Regulators Face Hobson’s Choice

February 22, 2021
Regulators must choose to boldly embrace the new, or cautiously cling to existing ways when it comes to direct retail access to mutual funds.

A Hobson’s Choice is a free choice in which only one thing is offered. Because a person may refuse to accept what is offered, the two options are taking the thing you do not want, or taking nothing at all. It is a choice many global regulators are currently faced with as the market shifts around them.

One of the hottest industry topics right now is the increasing trend towards direct retail access to mutual funds. One of the most discernible impacts of the global pandemic and subsequent lockdown has been the increased pace of digital acceleration that has washed over society like never before. In the days following lockdowns this digital acceleration began with widespread use of Zoom or Microsoft Teams for team meetings across all industries, the rapid explosion in volume of online purchases as the High Street and shopping malls became “no go zones”, and the reduction of cash transactions generally as online, prepayment, and contactless payments became the norm as a result of social distancing measures. Many of these digital ways have been in train for some time, but the lockdown has ensured more widespread use that may never contract even when the pandemic has ended.

Financial services, asset management, and the sale of funds are not unaffected by these strategic societal shifts in becoming a more digitally reliant world.

Some of the most discussed areas of disruption aided by the overall digital acceleration and altered consumer expectation include:

  1. The effect of the normalization of data, algorithms, Artificial Intelligence (AI), and prominence of social media on financial markets and asset management
  2. Increased direct retail participation also result in less market discipline (focus on financial fundamentals) and increased irrationality – Bitcoin & Reddit/GameStop just the beginning of something else

Policymakers play a large role in access to nascent financial innovations, they can often be a key stakeholder in fostering their growth or reducing or restricting their impact. It is fair to say that global regulators now have a pretty simple and binary choice to make: embrace and ride the momentum of these societal shifts to new technologies, or curb them in order to keep the status quo. Whichever way they sway will have significant impact to the future of asset management. And in many ways, they are left with a Hobson’s choice. They cannot ignore the rise of importance or usage of nascent technology in financial services, but by choosing inaction they also leave themselves exposed to factors that are inevitable anyway. As such, they really appear to have no choice at all but to act. The extent to which they chose to act could have significant ramifications for the next phase of industry evolution.

Can Regulators Solve the Data Dispersion Problem?

Data lies at the heart of the digital world. Before true broad based direct retail participation in markets, there is a significant rearranging of data sets that would need to occur in order to make market data accessible on equal footing to the widest possible population of users.

Before we can have a true democratization of investing across the spectrum, a bedrock of such a shift must be to provide a platform where everyone has simple, fair, and reasonably affordable access to reliable data. Direct market participation is often weighed down by the vast market data asymmetry between retail investors and institutions. Then there is also a moral hazard for policymakers about if overall, everyone is truly better served by having full autonomy over their investments even if it results in sub-optimal investments, which might have been better managed in the traditional model of using a regulated advisor. Personally, I know I would not trust myself to do better investing or risk management than the asset managers I work with day in, day out. This type of investing also remains a concern at the core of regulator thinking and one that perhaps the most vocal Reddit “wallstreetbets” advocates for financial liberty don’t totally appreciate at times. The most fundamental question is whether or not policymakers should allow full financial autonomy to retail investors even if it results in a degree of self-harm, or if the overall current mode of intermediation is better for both the investor and for overall systemic risk.

Again, conventional wisdom suggests that groups of retail customers if left to their own devices, are prone to riskier and possibly even dubious investment exposures. They are also more likely to feed financial bubbles by jumping onto “hot investments” without adequate fundamental analysis or prior due diligence.

This nervous tension between financial market investor protection and participation has played out globally, but in the United States in recent years, regulations such as Regulation Best Interest, DOL Fiduciary Rule, and accredited investor definitions each had suitability of investment for retail investors at their core. As populations look for more autonomy over their financial choices, a longer dated consideration becomes whether investor protection mechanisms begin to be viewed as restrictions on personal financial freedoms and autonomy. Regulators primary concern has always been investor protection and investor returns often comes a very distant second, hence why retail investors are often restricted from participating in higher yielding transactions in the private markets, IPOs, or complex derivative transactions. These transactions can bring large gains, but also higher risks and significant losses. 

In Europe, policymakers have tried to increase market data transparency through MIFID, EMIR, and recently SFDR for ESG disclosures, however usable market data is still very expensive and generally not accessible to those outside regulated financial firms. Even MIFID still lacks what is known as a “consolidated tape” years after its implementation so no one has a full view of E.U. marketing trading activity, even the large firms. The E.U. also has an ambitious plan (don’t they always!) in the form of large scale data disclosure regimes such as Non-Financial Reporting Disclosure Directive and the European Single Electronic Format (ESEF) which is meant to facilitate accessibility and comparability of financial reports of E.U. corporations through a free to view, single E.U. database, the European Single Access Point. Now, many have significant doubts about the ability to execute on this plan, but it does show that the “democratization of data”, the bedrock of reducing the data asymmetry that curbs retail investor access to markets is at least being considered with an ongoing public consultation.

The GameStop Effect: Is Direct Retail Upon Us?

Another strand of the growing digital acceleration in asset management is the rise of both trading platforms and social media channels enabling retail investors to share investment ideas and trade inexpensively. These two elements came together in spectacular fashion recently with GameStop. There is evidence that the enforced lockdowns have resulted in substantial increase in market activity of various forms from retail clients. Many of these new investors are younger than the usual demographic and perhaps have less trust in traditional providers, and more confidence to research or crowd source information via social media and trade directly through online brokers.

Trading through online brokers is a far-reaching development which although still small in relation to the overall market, has fundamental consequence for the traditional, and usually more costly fund intermediation model. Regulated distributors, advisors, and platforms along with their associated investor protection duties to offer proper advice on possible risks and suitability requirements now risk falling by the wayside as “do it yourself” investing increases in popularity. The wealth management industry is estimated to hold $89 trillion in assets under management and financial advisors play a central role to investors and influence where money is invested, a world where disintermediation of advisors occurs would be a seismic shift in how the system works currently.

The up and coming online trader appears to have no use for such assistance, they can self-serve and make their own decisions, or so the theory goes. Funnily enough, the “new investor” also might not wish to have to go through different providers to get access to the investments they want. It seems the investor of the future more and more wants a “one stop shop”, like Amazon, who can give them a single window into a range of services and products all through a single interface. This dynamic also has serious consequences for providers who have discrete propositions and do not wish to be “all things to all people”.  The new investor might not see a difference between taking out a loan or investing in mutual funds, direct equity trading, crypto-assets, ETFs, or access to ESG products; whereas traditional advisor mindsets would suggest these are all very different risk, liquidity, and investment horizon profiles.

There are a host of investor protection regimes in Europe that relate to product adequacy from UCITS to MIFID, from Market Abuse Directive to PRIIPs disclosure regimes. European regulators try to protect investors by forcing intermediation upon retail investors, but this manner of regulation is being challenged as we enter discernibly into a digital age. On the flip side, even in the case of direct to customer digital platforms, it seems highly unlikely that investor protection responsibility will be diluted but rather the education, disclosure, and access to complain should it go awry, will be done digitally – much like the way that online banking currently works.

To boldly embrace the new, or cautiously cling to the existing and incrementally integrate new ways is now the choice at hand. How it ultimately goes remains uncertain, but it sure does feel like we have reached an inflection point of the digital acceleration, and are on the brink of change.

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