Invest and the State Will Protect You

This Friday (April 22) the Bulgarian Parliament approved on second hearing the Amending Act to the Public Offering of Securities Act. One of the proposals was the creation of a Fund for compensation of investors in securities. The purpose of the Fund will be to “guarantee the customers' assets of investment intermediary up to 40 000 (1) leva by client. Customers' assets according to this law include cash, securities and other assets of the investment intermediary, gained by as result of its activity, including interest payments, dividends and other payments, made in relation to securities, and which the investment intermediary company should give back to its customers in accordance to the law and contracts”(art. 776, paragraph 1 and 2). In order to do this, each investment intermediary company that holds clients' cash and securities and for whom therefore can arise obligations, is obliged to make money payments to the Fund. These are affiliation and annual payments by the intermediaries, income from investing of these funds, as well as other sources as loans, donations and foreign aid. The control over the Fund is supposed to be exercised by the National Audit Office.

What is happening? We have investors that have liquid capital and decide to take certain risk and invest. They choose investment intermediary company, read the company rules, agree on them, sign a contract and deliver the money for acquiring certain stock.

The establishment of such Fund can be interpreted as following:

•  It appears that at the moment there are investment companies that are risky enough to provoke such reaction from the state. We have seen misleading advertisements of intermediaries that expect and/or promise unrealistically high returns. This obviously cannot be possible and therefore each investor assess for himself if one intermediary is reliable enough. The state is trying to intervene in area where by presumption the prognosis and speculations are part of existence. Good analysis, weighted risk, professionalism and publicity are enough to judge whether the investment is risky for an investor.

•  According to the draft law, the guaranteed “Customers' assets […] include cash, securities and other assets of the investment intermediary”. It is getting more interesting. It appears that investor who ordered to his intermediary to buy certain stocks and they are written in intermediary's liabilities (they include clients' securities and liabilities on clients' cash) can, in case of insolvency, be paid off by the Fund, up to 40 000 leva per investor. In regards to cash that is included in the definition of clients' assets, the question is for this little time period for transforming one asset in another (money in securities or securities in money). When one investment company has the possibility to fulfill its obligations. In relation to securities – it sounds really disturbing because they are written on the name of particular stockholder (he/she owns depositary note) who can always change its investment company ones he buy shares.

•  Payment of affiliation and annual fee (0.5% by the clients' assets for the last year, calculated on monthly average base) by all investments companies can lead to temporary liquidity problems.

The idea for creation of such Fund is very similar to principle of existence of Deposit Insurance Fund in Bulgaria. As IME has stated many times, the existence of such guarantee distorts the incentives for involved institutions to do their job properly. When such “protective” mechanism is in place we are witnessing a situation when some investment companies that are not so successful in their activity manage to attract clients with more tempting returns, but more risky too. Thus, it is obvious that the risk of insolvency of such companies is greater and they benefit the most from such guarantee. This is called moral hazard. Also, there can be extreme cases where unscrupulous investment companies can do a deal with false clients that can lead to insolvency and therefore using guarantee payment from the Fund. Similar to IME proposal for reform of Deposit Insurance Fund, something alike can be made. Namely, insurance of investment intermediary's activity by big insurance company, preferably foreign owned, that will review their work at least annually and will judge for the risk.

The idea of the Government to copy one to one the model of the Deposit Insurance Fund is based on the wrong perception of incentives for investment and saving. Investment, opposite on saving, is purposeful risk taking in order to gain certain returns.

And finally, the motives, attached to the draft law say that creation of such Fund is in accordance with EU Directive 97/9. However, we can assert that these changes can be interpreted as another example of state intervention in one sector that works properly and has witnessed no shocks until now.

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(1) Equals to 20 452 euro.