First of all, we would like to note that in contrast to the banks, US brokerages disclose much less information and, overall, they are less regulated by the government bodies. Some very large brokerages, such as Fidelity and Vanguard, do not disclose almost any data at all, while data from subsidiaries of banks, such as Bank of America Global Wealth & Investment Management and Morgan Stanley Wealth Management, are rather hard to obtain. There are only some numbers in the banks’ 10-K and 10-Q fillings. Another thing worth mentioning is that the brokerages do not disclose data on banks they are working with. This is actually a crucial point given that if a bank that is being used for sweeping money overnight has a liquidity issue itself, this can result in contagion and lead to liquidity issues at a broker.
We believe the biggest risk the brokerages face is a liquidity risk. In our view, there are two types of liquidity risks for a brokerage company. First, as mentioned, if a bank that is being used for sweeping money overnight has a liquidity issue itself, it can result in contagion and lead to liquidity issues at a broker. The problem here is that brokerages do not disclose data on banks they are working with; as a result, it is impossible to make a proper assessment of this type of liquidity risk based on the publicly available information. The second type of liquidity risk generally tends to arise from a fragile business model, unsustainable revenues, weak profitability and problems with a capital position. Our methodology and ranking system focus on an assessment of this type of liquidity risk. Recall the MF Global case: According to an FT article, the $6.3B trade known as a “repo-to-maturity” contract, which was related to the European peripheral sovereign bonds, was the catalyst that sunk the company. However, such a risky trade was the result of MF Global’s fundamental issues. Here is a quote from the FT article:
Discussing the ratio of a bank’s assets to equity, he (Jon Corzine, CEO and Chairman of MF Global), said in a Financial Times video last year: “We have to be disciplined. We cannot go running 30 to one leverage ratios. We need to manage risk.” Yet MF Global failed with a leverage ratio of more than 30 to one, as regulators and rating agencies pressed it to justify its aggressive gamble on the eurozone’s stability.
Obviously, it is a just a matter of time when a brokerage with a 30 assets/equity ratio faces a liquidity risk. Such a fragile capital position is a result of issues with a business model. As a result, we believe that brokerages with a strong business model, sustainable and predictable revenues, decent operating efficiency and prudent capital management, are less likely to face any liquidity issues in a difficult environment. As such, we reviewed brokerage firms that provided adequate public information to assess their overall financial strength and long-term stability based on 3 main categories: 1) Revenue generation capacity; 2) Cost efficiency; 3) Profitability & Capital. Each of these categories is divided into 5 subcategories, which are all crucial to sustainability of a brokerage's business model in a volatile environment:
We used the following rating scheme:
Hence, the maximum possible score is 60.
While we have analyzed the individual brokerages based upon the rigorous standards we have outlined above, we want to again reiterate that we are simply unable to quantify the risk of leaving cash in your brokerage account, which often gets swept to individual large banks. So, please strongly consider this risk going forward.