his year I wrote a column that argued it was time to start a debate about the definition of “sophisticated” investor. That was sparked by a saga bubbling in Italy, where investment banks have flogged numerous derivatives trades to local governments, and other entities (including convents) – and some of the deals are now turning sour, sparking law suits.
Now, however, this issue of investor “sophistication” is become doubly fraught, for reasons that have nothing to do with Italian nuns. Earlier this week, two Democratic senators filed an amendment to the US financial reform bill, that seeks to impose a fiduciary duty on all registered broker-dealers, when they deal with investors.
That would mean that a Wall Street broker would have to protect clients at all times, instead of the bank, even when acting as a counterparty. Or, as Arlen Specter, Democratic senator co-sponsoring the bill, said. “This is a commonsense amendment that seeks to close a gaping loophole in federal law where brokers and dealers can avoid putting their clients’ interest first.”
It is unclear whether that proposal will fly. The banking industry loathes it, and there are several versions of this “fiduciary” idea now floating around. The Specter bill, for example, wants to impose fiduciary duty for all investors. Other proposals “only” demand this in relation to municipalities or pension funds.
Nevertheless, the central theme that underpins this Washington fight – although it is rarely articulated – is that thorny matter of “sophistication”. Until now, the financial world has assumed that investors could be divided neatly into two mental camps: “unsophisticated” retail investors and everyone else. While the first group needed to be protected, the second group did not. If you were “sophisticated”, in other words, you were supposed to live by the principle of buyer beware.
But if US lawmakers now want to expand the fiduciary net, this definition of “sophisticated” players will shrink too. And that could overturn the entire business model of Wall Street, not least because it will mean that banks will no longer be able to suck fat fees from supposedly sophisticated clients.
Is this a good idea? Unsurprisingly, bankers insist not. More specifically, bank lobbyists argue that if the fiduciary net is expanded to cover municipalities and pension funds, this will stop them offering swaps contracts, or force them to impose dramatically higher fees. That would make it much harder for municipalities and pension funds to hedge risk, or so the argument goes.
But while there may be a grain of truth to this argument, in practice the banks are on very weak political ground. The recent Goldman Sachs hearings have shown on prime time television just how cavalier – and unscrupulous – Wall Street traders can be when they deal with clients. More important still, it seems likely that a wave of American municipalities will go bust this year, sometimes due to poorly constructed derivatives deals.
So, for my money, this suggests that the most sensible way forward would be for both bankers and politicians to look for some middle ground – in the most literal sense – by redefining this “sophistication” idea. Some bank clients, such as retail investors, clearly do need full protection. At the other end of the spectrum, however, there are other investors who are probably as sophisticated and savvy as the banks, and thus probably do not require or deserve such protection. The critical issue is the group that lies between those extremes, such as municipalities and pension funds, which are not “retail” (since they are run by professionals), but not as “sophisticated” as the banks. Personally, I think it would be an overreaction to treat that middle group in exactly the same way as retail investors. It would also be a pity if banks stopped offering swaps trades to that middle group. They can be beneficial, if handled sensibly.
Even if municipalities were not given as much protection as retail investors, there is a case to impose milder fiduciary standards. Banks could, for example, be forced to be completely transparent about the costs of products to this middle group. They could also be forced to reveal any conflicts of interest (say if their own proprietary traders were betting against the deal). Local governments could also be forced to engage a “swap transaction adviser”, to act on their behalf as their fiduciary in transactions with swap dealers.
But most important of all, US lawmakers could state emphatically that municipalities and pension funds are not “sophisticated” (nor retail) – but form a third, intermediary category. That three-tiered approach would force banks to amend their internal processes. It might also prompt Europe to follow suit. If so, this would be a thoroughly good thing – not just for American municipalities (or Italian convents) but the battered reputation of the financial industry too.