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.
A brokerage is the trader's counterparty in every trade, and the brokerage is the custodian of the trader's funds. The relationship is built on trust, and the trust is supported by regulation, segregation of funds, and the brokerage's reputation. The trader should understand the main risks of using a brokerage, and the trader should take steps to mitigate the risks before opening the first account.
The main risks
The first risk is the counterparty risk. The brokerage can go bankrupt, and the trader can lose the funds held in the account. The risk is mitigated by the segregation of client funds, which keeps the trader's money separate from the brokerage's operating funds, and the risk is mitigated by the investor compensation scheme, which covers losses up to a certain amount if the brokerage goes bankrupt.
The second risk is the platform risk. The brokerage's platform can have a technical outage, and the outage can prevent the trader from placing or closing trades. The outage is rare, and the outage can be caused by a server issue, a network issue, or a software bug. The trader should have a backup plan, and the backup plan should include a phone number to call the brokerage in case of an outage.
The third risk is the execution risk. The brokerage can fill the order at a worse price than expected, and the worse price is called slippage. The slippage can be positive or negative, and the slippage is more common during periods of high volatility or low liquidity. The trader should use limit orders when the price matters, and the trader should accept the slippage on market orders.
The fourth risk is the regulatory risk. The regulator can change the rules, and the rule change can affect the trader's account. The rule change can be a new leverage limit, a new reporting requirement, or a new product restriction. The trader should keep up to date with the regulatory changes, and the trader should be prepared to adjust the trading strategy.
The fifth risk is the hidden fee risk. The brokerage can charge fees that are not obvious from the fee schedule, and the fee can be an inactivity fee, a withdrawal fee, a currency conversion fee, or a data fee. The trader should read the fee schedule carefully, and the trader should calculate the total cost for a representative trading pattern.
The sixth risk is the data security risk. The brokerage stores the trader's personal and financial data, and the data can be exposed in a cyber attack. The data exposure can lead to identity theft, and the data exposure can lead to unauthorized access to the account. The trader should choose a brokerage with a strong security record, and the trader should use two-factor authentication.
How to mitigate the risks
The first mitigation is to choose a regulated brokerage. The brokerage should be regulated in a recognised jurisdiction, and the brokerage should keep the client funds in a segregated account. The trader should verify the licence, and the trader should read the brokerage's risk disclosure.
The second mitigation is to keep a small balance. The trader should not keep all the trading capital at one brokerage, and the trader should keep a portion of the capital at a second brokerage or at a bank. The diversification reduces the impact of a single brokerage failure.
The third mitigation is to use a stop-loss. The stop-loss limits the loss, and the stop-loss is the trader's main tool for managing the execution risk. The stop-loss should be placed at a level the trader is comfortable with, and the stop-loss should not be moved against the trader.
The fourth mitigation is to use two-factor authentication. The two-factor authentication adds a layer of security to the account, and the two-factor authentication reduces the risk of unauthorized access. The trader should enable the two-factor authentication on all the brokerage accounts, and the trader should use a strong password.
The fifth mitigation is to monitor the account regularly. The trader should check the account balance, the open positions, and the trade history on a regular basis. The monitoring helps the trader catch any unauthorized activity early, and the monitoring helps the trader react quickly to any issue.
Common questions about brokerage risks
Are brokerages safe? Yes, when the brokerage is regulated and when the brokerage segregates the client funds. The safety depends on the regulation and the brokerage's reputation, not on the discount model itself.
What happens if the brokerage goes bankrupt? The trader's funds may be lost, but the segregation of funds and the investor compensation scheme may cover a portion of the loss. The trader should check the brokerage's policy, and the trader should keep a small balance at any one brokerage.
Can the brokerage trade against me? Some brokerages act as market makers, and the market maker takes the other side of the trade. The conflict of interest is real, and the conflict of interest is one reason the trader should choose a brokerage that routes orders to an external exchange.
Related resources
Where to start
If you are evaluating the risks of using a brokerage, the most useful first step is to verify the licence, the segregation of funds, and the fee schedule for the brokerages you are considering. Our broker comparison lists the brokerages by jurisdiction and by regulation, which together tell you what the broker offers before you open the account.