Anti-competitive regulations and the harm they cause (Part 5)
This question is often posed to Brexiteers, usually by those who believe Eurosceptics lack detailed arguments or, worse still, didn’t know precisely what they were voting for. Though this may be true in some cases, EU-friendly commentators are also, at times, guilty of a myopia of their own – assuming that the current regulatory status quo automatically equates to ‘best practice.’
In reality, the European Union has been responsible for a raft of regulations which have caused great harm to businesses and consumers. While much is made of the compliance cost of certain regulations, less attention is generally paid to the anti-competitive harm they cause. Increasing costs for certain firms, and forcing some (especially smaller, firms) to exit the market can have the effect of raising prices for consumers and diminishing capacity. Anti-competitive regulations make it difficult for new competitors to enter the market, thereby entrenching existing companies and leading to the formation of oligopolies.
This blog series examines a number of regulations, with anti-competitive effects, to illustrate how they work and the distortions they cause.
Onerous Private Client regulations
Last week, we saw how EU regulation limiting the amount of equity that can be traded outside regulated exchanges have brought a number of harmful – though unforeseen – consequences.
The EU Directives MiFID II and MiFIR’s prescriptive, regulatory protection of retail investors is having a similarly detrimental effect. These rules require that investment firms providing investment advice or portfolio management for private (retail) clients must assess the “suitability and appropriateness” of any investments recommended to that client – documenting their financial knowledge, investment experience, financial situation, ability to bear losses, risk tolerance and investment objectives. The investment firm must ensure that this information is retained and kept up to date.
These regulations have made it more expensive for investment firms to focus their business models on individual wealth management and share ownership. Firms must now have a procedure to ensure that a private client understands the nature, features, cost and risks of an investment. They must also have a procedure to ascertain whether another financial instrument could better suit the client’s profile as well as demonstrating that the benefits of switching investments outweighs the costs of the transaction.
What was the goal of the regulation?
Presumably, the regulatory goal was to eliminate mis-selling of financial investments to inexperienced private investors. This has been partially achieved – though not due to the regulation per se, but because the additional costs and complications of servicing private clients is counter-productively reducing the number of companies willing to provide financial services to them.
Was this regulation ever necessary?
Although there have certainly been cases of mis-selling, this regulation is unlikely to prevent this as an investment deemed “suitable” today may not be in a month’ or a years’ time. It will also not prevent unregulated, “Boiler-room” sales firms from operating.
All investors should be protected from unacceptable conduct such as insider trading, but no investor should be effectively granted an option over their investment decisions, the unintended consequence of the current regulations. More importantly this regulation does not apply to ‘execution only’ orders where clients are only protected if they clear with the trading firm.
Why are the private client requirements anti-competitive?
The UK regulator must recognise the competitive implications of this onerous regulations on small and medium sized investment firms as well as on the ability of similar sized companies to raise capital in the equity markets.
The complicated process of assessing the “Suitability and Appropriateness” of investments and storing this information is driving many firms away from the private client market all together. This is especially problematic for SME companies who rely on private client share ownership to raise capital. Most SME companies are too small to appeal to large investment firms who must buy large tranches of shares for their much larger funds.
Ironically, although the additional regulatory costs of private clients could be covered by the big financial service firms, these firms don’t want the additional hassle of dealing with private clients, as the returns from private clients are small compared to the risks of unintentionally mis-selling investments that may be later deemed not “appropriate”, not “suitable”, or too “complex”. Meanwhile, small and medium size investment advisors, who should be catering to the private client market, find the complications and additional compliance costs crippling.
Financial advisors and stockbrokers, as with any business, will always take more interest in their repeat customers. A better solution for both the client and the economy would be to encourage better financial education and more active investment, thus reducing the number of inexperienced investors. Nobody is born knowing how to value a stock or calculate the time decay of an option. However clients soon learn by active participation in the investment market.
This already happens in the USA, where people are allowed to actively manage their pension funds – known as 401(k) plans. A similar scheme in the UK would encourage more people to actively invest and consequently learn more about company valuations and the investment market. A more active private client market would in turn encourage more competition amongst brokers to supply this market and allow more small companies to raise money via the equity markets.
Continue with the series here…