Fostering a culture of compliance, an alignment of regulation and incentives, through best interests standards.

Whether he realises it or not, Bill Rice has unwittingly argued for the introduction of best interests standards as a solution to the regulatory burden.

I wanted to make a further comment on a topic that spins nicely off Bill Rice’s Keynote speech, that applies to everyone who opposes the introduction of a best interests standard. 

“It is important to securities regulators that intermediaries are as effective as possible and, in that regard, that they be as skilled and experienced as possible, and are motivated by incentives to do as good a job as possible.”

That topic is compliance and the benefits of encouraging a culture of compliance.  At the moment the focus is on balancing the opposites of advice based service requirements and transaction based remuneration.   Compliance and incentives are in conflict and the hammer and the nail will always be needed to keep the two together. 

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Best interest standards…not a recent movement

As per Bill Rice’s recent keynote speech (to the IIROC – CLS Compliance Conference 2013), there is a mistaken assumption that the global movement towards best interest standards has occurred as a result of the most recent financial crisis, and that because Canada emerged relatively unscathed (although I would argue that Canada’s consumer debt dynamics would suggest otherwise) that best interest standards are an ill conceived knee jerk reaction to problems which do not exist in the Canada.

In point of fact, regulation in the UK has been focussed on issues of best interest standards for a much longer period of time. 

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The essential role of securities regulation…

Recognising and protecting the implied contract, to act in one’s best interests, between consumers of financial services and advisors should lead to more market efficient outcomes, should better maintain the integrity of the market place and raise the confidence of consumers in the advice they receive and the markets and securities in which they invest.

I wanted to address a central theme in Bill Rice’s recent address. This theme is the apparent regulatory focus on intermediaries (noted throughout his speech) to the exclusion of consumers.  

The following is taken from “The Essential Role of Securities Regulation, Duke Law Journal February 2006”.

“Any serious examination of the role and function of securities regulation must sidestep the widespread, yet misguided, belief that securities regulation aims at protecting the common investor….…The law of securities regulation may be divided into three broad categories: disclosure duties, restrictions on fraud and manipulation, and restrictions on insider trading.

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Euphemism: regulators still clinging to the past, still unwilling to face the fundamental problem?

Quite frankly I am gobsmacked, but at the same time eternally grateful to the many gifts this communication will provide the public debate on best interest standards.  I of course refer again to the Keynote Address by Bill Rice, Chair Alberta Securities Commission, on December 3, 2013 to the IIROC – CLS Compliance Conference 2013.

In this address he made a number of points that I think are worth pointing out and rebutting:

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Keynote Address by Bill Rice, Chair Alberta Securities Commission -December 3, 2013

I am just going through this key note address.   I will be blogging about this in greater depth, but I thought it would be useful to note some interesting statistics and one key observation:

Use of the word advisor/adviser – 0 times

Use of the word salesperson – 5 times

Use of the word intermediaries – 7 times.

It seems to me that the heart of the matter, as far as this key note address is concerned, is the differing view over the roles of advisors and the representation of that role.   Bill Rice views the role as one of salesperson and intermediary.   If the role was clearly one of pure intermediation, then I would agree with him, but it is not. 

This speech betrays an alarming level of ignorance, within the corridors of our country’s regulators, as to what is happening in the financial services industry. 

The ice is melting….and sun is not yet full out!

As Ken Kivenko pointed out to me, Invesco, Blackrock and Mackenzie and have managed to get agreement to push through lower cost DIY funds.  I think this is some achievement and credit should go to the OSC, Invesco (who have led the charge on this particular item) Blackrock and Mackenzie, and of course everyone else who has been putting pressure on the regulators and the industry to change to more accountable and responsible and professional advice based business practises.

But instead of stopping here, the message is clear, the industry can change and change with an alacrity that puts the post FDM process to shame.   Regulators should take note, if the mere threat of best interests can create what is in truth a vast sea change in fund distribution, just think what the planned implementation of Best Interest standards could be capable of doing!

We now know the industry can turn on a dime and while a move towards best interests will by no means be as easy, for a race that has built the pyramids eons ago, that which is intrinsically at the forefront of any renaissance, a simple change in attitude should be a breeze. 

Misdirected criticisms prove need for more reform in financial services

In recent comments in the National Post Ed Waitzer attempts to deflect criticism of his earlier article Regulate outcomes, not rules but fails to address the message of that article, which was ““It is now time to stand back and review the landscape and consider the impacts of the many new rules that have been put in place”.  This is also the argument of those who oppose the introduction of best interest standards and the removal of transaction based remuneration. 

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A short message: we have a regulatory bubble that needs bursting….

The real identity is lost: the ends and means of the regulation of the transaction have long ceased to be relevant to the retail end user. It is absurd. We have a regulatory bubble that needs bursting.

What are the biggest threats to regulatory change?  Are they the arguments brought forward by the industry that state that small investors will no longer be served and that advisors will switch to looser regulatory regimes (insurance).

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Tory’s Best Interests Standards Report: they have missed the point and this is remiss.

A quick point.  This is from the overview:

“This Paper concludes that, with specific reference to its current regulatory framework, there is no gap in Canada that need be or could be filled by imposing further statutory obligations on investment advisors and dealers as contemplated in CP 33-403.”

The current regulatory framework is a framework that regulates the transaction via the narrowly focussed know your client form.  It is neither structured to regulate advice in the context in which services are represented nor in the context in which the client is dependent on that advice.

Tory’s may well be correct in stating that there are no holes in the regulation of the transaction, if that indeed was a correct description of the market, but they have missed the point and this is intellectually remiss.  

From this point on the comment has rendered the entire report invalid!

One key point about making complex systems simple and hence making best interests standards manageable.

In terms of the investment outcomes, asset allocations, security selections, market cap, style, yield profiles, etc that are relevant to each and every investor, there are innumerable outcomes. 

If you have to monitor each outcome to assess its integrity you will be run ragged.  That is part of the problem with transaction driven regulation.  There are no processes and structures defining outcomes, most of which are loosely triggered by the wide girth of the narrowly defined Know Your Client form. 

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And so the fight continues….best interests versus the transaction!

Delaying the implementation of a best interests standard will solve nothing and will only ignore the widening gulf between outcome and representation. The costs of this misrepresentation are being borne by the individual retail investor and this transfer has no validity in fact and therefore should have no validity in law.

I am not going to go into a detailed head to head with the recent positions against best interest standards.  I will leave the detail to another post, and will for now take a shot at the heart of the matter:

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Stepping back from best interests…but why?

The voice and financial might of the retail financial services industry looks to be drowning out the voice and possibly the rights of the individual Canadian investor.   As people have been saying a lot recently, “I am disappointed”, but not about Rob Ford, who is no more than a red handed buffoon when it comes to a bigger game that is apparently being played out in financial services’ regulation.

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OSC Compliance reviews….we need enhanced KYC information standards.

The OSC does not regulate investment and financial advisors who are mainly regulated by IIROC/MFDA.  Many of those who are regulated by the OSC are actually held to higher best interest standards (portfolio managers, investment counsellors and fund managers). 

What continues to surprise me is that advisers that are held to supposedly higher best interests standards are continuing to be regulated under the much lower KYC information standard.   Some advisors continue to delegate fact finding and suitability profiling to advisors who are regulated by the transaction or who have little or no investment expertise.

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Designed to deceive: structured notes

Their high costs transfer return to the issuer and costs to the investor, skewing the risk/reward profile of investment outcomes; they also complicate the management of the portfolio by taking away liquidity and yield and ultimately return, forcing the portfolio itself to awkwardly adjust for their absence.  Most of those who recommend complex products on a regular basis have little respect for the portfolio and little fundamental construction knowledge.  The structure and the marketing of these products is designed to deceive.

I recently had a structured note placed under my nose for comment: a 3 year auto callable structure.  I really do not know how investors are meant to understand how these work and you really do need to understand how risk is priced to appreciate what it is you are buying and paying for.

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Do ethics really have no place in a relationship of trust?

In Canada, what we have at the moment are standards that even imbeciles could execute, but outcomes that mostly only experts could fully understand or, in  a moment of madness, would wish to own.

Best interests standards would likely lead to solutions that would pass the judgement of experts but that can be generically understood and accepted by the ordinary individual without legal consequence.

Best interests standards, contrary to the rote propaganda being churned out, would lower costs, increase standards, improve sophistication of output and reduce legal liabilities and negative investor outcomes.   They are the future!

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Ethics in the quantitative concerns itself with a surreptitious exchange of value without informed consent…

The boundaries of manufactured suitability are so wide that even an egregious deviation could appear to lie in the shadow of the rules.

I am a capitalist at heart and my belief in ethics has nothing to do with “social” policy per se, but the ethics of imperfect outcomes.  So when I read Barbara Shecter’s recent article, ‘Shocking’ crackdown on advisors threatens smaller players: Tony De Thomasis”, my ethics sense started to ring loudly.  It has been ringing a lot recently.

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Ethics and outcomes

One way of interpreting ethics in the financial services sphere, in my opinion, is that ethics is an awareness of the differences between an unfair and a fair competitive market outcome.  At the moment regulation enforces the rights of one (the transaction) while ignoring the rights of the other (the right to advice that equates with the representation). This is both unfair and arguably unethical.

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Between a rock and a hard place: in the absence of best interests the conflicts are growing….

The OSC’s mandate is “to provide protection to investors from unfair, improper or fraudulent practises, and to foster fair and efficient capital markets and confidence in capital markets.”.

Yet, it and the CSA have yet to make a definitive stance on the introduction of best interests standards, the very same standard that I believe is key to levelling the playing field between potentially fair and unfair outcomes.  Two recent pieces of news have led me to reiterate the importance of higher standards governing the provision of advice to investors:

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Fuzzy Lines and ample leg room…

The point is this, if you set the rules too low and the decision parameters too wide, the lines as to what can and cannot pass become fuzzy and the leg room for inappropriate transactions becomes much too large.

I am in the midst of writing up a blog that refers to the De Thomas OBSI name and shame decision, but was drawn towards a CBC News article that also commented on the case:

““De Thomasis said his firm did everything by the book:”It’s like you have a big hammer over your head, and you don’t know what to do,” he said. “You follow all the rules, all the regulations, and now what?””

Now the majority of investors are not aware of the niceties of retail financial services regulation.  Indeed, the rules regarding what can and cannot pass between the narrowly defined parameters of the know your client form allows in my opinion the unspeakable to pass, at times, between them.

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Why are benchmarks important in mutual fund point of sale documents?

In response to a recent blog on benchmarks and behavioural economics I have been asked to comment on the importance of benchmarks in point of sale documents.  The following is the detail supporting that response, and (at the end of the post) a set of answers to a number of questions:

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A green light for low ethical standards or has “best interest standards” been given the go ahead?

Leaders lead and set standards and examples.  Yet, with the Canadian mutual fund point of sale document we have, inter alia, a) something which has been allowed to be sent after the transaction and b) something in which information critical to making informed decisions has been taken out of the frame or dumbed down so as to be worthless.

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