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Securities ledgers are highly specialized accounting systems used by broker-dealers to control securities held for the account of clients or in their own portfolios. These ledgers track the location and ownership of securities from initial purchase, through clearings and settlement, to placement in central depositories, as well as other operations.
By understanding the mechanics of securities ledgers, you can better interpret what your brokerage account statement means. Many investors will be surprised.
The rules
The rules for a securities ledger systems are as follows:
- One ledger is set up for each different type of security held in custody. If there are 10,000 types of securities in custody, there should be 10,000 separate ledger systems.
- Each security ledger is a dual entry accounting system.
- The values posted to securities ledgers are not currency, but number of securities.
- The accounts on the debit side of the ledger show the names of owners of that security (which would include the firm itself, clients’ accounts, and other brokers, pending settlement) and the number of securities owned.
- The accounts on the credit side of the ledger show locations of the securities in custody, which may include the firm’s own safes and vaults, central custodians, as collateral with other brokers, in transit, or securities not yet delivered by the counterparty to a trade.
- Total debits and credits in each ledger must balance.
- The securities registered are fungible, which means that they are held in common (like bushels of wheat in a silo, represented by commodity receipts) and are not assigned to specific owners. (The implications of ‘fungibility’ vary between jurisdictions.)
- Securities ledgers must be balanced each day and reconciled through a sophisticated ‘interlock’ system with cash transaction accounts of the firm.
Bookkeeping machines in the mid-20th century.
- Because securities ledgers register the number of securities rather than monetary amounts, and because they are a non-monetary subsidiary ledger, the value of securities in custody does not appear on the financial statement of the broker-dealer. Nevertheless, for most broker-dealers, securities held in custody represent, by far, the largest financial obligation of the firm — information that is hidden from clients by the rules of generally accepted accounting practices.
The evolution of securities ledgers
In the mid-20th century, most securities held in custody with broker-dealers were in certificate form, usually registered in the name of the broker-dealer (i.e., a “street name”).
Securities ledgers were actual paper records, posted by clerks by hand.
Vaults like these are no longer needed to store securities in book-entry form.
Today, most securities are represented by jumbo certificates held in the name of a nominee for a central depository. In many countries, there are no certificates at all — only documents confirming that the securities are held in ‘book-entry form’ at a central depository.
Often the entire system, both ledgers and backup documentation, is entirely in digital form.
In some jurisdictions, the securities ledgers are not located with the broker-dealers, but with a central clearinghouse or custodian.
Securities ledgers are now electronic, posted and managed by sophisticated software that handles not only the movement of securities between owners and locations, but also the payment of dividends and interest, distribution of annual reports, processing of proxies, stock splits, the exercising of preemptive rights, redemptions, payments on bonds, and many other corporate actions.
Most securities are now held in electronic form in data centers like these.
Most importantly, these software programs print monthly statements for clients and provide an online interface for customers to check positions at any time via the Internet.
Modern electronic securities ledgers also handle the approval of credit and the authorization of transactions, margin accounts, and the borrowing and lending of securities.
If you are able to visit the custody section of a modern broker-dealer, you will probably not find a vault full of certificates and clerks posting entries on paper ledgers. Instead, you would find a computer complex with data coming and going through high speed cables.
In other words, your life savings exist only in cyberspace. If something happens to tear the invisible and tenuous fabric of this cyberspace, you may find yourself significantly poorer.
Keeping securities ledgers safe
If securities ledgers are lost or destroyed, and if clients’ statements are also missing, it may be difficult or impossible to determine the ownership of securities held with a broker-dealer.
Many brokers ask clients for permission not to send monthly statements in paper form. This is a very bad idea, both for the client and the broker. If a client depends upon the electronic records of a broker and these are destroyed, there may be no way to prove ownership and make a legal claim for the recovery of assets.
Cyber warfare training, US Navy, Pearl City, Hawaii
In the mid-20th century, when both securities and securities ledgers were in paper form, these documents could be stored in fire-proof vaults.
Today, with electronic records and book-entry ownership of securities, extraordinary measures must be taken to safeguard these records, not only against fire and physical damage, but against computer viruses, hackers, electronic sabotage, or the dangers of electronic or atomic warfare.
Terrible vulnerability
Terrorists that gain access to the security ledgers of a major financial institution — especially an institution that has weak internal controls and disaster recovery procedures — such an adversary could wreak terrible damage not only on the lives and fortunes of investors, but also on the economic stability of an entire country.
A terrorist could pose as a computer specialist to infiltrate the system.
A well-managed custodian will have daily backups of securities records stored safely in off-site locations — ideally in far distant states, underground — supported by well-designed systems for audit and control.
Unfortunately, most broker-dealers do not provide clients with information as to the security of their electronic records. The US SEC does little to monitor this essential aspect of customer protection. Nor do normal auditing procedures of broker-dealers provide clients with a report on the security of assets held in custody.
How an account statement misleads
Most investors think that if they have an account statement from their broker indicating that they own 100 shares of IBM Corporation that, in fact, the broker has the client’s 100 shares of IBM in custody.
With this understanding, it wouldn’t matter if the broker were to go bankrupt, because the client’s shares would be in the broker’s vault, held in custody, just awaiting to be delivered to the client by the administrator of the bankruptcy proceedings.
The days of stock certificates held in custody are long gone.
Unfortunately, this is not the case.
What the account statement really means is that the broker acknowledges the responsibility to deliver 100 shares of IBM to the client, on demand — not that the broker actually has these shares in custody or under his control.
In fact, the shares may not yet have been delivered from another broker, who may or many not have the shares in question.
It is even possible that the broker that ‘failed to deliver’ has gone bankrupt and will never deliver. The actual shares may, in fact, not even exist anywhere in the system.
When a broker goes bankrupt
Ordinarily, if the client in the above example had asked broker A to deliver the 100 shares of IBM that broker A had not yet received from broker B — broker A would simply go into the market, using the broker’s own resources, and buy the 100 shares of IBM to deliver to the client.
When a once-mighty investment bank fails, the sight is not pretty.
The client would never even be aware of this transaction.
If, however, broker A has gone bankrupt, broker A would not be able to access funds needed to buy the missing 100 IBM shares (unless the bankruptcy administrator were to agree).
The client would not get his shares immediately — in fact, the client may never get these shares nor any payment in lieu of the shares.
Securities Transfer Law
As if securities ledgers and accompanying software systems were not sufficiently complicated, the laws and regulations that govern the custody and transfer of securities and associated administrative services are even more complex.
The tender mercies of securities lawyers are to be avoided at all costs ...
Worst still, securities markets are now global and the international tangle of conflicting laws and regulations, as well as different contractual terms and conditions of multiple clearinghouses and central custodians operating in different legal jurisdictions, lays a mine field of traps and pitfalls that defy comprehension of ordinary investors and most broker-dealers.
The union of the New York Stock Exchange with Euronext, and the association of NASDAQ with the OMX Group, combined with the promotion of cross-border trading and investment, means that the bankruptcy of even a modest-size broker-dealer in Europe or the United States may bring unpleasant legal news to ordinary investors with securities in custody.
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