1
COMMENTS
by theInvestor Protection Fund (Hungary)
in response to the call for evidence by the European Commission in relation to the review of Directive 1997/9/EC on investor compensation schemes (ICSD)
Please find below a summary of comments offered in our capacity as representatives of the Investor Protection Fund, the single independently organised entity responsible for investor compensation in Hungary, in response to the questions listed in the call for evidence in relation to the review of the Investor Compensation Directive (Directive 1997/9/EC):
1) Should the operation of multilateral trading facilities be excluded from the scope of the ICSD?
Indeed, the operation of multilateral trading facilities (MTFs) should be excluded from the scope of the ICSD.
Our view is that the enforcement of MiFID and the repeal of Directive 93/22/EEC require a review of ICSD references and a clear-cut definition of covered investment services and the scope of service providers required to join an investor compensation scheme.
We consider that the approach taken by ICSD in that compensation serves to indemnify investor losses arising from the inability of an investment firm to return the money or securities placed with them but belonging to investors is fundamentally right and could be upheld in the future. Accordingly, compensation schemes should cover investment services where investor assets may be held by investments firms and hence the risk exists that the firm will not be able to return them.
There is, however, no justification for treating services that do not involve the receipt, management and possession of investor assets by investment firms as covered services and hence for including them in the scope of the ICSD.
2) Would it be appropriate to include in the scope of the ICSD all investment firms seeking authorisation to the provision of investment services, although their authorisation would not allow holding clients' assets?
It follows from the above that we do not see any justification for extending ICSD coverage to service providers that are not licensed to hold investor assets as part of their operations. In this regard, we consider it an important aspect that it would mislead investors and would render it easy for investment firms to adopt illegal practices and to manage investor assets without proper authorisation if such investment firmsparticipated in a compensation scheme.
Such investment firms would pay contribution to a compensation scheme without actually running a risk, which is unreasonable and is hard to integrate into a normal schedule of contributions.
3) Would it be appropriate to include in the scope of the ICSD all investment firms seeking authorisation to the provision of investment services, although they provide their services only to non-retail clients?
We think that the exclusion of investment firms providing investment services to non-retail clients from the scope of the ICSD is justifiable only in case their regulatory license or authorisation under law unequivocally prevents them from delivering services to retail customers. If that is not imposed by their regulatory license and is only the outcome of a business decision, they must be covered by an investor compensation scheme.
4a) Should investors be able to claim compensation in the case of default of the third party where their assets had been deposited?
4b) Should investors (such as UCITS or a UCITS unit holder) be able to claim compensation for loss of assets under the ISCD in those cases where the UCITS depositary or the institution which has been mandated to safe keep the assets, fail to perform its duty?
If follows from the regulations in effect in Hungary at present that whenever an investor firm uses a third party to act as a depositary of securities or money, the investor firm is also liable for the losses incurred by the third party, i.e. such a loss is covered.
Other third party participants, who hold investor assets in order to perform a deal and whose default incurs a loss for investors, form a different category, which is difficult to integrate into the present system but the problem could be resolved by legislative means.
UCITS and UCITS unit holders claiming compensation for loss of assets is not compatible with the original principles of the ICSD, which we approved, as these involve the risks associated with the security itself rather than those associated with investment services. The position of collective investments is strikingly different from that of retail investments as they have no oversight of the management of deposits and the role of control is wider. We do not think therefore that it is justified to grant them extra protection under the ICSD.
5) Should loss events include also any losses suffered by (retail) investors as a consequence of the violation of conduct of business rules?
We do not support this extension of the current scope of coverage offered by the existing provisions of the ICSD. We disagree with extending the scope of covered investment services to investment consulting, because the service and the nature of loss are fundamentally different from the present approach taken by the ICSD.
The amounts claimed in loss events of this kind depend on complex demonstration procedures only courts are capable of handling, and hence the likelihood of rapid compensation would be zero.
6) Do you agree with the idea that the amount covered by the ICSD should be adapted following the updating of the DGSD?
We disagree with the idea that the ICSD should be adapted to the updating of the DGSD and that the amount covered should be increased.
The protection granted to investors by investor compensations schemes defends them from a completely different set of risks than those covered by deposit guarantee schemes. By no means should investor compensation schemes and deposit guarantee schemes appear to offer identical coverage in different markets.
In the case of a deposit guarantee scheme it is the shattered financial position or the potential bankruptcy of a bank that leads to the inability to cover deposits with available funds, whilst in the case of investments, a shortfall of investor assets held by an investment firm separately from its own assets triggers compensation. The weakening of the financial position of an investment firm is not a sufficient condition precedent for such a shortfall, which will only come about if the investor firm is actively involved in illegally tempering with assets they hold for investors.
Whether or not the likelihood of such events materialising is higher in a financial crisis is not justified either in theory on in practice. Consistent regulatory control may play an important role in avoiding such an eventuality, though.
To put it simply, one might say deposit guarantee schemes protect against bank insolvency whilst investor protection schemes fend off the harm done by criminal acts. We do not think the threat of the latter grows in tandem with the risk of the former.
Coverage being limited to losses arising from investment services and the investor continuing to run all the other risks of the investment (e.g. issuer risks) are other major differences that distinguish investor compensation from a deposit guarantee. Consequently, an investor may not expect to recoup the money invested if the loss is due to a severe impairment of the value of the investor’s securities. The differences between the two types of cover should be emphasised to protect less sophisticated investors from the false illusion that investments run no risks whatsoever.
Although legal institutions are similar, they have several unique features; moreover there are fundamental differences that set apart deposit guarantee and investor compensation schemes, which is why we do not think it is necessary to adapt the ICSD to the reviewed DGSD.
When determining the limit, one must also take into account the fact that the assets of investor compensation schemes must cover potential claims for indemnity. We recognise that the assets of member state investor compensation schemes fall way short of the funds available to deposit guarantee schemes. Consequently, participants would be required to pay major amounts in supplementary contribution to allow the schemes to finance potential claims given the present level of compensation. The participants of investor compensation schemes include banks as well as broker firms and fund managers, and the financial capabilities of the latter are much inferior to that of banks. In a crisis, a new provision that imposes significant extra burden on the firms covered could incur additional hardship for market participants.
If the amount of compensation were to increase nevertheless, we would argue for introducing the rise gradually, which we think is the only feasible way, as the ability of compensation schemes to provide indemnity would otherwise be jeopardised.
7) The ICSD does not harmonize the funding systems of the schemes. Should the ICSD provide for some general principles concerning the funding of the schemes?
It would be practical to provide for some general principles as various national schemes are operated in markets that are becoming increasingly harmonized, which obliges different compensation schemes to cooperate in managing certain cases. Individual national systems of different financial power and quality should not be allowed to influence in merit either the competitiveness or the market and economic decisions of affected participating firms.
The fact that it would serve the purposes of the ICSD to ensure that the investor compensation schemes present in the member states do not only exist but are capable of actually settling compensation cases and effecting legitimate investor claims within an acceptable period is another argument for harmonizing the funding systems.
8a) Does the legislation of the MemberState you know the best provide mechanisms aimed atlimiting compensation schemes' obligations over time? If yes, how many clients saw their compensation unpaid as a result of such mechanisms?
8b) Should this kind of mechanisms be prohibited?
Hungarian legislation on investor compensation provides that investors may submit claims for compensation within a period of one year after the particular investor firm is brought under liquidation. If an investor fails to observe this deadline due to an excusable reason, compensation may be claimed within a period of thirty days after the obstacle is lifted even after the year mentioned above has elapsed. The organisation responsible for investor compensation evaluates excusable reasons flexibly.
Experience tells us that the majority (over 95%) of investors file compensations claims within a year and only a few lose their title to compensation due to falling overdue with exercising their rights.
9a) Should the process of recognizing the eligibility of the claim be regulated for the purposes of the ICSD?
9b) Should, at least, a mechanism be introduced providing for provisional partial compensation based on a summary assessment of clients' positions?
9c) Irrespective of the harmonisation of their funding systems, should compensation schemes
ensure that they have minimum reserve funds in order to comply rapidly with any immediate
needs?
The increasing penetration of cross border services justifies the additional harmonization of the way compensation schemes are operated so that investors can meet compensation schemes that function along similar lines even if service providers are headquartered in different countries.
The relatively wide experience of the Hungarian system of protecting investors does not seem to justify the introduction of provisional and partial compensation mechanisms. If figures concerning the size of missing investor assets are available, nothing prevents the final acceptance of a client’s claim, and if they are not available, even provisional compensation cannot be provided without running the threat of overpayment.
If partial compensation existed, the process of recognizing the eligibility of claims and multiple payment instructions would make the whole procedure more complicated and costly. A complicated and non-transparent procedure will increase the likelihood of errors and investors may lose confidence in the fair operation of compensation schemes as they would find it hard to follow the procedure of claims settlement.
As regards the third part of the question, we believe that the amounts lost by an investment firm can be of a size that would render settlement by a compensation scheme unfeasible without ensuring proper financing, and mandatory minimum reserve funds could be one of the financing mechanisms.
May we remark in this regard that ex ante systems presuppose that existing system participants will pay the contributions (annual fees) used for setting aside the funds that cover compensation payments, whilst in ex post systems are odd in that the insolvent participant will not be able to make a contribution any more, and the losses incurred by the insolvent participant must be settled from the contributions of other participants.
10) Do you think special attention should be given to money market funds?
There is justification for raising this as a problem, but we think it should by no means be resolved by regulating investor compensation schemes.
11) Based on the concrete application of the ICSD do you see further issues other than the ones mentioned in the present document that might be of relevance to this analysis?
We do not think that the position of investors engaged in transactions with branch offices set up in another member state and with investor firms providing cross border services is safe enough under the existing regulation. Doing business with an investor compensation scheme domiciled in another member state is complicated for a major part of investors due to both the physical distance and language difficulties. Moreover, the procedure of recognising the eligibility of claims is cumbersome and much more expensive as compared to claims enforced at a local investor compensation scheme.
We therefore think additional rules would be necessary to ensure that investors who conclude deals with a branch officeset up in another member state or with an investor firmthat provides cross border services do not suffer disadvantages as compared to the clients of local investor firms domiciled in their own member state.
The potential involvement of the investor compensation scheme of the host member state in settling the claims of investors dealing with branch offices (provided its costs are reimbursed) might be considered as a solution even if a branch has no supplementary insurance.
When a branch office is covered by supplementary insurance, it becomes necessary to match the different regulations existing in the two member states, but to do so would require more detailed rules than the existing principles (provided in Annex II). The present regulation is based on the premise that the investor compensation schemes of the host member state and the home member state can come to an agreement on every issue, which is not at all certain. The fact that some rules governing the rights of investors are not set forth in an act or regulation but in a bilateral agreement between two investor compensation schemes is also a reason for concern.
We wish to offer another remark in connection with branch offices covered by supplementary insurance about the provision set forth in Article 7(2).
Branch offices may take out supplementary insurance on a voluntary basis to ensure that they can provide compensation which is at par with that offered by investor firms headquartered in the host country and that their market positions are identical. It follows from this background consideration that the notice period of 12 months before exclusion is unreasonably long. If a branch office fails to pay contributions and hence fails to comply with the conditions for participation, it is not reasonable to force the investor compensation scheme of the host country to treat the branch office as a participant for such a long period. If that occurs, it seems more reasonable to terminate the supplementary insurance mach faster (within 2-3 months) than under the present system, because investors continue to enjoy the coverage offered by the home member state and actions would be needed other than to notify investors of the termination of the supplementary insurance and to ensure that they have enough time to swap investor firms if they think it is justified.
Consent by the competent authority that issuedthe authorisation also raises several practical problems as it means that the competent authority of the home member state can force upon the investor compensation scheme of the host member state a branch office that fails to meet membership requirements. We think this is not justifiable as the question at hand is supplementary rather than basic cover.
The last indent of Article 7(2) provides that investment business transacted before the date of exclusion shall continue to be covered after that date by the compensation scheme of which the branch was a voluntary member. We do not think the cover may survive after membership terminates, as from that point onwards the investor compensation scheme would be required to provide coverage without any consideration (contribution payment) for an unlimited period. If investors are informed in due course about the withdrawal of the supplementary cover, they may decide to leave their investment assets with the branch despite the withdrawal or to entrust them to another investment firm before the withdrawal takes effect. That way investors would be exactly as disadvantageous as if the branch office had not requested complementary cover, but no worse.