Brokers May Have to Put Customers First

(Bloomberg View) -- Best interests.

I went to law school and was a lawyer for a while, and as part of going to law school and being admitted to the bar you spend a lot of time thinking about fairly recondite conflicts of interest between lawyers and their clients. But there's one dumb simple conflict of interest between lawyers and their clients, which is that clients normally pay lawyers money for legal services, and lawyers want to get paid a lot, and clients do not want to pay a lot. This is a hard conflict to talk about, because, one, it is not very interesting, and two, there is not a lot you can do about it. You can say that lawyers should charge a reasonable hourly rate instead of an unreasonable one, but that doesn't actually address the conflict, which is that the lawyer will want that rate to be high and the client will always want it to be low. And you can say that lawyers shouldn't bill unnecessary hours, but it is hard to know which hours are necessary and which aren't, and the person best situated to know is probably the lawyer, and she's the one billing the hours. And so lawyers occasionally get in trouble for egregious overbilling, and law firms get their bills negotiated down all the time, but in general firms do not get in trouble for being extremely thorough in assigning associates to do legal research on a client's behalf. If in their legal judgment the lawyers think a lot of research is necessary, well, the fact that that research is also profitable for them is just a fact.

This conflict is not special to lawyers, of course; it exists in pretty much every business model. The person selling the thing wants the person buying the thing to buy as much of the thing as possible for as much money as possible; the person buying the thing wants to buy as little as necessary for as little money as possible. With a lot of business models, though, the buyer has a pretty good handle on his own desires, and caveat emptor works: The salesperson at a clothing store may want me to buy more clothes than I need, but I can probably figure out roughly what clothes I need, and say no to the rest. It is harder with legal advice: The point of going to a lawyer for legal advice is probably that I don't know how much legal advice I need or how much it should cost. And so we rely on fiduciary duties: The lawyer is supposed to look out for my best interests and make sure that I get the right amount of legal advice at the right price. She is obviously conflicted in making that decision, but on the other hand she went to law school and was admitted to the bar and we assume that she is an honorable member of a profession who will put her clients' interests ahead of her own. We deal with the unresolvable conflict by telling her to resolve it in the client's best interests, and looking very stern and serious when we tell her that. 

Yesterday the Securities and Exchange Commission issued a big set of proposed rules to require brokers who provide investment advice to retail customers to act in the "best interests" of those customers. Here are the 407-page release proposing Regulation Best Interest, and the 471-page release proposing a new Form CRS for brokers to hand to their customers to explain their relationship, and a 38-page release on fiduciary standards for investment advisers, and a press release, and a statement from SEC Chairman Jay Clayton, and an overview from Clayton, and a sample of the rather chatty Form CRS, but maybe the best place to start is the two-page proposed Regulation Best Interest itself. Here is the substance of it:

A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.

That is pretty much how the rule works for lawyers too, though this is of course not legal or ethical advice. But then Reg BI -- I assume that's what we're calling it; you'd feel a bit silly actually saying "Regulation Best Interest" -- goes on to specify that that obligation "shall be satisfied" if the broker (i) "reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship with the retail customer, including all material conflicts of interest that are associated with the recommendation," (ii) "exercises reasonable diligence, care, skill, and prudence" to make sure that the recommendation actually is in the customer's best interests, and (iii) has "written policies and procedures reasonably designed to identify and disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with such recommendations," and to at least disclose other (non-financial) conflicts of interest (like what?). 

So right away: This is a rule for brokers, not for investment advisers (who have a stronger fiduciary duty). The difference is complicated but can be summed up crudely by saying that a broker gets paid a commission when you do a trade, while an investment adviser gets paid an annual fee for advice. So every time your broker calls you up and says "hey you should buy ____," she has a conflict of interest, because if you buy ____ she gets a commission, and if you don't she doesn't. That is true of lawyers and doctors and everyone else too, of course. It is a well-known conflict of interest for brokers, and a longstanding subject of regulatory attention -- when brokers recommend too many trades it is called "churning" and they get in trouble -- but it is a hard conflict to eliminate. (Except by getting rid of commissions, I guess, but the SEC says that it in its rulemaking it "sought to preserve the ability of investors to pay for advice in the form of brokerage commission.") 

There are also more investing-specific conflicts. For instance there is a tendency for expensive actively managed mutual funds to pay brokers who sell those funds to customers, while inexpensive passive funds tend to pay less or refuse to pay at all. And large brokerage firms often offer customers both their own products (mutual funds, structured notes, loans, whatever) and outside products (other mutual funds, stocks, whatever). The inside products are more profitable for the firm -- they get paid the commission and the management fees on the product -- so the firm often encourages its brokers to sell the inside products rather than the outside ones, in the form of higher commissions or bonuses or sales contests. Obviously if a broker gets paid more to recommend Product X than Product Y, then that creates an incentive to push Product X.

There are three common ways to deal with that conflict, or any conflict really:

  1. Ban it.
  2. Disclose it.
  3. Tell the person with the conflict to work it out in the customer's best interests.

Approach 1 -- banning the conflict -- is common in many walks of life; judges are not allowed to take bribes from litigants even if they're confident that the bribes won't influence their decisions. Approach 2 -- disclosing the conflict -- is super-common in the financial industry, but has developed a bit of a bad reputation, because regular humans do not seem to be equipped to comprehend and address the conflicts that their brokers disclose at them. "I'm getting a huge kickback to sell you this fund," the broker says, in a multi-page disclosure statement, which the investor throws away because he'd rather pay the kickback than read the disclosure statement.

Approach 3 -- trusting the person with the conflict to act in the client's best interests -- is hard. It requires a lot of trust; if the person with the conflict is an expert, it is hard for outsiders to monitor her management of the conflict. In places where we take this approach (law, medicine, etc.), the people with the conflict tend to go through a long and rigorous process of socialization that is meant to select for and develop the type of person who actually will act in the client's best interests. If you just announce this approach one day -- if you say "hey from now on we will expect used-car dealers to look out for their customers' best interests" -- then people might not find it wholly credible. 

Reg BI is an odd hybrid. It doesn't ban financial conflicts for brokers, exactly, but it does demand that the brokers "mitigate, or eliminate" them; pages 181-183 of the adopting release contain an odd "non-exhaustive list of potential practices" to mitigate them, with things like "minimizing compensation incentives for employees to favor one type of product over another, proprietary or preferred provider products, or comparable products sold on a principal basis – for example, establishing differential compensation criteria based on neutral factors (e.g., the time and complexity of the work involved)." It requires disclosure of financial conflicts, but after long experience it doesn't really rely on it, and the adopting release repeatedly says things like "we do not believe a broker-dealer could meet its Care Obligation through disclosure alone." And it does kind of leave a lot to the broker's judgment. From the release:

When a broker-dealer recommends a more remunerative security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that—putting aside the broker-dealer’s financial incentives—the recommendation was in the best interest of the retail customer based on the factors noted above, in light of the retail customer’s investment profile. Nevertheless, this does not mean that a broker-dealer could not recommend the more remunerative of two reasonably available alternatives, if the broker-dealer determines the products are otherwise both in the best interest of—and there is no material difference between them from the perspective of—the retail customer, in light of the retail customer’s investment profile. 

If the broker, in her reasonable judgment as an expert, believes that her client should do the thing that pays her more, then she can recommend it.

It's hard to know exactly where this will end up. One possibility is that it won't do much: Brokers will be able to demonstrate a reasonable basis for just about anything, and so they'll be able to get away with most of the conflicts they have now. Another possibility is that it will overcorrect: Brokers will think it's too risky to recommend anything but cheap passive index funds, and so the range of investment advice will contract. From the adopting release:

We are sensitive to the potential that, in order to meet their obligations under the proposed Regulation Best Interest, broker-dealers may, for compliance and business reasons, determine to avoid offering certain products or limit recommendations to only certain low-cost and low-risk products that would appear on their face to satisfy the proposed best interest obligation. We emphasize that is not the intent of this proposal ... 

A third possibility is that it will ... work? That mitigating a few egregious conflicts of interest, and telling brokers that their job is now to act in their clients' best interests, will just encourage brokers to do that, that brokers will take their new responsibility seriously, and that the culture of retail brokerage will shift from being a sales culture to being a helping culture. It seems like a lot to ask from a two-page regulation. But it does seem to be what the SEC is asking.

VIX manipulation?

There's a classic form of market manipulation where you own a derivative on, say, gold, and it pays out 1,000 times the price of gold at a particular time, and you go into the market and buy 100 ounces of gold at that particular time to push the price up, and if you overpay for the gold by $5 and it pushes the price up by $5, then you lose $500 on your gold and make $5,000 on your derivative, and so it is worth it, but it is generally considered to be cheating, when you put it like this.

On the other hand there are other things that are not cheating that look a lot like this. If your derivative is expiring at the particular time, and you want to continue to have exposure to gold after the derivative expires, you might decide to buy gold right at the expiration time in order to maintain your exposure, which might push up the price of the derivative at settlement. If your derivative is an option, then your model might require you to dynamically hedge it, which might require you to buy a lot of gold right near the expiration time. Or, you know, right around the expiration time, you might get a random hankering to buy gold. No one could prove you didn't, right?

The CBOE Volatility Index -- the VIX -- is a thing on which there are derivatives (notably, VIX futures), except that instead of being a particular thing it is a mathematical combination of options on the S&P 500 Index. This makes the discussion above more complicated and less transparent: Depending on the circumstances, buying a lot of one S&P 500 option right at the time that VIX futures expire could easily move up the price of the futures enough to make your losses on the option worth it. And you occasionally see claims that that happens; we have talked about them before.

The VIX, which derives its price from S&P 500 options, was sailing along without incident until about 9 a.m. in New York, when it spiked as much as 11 percent in about an hour’s time. The jump coincided with a Cboe auction in which a monthly settlement value is set for the gauge, one that is critical to owners of some of the most popular futures in the country. ...

Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors, saw evidence the VIX was pushed higher intentionally. Among other things, roughly $2.1 million was spent in the runup to the settlement on “extremely irrelevant” options that were tied to a 50 percent drop in the S&P 500.

If you paid $2.1 million for those options and they turn out to be worthless, but you owned $20 million or so worth of VIX futures that expired yesterday, then that could have been a good manipulation trade. "These far downside options have a disproportionately large effect on the VIX settlement," points out Chintawongvanich in a client note.

Or it could have been something else, whatever:

“You can always find people that argue that this is just a normal thing to happen -- market makers need to unload their inventory, and they happened to have too many far downside options this time around,” Chintawongvanich said. “These are all legitimate explanations. We’ll probably never know who did it.”

Well! I am not sure I quite share that fatalism. It is correct in a narrow sense, which is that it is quite difficult for you or me or Chintawongvanich to infer manipulative intent from trading activity. The buyer of those options could have been a long futures speculator trying (successfully) to push up the price of his futures, or a futures trader trying to roll her exposure into the underlying, or a doomsayer genuinely betting on a massive near-term drop in stock prices, or someone who meant to spend $21,000 on S&P 500 puts and pushed the wrong button, or someone pursuing a fiendishly complicated multi-leg strategy in a dozen different markets that happened to have touched mysteriously on the S&P 500 options market at a critical time yesterday. 

But it does look weird, and someone could find out more about it. CBOE, the exchange where the VIX futures are traded, or the Commodity Futures Trading Commission, which regulates it, could find out who bought those options and send them a polite note asking what was up. They could perhaps examine some emails and chats, maybe do a keyword search for words like "manipulate" or "bang" or "gun" or "hahaha they'll never catch me" or misspellings thereof. Manipulation is fundamentally an issue of intent, and the way you prove intent is by (1) noticing unusual trading and then (2) finding the dumb chat where a trader says "I intend to manipulate, hope it works!" 

Crypto blockchain etc.

Ten years ago, Warren Buffett made a bet that the S&P 500 Index would outperform a group of hedge funds, and it felt like we'd never hear the end of it. Buffett won his bet at the end of last year, which was a relief, but another hedge-fund manager made a grab for publicity by offering to do the same bet all over again for another 10 years. No thank you, said Buffett, mercifully for all of us. But now there's this guy!

In 2015, Chinese entrepreneur Sam Ling and his partner spent $2.35 million bidding on a private lunch with Warren Buffett, hoping to get some investment advice from the legendary investor. ...

"Cryptocurrencies like bitcoin are too volatile, and that's why we are launching cryptocurrency indexes," Ling told CNBC. "Over the past six months, our index has a lower decline than bitcoin during corrections, but has outperformed bitcoin by 50 to 80 percent during upsurges."


"Warren Buffett just won a 10-year bet that an index fund would outperform a collection of hedge funds over that time," said Ling. "And I want to make a bet with him that my cryptocurrency index will outperform his portfolio over the same period."

Imagine hearing about this one for 10 years. The nice thing about the hedge-fund bet is that it was on a non-transparent selection of five funds-of-funds, so you only really found out who was winning about once a year, and once Buffett got up a head of steam there was not a lot of suspense left. (His counterparty, Ted Seides, ended up conceding here at Bloomberg View eight months early.) But with an index of cryptocurrencies you can check who's winning every day -- every minute, if you want -- and, worse, they'll probably be so volatile that, at least early on, the lead will change hands frequently. "Warren Buffett is winning -- wait, losing -- no, winning -- losing now -- winning again -- his bet against cryptocurrencies," the headlines will read, if he takes the bet, which please, I beg of him: no.

Elsewhere, here are some horrible sentences from a U.S. Commodity Futures Trading Commission enforcement action:

In or around October 2017, as part of an exit strategy, the Defendants began to migrate their fraudulent business model away from binary options into a new fraudulent scheme in an effort to conceal the Blue Bit fraud. Kantor contacted at least two Blue Bit customers who had large account balances and told them that he was getting out of the binary options business. Kantor told these customers that he had selected them because they were among his top 21 Blue Bit customers and that he, therefore, recommended that they authorize him to transfer at least part of their Blue Bit account balances to another company with which he had recently become affiliated.

Kantor said that the new company was called Bitsblockchain and that it offered customers the chance to purchase its new virtual currency called ATMC.

I tell you what: If you ever get a call from your binary-options broker telling you that he is getting out of the binary-options business and into the virtual-currency business, what I want you to do is go to the bank, withdraw all of your money, put it in a box, and mail the box to me. The downside is that you won't have your money anymore, but the upside is that I will have your money, and let's face it, if you're buying binary options from someone who also wants to sell you virtual currency, you're not going to have your money for very long anyway.

Investors in cryptocurrency startup Savedroid are wondering whether the founder ran off with their money, the site has been hacked, or if it’s all part of an elaborate joke.

A South Park meme with big, block letters saying "And It’s Gone," was the only thing on the company’s website on Wednesday.

Oh it's an elaborate joke all right.

Things happen.

People are worried about inverted yield curves. Selling to America: the radical makeover of Goldman Sachs. Sanctions Fallout Upends Metals as Aluminum, Nickel Burst Higher. Matt Zames Named President of Cerberus Capital Management. Katie Martin does not really run Vomiting Camel Asset Management. SoftBank Fixes Four Years of Tax Filings After Failing to Report Some Earnings. Rob Gronkowski Acquires Stake in Gronkowski (the Horse). Morgan Stanley's Morgan Stanley business cards are for sale on Craigslist.

If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Thanks! 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.

To contact the author of this story: Matt Levine at

For more columns from Bloomberg View, visit

©2018 Bloomberg L.P.