Sunday, October 5, 2014

Gresham's Dynamic: Why Bad Actors Dominate Financial Services

Economist George Akerlof wrote about “Gresham’s dynamic” in his famous 1970 article, "The Market for Lemons: Quality Uncertainty and the Market Mechanism." This paper by discussed information asymmetry, which occurs when the seller knows more about a product than the buyer. (A lemon is a slang term for a car that is found to be defective only after it has been bought.) Later, Akerlof, Michael Spence, and Joseph Stiglitz jointly received the Nobel Memorial Prize in Economic Sciences in 2001 for their research related to asymmetric information.

In his paper, Akerlof wrote: “Dishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.” Akerlof posited that Gresham’s Law – or Gresham’s Dynamic as he employed it and called it – wasn’t just related to money; it also applied to all businesses. In essence, businesses run with bad ethics tend to drive those who possess good ethics out of the market. Obviously, this is not the result our society desires.

What can counter Greham's Dynamic? Fiduciary duties are critical means of countering the problem of information asymmetry in the financial markets. Given that information symmetry is so vast, no amount of disclosure can empower consumers to make good choices.

In fact, academic research has revealed that not only do consumers possess behavioral biases which prevent the effectiveness of disclosures, but also that the sell-side of financial services industry is trained to take advantage of these shortcomings. In essence, Wall Street adores consumers, and trains its work force to construct relationships based on trust and confidence with its customers in order to sell expensive and poor investment products. This is why a bona fide fiduciary standard, applying the principles set forth in SEC vs. Capital Gains Research Bureau (the seminal 1963 U.S. Court decision in this area), requires much more than mere disclosure of a conflict of interest. You simply cannot disclose away your core fiduciary obligation of loyalty. Because no client would provide informed consent to be harmed.

There is a solution, however, to the problem of actors with bad ethics dominating the financial services industry. This solution finds its existence throughout the history of capitalism. It is simply this - the existence of fiduciaries enable consumers of financial products and services to hire trusted experts. These experts are "purchaser's representatives" equipped with the knowledge and skill to discern good investment products from bad investment products. They use this skill not in self-dealing activities fostered by bad ethics, but under the good ethics promulgated by the fiduciary standard of conduct.

Hence, the solution to the problem of vast information asymmetry in the financial markets can be found with the application of a principles-based fiduciary standard of conduct. It imposes a restraint on greed which no other form of regulation can accomplish. Perhaps this is why the fiduciary standard is opposed by Wall Street and its proxies so vehemently.

While the solution seems simple, the background against which regulation should be taking place is quite muddy. The U.S. Securities and Exchange Commission (SEC), long ago captured by the very industry it regulates, has steadily weakened the fiduciary duties of investment advisers over time. It now permits core fiduciary obligations to be waived by consumers (despite the anti-waiver requirement found in the express language of the Investment Advisers Act of 1940). The SEC, incapable of seeing the limits of disclosure, permits dual registrants to disclose away conflicts of interest, with no requirement that the transaction continue to be in the best interests of the consumer. [For more on this inappropriate disclaimer of fiduciary duties, see my prior post.]

Under pressure from Wall Street, the SEC has also been most hesitant to apply fiduciary duties to the advisory relationships of brokers who provide personalized investment advice. [For more on this point, visit my post on the undue influence of Wall Street at the SEC.] As of early October 2014, the SEC has delayed decision on this issue again, as yet another economic analysis is now being undertaken by the agency. Let us hope that the economic analysis will focus not on the cost/benefits to Wall Street - we know Wall Street firms will shrink over time if broad, bona fide fiduciary standards are imposed. Let us hope, instead, that the economic analysis will focus on the capital markets and investor protection - the SEC's mandates. As I have written about previously, the fiduciary standard is pro-growth, pro-business, and pro-consumer. In fact, it is essential for the future economic health of our economy, and it is essential to better secure the financial futures of our fellow Americans.

Sadly, I don't have much confidence that the SEC will act anytime soon, or that if it acts that it will reverse its course over the past few decades and apply a bona fide, non-waivable fiduciary standard upon all those financial and investment advisers in relationships of trust and confidence with their clients. The result will be many more Aunt Beas, whose financial futures are ruined by betrayals of trust and poor ethical standards.

There is possible help for some consumers, potentially coming from the courageous Phyllis Borzi at the U.S. Dept. of Labor. In early 2015 we hope that the Administration will permit the DOL to release for comment new rules which we hope will apply a strict fiduciary standard of conduct to advisors of defined contribution plans (i.e., 401ks, etc.) and IRA accounts. However, even this proposal may never see the light of day due to huge Wall Street financial contributions to the campaign coffers of those in Congress, and due to their influence at the White House and U.S. Department of the Treasury.

What can consumers do? Ask the right questions. Unfortunately, to find a financial and/or investment advisor who is truly committed to your best interests, and who eschews conflicts of interests (and their detrimental effects on consumers), involves a "deep dive" into the advisor's business practices. Consumers - the SEC won't protect you. So, consumers, ask the right questions to find one of those few thousand investment advisers who, despite Gresham's Dynamic, have not been driven from the marketplace.

Ron A. Rhoades, J.D., CFP(r) serves as Chair of the Steering Group of The Committee for the Fiduciary Standard, whose "Fiduciary Oath" should be required of all those who provide personal financial advice. See 

For a longer checklist consumers can use - to ask the tough questions, visit this article on this blog: 

Ron is Asst. Prof. of Business at Alfred State College, where he serves as Program Chair for its Financial Planning Program. Ron may be contacted at 


  1. Thanks Ron. As usual, another timely and informative article. Just wish the mainstream media would pick this article up in order to counter the financial service's ongoing campaign of misinformation.

  2. what a sad state of affairs. Asking the right questions does not always sort out the good from the bad. What protection do consumers have other than self-defense? Answer: None.

  3. Mr. Rhoades, I have read what you have written here several times. I wish that members of the 53 million investing households would receive this in their email inbox or in their snail mail mailbox as an Urgent Alert--Your lifelong, hard-earned savings may be at risk due to bad actors in the finance services (disservices) industry. Your words explain what so many of us have experienced firsthand but have been unable to put into words. Thank you for all the work that you do and for being a steadfast advocate for The People.

  4. Most important thing is in financial services is certified financial planner school.

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  6. a really great insight about gresham dynamic you have here
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