Wealth management firms are under growing pressure from regulators, litigators and their own advisors regarding the treatment of client cash held in sweep accounts.
In the past few months, major wirehouse firms including Morgan Stanley and Wells Fargo have been sued by clients who say that the firms used customers' cash balances to enrich themselves at clients' expense.
At the same time, regulatory filings suggest that the Securities and Exchange Commission is looking into the interest rates that brokerages pay customers on uninvested cash swept into bank accounts.
Against this backdrop, a detailed new report from Moody's warns that rising attention on cash sweep programs is "credit negative" for wealth managers because it could lower their spread-based revenue earned on clients' uninvested cash balances — while increasing legal and regulatory compliance costs.
Cash sweep revenue is particularly profitable for wealth managers because it typically does not accrue financial advisor compensation. Highly leveraged wealth managers face the greatest competitive risk from an increase in rates paid to clients and a corresponding decline in revenue, according to Moody's.
"Wealth managers regularly review and compare their rates paid to clients with what competitors are offering, and any moves by larger firms to shift to more favorable client rates will likely drive similar shifts across the industry, posing particular risk for highly leveraged firms," the report warns.
Regulatory risk is "less prominent" overall, although the scope may be widening.
"Wealth managers have operated cash sweep programs across several interest rate cycles without significant adverse regulatory actions," the report notes. "Regulators have generally limited their focus to ensuring proper disclosures to clients about options for their uninvested cash and the potential conflicts of interest posed by these arrangements."
However, the uptick in litigation and regulatory activities may bring fiduciary and best interest standards into the spotlight.
No new regulation has yet been proposed, and wealth managers with appropriate disclosures have a case to defend their current cash sweep practices. Nonetheless, Moody's warns, firms may very well end up yielding to competitive forces and offering higher rates, as well as incurring increased regulatory compliance costs.
How Cash Sweep Programs Work
A cash sweep program is a method used by wealth management firms to manage clients' cash balances, the report explains. Cash balances in these programs are typically transactional or transitory and do not represent cash as an investment or asset allocation decision.
The typical program automatically sweeps investors' idle cash out of their accounts on a daily basis, according to Moody's, depositing the balances in accounts at partner banks.
"Upon account opening, clients are shown this default option, but in some cases, depending on the product and the firm, clients have the opportunity to elect another vehicle for their transactional cash," the report explains.
These alternatives generally include taxable or tax-exempt money market funds or other non-bank options. As interest rates have increased, so has the relative attractiveness of such options relative to the default low-yield bank accounts.
