Nov 012011
 

You’ve probably seen that MF Global, one of the big brokers in futures, options, CFDs and other derivatives has gone bust. While we haven’t heard all the details yet, this seems like it might be a rather worrying case when it comes to the safety of your brokerage account.

MF Global went under because of trades it was making on its own account (known as proprietary or ‘prop’ trading). Specifically, it had bought European sovereign bonds on high leverage and couldn’t make the margin calls when these fell in value (fuller details at the FT).

This was an extremely stupid thing to do, but it was MF Global’s own bet. It shouldn’t have mattered to clients.

Well, that’s an exaggeration. It does matter to you when your broker goes bust, because of the hassle of transferring your account.  But your investments should not be at risk.

Your assets are your property and separate from the firm. When it goes bust, they’re still yours. To ensure this, they are held in segregated accounts – client money and firm money must never be “commingled”.

But in this case, it seems that client money may be missing or at least poorly accounted for. It may just be delayed in transit – some institutions may have held off on transferring funds to MF Global as it teetered on the brink. But there is a suggestion that some MF Global assets and client assets were commingled.

If true, this is completely against the rules. It’s the first principle of the business that client assets are always segregated from your own.

If it was an accident, it’s appallingly negligent. If it was done deliberately – eg client assets put forward as collateral as the margin calls against MF Global mounted up – then it’s fraud and people at the firm should be prosecuted.

Segregated accounts are supposed to be what protects your investments if the broker fails. It’s the first and main line of defence.

If assets are missing, that’s where the investor compensation schemes come in (eg SIPC in the US, FSCS in the UK). This is exactly what they are supposed to cover.

But there are limits to how much these schemes cover. They also don’t cover every type of investment – in fact, I believe SIPC does not cover many futures accounts, so some MF Global investors may not have this protection, if needed.

Investors need to understand what these limits and to what extent they are protected. They also need to be aware that obviously these schemes don’t pay out instantly.

So it also makes sense to have an account with more than one broker. That way if one fails, your inconvenience – and losses – are hopefully reduced.

I’d also always say that you should go with a reputable firm. After all, not having the broker go bust in the first place is the best investor protection.

But as MF Global may be demonstrating – if the allegations are true – that’s not easy. This was a reputable firm.

Yes, you hear rumours of client funds not being segregated properly at smaller firms. But if it has happened at a firm as large and well-known as MF Global, that would be pretty shocking.

Your best protection against this risk may be to have an account with a systematically important (‘Too Big To Fail’) institution. If they go to the brink, they’re likely to be bailed out and clients protected – whatever has happened internally.

The problem with that is that many of these aren’t very good. You’re essentially rewarding failure by using them, instead of an independent firm that’s trying to offer a better service. But it may be one way to stay safer.

I’m not suggesting that you should pull money out of other firms. I certainly won’t do so – indeed, I’m looking at opening an account with another small independent firm right now. But splitting your assets, knowing the compensation scheme limits and keeping some in an institution that’s almost certain to be bailed out is one way to hedge this risk.

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