Question: How does one mitigate the risk of a financial institution going insolvent or fraudulently mismanaging your funds? Are financial institutions regulated and are they obliged to insure against fraud or insolvency?
Anwer: It is important to distinguish between financial institutions managing discretionary portfolios and those involved in managing funds. Private client businesses manage discretionary portfolios for individual clients. This has to be approved by the regulator and must conform to prescribed standards.
The client’s securities, such as shares or bonds, are registered in a nominee company and housed in an individual client account. Nominee companies are also subject to regulation and it is required that business and client assets are separated to ensure client protection in the event of liquidation. A private client business is also required by law to have a compliance officer who is obligated to be independent and responsible for all reporting requirements.
This obligation mitigates against non-compliance with regulatory requirements, including fraud. Financial institutions are also required to be insured against fraud. In addition, capital adequacy requirements place strict obligations on businesses dealing with client assets. Internal and external audit requirements play a pivotal role in ensuring good governance and client protection.
Collective investment schemes, known as unit trusts, also have strict controls and protections.
A unit trust management company (manco) accepts money from investors, pools it together and invests it in securities such as shares and bonds. Each unit trust comprises three legal entities:
- The fund itself, which is made up of the cash contributions. It is not a company and therefore cannot become insolvent. It can be liquidated to pay unit holders.
- Every unit trust is governed by a trust deed under the supervision of the Financial Services Board (FSB). The trustee has two main functions, being to act as custodian of all cash and securities in the fund; and to ensure that the trust is managed within the terms of the trust deed.
- The management company is responsible for the administration of the fund, buying and selling of units; and making investment decisions In practise, the assets – your money – are not affected if the fund manager or management company were to go insolvent. The fund is kept separate.
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