There has been an age-old practice of allowing the cost of research to be bundled into dealing commission, thereby passing on the cost to underlying investors. This has provided start-up and developing asset managers and hedge funds with the flexibility to solicit a variety of opinions and trade ideas. This is how things have always been done, so why complicate things with change? No one likes change.
Yet, that is exactly what European regulators are working on—changing this long-established practice. The final version of this potentially draconian regulation has yet to be determined, but change is coming—that’s for certain.
But—maybe—it is time to move current practices progressively forward into a world with more transparency, clarity and efficiency? Maybe, just maybe, this time change will bring about good things? It’s just hard and sometimes expensive.
Let’s make an analogy by looking at how change has impacted the game of Hockey. Back in the day, enforcers used to roam the ice much more freely and frequently than they do in today’s games. The enforcer’s main purpose was to fight. According to an ESPN.com article by Katie Strang posted on December 26, 2014, the enforcer “is now practically extinct.” George Parros, who was recognized in the NHL as one such enforcer, was surprised in 2014 when no NHL team signed him for the upcoming season. The league has been heading in a different direction. Parros admits that “even if fighting comes back into vogue,” he doesn’t see the one-dimensional enforcer coming back with it.
The truth is that the way the NHL hockey game is currently officiated dictates a different style of play: faster, younger and more skilled. These skills increase a team’s chance of winning, evidently much more than having musclemen skating around looking to drop the gloves. Dropping enforcers has also allowed for a smoother, cleaner and safer game—for players and fans. Simply put: the NHL has instituted rules that have led to a more attractive, safer and more profitable contest on the ice.
But why? Something had to be done—of the four major sports in the U.S., hockey and the NHL found themselves at the high end of ticket prices and at the low end of franchise value, profitability and television contracts. It’s hard to argue that change was not needed. Hockey is now in the midst of a ratings upswing after declining year-over-year in the early 2000s. So, the seeds of change, however difficult to plant, do appear to have sprouted and even begun to bear fruit.
The same can be said for the unbundling that is so aggressively being pursued by some regulatory agencies across Europe, even though the French or German regulators are trying to push back. Certainly the FCA and ESMA see a cleaner “game” within reach, one that not only provides transparency, but also forces the less-valuable “players” out of the game—ultimately benefiting the “league” and its “fans.” These fans are comprised of asset managers, asset owners and underlying individual investors.
Unbundling the research from dealing commissions forces each and every research provider to stand with its product in hand and be chosen (or not), valued (or not) and (ultimately) judged. The best will survive, the worst won’t or will have to evolve. Research spend will go down because asset managers will count every penny when they are forced not only to write the check, but to justify it, too.
Time will be needed to adjust to the new world. Many enforcers, or research providers, will find themselves on the sidelines. Their skills and product scrutinized deeply with the goal of determining if they are offering real value—value worth paying for. And, how valuable exactly? Will they be able to bide their time as the industry stabilizes under the new regulation? Or will they exit and consolidate?
Let’s be perfectly clear, the creation of valuable research ideas is not going away. Rather, in this new environment, research will be properly valued and paid for. This will ultimately mean that research spend in aggregate will go down dramatically. The asset managers will either start paying for the research directly, having valued it at a level deemed commensurate, or start hiring sell-side analysts for the investment team. An additional benefit is that clients who could not afford to send their commission flow to multiple research brokers, and therefore could not receive all of those brokers’ research, should now be able to identify the exact research they need and value, and buy it on demand. Though the price will go down, availability and access should go up. The best research will survive and continue to be paid for and the buyside’s underlying investors will reap the benefits of their asset managers consuming the best research available at the best and most fair prices in the market.
When we look back on these years, we will be able to point to a better product delivered to the paying fans on the ice and a better research product delivered to asset managers in the financial markets. Attendance will be higher at games and players will be safer on the ice. The integrity of dealing commission and research spend will be restored, the best research will prevail and the underlying investors will benefit from lower costs and greater transparency.