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There have been three recent events that have made it imperative for investors to reexamine their portfolio strategies. These are:

1: In 2008 Bernie Madoff revealed to the world that his highly acclaimed fund was a Ponzi scheme and that it had collapsed.

2: In 2011 MF Global was found to have stolen funds out of segregated accounts that were used in collateralizing bad bets on European debt.

3: In 2013 Cyprus banks closed. Depositors that own supposedly insured bank accounts may potentially lose a portion of their assets held in Cypriot banks. As of now Cyprus banks are still closed (i.e., on "holiday") so that they will be protected from bank runs.

What all of these events should solidify in the minds of investors is that they need to be acutely aware of the risks they incur when they have their funds with potentially highly levered or criminal counter-parties. Furthermore they must maintain a healthy level of skepticism with regard to government insurance of bank accounts and brokerage accounts.

Monies that are held in banks, brokerage accounts, mutual funds, and hedge funds are not necessarily as safe as investors generally assume them to be. More generally investors need to understand the counter-party risks of all of their investments and allocate their funds in such a way that minimizes and diversifies these risks.

It is impossible to quantify the risks that: (1) the FDIC or SIPC will fail to pay account holders should their banks or brokers fail or rob them, or (2) the SEC or CFTC provide an appropriate level of oversight over fund managers or stock and futures brokers. However, these three recent events suggest to me that these risks are solidly greater than 0%, and consequently investors need to prepare themselves for the unlikely event that their investments and savings will be stolen or lost. The decision making process that goes into this preparation should not be unlike the decision making process investors use in diversifying their assets in other ways. In order to do this, I argue that investors must expand their current notion of "diversification" in order to include what I am calling counter-party risk diversification.

1: The New Diversification

A fundamental truism of investing is that every investment decision comes with some form of risk, and consequently it is prudent to diversify this risk in order to minimize the impact of unforeseen events adversely impacting one's portfolio. Financial advisors will advise clients to diversify what constitutes their portfolios (sectors of the economy (telecommunications, chemicals, shipping … etc.), asset classes (stocks, bonds, commodities, and currencies), volatility (high beta, low beta), and so on; however it is implied that such a "diversified" portfolio will be held in a single brokerage account, or even through a single "diversified" fund.

Using this limited diversification strategy investors might be protected from certain events such as rising interest rates in the United States, a recession in Japan or tensions between Israel in Iran. But they are not protected from others such as a bank holiday (Cyprus at the present time, 9/11 in the United States), a broker stealing assets from their segregated accounts, or the breach of an insurance contract. Consequently investors are not protecting themselves against the possibility of losing all or a sizable portion of their assets either permanently or for an extended period of time: Madoff's customers lost everything permanently; bank account holders in the United States on 9/11/2001 temporarily lost access to their assets. Investors who practiced counter-party risk diversification would have lost at most a small portion of their assets to Madoff, and they would have had cash available to make necessary expenditures on 9/11/2001.

Despite the risks that have been made apparent as a result of the three aforementioned events, very few financial advisors have anything to say regarding how investors should own their assets if these assets are not held with that advisor's brokerage house or bank. Aside from the obvious observation that such advice would not immediately be in a financial advisor's best interest, the sort of thinking that leads to the portfolio strategy considerations I offer here is often characterized as "paranoid" and should be reserved for lunatic fringe conspiracy theorists, despite the fact that recent history suggests otherwise. Investors need to ask themselves whether or not ATMs will work if there is another terrorist attack, and whether or not SIPC will really protect them if a crooked brokerage firm puts their assets up as collateral for risky bets and loses them. The fact that investors cannot answer these questions (and other's like them) with any quantifiable certainty necessitates that they seriously consider their counter-party risks in formulating their portfolio strategies. This is, in fact, not a paranoid statement based upon some far fetched conspiracy theory; it is rather something that is all too apparent only once in a great while, although when it is apparent this is the case because the losses incurred by those who ignore it are large and immediate.

2: What is Counter-Party Risk?

Counter-party risk is simply the risk investors expose themselves to by involving other people and institutions in their investments. There is no way to avoid counter-party risk: one can only diversify amongst several counter-parties in such a way that one's wealth can withstand a black swan event (or a series of black swan events) involving the failure or criminal activity of one or several counter-parties. If you have Apple (NASDAQ:AAPL) shares in a brokerage account with Morgan Stanley (NYSE:MS) then Morgan Stanley is one of your counter-parties. If you hold shares of GLD in that brokerage account then you also have HSBC (HBC) -- the custodian of GLD's gold -- as another counter-party. This means that potentially either Morgan Stanley or HSBC can fraudulently confiscate your wealth that is tied up in GLD. If you hold shares of JJG, which gives investors exposure to grain prices, then you have Barclays (NYSE:BCS) as a counter party because the JJG is an ETN, which is a form of debt instrument issued by Barclays. You also have the CME Group (NASDAQ:CME) as a counter party because JJG has exposure to grain futures contracts, and if there is a problem in the futures market that compromises the value of grain futures relative to the price at which farmers are selling their grains, then the CME Group is responsible. If you have money in the bank then you have that bank as a counter-party. If you store gold coins, diamonds and cash in a safe in your basement then a thief can break into your house rob you, and he is, in effect, another counter-party.

3: Mitigating Counter-Party Risk

As I suggested above there is no way to completely shield yourself from counter-party risk. The best you can do is to minimize its negative impact on your wealth.

There are two approaches to mitigating counter-party risks. The first is insurance. If Morgan Stanley steals your Apple shares then you have SIPC insurance. If Bank of America (NYSE:BAC) fails and loses your deposit then you have FDIC insurance. Insurance hedges counter-party risk, and the insurer is consequently a back-up counter-party for the original counter-party.

The inherent problem with insurance is that the failure of the original counter-party inherently puts the insurer at a greater risk of default. For example the FDIC is inherently better off financially if Bank of America doesn't fail than if it fails. As a result, while insurance can hedge against counter-party risk, the insurer is not a mutually exclusive counter-party (I use the term loosely; in a highly interconnected world there likely aren't any purely mutually exclusive counter-parties).

The second strategy for mitigating counter-party risk is to diversify amongst multiple counter-parties. If you have 100 Apple shares -- 50 with Morgan Stanley and 50 with Fidelity (NYSE:FNF) -- and if Morgan Stanley steals your 50 Apple shares, then you have only lost half of your position (assuming that there is no SIPC insurance).

What is preferential to me as an investor about counter-party diversification over insurance is that I am putting a limited portion of my assets at risk in the unlikely event that my broker, bank, or neighbor robs me. While it is possible that my bank can lose my deposit and that my neighbor breaks into my safe and steals my gold coins and cash at the same time, these events are not connected except under the most aberrant of circumstances.

4: Diversifying Your Counter-Party Risk

The following are ways in which investors can diversify their counter-party risks:

A: Investors should hold the money that they wish to keep in the bank with different banks. Further, since deposits in the banks of a single country are insured by the same institution, investors should have bank accounts in different countries. This protects investors from losing all or some of their bank deposits unless there is a global banking crisis. Cypriot citizens may have to learn this the hard way.

B: Investors should hold their stocks, bonds, and other non-bank deposit financial assets with different brokerage houses. In the United States all of these brokerage accounts are insured by the SIPC, and so if possible, investors should consider opening additional brokerage accounts overseas.

C: Investors should not hold all of their stocks in "street name" registration. When investors hold their stocks in street name these securities are held in the name of their broker and appear as book entries in investor accounts. There are two other options generally available to investors according the SEC. The first is direct registration, whereby the stock is held in the name of the investor but it still held by his or her broker. The second is to take delivery of a physical stock certificate. A stock certificate is issued by the underlying company and it is physical proof of the investor's ownership of the shares.

D: Investors should have some of their assets completely outside of the banking system. That is to say that they should have assets (physical dollar bills, gold coins and bars, fine art … etc.) at home in a safe or somewhere carefully hidden. In doing so they will be prepared for a catastrophic event whereby they cannot get their assets from any bank or brokerage house.

5: Conclusion

The following summarizes the key points I make in this article:

A: While most people have not been affected by black swan counter-party failures they do exist, and consequently investors should prepare for them. They can do this by diversifying their counter-party risks.

B: The conventional notion of "diversification" will protect investors from some negative events in the economy, but not all of them. The Madoff Ponzi scheme, the MF Global scandal, and the ongoing Cypriot banking crisis are all examples of this. By incorporating counter-party risk diversification into their portfolio strategies investors can shield themselves from losing all or most of their assets if there is a similar crisis in the future.

C: Specifically, counter-party risk refers to the risk one assumes by involving other people or institutions in his or her investments. A counter-party can be a bank, fund manager, or a a "common" thief on the prowl in your neighborhood.

D: In order to mitigate counter-party risk investors have two options: insuring their assets and diversifying across multiple counter-parties. The latter is more secure in that the value of insurance is dependent on the credibility of the counter-parties it insures.

E: In order to diversify counter-party risk investors should hold their assets in several accounts in different countries. They should also hold some assets entirely outside of the financial system in order to be prepared for a worst case scenario.

Investors who take these points into consideration when framing their portfolio strategies will not be able to shield themselves against every event in which a counter-party fails or turns out to be a criminal. However they will be the best equipped to handle and withstand such events when they do occur.

Source: Counter-Party Risk Diversification