Regulation Best Interest: The Future of Retail Investor Protection?
August 31, 2019
If you have money in mutual funds like Vanguard, or brokerage firms like Charles Schwab, you have a relationship with a broker-dealer. Relationships with such firms can range from simple execution of trades on behalf of clients to long-term investment advice, but previously, this advice had no standardized method for accountability.
On June 5th, 2019, the Securities and Exchange Commission voted by a count of 3 to 1 to approve of a series of rules and interpretations that would, among other things, mandate increased transparency in the relationships between retail investors and broker-dealers. This came as a result of almost 20 years’ worth of assessment and revision by the SEC. One of these rules, Regulation Best Interest (Reg BI), heightened the standard for broker-dealers’ fiduciary responsibility to its investors by stating, “Regulation Best Interest will enhance the broker-dealer standard of conduct beyond existing suitability obligations and make it clear that a broker-dealer may not put its financial interests ahead of the interests of a retail customer when making recommendations,” ensuring that retail investors are able to have faith that their brokers will work to execute trades favorable to them, not another entity.
Specifically, broker-dealers will have a:
- Disclosure Obligation, where they provide all material relationships of the products they provide;
- Care Obligation, where recommendations and associated costs and risks are explained thoroughly;
- Conflict-of-Interest Obligation, where procedures are created such conflicts of interest are, at the very least, disclosed to investors; and
- Compliance Obligation, where these new standards are consistently upheld.
One tangible method to disclose such relationships is through Form CRS (a portion of a mock-up is included below), a standardized, mandatory, and easily comprehendible handout for investors that these firms will be required to provide at the beginning of their relationship.
This rulemaking package also came about with a series of criticism, as a previous similar rule had failed to pass after it was struck down by the U.S. Court of Appeals. The Department of Labor had attempted to enact a ruling that would hold all investment advisors to a fiduciary standard, where investors would have the right to sue if they believed the advisors were not acting in their best interests. Opponents of Reg BI claim it is weaker in comparison, as investment advisors are not held to this same legally enforceable ruling. However, Reg BI allows for investors to be protected while still not stifling the range of investment options for individual retail investors to make. While some investors seek capital appreciation, for example, and would rather invest in safer assets, others seek higher returns, will look for more risky securities, and will pay a commensurately higher price for such an execution. In these instances, it would have been difficult for broker-dealers or advisors to balance the charging of a legally enforceable “reasonable price”, while still investing objectively more time and energy into such customers. Thus, though Reg BI lacks a legal precedent, it allows investors to have access to a range of investment products that suit their investing needs, as opposed to a strict blanket coverage of regulations.
Regulation Best Interest will clarify products such as robo-advisors and fintech services
Recently, JP Morgan released its own robo-advisor services, You Invest, that charged 35 basis points on assets each year, and unlike competitors, would waive all other fees related to trading and commissions. The rise of robo-advisors began about a decade ago, and now are mainstream and low-cost alternatives to personal advisors, which usually charge more on assets, at around 100 basis points. With Form CRS, distinctions between JP Morgan’s robo-advisor and another firm’s broker’s services will be made more clear, and investors can choose their own preferences for investing.
Fintech broker-dealer firms like Robinhood have also come under scrutiny for its business practices and is another firm in which more mandated disclosure could demystify the hidden fees for investors. Robinhood holds a strong appeal for millennials because it charges no commission fees and operates as an intuitive phone app. However, it profits through payment for order flow, where high-frequency trading firms, which utilize algorithms to place orders before human traders can, pay a sum of money on each traded share to see the bid and ask prices of Robinhood’s users. The diagram below illustrates a typical HFT firm’s business model, where a HFT firm is a market maker who profits off of the bid-ask spread for the same security during day-to-day trades.
For Robinhood, HFT firms create tighter bid-ask spreads for investors by buying and selling at slightly higher and lower prices. However, exactly how much price improvement is given to investors is directly impacted by the fees Robinhood charges HFT firms, which it charges quite a lot. Thus, Reg BI will, for the first time ever, help millennial investors understand just how Robinhood operates its line of business, and whether fintech firms like Robinhood truly have their best interests in mind, or if the premium they place on charging for payment for order flow results in profits mostly in their own pockets.
Reg BI will equip investors with clear and concise information on their broker-dealer’s conflict of interests and business model. This will allow investors to make smart decisions in terms of money management, while still providing them the accessibility of hands-off and hands-on approaches through not overly regulating the activities of firms seeking to return more value to customers.
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