When a broker goes bust

Cris Sholto Heaton looks at what can happen when your broker goes under, dragging your money down with it.

Two weeks ago, we wrote about the rules intended to protect your account if a broker goes bust. Account safety is rightly a big concern with investors, so we weren't surprised to receive more questions about the worst-case scenario when a broker fails and clients' assets are not segregated from the firm's own (as they are supposed to be). While it's difficult to generalise, two protracted cases give an idea of what can happen.

When Pritchards, a UK-regulated stockbroker, collapsed in February 2012, it turned out that the firm had been using clients' money to pay its own expenses. Around £400m in securities were intact (barring some record-keeping issues) and were transferred to a new broker, but there was a cash shortfall of £3.1m. Clients could get up to £50,000 from the Financial Services Compensation Scheme (FSCS) to cover losses; this, together with the cash remaining at Pritchards, means that the vast majority of clients should be made whole (the FSCS has already paid out £8.9m).

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However, the company remains in "special administration" the process for winding up an investment firm and costs for this have so far come to £5.2m. So four years on, clients who had high cash balances are still waiting to discover exactly how much they will eventually get back.

The problems at MF Global, a major US-based derivatives brokerage, which collapsed in October 2011, were rather different. MF Global, which traded for its own account as well as providing brokerage services to clients, had run uplarge losses and was effectively insolvent. As the situation became increasingly chaotic, client assets became mixed up with its own and posted as collateral for trades. When the firm collapsed, more than $1.6bn in client assets was missing. Surprisingly, most of it was recovered by the administrator but the process took more than two years, and some overseas clients have not yet received everything.

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These two cases are very different (and one was not primarily a UK firm), but they show assets can go missing even when the firm's managers did not intend to commit outright theft and that it can be a long wait to recover them. So it's not enough to rely on account segregation: you should also think about how solid and reliable your broker is (see below).

Four questions to help you find a safer broker

Where is it regulated? The UK's Financial Conduct Authority (FCA) isn't perfect, but it makes some effort to scrutinise firms, while the FSCS is among the better compensation schemes around the world. So UK brokers are safer than a broker based in an offshore financial centre with no effective regulation. Be careful with European firms "passporting" into the UK; they are authorised by the FCA, but are not regulated by it and are not covered by the FSCS. They will fall under their domestic regulator and compensation scheme, the standard of which varies more than it should between European countries.

Who owns it? You shouldn't necessarily stick to the biggest brokers: smaller firms may offer a better service and be betterrun. But it's wise to understand who the main shareholders are,what kind of influence they exert on the culture of the firm andwhat support they might provide if things go wrong.

What's its business model? Firms that trade for their ownaccount (or have an affiliate that does), or let clients trade withhigh levels of leverage, may be more likely to throw up nastysurprises. So with brokers that do this, look for a long trackrecord, solid risk management and plenty of capital (see below).

How solid are its finances? OK, this one isn't simple unlessyou're good at reading accounts. But if you are, some brokersare listed companies or post their accounts on their websiteanyway. You can also find accounts for other UK firms for free atCompanies House. Apart fromquestions such as profitability, look for the Pillar 3 disclosure,which shows how much capital they hold relative to regulatoryrequirements. Of course, accounts can sometimes be fiddled, soalways give careful consideration to how credible they seem.

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