Direct Registration System (DRS) for Stocks
As major corporations move further and further away from paper transactions by embracing electronic book-entry form, one type of security registration method called the Direct Registration System (DRS) has become popular for blue-chip stocks. Investors who hold paper stock certificates or participate in the dividend reinvestment programs, also known as DRIPs, of certain businesses are likely to frequently encounter DRSs.
The Direct Registration System
New investors are more likely to invest in stocks through a brokerage account. When you place a trade order and the purchased stock appears in your account, your shares of stock are registered in a street name.
That is, if you own 1,000 shares of Apple through a broker or global custody account—for example, Charles Schwab—your stock is pooled with all of the other brokerage clients who own shares of Apple through Charles Schwab, and are reported on the books of Apple's transfer agent under Charles Schwab & Company.
Investors became concerned about receiving their portfolios if their brokers went under. In 1996, the DRS was created for people who didn't want their stock registered in the name of their brokerage firm. This gave investors several options: buy or sell directly from the transfer agent, work with their favorite stock-broker to arrange trades registered through the DRS, or work solely through their broker.
Ownership, Bankruptcy, and Protection
Continuing the previous example, you are the beneficial owner of your 1,000 shares, but Schwab is the owner of record. Then, within its own accounting and database, Schwab breaks down which client owns which shares, and provides trade confirmations, brokerage statements, and tax records.
At least in the case of margin accounts, if the brokerage firm goes bankrupt, you are left holding the bag with a general claim against the firm. What happens to your shares that were held in street name? Historically, this hasn't been a problem, though every few decades there is a widespread issue that costs many investors a lot of money.
Generally, if there is a shortfall, you may find yourself relying on Securities Investor Protection Corporation (SIPC) insurance, which has its limits. Between asset segregation and SIPC insurance, it has been exceedingly rare for a brokerage customer to fail to receive his or her portfolio back in the event of a brokerage bankruptcy. The Direct Registration System provides an additional safeguard.
The Advantages of Using the DRS
Using a DRS provides you protection against counter-party risk. If your stockbroker goes bankrupt, and your shares were held in a street name, you are going to have to go through the recovery process through SIPC insurance—hopefully receiving a reimbursement. In contrast, if your stock is held through the DRS, it shouldn't matter because your claim is with the company you own part of, not the intermediary.
Stockbrokers are notoriously slow when it comes to delivering annual reports, 10k filings, proxy statements, and other materials from the companies of which you own shares. When you are registered directly with the transfer agent through DRS, the documents are mailed to your address of record, often promptly.
If you've ever owned a paper stock certificate, you know they can be misplaced, stolen, or destroyed. With the DRS, this a problem you will never have to face. This can save you money—whenever you mail stock certificates, you are highly encouraged to insure them for 3% of the market value, which comes out of your pocket (3% is the cost estimate of what the transfer agent will charge to replace your certificate).
Short Sellers, DRIPS, and Gifting
When you hold stock in a street name, your broker can lend your shares to short-sellers, who can drive down the price by selling short the stock (selling a borrowed stock, then buying it back cheaper, resulting in a profit for the short-seller).
This can sometimes lead to an interesting tax problem when the dividends you receive are technically taken away from you because the short-sellers reimburse you with something known as a Payment in Lieu of dividends. This causes your dividends to not meet the qualified dividend requirements for tax purposes, increasing your taxes on loaned shares.
Many companies offer dividend reinvestment programs (DRIPs). These are great for investors who want to reinvest their dividends by purchasing more shares of stock with little to no commissions or fees. Over time, reinvesting your dividends can have a massive influence on your ultimate wealth. When you use the DRS, you can make a phone call or send in a signature and enroll in the DRIP.
As an added bonus of using the DRS, you can often gift shares to family or friends by having the transfer agent set up a DRIP account for them, funded with a transfer of shares from your account into theirs. This can be a great option for an investor who has built up a large position in a particular company and wants to give their children shares (up to the gift tax limit exclusion) each year.
Disadvantages of Using the DRS
The biggest disadvantage of using DRS is that you can't sell your stock immediately. You have to submit instructions directly to the transfer agent, who then pools your sell orders with other sellers, and executes the trade on a predetermined schedule.
This makes it impossible to sell shares in the midst of panic if the world fell apart, or if you needed money quickly. At best, you'll need to allow a minimum of several business days before you can access your cash.
Another option for possibly-faster liquidations is to have the transfer agent managing your DRS entry in a particular company move your shares to the brokerage firm so the stockbroker can sell them quickly. This would take at least a few business days to achieve, perhaps longer.
The Ideal DRS Investor
Which type of investor should consider using the Direct Registration System? One who:
- Plans on buying large amounts of stock in a particular business
- Plans on holding those shares for the next few years at a minimum
- Doesn't want to lose sleep over the possibility of his broker or financial institution going bankrupt
- Prefers to receive annual reports and other documents as quickly as possible
- Wants to set up automatic reinvestment of dividends or electronic deposit of dividends in a bank account
- Doesn't want the hassle and physical security risk of holding paper stock certificates
There are many unique circumstances and situations to consider when deciding whether or not DRS is right for you. You'll have to figure out the opportunity cost of using DRS for your circumstances, abilities, and needs. Regardless, DRS is a process that warrants a closer examination for most investors.