The cost of regulation on small retail investors

In an article I penned and published last February entitled “MiFID II – product governance and impact on primary market”, I aimed at highlighting in a very basic manner the implications of the new Markets in Financial Instruments Directive (MiFID) regulations on consumers of investment services in the area of distribution and product governance. I questioned whether small retail investors will really see benefits from this new extensive regulation from a product distribution perspective. In terms of transparency, I believe that the rules have indeed contributed to increased clarity. All the information that investors may require before taking an investment decision are indeed available. Whether they are used effectively before the decision is taken remains something we will never really manage to clarify fully. A certain element of reliance on one’s advisor depending on the level of trust garnered over the years will, in my opinion, always remain a favoured option. To what extent is this still possible though?

Before attempting to clarify this point further, apart from transparency, one of the other main aims was to create enhanced protection. Only time will tell if this objective can really be increased through this new regulation however, from a practical perspective, it would seem that new protection rules have created an uneven playing field for financial advice. Small retail investors to my mind, have ironically been worst hit. Coming to terms with a new way of interacting with banks, stockbrokers and other intermediaries was never going to be easy as these licenced professionals ensure that they comply with the new stringent and sometimes very impractical regulations.

Under MiFID II, investment services licence holders authorised to provide advice may have or are likely to be taking a number of decisions that will reshape the way business is conducted depending on the type of customer being serviced. Whether it is related to deciding whether to position oneself as being independent or not independent, abolishing the receipt and/or payment of commissions, introducing specific fees for investment advice/assessments or assessing the feasibility of providing a particular service to a specific client profile in the context of these extensive new rules, the shake-up in the sector has only just started in my opinion.

From my perspective, the domestic investment services market is taking on a new mould fairly clearly. In prior years, we had a relatively good spread of licence holders providing more or less the same service for the same products to the same customer type almost across the board. This is changing. Today and looking ahead, I can see the players within the sector clearly differentiating themselves from one another, targeting different customer types with different products on the basis of the niche they seem to be creating for themselves. The new regulations are ‘assisting’ this process as the cost of servicing customers from a regulatory perspective soars. We are now slowly witnessing a divergence in operators’ models – some going down the mass market route while others becoming increasingly selective by servicing customers of a certain size to ensure feasibility and the maintenance of a specific service quality.

There is a school of thought suggesting that it has become almost impossible to service small retail investors the way the market was accustomed to for many years. This category of investors, ironically the largest by far (not only domestically), is fast becoming unserviceable. If intermediaries had to carefully cost the time they are now required to spend with these customers as a result of the fine detail that these new regulations have gone into, it would seem logical to conclude that, relative to the size of a standard investment, passing on this cost to small retail customers in the form of advisory fees becomes totally unfeasible for them. These fees would sit over and above brokerage.

From a protection perspective therefore, my concern is that regulation is pushing these small retail investors to an execution-only model which, given their overall general level of investment knowledge and experience, would not really provide them with the ‘protection’ they require and wish to receive had they managed to obtain advice. By protection I am referring expressly to the comfort and guidance they would find had they obtained advice from their trusted intermediary/consultant prior to transacting. The modifications in the service levels and associated fee structures now being charged will inevitably push a large number of these small retail investors (principally pensioners) out of the market. What choice do they have at this point? Is this what they really want and need? Or are they now being steered towards the ‘cheapest’ route of least resistance?

A concern to me is that ironically, rather than protecting investors, this new scenario could easily pave the way for this category of investor to go execution-only on products that do not match their risk profile but are perhaps easier to access and more straightforward and less challenging for an intermediary to provide.

Domestically, small retail investors have been the backbone of the capital market since inception. The concept of popularising new issuance by distributing it to a large, stable and sticky stakeholder base made sense from multiple viewpoints. We are now seeing an accelerated move towards different distribution styles where, principally as a result of these regulatory developments, targeting a different investor cluster and/or containing distribution seems to have taken on a more evident path. Gone are the days when investors could apply for bonds/shares en masse following a chat with their trusted advisor. This is not necessarily a bad thing as we all know what happened in certain cases in the past and mis-selling or target-oriented drivers had led to some unfortunate results. However, we are now witnessing the other extreme and, in both cases, the small retail investor is effectively paying the price. Regrettably (and understandably in most cases) regulation does not cater for the specifics of a particular market or custom so it is the market that always has to adjust irrespective of the nature of the market and the risks posed by the sale of more complex products as opposed to plain vanilla mainstream financial instruments.

The impact of regulation on investing is a complex matter. The potential inhibiting effect of regulation is often difficult to see and quantity. In fact, regulating fairly without discouraging well intended long term investment and the creation of a savings culture is indeed challenging. Naturally, regulation is vitally important but it needs to be applied appropriately for it to effectively achieve stability and confidence. Regrettably, post any form of trouble or crisis, we witness extremes that may not necessarily create the desired long-term effects. One can only hope that over regulation does not create unintended consequences which would in turn only result in further challenges down the line.

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