Some investors are concerned that that their mining stocks could be swiped away from them. Are your stocks vulnerable to bail-in?

What is bail in?

Bail-in and its relevance to retirement funds is described in more detail in a previous post. To summarize, bail out is when the taxpayer (via the government) injects funds to prop up the banks when they run into financial trouble. Bail-in is where the bank’s creditors inject funds to prop up the bank when it runs into financial trouble. Bank creditors include the bank’s shareholders, bondholders, and depositors.

Thee G20 met in Brisbane in 2014 and rubber stamped bail-in, which has since been written into law in many countries. The majority of the population have no clue that this law even exists, and few understand the implications of bail-in.

The exact details of bail-in laws differ between countries and so you will need to assess the specific situation in your particular country.

The stipulated trigger for bail-in can be rather vague and varies between countries. There is variation in terms of what exactly can be bailed-in, and deposit insurance may or may not be available in your country. It is worth checking out not only the value that is covered, but also what the conditions are.

Can stocks be bailed in?

The stocks of the bank that is running into financial trouble can be bailed in, indeed bank stocks are probably going to be one of the first assets to be swiped. Can other types of stocks such as mining stocks be bailed-in?

This isn’t an easy topic to grasp as there are some murky areas and the answer will vary depending on which country you live in. This post provides an answer that is specific to New Zealand and Australia. Although this answer won’t necessarily be completely suitable for those living in countries such as USA or UK, it is still useful in providing you with pointers as to what questions you need to ask and how to research this for yourself.

Do you control your stocks?

The first question we should ask is regarding the stocks you own, do you have full control of them and does anyone else control them?

Australasia has CHESS which stands for Clearing House Subregister System. This is the computer system used by the Australian stock exchange to manage the settlement of share transactions and to record shareholdings. Investors are also assigned a holder identification number.

If you buy your Australasian listed stocks through a broker that is CHESS sponsored, that means that you own the stocks directly. There is no intermediary. Note that not all brokers offer CHESS and instead they hold the stocks on your behalf. This option seems less desirable.

The CHESS system does not apply when purchasing foreign stocks i.e. stocks that are not listed on the ASX or NZX. In such a case, the local broker will purchase the stocks through a foreign broker, and those stocks will be held by a sub-custodian. In many cases the stocks are held in a pooled account where all international holdings are combined and held together in one place rather than in individual accounts.

In summary, for Australasians, ASX or NZX listed stocks can be held directly, but foreign stocks are held by an intermediary.

Stock custodians

Does that really matter if an intermediary looks after your stocks? To answer that question we first need to understand custodians.

A custodian is a financial institution, usually a large one. Examples of custodians include JP Morgan, or Barclays bank. Such institutions can hold custody of trillions of dollars worth of assets. Custodians hold their customers securities for safe keeping to prevent them from being lost or stolen. Note that all custodians are brokers, but not all brokers are custodians.

In most countries institutional funds such as mutual funds and retirement funds are required by law to have a custodian for their assets. Bespoke agreements are drawn up between the custodian and the customer (the fund). Most of the agreements include limited liability for force majeure events. How do you define a force majeure event anyway?

Looking through custodial agreements that are available on the internet it seems that the assets of each custody account is kept separate from the assets of the custodian and maintained under joint control. That would mean that unlike cash, the assets would be held separately from the bank. This sounds promising but there are still some unanswered questions. There seems to be variation in terms of whether the assets are segregated or pooled. Can the assets be easily identified?

Is it possible for a custodian to lose the assets it looks after?

Interestingly, it is common for a custodian to have a sub-custodian, which in turn has its own sub-custodian. Custodial chains can come in a variety of lengths. Why long custodial chains exist is unclear.

The contract that the customer has with the custodian can differ from the contract between the custodian and the sub-custodian. If the sub-custodian were to go bankrupt, the customer does not have a contract with that sub-custodian and so would not be able to make a claim for the assets. The customer only has a contract with the custodian. Another question is whether the sub-custodian bankruptcy be considered a force majeure event? In that case, the custodian will have no liability.

An example of a sub-custodian contract clause:

“for greater certainty the custodian shall not be responsible for any loss or diminution in respect of any or all property resulting from the bankruptcy or insolvency of any such agent of the custodian except to the extent that the custodian fails to meet its standard of care set out in section [X.X] with respect to the section and monitoring of such agent.

An interpretation of this might be that if the sub-custodian goes belly up, it’s not the custodian’s problem and the customer has to suck up the loss!

Are stocks insured?

Surely there is government protection for broker insolvency? Investors in USA have Securities Investor Protection Cover (SIPC). SPIC covers brokerage accounts of up to $500,000 in securities of which $250 000 can be cash. Some may derive some comfort from SIPC however making a claim is unlikely to be a simple or rapid process. Asset retrieval from bankruptcy can be difficult and time consuming. During that time you would be unable to trade your stocks. SIPC only protects the number of stocks rather than the value of the stocks. For example if you held 200 shares of Apple and the custodian subsequently failed, SIPC will work to replace and restore the same number of shares. If the Apple stock plummets in price in the time it takes to sort through the administration, you won’t be reimbursed for the currency you lost through not being able to trade the stock.

Conclusion

Overall this is a very complex and murky area of finance. You would need to have a lawyer with in depth knowledge of financial contract law to provide a definitive answer to the questions posed in this article. However, there are some lessons we can learn from this discussion.

Firstly, it is very important to understand exactly how your stocks are held and what the custodial structure is. For Australasians that hold ASX or NZX listed stocks individually, it is preferable to purchase them through the CHESS system so that they may be held directly without an intermediary. Australasians would usually require a custodian to hold foreign listed stocks. For stocks held in any kind of fund (e.g. mutual fund, retirement fund), the law requires a custodian to be involved.

Although it remains a possibility that your stock holdings could be bailed in, this doesn’t mean you necessarily have to go out and sell all your stocks. Bail in of non-bank stock holdings is a low probability event, but the probability is not zero. No, this is just simply a discussion of the risks and worst case scenarios. When investing, it is important to consider what could go wrong. Such extreme risks should be taken into account when considering how you apportion your investments. Putting everything that you own into a basket of paper assets has its risks. Although large paper profits are possible, what is the worst case scenario? Those profits could all disappear overnight. Owning physical assets which you have full control over as a proportion of a portfolio is an important form of diversification.

If you hold physical gold you can actually hold it in your hand, there is no contract involved. You don’t need to decipher pages and pages of complex lawyer language to to assess risk.