Competitive markets and regulatory intervention–TD Bank Mutual Funds submission.

Transaction remuneration within an advice based market place results in 1) advice market failure, 2) transaction market failure, and 3) fund management market failure.

The TD Bank Financial Group argue that the market for mutual funds is already competitive and that further regulation will negatively impact competition.  It also asserts that if the perceived market failure is one of conflict of interest, then this is best dealt with by clear disclosure. 

It is my opinion that these arguments are severely flawed and that only a best interests standard free from transaction remuneration conflicts can lead to a competitive market outcome in all 3 key areas noted:

For one, disclosure does not mitigate a conflict of interest: that is it does not remove it or alter its influence.  Disclosure only works if the end result, in the presence of a conflict of interest influence, is market failure.  That is, the investor perceives that the conflict of interest has sufficiently impaired the value of the transaction and decides not to proceed with the transaction(s) at that price.  This would result in a competitive market outcome, because the industry would need to remove the conflict, or adjust its impact, to do business.  

Where the investor does not possess the necessary subject matter expertise to process the disclosed information, the market may continue to operate, but it will not be a competitive market.  Disclosure on its own is insufficient to lead to competitive market outcomes.

If the investor thinks someone is advising in their best interests, they will defer the competitive market decision to the “advisor”.  They will assume that the costs of the transaction and the management have already been processed because the advisor has recommended it.   

While many industry best interests standards submissions stated buyer beware did not apply, it surely does within the context of the TD Bank Financial submission on mutual fund fees.  If buyer beware does not apply, and buyer beware is a key component in determining a competitive market outcome, then it is the advisor that should be setting the market outcome in favour of the investor and disclosure has no role.   If he or she is conflicted in this market place, then there cannot be a competitive market outcome for investors.

It is my opinion that given the complexity of the suitability process, disclosure on its own is insufficient for most investors to be able process effectively and act on and this is why there is a demand for advice led service processes.  

Secondly, TD frame the competitive market landscape in terms of the market for mutual funds, or the market for mutual fund sales.  

In this case, the remuneration is for the transaction, and the relationship which sets the price for the transaction, is between the fund manufacturer and the distributor, or between the manufacturers and the sellers.  The mutual fund buyer is only able to influence pricing if they are able to make independent objective decisions over the purchase decision. 

A purchaser making an independent objective decision would want the lowest price possible and would not need a middle man if they could go direct to the manufacturer.  Indeed, an inability for a fund manufacturer to sell units, without a trailer fee, through a discount broker is a market failure in this respect.  

If, on the other hand, the market we are dealing with is the market for financial advice, of which the transaction is only an aspect of that advice, then the defining relationship is between the advisor/firm and the investor, and the objective of the advisor, on behalf of the investor, is to get the cheapest price possible for the transaction within the context of the advice– the advisor/firm needs to be the competitive dynamic in the market place driving price down.  The demand curve for mutual funds is that of the advisor and not that of the investor, whereas in a transaction only market the demand curve is that of the investor!  The advisor is buyer beware in the advice market and the consumer buyer beware in the transaction market.  Note that the demand curve incorporates all costs and dynamics.

In an advice based market place, the market place needs to price and clearly disclose the service, and the pricing and service option pricing needs to reflect the quality and quantity of the advice.  Transaction remuneration within an advice based market place results in 1) advice market failure, 2) transaction market failure, and 3) fund management market failure because a) we do not have an intersect between the supply of services and the price of those services determining service price and quality, and b) we have an inappropriate demand supply curve intersection (self interested advisor demand curve and manufacturer supply curve) in the mutual fund market determining transaction costs and asset management costs and supply.    

  1. We have market failure in the advice market place because we are not pricing or defining the service.  There is no intersect between service supply and demand, because the two are unknown in relation to each other.  Pricing for this market place is determined by the pricing of the transaction.
  2. Where we have an advice led market place, with no (but implied) best interests standards, we risk market failure in the transaction pricing market, because the demand curve is the conflicted advisor/distributor demand curve, when it should either be an informed independent objective consumer demand curve or a best interests advisor demand curve.
  3. We also have failure in the market determining the cost, quantity and quality of mutual fund management.   An independent objective market participant would not just want to drive down the transaction cost, but would also want to drive down the asset management cost.   Indeed, where the manufacturer owns the distribution and the service provided is that of advice, there can be no competitive market for transaction and asset management costs.

If the consumer was aware of the conflict of interest and its impact and consequence, which is not just the fact that a transaction earns a return, but the fact that such a return can a) influence the advice provided and b) influence the price of the transaction and the cost of the product/fund throughout the lifetime of that product and/or fund, then we would have market failure.

The only way to make sure that the market for financial advice is competitive and clears, is to take away the transaction return and to implement a statutory best interests standard on advisory relationships.  This will create a supply curve for services against the client’s demand curve and establish a best interests advisor demand curve in the securities market place against the manufacturers supply curve.

And here are the relevant excerpts from the TD Bank Financial’s submission:     

“We support the principles of investor protection and fairness, and we also believe that Canadian investors are best served by a fee structure that furthers competition and investor choice alongside these principles.”

“In most cases, clear disclosure mitigates potential conflicts of interest; and a mutual fund fee structure based on the principles of investor protection and fairness as well as competition and investor choice, produces fair beneficial outcomes for investors.”

“In cases where industry regulation is required to serve a public interest, especially as it pertains to market failures, the response should focus on enhancing transparency through clear disclosure. POS and CRM are excellent examples of this approach.”

“Competition Bureau quote “The only time it is desirable to supplant competition by regulation is when markets are not functioning as well as they should be and when the benefits of regulation demonstrably outweigh the benefits of competition alone.”

“The fee paper indicates that the fundamental market failure mutual fund fee models produce is conflicts of interest, which may not be effectively mitigated due to information asymmetry. If information asymmetry is the source of market failures which are at issue, we consider the appropriate regulatory response to be one focused on enhancing transparency through clear disclosure. “

“A mutual fund market that encourages both competition and investor protection provides investors with an array of fee structures and investors may select the option that works best for their individual circumstances and needs….”

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