Will rising interest rates spark SEC crackdown?

Some broker-dealers are 'in a bit of a pickle' due to how they invested client cash, industry executive says.

The revenue that broker-dealers generate from client cash is turning into a double-edged sword: a benefit to firms in the current rising interest-rate market but also a concern as regulators ask questions about firms’ cash sweep accounts.

Broker-dealers profit from cash held in client accounts, margin loans used to buy more securities and banking activity in general. And now that interest rates have spiked from near zero at the start of 2022 to more than 5%, the Securities and Exchange Commission has started making inquiries about whether firms are maximizing returns on client cash in advisory accounts.

Wells Fargo & Co. revealed last month that it was facing an “advisory account cash sweep investigation” by SEC, and that the commission “has undertaken an investigation regarding the cash sweep options that the company provides to investment advisory clients at account opening.”

The SEC has been focused on cash sweep account options for the past few years and has reached sizable settlements regarding the issue, most notably with Charles Schwab Corp. last year for $187 million.

According to the SEC, from 2015 to 2018, Schwab made money from the cash allocations in its robo-adviser portfolios by sweeping the cash to its affiliate bank, loaning it out, and then keeping the difference between the interest it earned on the loans and what it paid in interest to the robo-adviser clients.

Clients haven’t made money from interest on cash held in brokerage and advisory accounts since the credit crisis in 2008, but that’s changing. In late November, InvestmentNews sat down with Steve Sanders, executive vice president of marketing and product development at Interactive Brokers, to discuss how firms and financial advisors are handling client cash.

“The SEC and regulators in the banking industry might be interested in the same thing,” Sanders said. “If Treasury yields and interest rates are high, at 5% or higher, why are the brokers paying their clients next to nothing on their cash?

“These brokers, because of the way they funded, are in a bit of a pickle because they have client cash invested and perhaps yielding at 1% or 2%,” Sanders said. “So how do you pay out your clients 4.83%, which is what Interactive Brokers is paying on cash, when you’re only earning 1% or 2%? It’s a real problem.”

Financial advisors, of course, can use different vehicles for client cash other than what their broker-dealer offers, but shopping around and performing due diligence on various money market funds or Treasury bills is time-consuming and requires constant monitoring, noted Sanders, who has worked at Interactive Brokers for more than 22 years.

“If the SEC does crack down, firms will probably have to bite the bullet and take a loss,” he said. “If an advisor or a broker brings their business to Interactive Brokers, they will automatically get that interest rate.”

The firm calculates the yield on cash by subtracting 50 basis points from the fed funds rate, he said.

When interest rates were near zero prior to 2022, some broker-dealers looked to profit by investing cash in longer-term, higher-yielding securities and locked themselves into those investments for two to five years, Sanders said. That’s contributing to the problem preventing firms from paying yields on client cash closer to today’s short-term interest rate of above 5%.

“Those firms can’t get out of this without paying a penalty, and they’re earning a lot less on cash right now,” Sanders said. “That hinders them from offering a higher yield, because if they did, those firms would be paying out to clients more than they’re earning on the invested funds.”

“We never played that trick,” he added. “And we got beat up by the analysts for that in the past.”