IB - Yield Enhancement Program Question

[Sig]

I *THINK* and I can be wrong here:
You are 100% FDIC/SIPC covered for stock positions up to 500k.

I *THINK* you are NOT covered for the positions that are LENT OUT.

Note: There should be little concern about a company like IB going bust and loosing the ability to reclaim your lent out stocks. But still risk... ergo, I wonder why one would do this.

If you're not covered by SIPC (FDIC is only for banks) in the event that your securities have been lent, then anyone with a margin account at any broker is at risk. If you have a margin account, in almost every case you've also agreed to allow the broker to lend your shares. In the vast majority of cases you don't even know when "your" shares have been lent and you're not compensated (of course in reality the broker holds all the shares under a street name in a big pool and just lends out of that pool). That means that all of us with margin accounts could have a large number of our stocks that have been lent, and not even know it. Signing up for the yield enhancement program doesn't change that at all, you'd be at the same risk simply because you have a margin account.
That said, from my research the real risk is if the firm your stocks were lent to went under, i.e. if IB lent stock to PFGBest, when PFGBest went bankrupt IB became an unsecured creditor in the back to of the line to receive those securities back, behind all of PFGBest's actual customers. In most cases IB would just eat that loss and you as a customer wouldn't even know about it. In fact they make so much off the cash cow of lending fees that they can afford to have a counterparty go bust every year or so and still break even, but I suppose if it happens to someone big enough with enough shorts it could have a domino effect.

 

[IB-AN]

If you're not covered by SIPC (FDIC is only for banks) in the event that your securities have been lent, then anyone with a margin account at any broker is at risk. If you have a margin account, in almost every case you've also agreed to allow the broker to lend your shares. In the vast majority of cases you don't even know when "your" shares have been lent and you're not compensated (of course in reality the broker holds all the shares under a street name in a big pool and just lends out of that pool). That means that all of us with margin accounts could have a large number of our stocks that have been lent, and not even know it. Signing up for the yield enhancement program doesn't change that at all, you'd be at the same risk simply because you have a margin account.
That said, from my research the real risk is if the firm your stocks were lent to went under, i.e. if IB lent stock to PFGBest, when PFGBest went bankrupt IB became an unsecured creditor in the back to of the line to receive those securities back, behind all of PFGBest's actual customers. In most cases IB would just eat that loss and you as a customer wouldn't even know about it. In fact they make so much off the cash cow of lending fees that they can afford to have a counterparty go bust every year or so and still break even, but I suppose if it happens to someone big enough with enough shorts it could have a domino effect.

A margin account alone does not afford the broker the right to lend out your securities, it's the actions you take in that account. If, for example, you maintain a margin account with fully paid securities (i.e., do not have a margin loan), then, absent a program like the Yield Enhancement being discussed here, the broker has no right to lend out your securities and must segregate them in what is referred to as a good control location (special bank or DTC account). If the broker has financed the purchase of your securities via a margin loan, then the broker has the right to hypothecate (loan or pledge) securities but only in an amount up to 140% of your debit or margin loan balance.

 

[Sig]

A margin account alone does not afford the broker the right to lend out your securities, it's the actions you take in that account. If, for example, you maintain a margin account with fully paid securities (i.e., do not have a margin loan), then, absent a program like the Yield Enhancement being discussed here, the broker has no right to lend out your securities and must segregate them in what is referred to as a good control location (special bank or DTC account). If the broker has financed the purchase of your securities via a margin loan, then the broker has the right to hypothecate (loan or pledge) securities but only in an amount up to 140% of your debit or margin loan balance.

Your own U.S. customer agreement seems to conflict with or at leas is confusingly unclear about what you just posted. It states (https://gdcdyn.interactivebrokers.c....formSampleView?ad=us_customer_agreement.html) "IB's Right to Loan/Pledge Customer Assets: As allowed by law, IB or an IB affiliate is authorized by Customer to lend to itself or others Customer securities or assets held in any IB account in which Customer has an interest (whether in the name of Customer of in the name of an entity (corporation, partnership or trust) controlled or owned by Customer or under Customer's trading authority). IB or an IB affiliate may, without notice, pledge, re-pledge, hypothecate or re-hypothecate such Customer's securities and assets, separately or together with those of other customers, for any amount due in any IB account in which Customer has an interest, without retaining in IB's possession or control a like amount of assets. For loans of securities, IB or an IB affiliate may receive financial and other benefits to which Customer is not entitled. Such loans could limit Customer's ability to exercise securities' voting rights."

Why wouldn't you include the bit about "broker has the right to hypothecate (loan or pledge) securities but only in an amount up to 140% of your debit or margin loan balance." in there instead of writing it to appear as if you have an unlimited right to hypothecate? What is the law that creates the restriction you listed above, and why not just make that clear on in your user agreement, where most customers go for guidance on your policies? To be honest between you saying this on a bulletin board and the written policy on your website indicating otherwise I'm inclined to not take your word on it. Certainly if I ever had a disagreement with your company they'd point me to the verbiage I signed, and you can imagine how much credence they'd give to "but I read this guy from IB on the internet who said...".

 

[Sig]

To be clear, the lending of securities through this program does not introduce unsecured credit risk. As is industry convention, the borrower of the stock has to deposit cash collateral (often originating from the proceeds of a short sale) with the lender to secure the return of the stock. The actual amount of cash required is equal to 102% of the stock value, rounded up to the nearest whole dollar. For example, a loan of 100 shares of a stock which closes at $59.24 would be equal to $6,100 ($59.24 * 1.02 = $60.4248; round to $61, multiply by 100).

In addition, the loan is marked to the market daily with the cash collateral adjusted between the lender and borrower accordingly. Moreover, the cash is deposited in a segregated bank account.

I'm going to say you're either just wrong about this or you're being purposely misleading. I finally dug around and in your yield enhancement agreement it actually states (https://www.interactivebrokers.com/download/IB_LLC_Agreements_and_Disclosure_Package.pdf)
"6. Securities Loaned Out By Customer May Not Be Protected by SIPC:
The provisions of the Securities Investor Protection Act of 1970 may not protect Customer as a lender with respect to securities loan transactions in which Customer lends to Interactive Brokers Customer's Fully-Paid Securities. Therefore, the collateral delivered to Customer (and indicated on Customer's account statement) by Interactive Brokers may constitute the only source of satisfaction of IB's obligation in the event that IB fails to
return the securities." So basically, you're not covered by SIPC if you participate in this program, which was the big question everyone was asking. Instead you go to the back of the line of unsecured creditors. If IB failed to properly segregate funds, as was the case with PFGBest and pretty much any other major broker failure in recent history, the customer's getting pennies on the dollar. Even if it is maintained, the customer's waiting months or years through the bankruptcy process to get paid, vice weeks if covered under SIPC. So clearly there is a counterparty risk anyone takes when participating in this program, and to say otherwise is pretty dishonest at best and certainly doesn't help IB's already horrible reputation for providing misleading or just plain incorrect customer service responses.

 

[IB-AN]

Your own U.S. customer agreement seems to conflict with or at leas is confusingly unclear about what you just posted. It states (https://gdcdyn.interactivebrokers.c....formSampleView?ad=us_customer_agreement.html) "IB's Right to Loan/Pledge Customer Assets: As allowed by law, IB or an IB affiliate is authorized by Customer to lend to itself or others Customer securities or assets held in any IB account in which Customer has an interest (whether in the name of Customer of in the name of an entity (corporation, partnership or trust) controlled or owned by Customer or under Customer's trading authority). IB or an IB affiliate may, without notice, pledge, re-pledge, hypothecate or re-hypothecate such Customer's securities and assets, separately or together with those of other customers, for any amount due in any IB account in which Customer has an interest, without retaining in IB's possession or control a like amount of assets. For loans of securities, IB or an IB affiliate may receive financial and other benefits to which Customer is not entitled. Such loans could limit Customer's ability to exercise securities' voting rights."

Why wouldn't you include the bit about "broker has the right to hypothecate (loan or pledge) securities but only in an amount up to 140% of your debit or margin loan balance." in there instead of writing it to appear as if you have an unlimited right to hypothecate? What is the law that creates the restriction you listed above, and why not just make that clear on in your user agreement, where most customers go for guidance on your policies? To be honest between you saying this on a bulletin board and the written policy on your website indicating otherwise I'm inclined to not take your word on it. Certainly if I ever had a disagreement with your company they'd point me to the verbiage I signed, and you can imagine how much credence they'd give to "but I read this guy from IB on the internet who said...".

We don't put that language in our agreement because it's part of the SEC rules. No broker could create a customer agreement that's enforceable if it violated those rules. That is why the language in the agreement which you cited above includes the phrase "As allowed by law...."

 

[IB-AN]

I'm going to say you're either just wrong about this or you're being purposely misleading. I finally dug around and in your yield enhancement agreement it actually states (https://www.interactivebrokers.com/download/IB_LLC_Agreements_and_Disclosure_Package.pdf)
"6. Securities Loaned Out By Customer May Not Be Protected by SIPC:
The provisions of the Securities Investor Protection Act of 1970 may not protect Customer as a lender with respect to securities loan transactions in which Customer lends to Interactive Brokers Customer's Fully-Paid Securities. Therefore, the collateral delivered to Customer (and indicated on Customer's account statement) by Interactive Brokers may constitute the only source of satisfaction of IB's obligation in the event that IB fails to
return the securities." So basically, you're not covered by SIPC if you participate in this program, which was the big question everyone was asking. Instead you go to the back of the line of unsecured creditors. If IB failed to properly segregate funds, as was the case with PFGBest and pretty much any other major broker failure in recent history, the customer's getting pennies on the dollar. Even if it is maintained, the customer's waiting months or years through the bankruptcy process to get paid, vice weeks if covered under SIPC. So clearly there is a counterparty risk anyone takes when participating in this program, and to say otherwise is pretty dishonest at best and certainly doesn't help IB's already horrible reputation for providing misleading or just plain incorrect customer service responses.

If you read what I said carefully, you'll note I made no mention of SIPC protection and what's written in the agreement you've cited is accurate. What is also accurate is that the lending of stock under this program is not unsecured and that cash which comes from the borrower of the stock is deposited in the same "Special Reserve Bank Account for the Exclusive Benefit of Customers" as any other segregated cash for securities accounts. It's therefore subject to the same investment restrictions as any other customer cash and is considered customer property which would be applied to satisfy customer claims in the event of broker default.

Comparing IB to a firm whose failure allegedly resulted from embezzlement is a bit of a stretch when one considers the stake that management and employees hold in this company...it's a substantial vested interest that makes such actions irrational.

 

[Sig]

If you read what I said carefully, you'll note I made no mention of SIPC protection and what's written in the agreement you've cited is accurate. What is also accurate is that the lending of stock under this program is not unsecured and that cash which comes from the borrower of the stock is deposited in the same "Special Reserve Bank Account for the Exclusive Benefit of Customers" as any other segregated cash for securities accounts. It's therefore subject to the same investment restrictions as any other customer cash and is considered customer property which would be applied to satisfy customer claims in the event of broker default.

Comparing IB to a firm whose failure allegedly resulted from embezzlement is a bit of a stretch when one considers the stake that management and employees hold in this company...it's a substantial vested interest that makes such actions irrational.

Well that's an ironic statement. Russell R. Wasendorf Sr. had his entire net worth tied up in PFGBest, so much so that he attempted suicide when the failure of the company was imminent. And yet, PFGBest still happened.
I don't think you grasp the concept of counterparty risk in the financial world and the role of SIPC insurance. It has little to do with your particular company or how much vested interest you have in keeping it afloat, it's assumed that every company's principals have a vested interest in keeping it afloat and every broker looks solid until it doesn't. I have a very vested interest in keeping my house from burning down and am very careful to avoid that, but that doesn't keep me from ensuring I have insurance in case it does. Houses burn down, and the PFGBests of the world happen. The concept of counterparty risk is the inherent assumption that periodically these events will happen and it's very difficult to know when and to whom they will happen, so you need to asses what you exposure to such events will be when they inevitably occur. SIPC protects covered investments, greatly reducing your exposure to the idiosyncratic risk of a single firm failing. When you forgo that protection, for example by participating in IB's yield enhancement program, the benefit you gain from that program needs to exceed the expected value of your loss in case IB happens to be one of the brokers that fails. While the results of that equation vary by investor, letting that investor know that their securities aren't covered by SIPC in such an eventuality is the most important thing you can do as an employee of your firm if you want to ensure your customers know what they're getting into before they do. Obfuscating with a bunch of boilerplate about how investor cash is handled when the entire focus of this part of the thread was on if SIPC coverage applied or did not does your customers a disservice and makes you look like you're either untrustworthy or lack understanding of basic counterparty risk concepts. Based on your replies so far I'll give you the benefit of the doubt and assume the latter.

 

[ET180]

For what it's worth, I've had a good experience with IB over the past few years. I think they are one of the best brokers in the business and have been enrolled in the yield enhancement program for a few weeks. As far as my positions, I can't tell that I have anything lent out...only when I look at my statement do I see some extra interest getting collected. It's nothing huge, but sure, I'll take whatever I can get.