June 3, 2016
What We’re Reading this Week
Earlier this year the Obama administration finalized a fiduciary rule for advisors that give advice on retirement accounts outside of 401(k)s. Investors are already protected by a fiduciary standard in company retirement plans but when they roll money out of these plans into IRAs they lose that protection. As of this April, advisors overseeing IRA accounts will also be held to a fiduciary standard. Now, the US Chamber of Commerce, the Securities Industry, the Financial Markets Association and as many as three other trade groups are preparing to file a lawsuit to try and block the new legislation. Opponents to the rule argue that it will open the industry up to expensive litigation. There are two things I love about this this. One, you have to appreciate the irony of entering into expensive litigation (suing regulators is expensive) because you are worried about expensive litigation. And two, trying to stop a rule that would allow people to sue you when you do something bad is sort of an admission of guilt isn’t it? The fact that the financial services industry has fought so hard to stop these regulations just sort of just highlights why we need them doesn’t it?
High Frequency Trading
I have written about high frequency trading and what is means for investors before and this issue is starting to gain momentum in the courts. Basically, the issue at hand is the idea that a company executing trades has access to two sets of data. The high speed, very accurate, market prices it receives from the exchange and the old, somewhat stale prices it tells clients it received from the exchange. The firm then has the ability to execute trades for clients after executing trades for themselves, conceivably at a profit or net neutral position. If it sounds like they can make pennies, it’s because they can. It’s just that they do hundreds of thousands of these trades every day. It’s a lot of pennies. FINRA fined E*Trade for doing just that, with the exception that E*Trade wasn’t paying a market maker, they were the market maker. E*Trade was ordered to pay $900,000 for trades executed between 2011 and 2012 because it’s “Best Execution Committee” turned out to be just an “OK Execution Committee.” The BEC at E*Trade was meant to be its internal control but they did not really do their job. It seems that the BEC focused on making sure the order routing system was doing what E*Trade and G1X (it’s market maker) wanted but didn’t really address what it meant for the clients. Frequently, G1X would change the execution priority of trades to favor E*Trade and this went unnoticed by the BEC either through lack of oversight or something more nefarious. How you interpret the data depends on your perception. Was E*Trade hoping to make markets more efficient by making better trading choices for clients that are relatively uninformed or where they positioning their own trades ahead of client orders to make more money?
Many financial advisors have been concerned about the recent growth of what has been deemed “robo-advising.” This is where a computer or your phone or some technology somewhere does, for fractions of a percent, what a flesh and blood advisors does, for several percent. Modern portfolio theory is modern again, if only because modern technology is capable of doing it. This has led to fee compression and will undoubtedly lead to more. But what about the robots themselves? Robo-advising is cheap because it doesn’t require (as much) human capital for trading, administration (most accounts are opened electronically by clients, or service. This has launched several robo-advisor businesses that have boomed over the past few years. It seems that they never stopped to ask, “if we can do this for cheap, can another company do it for free?” JP Morgan may be doing that. At an investor presentation, CEO Jaime Dimon said, “When you talk about robo and investing, well we can do that, and give it away for free if we want.” As an aside he also asked how many people at the presentation would open a Chase account if they gave away five to 10 free trades every month. In the face of less than an enthusiastic response Dimon stated “We’re going to build it anyway, folks, and then we have to decide how to price it.” Full diclsosure, I used to work at Chase and that anecdote sort of sums up my experience there.
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