Rogue activity, client money fraud - What if your Broker goes bust?
With Stock Market at all time high, increased speculation, signs of exuberance that can drag down multiple brokers at the same time, advent of ‘free trading’ and gamification of investing, it is a matter of time before the market experiences stress again.
Can a Broker fail? Could it be yours?
It may be surprising that a big focus is on fees and less on safety. Whether you are looking to open an account or check safety of existing one(s), there may be some takeaways below.
Did you know that some countries want Investors to do their homework with Broker selection and won’t 100% compensate for your losses when a Broker fails?
This analysis takes a view of a long term investor, that has a 10+ year horizon and may be preoccupied with the survival of a Broker at least as much as reducing the drag of additional fees. Let’s break it down into the following questions:
- Has a large Broker ever failed?
- How likely is it?
- If it does, what can I do about it?
Here is what you need to know.
Table of contents
CAN IT HAPPEN TO MY BROKER?
One giant Casino
How many brokerage firms went out of business?
The largest broker Bankruptcy of the past decade, and the 8th largest Bankruptcy in the US corporate history has all the ingredients of what a high profile failure looks like (there is even a European twist to the story!)
MF Global had a mix of retail investors as well as a derivatives business with customers such as farmers, ranchers or financial advisors. It went from a rather boring clearing and execution shop, initially belonging to a Hedge Fund, to an ambitious broker-dealer that wanted to become the next Goldman Sachs.
This is where things took a wrong turn due to the strategy of Jon Corzine, its CEO. Caused by aggressive bets on European Sovereign Debt in the middle of the European Debt Crisis, in 2011 the Broker faced liquidity issues and margin calls from Wall Street counterparts and shortly after collapsed into Bankruptcy. To manage liquidity issues MF Global has been dipping into client accounts for entire weeks before it collapsed.
Interactive Brokers were considering taking it over before it collapsed but thankfully it did not pass the smell test.
One of the key take-aways of this story is perhaps that dipping into client money, like for Nick Leeson, happened not as a premeditated action but rather as a consequence of proprietary trading.
It happens more often than you think
Just in the UK, a number of low-profile Brokers went bust over the past few years.
SVS Securities went out of business in 2019, after the UK Regulator found questionable commission arrangements, promoted high-risk bonds to retail investors and could not explain how it valued illiquid assets.
A year earlier, Beaufort Securities, a company named by the London Stock Exchange among the UK’s 1,000 Companies to Inspire for 2017, collapsed in 2018 including a scandal involving sale and resale of ‘Personnages’, by Picasso, through a London art dealer which was part of a money laundering scheme. Ultimately undercover FBI agents brought down rogue brokers.
Other Brokers’ collapse was more predictable and were flashing red like Fyshe Horton Finney’s long periods of underperformance.
But maybe not to you?
The good news is that most of the examples above wouldn’t exactly fit Broker criteria of a long term Investor. Giving inappropriate Investment advice would not pass Bogleheads’ BS detector.
A broker with high volume of proprietary trading and expanding into an Investment Bank wouldn’t probably fly either.
But human error, risky behavior, external factors and aspects we may not think of may still trigger a chain of events leading to a bankruptcy. Tiny probability doesn’t matter in the short run, but repeated over and over it does represent a certain risk.
Can you lose money in a Brokerage account?
In order to lose money you would need two events to happen.
First, your Broker would need to become insolvent as a result of one or a combination of liquidity issues, fraud and/or other events.
Second, your 3 layers of protection (i) asset segregation (ii) adequate Broker capital and (iii) government compensation scheme would all fail to cover losses.
What else is at stake when Brokers collapse?
Even if you do ultimately recover your funds there are other considerations to take into account.
Opportunity cost is a major issue. You just don’t know how long the bankruptcy process will last and how many entities/intermediaries were involved.
Until then you have no access to your investments and can’t sell/rebalance.
In MF Global case, while I suspect that retail clients got their assets/money transferred or back much earlier, other customers not covered by SIPC guarantee had to wait years to recover their assets.
In fact, Bankruptcies have a tendency to be very long (lawyers get paid by the hour). The MF Global saga ended in 2016.
For example, in the UK the FSCS that provides a guarantee to investors in case of an insolvency, does have to identify and quantify the shortfall before it pays investors.
That will depend on the administrator (party hired to manage the Bankruptcy) reconciling the accounts to check the cash and assets are there and can take time depending on the complexity of the task.
There is no formal time frame for returning money to investors and a firm with properly segregated assets and good records is likely to be quicker than a firm where there has been a fraud or some other poor behavior.
For Beaufort Securities that failed in March 2018 the first transfer took place at the end of September 2018.
BROKER FAILURE - WHY AND HOW TO PREVENT
What can bring it down?
Understanding the probability of bankruptcy is not a trivial task for a Retail Investor given the lack of access to data and expertise to estimate the likelihood of default.
Some drivers (and hard stops for certain investors) include:
Does your Broker have a risky business model? Excessive risk taking may be a red flag. Trading on behalf of clients and its own account can lead to conflicts of interest.
An extreme case is MF Global, but other operational risks can also be monitored. One of them is market making on exotic products including options and the wind down of such activities is viewed positively (Interactive Brokers Rating upgrade).
Another could be offering a lot of leveraged products to clients and re-hypothecate securities (which is why client assets disappeared in MF Global)
Does your Broker have enough capital to cover risks its taking? Reserves must cover potential losses related to the nature of the business (more capital is necessary if the Broker has a risky business model).
Profitability can be monitored for Brokers listed on the Stock Exchange.
Is anyone watching? Does the company have rules in place internally to avoid operational issues. Who is the regulator and are they properly equipped to oversee the activities?
What can I do about it?
Now that we know possibly reasons causing a collapse, and since we have limited data, what can we do about it?
One of the options is making sure the Broker gets pressure from people having more data and expertise. These are not default risk drivers per se, but they are indirect way to monitor Brokers.
Some soft indicators include:
The more public markets scrutiny your brokers has, through a listing on a Stock Exchange or a Rating Agency, the better! Choosing a broker that is monitored by market participants may provide comfort
A private broker has much lower requirements to disclose data about its business model, profitability and debt than a publicly listed entity.
Since there is little external oversight, I’d be especially vigilant about the regulator in that case.
If your Broker is listed on a Stock Exchange, Institutional Investors will analyze the company, produce internal reports and scrutinize profitability vs competitors.
As a retail investor, you can access your Broker annual report to understand its business, too. A price action may draw your attention, especially if it’s a long trend related to things like profitability, not necessarily a quick way down like MF Global back in 2011
The ideal scenario is a broker that is also rated by a rating agency (which is quite rare).
The reason is that a rating agency takes a view of a debt investors that are very sensitive to risk of default which exactly aligns with your interest, as a customer.
As a retail investor, you can track the credit rating of your broker and access reasons behind a downgrade.
Are Rating Agencies reliable?
Rating Agencies have been heavily criticized during the Global Financial crisis, for good reasons. Note that the way to rate a single deal vs. rating a company on an on-going basis is a bit different.
How do Rating Agencies approach this?
The reasoning is similar to what I introduced earlier. They assess the probability of default (PD), broadly as I laid out above, and then potential loss when default occurs (LGD), as I explain below. They do it for unsecured creditors, which just like you are worried about possible collapse.
Depending on asset type and data, the analysis can go from quantitative models to qualitative scorecards related to profitability, debt and business model.
Do some wear blinders in 2020?
There will be warning signs when a broker runs into issues. Whether investors and/or rating agencies spot them is another issue, but it’s much better to have oversight than running blind without a rating agency or Stock Exchange listing.
Rating Agencies also rate the Banks that keep your CASH
As investment brokers, firms are not allowed to keep your cash.
If you are not fully invested, this needs to be parked somewhere safe. The best course of action is to place it with a custodian Bank. This Bank is sometimes disclosed by the broker so you can check its credit rating with a rating agency.
This bank is much more tightly regulated than your broker, so risk of your Bank going down is potentially lower. Additionally, depending on Broker setup with the Bank, there could be a separate Bank Deposit Guarantee Scheme as it relates to cash holdings (e.g. if you have a segregated bank account in your name arranged by your broker)
Another alternative is for your Broker to park the cash in a money market fund. Even if these are, given their Bond holdings, very safe they do not fall under the same cash guarantee scheme as the Bank accounts.
SELECTING A SAFE BROKER - Your three protection layers
What happens when a Stock Broker goes bust?
Depending on the Insolvency Regime in your country, an administrator may be appointed to liquidate the company. It is important to make a distinction between your Investments and your Cash, both managed by the Broker.
Your losses on investments depend on three layers of protection. The relative importance below relates to potential impact and what you can actually do about – the easiest and most impactful check is to verify the compensation scheme limits.
Where are my Investments held?
Although old terms such as ‘custody’, ‘deposit’ or ‘safekeeping’ are still used, shares have not been held in paper form for many years, but are booked as a credit balance on an account. In practice, unless a chain of rights is in place (see graph below), in which you, the investor, are the ultimate beneficiary.
This is the way in which all investment firms and banks hold positions in Securities for clients.
Each market has a Central Securities Depository that tracks the ownership of shares. Because Omnibus accounts are used in most cases, your name won’t be listed on this Depository, but rather your Broker name as the ‘Nominee’ or another Broker (using a sub-custodian) that has executed the order for them, because they may not have direct access to the exchange.
At the Central Securities Depository level, all of these client assets are held together, and this is common practice.
Layer #1 - Asset segregation
Asset segregation is designed to keep client assets separate to avoid the commingling of customer assets with the working capital of the brokerage firm (but also its own securities if they are engaged e.g. in market making activity)
The process involves having separate legal entities e.g. an SPV, that is bankruptcy-remote from the Broker and can’t be accessed by Broker creditors during an insolvency process.
Does Asset segregation protect me before Broker collapse?
All brokers will claim asset segregation, because it’s a regulatory requirement. But segregation is not any guarantee since the Broker is managing these accounts until collapse.
This protection only works if the employees of the broker don’t act in a fraudulent/criminal matter while mismanaging client assets of the separate entity.
Segregation is unlikely to provide protection when you need it most. When the Broker is on the edge of collapse, needs cash or assets to meet its own liabilities the temptation to ‘borrow’ client assets, could become appealing.
Even if no fraud is committed, when a Broker collapses, and the music stops, there will be operational errors.
Does Asset segregation protect me after Broker collapse?
Implementation of asset segregation varies, due also to various regulatory requirements in each country, and can have a major impact. In the best case, if Broker systems are good and records were maintained property administration process and transfer of shares will be much smoother.
Layer #2 - Broker capital
Brokers have capital requirements designed to cover administration costs if they collapse.
But it is possible that the capital held by the broker isn’t sufficient to cover the costs of administration, in which case Investors may (depending on insolvency regime) bear some administration costs.
Layer #3 - Investor Compensation Schemes
Ultimately, the shares belong to you. If records do reflect it correctly there won’t be any need for an investor compensation scheme to kick in and these will be transferred to another broker.
The regulators do emphasize that it covers cash and any receivables from securities such as dividends and interest. However, the scheme is there because of risk of fraud and that’s why it’s the ultimate safety net.
The European Commission notes on its website:
“Investor Compensation Schemes protect investors using investment services by providing compensation in cases where an investment firm is unable to return assets belonging to an investor. This might occur for example where there is fraud or negligence at a firm or where there are errors or problems in the firm’s systems“
This would be confirmed by your local regulator. E.g. In Germany BaFin notes the following on its website:
“The schemes also protect your claims against your bank for the return of the securities held in custody for you. You are eligible for compensation if an institution has embezzled or misappropriated your securities or funds and is no longer able to return them.
What is the compensation if my Broker can't return my securities?
The process is usually triggered automatically and you will be notified how to apply. Most likely, you will never need it. But before opening an account make sure, by visiting regulator website that your Broker is covered. It is important to know which broker entity you have opened account with (European Brokers tend to have multiple) because this may determine the limit of the compensation scheme. Then, check which country is regulating this entity.
- In the US, the SIPC limit is $500,000. It also includes the cash component up to $250,000.
- In the UK, your limit is £85,000 per eligible person, per broker. You can verify the amount on the FSCS website
- In Europe, there is a EU directive on investor compensation schemes (which gives guidelines to member states) ensuring a minimum of €20,000. The implementation of this directive varies a lot. Certain member states go well beyond that, e.g. Spain limit is €100,000 guaranteed by FOGAIN, France has a €70,000 limit per AMF, but it drops to €25,000 in Portugal and only €20,000 in the Netherlands, Poland or Germany.
Am I going to get 100% of the claimed amount back?
The compensation may be 100% or 90% of the value, depending on the member state. The EU gave member states that flexibility to make investors share some losses.
In a nutshell, some countries want you do to your homework and assess how risky is your broker. Examples of countries with this limit include Germany or Poland that only guarantee 90% of €20,000.
Can the value above compensation scheme limit be subject to losses?
While it’s unlikely, there could be, as we’ve seen, two cases where money/investments above the compensation scheme limit be subject to a haircut:
- In case of fraud and insufficient capital
- In case of complex work-out (e.g. if broker has some illiquid securities and administration involves valuation of these securities). In certain jurisdictions (e.g. UK), the regulator can make investors bear the costs of administrative fees. Remember, other Broker creditors can’t access your investments but an administrator is not a Broker’s creditor. These fees tend to be very high – for a Broker like Beaufort Securities (where some illiquid securities were revalued), PwC was paid £100m. MF Global Bankruptcy ran into hundreds of millions USD. These may be covered by the regulator, but it’s at their own discretion.
Should I have accounts with multiple Brokers ?
Broker diversification is recommended. Being without ability to access investments for a few months can create significant stress.
Compensation schemes typically apply the limit across all accounts you have with a Broker – but, of course, not across Brokers. If you have a large savings and you want to improve your protection, the obvious thing to do is to have accounts at more than one broker.
What happens to my Cash when my Broker goes bust?
Under EU law, investment firms must hold the money (including any dividends or interest paid) that they hold for the account of their clients in a safe, protected way. Such safely held money often is referred to as ‘client money’. It is usually part of the overall guarantee with your Investments.
There could be exceptions, though. If a separate Bank account is opened in your name, you benefit from the European Deposit Guarantee Scheme up to €100,000 on your cash amount.
Unless your broker-bank arrangement falls into this category (e.g. DEGIRO has launched this after merging with FLATEX), or your country has some additional provision for such situations (e.g. France usually gets brokers to open a Bank account in your name), I would keep cash amounts relatively low because Banks have a much higher deposit guarantee.
To avoid this arbitrage by investors, some countries (e.g. Spain) have the same €100,000 compensation scheme for both cash and Investments.
OTHER things to watch out for
Watch out for other aspects that are relevant for European Brokers:
- Securities Lending – along with payment for order flow, lending securities is how some ’emergent’ Brokers make money. DEGIRO, Trading212 or eToro all fall into this category. For DEGIRO you have the possibility to opt-out with a Custody Account. These brokers lend them out (e.g. to short-sellers) in return for interest payments, with the added risk that if there is a market crisis and liquidity for your security dries out, they might not be able to recover your shares (you have to trust them on how they manage collateral and counterparty risk)
- Doubling the risk of insolvency – You may be surprised but some brokers (e.g. Trading212) don’t even have direct access to main ETF Exchanges (Xetra, LSE and Euronext). Essentially they are fully reliant on other Brokers that execute for them. Why is this important? Remember that each entity has a probability of default on its own. If you have to rely on another party to execute 100% of your trades you are essentially doubling the counterparty risk
- Don’t ignore local Investment Firms – One example that doesn’t fit the pan-European landscape is Vanguard that I have listed for illustration below. Similarly, traditional players such as Banks can sometimes be more expensive (if you don’t look at hidden costs) but can provide solid, transparent service without additional risks. The popular counterargument goes – I can use a broker for its cheap ETFs because they make money on other risky products (back to square one -> Business Model)
POPULAR PAN-EUROPEAN BROKERS
Broker selection, like most things in Investing is very individual. There is no one size fits all. A lot more considerations come into play including (i) type of products (ii) fees (iii) country/language or (iv) convenience like tax reporting.
In terms of safety rest assured, though.
The system usually works well in case of a collapse and you should ultimately receive the investments you legally own and any money (including dividends and interest) back. But extra vigilance in Broker selection can pay off.
At a minimum, keep in mind the following:
Good Luck and keep’em* rolling !
(* Wheels & Dividends)
- ‘What SIPC Protects’, US Compensation Scheme, SIPC
- ‘What we cover’, UK Compensation Scheme, FSCS
- ‘EU Rules to protect Investors’, EU Compensation Scheme, European Commission
- ‘Rogue Trader’, British biographical drama film written and directed by James Dearden and starring Ewan McGregor, Pathé Distribution
- ‘The Big Short’, a 2015 American biographical comedy-drama film directed by Adam McKay. Written by McKay and Charles Randolph, it is based on the 2010 book The Big Short: Inside the Doomsday Machine by Michael Lewis, Paramount Pictures
- ‘SNS Securities: familiar story of another collapsed UK brokerage’, August 2019, Financial Times
- ‘Share pumping and Picassos: $50m scam that killed a London brokerage’, March 2018, Financial Times
- ‘Customers See Full Assets Restored as MF Global Liquidation Ends’, SIPC, February 2016
- IBG LLC And Subsidiary Interactive Brokers LLC Rating and Outlook, March 2020, Standard and Poors
- Principles on Asset Segregation Due Diligence and Collateral Management, September 2016, AFME
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