Are you exposed to the coming financial defaults?

First, an apology. I'm sorry if you followed me into the spread bet on a euro break-up with Worldspreads. As you may be aware, Worldspreads' shares were suspended on Friday and the firm went into administration on Sunday. And it's left behind a rather messy situation for anyone with an account.

I expect to get my money back as the firm is regulated by the FSA and covered by the Financial Services Compensation Scheme (FSCS). But now is a good time to take a look under the bonnet of this compensation scheme. Because it's widely misunderstood.

In fact, once you've seen howthe systemworks, you may want to consider carefully the stability of the financial system as a whole.

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Here's how the scheme works

Most punters with Worldspreads should be covered as the limit for any one person is £50,000. And given that with spread bets you only need put down a fraction of your full exposure, I can't see many traders having more than £50,000 in their accounts.

But it'll take time for me to get my money back (though last time this happened to me the process ran very smoothly) and it's a shame because I was quite keen on the bet I had open. Presumably all open bets will have been closed out on Friday. We'll have to wait and see.

I guess this just goes to show the value of spreading your investments around. I know it's tempting to consolidate all your accounts into one place it makes life easier. I know the more accounts you have, the more paperwork and admin hassle it creates. But if ever there was a gentle reminder that you shouldn't have all your eggs in one basket, then surely this is it.

Though it's too early to mete out blame, it seems these guys didn't follow the rules on ring-fencing client cash. That's either negligence, or fraud. And that's why we're all pleased to have the FSCS.

But be aware, this compensation scheme isn't there to cover you against any losses on investments (alas!). It's there to cover your investment against default by the financial entity. If these guys legally' fritter away your savings through bad investments, then you aren't covered.

And the cover is up to £50,000 for investments and mortgages (though quite how you can lose that much if your mortgage provider defaults, I don't know), and £85,000 for cash. These are the amounts per person, per institution. So when you spread your cash around between financial firms, make sure they're not ultimately owned by the same financial institution.

Interestingly, insurance businesses are dealt with differently. Basically, here you're covered for 90% of your full claim. I guess that allows investors with endowment and annuity policies to sleep a little easier at night.

But who pays?

Now that's an interesting question. Many wrongly assume that this is a government scheme. It isn't. The FSCS is very clear that it is independent of thegovernment.

The scheme is actually funded by a fee levied on FSA regulated companies. But there's a limit as to how much the FSCS can sting them for. And that is £4bn a year (I gather that, in extremis, it can ask for a little more).

Now £4bn may sound like a lot of cash, but relative to the size of potential liabilities, it isn't. Especially when you consider how shaky a few of our big banks look.

But though theFSCS isn't a government-backed scheme, in the event of a major bank breakdown, it's very likely that thegovernment will step in and lend a hand. In the unlikely event that the government allows a bank to fail, they will probably lend the FSCS whatever it needs to make good on its pledges.

But make no mistake, this will be a loan. The industry will have to pay it back.

Already, the FSCS is struggling. The new chairman, Lawrence Churchill, acknowledges "A huge increase in claims and compensation paid out in more recent years has created significant challenges for the FSCS, and has impacted on all of its stakeholders."

What we're looking at is a system where failing institutions draw resources from the stronger ones. I'm not saying that's a fundamental flaw and I'm not saying it isn't secure, given the fact that government will ultimately have to get involved. But what I am saying is that it's another reason to steer clear of financial sector shares. Because even if you're doing ok as a financial institution, you're still left holding the can for the weak.

It's not as if I was about to buy into the recent rally in bank stocks; but this open-ended liability hardly helps.

Don't suffer a life-ruining experience because of apathy

As I mentioned earlier, the real lesson with the collapse of Worldspreads is that it's worth having accounts with a variety of brokers. In fact it's not the only reason.

For instance, I use a discount online broker to deal in large quoted stocks (where the spread is tight); but when it comes to less liquid stocks, I always use a premium' broker. I don't mind paying a higher commission when they can save me much, much more by getting me a decent price on the stock.

The same is true of SIPPs for your self invested pension. There are many different levels of service and you may get some benefits by spreading your pension assets between a couple of providers.

And of course, the same is true of spread bet providers. Some offer different markets, different bets and different prices.

I know we all like to make life easy for ourselves... most of us haven't the time for all this extra administration, extra log-ins, passwords etc, etc. But I urge you to be aware of the risks you're taking on if you consolidate everything into one place. I know personally of two cases where individuals faced six figure sum losses from institutions at default.

Believe me, this causes a great deal of heartache. You really must do whatever you can to diversify your exposure to financial institutions.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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