Side Trading of Stocks and Bonds: Broker-Client Conflict of Interest . by Alice B. Clagett

Written and published on 18 February 2020; updated on 12 June 2020
Previously titled: Question About Stock Brokerage Integrity and Hidden Client Risk

Image: “A Section of Midtown Manhattan in Daytime,” by user: AngMoKil, in Wikipedia … https://en.wikipedia.org/wiki/Architecture_of_New_York_City#/media/File:Pano_Manhattan2007_amk.jpg … CC BY-A 2.5

Image: “A Section of Midtown Manhattan in Daytime,” by user: AngMoKil, in Wikipedia … https://en.wikipedia.org/wiki/Architecture_of_New_York_City#/media/File:Pano_Manhattan2007_amk.jpg … CC BY-A 2.5

  • PUTTING SAVINGS IN BANKS
    • Potential Risks
  • INVESTING IN STOCKS AND BONDS THROUGH A STOCK BROKERAGE FIRM
    • Potential of Brokers Skimming Margin Cream
      • Question: Is This Type of Skimming Maybe Common Practice?
    • Possible Need to Liquidate a Client’s Holding without Their Knowledge: A Workaround Not in the Client’s Best Interests
      • The Temptation for Stock Brokers to Advocate High-Risk Instruments to Cover ‘Phantom’ Trades

Dear Ones,

It seems possible to me there may be stock and bond brokerage conflict of interest with individual investors because of side trading by brokers. I say this because of experiences I had as an individual investor with a prestigious stock broker in years past. First some background regarding putting savings in banks, and then the question regarding side trading by brokers, and the ensuing conflict of interest …

PUTTING SAVINGS IN BANKS

If banks, say, take our savings into a savings account or CD, they are allowed to provide us a low rate of interest, and then they may invest that money in somewhat riskier ways, so as to earn our profit on the money we invest.

Potential Risks

The potential risk for the person who places his or her savings into a savings account or CD is the possibility of large-scale bank failures, as in the case of the Great Depression, when I recall my mom said people lined up on the streets trying to withdraw their savings from the banks, but were not able to because the banks failed.

These days, as I understand it, our bank savings are secured by the SEC or maybe FINRA, up to a certain per-person limit. That may mitigate the risk of large-scale bank failures … at least, up to a point.

INVESTING IN STOCKS AND BONDS THROUGH A STOCK BROKERAGE FIRM

Potential of Brokers Skimming Margin Cream

When we invest our savings in stocks and bonds, say, in a margin account, then it seems to me that the opportunity exists for the stock broker to benefit from our holdings in a way a little reminiscent of banks. For instance, might not the stock broker use our margin account to day trade equities or maybe bonds in hopes of skimming some cream off our account, with the client being none the wiser?

Question: Is This Type of Skimming Maybe Common Practice? Is that allowed, on Wall Street? Maybe it is common practice amongst stock brokerages, and I am not familiar with the practice?

This is the question I have: Do any of my readers know whether this skimming of margin cream is standard stock brokerage practice? If it is, then, I feel, there would be a potential broker-client conflict of interest …

Possible Need to Liquidate a Client’s Holding without Their Knowledge: A Workaround Not in the Client’s Best Interests

I know, from a year of day trading myself, that it is hard to beat the market through day trading. Sometimes, though, people get into the thrill of day trading, so much so that they do not want to look at the bottom line and find out for sure whether they bettered the market over the course of a year. Do you not feel this to be true?

I myself found, using the best software I could obtain, that after a great deal of work every morning, and plenty of thrills, I ended up with no profits (and no losses) at the end of a year.

The best of stock brokers intent on skimming margin cream would most likely know what I learned … that the chance exists that some of the client’s stocks would need to be liquidated because of a broker’s side traded margin deal gone south, unbeknownst to the client.

I remember in my mom’s time, stocks and bonds were actual pieces of paper that a brokerage handed to a client. Thus the client knew for sure what he or she owned; the stockholder or bondholder had the paper to prove it.

Today, however, investors often chose to leave their stock and bond certificates with their brokers. It is true, the investor can see on their monthly statement that they have such-and-such investments, numbered such and such. That, however, is the only proof they have that they have purchased and now own these stocks and bonds.

In a way, these stock brokerage statements are but figments; surely it might be possible, through sleight of hand, to sell some of the underlying instruments to pay off margin debt, without the client being wiser, the presumption being that similar instruments might be purchased, and their CUSIPs, for example, jimmied round, in the event the client wished to sell the (already sold) stock or bond, or to transfer the entire account to another brokerage.

In a sense, then, the stock and bond holdings of the modern-day brokerage client might be viewed as ‘phantom’ holdings. While possible, it seems to me such an approach to skimming margin cream might cause some last-minute sweat of the brow of the broker if the client were to decide to trade or transfer a ‘phantom’ stock or bond.

The Temptation for Stock Brokers to Advocate High-Risk Instruments to Cover ‘Phantom’ Trades. Here is a more difficult call from an ethical standpoint: The broker might wish to cover losses from ‘phantom’ margin trades by persuading the client to accept risky stocks and bonds that are likely to decrease in value. Then the risky instruments might be sold by the broker … while remaining as if held on the client’s statement … and the money from the sales used in ‘phantom’ day trading, with profit going to the broker, and phantom trading losses covered by the decreased cost of the broker’s purchase of the risky stocks as they go down in price.

What I am thinking is that the desire of stock and bond brokers to profit from ‘phantom’ trades might lead them to push very risky stocks onto a client, to cover the broker’s losses. In such instances, the financial interests of the broker would be opposed to the financial interests of his client, do you not think?

In love, light and joy,
I Am of the Stars

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finance, banks, banking, stock brokerages, stocks, bonds, economy, economics, disclosure,

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