Transparency

Our American system of capitalism isn’t perfect, but the competition it creates encourages innovation, inventions and drives solutions to economic and social problems.

The dark side of capitalism creates Bernie Madoff, Enron and others who use the system to their advantage.  Capitalism requires a level of skepticism on the part of consumers to keep from being taken, and at the very least, an understanding that not everyone or everything is operating on the level you think they are.

Flash Boys, Michael Lewis’s book about high frequency traders, provides a great illustration.  The conduct of high frequency traders is not illegal – though an argument could be made that it should be – but at a minimum it undermines the basic principles of transparent trade that is the basis of our capital markets.

On a very simplified basis, high frequency traders (HFTs) find out when someone wants to buy or sell a stock on one exchange, then race ahead to another exchange where they buy or sell the same stock before the original trade can be placed, and profit on the difference – a practice also known as front-running.  On the surface, it sounds like a classic example of American capitalism at its best.  An entrepreneur finds a weakness in the system, capitalizes on it for their own benefit, and drives positive change.  But it’s more complex than that.

The exchanges the HFTs use to get advance knowledge about trades are known as ‘dark pools,’ essentially private trading pools created by banks and brokerage firms to match up their customers’ requests to buy and sell stocks.  HFTs pay banks and brokerage firms large fees to participate in the pools, allowing them to see client trades and use this information to drive up or down stock prices on public exchanges.

Banks and brokerage firms convinced their own clients to use the pools by promoting them as more efficient and cost-effective than a public exchange like the New York Stock Exchange.  Meanwhile, they collected significant payments from HFTs for giving them access to their clients’ trades without their knowledge.  Not exactly a level playing field.

Now, as the Dow Jones Industrial Average marches toward 22,000 (Remember when it was 6,000 in March 2009?) and investors are beginning to forget the market goes down as well as up, Morgan Stanley, Merrill Lynch/Bank America, Wells Fargo and UBS are promoting another alternative revenue source.

Portfolio loans have reached over $100 billion dollars among banks and brokerage firms, according to a report by the Wall Street Journal last week. The fees and interest paid by investors on the loans are significant and growing, with Morgan Stanley highlighting them in a recent earnings report, and Merrill Lynch brokers receiving bonuses and continuing payments for getting clients to sign-up and borrow.

Like traditional margin loans, the investments inside client accounts act as collateral, but these loans aren’t being used to purchase additional stocks.  Instead, clients are encouraged to use the loans as an alternative to selling stocks, bonds and mutual funds and withdrawing the proceeds.  This allows brokerage firms to collect asset management fees on the entire portfolio as well as interest on the outstanding loans.

Of course, if the stock market falls the client will be in the unfortunate situation of owing money, with a much lower-value portfolio to liquidate to pay off the loan.

At TAAG, we repeatedly emphasize the importance of transparency in your financial dealings.  But in today’s world, it doesn’t hurt to be reminded about conflicts of interest, and why it’s important to understand what’s driving someone to put you in a financial product.

If you get tired of all the work it takes to uncover the motivations of your current advisor, consider working with a company that values transparency.  And if you’re already a TAAG client, you can add the above items to the list of things you don’t have to worry about.

Share this post:
  • email
  • Facebook
  • Twitter
  • StumbleUpon
  • Technorati
  • del.icio.us
  • Digg