Warning Sign: If Your Advisor Does Not Have a Clearinghouse

Here’s a riddle: What did scam artist Bernard Madoff lack, other than a conscience? Answer: a clearinghouse. This little-known entity is vital to your investment portfolio. If your advisor doesn’t have one, be very afraid.

Investors should ask their advisors about clearinghouses. Checking this is akin to what a homeowner does when hiring a roofer: Making sure that the contactor is licensed and has a surety bond. Clients must receive written information about clearinghouses, according to federal regulations. Many, unfortunately, do not pay attention to these disclosures.

Much of the advisor world that manages investor money farms out the back-office work to third parties because it is too much of a headache to do in-house. These little-known backstops of the brokerage industry hold your portfolio, take your investment dollars, send out statements and do all the other administrative tasks you need – and they do them independent of your broker. Clients make out investment checks to the clearing firms, not the advisors.

For fee-only advisors, at least those who run clients’ money, these third-party organizations are called custodians, but they perform the same service.

Madoff did not have a clearinghouse. He told clients that he handled clearing chores himself. Because he had custody of his clients’ money, Madoff could perpetrate his fraud with no one checking on his actions. “Madoff got away with his Ponzi scheme because he didn’t have someone else taking care” of the clients’ holdings, notes Bill Coppel, chief client growth officer at St. Louis-based First Clearing, an affiliate of Wells Fargo and one of the leading clearinghouses.

Clearinghouses that are part of major banks, such as Wells Fargo, JP Morgan Chase and Bank of America, cover at least half of U.S. brokerage money. They have been around for a long time, first appearing around 150 years ago. One notable clearinghouse, Pershing, started in 1939, focused on serving U.S. regional financial firms – meaning, firms outside of New York – and now operates around the globe. It is a unit of BNY Mellon.

Custodians do the same job for fee-only advisors who run people’s portfolios. (Some fee-only types don’t manage your portfolio: They give advice on what to hold, and leave the rest to you.) Among the leaders in the custodian field are Fidelity, Pershing, TD Ameritrade, Charles Schwab and Raymond James.

Giants, like Morgan Stanley and Bank of America’s Merrill Lynch, take care of their own clearing. But unlike Madoff, these huge firms operate under strict regulation. To be what’s called “self-clearing,” they must set up separate entities to guard clients’ assets, complete with capital set aside to cover problems.

Regardless of how it is set up, you owe it to yourself to ensure that your advisor has a stand-alone clearing operation. That’s the first step to Madoff-proof yourself.

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