Black Swans & Broker Diversification
You’ve diligently saved your hard-earned money, but after having it sitting for months in the bank account, you realize you are slowly but surely losing wealth. Every time you go to the supermarket, everything is more expensive and your salary has hardly made improvements in the past year. Then, you decide you have had enough and after watching a video of your favourite financial YouTuber, perhaps even reading <Rich Dad, Poor Dad>, you start to delve into the world of investments. You are quick to open an account in the broker your YouTuber of reference, and start to invest in and out in all the recommended assets, since diversification is quite important, right? Perhaps you start making some money, giving you the false illusion that you have got this, you know how to invest and outperform the market. However, around eight months later your investments start to go wrong, and you lose some of your money and faith in the market.
After a few adventures with cryptocurrencies, meme stonks, and technical analysis, you decide this time you will take a different approach, focusing on long-term investing, studying, buying, and holding indexed funds, ETFs, or quality stocks of your own choosing. With this in mind, you open a new brokerage account, in DEGIRO or Interactive Brokers with the idea of making a fresh start from scratch, this time without stupid mistakes. As a European investor, you diligently assess the companies you want to invest in and choose some names with good business models like ASML or Ferrari, what could go wrong?
Let me tell you what could go wrong, your broker.
You have been accumulating quite a bit of money in your brokerage account, expecting that European financial authorities would carry a proper due diligence on those brokers. And they have probably done so, or maybe not, or perhaps your broker decides to liquidate all your positions in a certain country that enters into war, like eToro during Russia’s invasion of Ukraine.
But they cannot do that, right? How would they sell pieces of business that you own? Because you do not really own those stocks, they are owned by a segregated account in the name of your broker, which pools assets together to reduce the commissions.
Understanding Broker Insolvency: A Simple Guide
When we talk about a broker going bust, we’re referring to the unfortunate scenario where the brokerage firm fails to sustain its operations. This can happen due to various reasons, such as inadequate customer acquisition, stiff competition, or even fraudulent activities by its employees. In such a situation, the company becomes insolvent, unable to pay its debts, and undergoes a process of liquidation or restructuring.
How Brokers Operate: Behind the Scenes
Brokers play three key roles:
- Facilitating Transactions: A broker acts as your intermediary, enabling you to buy or sell investments like ETFs on stock exchanges.
- Safekeeping Assets: After a transaction, a custodian ensures that your ownership of assets, like ETF shares, is accurately recorded. These custodians safeguard your assets, ensuring they remain yours, not the broker’s.
- Managing Cash: Your uninvested money is also handled by the broker, which manages it prudently.
Understanding Investment Compensation Limits: A Crucial Factor
One of the most significant aspects to consider when evaluating your broker’s safety net is the investment compensation limit. This limit, the maximum amount you can be compensated in the event of your broker’s failure, varies significantly based on the country of the legal entity. Each country has its own regulations and policies governing these compensation limits.
In the European Union, for instance, the minimum compensation limit is set at €20,000. However, this minimum threshold is not universal; some countries within the EU have higher limits. It’s imperative to research and understand the specific compensation limit applicable in the country where your broker is registered.
Why Country-Specific Limits Matter
The reason for these varying compensation limits lies in the differences in financial regulations from one country to another. Financial authorities in each country establish these limits to protect investors. For example:
- In Luxembourg, the compensation limit might be €20,000, safeguarding investors up to this amount in case of broker insolvency.
- In the United Kingdom, the Financial Services Compensation Scheme (FSCS) might offer compensation up to £50,000.
- Meanwhile, in the United States, the Securities Investor Protection Corporation (SIPC) covers up to $500,000 for each customer, including a $250,000 limit for cash.
Protective Measures: Pooled Nominee Accounts and Asset Segregation
When you invest in ETFs, your broker doesn’t list you as the official shareholder. Instead, your broker holds your assets in a custodial chain, often pooling them with other customers’ assets. This pooling strategy, while cost-effective, means that in the event of the broker’s failure, customers might be exposed to each other’s risks.
However, here’s the crucial point: your assets are segregated from the broker’s own assets. This segregation means that, under normal circumstances, if your broker becomes insolvent, your assets can be transferred to another broker, ensuring you don’t lose your investments.
The Safety Net: Investor Compensation Schemes and Regulations
Governments and financial authorities understand the importance of safeguarding investors. Hence, they have established investor compensation schemes, which kick in if a broker is unable to return your assets. These schemes apply to all customers, irrespective of their location.
Financial regulations vary by country, dictating how brokers manage client securities, handle cash, report to authorities, and compensate investors in times of failure. While these regulations significantly reduce risks, it’s important to note that they can’t eliminate all possibilities of fraud or malpractice.
Case Studies: DEGIRO and Interactive Brokers
Let’s delve into two specific examples to illustrate these concepts:
DEGIRO, regulated by The Netherlands Authority for the Financial Markets, segregates client assets into distinct entities. Although they utilize omnibus accounts, their setup ensures your securities are secure. However, it’s vital to understand the specifics of their lending activities to gauge your exposure to counterparty risks.
Interactive Brokers operates through multiple legal entities worldwide, each regulated by local authorities. They meticulously segregate client money and securities from their business accounts, ensuring your assets are shielded from default or bankruptcy. The compensation limits vary by country, offering added security to investors.
Your Due Diligence: Questions to Ask Your Broker
As a responsible investor, you should inquire about:
- Segregation of Client Assets: Are your assets kept separate from the broker’s own assets?
- Compensation Schemes: What is the compensation limit in your country?
- Additional Security Measures: Does your broker undertake extra precautions to protect its investors?
- Transparency: Are all terms and conditions clearly outlined on the broker’s website?
Conclusion: Your Path to Informed Investing