Creating a Level Playing Field
Much of the modern financial services edifice has been built on structures and arrangements that have relied on certain participants having exclusive access to information, third party human involvement due to complex and risky nature of financial services, and an opacity of transactions to preserve business models of certain parties. Such structures and arrangements have worked just fine until now, but now the balance is tilting in favor of creating a more open environment where trust and transparency is improved, and bias and conflicts of interest are mitigated. Toward this end, a variety of regulations are being proposed and enforced, and technology is increasingly creating opportunities as well. There is also a focus on simplification and enablement to empower the traditionally disadvantaged parties, and automation so as to minimize the principal-agent problem. Fintechs are at the forefront in driving a large part of this. This last installment in the Fintech series (The Five D’s of Fintech) focuses on how opacity of information, bias, and conflicts of interest in financial services are being targeted by fintechs that want to create an open, level playing field through technology and new business models.
Opacity of Information, Lack of Trust & Transparency
Trade execution is one area where various issues related to trust and transparency are being targeted by fintechs. The information asymmetry that exists between large institutional players such as market makers and small retail investors inevitably leads to inefficient outcomes for the latter – this is true in case of certain exchanges whereby high speed traders, because they get up to date market information quicker, are able to jump in front of retail investors during order execution thereby giving the former a price advantage. IEX Exchange in 2012 came out with a new model for providing trade execution services with the goal of leveling the playing field and providing transparency. For example, IEX’s “speed bump” was an innovation that introduced a delay in their trades with the goal of negating the high frequency trader’s speed advantages. IEX also does not engage in “payment for order flow” – an arrangement in which HFT’s and market makers make payments to brokers for retail orders – which could potentially lead to conflicts of interest and ultimately shortchanging the retail investors. And it also actively publishes a comprehensive set of metrics and KPIs to demonstrate execution quality.
In other cases, there is lack of transparency on asset price, which provides an unfair advantage to the seller – as in the case in the digitally archaic corporate bond market where in many to most instances, there is a lack of visibility of order books across markets, and dealers unilaterally set the price of the bonds (since they may be the only ones that carry those securities on their books), leading buyers to be meek price takers. Electronic bond trading platforms such as MarketAxess and TradeWeb have recently introduced “all to all” trading in corporate bond markets whereby buyers can get broad market visibility and price transparency and trade with any dealer or asset manager in the network. New outfits such as LiquidityBook are jumping in with new solutions centered on pre-trade and post-trade transparency.
Pre-trade and post-trade transparency and ‘best execution’ are becoming the norm, thanks to regulations like MIFID2. Investors, retail and institutional asset managers alike, are looking to find out more about where brokers are sending their orders. For many years now, full broker transparency on order routing has been difficult to attain. These issues have increasingly become the focus of both regulators as well as fintech players. As full order routing transparency continues to top the ever-growing list of concerns for asset managers, trading technology companies are slowly but surely emerging to provide such solutions to the buy-side. Dash Financial Technologies is a technology and services company that provides order routing and customized trading solutions for the buy side enabling full order routing transparency. The firm has seen considerable growth in recent years, in large part due to its transparency services. Another example is Luminex, which is a consortium formed by major buy side players that provides order execution transparency.
Portfolio manager and financial advisor bias in asset and wealth management has been the focus of study and research for some time now, with well-known biases and subtle preferences factoring into investment decisions. For example, portfolio managers are prone to confirmation and overconfidence bias, which may ultimately lead to investment underperformance. Financial advisors, despite having fiduciary focus, can be susceptible to a range of cognitive biases. After all, portfolio managers and financial advisors are only human, and as behavioral economics has proved, no matter how rational advisors may think they are, subtle biases do often creep into decision making.
The application of behavioral economics to personal finance – dubbed “behavioral finance” – is the latest development in the wealth management industry purported to help drive investor outcomes. Behavioral finance techniques can help reduce bias in investment decisions. While bias in the context of wealth management has traditionally focused on end investor/client bias, equally important are the biases of the financial advisors themselves – indeed biases on either side can reinforce and influence each other. Time-tested, automated, and quantitative strategies can help take human emotion out of investment decision-making, both for financial advisors and their clients. As financial advisors increasingly focus on financial planning and driving investor satisfaction and outcomes, they realize the importance of leveraging behavioral finance techniques that can help advisors consistently apply the wisdom of proven investment strategies across clients and across market cycles. However, per recent surveys, they cite difficulty translating theory into implementation, and a lack of software/tools as the primary reason preventing adoption (Charles Schwab survey) – until now.
Many technology savvy advisors and wealthtech firms are focused squarely on enabling behavioral finance capabilities through technology. United Capital for example recently unveiled FinLife Partners, a tool for advisors that taps into clients’ views on money and spending and how they prioritize their decision-making (United Capital, a well-known financial advisor, was recently acquired by Goldman Sachs). Advisor Software has released Behavioral IQ, which aims to get a clearer picture of six behavioral traits influencing clients’ approach to risk and decision-making though a series of questions and follow-ups. The tool, which essentially weighs biases by analyzing such factors as confidence and loss aversion, lets advisors make more appropriate recommendations. Lirio’s Finworx also applies insight into clients’ risk tolerance and decision-making approaches derived from questionnaires.
As technology commoditizes parts of wealth management (tax loss harvesting, rebalancing, notifications, to name a few), it is moving increasingly upstream to functions such as asset allocation and financial planning that have been the sole preserve of human financial advisors, thanks to machine learning and more generally, AI. As technology revolutionizes wealth management, it reduces the risk of mistakes and bias, intentional or not. Although AI can introduce bias and discrimination of its own, new techniques and methods to manage and mitigate such issues are already paving the way to widespread AI adoption.
Conflicts of Interest
The retirement industry is increasingly delivering on its fiduciary responsibility toward investors thanks to a string of successful class action lawsuits that has forced large plan sponsors and providers in the 401(k) space to clearly disclose fees and conflicts of interest. However, there are segments of the industry where the problem is still rife. For example, the small 401(k) plan market is not only underserved and overpriced, but it also pays high compliance fines due to failed DOL audit checks. 403(b) plans, offered to schoolteachers and employees of tax-exempt organizations, are particularly notorious for shirking their fiduciary responsibility. 403(b) plans, unlike 401(k) plans, are not subject to ERISA mandates, which have been key to ensuring fiduciary treatment of plan design and operation. Indeed, many 403(b) plans suffer from higher costs, lack of transparency and conflicts of interest where, for example, administrators, who receive kickbacks from asset managers, promote highly priced and complex investment products (such as annuities) to sponsors and participants. No wonder, New York’s Department of Financial Services recently launched an investigation into the 403(b) plan practices of brokers and investment providers such as insurers, the well-known purveyors of annuity products.
It is these segments that retiretech firms are beginning to target by bringing new value propositions and models to not just provide ease of use and fiduciary support, but also transparency and elimination of conflicts of interest. Backed by private equity, these firms are targeting the RIA channel, leveraging cloud, APIs, machine learning, low-cost passive investments and the latest in “on-boarding” practices to make plans cheap, easy, and riskless enough for small company employers to sponsor. Fintech firms like Vestwell are offering a full white-label retirement platform to RIA’s including investment services, trading, administration, recordkeeping, as well as taking on the fiduciary responsibility through the so called 3(38) and 3(16) arrangements whereby advisors are relieved of the financial cost and legal liability associated with providing retirement services. Outfits such as Dream Forward and ForUsAll are providing advisor focused retirement platform services and solutions by partnering with low cost asset managers and third party recordkeepers, thus eliminating conflicts of interest that typically arise with traditional bundled retirement plan service providers. BidMoni offers a retirement plan marketplace that allows sponsors and advisors to manage provider bids and RFPs, and provide comparisons and ongoing fee analysis – all with the purpose of reducing the fiduciary responsibility burden on sponsors and advisors. Furthermore, many of these innovators are approaching retirement planning with the context of the broader financial needs assessment and planning – which helps to align retirements products and services with the participant’s true financial picture.
As the wealth management and the retirement industry takes on the fiduciary challenge, industry structures favoring such arrangements as commissions and revenue sharing are slowly giving way to ones where investors are in charge of devising their financial future in full freedom and transparency, and fintech, starting with small corners in a vast industry, is leading the way for a broader transformation.
It is still early days, but financial services are slowly but surely becoming more accessible, more equitable, and end consumer focused, and credit goes in large part to fintechs that are demonstrating what is possible and motivating the staid incumbents to change. Driving transparency, reducing bias, mitigating conflicts of interest is laudable, however, achieving perfection is neither practical, nor desirable. Industry structures and business models do need to evolve from what and where they are today, nevertheless, and fintechs are demonstrating what is feasible while still preserving the economics of the industry.