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.

Recommending $150,000 of leverage to a 74 year old woman with a circa $300,000 dollar investment portfolio at the top end of one of the biggest bull markets in history is beyond belief, but it is by no means beyond the range of possible outcomes capable of originating from our transaction driven industry.  

The boundaries of manufactured suitability are so wide that even an egregious deviation could appear to lie in the shadow of the rules.  The rules are not there to protect investors, remember that, they are there to lay the highway for product and transaction distribution.  Most investors could get away with simple products, simple allocations and basic advice and eschew the costly merry go round of Transaction-Ville.  So you see, there is a disconnect between rules designed to facilitate the transaction and rules that would otherwise be designed to facilitate advice, and this is not being picked up by the press.  

A perfect competitive market outcome is the enemy of the transaction highway, which rests on the uninformed consent of the masses.  In other words it rests on an ethical divide which is an unfair transfer of value from and costs towards the consumers of financial services.

In a transaction, if an investor walks in and asks to take out a loan of $150,000 to buy investments, the advisor would note the client’s request and would make sure that the client’s risk profile and knowledge would fit the transaction for the record.  Now an advisor is not technically able, in my opinion, under current regulation, to recommend leverage, because leverage technically is a sum of capital that an investor is bringing to the table: this input should come from the investor. 

But, for whatever reason, and in keeping with the general fluidity of our rules and regulations, it has passed the “radar invisibility test”: advisors are allowed to circumvent the rules and recommend a leveraged amount.  In a wider sense this is one of the key problems of the KYC in that it can be manufactured: risk profiles, investment objectives and leverage can all be influenced by the advisor to fit the transaction return the advisor wants, and if even when it does not, the shadow of the rules covers many an ambiguity. 

There are a number of issues that need to be reiterated  in order to understand the dilemma and the reality:

Investors are not aware that they are in a buyer beware sales relationship and that recommendations made by many advisors may not be in their own best interests.   Unfortunately the industry at large is all too willing to claim they act in their client’s best interests without the type of processes, levels of accountability and indeed professional training required to deliver such.

The fact the industry is tethered around a transaction protocol(input the KYC parameters and out pops a transaction) that cannot place their clients’ needs at its heart is always going to lead to unfortunate outcomes.  

A service process based on best interest standards would place the transaction as the least important point of the process.  Indeed, investors would no longer be sanctioning transactions but portfolio structure, planning and management profiles for which responsibility would lie at the foot of the advisor.   Advisors would be responsible for the integrity of the process and the investor the much simpler decision of accepting the generic risk/return profile of the portfolio/wealth management solution.   But even here, the solution would be anchored around their liability profiles – it should have been impossible to recommend a $150k loan for the client profile noted in the current case, yet the transaction process had no such procedural input.   The driver of the decision, the transaction, overrode the interests of the investor.  

Hand in hand with this evolution of process would go education, much lower levels of transaction and cost effective investment vehicles.  Payment would be for the process, the level of personalisation (and hand holding) and the overall value added.   Outcomes would be client interest specific, which is the opposite of a transaction return driven process.  In other words the means would become the end and the end the means, a complete reversal of the current process.

Why does this worry the industry?   Because processes and structures can be automated lowering costs and eviscerating the industry of its transaction infrastructure.   Thousands of people and firms would no longer have a rationale for being.    The needs of the client trump the needs of the transaction.

The difference between a process which places the client at its epicentre and a process which places the transaction at its centre is the ethical divide.  The better the process is at relating (and assessing) risk and liability profiles to portfolios capable of matching and managing such the narrower will be the ethical divide.  

Ethical boundaries are always going to have an element of fuzziness in terms of a quantifiable differential outcome, but I think we can define ethics in the quantitative as opposed to merely the qualitative sphere where I believe it primarily resides at the moment. 

An exchange has value and, in a truly competitive market with rational individuals, a fair outcome would assign value and cost to different parties.  In an imperfect outcome value and/or costs are transferred between parties in a way which would not be viewed as optimal if everybody were able to make a fully informed decision. 

In a sense, ethics concerns itself with the surreptitious transfer of costs and value without informed consent, in other words “theft”.

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