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Do you hold some of
your investments at home (or perhaps in a bank safety deposit box) in the form
of traditional certificates in paper form? Perhaps your investments are held on
your behalf by your broker in so-called street
form. In the first commentary
in this series we compared holding your securities in paper form versus in
street form. Both alternatives have
advantages but also some disadvantages for individual investors. You may not be
aware of an emerging third alternative way to hold your investments called DRS
for direct registration system. We will now describe the DRS alternative which
can be advantageous to many investors, even though the Canadian financial
system does little to promote it or even to bring to the attention of retail
investors, and Canadian regulators have chosen to date to leave it unregulated.
The
ideal system from an investor perspective
Before discussing
DRS, let us begin by describing the ideal system that
investors could use to safeguard their securities:
1-Cheap-
Readers of our
site know our mantra - the only thing investors can control are their investment costs, so
minimizing initial set-up and ongoing costs are an important factor for us. Going
paperless reduces costs:
The Canadian stock
transfer association has estimated that transfer agent processing costs of a paperless
transfer compared to an equivalent certificated transfer is estimated to be 40%
to 60% less than the comparable process of a paper-based transaction. STAC SEC
letter or as a PDF doc.2202. And CDS, the Canadian
central clearing agency, describes paper transfers as an outdated "tradition”. See
CDS
or as a PDF
doc.2192.
2-Safe
(physical and electronic loss risk
A safekeeping system
should minimize risk of physical loss of your investments, for example through
theft, flooding, fraud or fire. In this category we would throw in losses due
to unauthorized electronic access to securities in paperless form.
3-Safe
(insolvency risk)
Here we are
concerned by the impact on you of the insolvency of the entity where you have
placed your investments, whether that be your local bank or your investment
dealer.
4-Liquidity
A safekeeping
system should offer easy, timely access to locate your investments, which you
will generally only do for purpose of disposing of them.
5- Convenient
access to income
A system
should facilitate easy access to income generated by your investments.
6-Convenient
access to add to your holdings
This is most obvious
where you hold shares and wish to add to your holdings through additional
purchases including but not limited to the automatic reinvestment of dividends.
7- Under my control (what is called the touch factor *)
Finally, as
do-it-yourself investors, the ideal system should permit as direct an access and control as possible. By direct we also mean an access without being subject
to theview of your financial intermediary except when you so wish. Who has not had the
(disagreeable) experience of withdrawing a sizeable amount from your bank
account, and having the teller inquire what the purpose of your withdrawal is,
and whether you have you considered the bank’s investment products.
The principal advantage of
holding a certificate is that you can take the asset with you.Registered certificates
that are placed in “negotiable” form are another form of portability to avoid detection of
ownership. There are always those, for various reasons, who wish to keep their ownership of certain
assets private and portable. ….. Electronic ownership in nominee or DRS (both
have an electronic trail back to the beneficial owner) enhances
portability and provides investor choice over the degree of privacy. STAC
or as a PDF doc.2202.
*See InformedTrades
video.
Regrettably no
system fully meets all these criteria. This said, let us now assess the traditional
ways of holding our securities against these criteria.
Disadvantages
of the traditional ways to hold your investments
In our previous
commentary we compared holding your securities in
paper form versus in street form.
Worrying about losing
the paper certificates evidencing their investments is enough for most people
to not keep traditional certificates in paper form. But keeping them in street
form also has some features that some investors may find objectionable. The two
most obvious are intermediary risk and
lack of separation:
Intermediary risk
What do we mean by intermediary risk? In street form your ownership is no longer
direct. It now depends on the broker correctly recording your ownership in its
accounting records, not improperly dealing with your investment, and in the
worse case not going bust. In the bankruptcy scenario you will be dependent on
the financial ability of the local industry protection fund to make you and other
clients of the broker whole. We have looked in detail at this issue recently (
see Your
investment dealer goes bankrupt- part 3- preventive measures ) and while the risk is very low, given the
lack of a government –run plan protecting investors against broker insolvency (similar
to deposit insurance), it is not NIL. This may bother some very risk-adverse
investors:
Here is how US investors in DRS are
protected:
Since
the direct registration puts shares in your name, rather in street name, these
investors feel that this gives them greater protection against a brokerage
collapse in which client assets turn out to be missing. This concern has become
much more widespread since the failure of MF
Global. The International Investor
description of DRS or as a PDF doc.2185
Robert Malcolm of Computershare explained to us that DRS in Canada
operates in much the same way:
Securities
in DRS not subject to broker insolvency risk?-correct, as they are registered
to the holder and therefore are not being held by the broker. Although any
reputable broker is insured and the holder therefore covered up to a certain
amount in the case of insolvency. See also Contrarian Investor or as a
PDF doc.2171.
Lack of separation
What we call lack of separation has 2 aspects.
-
First, full service brokers like to have all or most of
your investments on deposit with them for at least three reasons. It gives them
a good overall picture of their clients’ financial situation, and therefore puts
them in a position to give better, more personalized advice. In addition, if
securities are to be sold quickly the fact they are already held by the broker
accelerates the process. Finally, cash from securities on deposit with your
broker (e.g. dividends, interest, sales proceeds) is automatically deposited to
your broker’s account, and available for re-investment.
- But there is a flip-side to this. Many do-it-yourself
investors are not comfortable with their full service broker having this much knowledge or control
over their affairs. Many investors (probably well over 50%) use more than one
broker, and do not necessarily want to centralize their investments at one
broker. They may not appreciate calls from their broker every time they have
accumulated enough cash to make new investments. Often they prefer that their
cash proceeds be automatically deposited to their bank account rather than into their broker account where
they have to request that the money be sent to them and often to explain to
their sometimes too-inquisitive broker what they are intending to use what
after-all is their money.
There is an
alternative system that is available to address these disadvantages for some,
but not all, types of investments: DRS or direct registration system.
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