Consistent with emerging international evidence, a new Canadian survey finds millennials have a strong interest in ‘investments that are dedicated to solving social or environmental problems.’ If the demonstrated benefits of differentiation were not enough to convince financial institutions to offer social investment products to their customers, this new market research should lead to more interest. On a societal level, retail impact investment products represents the potential to democratize finance by ensuring that, in the words of Robert Shiller, ‘opportunities afforded to Wall-Street investors are available to Wal-mart shoppers.’
But to date, impact investment products are not being supplied to the masses of retail investors. To be sure, Canada is home to a handful of retail impact investment products, including at least five community bonds and a couple of term deposit products. In the US, the Calvert Foundation allows individuals to invest as little as $20 in a range of impact opportunities through an on-line platform. While these examples show that it is possible to develop investment products that meet an investor’s financial return objectives while also creating positive social and environmental impacts for communities, what they do not show is the possibility of scale that is required to achieve the democratization of finance.
There are many reasons why supply falls short of demand. One explanation is that the barriers to entry are too high. Common barriers to entry include economies of scale, natural monopolies and high switching costs for consumers. Retail impact investment products do not share the characteristics of a product market that has high barriers to entry. For example, banks and credit unions can leverage their existing distribution channels and there are no natural monopolies associated with retail impact products.
Another commonly cited barrier to supply is restrictive securities regulations. Securities regulations are intended to protect individual investors from unmanageable risk and fraud. Nova Scotia’s securities regulations are often the source of envy; co-operatives are permitted to raise capital for investing in local businesses through a simplified offering document. In other provinces, an offering memorandum exemption that is required of co-operatives seeking to raise capital for investment in local business or social enterprise can prohibit market entry (~$15,000- $20,000, plus on-going costs).
But regulatory barriers do not explain the lack of deposit retail impact products. Products like term deposits and guaranteed investment certificates are not governed by securities regulations. These products are backed by the balance sheet of the lending institution and are therefore not considered risky for individual investors. Creating new deposit products requires approval from deposit insurance authorities. Some Canadian credit unions have already successfully navigated the approval process. Even among securities products, regulatory barriers do not explain why there has not been a flood of new retail impact investment products in regions where regulations are more favourable.
If regulatory barriers and barriers to entry cannot explain the dearth of retail impact investment products relative to the demand, what does explain the mismatch?
High transaction costs provide a more comprehensive explanation for the lack of supply. Transaction costs refers to the costs of using the price mechanism to coordinate production. These costs include search and information costs, and costs of negotiating price and terms of exchange and monitoring. Factors like frequency of transaction, uncertainty, complexity and asset specificity affect the cost of the transaction. In conventional economic accounts of transaction costs, the market is synonymous with the price mechanism. In other words, the market is waiting to be used, and as products and services for exchange become less complex and less uncertain over time as more information becomes available, firms will move to market to coordinate their production.
But as some scholars point out, the costs of searching, negotiating price and establishing contractual arrangements depend not only on the price mechanism but on a wide range of market institutions. The existence of market institutions is not given. In other words, the market needs to be invented before a large number of firms can participate in it. “A transaction may be highly complex and specific at one point in time, but much less so once market institutions are developed to support it.” 1
The authors demonstrate this co-evolution of market institutions and industry structure, using an example of a mortgage. Initially, a mortgage was a complex and rare financial product that was coordinated internally by the bank. But over time, standard securitization contracts allowed the banks to sell loans to investors, creating vertically disintegrated market structure. But this required a range of market institutions to support this disintegrated market structure, including “standardized contracts to facilitate sales of loans, institutions for transferring foreclosure rights, rating agencies … and functioning markets to allow investors who have bought securities to later sell them.” The authors conclude that transaction costs are dependent on market institutions.2
For retail impact products, we are beginning to witness the evolution of new institutions to facilitate transactions, such as new distribution platforms for impact investment and the emergence of impact measurement standards. Similarly, as contracting standards for investment management services are established, cooperatives and financial institutions will have more options to outsource production of retail impact products and reduce internal costs of coordinating these services. Indeed, several community bonds in Ontario use the investment administration services of the Toronto Renewable Energy Corporation.
But paradoxically, the same institutions that are required to democratize finance also have the potential to undermine the democratization of finance. As mortgages became easier to coordinate in the market and securitization became possible, investors were able to move risks off of their balance sheets through packaging loans and selling them to other investors, creating a complex chain of incentive problems. Indeed, many sophisticated investors and intermediaries profit from complexity.
Peer-to-peer lending platforms are another cautionary tale. Initially viewed by many as a mechanism for the democratization of credit as lending was dominated by retail investors, Wall Street investors are now participating in these lending platforms and securitization has led to a new era where, as the Financial Times reports,” what started as peer-to-peer lending has become enmeshed in the machinery of Wall Street.” (Jan 11, 2016 – Alphaville).
The good news is that if market institutions are invented and not simply given as is often assumed, then we can shape these institutions in ways that lead to more socially desirable outcomes. Providing access to impact investing to the masses of retail investors in a way that is consistent with democratization of finance will require its architects to invent new market institutions and avoid the temptation to import of existing market infrastructure.
1 Bresnahan, T. and Levin, J. (2013). Vertical Integration and Market Structure, in the Handbook of Organizational Economics. eds. Robert Gibbons and John Roberts. p 879
2 ibid pg. 879