Brokers Break Down Trust in the Market

Despite recent platitudes to the contrary from Securities and Exchange Commission Chairman Christopher Cox, the stock market is not healthy. As I have discussed in two previous columns on this topic -- Why Does Failure to Deliver Go Unpunished? and The Stock Market Is Patently Unfair -- the market suffers from serious structural deficiencies.

And market regulators and lawmakers should take note. The foundation for a healthy, vibrant stock market rests on a triangle of trust between brokers, companies and investors. As investors learn more about how their property rights are being trampled on, their trust in the system may not endure.

The source of the market's structural problems should surprise no one -- it's all about money and power.

Stocks are the only type of asset where brokers wield inordinate power over the asset owners. No broker of real estate, for example, can lend your property to someone else without your knowledge. And after facilitating a loan of your property, no real estate broker would have the gall to retain 100% of the interest income.

But it happens every day in the stock market. Property is taken from margin-account holders and lent to short-sellers. This is not an indictment of short-selling. Legal shorting of stock is a perfectly legitimate investing activity. What is not legitimate is to lend out someone else's property without compensating them.

Fairness Is a One-Way Street

Investors have a right to be upset when they consider this simple example.

Say that, in your margin account, you borrow from your broker to buy shares in Netflix (NFLX - commentary - Cramer's Take). You pay fair compensation to your broker for both the trade and your margin loan.

But fairness is a one-way street in this case, because your broker can lend your Netflix shares to someone else and pay you nothing -- no rebate, no credit to offset the cost of your margin loan, nothing.

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At time of publication, Alsin and/or ACM was long Commerce Bank, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.