How safe are your shares?

MoneyWeek readers often ask about the safety of their investments. What happens if one of the firms holding them goes bust, for example? It sounds an easy question, but the answer isn't as simple as it might seem.

When you invest through a stockbroker or fund supermarket, the shares, bonds or funds you buy will usually be registered in the name of the broker you use. However, you are the "beneficial owner" of the securities, which means that you have rights over them. So if the broker collapses, your assets can't be taken by the broker's creditors. In the UK (but not all other countries), brokers hold client assets in the name of a nominee company set up solely for this purpose, which reinforces the separation between client assets and their own.

So in theory, the collapse of a broker should result in nothing worse than some disruption while your assets are returned to you. However, this depends on the broker segregating client assets correctly and keeping accurate records. In practice, things can go wrong and assets may be missing either due to fraud or negligence. If that happens and there's not enough money left in the broker to compensate clients for their missing securities, the Financial Services Compensation Scheme (FSCS) will step in (see below).

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Behind the scenes, things get more complicated. If you're invested in a fund, the fund is run by a fund-management company, but the assets willbe looked after by a fund administrator and held at a custodian (a firm that specialises in holding assets for others). In some cases often if you're dealing in international shares your individual securities might also be held at a custodian, rather than directly in the name of your broker. Custodians may in turn appoint sub-custodians to look after assets for them in certain markets.

And ultimately, ownership of all these securities is usually electronically recorded in a national central securities depository (CSD), allowing easy transfer of ownership. We've come a long way from paper certificates and registers.

Find out how you're protected

The upshot is that it's extremely difficult to understand all the theoretical points at which the failure of a company you've never heard of could affect your investments (the above paragraph isn't intended to explain anything, but just to hint at the complexity). That said, realistically, there's little point in worrying about the biggest fund managers, the global custodians and the CSDs. These entities control many trillions of dollars of assets and must be considered too big to fail. The most likely risk is the collapse of a stockbroker, fund supermarket, trading firm or a small fund manager, which is why it's important to understand how the FSCS protects you if the worst happens (see box below).

What's protected and what isn't

The protection that the FSCS compensation scheme provides for investments is different to the cover it provides for bank accounts. If you deposit cash with a bank and the bank goes bust, the FSCS will pay compensation of up to £75,000 (per person per bank) to cover your losses. If you hold more than £75,000 and the bank goes bust, it's likely you will lose some of the excess.

If you hold securities or cash with a broker that fails, you should still get back your assets. The FSCS provides cover of up to £50,000 (per person per firm) to help cover any shortfall. Since you should also get some of your assets (unless every penny is missing from the firm), an account with, say, £60,000 in it probably wouldn't take a loss but one with £600,000 might be less certain. The same £50,000 limit applies if a fundmanager fails and assets are missing from its funds due to its actions.

If you have cash in your brokerage account, the broker will usually keep that cash in a "client money" account with a bank (unless it has its own banking licence). If that bank goes under, you get the same £75,000 protection on that cash as you would if you held a bank account directly. However, if it's the broker's fault that the cash is missing, it's part of the overall £50,000 limit for your brokerage account. All this only applies to UK-based firms. Offshore funds and brokers based outside the UK (including European ones "passporting" into the UK) will only be covered by their local compensation scheme (if any). In most cases, these are less comprehensive than the UK scheme.