Investors who hold paper stocks or who participate in dividend reinvestment programs (DRIPs) will often encounter DRSs. Learn more about what the DRS involves.
The Direct Registration System
New investors often invest in stocks through a brokerage account. Your shares of stock are registered in a street name when you place a trade order. The stock then appears in your account. If you own 1,000 shares of Company XYZ, your shares would be pooled with all of your brokerage’s other clients who own shares of XYZ. It’s reported on the books of XYZ’s transfer agent under the name of your brokerage. But investors become concerned about claiming their portfolios in case their brokers were to go under. The DRS was created in 1995 for those who didn’t want their stock registered in the name of their firm. This change gave investors multiple options. You can now:
Buy or sell from the transfer agent. Work with a favorite stockbroker to arrange trades through the DRS. Work only through a broker.
Ownership, Bankruptcy, and Protection
In the above example, you would be the owner of your 1,000 shares of XYZ, but your brokerage would be the owner of record. Your brokerage then breaks down which client owns what shares within its own accounting and database. It provides trade confirmations, brokerage statements, and tax records. In the case of margin accounts, you’re left holding the bag with a general claim against the firm if the firm goes bankrupt. You may have to rely on Securities Investor Protection Corporation (SIPC) insurance if there’s a shortfall. This option has its limits. But between asset segregation and SIPC insurance, it’s very rare for a customer to fail to get their portfolio back in the event of a brokerage bankruptcy. The Direct Registration System provides an extra safeguard.
Pros and Cons of Using the Direct Registration System
Pros Explained
Protection against risk: Using a DRS provides you with protection against counterparty risk. You’ll have to go through the recovery process through SIPC insurance if your stockbroker goes bankrupt, and if your shares were held in a street name, but ideally you’ll receive a reimbursement.
Prompt documentation: Stockbrokers are famous for being slow when it comes to delivering annual reports, 10k filings, and proxy statements from the companies of which you own shares. But the documents are mailed to your address of record, often promptly, when you’re registered directly with the transfer agent through the DRS.Safer than paper: Paper stocks can be misplaced, stolen, or destroyed. Those are problems you’ll never have to face with the DRS, which can save you money. You’re advised to insure your stocks for as much as 5% of the market value when you mail stock certificates. This comes out of your pocket. It’s the cost estimate of what the transfer agent will charge to replace them.
Cons Explained
Lower liquidity: The biggest disadvantage of using the DRS is that you can’t sell your stock right away. You have to submit instructions to the transfer agent, who then pools your sell orders with those of other sellers. They then execute the trade on a preset schedule. That would prevent you from selling shares in the midst of panic or if you were to need money right away. At best, you’d have to allow for many business days before you could access your cash.
Short Sellers, DRIPs, and Gifting
Your broker can lend your shares to short sellers when you hold stock in a street name. Short sellers can drive down the price by selling the stock short, which is selling a borrowed stock, then buying it back cheaper. This practice results in a profit for the short seller. It can lead to a tax problem when the dividends you receive are technically taken away from you. The short sellers will reimburse you with something known as a “payment in lieu of dividends.” Your dividends won’t meet the qualified dividend requirements for tax purposes, thus increasing your taxes on loaned shares. Many companies offer dividend reinvestment programs (DRIPs). These are great if you want to reinvest your dividends by buying more shares of stock with little to no costs or fees. Reinvesting your dividends can have a great effect on your wealth over time. You can make a phone call or send in a signature and then enroll in the DRIP when you use the DRS. As an added bonus, you can often gift shares to family or friends by having the transfer agent set up a DRIP account for them. It would be funded with a transfer of shares from your account into theirs. That can be a great option if you’ve built up a large position in a company and want to give shares up to the gift tax limit exclusion each year.
What It Means for You As An Investor
Should you think about using the DRS? It might be a good choice if you plan on buying large amounts of stock in one business that plan on holding for at least the next few years. You won’t have to worry that your broker or financial institution will go bankrupt in that time. The direct registration system could serve you well if you prefer to receive yearly reports and other documents as soon as possible. It’s also a good choice if you want to set up automatic reinvestment or electronic deposit of dividends in a bank account. You don’t want the hassle and physical security risk of holding paper stocks. There are many unique circumstances to think about when you’re deciding whether the DRS is right for you. You’ll have to figure out the opportunity cost of using it for your abilities and needs. The DRS is a process that warrants a closer look for most investors.
