According to FINRA, Interactive Brokers LLC was censured and fined $475,000 on October 22, 2024, for creating or increasing its segregation deficits for securities by returning borrowed shares when it should not have.
The firm incorrectly calculated the number of excess shares of stocks listed on European exchanges it had available to return to customers from whom it had borrowed them as part of the firm's fully paid securities lending program. The firm updated an algorithm it utilized to identify securities for which the firm possessed an excess and was therefore available to be returned to customers. The firm updated this algorithm for shares traded on European exchanges in a way that resulted in the firm inadvertently creating or increasing its segregation deficits on multiple occasions.
The firm relied on anticipated loan return activity in calculating the number of shares in its possession or control, but then failed to receive the expected shares. The firm thereby created or increased existing deficits, the sums of which were approximately $30 million. In these instances, the firm returned to customers fully paid shares that it had borrowed from them via its fully paid securities lending program (and thus stopped paying those customers the applicable daily rate for borrowing those shares) even though the firm should have continued to borrow those shares to avoid creating or increasing a segregation deficit.
The firm also failed to establish and maintain a supervisory system reasonably designed to comply with its possession and control obligations. The firm's written supervisory procedures failed to address how the firm should identify or resolve deficits caused by early returns and did not have a system to detect issues that might cause early returns or deficits as a result of its stock lending program. Furthermore, the firm did not have a registered principal or Operations Professional directly supervise the creation, launch, or testing of the algorithm the firm relied on to identify securities available to be returned.
Additionally, the firm allowed an unregistered associated person to lead and oversee some software development efforts concerning the firm's securities finance business, including its securities lending program. As securities lending is a covered function, that person was required to have been registered with FINRA as an Operations Professional.
Securities lending programs allow investors to earn additional income by lending their fully paid securities to the broker, which then lends them to short sellers or other borrowers. However, these programs come with risks, and firms have strict obligations to segregate customer securities and maintain possession and control. When a firm creates segregation deficits, it means the firm has failed to maintain adequate securities to meet its obligations to customers—a serious breach that could leave customers at risk if the firm were to fail.
This case demonstrates the dangers of inadequate oversight of automated systems. The firm's algorithm error went undetected because no registered principal or Operations Professional supervised its development and implementation. The fact that an unregistered person was leading software development for a critical regulatory function is particularly concerning. Investors participating in securities lending programs should understand the risks and ensure their broker has robust controls to protect their securities. While these programs can generate income, this case shows that operational failures can result in customers being deprived of lending fees they should have received.
