Sovereign Man Notes From The Field By Simon Black
March 9, 2016 Sydney, Australia
This Bizarre Rule In The US Is A Huge Risk To Your Investments
Human beings have come up with some crazy ideas for money and finance over the years.
Conch shells. Beads. Animal skins. Salt. Rice. All of these were used as a form of money at one time or another.
But the strangest by far has got to be the Rai Stones of Yap Island.
Yap is a tiny speck in the western Pacific, a few hours by plane from the Philippines and Guam.
Long ago, islanders began using gigantic limestone discs called Rai Stones as a form of money
Rai Stones were large-- the size of a mid-sized car-- so they were seldom moved.
And they could be anywhere… at the bottom of the ocean, in the middle of the jungle.
So rather than roll your Rai Stones down to a local bank, or pile them up in the back yard, everyone on the island just sort of knew who owned which Rai Stones.
And whenever there was a transaction, word got around that ownership of a particular Rai Stone had changed hands.
It was crude, but it worked.
This is the hallmark of any well-functioning financial system: the ability to properly account for private property ownership.
Think about it-- when you buy a house, there’s a deed that’s recorded in the local clerk’s office. When you buy a car, a certificate of title is issued.
This makes the chain of ownership very clear and unmistakable. You know with 100% certainty that whatever you buy is exclusively yours.
But strangely enough, this isn’t the way it works when you buy stocks in the Land of the Free.
There’s a concept in the US financial system called “Street Name Registration”.
This means that when you open a brokerage account and buy shares of Apple, your broker registers those shares in THEIR name, not yours.
In other words, your broker officially owns the shares.
On their internal books, the broker maintains a liability that they owe you the shares. But the Apple stock isn’t your asset. It’s the broker’s.
The reason they do this is convenience. It’s easier for them to buy and sell stock on your behalf if the shares are held in their name.
This strikes me as totally ludicrous.
Imagine if when you buy a new car the dealer registered the title in HIS name instead of yours; or if your home was held in the name of your real estate broker.
This makes no sense. Financial securities should work like any other asset: when you buy it, it’s yours. Simple.
That's how it works here in Australia, where they have a system of direct ownership; it’s called the Clearing House Electronic Sub-register System, or CHESS.
That’s a fancy way of saying that, in Australia, when you buy or sell stocks, ownership of the shares passes to you directly.
The database is maintained electronically, and brokers have no control over these records.
This ensures there is no feckless intermediary standing between you and your assets.
It’s such an easy concept-- to actually own the stocks that you buy. But that’s not the way the financial system is set up in the US.
The even bigger issue is that Street Name Registration in the US leads to serious problems whenever there’s financial turmoil.
Banks and brokers have a bad habit of ‘borrowing’ from their customers. They call it ‘hypothecation’ and ‘re-hypothecation’.
Essentially, brokers routinely take the shares that they’ve purchased on your behalf (and registered in their own name) and pledge them as collateral in other deals over and over again to boost their profits.
Assuming everything else goes OK, problems seldom arise.
But as soon as the financial system hits a speed bump (like it did in 2008), it can get very bloody for the original investor who put up the money.
Bottom line, you might not own what you think you own.
And given all the serious challenges facing the financial system, it makes sense to pay attention to how your investments are registered.
It may be worth checking with your broker to see if you can do ‘direct name registration’, whereby they re-title the investments in your own name.
This would help ensure that if your broker ever ran into trouble down the road, you would still have control of your assets.
You might also want to consider investing in better jurisdictions like Australia where you can have a lot more certainty over the assets that you own.
Besides, there are plenty of great investment opportunities down here.
The Australian dollar is at a multi-year low against the absurdly overvalued US dollar. So assets are already quite cheap.
Besides, the commodity recession has pushed valuations so low that many Australian companies are trading for less than the amount of cash they have in the bank.
This has been a winning investment strategy for us (and premium members), with returns in excess of 30%. More on this another time.
Simon Black Founder, SovereignMan.com