What are examples of churning?

Understanding Conflicts of Interests

The practice of churning arises out of the inherent conflict of interest existing between the commission broker and his/her client. Brokerage houses advertise themselves as sources of reliable guidance for people who have the money to invest but may lack the necessary expertise to formulate an appropriate investment strategy.

A major portion of the broker’s income comes from commissions charged for executing buy and sell orders in the securities markets. Therein lies the conflict of interest: the broker makes little or no money unless the customer buys and sells securities.

Brokers who cause their customers to execute transactions that are solely for the broker’s benefit – that is, cause their customers to trade just to generate a commission for the broker with little or no benefit to the customer – are engaging in the practice of churning.

Forms of Churning

Mutual funds with an upfront load (load is the sales charge or commission paid by the mutual fund investor to the broker) called A shares, are long-term investments. The sale of an A-share fund and purchase of another within five years must be substantiated by the broker with prudent reasoning. It may be a case of churning if the trade results in no noticeable portfolio gain to the investor.

The most common form of churning is excessive trading in stocks and bonds by the broker. However, churning is not limited to such types of securities alone. Brokers may often churn mutual funds, annuities, and life insurance policies.

Reverse churning

The practice of charging customers hefty fees in accounts that do not generate much activity is known as “reverse churning.” It typically occurs when clients who trade infrequently are put into a fee-based brokerage account.

How to Detect Churning in an Investment Account

The investor can detect churning by the broker when the frequency of trades becomes counterproductive to their investment goals, driving commission fees higher without observable results over time.

Another indication is when the investor is paying more in commissions than they are earning on the investments. Courts take into account the number of times the investment capital is re-invested during a year. In cases of churning, the entire assets of the investor are generally traded once a month or even more frequently.

Opening a wrap account (an account that is managed for a flat rate instead of charging a commission on every transaction) is a way for investors to safeguard themselves against churning.

Legal Consequences of Churning

Churning is regarded as a form of manipulation and is illegal in most jurisdictions. Regulatory agencies are often authorized to impose fines, suspend brokers, or even bar them indefinitely if caught churning accounts. The investor can legally claim the return of excessive commissions paid and of any losses resulting from the broker’s choice of stocks.

In the U.S., the Securities and Exchange Commission (SEC) lays down three key rules that make up the legal basis against churning.

1. SEC Rule 15c1-7 classifies a broker’s actions as fraudulent if they use their discretionary power over the investor’s account to engage in transactions that are excessive in view of the financial resources and character of the account in question.
2. FINRA (Financial Industry Regulatory Authority) Rule 2111 advocates that brokers must always act in the best interest of their clients. It states that a broker must have a reasonable basis to believe that a trade will be beneficial for the customer based on their investment objectives, liquidity needs, tax status, and risk tolerance.
3. NYSE Rule 408(c) prohibits investment firms from legally allowing their brokers to churn accounts.

Related Readings

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Definition: Churn is a measurement of the percentage of accounts that cancel or choose not to renew their subscriptions. A high churn rate can negatively impact Monthly Recurring Revenue (MRR) and can also indicate dissatisfaction with a product or service.

Churn is the measure of how many customers stop using a product. This can be measured based on actual usage or failure to renew (when the product is sold using a subscription model). Often evaluated for a specific period of time, there can be a monthly, quarterly, or annual churn rate.

When new customers begin buying and/or using a product, each new user contributes to a product’s growth rate. Inevitably some of those customers will eventually discontinue their usage or cancel their subscription; either because they switched to a competitor or alternative solution, no longer need to product’s functions, they’re unhappy with their user experience, or they can no longer afford or justify the cost. The customers that stop using/paying are the “churn” for a given period of time.

How is Churn Calculated?

In its most simplistic form, the churn rate is the percentage of total customers that stop using/paying over a period of time. So, if there were 10,000 total customers in March and 1,000 of them stopped being customers, the monthly churn rate would be 10%.

But where and when you start counting and calculating can impact the math and eventual churn rate. For example, if the product began March with 8,000 customers and added 2,000 new customers that month, should the 1,000 customers who quit be divided by 10,000 (total customers at the end of the month) or 9,000 (total customers at the beginning of the month, factoring in the addition of 2,000 and the subtraction of 1,000.) or 8,000 (total customers at the beginning of the month, regardless of how many were added)? That could change the monthly churn rate from 10% to 11.1% or 12.5%.

Beyond that, there’s also settling on the “moment of churn”: do you calculate churn based on when users cancel or when their subscription actually ends (which maybe later in the month or even the end of the year). If you choose the latter option, it becomes impossible for a customer to churn in the same month they sign up, which may hide the fact that some customers are quickly dissatisfied enough with the product to cancel almost immediately.

However, many companies have adopted slightly more sophisticated and nuanced approaches to calculating churn. Some will take an average of the number of customers at the beginning and end of the time period in question as the denominator in the churn equation. Others will use weighted averages or rolling metrics to try and divine more accurate churn rates.

Other tactics may include breaking out the total customer base into different cohorts and calculating individual churn rates for each one. This more granular approach can identify which customer types are churning more often, as well as breaking out new customers from long-standing ones.

Regardless of which calculation method is ultimately used, the most important thing is using the same formula consistently for accurate period-to-period comparison and creating a reliable KPI. There may be dips and spikes when there’s a large influx of new customers, but it at least provides a reliable methodology.

Why Do Customers Churn?

Although there is no magic answer to this question, there are a few likely causes for churn:

• Customer no longer values the product—Whatever first attracted the customer to the product and inspired initial usage is no longer present. This could be a change in customer priorities or a change in the product itself.
• Motivating factors to use the product no longer exists—Customers purchase and use a product because it solves a problem or addresses a need, but not all problems and needs are permanent.
• Customer frustrated with product user experience—Dissatisfaction with usability, lack of features, or persistent bugs and performance issues can drive a customer away.
• The product lacks a mandatory capability required by the user—A customer needs the product to do something, but the product does not offer that functionality (or the customer lacks awareness or training of how to access and utilize that capability).
• Value to the customer does not justify the expense—The ROI for the customer is no longer there.
• The customer has found/switched to an alternative solution—This may be a direct competitor or an indirect alternative that is free or already available (i.e. instead of a reminder app the customer will just write down their notes on paper).
• Damage to product reputation—This could be a cybersecurity issue, noteworthy performance problems, terrible customer service or bad acts by the company or company employees.

Of course, each departing customer has their own motivation for discontinuing their usage. Exit surveys/interviews and analyzing the usage behavior of churned customers may reveal larger trends.

What Does Churn Mean for Product Managers?

Churn could quite possibly be the most important metric for SaaS product managers since it is a very telling measure of the perceived value the product delivers. While marketing and sales are primarily responsible for bringing in new customers, the product experience itself will determine how many stick around and for how long.

“In SaaS, but especially in times like these, existing customers are your life blood. The more that you can retain existing customers, the more predictable your revenue stream will be in the future.”

– Kristina Shen and Kimberly Tan, Andreesen Horowitz

The cost of acquiring new customers is much higher than the cost of retaining those already onboard, so reducing churn is a real financial priority. Everything possible should be done to keep current customers satisfied, maintaining their usage and increasing their lifetime value. Plus a high churn rate can also damage a product’s net promoter score.

Product managers have two key tactics to employ in reducing churn: user research to understanding customer behaviors and proactively addressing product shortcomings. Having a sense for which usage patterns are predictors of potential defection allows for both forecasting future churn and activating account management to engage wavering users while prioritizing features and enhancements specifically targeting the concerns of current customers both displays customer-centricity and reduces their reasons for leaving.

How Can You Reduce Churn?

Churn is reduced by increasing the perceived value proposition of the product to current users. This can be achieved in a number of ways since the value is determined based on several factors.

• Make sure customers get the most out of the product—It doesn’t matter how much a product can do if end users aren’t aware of those capabilities, can’t figure out how to use them and aren’t positioned for success. Invest in onboarding, training, tutorials, contextual help, and proactive customer support to increase the chances that customers will understand how to actually use the product to its fullest.
• Recruit the right kind of customers—Not all products are right for everyone, so work with sales and marketing to target prospects matching the product’s ideal buyer personas. Ensure messaging is accurate and highlights actual product capabilities and benefits.
• Price based on value—Customers don’t care about vendor profit margins, growth rates, and revenue targets; they want to pay what they think a product is actually worth to them. Use customer-focused pricing strategies for your product that present a clear ROI to users.
• Continually add value without breaking what already works—Current customers don’t mind and may appreciate new features, but this should never come at the expense of diminishing existing capabilities or disrupting the user experience.
• Don’t take customers for granted—No renewal should be considered a given and any customer may cancel at a moment’s notice, so continually engage customers to understand their likes and dislikes as well as what could improve their experience.