Price Spawns Conflict of Interest?

A May 6, 2012 New York Times article, Study Says Broker Rebates Cost Investors Billions, by Nathaniel Popper indicates that the stock exchanges are offering rebates to brokers to effect their clients trades on that exchange creating a conflict of interest.

These kinds of conflicts aren’t new, nor are they limited to the financial services industry. The question we should be asking is “Why do companies get lured into these kinds of activities?”

Greed
Greed is always a possible explanation and it certainly does exist in every industry. I’ve been around a long time and worked with literally thousands of people in virtually every industry imaginable yet have found that few people are motivated by greed. That’s why I tend to discount greed as a possible explanation. So what’s the alternative?

Price Pressure
My experience is that business people are more likely to engage in activities that could be construed as a conflict of interest when they are feeling pressure from their customers to reduce prices.

When businesses find it increasingly difficult to make money and are getting pressure from their customers to reduce prices, they feel trapped. They need additional revenue, but don’t know how to generate it from their existing customers.

Is this the case for brokerage firms? I can’t answer that question with certainty, but I do know that there has been incredible pressure to drive down the costs of both transacting trades and managing mutual funds. This kind of pricing pressure will ultimately drive these service providers to pursue other forms of revenue which opens the door for conflicts of interest.

Solution
To minimize conflicts of interest, there’s a two-pronged approach we can apply. First, as buyers we can remind ourselves that while low prices are attractive, they do carry a cost as well. The more we pressure sellers to accept lower prices, the more likely we are to be dissatisfied with the service we’re getting. So let’s do a better job of evaluating the price/service mix we’re buying.

Second, as sellers, we have to do a better job of reminding buyers that to get the lower prices they need to give some aspect of quality or service. In essence, we need to force them to make a conscious choice between the value they receive and the price they’re willing to pay.

If that sounds too simple I’d like to remind you of Albert Einstein’s caveat “Any intelligent fool can make things bigger, more complex, and more violent. It takes a touch of genius — and a lot of courage — to move in the opposite direction.”

Show your genius, make these two simple techniques an everyday habit.

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