2. Where your money really is: custody, counterparty and compensation schemes

Risk 7: The risk that is not in the prices

Ask an investor where their money is and they will point at an app. The app is a screen; the money is somewhere else, and knowing where changes completely what happens on the day something fails. This module is about concrete details, with no alarmism: the conclusion is not that everything is in danger, but that you have to be able to tell apart three things most people run together.

Three layers that are not the same thing

When you buy a share at least three parties are involved. The broker, who executes the order. The custodian or depositary, who keeps the securities recorded. And the issuer, the company or institution that created what you bought. Each can fail separately and the consequences bear no resemblance to one another.

The general rule in the European Union and in most developed markets is that client securities do not form part of the intermediary's balance sheet. They are segregated from the firm's own assets, and that is why its failure should translate into a transfer to another intermediary, with delays and nuisance, but without loss. That word, should, is what holds up the rest of this module.

Segregated accounts and omnibus accounts

In a segregated account your securities are recorded in your name in the relevant register, with an individual reference. In an omnibus account the broker appears as the holder of a single global account in which the securities of all its clients are mixed together, and who owns what is recorded only in its internal books.

The omnibus account is legal, commonplace, cheaper, and it usually explains why some firms' fees are lower than others'. Its risk is not that the intermediary keeps your money, but something more prosaic: if its internal records are badly kept, on the day of the failure someone has to reconstruct who held what, and that means lawyers, insolvency administrators and years. On top of that, in several jurisdictions the costs of that administration can end up being charged against the clients' own assets, so that you watch your money, which was yours, pay the bill for getting it back.

What the compensation schemes cover, and up to how much

Here there is an almost universal misunderstanding. Compensation schemes do not cover your investment falling in value. They cover the firm failing to give back what was yours. The reference figures, worth keeping in mind:

• FOGAIN, in Spain, covers up to 100,000 euros per holder and firm against the failure of an investment firm or a fund management company to return cash and securities.
• The Deposit Guarantee Fund, also Spanish, covers up to 100,000 euros per holder and institution, but on cash deposited at a bank, which is a different matter entirely.
• In the United States, SIPC covers up to 500,000 dollars per client, of which a maximum of 250,000 in cash. In the United Kingdom, the FSCS covers 85,000 pounds.

If you have 400,000 euros in shares and your broker fails, the relevant question is not how much the compensation scheme covers. It is whether your shares turn up. If they do, they are transferred and the scheme never comes into it. The scheme is the net that gets spread when they do not turn up, and its limit leaves most of a medium-sized portfolio exposed.

Your broker failing and the issuer failing are not the same thing

This distinction is worth the whole module. If your broker fails, your shares and fund units are still yours: they are third-party assets it was holding in custody. If the issuer of a product that consists of a promise to pay fails, you stop having an asset and become a creditor.

The second category includes plenty of things that look identical on screen to an exchange-traded fund: exchange-traded notes, certificates, structured products, a good part of leveraged or inverse products, and in general anything that is debt of the issuer referenced to an index. The underlying can behave perfectly and you can lose the lot, because you never had the underlying: you had somebody's promise.

Swaps and uninvested cash

A synthetically replicated exchange-traded fund does not buy the index: it signs a swap with a bank, which undertakes to pay it the return of the index in exchange for the return of a collateral basket. There is therefore counterparty risk, but bounded by two seams: European rules limit exposure to a single counterparty to a small percentage of assets, and in practice collateral is posted daily, often above one hundred percent. It is not zero and it is not enormous: it is an exposure worth knowing about.

And there remains the point almost nobody looks at. The uninvested cash in your account may be deposited at a bank in the broker's name, invested in a money market fund, or paid interest on within the intermediary itself. The three situations carry different protections, and only the first comes close to what the investor imagines. It is worth knowing which one you are in before leaving a large sum sitting there waiting for an opportunity.

A real case: segregation as a rule and as a practice

In October 2011 MF Global failed, a futures intermediary with decades of history, after a heavily leveraged bet on European sovereign debt. When the books were opened a hole of the order of 1.6 billion dollars appeared in the client accounts: money that should have been segregated and that had been used to cover the firm's own needs. Segregation existed as a rule and had failed as a practice.

The ending is the instructive part. After litigation and liquidation, the US futures clients ended up recovering one hundred percent of their balances, something exceptional in a case like this, but the process dragged on for around three years. During that time the money existed on paper and was no use to anybody.

In parallel, the collapse of Lehman Brothers in 2008 supplied the other half of the lesson: thousands of retail investors in Asia and Europe held notes and certificates linked to indices and baskets that looked like funds on screen and were debt of the issuer. Their brokers were in perfect health. What broke was whoever had signed the promise.