People who have bought stocks, bonds or other securities tend to think, that they “own” them. But what happens if your broker – be it the subsidiary of a bank, a large online broker or a smaller player – becomes insolvent? Can you get possession of your assets quickly and without much trouble?

On their websites, many brokers avoid the topic of their own default altogether. Some refer to a public investor protection scheme, but often fail to mention limits in the scope and size of the coverage. The lengthy customer agreement, that you are required to sign in order to open a brokerage account, is usually also not very revealing. It lists your duties and the rights of the service provider in detail, but provides little if any information on the custody of securities.

 

Standards for the custody of securities

There is no global regulation for the holding and safeguarding of customer’s securities. Most information on the internet only applies to the USA. The EU has different rules and even within the EU, legislation can differ between member countries. Offshore jurisdictions also have their own regulations. Nevertheless, some common industry standards have evolved over the years.

For the average retail investor, the following applies:

  • Brokers are usually required to hold their customer’s securities in separate accounts, in order to keep them fully segregated from their own assets. This ensures that your securities don’t become part of the bankruptcy estate, if your broker defaults. However, be aware that in some jurisdictions, asset segregation is not legally required for some market participants
  • Paper certificates are hardly issued anymore. Like money, securities are booked as a credit balance on an account and therefore held in “book-entry” form
  • The assets of many customers are ‘mingled together’ in so-called “pooled accounts” or “omnibus accounts”. No specific security is therefore allocated to you
  • There is a chain of custodians, as your contract partner will most likely appoint sub-custodians, nominees or other parties as service providers. The actual “holder” of the shares, though only in book entry form, is usually a Central Securities Depository (CSD). A “chain of rights” is supposed to ensure, that you, the investor, are the ultimate beneficiary

To give an example of potential counterparty risk in the purchase and safekeeping of securities, let’s assume that you have a German brokerage account and want to buy a specific stock listed on the New York Stock Exchange. In this case, your German Broker (A) commissions an U.S. Broker (B) to purchase the stock. B then arranges a U.S. custodian (C) to receive an entitlement to the share from the U.S. CDS (D). In the shareholder register of the company, that has issued the shares, D is listed as the shareholder. C books an entitlement to the share in favor of the German Custodian (E) of A. E books an entitlement to the share in favor of A and A then lists the stock as your assets in your monthly brokerage statement. This is just a “simple” example. Depending on your broker and the jurisdictions involved, additional players can be engaged.

It is important to be fully aware of this chain of custodians and the corresponding counterparty risk. Even if your contractual partner is doing fine, your assets might still be in danger, if one of the sub-providers fails. A large global broker puts it very bluntly in its UK Business Terms: “Where your Securities are held by a nominee or sub-custodian, independent to us, we cannot guarantee or accept any liability, that you would not lose your Securities if the nominee or sub-custodian fails.”

 

The role of margin accounts and securities lending

Brokers are exposed to fraud, embezzlement of funds and normal business risks like any other company. However, they face two particular risks, that are special to the brokerage industry: margin and securities lending.

Most brokers offer margin accounts that allow you to purchase securities with a loan provided by them. The loan is subject to regular interest payments and collateralized by assets in the customer account, such as securities and cash. If the value of the portfolio drops below the required security level, the broker issues a “margin call” by asking for additional funds as securities. If the portfolio value declines further, the broker can sell some of the customer’s assets at its discretion, to bring securities back to the required level.

All this works fine under normal market conditions. However, in rapidly falling markets, the broker might not be able to sell enough assets at acceptable prices or at all, and the customer might not be able to meet his or her obligations to cover the remaining shortfall. If this does not only apply to one but many accounts, the broker might default.

To earn extra income, most brokers engage in securities lending, where they lend securities, that are owned by their customers, to themselves, other customers or even third parties. This enables the short selling or shorting of stocks, whereby a speculator sells a stock, that it does not own, hoping to buy it back at a much lower price in the future. If the price of the underlying security drops sharply, the speculator makes a huge profit. However, if the price rises, the speculator will incur losses and might even face a “short squeeze”, where stock repurchases of many short sellers rapidly drive up the price of the shorted stock.

If a short squeeze occurs, speculators may not be able to purchase the shorted stocks back and might default on their obligation, to return the stocks to the broker. If securities provided are insufficient, the broker will incur losses. If this happens with many of its customers, the broker might go bankrupt.

Margin accounts and securities lending distort prices, add to market volatility and promote speculative behavior. Brokers offer them as a lucrative and allegedly safe way of earning extra money. They are confident to have the right systems in place to deal with all risks, but when severe turbulence occurs, some may blow up in spectacular fashion.

 

Broker insolvency

If your broker defaults, you can request that your assets are transferred to another broker. However, there is no guarantee that this will actually be done. According to the U.S. Securities Investor Protection Corporation (SIPC), the following applies in case of the liquidation of a broker in the USA: “Cash and securities held by the broker-dealer for customers comprise a fund of “customer property” which is shared pro rata by customers … For example, if the fund of customer property consists of 90% of what should have been held by the brokerage firm for customers, then all customers receive 90% of their .. claims from this fund …. In many liquidations, the fund of customer property is not sufficient to satisfy fully every customer’s .. claim. In that case, SIPC advances its funds – up to $500,000 per customer (but not more than $250,000 for cash claims) – to make up any shortfall.” These amounts are probably sufficient for most middle-class investors, but if you have invested a lot of money, you will suffer a partial loss.

Unfortunately, the SIPC funds available for investor protection are limited. According to its website website, SIPC has USD 3.1 billion in assets and a USD 2.5 billion line of credit with the U.S. Treasury, in total USD 5.6 billion. If a small broker with 100,000 customer accounts becomes insolvent, SIPC can on average cover up to USD 56,440 per account. This amount should be sufficient. However, if one of the big players with well over 10 million accounts goes bust, the available amount for coverage will drop to less than USD 500 per account. This is hardly enough.

Apart from SIPC protection, most brokers have arranged for additional insurance coverage. For instance, the total aggregate excess of SIPC coverage is USD 1 billion for Fidelity, USD 600 million for Charles Schwab and USD 500 million for TD Ameritrade. However, in view of the fact that each of these players has well over USD 1 trillion in assets under management (AuM) and more than 10 million accounts, this coverage does not look reassuring.

Similar protection schemes exist in other Western countries. They will be able to handle the default of small and medium-sized brokers. But don’t expect them to cover the bankruptcy of a big player or several players at the same time, which can happen in a severe crisis.

 

Do you really own your securities?

Based on the above, we can summarize as follows:

  • You are usually not the real owner of the securities that you have purchased, but just have a claim to them or rather a respective amount of money. To be the undisputed owner, your ownership would have to be directly registered with the issuing company or at least with the Central Securities Depository, or you would have to hold bearer shares. This is unrealistic for the average retail investor
  • In normal times you will likely get your money back if your broker defaults, provided that your investment is fully covered by the relevant public protection fund and the private insurance taken up by your broker. However, when markets crash, some brokers might become insolvent and you might lose some of your money, as total losses will overwhelm available coverage. In both cases, you might not be able to trade for a few months, which could result in additional losses or cause other discomfort
  • If you want to own publicly traded stocks, bonds or other securities, you have no other choice, but to employ the service of a broker. Make sure that you read the terms and conditions as well as other documents, so that you are fully aware of your legal position. If you are unclear, ask specific questions and if there are no clear answers, opt for another broker. To pay low or no fees is good, but they usually come with a price and the cheapest provider is often not the best from a cost-risk perspective
  • A minimum requirement in the selection process should be, that your assets are fully segregated from the assets of your broker and other service providers involved. If this is not guaranteed by the broker, then it is better to walk away
  • Do not rely on just a single broker. Use several brokers preferably in various reputable jurisdictions. In case that you buy a lot of foreign stocks from a specific country, think about opening a brokerage account there, provided that it offers sufficient asset protection
Disclaimer: The above is for informational purposes only. It is not an offer or advice to buy or sell any products or services. LBB and its owner do not provide investment, tax, legal, or accounting advice. Neither the company nor the author is responsible, directly or indirectly, for any damage or loss caused or alleged to be caused by or in connection with the use of or reliance on any content, goods or services mentioned in this article.

 

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