Are my investments secure?

Well hello again, it’s been a while. I hope you had a nice summer and have been enjoying getting to see loved ones again. I took a bit of an unplanned break from the blog and have been busy knocking things off my personal to-do list.

Of note:

• I submitted my citizenship application!
• we finished off our back garden renovations which involved a bit more work by us than we had planned
• I ripped up some old carpet and prepped, sanded and stained the floor boards
• we got a “new” car which required a good bit of research
• we took a week off to visit family and have been spending a bit more time catching up with friends now that we are vaccinated

I have plans to write up a bit more on our renos and the car research but this weekend I started researching the security of my investments in terms of where they are held and I wanted to document it so I don’t forget. Hopefully, it’s of use for you too as a consideration for your own long term due diligence. Caveat: I’m in no way an expert and my findings should be taken with a grain of salt and I’m happy to be corrected if my understandings are inaccurate.

Lesson 1: Securities lending

When signing up for a Degiro account you are given the choice of a Basic account or a Custody account. The main difference is that the basic account allows Degiro to lend out your shares which lowers your fees.

But what does this really mean and why do they do it?

This sent me down a rabbit hole.

What is securities lending?

Lending out shares is also known as securities lending. This is where stocks, commodities or other securities are loaned out to other investors or firms.

Benefits of securities lending for the lender (you)

The benefit to the lender (you) is that the borrower is charged interest on what they borrowed. This results in an extra income stream for the fund/investment firm on top of capital gains and fund fees which is usually passed onto you. In the case of a Degiro Basic account, this results in lower fees than the Custody account where securities lending is not done.

Benefits of securities lending for the borrower

The borrower typically borrows securities in order to short stocks. Ultimately they believe that they can make more money by shorting stocks than the cost of the interest from borrowing the stocks.

Risks of securities lending

This practice has different regulations depending on where the investment firm is located. I believe the location of the investment firm determines the regulations rather than the location or domicile of the funds themselves but I’m happy to be corrected. For investment firms regulated within the EU, I believe borrowers need to secure the loan with non-cash collateral of equal value to what they are borrowing. In the US, there is slightly more risk as cash can also be used as collateral which can be easily spent but they also need to put up 102% of the value being borrowed as collateral. The collateral regulation reduces the risk to the lender (you).

Another thing I learned is that most low free brokers operate with something called an omnibus account. What this means is that individual stocks/shares that you purchase are not technically in your name, instead a type of ledger is used to keep track of who owns what but the share remains in the brokers name so that they can loan them out for securities lending. I’m not 100% sure on the true risk here but have seen on reddit forums that some people have had very long delays getting money out of some of these brokers which I can only assume are somewhat related to securities lending through this omnibus structure.

Who does securities lending?

Most low fee brokers do securities lending. Even exchange-traded funds (ETF’s) do securities lending.

Stocks, commodities and other securities

Degiro Basic account, Trading 212, Bux Zero all likely do securities lending.

ETFs

No matter who you buy ETFs through, my understanding is that the firm themselves cannot lend out the underlying funds but the ETF fund manager can and usually does. You can see the level of securities lending done by each fund on their annual report.

From what I can tell, Vanguard do LESS securities lending than other funds like iShares. Additional reading on securities lending in ETFs in the EU here.

As an example: The Vanguard 2020 Annual report here, shows that for the Vanguard S&P 500 there are 24 trillion in net assets and 7.1 million lent out for securities lending. This means that only 0.029% of the net assets are lent for securities lending. On page 557 you can see that of the 7.1 million lent out, there is 7.5 million in collateral held against that mostly in AA and AAA bonds (less volatile). On page 585 you can see that across all the Vanguard funds, only 6-9% (14,000) of the securities lending income (146,000) goes to the lending agent with the rest going into the fund. Only 0.009% of the income for the year came from lending securities (146k of 1.6 trillion).

Who doesn’t do securities lending?

Interactive brokers, Degiro Custody account (for non-ETF securities like stocks and commodities)

Take away

As I’m investing mostly in ETFs through Vanguard, I’m happy to leave my account in a low fee broker as the securities lending is managed and regulated through Vanguard rather than the investment company and I’m comfortable with the level of risk as the level of securities lending done by Vanguard is relatively low.

If I was investing more heavily in individual stocks, I would probably move to an Interactive Brokers tiered account which seems to have lower fees for an account that does NOT do securities lending according to this analysis by the Poor Swiss.

Lesson 2: Delayed withdrawals

In addition to lending shares, most low fee brokers operate in the Stock Exchange with Chi-X (known as Chi square), which allows significant cost savings. As Chi-X’s market share is small, they have less liquidity and volume compared to others, which usually results in delays for both buying and selling as far as I can tell, so it can take longer for you to access your money if you need to sell but I’m not sure how long these delays can take. Degiro’s site for example says it takes 2-5 business days to process withdrawals. I can confirm that I have withdrawn large sums in this time frame with no problems but something else to consider in due diligence for the longer term.

Lesson 3: Security of investment firm

The second rabbit hole I went down was the security of the investment firm themselves. As I eventually plan on having a large portfolio that will fund our livelihood I want to be comfortable that my money is secure in the off chance the broker/investment firm goes into liquidation/bankruptcy or mishandles my money.

While some people may say the chances of this are very slim, it has happened three times in Ireland alone since 1999 with Money Market International, W&R Morrogh stockbrokers and Custom House Capital Limited.

In the W&R Morrogh case, some investors lost between 50,000£ and 500,000£.

Firms that provide investment services are under a statutory obligation to segregate their own capital from their customers’ investment assets. This ensures that such assets are kept safe if anything should go wrong. However, if a failing firm has not sufficiently segregated these assets, it runs the risk of taking investors’ assets down with it. 

If for example, the investment firm owes more in debt than it has in assets and it goes into liquidation its existing assets go towards paying its creditors which include investors (you), but in some cases, there are not enough assets left to repay everyone.

In 1998, the Investor Compensation Scheme was brought into existence. This is an insurance scheme that investment firms pay into in the case they or other firms go into liquidation. If after the creditors are paid, you are still at a loss, you can claim 90% of your net loss up to a maximum of 20,000€ from this compensation scheme.

The ICS only pays you compensation when:

• A firm is put into liquidation by the High Court or
• The Central Bank determines that the firm is unable to meet the claims of clients

The ICS doesn’t pay compensation if:

• You incur losses due to receiving bad investment advice
• Your investment is poorly managed or
• Your investment performs poorly due to market conditions or other economic forces.

Each EU country has its own scheme regulated by its central bank equivalent. I believe Degiro falls under the German scheme, while Bux 0 falls under the Dutch scheme while Interactive Brokers Ireland falls under the Irish scheme. In the UK, their scheme covers up to 85,000£ per person per firm though I’m not sure if as an Irish resident you can open an investment account in the UK?

In Ireland, the scheme is run by the Investor Compensation Company Limited and regulated by the Central Bank of Ireland. I can only assume there is a similar structure in other EU countries. The success of this scheme relies on the successful running of the holding company as well as the contribution into the fund by the investment firms themselves. You can see if your investment firm is covered here. At the moment this seems to be going well per the 2020 annual report, but that may not always be the case and cannot be taken as a given.

Additional CPCC guidance here.

Although I could not confirm this for Ireland, it seems the ICS scheme in other EU countries is per person per firm including if you hold a joint account.

The investment compensation scheme is separate from the Guaranteed Deposit Scheme which covers up to 100,000€ per person per institution in uninvested cash held in bank accounts.

Take away

No matter what you invest in there will be risks, both with the investment themselves but also with who you invest through. To help hedge our risks on the investment firm front, I think both myself and Mr. MH will each hold our own investment accounts or at least hold a joint account in multiple investment firms preferably covered by multiple counties’ investor compensation schemes. This will not only hedge the risk of all of our funds being managed by one company but also the risk of all of our funds being subject to the successful operation of one ICS company.

If we each have our names on 3 different accounts in 3 different investment firms covered by investment compensation schemes in multiple countries we are reducing the overall risk of any one of those companies going into liquidation including the investment compensation scheme operator themselves. We also increase our maximum compensation from 40,000€ (20k each) to 120k (60k each).

The downside to this is managing 3-6 different accounts both in terms of asset allocation and tax reporting but that is a price I am willing to pay for more security on our livelihood longer term.

This approach also hedges our risks of there being delays in withdrawing money if one firm has delays as we will have access to money in a different firm if needed.

Did I miss anything?