What happens if my broker goes bust?

You are ready to start investing your savings and you start wondering: what if the broker goes bust? How safe is the money I worked so hard to earn? Do the broker’s investor protection mechanisms also apply to me given I don’t live in the broker’s country? Can I trust a broker for 30 years? Is there a certain amount of money that is safe to keep in a certain broker?

The answer: it depends!

First I have to clear out that I am talking about what happens in the event of failure of the brokerage firm. I am not talking about a scenario in which your investments loose their value due to market conditions.

How can a broker fail?

Before we go into details we first have to understand how a brokerage firm can fail.

A brokerage firm is a company. Like any company it may fail to make the business viable. That failure may be caused by:

  • not finding enough customers;
  • existence of better competitors which are better at satisfying customer needs ;
  • fraudulent/criminal behavior from the company’s employees;

In the event of failure, a business typically looses its ability to pay its debts – it becomes insolvent. As part of the Insolvency process a company may be liquidated or restructured. During an Insolvency process, the priority is to pay back the creditors using the existing assets of the company.

How a broker works?

A broker has three main jobs:

  • facilitating stock exchange transactions – You can’t just show up at the Euronext Amsterdam and buy IWDA from the first person you find. A broker is the intermediary you have to use to buy/sell ETFs through a stock exchange.
  • keeping custody of assets/securities – once a transaction is done someone has to keep a record that you effectively own some ETF shares. A custodian takes care of this. The custodian keeps your assets safe on behalf of you. The custodian does not own the assets, you do.
  • managing cash – All your uninvested money needs to also be managed by the broker.

Pooled nominee accounts / omnibus accounts

When you buy an ETF, you aren’t listed as the shareholder of the ETF in the “official” list of shareholders. Instead, your broker, which acts as custodian of the assets, is. Legally, you still retain ownership of the security through this custodian relationship.

Additionally, the securities from multiple customers are grouped into a single (custodial) account in the broker’s name. These are called pooled nominee accounts or omnibus accounts. The broker is responsible for keeping an accurate record of who owns what. These nominee accounts allow discount brokerages to cut costs.

The fact that these accounts are pooled means that customers may be exposed to each other in the event of failure of the brokerage firm.

Technically usually your assets are held through a custodial chain. Your broker may use another broker to trade a foreign asset which may result in multiple relationships of custody accounts in different custodial banks between all brokers involved. This custodial chain also means that you may be affected by issues on entities other than your broker.

Segregation of assets

Brokers will typically keep client assets in a separate legal entity. That means that the broker would have one entity for the brokerage business (e.g. paying salaries, paying for offices, collecting commission fees) and another entity for the client assets (e.g. securities held, investor’s cash).

The advantage of this arrangement is that during an insolvency procedure the creditors of the business entity of the broker can’t be paid with assets from the clients – because they are in a separate legal entity.

Naturally, this scheme only works if the employees of the broker don’t act in a fraudulent/criminal matter while mismanaging client assets of the separate entity.

Asset segregation is a key difference between a broker and a bank. When you deposit your money to your bank account, your money becomes part of the bank’s assets. If the bank goes bankrupt your money may be seized by the bank’s creditors. That does not typically happen in a broker due to segregation of assets.

If the assets are properly segregated, whenever a broker fails, the assets can be transferred to another custodian/broker. This would allow the investor to not be affected by the broker’s failure.

Investor compensation schemes

Investor compensation schemes cover scenarios in which a broker is unable to return to investors the assets that belong to them. The assets may be securities or money. These investor compensation schemes would be triggered if asset segregation didn’t work properly.

Investor compensation schemes are typically applied to all customers of a brokerage firm regardless of where they live.

Financial regulations

Brokers are regulated by the financial authority of the country where they are domiciled. Different financial authorities have different requirements regarding:

  • how brokers are supposed to keep custody of client securities
  • how brokers are supposed to manage cash
  • how brokers are supposed to report to authorities
  • which capital requirements brokers have to comply with
  • how investors are supposed to be compensated in the event of failure

Keep in mind that the regulators do a great job at ensuring the health of the financial industry. Yet they can’t stop all fraud from happening.

Some brokers may undertake additional security measures to increase the customers’ trust in their business.

Therefore, the answer to “what happens when my broker goes bust?” is different depending on the country of the broker and the broker itself. Let’s take a look at DEGIRO and Interactive Brokers to get a more concrete understanding of things.

DEGIRO

DEGIRO is accredited by The Netherlands Authority for the Financial Markets (AFM).

You should read their Investment Services Information and their Client Agreement to understand how your assets are managed.

DEGIRO segregates client assets into two separate entities (other than the main business entity):

  • SPV Long Short – an entity with client assets meant to be used for lending activities (e.g. derivatives, borrowed money/securities).
  • SPV Long Only – the remaining securities.

DEGIRO uses omnibus accounts to hold clients assets. Assets held by SPV Long Only are as safe using omnibus accounts as individualized accounts would be. But for assets held by SPV Long Short, clients within the same omnibus account are exposed to each other due to the inherent counterparty risk of the lending DEGIRO’s lending activities.

Securities of customers of the Custody Account are always held by the SPV Long Only entity and are not exposed to each other. Securities of customers of the Basic Account may be exposed to each other whenever they are transferred between SPVs in order to be lent to another customer.

DEGIRO used to not hold money (i.e. cash) for clients. Before, all uninvested client money was invested in a Money Market Fund. So your money was treated like any other investment from an investor compensation point of view.
By the end of 2020, this setup will be replaced by an account at a licensed bank.

The Investor Compensation Scheme in the event a Dutch broker fails to meet its obligations is 20,000€, the minimum at the EU.

Interactive Brokers

Interactive Brokers (IB) is regulated by the US Securities and Exchanges Commission (SEC).

IB’s strength and security is really well documented in its website.

Interactive Brokers segregates client money and securities into accounts separate from the IB business accounts.

IB holds client money for customers and invests part of them in U.S Treasury securities.

Client assets are covered by the SIPC (Securities Investor Protection Corporation) up to $500,000 (cash coverage is limited up to $250,000) in the event of a broker failure. Additionally, Interactive Brokers has coverage in excess of the SIPC policy up to $30 million (cash coverage is limited to $900,000).

What about other brokers?

The insolvency/bankruptcy procedures vary between brokers and countries. You will need to understand how your broker is set up to handle these scenarios. Some triggering questions:

  • Are the client assets segregated?
  • What is the investor’s compensation scheme? Even in the EU, the investor compensation scheme varies between countries. 20 000 EUR is the minimum, but some countries have higher limits.
  • How is client money managed?
  • Which additional measures is your broker taking in order to protect its investors?
  • Are the securities held in a pooled nominee account?

Take some time to read the terms and the site of the broker.

Conclusion

  • What happens to your investments in the event of a broker’s insolvency varies between countries and brokers
  • Your broker takes custody of your assets but is not their actual beneficiary/owner.
  • Your assets are typically segregated from the broker’s assets. That means that (in normal circumstances) if your broker becomes insolvent, your assets can be transferred to another broker.
  • There are investor compensation schemes which may compensate you in case your broker is unable to return assets that belong to you.
  • The broker’s and regulator’s compliance processes are designed to mitigate risk. Nevertheless, they may fail in the event of fraudulent or criminal behavior from the broker’s employees. So, you will always have some risk even if low;
  • You should read your broker’s terms to understand what they do with your assets;