How to Avoid Being Robbed by Robinhood
The GameStop, wallstreetbets, and Reddit saga will go down in history as one of the most bizarre events to play out in financial markets.
But scarcely anyone will learn the lesson they actually need to from the episode.
The arcane sounding ‘counterparty risk’ was my number one warning for readers when I was interviewed in the UK for a video series called ‘Lessons Learned the Hard Way’.
Today, I’d like to share that lesson with you. It begins with a question…
How many people do you rely on, just to get your hands on your money?
It’s a surprisingly long list, isn’t it?
Bankers, stockbrokers, stock markets, ATM machines, pension fund managers, annuity providers, fund managers, financial advisors, exchange intermediaries, the managers of the companies you receive dividends from, insurance companies, the Reserve Bank of Oz, lawyers who hold your money in trust, payment processing companies like Visa, accountants, the ATO, and plenty more.
Now, we live in Australia. We don’t really worry about any of those people failing to show up with our cash, right? We just trust they’ll do the right thing.
Of course, there are the occasional stumbles. But the problems exposed by the Royal Commission were just a blip. It looked into the very rare cases of misbehaviour. Nothing systemic or anything like that…
Even the banks aren’t 100% safe. Thanks to some new regulations agreed on at the G20 summit in Brisbane, the next time a bank in Australia fails, the depositors’ money could be taken to fund the bailout. They call it a bail-in.
Although that scenario is unlikely, can you imagine having your hard earned savings taken to save your banker’s career? And we’re not talking taxpayer money — the law says your own personal deposits could be taken.
And what about the companies which cut their dividends during the COVID-19 crisis? And the interest you get…used to get…on your savings? And internet banking crashes? ATM outages? Pension cuts? And claim-dodging insurance companies?
Hmmm. This is starting to add up a bit, isn’t it? Perhaps your money isn’t so safe in other people’s hands after all?
Perhaps it’s not even ‘yours’ if you can’t get it back when you want it.
My point is that you need to start worrying about a type of risk which no financial advisor will mention. Outside of their small print, of course.
It’s known as…
This isn’t jargon. It’s a simple term you need to understand to protect yourself from it as best you can.
So, let me walk you through it…
In any transaction, your counterparties are the people on the other side of the transaction. The people you rely on to do their job. If you are buying or selling shares, for example, this includes the banks that your accounts are with, the payment processing company, the stock exchange, the company whose shares you’re buying, and the seller of the shares.
Like I said, most people never consider the risk of being let down by any of these big institutions. When they buy shares, they don’t even consider the risk of their bank failing, the stock market being shut down, the company engaging in accounting fraud, or whoever else may fail you.
But those risks are very real, however small. Every now and then, banks fail, stock exchanges are frozen, accounting scandals are exposed, and payment companies experience outages.
The Robinhood story is just the latest example. The broker simply stopped people from buying the stocks they wanted to. Or restricted position sizes. Meanwhile, Wall Street hedge funds were able to continue trading. This tipped things in the big player’s favour. And exposed that investors are at the mercy of their brokers.
But how do you actually address any of this? I mean, short of becoming a hermit in a cave, it’s tough to avoid banks. And you can’t invest in shares without being exposed to the stock market as a counterparty.
So, yes, it’s impossible to eliminate counterparty risk.
But you can reduce it.
And I believe you can reduce it dramatically by following just a few simple rules that won’t take up much time. They’re the first steps in taking back control of your money.
Hold in your hand wealth
The first is simple. Own some assets that don’t have counterparty risk. Meaning nobody can disappoint you in any way. You don’t rely on anyone else to get your hands on them.
The obvious one is cash. And I don’t mean in a bank account.
When Greece imposed ATM withdrawal limits in June 2015, cash suddenly became incredibly valuable. When I travelled through Greece in 2016, I spoke to people who told me about what life was like back then. One story stuck with me, not only because I heard many variations of it.
Mistrustful Greek grandmothers who remembered the bad old days of the drachma never fully trusted the new euro banking system either. They kept stashes of euros literally under their mattress. And their grandchildren laughed at their backwardness.
Until the cash withdrawal limits hit. Suddenly, Greek grandmothers were worth more than bitcoin.
There are a few other cash shortage stories I could tell you. Like when I got stuck in an Australian desert and the internet cut out. The petrol station’s electronic payment systems stopped working. And I didn’t have enough cash to fill up the tank enough to make it to the next petrol station on the far side of the desert.
Eventually we discovered the cash stash my father-in-law had given my wife ‘for emergencies’. I haven’t heard the end of it since.
Or the time my mentor had to grab his emergency cash stash to secure a bank cheque for me. It was the only way to pay a deposit on my rental property. My own bank didn’t provide such cheques.
The examples are instructive. I’ve learned my lesson, even if it took three reminders.
But what’s the principle at work here? Well, having a large stash of cash makes you counterparty risk-proof in the short term, at least. Cash in your hand doesn’t rely on anyone else to do their bit. Having cash beats having to rely on your father-in-law in an emergency too.
There are other, similar assets without counterparty risk. Some provide decent investment returns, too. The key thing they have in common is the lack of a counterparty.
You own them directly, usually in your very hands.
Lots of eggs, lots of baskets
Another rule to follow, if you want to minimise your counterparty risk, is diversification. And not the sort you’ll hear your financial advisor talk about.
Your share portfolio might have a number of different stocks to diversify the risk. But what about the risk of that brokerage company or exchange being shut during a stock market crash or technical problem?
You need to diversify your counterparties too.
For example, having your stock brokerage account, pension, Super, personal banking, and mortgage all with the same bank could be dangerous. Your entire financial life could be frozen from the failure of a single firm.
Think about how you can avoid being overexposed to a single company in your financial life. It may be convenient to have all your eggs in one basket. But it also might be too much counterparty risk.
Investing your money with a fund, instead of directly in companies’ shares, means you’re adding another counterparty. One more counterparty than necessary, who may or may not be doing the right thing.
By taking back control of your money,
you can cut out such middlemen
Not just their costs, but the risk of them failing you in some way.
Hopefully following some of these suggestions will make you sleep better at night.
That’s the real aim — peace of mind. If you don’t handle your money to improve the quality of life for you and your family…well, what’s the point in having any?
Being aware of the risks, taking care of them as best you can, that is an important step most people never take. But one that can have a transformative impact.
If you’d like to go on living your life as though the risk didn’t exist, then my apologies for the interruption…
But if you’ve realised it’s time to take back control of your money, thinking about counterparty risk is the best place to start.
So, who do you rely on to get your hands on your money?
Until next time,
Editor, The Daily Reckoning Australia Weekend