How Could J.P. Morgan Deliver Stocks and Bonds Cheaper Than Today’s Industry?

New research shows financial intermediation costs trending upward exactly when IT should have driven costs down. A wasted $280 billion?

While the Occupy Wall Street movement regards Wall Street greed as the reason for all the money sloshing around lower Manhattan, new academic research suggests that today’s huge appetite for trading may explain the financial industry’s large size.

In a paper titled “Has the finance industry become less efficient? Or where is Wal-Mart when we need it?” Thomas Philippon, a finance professor at NYU’s Stern School of Business, observes that the cost of financial intermediation has been steadily rising since the 1970s–a trend he calls counterintuitive given the cost-reducing surge in IT during that same time period.

J.P. Morgan (Photo: AP)Looking at historical data reaching all the way back to 1870 when J.P. Morgan (left) ruled, Philippon finds that the cost of financial intermediation has shifted many times, from a low of 1.3% of GDP to a high of 2.3% of GDP. Economic modeling would suggest a lowering of those costs over time as a result of technological improvements. “Essentially, the physical transaction costs of buying and holding financial assets must have decreased because of IT,” Philippon conjectures. “This effect must have lowered the amount spent on intermediation.”

Yet we are at peak costs today at exactly the time when IT has dramatically reduced costs in other industries. “Based on what we see in wholesale and retail trade, IT should have made finance smaller, not larger.” (Hence, Philippon’s title question about Wal-Mart, whose IT-based efficiency has shrunk retail’s intermediation costs.)

Philippon suggests the answer may lie in the voluminous increase in trading over the past couple of decades. “The recent levels of trading activities are at least three times larger than at any time in previous history,” he writes. While technology has clearly reduced the cost of a single trade to retail investors, the surge in volume of trade may explain why the cost of, say, active fund management remains stubbornly high.

The NYU finance professor then asks why fund managers and retail investors trade so much today and whether that increase has resulted in more efficient pricing or risk sharing.

“If the answer turns out to be no,” he writes, “then we would have to conclude that the finance industry's share of GDP is about 2 percentage points higher than it needs to be and this would represent an annual misallocation of resources of about $280 billion for the U.S. alone.”

Philippon’s questions should be of at least as much interest to financial advisors as to Wall Street protestors. If J.P. Morgan was able to procure stocks and bonds for clients more cheaply than today, where is all the money going and what are we getting for it?

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