An inconvenient truth about the financial industry is that it cannot be trusted; there have been too many scandals to remember. Common solutions, such as rules and regulations, no longer seem to be improving trust, necessitating the exploration of new measures.
Trust
A positive correlation exists between economic growth and trust; people who trust each other are more likely to engage in transactions together. The purpose of rules and regulations is to foster trust among economic participants so that they can transact securely.
However, rules and regulations come with the downside of adding unwanted bureaucracy, resulting in more costly and slower transactions.
Scandal
Unfortunately, rules and regulations are necessary due to the numerous instances of dishonest behaviour in the industry. For instance, in the fund industry, there are many recorded cases of closet indexing, where funds marketed as active are actually managed passively.
Instances of fraud are challenging for retail investors to identify, hence regulators play an essential role in curbing such activities. Recently, the European Commission has taken an additional step by adopting the Retail Investment Package, which places significant emphasis on providing value for money for investors.
Fund Cost Benchmarks
The most contentious aspect of the package is a proposal for ESMA to create cost and performance benchmarks for around 30,000 UCITS sub-funds. Fund manufacturers would be obligated to compare their funds to these benchmarks and take action in case of deviations.
This proposal seems to go too far. While regulatory authorities should ensure market honesty, directly influencing the prices charged to investors might not be their mandate. Healthy competition among funds is the best way to ensure that investors receive value for their money.
Education & Licensing
Relying solely on new regulations to protect investors from dishonest actors and to ensure value for money is likely to have limited effectiveness. The actual issue in the industry is that investors have a low level of financial literacy and struggle to differentiate good investments from bad ones.
Instead of continually relying on new regulations, we should concentrate on educating investors to make them less naive about investing. Upon passing an evaluation, they could be issued a license to invest.
Such a license would empower investors to make better investment decisions, ultimately increasing market competition and addressing concerns about value for money. Moreover, the higher risk of being caught out would deter dishonest behaviour in the market.
Regulations that enhance trust and ensure a level playing field among market participants should be upheld, while those that have led to excessive bureaucracy could be reconsidered. A licensed investor would require fewer checks and reporting.
Conclusion
Ultimately, there is a limit to how many rules and regulations can be imposed on the market. Exploring alternative ways to protect investors and ensure value for money from their investments is essential. Issuing licenses to investors could potentially be a solution.
Gregory Kennedy is a columnist for Investment Officer Luxembourg. His columns appear every other Wednesday. He also works as a business development manager at Finsoft Luxembourg.