What does Wealthfront Cash account do with your money?

Question

Currently Wealthfront Cash account pays 3.8%, way higher than the deposit rates of their 10 partner banks. So I wonder what they do with customer money. I suspect that they use the money to buy term CDs from their partner banks at a negotiated rate higher than 3.8% - so they can still make a profit.

Here is the problem. The account allows customers to withdraw at any time. If many customers withdraw at the same time, say $10 billion in total, then Wealthfront probably would not have enough cash to repay. So they have to sell their CDs at a discount or redeem them from banks at a penalty. Despite that the CDs are FDIC insured, the cash they get from the sales or redemptions may not be enough to repay the customers who ask for their money back. If other customers know this, they would also ask for their money back... Would this be like a bank run?

Note that this problem differs from the problem faced by depositors of a real bank. For a bank, if your deposit account is FDIC-insured, you don't need to worry about loss - if the bank fails, FDIC pays you. But for Wealthfront, customers are not directly holding IOU from banks: they hold IOU issued by Wealthfront, who in turn invests in bank deposits. Even if bank deposits (CDs) are FDIC-insured, before they mature, Wealthfront doesn't get paid. So If many customers withdraw before CDs mature, the FDIC insurance cannot help ensure all customers get paid - unless Wealthfront delivers CDs to customers rather than cash (pay in kind). I think this is a classic risk in maturity transformation.

Answer 1

This is common with "fintech" companies, which Wealthfront even states in their FAQ with small text at the bottom. I personally use a different fintech service that works exactly the same way.

First off:

Cash Account is offered by Wealthfront Brokerage LLC (“Wealthfront Brokerage”), a member of FINRA/SIPC. Neither Wealthfront Brokerage nor any of its affiliates are a bank, and Cash Account is not a checking or savings account.

They are not a bank, but use affiliates like you stated in the question:

The cash balance in the Cash Account is swept to one or more banks (the “program banks”) where it earns a variable rate of interest and is eligible for FDIC insurance.

So to directly answer your question, they simply make a cash deposit in your name at their partner banks. Note that they also have a full legal disclosure which states that the money is covered under SIPC insurance until it reaches the actual banks.

I think that it is less of an "IOU" and more of a "money held in trust for RandomBear" type of situation. So if the bank went under (or there was a run on the partner bank) you would still be the beneficiary because your name is on the account.

If there was a "bank run" on Wealthfront itself, I would assume the same things would happen as a regular bank run. Specifically, withdrawals would be delayed for a few days to give the partner banks time to collect or borrow more cash.

Answer 2

Presumably they do the same things every other bank does: make loans which pay a higher rate than they're paying you (the traditional way banks made money) or other investments (now permitted though many would argue that was a bad change).

Many customers withdrawing money at the same time is always a risk, and the banking system plans for it. For reasonable amounts of unexpected withdrawals, the bank borrows money to maintain liquidity; they can borrow at lower rates than you can (eg from the government at prime rate) so that cuts into their profit but is just part of being in that business.

If there is a run on the bank -- everyone wants all their money out at once, the bank can't borrow that much, and implodes -- then what county you're in, and whether this is a real bank, becomes important.

In the US, that's when FDIC insurance kicks in; banks are required to carry this and it guarantees that each customer will get at least some of their money. I believe that currently each depositor is insured up to $250,000; if you have more than that, to be fully insured you should spread the money across multiple banks. In other countries there may or may not be a similar safety net; do your research.

Note that not everything that behaves like a bank account is a bank account. If the bank offers investment accounts, those are not protected by FDIC insurance; the same is true for investments elsewhere. It's up to you to understand whether your account is or isn't. If in doubt, check the bank's marketing material for your type of account; if still in doubt ask them to send you a printed description of the account which includes that statement.

Of course you can still choose to put your money somewhere that isn't insured. Risk and reward tend to be tied together by market forces, so legitimate (again) investments generally pay higher average returns to justify the risk of losing some or all value; it's up to the investor to decide if they like the odds or not. The market as a whole, and on the average, tends to increase in value... but we've just seen that some changes may only be short-term.

(I expected a correction after the apparently unjustified jump during the first two plague years; unfortunately I guessed right. But it looks like that just puts me back into the overall long-term market rate of return of about 8%. Someone who started investing during the bubble would have been hurt much more.)

There ya go: banking in a nutshell. Your next step is to find out whether your particular account is protected or not, and to what extent.

Caveat: I did say "legitimate". Scams can look pretty convincing until you try to get your money back. I haven't researched Wealthfront. Odds are they're an honest business. But if you haven't checked, you should, preferably before you send them any money.