Is Your Broker Running a Bucket Shop?

Perhaps the most engaging book on speculation I have read is Reminiscences of a Stock Operator. It is about a world that happened many decades ago, before television, before Stalin was dead, even before radio, and yet it speaks of the core experiences of equity and commodity trading that ring true even in this day.

Early in the book, the protagonist has his formative experiences in a retail venue that has no modern equivalent--a bucket shop. Back in the day, those without sufficient capital to buy genuine common shares of corporations could instead go to the local bucket shop and gamble on price fluctuations. It was gambling in part because no shares ever traded hands. The customer put down a deposit, essentially buying a $100 stock for a few dollars, and if the stock rose they could rapidly double their money, but if it fell even a few dollars, they were wiped out.

There is supposed to be a primary difference between bucket shops and brokers, in that while a bucket shop takes your money in exchange for a promise to pay if you win, a broker theoretically delivers shares, which are at least somewhat tangible, even if just paper. Bucket shops, being gambling establishments, certainly aren't or weren't as reputable as brokers, who theoretically had greater probity.

But look at modern brokers: You deposit your genuine capital or its electronic equivalent, and the broker in return issues a periodic statement. You buy shares, sell shares, collect dividends, and everything is regular and above board. Except for one fact: The vast majority of customers will go many years, or even decades, between putting their money in and taking it out. There is a huge time delay in the flow of the physical capital. And there is the problem.

An unscrupulous operator can take advantage of this time delay to operate a Ponzi scheme, as Bernie Madoff pleaded guilty to running, and several other investment promoters have been accused of. The uncovering of investment frauds and Ponzi schemes has been one of the defining characteristics of the recent financial distress.

Which is to be expected. As Warren Buffett said, "It's not until the tide goes out that you learn who has been swimming naked." A financial crisis tends to cause cash flow problems for operators of Ponzi schemes, who then get discovered and prosecuted, we hope.

The problem I put to you is this: Have we discovered all of the Ponzi schemes? Or have we just discovered the bad ones, those operating with a little too much deficit? Can you know for sure that all of the existing investment managers and brokers aren't, in reality, just bucket shops that don't actually have the shares in storage, but instead just say they do?

Genuine crises cause deflation of asset values and abnormal calls for capital that will put even the most conservative and honest financial institutions into some distress. I am not saying that the financial crisis was caused by major institutions because they were "Ponzi schemes." The purpose here is to point out that, statistically, there are likely to still be more problem organizations out there that haven't yet been exposed.

How do you guard against fraud? Look out for excessive fees, extra or unneeded assurances that your money is safe, late delivery of withdrawals, and promises of high performance. Test the system by suddenly moving money out, and what the reaction of the organization. Most importantly, diversify your accounts to minimize the damage that a 100% loss in any one account would cause.