With a lot of talk about the wealth gap recently, I thought I’d point out the financial side that is contributing to the problem. If you’re a small investor there are quite a few factors at play that are likely putting you at a disadvantage in everyday investing and trading. Despite the surging stock market, there are deeply entrenched systems that skim off the backs of less connected and wealthy.
Instead of concluding with how fintech will help solve these problems, I will first start out with the solution—and hopefully some optimism. The benefits of fintech go first, from there, you can see how it can address the latter, more pessimistic half of this article.
What Fintech Brings to the Table
First, fintech will bring to bear much wider access to investments that weren’t previously available. The SEC has opened up somewhat in this regard, allowing ordinary investors to buy shares of startups at a very early stage of seed funding. Kickstarter is one example of this new fundraising model. Of course there is more risk, but the reward is sometimes extraordinary, and something only Venture Capitalists and Angel Investors have been able to enjoy until now. ICO’s are a more tricky story, but believe a new framework will be developed to encourage innovation while employing regulation based on the finer categories of “cryptocurrency”, “utility token”, “security token” and “stable coin”.
Second, the concept of “staking” in the context of cryptocurrency. It’s important that people are tied to the consequences of their actions. Just as Nassim Taleb outlines in his new book “Skin in the Game”. He elaborates that the most successful societies in history had systems that held people accountable for any damage they may cause, even if indirectly. Although western legal systems were originally based on this system of civil law, unfortunately it has been distorted over time. Complex statutory law has exploded, and often acts as a buffer obscuring criminal deeds. Conversely, many people are locked up each year and face stiff punishments for petty crimes, where there is no victim involved. The concept of “staking” however offers a new and efficient method of aligning goals in a new and efficient way. I believe many new business models will be created based on this new concept. One of encouraging stake in any community in the same way that CEO’s are aligned with their shareholders by owning some stock. This way, they have “skin in the game.”
Third, transparency and immutability. Blockchain tech will allow easy audit of public companies for all to see. Immutability is another important feature of this new financial system. Scheming financial manipulators often try to cover their tracks, and often succeed. Requiring communications and transactions to proceed on an immutable ledger will make it impossible for this destruction of history.
Fourth, Decentralization. Fintech and blockchain have already made great strides in cutting out the middle men in the financial system. This trend will continue. One promising development is decentralized exchanges that are open source. This might hope to eliminate many of the perverse incentives that go along with centralized systems, such as regulatory capture.
- Front Running
- Decrease in Equity Availability
- You’re Being Corralled
- Brokerage Shenanigans
- Rules don’t apply to big fish
You’re Being Front-Run
High frequency trading is where your electronic signal to buy or sell a security is seen before it arrives at an exchange and can be executed. More specifically, it takes advantage of the time it takes for a bid to arrive between one exchange or another in large orders. The HFT then “front runs” your trade by purchasing it before your order executes, using advanced knowledge of your trade. This may cause your order to be executed at a higher price than originally quoted. Of course, when you’re trading in small amounts it doesn’t make much of a difference, however most people have a share of large mutual funds or ETF’s that do trade in size. It’s a death by a thousand cuts.
You Have Declining Public Equity Available to Purchase
There has been a dearth of publicly traded companies due to companies choosing to stay private, company acquisitions, and record breaking corporate buybacks. Accredited investors on the other hand, have innumerable private options available to them that retail investors are restricted from buying. Accredited investors can compensate for the decline in public companies with this wider net of investment opportunities.
Corporations have been on an acquisition spree. Another, lesser known disadvantage of the public equity drain is the inability to capitalize on specific technologies and trends. Small investors can be blocked out of “pure play” opportunities in this way. When choices are already slim, it forces them to buy into a wide range of horizontally integrated businesses that might not fit into their investment thesis. One example of this is the “API economy” startups. Many of these niche but fast growing companies were hoovered up by Google before they even had the chance to IPO. Others, like Mulesoft were aquired having only been trading for a few months. Overall, retail investors are stuck with an increasing percentage of publicly traded mega corporations that will never hope to achieve the Alpha return they may seek.
You’re being corralled
As part of many retirement plans, investment allocations are based on modern portfolio theory. As such there is only a certain amount of “risk adjusted return” that can be taken using a certain mix of stocks and bonds. Small investors are often limited to a handful of mutual fund choices that are proportionately contributed to over time. Of course this passive and diversified investment style can be effective over time. This is especially true of many investors that would otherwise over trade and take undue risk. Even so, from a game-theory perspective, there are many ways that this style of passive, indexed investing can be a great danger.
Setting aside the virtues of index investing and portfolio theory, there are a number of ways this captive investment class can be taken advantage of. It’s precisely because of the rules imposed on them, rendering them immobile. The restrictions as part of retirement plans often make it impossible to maneuver in a reasonable amount of time. Once they do, high fees for switching funds are levied. Small investors are slowed down and penalized whenever possible. In fact, these retirement funds for ordinary working people often act as a liquidity pool to be dumped on by banks, brokerages, and wealthy family offices.
A more concrete example of this was how in 2005, the S&P 500 index rules were changed to be calculated based on “Float Adjusted Market Capitalization”. This means that inclusion of specific stocks in indexes are weighted according only to the “float”—shares that are freely available for trade in the market. This excludes restricted stock held by insiders. It means that, as the change was implemented, and insiders sold their shares, they became part of the float. Since the index calculation changed, many retirement plans were forced to buy an ever increasing share of stocks, just as insiders were dumping on them.
Brokerage Shenanigans
Financial advisors and brokers tend to funnel their clients into certain products that they get kickbacks for selling. This often happens even when there are better products available to suit their client’s goals, and often at a lower fee. Brokers sometimes work as part of a sales team in initial public offerings, private placements, and secondary offerings. In a concerted effort with their firm’s corporate finance office, brokers try to sell clients on deals in order help a company raise capital. In exchange, the broker may receive a commission, shares or warrants in the issuing company.
Although many have the upmost confidence in our financial institutions and laws, the more jaded among us know that people don’t always follow those rules. Even the rules themselves aren’t always designed with benevolent intentions, even though they are of course branded and marketed in that way. One common brokerage trick is called the “Ticket Switch”. In this scheme, your buy order in your account is used as cover for the broker’s own orders. the broker buys your stock ahead of you, then sells it back to you at a higher price. If the price goes down before the broker gets the chance to profit from the difference, it simply changes the original order to your account instead of the broker’s. The house always wins.
The Rules Don’t Apply to Big Fish
Anyone who closely follows news understands that the legal system tends to capture the low level criminals but not the biggest How the aftermath of the 2008 financial crisis was handled is a good example of this.
“To date, a few loan officers — small fish — have been convicted of various offenses related to the financial crash. But none of the big bankers have faced any charges. And it’s not that the government has been losing cases in the courts. There’s simply been no concerted effort to prosecute these guys.”
Joshua Holland, Billmoyers.com
“In 2015, Abacus Federal Savings Bank was the 2,651st largest bank in the United States. It was also – and still is – the only U.S. bank prosecuted for the 2008 financial crisis.”
Daniel Hautzinger, WTTW
Although you don’t have to look very far to find that it’s a pervasive and 2008 was no exception. Numerous stock options back dating fraud has been uncovered and shady financial engineering is rampant.
To be continued
In our next article we’ll discuss another financial problem that is contributing to the wealth gap in America…inflation. And one bill in the works that aims to help reduce it.
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