The counterparty risk thread - brokerage operations for the paranoid

Discussion in 'Retail Brokers' started by Ghost of Cutten, Apr 26, 2010.

  1. I'm quite averse to counterparty risk when it comes to brokers, so I thought I would start a thread where people of similar persuasion can swap comments, recommendations, and experiences with the "safer" brokerage firms, what to look for, and what kind of setup is best.

    I was reviewing my trading setup recently, and concluded that even firms like IB which I would say are pretty safe, still have some risks that can be avoided. The main risk seems to be that your assets, even stock purchased with cash, are held in "street name". So in a Lehman Brothers scenario, if IB ever went under, you'd become (AFAIK) a general creditor along with some gogo hedge fund or daytrader on 10:1 ES margin, even though you just paid cash for some long stock or even t-bills.

    Banks have their own problems. Above the deposit insurance limit, you are totally exposed if they go under. In today's environment, I no longer assume that any bank that blew up would automatically be bailed out by the government, no matter how big.

    Here are my thoughts so far.

    1. For investments & savings - a stock broker, for general stock investments. The idea would be to hold stock and ETFs in certificate form for maximum security. I haven't really looked into counterparty risk for stockbrokers, but assume it would be reasonably low if you buy in certificate form due to the high 50% margin requirements and being the direct owner of the stock. Only risk seems to be fraud or bankruptcy during the settlement period or if you keep a cash reserve above SIPC limits. A broker with no margin capabilities would be less risky, but then you have a potential problem of cash settlement delays. Any thoughts on whether a cash account or margin account would be better?

    2. For position trading, "one-man hedge funds", and portfolio trading - a combined futures/stock brokerage with reasonable margin and short selling capabilities. You need the futures side to hedge, ETFs are less liquid, have management fees, and are not even so easy to short nowadays with the new rules. Plus it's much more efficient to have your entire active portfolio at one place. Because of this concentration of funds (position trading is relatively capital-intensive), and exposure to broker insolvency and co-mingling + lending out of customer funds, lower counterparty risk is essential. Access to many markets across all global timezones is also essential - not just for more trading opportunities, but more importantly so that in a 9/11 kind of scenario you can hedge via foreign markets if your main market closes (as happened in the US in September 2001).

    3. For intraday futures/stock trading - a separate account with the best software, exchange access, and commissions, along with low margins. Since you will not need much capital to fund most daytrading accounts (prop stock trading, or intraday futures accounts generally offer very high leverage), the best credit risk control is to have a small account balance. Just withdraw like clockwork each month to make sure you don't build up unnecessary risk exposure.

    4. Cash in the bank. Choose any domestic bank with a decent branch network local to you, that is covered by deposit insurance.

    5. Surplus cash. Buy treasury bills or government bonds direct from the lowest-risk government in your currency of choice.

    6. SHTF emergency reserve. Physical gold held in insured vaults in at least 2 separate politically stable countries.

    There's another issue which is credit-risk with ETFs. Now they have the advantage that as the owner, you actually have the rights to the underlying stock. In a Leeson/Madoff scenario, is there any chance you could still get screwed? Even if you get your underlying asset eventually, it could be tied up for years in litigation. One way around it is to simply use ETFs for 2-3 different firms, that would cushion the blow. If anyone knows the true counterparty risk from ETFs, I'd be interested to hear about it.

    Regarding suitable firms, I think IB is the best for number 2. I'm not really sure about the whole stockbroker credit risk issue, so unless someone comes up with a reason why it might be dangerous, I'd say any "name" broker should be fine as long as you buy in certificate form not street name. Any thoughts on the intraday brokers? Ironically it might be that the "high-risk" brokers are preferable in a way as the required margins are so low. Option 4 is self-explanatory, option 5 is simple (Bunds if you live in the Eurozone, Treasuries if in a dollar economy etc), I have no clue on option 6 thought, so any tinfoilers willing to offer advice, it would be great to hear from you.
  2. I'd say that you should be able to do a bit of cross-hedging of some cpty risk, assuming you can have multiple accounts. Obviously, this may in itself be capital-intensive, so there's a tradeoff. Then there's also a question of what the best cpty risk hedge might be.