Principle based versus rule based regulation and the hidden benefits of a best interests standard.

Regulation and investor protection begins at home, not at the regulatory level or with the courts.

There is a lot of confusion amongst the regulated that a move towards a best interests standard will lead to more rules.  This is incorrect.  They will lead to more principles and fewer rules, less conflict and better outcomes, greater self regulation and higher levels of investor protection and much reduced regulatory intrusion.  But not overnight!

The ability to deliver best interests standards depends on well structured processes that depend on a well defined set of decision rules.  Strong processes need only be regulated by principles, as the processes contain all the rules.   The trick is to make these processes transparent and accountable to a standard (best interests).  

Regulation + process = leverage. 

Lower transaction based suitability standards are processes that depend on ill defined principles (the KYC parameters for example) that cannot be regulated by principles and hence the rules. 

The trouble is, if you leave conflicts of interests in the mix and then apply this to the innumerable permutations of the transaction outcome, rules alone will not suffice.  Over the last decade (or more) Canadian regulators have been attempting to fine tune the regulation of the transaction, to make consumers more responsible for the decision and to tie down the transaction to some well defined set of rules, but to no avail.  I believe they have come to the end of the road, although they may not fully appreciate it.   You only need to read the recent tirades against the regulators and investor advocates by Mr Thomas Caldwell in the National Post to appreciate this point and of course, please also read the Ken Kivenko and David Yudelman rejoinder.

A paradigm without structure and imbued to the gills with conflict of interest will forever conflict with any attempt by regulation to make it compliant.  Regulation and the transaction based processes we see are in a natural state of conflict.   Regulators fail to understand this for a number of reasons, one of which is that most of them are lawyers and lacking in the expertise that would allow them relate their principles to a working regulatory/process paradigm.   

A best interests standard, once implemented and adopted by the industry within its own processes will simplify regulation.   Why?  Well, a well defined process can directly link the inputs (assets, financial needs, risk profile, investment discipline, portfolio construction decision rules, risk/return assumptions, modelling) to the outputs, to the point that there can be no mismatch between a client’s mandate and the recommended solution.   In such a scenario the rules of the operation are well defined and accountable, and if you remove conflicts of interest, much less likely to be subverted.   These processes and decisions rules are also open to assessment by regulators and independent assessors of processes (note CEFEX). 

More importantly, firms and advisors will be able to define their own rules and their own well defined, well structured processes.   Regulation and investor protection begins at home, not at the regulatory level or with the courts.   

Regulation after all, in its current form, exists because of market failure.  Best interest standards free of conflicts of interest are the route by which investors will be better served, firms can free themselves from the red tape of regulation and through which regulators can focus on core rules and principles and offensive breaches of those rules and principles.

Developing those processes and the accountability that will make firms and not the regulators the first port of call for investor protection will not happen over night, and best interests standards cannot be superimposed on a transaction framework.  One is a square peg, the other a round hole and no amount of legal acumen will make them fit. 

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