Keeping you safe
Keeping you safe
Over the passed five years both the range of financial services and products available to retail clients and the method through which they are delivered has proliferated. Retail clients, once principally provided services by stockbrokers and fund managers, can now chose between them and new entrants including boutique brokers, advisors with trading access to client accounts, wrap accounts, contract for difference trading, forex trading and other derivatives trading and black box systems for the do it yourself trader.
Historically stockbrokers, as part of their account opening process, reviewed the Stockbrokers Mutual Reference Society (SMRS) database. Now known as Fraud Register, the database records persons who failed to meet their financial obligations. This allowed the broker to specifically manage or decline accounts where the business may be promising but the client’s prior history indicated the risk of non payment.
AFSL holders providing clients trading services, may effectively guarantee their clients’ financial performance. There are circumstances where clients may not pay and leave the AFSL holder liable. The Financial Services Protection Limited service provides AFSL holders a tool to identify client accounts where payment risk may be greater than other accounts, but otherwise not identified.
Know your client obligations introduced in recent years oblige the AFSL holder, before providing financial services, to formally establish the client’s identity when the client – advisor relationship is first formed. These are well explained in other content available (link) so are not discussed further. However, while the KYC process could be considered as fortressing the front end, they do not look for instances where the prospective client has an adverse payment history.
It is not always possible or not always one hundred percent effective for an AFSL holder, providing securities trading capability to establish a prospective client’s credit worthiness. There are strict rules defining the circumstances upon which credit agency enquiries can be made. Generally unpaid trading losses do not meet the criteria for a person being reported to a credit agency. The cost of credit agency searches can be significant.
The Fraud Register service can add a credit measure at account creation and also provide a valuable “in production” credit validation while accounts transact.
Members pay an annual fee, providing them unlimited searches of the database. The fee equates to a little over $10 per business day. Searches are made online, at any time, on the basis of a single name, address characteristics or a batch of multiple names.
Prospective Members should contrast the potential loss that may arise from a single client not paying their obligations against the Fraud Register membership fee.
Prospective members may wish to consider the time, effort and cost in dealing with a client with a poor payment record, where a loss does not arise but the funds are slow in coming. Would that client be your client if you knew another member had recorded them in the Fraud Register data base? Do you know if you have a dormant account that is listed in the Fraud Register data base?
Where a member finds a potential name match, it is the Member’s sole decision as to services it will provide the person and any attached conditions.
Members can list clients where certain criteria is met, generally where the client has not met their financial obligations.
Access to the Fraud Register data base is via secure web based logon. Individual users are registered to Member’s account and are provided personal logon details. A single name search can take as little as a minute. A one minute investment can give you peace of mind that your client is not mentioned in the Fraud Register database.
The Fraud Register data base is populated by members with client details, upon a client default. Members can search the data base on either an individual or many individuals search for matches to name or address characteristics. Names with a match are returned immediately upon the enquiry (if the number of matches exceeds a maxima, a refined search is required). Name matches have a click through link to display the full client details held to allow for more precise matching.
Upon a client default, Members can add a name to the Fraud Register data base. Names are removed from the data base after 7 years.
The Fraud Register web site provides Members the capability to manage their users, it provides records of useage, it allows users to manage their account. It also provides for the Member to maintain their contact details.
These examples are drawn form real life experience. Some examples arose where the client name was already noted in the Fraud Register data base and a second loss was taken on a account after another AFSL holder hade entered the name.
Misuse of trust
In this scenario the client has no intention to pay and is seeking free market exposure. If the trade fails to generate a profit by settlement date, payment fails. Effectively the client places trades, taking advantage of a broker’s trust, without first advancing funds. The client may say that a sell trade will be executed before settlement is due. Because the client has a strong conviction that the trade will be profitable they promise they can cover any shortfall (which they confidently predict, wont arise), they simply want net proceeds paid. However if the stock price does not improve above the buy price, settlement funds never arrive. This scenario may be complicated by the client paying small losses, establishing a track record of successful trading. Ultimately their activity may lead the advisor to accept a much larger trade which causes a larger loss. The client can’t be found any where, except on the Fraud Register data base!
Contra trade scenario
The client wants to trade immediately and they undertake to pay by selling other stock. The client may claim the stock is registered with another broker, there is just a delay (with your back office) in moving it across. The client may present copies of CHESS statements. The client may even have CHESS stock in their account. The client also wants to trade in excess of the stock value and they only want to sell when the buy is completed. Sometimes the sell part of a contra trade can’t be completed, stock may be halted or suspended, perhaps the stock is not transferred, or the stock price may fail. If the buy trade can not be satisfied selling the holding just bought, its settlement still occours. At best a trading halt may delay delivery of settlement funds, most likely you will fund it and the fail fees. If the trading halt leads to a suspension of the stock, realizing funds may not be possible. Either way you will fund the buy until the position is sold out and you are left with the trading loss.
Urgent “cash” backed trading
Performance risk may be managed by employing a “cash up front” requirement, all buying is based on cash deposits. Consider that your new client provides you a large value cheque and wants to trade immediately. The funds have not cleared and the client is applying pressure. There is some immediacy and the threat to go elsewhere and lay waste to the best new client you have had for a while. The trades are placed as soon as the cheque is passed over, now the fun starts as you scramble to get the cheque cleared. If it does not you find you are watching the newly bought stock like a hawk, if it falls in value who will make good the shortfall?
Mulitiple Identities
Persons who make a habit of not paying may use a number of identities to avoid being caught out through the Fraud Register data base. However they may recycle an address. An address search may disclose an entry (sometime entries) from the same address as your new client.
Risk on the sell side?
Its not just the buy side where a default can arise. Consider the client who fails to deliver stock for a sale you have made. The client may have convinced you they held the stock, otherwise you would not have accepted the trade. However the client has no intention (or ability) to deliver stock for settlement . A failed settlement may give you both a regulatory problem, penalties with short selling rules as well as being exposed to the market risk of the stock price increasing after the sale is made.
After an initial deposit is made the client may wish to trade immediately, before the payment has cleared. If the relationship appears lucrative there may be a temptation to bend the rules to facilitate the client’s preference rather than risk the relationship.
Trouble with Margin?
Derivatives positions require margins at formalized levels. Imagine a position where the market gapped at a rate greater than expected by margining requirements. If the client does not fund the additional margin will you cover it? If so, for how long? If the position is liquidated with funds owing are you certain the client will ante up?
Margin loans
Settlement to a margin loan would seem to be safe, you check with the lender that the loan has adequate capacity to cover the trade. Its only at settlement that you find out that security was removed after you completed the order, that other trades have priority or that market movement means that your trade will not be settled.
System or process failure
Do you have absolute confidence in your systems and procedures? Are client limits ever miscalculated with excess orders accepted? Generally such events are fine as clients operate within their own controls. However if you have a client who will take advantage of a systemic failure would you want to know before hand that they had an adverse payment history?
Have you ever paid out funds greater than the client is owed or paid in error to a client? Even if the possibility is remote would you want to know if another broker terminated a client account because of unpaid obligations?
The timing of a search for a name match can be managed by the Member relevant to its circumstances and processes. Most members have the Fraud Register data base search embedded in their account opening procedures. Some Members search for name matches when they have a payment failure. For example daily reports of failed debits, Bpayments not received or contra sales not effected. Names on your failed settlement reports can be tested by either the single name searches for matches or by a batch search of all accounts with a payment problem each day.
Members can also search segments of their client base on a regular basis by using the batch search method. For example any account with elevated risk characteristics can be quickly searched.
Searching for name matches after an account is created is justified as it is not unknown for a person who knows they will not settle their account with a Member to open a new account prior to their name being listed in Fraud Register data base. Alternatively a person may establish accounts with several Members before they have any payment difficulty. Clearly Member (B) who opens an account before Member (A) has a payment failure will not find a name match unless they search some time after account opening. The ability to make unlimited single name and batch searches provides Members a powerful tool to manage their credit risk at both account creation and during the course of the client relationship. Prospective members may explore if any of the number of accounts opened that have never traded, no holdings and no cash have a name listed on the Fraud Register data base?
Fraud Register has provided Members comment that they should hold client agreement to search their names against listings of unpaid debtors and enter their name to a debtors data base in the event of a default. This entitlement can be achieved via the terms and conditions the client agrees with the Member. The question of whether a licensee’s actions breach any governing laws, including those concerning privacy, is for the licensee and their advisors.
Fraud Register operates in a manner such that it has not had any privacy issue.
Dealing with a client’s failure to pay may intrude on your ability to focus on your better clients. Generally a failed settlement will require the following;
Daily review of reports of settlement failure and potential risk,
Contact (if you can) the client and monitor accounts with settlement failure,
Disable the account from further trading,
Prepare formal demand for payment communications and serve on client,
Execution of fail process, sell stock, accounting entries,
Make up shortfall,
Follow up the client for payment,
Close account,
Enter name to Fraud Register database,
Complete accounting entries for unrecoverable debts,
Consider regulatory reporting.
All the while you will need to take care, ensuring processes are properly followed, you do not lay the grounds for a complaint. There is considerable effort to deal with a failed settlement before one starts to make good any trading loss.
The Fraud Register data base is populated by Members with names of clients who have not paid their trading related financial obligations.
Members can control who in their organization has access to the online data base.
Checking names at account creation can catch prospective troublesome accounts before trouble arises.
Checking names during the client relationship can catch prospective risky accounts before trouble arises.
Members can search Fraud Register data base at any time to determine if their client is listed.
Members can add a name to the Fraud Register data base according to Fraud Register rules.