This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
Using a brokerage for stock trading carries several distinct risks, and the risks are different from the risks of trading itself. The trading risk is the risk of losing money on a position. The brokerage risk is the risk of losing money because the broker fails, the platform fails, the regulator fails, or the execution is bad. The brokerage risk is usually smaller than the trading risk, but it is the risk that the trader cannot control through strategy or position sizing.
Counterparty risk
The first risk is counterparty risk on the broker. The trader holds cash and securities with the broker, and the broker is responsible for safeguarding the assets. If the broker fails, the trader's assets are at risk. The protection is the segregation of client funds, which is required by the regulator, and the protection is usually sufficient.
The segregation rules vary by jurisdiction. In the US, the SIPC protects customer accounts up to $500,000. In the EU, the investor compensation scheme protects up to €20,000. In the UK, the FSCS protects up to £85,000. The coverage is a floor, not a ceiling, and the trader should know the coverage in the broker's jurisdiction.
A broker regulated only by a small offshore authority does not have the same coverage. The trader who holds assets with an offshore broker is taking a real counterparty risk, and the risk should be reflected in the position size.
Platform and technology risk
The second risk is platform and technology risk. The trader's orders are placed through the broker's platform, and the platform can fail. The failure can be a crash, a disconnect, a slow execution, or a glitch in the order routing. The trader who needs to place an order at a specific moment can find that the platform is unavailable.
The platform risk is mitigated by redundancy. Most brokers offer a mobile app, a desktop platform, and a web platform. Most brokers also offer a phone trading line. The trader who relies on a single platform is exposed to the failure of that platform, and the trader should have a backup.
Regulatory risk
The third risk is regulatory risk on the broker's jurisdiction. The authority sets the leverage cap, the client money protection rules, and the disclosure requirements. The authority can change the rules, and the trader is exposed to the change.
The most common regulatory change is the leverage cap. ESMA in the EU has tightened the cap on retail leverage several times. The trader who has built a strategy around 1:30 leverage can find that the cap is reduced to 1:20. The trader should know the regulator's recent actions and the trajectory of the rules.
Execution risk
The fourth risk is execution risk. The trader's order is routed to the broker's execution venue, and the venue fills the order at a price that may be different from the price the trader expected. The difference is the slippage, and the slippage is a real cost on the trade. The slippage is small in a liquid market and large in a thin market, and the slippage is highest in a fast market around a news event.
The execution risk is mitigated by the broker's order routing policy. The policy tells the trader where the order is routed, and the trader can choose a broker that routes to lit exchanges rather than internalising the order. The internalisation is not necessarily bad, but the trader should know whether the broker is on the other side of the trade.
A second mitigation is the use of limit orders. A limit order caps the maximum fill price, and the cap protects the trader from the worst slippage. The trader who uses market orders in a fast market is exposed to the full slippage, and the slippage can be large. The trader who uses limit orders is exposed to the risk of a partial fill or a missed fill, but the cap on the fill price is a real protection.
Operational risk
The fifth risk is operational risk on the broker's business. The broker can have a technology outage, a cyber attack, a fraud event, or a key-person departure. The trader is exposed to the disruption, and the disruption can last from minutes to days. The trader who needs to place an order during a disruption is unable to do so, and the missed order is a real cost.
The operational risk is mitigated by the broker's redundancy and disaster recovery. Most brokers have a primary data centre and a secondary data centre, and the broker can fail over to the secondary in the event of an outage at the primary. The trader should know the broker's redundancy posture, and the trader should have a backup broker for the cases where the primary is unavailable.
How to manage the brokerage risks
The honest answer is to choose a broker that is regulated in a tier-one jurisdiction, has a strong redundancy posture, and has a transparent execution policy. The trader should also hold a smaller position with the broker than the trader would hold with a fully diversified custodian, and the trader should monitor the broker's regulatory actions and the broker's financial statements.
The trader who is serious about managing the brokerage risks should also have a backup broker, with a smaller allocation, in case the primary broker is unavailable. The backup broker should be a different legal entity, in a different jurisdiction, with a different platform. The trader who relies on a single broker is exposed to the failure of that broker, and the failure can happen at the worst moment.
Related resources
Where to start
If you are choosing a broker, the most useful exercise is to check the regulator, the segregation, the execution policy, the redundancy, and the financial strength. Our broker comparison lists the regulator and the fee schedule at each broker, which together tell you what the risk and the cost look like before you fund the account.