How do investor compensation schemes work?

Most bank customers are familiar with the deposit protection schemes in their countries. These government backed funds protect qualifying bank deposits up to a predefined insured amount. What most consumers are unaware of is that investor compensation schemes also exist and cover specific losses when financial institutions fail. The fund is separated from the domestic deposit guarantee scheme and therefore the qualifying creditors may be compensated by both guarantee schemes.

To maintain confidence in the financial system and avoid public outrage, investor compensation schemes protect investors when regulated investment firms are unable to repay money or assets held on behalf of investors. Compensation is capped to a maximum insured amount and payment is made only to qualifying investors. An understanding of the workings of collective investment guarantees can be found in the European Investment Compensation Scheme Directive (ICD). The directive provides for an extensive outline of the background, scope, application and regulatory implementation of the schemes throughout the European Economic Area. As with all European directives, there is no direct effect while member states must safeguard an equal outcome on the subject.

An investment contains risk. In general risk and reward are interconnected and the higher the risk being taken, the higher the potential return on investment. The agreement between the investor, his adviser and the investment firm clarifies the agreed risk profile of the investor and the appetite for and willingness to take risk. Such risk can result in losses but also has an upside component where above market returns can be achieved. Investor compensation schemes do not cover market risk and regular investment risk, they only apply to the failure of the applicable financial institution.

In an open and free market economy, supply and demand should find each other without restrictions. From a theoretical aspect, competition ensures quality and stabilizes pricing levels. As such, consumers influence the behavior of businesses and their activities. However, theory does not always apply to real life events, and excludes misconduct and deliberate illegal behavior of market players. Investment fraud therefore makes the application of insurance into a difficult task.