Ask Brad: How Custodians Set Interest Rates on Swept Cash
This is the latest installment of a regular column to answer questions from advisors who are considering transitioning to an RIA model. To see Brad’s previous articles, click here. To submit your question, please email Brad here.
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For the better part of a decade, this article was moot. Interest rates were so low that swept cash, no matter the custodian, received a return that rounded to zero.
With the changed rate environment, it is instructive to understand what drives interest rates in cash sweeps.
A few caveats: 1) This applies to broker/dealers as well. I am explaining how this works with RIAs and their custodians, but it applies similarly to how broker/dealers generate revenue; 2) This explanation applies to when a custodian sweeps idle client cash to an affiliated bank and/or series of banks. If cash is swept to an affiliated money market fund, the custodian generates revenue primarily from the fund's expense ratio.
A cash “sweep” is an account benefit where idle cash in an investment account is “swept” to an interest-generating solution. Whether cash is being held in an account for future investment, a result of dividends or bond coupon payments, a recent deposit, etc., there is utility to having idle cash effortlessly swept to an interest-bearing vehicle.
The revenue a custodian generates from cash sweeps is banking 101. Clients lend their cash to the custodian and are paid a rate of interest. The custodian then lends/invests the cash at a higher rate. The “spread” (a.k.a. “net interest income”) between the two rates is the revenue generated.