Why did the Financial Conduct Authority of the United Kingdom ban commission-based fee systems among investment advisories, and what does it tell us about the century-old commission systems of the shipping markets? Okan Duru, author of Shipping Business Unwrapped, calls for an overhaul in how people are paid in this industry to ensure investors are getting a real picture of the markets.
The Financial Conduct Authority (FCA) (the Financial Services Authority before 2012) is the regulatory board in the United Kingdom dealing with the integrity of the financial markets. FCA is responsible for monitoring the financial system and detecting fraudulent actions as well as systemic problems. One of the key regulations of FCA in the last decade is on the commission ban. Let me run the tape back to understand what the commission ban is.
Soon after the 2008-2009 financial crisis, financial regulatory bodies around the world investigated their financial systems to find any systemic problems or incentives leading markets to vulnerable states. FCA concluded that the commission-based advisory services for investment decisions played a significant role in inflating the asset bubble and causing a false incentive for investing more and more along with increasing stock prices. A significant amount of investment advisors are still paid according to the amount of transactions and the size of portfolio. When the portfolio expands under management, an advisor makes more money. When the market is poor and the economy is not doing well, then it is quite difficult to persuade customers to invest in riskier financial products and expand their investment portfolio. However, when a market develops and especially breaks historical records, then customers turn to be easier to attract for more investments and shift to riskier alternatives. The best thing about this phenomenon is the growth of commission. So, advisors have a strong incentive to push customers to expand their portfolio, reinvest in riskier products and make more money.
There is actually one more hidden fact here. I mentioned this fact in my recent book titled Shipping Business Unwrapped and also publicly promoting the idea in various platforms to develop awareness on predictive products in the market. I call it the Naïve Forecaster Trick. Financial markets usually expose upturns and downturns which are figured with trending prices. When markets reach higher price bands, then the periods of trending prices expand and get longer. As an advisor, you can be a very successful predictor, even called a prophet of the markets at certain stages by just reiterating past trends. If it was growing 10% yesterday, you just predict a 10% increase for tomorrow. You do not need any special education or quantitative skills to do that. Now think about those longer periods of trending prices. You would achieve a fantastic predictive accuracy without doing anything. Your naïve forecasts would actually do great, and customers would love it! That is what happening in almost all monetary markets when a smooth and longer trend is captured.
So, FCA basically noticed the fact that the commission-based system misleads the market (i.e. commission bias). When a market develops rapidly, all numerical indicators beautifully support the growth argument. Advisors monetise the trend with the naïve forecaster trick and dazzling indicators. In 2012, FCA banned commission based fee schedules in advisory services in the investment management for this very legitimate reason. What FCA doesn’t know is that the maritime industry is one of the most commission intensive industries in the world. Financial intermediaries, sale and purchase brokers, shipbrokers, newbuilding brokers and many other commercial players in this market work on the commission-based system.
Let me disclose a natural fact of this industry: Ship investors are so lonely. The incentive system of the entire industry is led by commissions, and commission is indexed to freight rates. At the recovery stage of shipping markets, this incentive scheme seems less harmful, even helpful. However, the commission system becomes a deceptive and very harmful instrument when markets mature. The reason is very simple. If you consider the equation of ‘asset play’ (i.e. counter-cyclical investment) in the shipping business, it is the worst time to place orders or purchase ships when the market hits historical records. It is such a straightforward thing. However, commercial intermediaries will be motivating for further investment.
There is definitely more than just the commission bias, such as the ship mortgage crisis. When the market develops massively, and freight market hits records, almost all numerical evidences of a loan facility assessment can easily be ensured and satisfied. That means a cash flow analysis based on long-term averages (how long?) will bring terrific results. Now ship investors have another significant reason to invest in ships at the worst time. The banking industry will support your fallacious decision forever.
I recall a recent tweet by Sam Chambers regarding impairment losses in shipping assets:
One ship sale today highlights the mad volatility of shipping valuations. The Nerissa cost its Indian owners $170m 10 years back in a very ill timed bet. Thanks to @VesselsValue for the graph! https://t.co/dwAQNVPqS6 pic.twitter.com/zcY3HLE9pA
— Sam Chambers (@SamChambers) December 10, 2018
A capesize bulk carrier was sold for $140m in June 2008. The same ship was valued at just $40m in December 2008. Ironically, this ship investor lost $100m in six months without doing anything but trusting naïve predictions generated by doing nothing.
The commission system of the shipping business has a much bigger impact on the volatility and sustainability of the industry than an average person perceives. This up-down nature of the market is a by-product of various misleading drivers, and the commission system is at the top of the list. Large banking corporations managing multi-million dollars have been forced to quit the commission system in the UK financial markets to establish sustainability and integrity. The shipping business is not immune to any of these suspicious and delusive aspects of the markets. A New York Times journalist, Ian Urbina, has led a groundbreaking series of articles on the outlaw of oceans. The international shipping markets are like oceans; less known, hidden and unmonitored.