The Changing Face of Equity Trading: Paying For Research

The looming pensions crisis in Europe is shifting the spotlight from the sell side to the buy side to account for current practices in the consumption of research. Opacity and confusion over costs and fees has led some to believe that the use of dealing commissions to purchase research is fatally flawed. On the back of a string of financial services scandals, such views are understandable, but hardline responses rarely deliver intended results.

European regulators now believe the link between turnover and payment for research must be severed. Only through complete unbundling of dealing commissions will firms reduce any wastage in the research purchasing process, and uncover new cost-effective independent research sources to deliver value for money. Like all seismic changes, there will be considerable disruption to the current commission-based framework in the process: 67% of participants anticipate research commissions will decline (see Exhibit 1).

The end objective of improving transparency and achieving value for money for investors is without question. Few would disagree of the necessity to break the monopoly of research provision by global investment banks in order to encourage competition, or even that more could be done to improve the research payment process. What is questionable however is whether the perceived decline of research consumption is an inevitable or advisable outcome; and if this outcome will benefit the end investor in the longer term.

The reality is that dealing commissions is yet another area of financial services where the industry is undergoing painful metamorphosis. Constrained resources and greater accountability have already created demand for an improved understanding of costs versus profitability. The sell side is becoming more selective of what they provide, while the buy side is being more discerning of what it chooses to consume and how this is paid for. However, regulators have lost patience with the perceived limited progress the industry is making and is now ratcheting up the legislation.

It was once a simple process. Asset managers would receive research from their brokers in order to make the most appropriate investment decision for their clients. Any subsequent transaction was then passed to the broker who added fees for providing the research on the back of the cost of executing the trade.

The risk with the bundled model is that fund managers may or may not receive best execution if they are automatically routing orders to favoured providers of research. Nor is there any guarantee that the fund in question is paying for the correct level of research. Cross subsidisation among funds and firms may lead to end investors paying for services they did not use. There is a (mis)perception that funds may be encouraged to trade more than necessary in order to “pay” for research, although heads of dealing desks would refute this given the internal processes now required ahead of placing a trade.

European regulators now believe the link between turnover and payment for research must be severed. Only through complete unbundling of dealing commissions will firms reduce any wastage in the research purchasing process, and uncover new cost-effective independent research sources to deliver value for money. Like all seismic changes, there will be considerable disruption to the current commission-based framework in the process: 67% of participants anticipate research commissions will decline (see Exhibit 1).

Smaller European brokers are likely to suffer. A decrease in consumed research will lead to a decline in investment in research provisions, which will lead to a fall in revenue, which will in turn make the provision of research an expense few can afford. Unattractive sectors may also suffer. We have already witnessed the widespread closure of small-cap execution desks. Few global investment banks will be motivated to carry out research on SME firms given the lack of profitability; if research is not produced, funds will also be less likely to invest. The contra argument is that this opens up the market to competition from more bespoke research providers and sector specialists facilitating a flight to quality.

On the buy side there is little doubt of the impact (see Exhibit 2). Larger buy side firms are widely perceived to have the ability to weather the storm, whereas smaller asset managers may not have the resources to pay for access to all the research previously available to them, nor can they fund this internally. In this competitive environment where few can afford to increase their fees, should market forces then dictate the outcome?

It is not only about the research. Other important considerations remain. If research payments are unbundled from commissions the buy-side may have to foot a potential VAT bill, negating any potential savings from supposed misspent funds. Complex management of commission allocation payments to end funds will require in-depth technological solutions to solve new administrative headaches. Recent advances in the fintech space will undoubtedly provide some answers, but the level of disruption to the industry is yet to be determined.

With the asset management industry continuing to consolidate and operate on a global basis, these changes will resonate beyond Europe as firms adopt common systems globally to reduce business complexity. To investigate these issues TABB spoke with 51 asset managers trading European equities globally (see Exhibits 3 and 4) to establish how they propose to meet the new regulations.