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Churning

Definition

Churning, in finance, refers to the practice of a broker conducting excessive buying and selling of securities in a client’s account primarily to generate commissions. This unethical practice is illegal under U.S. Securities and Exchange Commission (SEC) rules as it can result in significant costs, unnecessary risks, and potential losses for the investor. Its main purpose is to benefit the broker, not the client.

Phonetic

The phonetics of the word “Churning” is /ˈCHərniNG/.

Key Takeaways

  1. Definition: Churning is a business term that describes the process of customers moving away from a particular product or service, resulting in customer turnover. It’s usually considered as a negative indicator of customer loyalty and business health.
  2. Impact on Businesses: High churn rate can significant impact a business’s revenue and growth. It is more expensive to acquire new customers than to maintain existing ones. Therefore, most businesses strive to reduce their churn rate.
  3. Importance of Customer Retention: Churning emphasizes the importance of customer retention in sustainable business practices. By understanding the reasons why customers churn, businesses can improve their products, services, and customer service to maximize customer satisfaction and loyalty.

Importance

Churning is a significant term in business and finance as it represents the practice of excessive buying and selling of securities in a customer’s account by a broker, focusing on generating commissions instead of considering the customer’s investment objectives. This unethical and often illegal activity can lead to considerable negative impacts on an investor’s portfolio through the unnecessary accumulation of transaction fees and potential for improper investments. It primarily occurs in accounts where the brokers charge their clients per transaction. Thus, the term is essential for investors to understand and recognize to ensure their investments are managed effectively and ethically.

Explanation

Churning in finance and business entails a high volume of transactions primarily for the purpose of earning commissions or achieving other direct benefits. It is most notably used in the brokerage industry where brokers may engage in excessive trading on a client’s behalf to increase their own commissions. Since every transaction typically results in a commission for the broker, this frequent buying and selling of securities can generate increased earnings for them. It is important to note, however, that these transactions might not always be in the best interest of the client and may not serve any real investment purpose. On the other side, the practice of churning can lead to significant financial loss for the client. This is because each executed trade usually comes with transaction costs which can quickly accumulate, eroding the value of the client’s portfolio. Additionally, the financial gain of a frequent trading strategy may not be able to top these excessive trade-related costs. Consequently, as a strategy, churning is highly regulated within the brokerage industry in many jurisdictions and considered unethical, or even illegal, due to its exploitative nature.

Examples

1. Brokerage Churning: This may occur when a broker continuously buys and sells assets, generally stocks, to generate profits from the transaction fees instead of focusing on their client’s long-term investment objectives. This unethical practice can lead to significant losses for the client as the costs of the constant trades outweigh any profits earned.2. Credit Card Churning: This refers to the practice of signing up for credit cards with large signup bonuses, and then once received, preventing use or cancelling the card before the end of the grace period. This is often done repeatedly to exploit the rewards system. However, this practice can severely affect the person’s credit score and banks have established mechanisms to detect and prevent it.3. Insurance Policy Churning: This happens when an insurance agent convinces a policyholder to drop a life insurance policy and purchase a new one. The goal here is to earn more commissions. For the customer, though, the cost of the new policy might be higher than the old one and the value of the insurance may not grow as much because it’s a new policy. This practice is considered unethical and illegal due to its detrimental effects on the clients.

Frequently Asked Questions(FAQ)

What does Churning mean in finance and business terms?

Churning in finance and business refers to the practice of excessive buying and selling of securities in a customer’s account, primarily to generate commissions for the broker.

What are the potential impacts of churning?

Churning can drain a customer’s investment returns due to the costs associated with constant buying and selling of securities. Furthermore, it may also lead to improper tax consequences and unsuitable investments.

What are some signs that my broker might be engaged in churning?

Some warning signs may include frequent buying and selling in your account, incessant recommendations from your broker to buy or sell securities, or noticing your portfolio being invested in high-risk securities without your consent.

How can I protect myself from churning?

It’s crucial to check your account statements regularly and understand each transaction that’s taken place. Building a trusted relationship with your broker, keeping the line of communication open, and getting any recommendations in writing can also help.

How is the level of churning determined?

The level of churning can be determined by evaluating the turnover rate or the cost-equity ratio. A turnover rate of six or more or a cost-equity ratio above 12% generally signals excessive transactions.

What actions can I take if I suspect my broker of churning?

If you suspect that your broker is indulging in churning, you can contact the firm’s compliance department, consult with a securities attorney, or file a complaint with the Financial Industry Regulatory Authority (FINRA), or the Securities and Exchange Commission (SEC).

Can churning occur in mutual funds?

Yes, churning can occur with mutual funds when fund managers perform excessive trading to boost their perceived performance and attract more customers.

Are there legal repercussions for brokers who churn accounts?

Yes, churning is considered an unethical practice and is illegal under both state and federal securities laws. A broker found guilty of churning can face severe fines, loss of license, and even jail time.

Related Finance Terms

  • Broker Misconduct
  • Excessive Trading
  • Securities Fraud
  • Trading Frequency
  • Commission Fees

Sources for More Information

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