Since the product was announced on Thursday I’ve been following with interest the drama surrounding Robinhood’s “Checking and Savings” product, which has since been put on hold and rebranded as a “Cash Management” account. It’s an interesting story about the brokerage and banking industries, and I think it’s possible at this point to piece together what Robinhood was thinking, and what went wrong.
Cash in brokerage accounts absolutely is insured by SIPC
This is something a lot of people seemed to get hung up on in the early stages of the drama, but Robinhood was 100% correct that cash deposits with a SIPC-insured brokerage are insured by SIPC up to $250,000.
Doctor of Credit’s early take on this was that SIPC insurance might somehow be less trustworthy than FDIC insurance, but there’s no reason to believe that’s the case. Essentially 100% (“well over 99%”) of SIPC-insured claims have been paid in full over the 45 years the program has been in existence.
Despite the now-famous quote from the chairman of SIPC, it’s totally normal and legal for brokerage accounts to hold cash. If you own dividend-paying stocks or ETF’s in your Robinhood account, the dividends are paid out in cash and deposited in your Robinhood account as cash. No one has ever questioned, nor would it occur to them to question, whether those cash holdings are SIPC-insured in full up to $250,000.
But most brokerage accounts hold very little cash
Back in August Jason Zweig wrote usefully about how brokerages handle idle cash. Best-in-class firms like Vanguard sweep idle cash into a money market fund like the Vanguard Federal Money Market Fund, which currently has an SEC yield of 2.24%.
Interactive Brokers, a popular choice for active traders, currently pays 1.69% on idle cash balances above $10,000, but only for accounts with a net asset value above $100,000.
As Zweig explains, even less scrupulous firms sweep idle cash balances into accounts with partner banks, where the cash is FDIC-insured but earns virtually nothing in interest, with the bank and brokerage splitting the difference between prevailing interest rates and what they pay out to customers. This is how Fidelity Cash Management accounts work, which currently share just 0.31% in annual interest with accountholders.
Money market funds are neither fish nor fowl
Money market funds are interesting because they have characteristics of both mutual funds and bank deposits. Like open-ended mutual funds, they collect money and issue shares, and are priced based on their net asset value. But like bank deposits, they seek to maintain a price per share of exactly $1. In order to achieve this, they hold very short-term, government-backed assets, precisely the kind of assets Robinhood promised to invest in.
Figuratively speaking, they use the interest from those securities to “top up” the value of shares, and pay out any excess interest as dividends in order to maintain the value of each share at $1.
Most importantly for our purposes, until 2008, money market mutual funds were not FDIC-insured, and since they were securities, their value was not insured by SIPC either. To be clear, the securities themselves were insured (so your broker couldn’t run off with your money market fund shares), but if their value dropped below $1 per share, you were out of luck. Investing involves risk: it’s a cliche for a reason.
Money market funds were more vulnerable than people thought
And indeed, that’s just what happened in 2008, when the system broke down after the Primary Fund “broke the buck” by reporting a share price below $1.
This posed a catastrophic risk to the financial system: for years, investors had been encouraged to invest their cash in supposedly-safe money market funds instead of ordinary bank accounts or certificates of deposit in order to earn perhaps another 0.5% in interest on their balances. But if money market funds were no longer safe from market volatility, what was the point in holding them? The threat was a flood out of money market funds, a collapse in the price of short-term securities, and a spike in interest rates at the very moment they would do the most damage to the economy.
In response the federal government stepped in, temporarily extended FDIC insurance to money market funds, and provided unlimited liquidity to the financial system. The day was saved.
What Robinhood could have done
All this background is meant to illustrate the options Robinhood had available:
- they could have contracted with a bank to sweep idle cash into an FDIC-insured deposit account and passed along the interest to their customers. If they wanted to be “good guys,” they could have passed along their entire share of the interest, which might add up to as much as 1.5% if they partnered with a particularly good bank or banks;
- they could have chartered a bank and swept idle cash into accounts at their own in-house bank, paying out as high an interest rate to their customers as their lending was able to support;
- they could have contracted with a mutual fund company like Fidelity or Charles Schwab to sweep idle cash into a third-party money market mutual fund;
- they could have registered their own money market mutual fund and swept idle cash into it, as Vanguard does.
Each of these options has advantages and disadvantages. But the disadvantage they all have in common is that they’re expensive. Using an outside bank or mutual fund means you don’t have any more interest to pay your customers than the outside firm is willing to share with you. Using an in-house bank or mutual fund would provide more flexibility but incur vastly higher start-up and regulatory costs, not something that appeals to an asset-light startup like Robinhood.
What Robinhood was thinking
So, they got clever. If they could create an account under the auspices of their brokerage, then the cash would be SIPC-insured just as it is today. Short-term treasury rates aren’t quite at 3% yet, but you could imagine a blend of short- and long-term treasuries that gets you within spitting distance, which you could then top up with MasterCard interchange fees from the debit card and your investors’ capital as needed, at least until it ran out.
Put this way, you can see why the CEO of SIPC was skeptical of the project: if Robinhood wants to guarantee the value of deposits from loss, then they need a bank charter and FDIC insurance, while if they want to pass along the performance of actual securities then the money is being invested and the SIPC doesn’t insure the value of investments from losses.
There are two ways to think about the interest a depositor receives. On the one hand, it’s the price banks pay for the money they need to lend out: a bank is willing to pay depositors 3% on a 10-year CD if it can loan out that money at 5%.
The other way to think about the interest a depositor receives is that it’s “what’s left over.” A bank that lends out money at 5% and pays 3% of that in broker commissions and overhead only has 2% left to pay to depositors.
As a thought exercise, forget the 3% offered by Robinhood. Why doesn’t some bank decide to pay depositors 10% on their balances? They’d immediately attract hundreds of millions of dollars in deposits and become one of the largest banks overnight, crushing their competitors.
Well, it’s because no bank has 10% left over after expenses. Any bank that tried it would immediately deplete their capital reserves and the FDIC would have to step in to bail out their customers.
Whom amongst us doesn’t have a brilliant strategy to turn a small fortune into a large fortune? If Robinhood thinks they can return 3% to depositors after paying their expenses and providing their investors with an expected return on capital, they’re welcome to try.