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Regulation Best Interest: The Future of Retail Investor Protection?

August 31, 2019
When you visit your physician with an ailment, you hope your doctor prescribes medicines that are, to their absolute best knowledge, the right ones for you to get better. When you purchase a vehicle at the used car dealership, you would like to expect that your dealer discloses pertinent information about the car’s condition, especially any hidden issues that may exist. And when you go to your broker-dealer with your hard-earned money, seeking sufficient returns that will allow you to plan for retirement, a child’s education, or a rainy day, you might want to hear that your broker is working for you and has your best interests in mind.

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.[1]

Specifically, broker-dealers will have a:

  1. Disclosure Obligation, where they provide all material relationships of the products they provide;
  2. Care Obligation, where recommendations and associated costs and risks are explained thoroughly;
  3. Conflict-of-Interest Obligation, where procedures are created such conflicts of interest are, at the very least, disclosed to investors; and
  4. 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.[2]

Image: Mock-up of Form CRS. Source: SEC.Image: Mock-up of Form CRS. Source: SEC.

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.[3]

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.[4]

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.[5]

Image: High-frequency trading for large orders. Source: Wikipedia.Image: High-frequency trading for large orders. Source: Wikipedia.

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.

Student Blog Disclaimer
  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

References

  [1]https://www.sec.gov/news/press-release/2019-89

  [2]https://www.sec.gov/news/statements/2018/annex-b-2-bd-registrant-mock-up.pdf

  [3]https://www.marketwatch.com/story/is-the-fiduciary-rule-dead-or-alive-what-its-fate-means-to-you-2018-03-16

  [4]https://www.cnbc.com/2019/07/10/jpmorgan-creates-robo-adviser-you-invest-portfolios-with-free-etfs.html

  [5]https://www.wsj.com/articles/why-free-trading-on-robinhood-isnt-really-free-1541772001

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RESOURCE SPOTLIGHT:

  • <h3>MapStats</h3><p> A feature of FedStats, MapStats allows users to search for <strong>state, county, city, congressional district, or Federal judicial district data</strong> (demographic, economic, and geographic).</p><p> Quick link: <a href="http://www.fedstats.gov/mapstats/" target="_blank">http://www.fedstats.gov/mapstats/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
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  • <h3>Internal Revenue Service: Tax Statistics</h3><p><img width="155" height="200" alt="" src="/live/image/gid/4/width/155/height/200/486_irs_logo.rev.1407789424.jpg" class="lw_image lw_image486 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/155/height/200/486_irs_logo.rev.1407789424.jpg 2x" data-max-w="463" data-max-h="596"/>Find statistics on business tax, individual tax, charitable and exempt organizations, IRS operations and budget, and income (SOI), as well as statistics by form, products, publications, papers, and other IRS data.</p><p> Quick link to <strong>Tax Statistics, where you will find a wide range of tables, articles, and data</strong> that describe and measure elements of the U.S. tax system: <a href="http://www.irs.gov/uac/Tax-Stats-2" target="_blank">http://www.irs.gov/uac/Tax-Stats-2</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>Congressional Budget Office</h3><p><img width="180" height="180" alt="" src="/live/image/gid/4/width/180/height/180/380_cbo-logo.rev.1406822035.jpg" class="lw_image lw_image380 lw_align_right" data-max-w="180" data-max-h="180"/>Since its founding in 1974, the Congressional Budget Office (CBO) has produced independent analyses of budgetary and economic issues to support the Congressional budget process.</p><p> The agency is strictly nonpartisan and conducts objective, impartial analysis, which is evident in each of the dozens of reports and hundreds of cost estimates that its economists and policy analysts produce each year. CBO does not make policy recommendations, and each report and cost estimate discloses the agency’s assumptions and methodologies. <strong>CBO provides budgetary and economic information in a variety of ways and at various points in the legislative process.</strong> Products include baseline budget projections and economic forecasts, analysis of the President’s budget, cost estimates, analysis of federal mandates, working papers, and more.</p><p> Quick link to Products page: <a href="http://www.cbo.gov/about/our-products" target="_blank">http://www.cbo.gov/about/our-products</a></p><p> Quick link to Topics: <a href="http://www.cbo.gov/topics" target="_blank">http://www.cbo.gov/topics</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>HUD State of the Cities Data Systems</h3><p><strong><img width="200" height="200" alt="" src="/live/image/gid/4/width/200/height/200/482_hud_logo.rev.1407788472.jpg" class="lw_image lw_image482 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/200/height/200/482_hud_logo.rev.1407788472.jpg 2x, /live/image/scale/3x/gid/4/width/200/height/200/482_hud_logo.rev.1407788472.jpg 3x" data-max-w="612" data-max-h="613"/>The SOCDS provides data for individual Metropolitan Areas, Central Cities, and Suburbs.</strong> It is a portal for non-national data made available through a number of outside institutions (e.g. Census, BLS, FBI and others).</p><p> Quick link: <a href="http://www.huduser.org/portal/datasets/socds.html" target="_blank">http://www.huduser.org/portal/datasets/socds.html</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>USDA Nutrition Assistance Data</h3><p><img width="180" height="124" alt="" src="/live/image/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg" class="lw_image lw_image485 lw_align_right" srcset="/live/image/scale/2x/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg 2x, /live/image/scale/3x/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg 3x" data-max-w="1233" data-max-h="850"/>Data and research regarding the following <strong>USDA Nutrition Assistance</strong> programs are available through this site:</p><ul><li>Supplemental Nutrition Assistance Program (SNAP) </li><li>Food Distribution Programs </li><li>School Meals </li><li>Women, Infants and Children </li></ul><p> Quick link: <a href="http://www.fns.usda.gov/data-and-statistics" target="_blank">http://www.fns.usda.gov/data-and-statistics</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>Federal Reserve Economic Data (FRED®)</h3><p><strong><img width="180" height="79" alt="" src="/live/image/gid/4/width/180/height/79/481_fred-logo.rev.1407788243.jpg" class="lw_image lw_image481 lw_align_right" data-max-w="222" data-max-h="97"/>An online database consisting of more than 72,000 economic data time series from 54 national, international, public, and private sources.</strong> FRED®, created and maintained by Research Department at the Federal Reserve Bank of St. Louis, goes far beyond simply providing data: It combines data with a powerful mix of tools that help the user understand, interact with, display, and disseminate the data.</p><p> Quick link to data page: <a href="http://research.stlouisfed.org/fred2/tags/series" target="_blank">http://research.stlouisfed.org/fred2/tags/series</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>National Center for Education Statistics</h3><p><strong><img width="400" height="80" alt="" src="/live/image/gid/4/width/400/height/80/479_nces.rev.1407787656.jpg" class="lw_image lw_image479 lw_align_right" data-max-w="400" data-max-h="80"/>The National Center for Education Statistics (NCES) is the primary federal entity for collecting and analyzing data related to education in the U.S. and other nations.</strong> NCES is located within the U.S. Department of Education and the Institute of Education Sciences. NCES has an extensive Statistical Standards Program that consults and advises on methodological and statistical aspects involved in the design, collection, and analysis of data collections in the Center. To learn more about the NCES, <a href="http://nces.ed.gov/about/" target="_blank">click here</a>.</p><p> Quick link to NCES Data Tools: <a href="http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4" target="_blank">http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4</a></p><p> Quick link to Quick Tables and Figures: <a href="http://nces.ed.gov/quicktables/" target="_blank">http://nces.ed.gov/quicktables/</a></p><p> Quick link to NCES Fast Facts (Note: The primary purpose of the Fast Facts website is to provide users with concise information on a range of educational issues, from early childhood to adult learning.): <a href="http://nces.ed.gov/fastfacts/" target="_blank">http://nces.ed.gov/fastfacts/#</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
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  • <h3>The World Bank Data (U.S.)</h3><p><img width="130" height="118" alt="" src="/live/image/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg" class="lw_image lw_image484 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg 2x, /live/image/scale/3x/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg 3x" data-max-w="1406" data-max-h="1275"/>The <strong>World Bank</strong> provides World Development Indicators, Surveys, and data on Finances and Climate Change.</p><p> Quick link: <a href="http://data.worldbank.org/country/united-states" target="_blank">http://data.worldbank.org/country/united-states</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>The Penn World Table</h3><p> The Penn World Table provides purchasing power parity and national income accounts converted to international prices for 189 countries/territories for some or all of the years 1950-2010.</p><p><a href="https://pwt.sas.upenn.edu/php_site/pwt71/pwt71_form.php" target="_blank">Quick link.</a> </p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>National Bureau of Economic Research (Public Use Data Archive)</h3><p><img width="180" height="43" alt="" src="/live/image/gid/4/width/180/height/43/478_nber.rev.1407530465.jpg" class="lw_image lw_image478 lw_align_right" data-max-w="329" data-max-h="79"/>Founded in 1920, the <strong>National Bureau of Economic Research</strong> is a private, nonprofit, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works. The NBER is committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.</p><p> Quick Link to <strong>Public Use Data Archive</strong>: <a href="http://www.nber.org/data/" target="_blank">http://www.nber.org/data/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>