrars in some countries)

In practice, depository institutions and the settlement system is different from country to country. For example, the DTCC can also act as a custodian. Likewise, many brokers also offer custodial services, especially for foreign shares which you purchase through them. They may in turn, use other custodians (through sub-custodial accounts) and brokers in other countries to carry out your foreign trades. The way the DTC in the United States works is described here:

You'll notice that so far, the stocks aren't registered in the name of the person buying the stock. Instead, the stocks are usually held in the name of the broker. This is known as holding your stocks "in street name", because for all appearances to the rest of the world, it is your broker who owns the stocks. It is only in your broker's books that an entry is made to say that the stocks belong to you, to make you the "beneficial owner". Many people do this, because it makes it easier to get the broker to sell the stock later on.

So do you legally own the shares?
- No, but the law does offer some protection against broker misbehavior

Strictly speaking, you are the legal owner in the eyes of the company (that you invested in) only if you have registered your stock with a company's stock transfer agent and appear on the company's shareholder register. Otherwise, the securities technically belong to the brokerage firm or the custodian bank. So in general, it is important to use reputable and financially sound brokerage firms and custodians. Simply going for the cheapest broker isn't necessarily the wisest course of action.

Nonetheless, the Securities Investor Protection Act of 1970 does offer some protection to investors in the United States. It empowers the Securities Investor Protection Corporation to offer compensation to investors in the event a brokerage company fails. However, it is not a general insurance fund like what the FDIC does for savings accounts. Notably, it does not compensate investors if there is investment fraud or if your broker simply makes a mistake in executing your trade.

How to get yourself registered as the legal owner
- and protect yourself from broker failure

However, you can always ask for the stocks to be registered in your name in the company's register of stockholders. If you ask, most publically listed companies will explain to you how you can contact their stock transfer agent and get your stocks transferred from your broker's name to your name. The benefit of this is that you won't have to worry that you'll lose your stocks if your broker goes bust, or if some massive fraud is taking place at your broker's office. The downside is that it becomes much harder to sell your stock. To sell your stock, you'll need to tell the stock transfer agent to transfer ownership of the stock to your broker, then ask your broker to sell the stocks for you. Brokers often charge extra for this service, because of the hassle of deregistering them from your name on the stockholder register.

Some buyers, especially large institutional player like mutual fund managers, will ask their brokers to transfer ownership of the stocks to custodian banks, like State Street, instead of registering the stocks directly in their name with the stock transfer agent. They do this to use the services which the custodian banks provide, such as portfolio management and reporting. The separation of duties between trading (the broker) and holding inventory (the custodian bank) also reduces the chances of fraudulent activity. For example, with this separation of duties, it would be difficult for a broker to take money from the buyer without actually buying the securities it was supposed to buy.

Bottom Line: How to protect your right of ownership

The bottom line is, if you are investing a significant sum of money, go with an established and reputable brokerage. That way the probability of the broker failing to make good on its mistakes (or the possibility of fraud) should be lower.

If you intend to hold your stock for a long time, then consider having it registered with the company's stock transfer agent. That way, you will be officially recognized as being an owner of the company. 

[ You might wonder how depository institutions, custodians, and brokers identify the thousands of stocks that are traded. Wouldn't there be confusion especially since many companies trade on different exchanges? Fortunately, the industry has standardized on the use of a unique CUSIP/ISIN number for each security. This makes it possible to clearly identify a particular security.]

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