What happens if your broker goes bust?

The Swiss National Bank's (SNB) entirely unexpected decision to allow the Swiss franc to float freely against the euro last week had major consequences for firms that offer currency trading services.

Many traders had been betting on the euro remaining above SFr1.20. In the chaos that followed the SNB's decision to let the euro go, liquidity in the currency markets dried up and they were unable to close their positions before incurring substantial losses. The high levels of leverage (borrowed money) that many traders were using magnified these losses.

With many clients unable to meet their obligations, responsibility for the losses fell on their foreign-exchange (FX) brokers. In the two most high-profile examples, FXCM, the largest US FX trading firm, lost $225m, while UK firm Alpari suffered "substantial" undisclosed losses.

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In both cases, these losses exceeded the amount of capital regulators required them to hold. FXCM had to obtain a $300m bail-out from investment conglomerate Leucadia National. Alpari was unable to find a white knight and has been put into special administration, the UK system for dealing with insolvent financial firms.

It remains unclear what will happen to Alpari. Other FX brokers have expressed an interest in buying it, so it may still be sold as a going concern. But money belonging to Alpari's 100,000 clients is presently trapped in the firm.

These clients are wondering when and how much of their money will be returned. Some clients of other brokers will be worrying whether they could end up in a similar situation. So what rules are in place to protect you if your broker goes bust?

Segregation is the bare minimum

First, investment firms in the UK and most other markets are required to segregate client assets from their own assets.This means that when a firm gets into trouble, its creditors have no claim on clients' assets and they can be returned to the rightful owners. This is an extremely important principle, but it's only a starting point.

Unfortunately, since regulators can't keep an eye on what brokers are doing all the time, it frequently turns out that segregation has failed when a firm gets into trouble. That's not entirely surprising: even if management isn't habitually fraudulent, the temptation to dip into client assets to keep going can become too much to resist when the alternative is seeing your company go under.

While almost all investors in the UK benefit from client money segregation, different rules applyfor those who have chosen to be classified as "professional clients" investors with more experience who are not subject to as many regulatory protections as ordinary "retail clients".

Firms are not required to segregate money belonging to professional clients, although some still choose to do so. So professional clients' money may be mingled with the firm's assets and they could end up as an unsecured creditor if the firm goes bust.

While details of Alpari's situation have not yet been confirmed, it currently appears that segregation has been conducted correctly and there is no shortfall in client money. If this turns out to be correct, it should simplify the process of returning money to clients.

Better protection from the FSCS

Segregation clearly provides a bare minimum of protection. So what happens if a firm becomes insolvent, or ceases trading, and there is a shortfall in client assets? That's where the Financial Services Compensation Scheme (FSCS) comes in. The FSCS pays up to £50,000 per client (not per account) to top up whatever can be recovered from the firm.

So if a broker owes you £70,000, but you only get back £40,000, you should be entitled to an additional £30,000 from the FSCS. However, if you have two accounts with the same broker holding £70,000 and £80,000 and you get back £40,000 in each, the FSCS will pay you a maximum of £50,000 leaving you £20,000 short.

You can choose to make an FSCS claim after getting some money back from the insolvent broker, or before it pays out anything. When you make an FSCS claim, the FSCS takes over your claim against the insolvent company. So, if you are owed £70,000, the FSCS will pay £50,000 and make a claim for £70,000.

If it gets £15,000, it passes all of that onto you. If it gets £30,000, it pays you £20,000 meaning that you get all your money back and then retains the remaining £10,000 to recover some of its losses.

Since there is currently no evidence that any client money is missing at Alpari, clients can't yet make claims against the FSCS. They will only be able to do so if the administrators determine that there is a shortfall.

With investment firms, the FSCS has a target of paying compensation within six months of the firm being declared in default, although in simple cases this should be relatively fastonce the administrator has confirmed client positions.

Beware: other rules apply overseas

If you invest using a non-UK firm including European ones that "passport" into the UK you won't be covered by UK rules and the FSCS. Instead, you'll be subject to whatever protection exists in the firm's home market.

In most reputable markets, account segregation is standard, but forex can be a special case: for example, client funds are not segregated at American forex firms. This meant that FXCM's problems were potentially more worrying for US clients than the situation at Alpari (FXCM's UK arm is UK regulated, so those assets were subject to segregation).

However, account segregation is not sufficient and most compensation schemes are less thorough than the FSCS. The minimum standard across Europe is €20,000, while small offshore financial centres usually have no compensation scheme at all. So it's important to make sure you understand the local rules before opening an overseas account.