CHESS sponsorship for Australian share trading platforms

What are CHESS Sponsored Shares vs Non CHESS sponsored shares? Is one better than the other? Is CHESS sponsorship safer? Read on as I explain.

CHESS stands for the Clearing House Electronic Subregister System. Operated by the Australian Securities Exchange (ASX), CHESS is a computer system that facilitates the clearing, settlement, and registration of transactions in shares of companies listed on the ASX.

If you own shares listed on the ASX which you bought through most brokers, its highly likely they are CHESS sponsored – making you the legal owner of the shares. However, some newer brokers use a custodian-based approach in order to cut costs, which might be surprised to hear, means if you purchase shares through them you don’t actually have legal ownership of the shares, and receive beneficial ownership only.

Confused? Yep, me too. So is this a problem? Read on for more info

CHESS sponsorship

CHESS stands for Clearing House Electronic Subregister System.

“CHESS stands for Clearing House Electronic Subregister System and is the computer system used by the ASX to manage the settlement of share transactions and to record shareholdings. In practical terms, it allows brokers and other market participants to settle trades via CHESS by themselves or on behalf of their clients.”

When an individual invests in shares of companies listed on the ASX, they have two options for how their shares are held:

1. CHESS Sponsored: Shares are managed by a broker (the sponsor) and are kept in a single account. This method offers greater flexibility for active traders, as it allows for more efficient settlement processes. An individual under CHESS sponsorship is given a unique holder identification number (HIN) that applies to all their investments managed by that broker.
   
2. Custodian sponsored: Shares are managed by a custodian. They hold the legal title for you, meaning they are the legal owner and you are the beneficial owner. You receive the benefits of the asset (proprietary interest in your investments and the income and rights attached to your investments) without legal ownership.

For share investors using CHESS sponsored brokers with a conventional HIN (Holder Identification Number) or SRN (Security Holder Reference Number) – in the case of issuer sponsored shares, if the broker goes bust you can simply initiate a HIN transfer to another broker which might take anywhere from a day or two, up to a week – you have control, and you can yoink your shares right out from the platform and put them where you want them.

“In practical circumstances if you own the underlying shares and are not in a CFD scenario where by the underlying asset is held by a counterparty, those shares should be your property.”

Deloitte (MF Global)

A HIN gives you the power – but having said that, in the case of a collapse of a share trading platform it would be naive to assume that there wouldn’t be any delays or extra checks and balances to the transfer on part of the regulators (i.e. ASIC).

“Section 12.19 of the ASX Settlement Operating Rules deal with suspension and termination of Participants. In simple terms, ASX will not accept any instructions from that Participant with respect to Holdings under its control. i.e Holdings cannot be moved and registration details cannot be changed.

Clients of the bankrupt broker can instruct ASX to move their Holdings to another broker or convert their Holdings to Issuer Sponsorship. If ASX has not received any instructions from the Holder, ASX may, after providing due notice to the Holder, convert their Holding to Issuer Sponsorship or move their Holding to another controlling Participant.”

Australian Securities Exchange

• Transactions on a CHESS holding can only be effected by the CHESS Sponsor. By law, your CHESS Sponsor may access your CHESS holding only when you have given them specific instructions to do so. Your CHESS Sponsor must authenticate your identity when you give them instructions. We suggest that you check that your CHESS sponsored broker has adequate security measures in place to ensure that when you call they can verify your identity, for example by means of a password or PIN.
  
• The Corporations Act and the ASX Settlement Operating Rules regulate the actions of all ASX Settlement participants, such as stockbrokers, and what sort of transactions they can perform against the CHESS subregister.
  
• ASX audits ASX Settlement participants to ensure they comply with ASX Settlement Operating Rules and relevant legislation.
  
• ASX Settlement notifies you by mail of any change to your holdings on the CHESS subregister. To maximise the security of your holdings, make sure you register them using your direct address rather than an address ‘care of’ an intermediary, thus ensuring you receive all such notices directly.
  
• Your CHESS Sponsor must keep an electronic audit trail of all ASX trades and movements in your CHESS holding.
  
• ASX Settlement has implemented a range of security measures to minimise unauthorised access to CHESS, including message encryption and the limiting of each CHESS user’s access to a specific and secure telecommunications line.

You can have multiple CHESS sponsored portfolios each with a unique shareholder HIN.

Benefits of CHESS Sponsorship

Here are a few of the benefits of choosing a broker with CHESS sponsorship.

Consolidation: All your shares are held under a single HIN, regardless of how many companies you’ve invested in, which simplifies tracking and management.

Efficiency: Transferring and selling shares is often faster and easier under CHESS sponsorship.

Transparency: You can view your share holdings from your share registry account, outside the control of your brokerage platform account.

Safety: CHESS registers ensure that the legal title of shares is correctly held, providing an added layer of protection for investors.

Access: CHESS sponsored brokers have access to all listed companies and funds.

Electronic Statements: CHESS provides regular electronic statements for your investments, ensuring you have up-to-date information on your holdings.

Divident reinvestment or credit: Investors can have dividends automatically reinvested (DRP), or directly credited into their nominated bank accounts.

Communication: Issuer communications such as annual tax statements and AGM’s are disseminated through the CHESS system

Tax Pre-fill: You get the ATO MyTax pre-fill which is organised by the issuer, covering all taxable events such as dividends and franking credits.

Non CHESS sponsored – custodian based brokers

Custodian-based brokers, as opposed to CHESS-sponsored brokers, hold shares in trust for their clients rather than registering those shares directly in the clients’ names.

When we start talking about custodian holding structures, things become less clear. As a beneficiary, you still have a legal right to the share, but you are technically not the shares legal owner – all in terms with the financial services guide and product disclosure statement you agreed to.

The biggest risk is that if a custodian model broker collapses, it could potentially take a long time to unwind as regulators, liquidators, lawyers and potentially even the justice system get involved to wade through who belongs to what. As the custodian structure has you listed as the legal beneficial interest, you should eventually get what is yours, but this could take a long time and its not clear if or when you would receive your shares or money

Further, in the event of corruption or embezzlement, meaning the company is insolvent or does not have the shares under custody (like what happened to Opes Prime in 2008), there is a risk you can lose some or all of your investments. There is sometimes insurance attached to a custodian holding structure, but this needs to be confirmed through the company’s terms and conditions and product disclosure statement.

Usually, the choice to use a custodian based broker comes down to cost, but benefits of custodian-based brokers typically include;

International Access: Custodian-based brokers can often provide easier access to international markets. An investor looking to diversify their portfolio across various countries might find this feature particularly appealing.

Consolidated Reporting: With a custodian system, an investor can receive a consolidated report of all their holdings across different markets, simplifying the tracking process and providing a comprehensive view of their investments.

Cost Efficiency: Sometimes, using a custodian-based broker can be more cost-effective, especially for investors who trade frequently or operate in multiple international markets where settlement and clearing costs can vary.

Lending and Margin Facilities: Some custodian brokers offer additional financial products and services, such as stock lending or margin lending facilities, which might not be available or might be more restrictive with CHESS-sponsored brokers.

Benefits of publicly listed stock brokers

One huge benefit of listing and being publicly traded is that a company can generate significant capital to ensure the business thrives, but there is a significant secondary benefit to a company’s customers. Publicly listed companies MUST provide financial and company reporting and get audited by regulators – this means any customer of a publicly listed stock broker is getting an additional layer of protection from the ASX reporting requirements.

Broker collapse case studies

There has been a few cases of brokers collapsing impacting investor holdings and funds. Here are some case studies of brokers which collapsed leaving investors significantly or totally out of pocket.

Halifax investment management collapse

Halifax carried on a financial services business in Australia under an Australian Financial Services Licence. It facilitated the acquisition of financial products by Investors via various online trading platforms which were not CHESS sponsored (such as Interactive Brokers).

• Over 12,000 clients across Australia and NZ
• Offered share investing, derivatives and CFDs without CHESS sponsorship
• Over $200 Million in client funds frozen in 2018 pending investigation
• Shortfall between book balances of approx $20 Million (‘missing’ client funds)
• 20 March 2019, at the second creditors meeting, it was resolved to place Halifax into liquidation and the Administrators were appointed as Liquidators.
• Halifax collapse left investors who had used their services unable to access money from their investments
• 19 May 2021, the Federal Court of Australia and the Hight Court of New Zealand handed down their judgements regarding the valuation of investments and the return of shares and client moneys to investors.
• Investors began to receive their money 3 years after being frozen
• Halifax directors legally banned from working in financial services for six years.

BBY Australia collapse

BBY Ltd was a stockbroking and financial services firm in Australia that was founded in 1987 which collapsed in 2015. At the time of its collapse, BBY was one of Australia’s largest independent stockbrokers and had a substantial client base and operations across equities trading, futures, corporate advisory, and other financial services. The firm’s collapse impacted a large number of clients, and it became a notable event in Australia’s financial industry.

BBY had a history of poor governance, entering into risky business ventures, financial irregularities within the company (including client fund missappropriation), as well as failing to meet ASIC financial requirements in regards to financial resources to meet its Australian Financial Services License (AFSL) obligations.

• Made a massive trade resulting in margin calls which caused it to become insolvent – illegal act
• ASX did not report this to ASIC, and instead offered to manipulate margin calls to prevent insolvency
• Within a year, BBY was in administration and under investigation by KPMG : “BBY, and others of the BBY Companies as a result, became insolvent on or around 11 or 12 June 2014 when BBY executed the AQA trade ” – KPMG
• ASX worked with the Securities Exchange Guarantee Corporation (subset of the ASX which deals with the National Guarantee Fund) to ensure BBY customers who were eligible for insurance claims had been paid out.
• If you owned direct shares with them you eventually got your money ~2018-2019
• Derivatives such as Contracts for Difference and Options – you lost your money
• Money held with them – you lost it
• Margin trading with them – you lost it

Opes Prime Broker collapse

Opes Prime was founded in 2003 by Laurie Emini and Julian Smith as a specialist securities lending and margin lending broker using a custodian model. They essentially made money by offering custodian based share trading, and then lending investors shares out to other investors and institutions – for example to short sellers.

The company borrowed hundreds of millions from banks such as ANZ and Merrill lynch to facilitate its operation. Money was mismanaged, and certain ‘key clients’ were allowed to trade in deficit despite losing hundreds of millions in shortfall, which was then deliberately covered up from auditors. Client funds were comingled and additional loans were saught to cover the shortfall, and these frauds eventually led to the collapse of the company. In 2008 an investigation was launched by ASIC following the company going into receivership

Opes Prime operated using a custodian-based system, not a CHESS-sponsored system. Clients of Opes Prime effectively handed over the title of their shares to the firm in return for a loan. This structure was a significant factor in the controversies and issues that followed the firm’s collapse, as clients found out they didn’t have the direct ownership and protection they might have assumed they had. The collapse highlighted the risks associated with custodian-based systems when not properly managed or understood by clients.

Key points

• Over $1B in secured debt owed by the company to ANZ ($650M) and Merrill Lynch ($400M)
• ANZ and Merrill Lynch took ownership of client shares and funds to repay Opes Prime debt owed to them
• Criminal charges laid against Opes Prime director Laurie Emini as well as other executive staff, leading to jail time
• Investors who used their margin facility had ALL of their investments assigned beneficial ownership – including original collateral.
• Over $550M of investor funds were effectively ‘lost’ from 1200 Opes clients accounts
• Margin loan clients – you lost your money (even your deposits)
• Derivatives such as Contracts for Difference and Options – you lost your money
• Money held with them – you lost it
• Direct share owners (who opted to not using margin lending accounts) eventually received their shares from 2011

Sonray broker collapse

Sonray Capital Markets was an Australian-based brokerage firm that collapsed in 2010, leaving many clients with significant losses. The firm was involved in providing financial services, including trading in contracts for difference (CFDs), margin loans and foreign exchange. The collapse of Sonray serves as a notable event in the Australian financial services industry, with several lessons for both regulators and investors.

• Misuse of clients’ funds by comingling client funds and its own operational funds had violated regulatory requirements
• The company faced a shortage of funds and had liquidity issues
• ASIC began investigating Sonray due to irregularities and failure to comply with the Corporations act
• Sonray went into liquidation in 2010 with debts of over $46 Million
• Sonray CEO and director both faced criminal charges for false accounting, theft and deception and received prison sentences
• Due to comingling and misappropriation of client funds, the shortfall during the liquidation of the business meant that Sonray clients faced significant losses

Summary

Using a CHESS sponsored system, you will have legal ownership of your shares, whereas with a custodian model, you have a legal right to the shares, but you are not the legal owner of those shares. This is the beneficial ownership model, and it’s up to you whether you are comfortable with that model or not.

Generally speaking, the micro investing platforms such as Raiz, Spaceship and Sharesies have a custodian model and you will not have legal ownership of any shares directly. You also need to keep an eye on brokerage fees to see if micro-investing is right for you, as sometimes the fees can erode any returns.

Brokers such as Pearler, CommSec, NABTrade and Self Wealth have ASX CHESS sponsorship and any shares you purchase through these brokers will be legally yours.

It’s essential for investors to understand the differences between Issuer Sponsored and CHESS Sponsored shares and choose the system that best fits their investment strategy and needs.

For those trading less frequently and who have larger investments, CHESS sponsorship may offer advantages in terms of safety and transparency, however for those trading more frequently with smaller amounts may prefer the convenience and lower costs of custodian based brokers.

However, every investor’s situation is unique, so considerations should be made on a case-by-case basis.

What are your thoughts? Does CHESS sponsorship make you feel more comfortable, or do you prefer a custodian model? Do you have shares in both? Let me know in the comments!