ValueStream Labs | May 12, 2014
I recently grabbed coffee with a friend who had just finished reading Michael Lewis’s new book, Flash Boys, and wanted to talk all about it. The book had raised a big question for him, but it had nothing to do with High Frequency Traders or latency arbitrage. His question was much simpler and more human: “Why is there so much conflict of interest in Financial Services? I feel like all I ever hear about is scandals from your industry.”
The most obvious answer is that there is a lot of money at stake in FS, and people will aggressively pursue that money whenever given the chance. However, when you consider the unique incentives and motivations of different participants in the capital markets value chain, a deeper insight emerges.
Consider the graphic below:
The exchange is driven by order revenue (which caters to high frequency traders), the broker leverages information asymmetry to drive maximum revenue from his customer, and the asset manager is driven by the AUM he can raise. The poor end investor…whether retail or a large pension fund, he’s the only participant in the chain that is fully dependent on financial returns as a measure of compensation.
When it comes to the number of varying incentives for different parties across the value chain, this graphic is the tip of the iceberg, and with so many different compensation metrics, no one’s interests are fully aligned. Thus, it’s not just greed that drives the scandals on Wall Street—it’s a fundamental misalignment of interests across so many layers of the value chain.
After all, Financial Services is all about trust…and how can you truly trust someone whose incentives and interests are so different from your own? It’s no wonder there is so much conflict of interest in the industry.
When looking for a solution, many turn first to the institutions themselves to change their incentive models, but this would require a monumental, coordinated change among parties who are satisfied with their incentive structure today – not an easy sell. Next, they look to regulators, which have stepped in after each crisis to create new rules to prevent that particular crisis from occurring again. But perhaps the simplest and most effective way a market participant can reduce conflict is to look at the people he does business with.
Right now there are countless startups using technology to better align incentive models. AngelList made headlines when they launched their syndicates program, which pays mini-VCs purely on capital gains without fees. The Compstak platform shares commercial real estate lease terms, increasing transparency in the CRE market. Estimize, a VSL portfolio company, introduced crowdfunded earnings, revenue, and now macroeconomic estimates, removing the sell side conflict of interest from the equation.
Sometimes the most difficult change has to come from outside the system.