Brokers Break Down Trust in the Market

In the open market, your broker would have to pay about a 5% yield to borrow Netflix shares. So, of course, your broker will not go to the open market and pay competitive rates. Your broker can borrow your property for free and pocket the extra profit.

Owners of the same property, as a result, are treated very differently. The difference turns on whether the shareholder is informed. When a shareholder is informed (such as an institutional investor), brokers pay fair compensation when they borrow property. When a shareholder is uninformed (such as the average retail investor), the broker pays no compensation. There's no need for a broker to pay the open-market rate (5% annualized) to an owner of Netflix shares in a margin account. Since the account holder doesn't know about the loan of property, the broker can keep 100% of the proceeds from the loan.

Brokers make over $10 billion a year by lending other people's property. The incentive to keep the average retail investor uninformed on this issue is enormous. On any particular stock loan, profit dollars are often three or four times greater when the broker dips into retail accounts for stock to borrow instead of going to the open market for borrowing.

In addition to generating extraordinary profit for brokers, keeping the retail investor uninformed has other consequences.

For example, as noted here, voting has become a sham. The right to vote follows shares. So if your shares are lent to a short-seller, you can't (legitimately) vote. But you don't know when your shares are lent. And since your broker doesn't want you to know, your broker will send voting proxies to you and allow you to (wrongfully) vote.

Keeping retail investors uninformed can also create some serious tax consequences. As I explained in my column "The Stock Market is Patently Unfair," I paid more than twice my expected tax on dividends from my holding in Commerce Bank (CBH - commentary - Cramer's Take).

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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.