Could UK financial regulation be at a turning point? The imminent arrival of a new interim chief executive at the Financial Conduct Authority (FCA) gives an opportunity to change direction. This follows a raft of regulation in recent years - from MiFID II to Assessment of Value. All well-meant rules aimed at better consumer outcomes, but unfortunately with some unintended consequences. Pushing down costs may be creating systemic risk for the whole industry.
Woodford and London Capital & Finance have sparked debate on just how effective consumer protection is. Investors suffered big losses on regulated funds. But the remedy is not clear. Are there gaps needing new regulation, or is enforcement the main issue? It looks like a good time for the FCA to assess the direction of travel.
Lowering cost for investors has driven mergers, and increased industry concentration. Small providers struggle to cope with massive technology and regulatory costs. The sheer pace of new regulation and its complexity has left just a few big players in some key parts of the chain.
Well-designed systems need built-in resilience. The challenge is how to balance that strength against cost. Buffers in the system can look like inefficiencies that no-one wants to pay for. Regulation has driven out diversity and discouraged many of the informal defences that previously protected the financial eco-system. Regulation and competition have shaped industry structure: uniformity is now the problem.
Some signs of stress are already visible. Ever since the Brexit vote gated some UK property funds, the FCA has been wrestling with effective policy on liquidity. New guidance certainly helps, but these rules have still to be tested. And this is not the only systemic risk.
Each area of the system shows signs of increasing concentration. There are now just a handful of providers of the transfer agency services that handle the flows of investors in and out of unit trusts. Investment platforms servicing financial advisers and their clients also have scaled-up, reducing choice. Similarly, online brokerage and custody are each now dominated by just a few players. The largest wealth managers have gathered assets and imposed standardised compliant decision-making, but at a cost. The concentration is seen as encouraging herding into a relatively small group of “star” managers. Many of those are focused on buying the same “quality growth” stocks.
Undoubtedly the diversity of business models has narrowed, creating an eco-system with less resilience. And, it is difficult for customers at each stage in the chain to plan effective contingency. The process of moving between transfer agents or platforms is complex, lengthy and expensive. Certainly, businesses have plans in place – wind-down planning is compulsory. But, contingency testing tends to focus on the failure of single providers, not a cascade of collapsing linked services.
The scale of some parts of the chain is a challenge for innovation. Robust handling of transfer agency means reducing the diversity of fund structures and pricing models. This simplifies the technology challenge, but at the cost of choice. Gradually, barriers to entry have built up and the high valuations of, for example, investment platforms point to the moats those businesses have. It is hard for clients to change platform, and increasingly private investors are becoming locked into an online brokerage. Consolidation in these areas in particular points to a cynical view that customers are there for life, whatever the pricing and service.
Although technology might bring some innovation, few new entrants have grown to compete effectively with the incumbent providers. In theory, artificial intelligence and robo-based business models should bring more choice at low cost, but none yet looks like a threat to the established players. The regulatory focus on cost encourages scale and standardisation, and has created a dull uniform landscape with big risks. The market infrastructure serving retail investment clients only looks fit for purpose if cost is all that matters.
Lack of challenge breeds complacency, and some of the service providers involved may start to behave as if they are too big to fail. The public purse should not be underwriting this systemic risk. The challenge for the regulator now is to consider whether the overall industry structure is safe, and if customers deserve more choice and innovation.
A version of this article was published in Financial News on 17/03/2020.