A lot is written about the risks of stocks and bonds these days. However, what I don’t see mentioned very frequently is Counter Party Risk. Counter Party Risk is related to the risk of the organization or company you’re dealing with defaulting on their obligations. So unlike a stock which might go bankrupt due to the company failing, Counter Party Risk would be the brokerage who holds the stock for you going under. Another more common example you might be familiar with is the bank busts of the 1920s. We rarely think about it except when studying history, and yet there was a time when banks regularly went bust, and you simply lost your savings, or checking account balance.
Banking Protections from Counter Party Risk
Both Banking and Brokerages have insurance against Counter Party Risk. The bank insurance you are likely familiar with is FDIC. FDIC is the Federal Deposit Insurance Corporation. It was created during the aftermath of the Great Depression to insure faith in banks. Essentially this government run corporation requires banks to pay in fees to insure their deposits/cds/etc. The insurance money along with a line of credit from the US Treasury insures the replacement of your cash should a bank go bust. Credit Unions have similar insurance from the National Credit Union Administration.
In general your deposits are covered up to $250,000 per bank depending on certain account categorizations. For example regular accounts, retirement accounts, joint accounts, pension plans, corporate accounts, and revocable trusts are all viewed as separately insured. If you’re going to hold more then $250K then it is probably best to do it across multiple banks. I would be remiss if I didn’t give you a word of warning before I move on from FDIC insurance. In theory it is backed by the full faith of the US government in addition to the insurance premiums. In practice there is no law that says the government will bail it out should there be a massive bank run. I say this only as I think back to 2008. A similar discussion was had about Fannie Mae, the government owned issuer of mortgage securities. Ultimately, for political reasons the government bailed Fannie out, but it could have gone the other way. Anyway, unlikely but just something to be aware of.
Brokerage Protections from Counter Party Risk
Brokerage firms are protected by SIPC, the Securities Investor Protection Corporation founded in 1970. Like FDIC, SIPC is a government run insurance where Brokerages pay fees that pay for the insurance. Also like FDIC, SIPC can loan money from the US treasury if sufficient funds are lacking. SIPC protects your holdings up to $250K in cash and $500K in overall holdings. However, note SIPC is significantly different then FDIC. It does not protect the value of your holdings, but rather will attempt to restore to customers their holdings from the point when the firm liquidates. Customers are entitled only to what they had on hand (either in the exact stock holding or potentially cash) when the liquidation proceedings began. As such if the stock plummets or rises while you wait for the dust to settle you may be out of luck. SIPC also does not cover commodity trading or investment contracts. Big Brokerages also tend to have separate insurance they purchase from other companies to cover beyond $500K for the purpose of their customers’ piece of mind. This is called Excess SIPC insurance.
Brokerage failures are actually quite common, but generally people don’t lose their money because of the various insurance types I mentioned above. The people that do have issues are those that invest on margin. When you invest on margin you’re essentially lending out securities. The securities you lend are held by another entity to which you loan. The problem here is as a brokerage goes under they may also owe that other entity money, to which your assets may be withheld until that other entity gets paid. Ergo, it can get quite messy.
Index Funds and Counter Party Risk
One final thing to note about SIPC. It doesn’t cover the underlying investments, as I noted before. Brokerages often have their own line of index funds to which they give you a discount to invest. While the brokerage portion is covered, the index fund is not. That doesn’t mean your index fund is at risk if the brokerage goes under, however, typically the assets associated with the fund are held separate from the manager of the fund. Creditors of the fund manager (Vanguard for example) are not creditors on your investment, which reduces your risk of losing your mutual fund holdings due to a fund manager issue to near 0. However, like a brokerage there may be a time where the dust needs to settle should an issue occur where you would not have access to funds and then could conceivably lose money.
The risk to index funds, however, is all together different from a private investment fund like what Bernie Madoff ran, where the funds and fund manager are the same entity. When Madoff went bankrupt the funds assets were also on the line.
Annuity Counter Party Risk
Annuities are another hot area of investment. Unfortunately, they have significant counter party risk. If the issuer of the Annuity collapses you may end up with nothing. I’m not a big fan of annuities for other reasons, but if you plan to invest here read the contracts very closely for what happens if the insurance company goes bankrupt.
Foreign Stock Counter Party Risk
One last counter party risk that sticks in my head comes into play with foreign stocks. It’s actually fairly common if you buy individual foreign stocks that they come in the form of American Depository Receipts. When a stock does not sell on the US market, the shares are often bought on the local market and held in an overseas bank. You are given rights to those shares as issued by that bank when you buy the American Depository Receipts. Well here again you’ve assumed a risk that the bank might default in addition to the value of the stock itself. Even worse you likely have no clue whom that bank is or what protections you’re afforded. Unless your investing in foreign stocks directly you’ve likely not encountered this, but I give this final example as lead in to the point of this article.
What should you do about Counter Party Risk?
My goal in writing this post and the point I hope you’ve gleaned is that its important to question who the counter parties are in any investment transaction you do, what protections you have against their default, and whether you believe they will remain an ongoing concern. Pay close attention to your limits on those protections and remember to diversify. You should not overlook this risk in your investing. If you stay within the bounds of mutual fund investing you’re likely safe, but the more outside the normal you go the more at risk you are.