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Saturday 6 March 2010

Finance: Where The Law Of One Price Doesn't Apply

Differentiating Financial Products

Even the smartest amongst us can be fooled by the pricing structures of relatively simple financial products. In any normal industry we would expect the law of one price would be prominent – in efficient markets all identical goods must have only one price.

Now whether or not the market for financial services is efficient or not is a moot point but the industry’s ability to create a vast swathe of differentiated products could almost have been designed to prevent the law of one price from operating. With the documentation for even simple financial products running into several pages of hieroglyphics in a convoluted and slightly sinister attempt to promote “clarity” the chances of anyone actually recognising that any two products are identical is minimal. In such a situation efficiency is a pipe dream.

Avoiding Competition

Competition is, of course, at the heart of capitalist economic systems – the idea being that it’ll keep prices in check to the benefit of consumers and, ultimately, to the whole financial system. This process happens even as individuals and corporations seek to maximise their profits and should have the outcome of stimulating innovation because new products and services will command excess profits until the competition catches up.

However, corporations will go to considerable lengths to maintain their profit levels while not having to increase their costs by investing in new products. Those rare companies for whom this is a natural situation, because they have some in-built but non-monopolistic advantage, usually trade at a premium. These are the classic “moated” businesses that come with built in defences against competitive forces.

Creating Your Own Moat

For the most part, however, companies need to create their own artificial moats. At one end of the spectrum are illegal monopolist behaviours where companies collude with their competitors to artificially keep prices high. At the other end is a more difficult to discern, but equally troublesome problem – an industry that provides a vast array of slightly different, highly complex and difficult to compare products. Now, does that sound familiar?

As we’ve repeatedly seen, financial services seem to be a special case amongst consumables. Part of the problem is that humans are attracted to today’s successes, which is unfortunate in the mean reverting world of finance because they’re likely to be tomorrow’s flops. It’s no coincidence that a lot of marketing effort and manipulative spin goes into focussing on the performance record of the best products – see Survivorship Bias in Magical Mutual Funds for an example.

Hidden Fees

However, the whole industry can’t survive on promoting the top performers when, underlying all of the flim-flam around wondrous new offerings you actually only have a few tired old products that have mostly been around for eons. At this point you need to get really creative in order to avoid having your profit margins decimated by the law of one price.

Partly this is done by hidden fees – some people are pretty good at focussing on the actual fees charged, but often miss loadings on sell prices, for instance. There are other sorts of hidden charges, as well. For example, George Serafeim looked at the effects of the SEC introducing new regulations in 2004 banning funds from using directed brokerage. He speculated that brokers who recommended clients to specific funds, thus boosting funds under management and fees, would have trades directed to them by the funds, thus earning the brokerages extra commissions.

Overall, his research concluded that the new SEC regulations had reduced this problem and, not uncoincidentally, had improved the returns of the funds by giving them less reason to overtrade. Of course, funds producing better performance doesn't matter to the fund managers if their fees are reducing and, so, Serafeim also showed that funds seemed to be finding new ways of replacing their lost revenues at customer expense.

Complexity Through Differentiation

The most likely source of creativity in financial services, though, is around the plethora of complex products promoted by the industry. If these products were genuinely different then this wouldn’t represent a market failure, merely a very complex market. Unfortunately the research suggests that the complexity is artificial and that the underlying products are homogenous – that is, they’re much of a muchness. The effect of this artificial complexity is to raise the barriers to understanding sufficiently to prevent consumers from being able to make an informed decision and the result is a failure of competition on a grand scale.

Bruce Ian Carlin in Strategic Price Complexity in Retail Financial Markets has looked at this issue and argues that “Producers of retail financial products create ignorance by making their prices more complex, thereby gaining market power and the ability to preserve industry profits”. In particular he suggests that “Industry confusion is the way high-price firms gain market share”.

This actually leads to what seems at first sight a completely contradictory hypothesis: that as more companies enter the market the price of products will rise. In normal markets, of course, new entrants will cause prices to fall – we’ve seen this in the last two decades in telecoms markets, for instance. However, in a market which is dominated by complexity Carlin argues that the addition of new entrants will increase the overall complexity – even if they’re actually offering simpler products – and this will increase the barrier to understanding for consumers and, hence, increase costs.

Sidestepping Disintermediation

One argument against this model is the intervention of intermediaries whose business model is to reduce the complexity and make it intelligible to consumers. Advisors, cost comparison websites and the like can all offer these services, for a fee, and given the excess returns in the industry should be able to make a turn for themselves. However, this assumes that the industry is prepared to stand aside and let this happen. Carlin suggests several ways in which this can be prevented:
"...they can raise industry complexity, decrease the benefit to becoming informed, or offer the advice channel incentives to share in industry profits. Rising industry complexity causes the cost of education to rise, making it less profitable for the advice channel to market its information services. Decreasing the expected benefit of information involves making industry prices more concentrated (decreasing price dispersion). Concentration in prices is not equivalent to decreasing prices, however, as it is possible for prices to rise, while still preventing the advice channel from enforcing competition. Signing incentive contracts makes it more profitable for the advice channel to hold back information from consumers and preserve industry profits".
Limit Complexity Or Enforce Separation

If Carlin is right this has some significant implications for the approach of regulators in future. He suggests that either regulating to limit industry complexity in terms of pricing disclosure or enforcing separation between financial services companies and advisors or improving financial education would improve matters. However, as we’ve seen elsewhere, better financial education doesn’t seem to improve financial decision making so that’s unlikely to be a useful starting point.

To end with a caveat on this research: it starts from the assumption that financial products are all the same. Although that’s probably a fair starting point it’s not entirely true to argue that all products are the same (Carlin doesn’t). However, ensuring that product information is simple and that comparison is relevant is essential to making the financial services industry transparent. More pertinent, though, is introducing regulation to enforce separation between product providers and advisors which can be policed. Until this is done the complexity of the finance industry will ensure that the law of one price doesn’t apply in the one place that it ought to above all.

The Wealth of NationsCommon Sense on Mutual Funds: Fully Updated 10th Anniversary EditionThe Economic Naturalist: In Search of Explanations for Everyday Enigmas

Related Articles: Intelligence Can Seriously Damage Your Wealth, Disclosure Won't Stop A Conflicted Advisor, Financial Lessons In Mass Deception


  1. What prevents arbitrageurs from enforcing the Law? In the case of Palm and3Com, short-sale constraints limited the amount of money that could be made and the amount of price pressure arbitrageurs could bring to bear. In some of the examples of closed-end country funds

  2. The documentation for even simple financial products running into several pages of hieroglyphics in a convoluted and slightly sinister attempt to promote “clarity” the chances of anyone actually recognising that any two products are identical is minimal.he benefit to becoming informed, or offer the advice channel incentives to share in industry profits. Rising industry complexity causes the cost of education to rise, making it less profitable for the advice channel to market its information services.

  3. You could replace "financial services" with "mattresses", "airline tickets", "cell phone service", or any number of other products.

    Also another way prices can stay high is by the providers to simply block the intermediaries. If one provider blocks one or more intermediaries, it's possible they will simply lose by loss of exposure to potential customers. However if many do it, the intermediary cannot function. This has happened for instance with airline tickets.

  4. One of the challenges in todays world of finance is to make comparisons to the past. With deficits in excess of 15T and an explosion liquidity like no other time in history - the challenge will be to strive to understand the world that we've created.