Product × Finance × AI: Financial Products in the Age of AIPart One From 0 to 1中文
Chapter 11

Trustees may not do their dutyCustody, disclosure, suitability and regulation

After delegation, the fleet manager holds the whole village's ship shares and knows the details of every ship better than any household. He can quietly sell some of them and keep the grain for himself, or sell the riskiest ship shares to the elderly people least able to bear a loss. When principals cannot tell who is reliable, they will pay only for the average, and reliable managers, finding it not worth their while, leave the trade. Four arrangements grow up in response: assets are kept by someone unconnected with the manager, who can only give instructions; the manager must regularly disclose where the ship shares have gone and what risks they carry; whoever sells ship shares must first find out what the buyer can bear; and someone accepted by all parties checks and punishes. All these arrangements have costs, and the people doing the regulating also need to be constrained.

1. The manager holds everyone's ship shares

The fleet manager manages ship shares for forty households. All the share certificates are in his hands, and each year he reports to every household how much more the fleet has earned. But the households cannot see the certificates and do not know whether the shares are still there. If he quietly sells some, keeps the grain for himself and pays old principals their returns out of new principals' grain, the books can be kept up for many years, until one day the incoming grain is not enough to pay out.

There is one new constraint: trustees and sellers know more than principals, and their interests do not fully coincide with the principals'.

Today's counterpart. Frauds that pay old investors' returns out of new investors' money have occurred in many countries, and are often discovered only when the flow of money breaks down.

Reported figures and real assets

The manager reports a return of 8% every year, though the fleet actually earns only 6%, and he quietly keeps a portion for himself. Drag the share he takes each year to see how the reported figures and the real assets diverge, and how long new money from principals can keep it going.

Assets the manager reportsReal assetsGap

Illustrative: 100 portions are entrusted at the start, and 3 portions of new money flow in each year after that; principals withdraw 6% a year based on the reported figures. When the real assets are not enough to pay withdrawals, the fraud collapses.

2. A market where good cannot be told from bad

If principals cannot tell which managers are reliable, they can only pay at the average level. Reliable managers receive the same as unreliable ones, find it not worth it and leave; among those who remain, a larger share is unreliable, principals are willing to pay even less, and another group of reliable managers leaves. This process repeats round after round, and in the worst case all the reliable managers leave and delegation itself cannot be sustained.

The fleet is even harder to judge than a used car. Someone who buys a car will eventually find out whether it is good after driving it for a while. A principal, even after a year, who sees that the fleet lost money cannot tell whether it met a storm or the manager failed in his duty; seeing that the fleet made money, he does not know whether another manager would have made more. Moreover, the person who judges what needs to be done is often the person who does it: if the manager says a ship needs a major overhaul, the principals can only pay. With no way for principals to compare, competition among managers can hardly eliminate this kind of fraud.

Today's counterpart. When investors lose trust in a whole industry, reliable firms suffer along with the rest, and money leaves the market.

When good cannot be told from bad, the good leave

A reliable manager creates 10 portions of value a year for principals; an unreliable one only 4. Principals cannot tell them apart and will pay only the average; reliable managers change trade if they earn less than 8 portions. Drag the initial share of unreliable managers to see who is left after a few rounds.

Illustrative: principals pay the average value of the managers who remain; in each round, if the pay is below 8 portions, half the reliable managers leave (a simplification of Akerlof, 1970).

3. Custody: assets out of the manager's hands

The most direct remedy is to give the share certificates to someone unconnected with the manager for safekeeping. The manager can decide which ship to buy and which to sell, but can only give instructions to the custodian and cannot take the shares away himself; the custodian acts on the instructions and reports directly to each principal how much is held in their name. Then even if the manager wants to misappropriate, there is nothing he can take, and the figures principals see no longer come only from the manager's mouth.

Today's counterpart. Fund assets are held by independent custodian banks. The custody rule amended by the US Securities and Exchange Commission in 2009 requires that client assets managed by investment advisers generally be held with a qualified custodian, that the custodian send account statements directly to clients, and that an independent accountant conduct a surprise examination each year.

Custody: assets out of the manager's hands

Switch between having an independent custodian or not, and see which of the manager's crooked paths are blocked.

Illustrative. Independent custody cannot guarantee that the manager judges correctly; it can only guarantee that the assets are still there and the figures are true.

4. Disclosure: making the invisible visible

Custody ensures the assets are still there, but cannot tell principals whether the manager is doing well or how much risk he is taking. Another remedy is to require the manager to disclose regularly which ships he has bought, how risky each one is and how much he has charged in fees. As long as principals can tell good from bad, reliable managers win more mandates, unreliable ones have nowhere to hide, and the collapse of the lemons market can be avoided. For disclosure to be truthful, an independent party is often also needed to check the accounts.

Greenstone, Oyer and Vissing-Jørgensen (2006) studied the 1964 US legislation that extended mandatory disclosure to over-the-counter companies. They found that the most affected companies earned excess returns of 11.5% to 22.1% relative to matched companies between the bill's proposal and its taking effect, showing that investors valued the additional information.

Today's counterpart. Funds must regularly publish their holdings, performance and fees; listed companies must publish audited financial reports.

Disclosure keeps the good ones

Again twenty managers, 35% of them unreliable at the start. Once managers must disclose their holdings, risks and fees, principals can tell good from bad with some confidence and pay only for the value they can see. Drag how well disclosure lets principals tell them apart to see how many reliable managers remain after six rounds.

Illustrative: when they can tell, principals pay reliable managers 10 portions and unreliable ones 4; when they cannot, they pay the average; a reliable manager's actual pay is the two weighted by how well principals can tell, and when it falls below 8 portions, half of them leave. The rules are the same as in the previous figure, with disclosure added.

5. Sellers know more: suitability

Another conflict arises on the selling side. The manager earns different commissions on different ship shares; the riskiest shares often carry the highest commissions, and the elderly, who most need safety, are least able to understand the risks involved. If sellers look only at commissions, they will sell unsuitable things to the people they suit least.

Mullainathan, Noeth and Schoar (2012) sent trained auditors posing as clients to consult financial advisers. They found that advisers often failed to correct clients' biases and instead reinforced those biases that worked in the advisers' favour, and tended to recommend actively managed funds with higher fees. Hence the requirement of suitability: sellers must first understand what buyers can bear and what they need, and recommend only products that match.

Today's counterpart. Risk-tolerance assessments before opening an account or buying a product, and rules that match products to clients by risk level.

Suitability: sell to those who can bear it

Ten households can each bear a different level of loss, and three kinds of ship shares differ in risk and commission. Switch the basis on which the seller recommends to see how many households end up with ship shares beyond what they can bear.

Safe ship shares: 1% commissionMedium risk: 2% commissionHigh risk: 4% commission

Illustrative: each household's capacity to bear loss is low, medium or high; buying ship shares riskier than that capacity counts as unsuitable.

6. Who watches the watchers

Custody, disclosure and suitability all need someone to check and enforce them: who confirms that the custodian really keeps the assets, who checks the disclosed accounts, who punishes those who break the rules. That role is the regulator. The stricter the regulation, the less fraud, but every household and every manager pays a cost for it: filling in reports, undergoing inspections, waiting for approvals. When the cost is too high, small managers cannot bear it, and the industry is left with only a few large players.

Who makes the rules also shapes what the rules say. Each of the forty principal households is affected only a little by the rules, so few are willing to spend time pressing for better ones; the few large managers, by contrast, have a great deal at stake and find it easy to band together, so they actively try to influence the rule-makers. The rules may thus drift in favour of the existing managers: requiring newcomers to obtain licences first and limiting competition on fees both keep newcomers out and protect the incumbents.

The strength of the rules therefore has a suitable range: it must keep losses from fraud small enough, without letting compliance costs swallow the benefits that delegation brings.

Today's counterpart. Securities regulators set rules for custody, disclosure and sales conduct and carry out inspections; regulators themselves are accountable to the legislature and subject to public scrutiny.

How strict the rules: fraud losses and compliance costs

Drag how strict the rules are to see the losses caused by fraud, the costs all parties pay to comply, and the sum of the two.

Losses from fraudCost of complianceSum of the two

Illustrative: fraud losses fall as the rules get stricter, while compliance costs rise; where the sum of the two is smallest lies the suitable range for the strength of the rules. Overly strict rules also push small managers out of the industry, which the figure does not count.

7. A village that sets rules: Civilization Simulator, version 11

The simulator unlocks the rule "Regulation & custody". The village has twenty managers, some of them unreliable: without custody they misappropriate assets, and without a suitability requirement they sell risky ship shares to people who cannot bear the loss. You can switch custody, disclosure and suitability on or off separately and adjust the share of unreliable managers, and see principals' losses over twenty years and how many households are willing to delegate.

Civilization Simulator · Chapter 11: a village that sets rules

Some of the twenty managers are unreliable. Switch custody, disclosure and suitability on or off separately to see principals' losses over twenty years and how many households are willing to delegate.

SharesMarketInformation in pricesDelegationRegulation & custodyDefaults · Ch. 12
Households willing to delegateYears with a fraud collapse or risk event

Illustrative model: forty households, 80% of them willing to delegate at the start; households that do not delegate store their grain themselves and earn nothing. The fleet's average return is 6% a year. Without custody, unreliable managers take 8% a year and cover it with false reports; once the cumulative theft exceeds 30%, the fraud collapses. With disclosure, principals have an even chance each year of seeing through them and switching managers. 30% of households cannot bear a large loss; without a suitability requirement, unreliable managers sell them high-risk ship shares, which suffer a 30% loss about once every seven years. With each loss, fewer households are willing to delegate, and the number recovers slowly in quiet years.

8. What this step leaves open

Rules constrain trustees and sellers, but several questions remain unresolved:

  1. People make their own mistakes. Even when products are reliable and information is public, principals still chase rising prices, sell into falls and redeem too often, earning less than the products themselves.
  2. Rules can govern only what can be seen. What is disclosed are past figures; the rules cannot fully see the manager's judgement and motives at this moment.
  3. New trustees. If the one acting on others' behalf is no longer a person but an agent that can place orders directly, who holds custody over its actions, who checks them, and who is responsible when it makes a mistake?
  4. Whether the regulator itself can be trusted. Enforcing the rules depends on someone all parties trust, and that trust likewise needs constraints and accountability.

What this step leaves open

Four questions still unresolved once rules exist. Select a question to see the assumption it rests on.

A village that sets rulesCustody, disclosure and suitability

9. Implications for products

Custody, information disclosure and suitability management are all now written into financial products themselves. Three implications follow. First, trustworthiness comes from institutions, not just from promises: who holds the assets and who can move them should be clear to users at a glance. Second, the value of disclosure lies in letting users tell good from bad; spelling out risks, fees and conflicts of interest is how a reliable product gets recognized in a market for credence goods. Third, whether a product suits the user matters as much as whether the product itself is excellent; suitability should be designed as a product feature, not treated as a formality before the sale.

Chapter summary: regulation and custody

Four conclusions, each corresponding to one mechanism in this chapter.

LemonsWhen good cannot be told from bad, the good leave

Principals will pay only the average, reliable managers leave, and those who remain get worse and worse.

CustodyAssets out of the manager's hands

The manager can only give instructions, and the custodian reports directly to principals: theft and false reporting have nowhere to hide.

Disclosure and suitabilityVisible, and sold to the right people

Disclosure lets the good be recognized; suitability makes sellers act in buyers' interests and recommend only matching products.

The price of rulesRegulation needs limits and constraints too

Compliance has costs, and overly strict rules push out small managers; regulators themselves also need to be held accountable.

References