Numerous urgent issues are facing the long-lived practices and business model of sell-side research in the investment management and banking industry. The foundational premise of the sell-side research is to provide actionable insights and ideas for their clients so that the investors would better understand financial markets and its peculiar dynamics. 1)Not all research is created equal, and as more and more information is accessible, sell-side research will need to differentiate even more than is experienced as today. And, as sell-side analysis is available in various sources for multiple parties, it should also, among other things, decrease the information asymmetry problem inherent in the financial markets.
Some experts have concluded that the sell-side research is not currently living up to its promises as sell-side incentives, interests, expectations and commercial relationships between the producers and consumers of the research are misaligned. Whatever happens to the sell-side research in the near future, transparent, high-quality, differentiated, personalized, and value-oriented sell-side research and analysis are necessary for well-functioning and efficient capital markets as, for example, they can actually influence decision-making and persuade buy-side clients to act in particular ways. Sure, not only sell-side analysts matter, as the buy-side also has its analysts, but the sell-side serves specific functions in the markets. 2)Madureira, L. & Underwood, S. (2008). “Information, sell-side research, and market making“. Journal of Financial Economics 90(2): 105-126; Arand, D. & Kerl, A. G. (2015). “Sell-Side Analyst Research and Reported Conflicts of Interest“. European Financial Management 21(1): 20-51; Arand, D., Kerl, A. & Walter, A. (2015). “When Do Sell-side Analyst Reports Really Matter? Shareholder Protection, Institutional Investors and the Informativeness of Equity Research“. European Financial Management 21(3): 524-555; Kerl, A. & Ohlert, M. (2015). “Star Analysts’ Forecast Accuracy and the Role of Corporate Governance“. Journal of Financial Research 38(1): 92-120.
These issues, whether deemed positive or negative in the long run, will fundamentally alter the existing value constellation as all stakeholders, the direct and indirect retail and institutional consumers and providers of the sell-side research. The business reason for providing sell-side research vary, but it can be reasonably argued that they are on the job of convincing their buy-side client representatives that their research is worth every penny they are paying for it. So at the end of the day, sell-side analysis serves an important dual role in the business.
First of all, the buy-side analysts need to carry out their own, preferably independent, research and generate compelling cases for the buy-side with the help analysis, valuation, insights, estimates and various other means. Secondly, the sell-side research needs to convince the buy-side client to trade and preferably carry out those trades through sell-side’s trading desk. Also, sell-side research and different services associated with it have been historically bundled with various other activities deemed valuable such as execution and trading, clearing and settlement, prime brokerage, market access, IPO allocations, management access, margin lending, short selling, mergers and acquisitions, etc. To summarize, the tendency for the sell-side to bundle their research with their core services lines such as investment banking, brokerage and trading, market access, and corporate finance is a problem as the price and value of research has not been visible enough.
Sell-side analysts, to put it very bluntly, is often treated both by the sellers and buyers of the research, as a free gateway drug. It will keep buy-side clients somewhat locked with a particular buy-side player through various other services and products they offer, and at the same time, as there are information asymmetries, there is a need to understand the importance of agency theory and signalling theory in the case of analysing the interactions and relationships between the sell- and buy-side. For example, as I see it, research function can be treated as an honest signal of quality and commitment.
This issue, namely that the sell-side research has often been bundled together with an enormous range of numerous non-research activities, has become a problem as the practice has now become under considerable scrutiny, not only by the buy-side that has been using sell-sides research services and products for years but from the buy-side’s end customers, retail investors and, most importantly, the regulators themselves. This age-old practice, bundling research within sell-side execution and brokerage services, is now being attacked by many sides.
While the role, value, and nature of the sell-side research are well-known, it still poses a significant challenge for all the players operating in the sell- and buy-side landscape for years to come. Why are some observers saying right now that sell-side research faces an existential threat? It’s because of the new European securities markets rules, collectively known as MiFID II, that come into effect in January 2018. These new regulations, as it has been widely reported, require sell-side and buy-side break their age-old cozy relationship as research and execution need to be tightly separated from each other. This requirement, unbundling, is a real challenge as, for example, some content is can still be exempted from the MiFID II obligations.
As Accenture’s ninth annual Top 10 Challenges for Investment Banks series points out, “Sell-side research is one of the most challenging issues facing the investment banking industry in 2017”. 3)Accenture (2017). “Rethinking the Research Function“. Top 10 Challenges for Investment Banks.
The sell-side business model has already changed and will continue change
As it’s argued in Accenture’s paper on the research function, there is something deeply problematic and even destructive with the traditional sell-side research business model. The authors argue in the paper that the sell-side research service is giving their product for free to position themselves favorably for the future by bundling research and execution. These things, of course, raise numerous questions.
In the history, as pointed out in an article published by Integrity Research Associates back in 2007, various regulative and legislative changes have taken place throughout the buy-side world. As it has been pointed out by Michael Mainelli, Jamie Stevenson and Raj Thamotheram in their article and an extensive report commissioned by The Investment Funds Institute of Canada entitled “Economic Impact Assessment of Banning Embedded Commissions in the Sale of Mutual Fund” demonstrate, there have already been numerous legislative actions against research bundling throughout the world. 4)The issue of bundling vs. unbundling has a long history, and although getting rid of “softening” and “unbundling” research has been discussed for a long time in the global financial community, things have not dramatically changed. See, about other businesses facing demands for unbundling, Greiner, D. J. & Jennings, M. M. (2013). “The Evolution of Unbundling in Litigation Matters: Three Case Studies and a Literature Review“. Denver University Law Review 89(4): 825–849.
Several countries have already taken various actions to weed out conflicting remuneration structures, commissions that financial advisors and product manufacturers receive and/or share, raise the bar for different players by emphasizing fee and commission disclosure requirements, and inform the clients about potential conflicts of interest in relation to the advice, recommendation and distribution in relation to a range of investment products and services. It’s important to note, as PwC report on embedded commissions states, that regulatory regimes differ, and as MiFID II regulations come into effect at the beginning of January 2018, things will change in the mutual fund industry too. Accenture’s paper also refers to self-regulatory organizations (e.g., FINRA) and particular dispute settlements between various governmental, private and regulatory actors (e.g., 2003 Global Analyst Research Settlement aka the Spitzer settlement) to reinforce the fact that many changes have taken place in the sell-side research industry over the last couple of decades. Not but least, one needs to remember that direct criminal cases, such as SEC v. Rajaratnam and the whole criminal investigation brought against Galleon Group, have also created additional pressure against sell-side and the common usage of the so-called “expert networks.”
It’s evident that the 2003 Global Settlement, as explained in FRONTLINE’s The Wall Street Fix, introduced numerous significant changes, alongside Regulation Fair Disclosure (Reg FD) adopted in the USA back in 2000, to the way investment banking and research function operate. These new regulations and interventions, as it has been argued by the regulators and self-regulatory organizations, have been adopted to improve the quantity, quality, timing and distribution of information produced to investors. As research functions have been more clearly separated from trading, investment banking and other corporate activities, and they have been forces be more transparent; now we are witnessing new competition, regulatory and operational risks emerging.
These changes mentioned above, as one can expect, have had a considerable global impact on the way different financial services operations are set up and governed as well as day-to-day practices. It’s no news that there is constant movement between buy- and sell-side, and therefore it’s important to keep in mind that regulatory actions also affect the way people move around the industry. 5)Healy, P. M. (2007). “How did Regulation Fair Disclosure Affect the US Capital Market? A Review of the Evidence“. Conference Paper; Kwag, A. & Small, K. (2007). “The impact of regulation fair disclosure on earnings management and analyst forecast bias“. Journal of Economics and Finance 31(1): 87-98; Hovakimian, A. & Saenyasiri, E. (2010). “Conflicts of Interest and Analyst Behavior: Evidence from Recent Changes in Regulation“. Financial Analysts Journal 66(4): 96-107; Keskek, S. Myers, L. A., Omer, T. C. & Shelley, M. K. (2017). “The Effects of Disclosure and Analyst Regulations on the Relevance of Analyst Characteristics for Explaining Analyst Forecast Accuracy“. Journal of Business Finance & Accounting 44(5-6): 780-811. As Paul M. Healy has demonstrated in his study on the effects of Reg FD, “the new rules had the intended effect of increasing company public disclosure and reducing analysts’ access to private information. ” In the case of the Reg FD, Healy concludes that it “appears to have been neither as onerous as its critics feared nor as beneficial in increasing investor confidence as regulators anticipated” but his conclusions regarding the Global Settlement are even more interesting:
“Preliminary analysis and descriptive data on the subsequent Global Settlement indicates that it may have had a more significant effect on information. By restricting banks from using equity research to support banking, the new rules affected the model used by banks to fund research. This led to a reallocation of research in US equity markets from the punished banks to brokerage firms, research boutiques and buy-side firms.”
As it seems, not all regulation is created equal in terms of their effects, and as Jeff Madura and Arjan Premti have previously argued, “all three [U.S.-led] regulatory actions [namely, Reg FD, GARS and the case against Galleon Group] have significantly reduce the leakage of information prior to analyst recommendations.” So, the question arises, how will MiFID II with its extensive scope, complexity and potentially global reach change the sell-side research industry, and how will sell-side operate in the post-MiFID II world? .”
MiFID II will have a global impact
MiFID I, the predecessor of the MiFID II, came into force on 1 November 2007 and replaced over a decade old Investment Services Directive. As the second Markets in Financial Instruments Directive (MiFID II), one of the numerous regulatory reforms affecting the financial services industry comes into effect on 3 January 2018, brokerage, execution or trading will be separated from research functions almost entirely. 6)Hereafter will refer to MiFID II and MiFIR collectively as “MiFID II”. MiFID II much more than an upgrade to the MiFID I, and although it could very far-reaching consequences to the global financial markets, law firm Hogan Lovells argues that “the impact of MiFID II is not expected to be as radical as that of MiFID [I].” MiFID II should have entered into force already in January 2017, but back in 2016, its implementation was postponed to 2018 due to several issues.
After ESMA concluded in October-November 2015 that various affected parties, most importantly competent authorities, and market participants, face several technical challenges in implementing the new regulatory requirements with the MiFID II rulebook, a decision was made in May 2016 by the Committee of Permanent Representatives (COREPER), on behalf of the European Council, and the European Parliament that a one-year delay was needed to get everything in order regarding the new securities markets rules. In June 2016 it was clear for everyone that postponement to 2018 is clear. 7)Council of the European Union (2016). “Markets in financial instruments: One-year delay enacted“. Press Release, 17.6.2016. As Inside Reference Data‘s editor Michael Shashoua pointed out back in 2015, there were numerous issues that led to the decision, but according to him, financial services companies were ready to abide the new rules for 2017 deadline.
There are numerous good papers, studies, comments, reports and various kinds of other resources on MiFID II and MiFIR so I won’t be discussing these here. The most important thing to remember in all this is that the European Union’s stated objective, with the help of various directives and regulations, is to “promote financial markets that are fair, transparent, effective, and integrated.” More precisely, as ESMA describes the upcoming new legislation, MiFID II is based on “the rules already in place, these new rules [imposed by MiFID II] are designed to take into account developments in the trading environment since the implementation of MiFID in 2007 and, in light of the financial crisis, to improve the functioning of financial markets making them more efficient, resilient and transparent.” It’s also good to remember that MiFID II, as EY sees it, is construed of five main components: investor protection, market structure, market transparency, internal controls/reporting and external controls/governance.
MiFID II, alongside the more reporting-oriented MiFIR, is not just a bunch of new legal requirements just for some financial market operators but instead, it will affect the whole ecosystem, including liquidity providers, asset managers, custodians, data providers, and other financial service providers. It will change the way various financial instruments, including stocks, bonds, ETFs, mutual funds, derivatives, commodities, and structured finance products are treated from the pre-trade activities all over to the operations carrying out clearing and settlement all over the European Economic Area. So, in the end, the whole basic anatomy of an investment is changed in one big sweep.
As it has been pointed out by many, the enormous scope, sheer complexity, and global reach of MiFID II have posed a considerable challenge for those (financial) firms and trading venues that offer financial instruments and related services within the EU area (and EEA). 8)Healey, R. (2017). “Global Impacts of MiFID II: Part 1, Part 2, Part 3“. Liquidnet, August 2017; EY (2017). “Does MiFID II impact APAC? Extra-territoriality of MiFID II“. This actually means that numerous actors throughout the financial services ecosystem will be affected in different ways, and it’s not clear how the MiFID II will eventually play out in changing the existing capital markets landscape in Europe and throughout the globe. New rules and requirements on prohibited inducements, unbundling research, product governance, taping, best execution, market transparency and, transaction and post-trade reporting will affect numerous financial services firms. 9)Linklaters (2017). “MiFID II/ MIFIR and Asset Management: In a nutshell“. They need to figure out how to conduct their business in the EEA region as the rules will be tightened, and the number of exceptions has significantly decreased from MiFID I. 10)See Article 2(1) of Directive
Upcoming challenges in the sell-side research business
As MiFID II comes into effect next year, investment research cannot be bundled together with other (financial) services or paid with commission payments, i.e., research and trading are now strictly separated, distinct activities. 11)Christian, C. D. & Frase, D. (2016). “MiFID II: Key Considerations for US Asset Managers“. The Investment Lawyer 23(5): 1-13. Research, in the context of MiFID II, is defined in Recital 28 as
“[…] research material or services concerning one or several financial instruments or other assets, or the issuers or potential issuers of financial instruments, or be closely related to a specific industry or market such that it informs views on financial instruments, assets or issuers within that sector. That type of material or services explicitly or implicitly recommends or suggests an investment strategy and provides a substantiated opinion as to the present or future value or price of such instruments or assets, or otherwise contains analysis and original insights and reach conclusions based on new or existing information that could be used to inform an investment strategy and be relevant and capable of adding value to the investment firm’s decisions on behalf of clients being charged for that research.” 12)So, in the context of MiFID II, research materials and services covers a lot of ground. 13)Emphasis added by TB.
The unbundling requirements are laid down in Recitals 26-30:
“(26) Investment firms providing both execution and research services should price and supply them separately in order to enable investment firms established in the Union to comply with the requirement to not accept and retain fees, commissions or any monetary or non-monetary benefits paid or provided by any third party or a person acting on behalf of a third party in relation to the provision of the service to clients. […]
(27) In order to provide legal certainty concerning the application of new rules for the reception or payment of inducements, in particular with respect to investment firms providing investment advice on an independent basis or portfolio management services, further clarifications in relation to the payment or reception of research should be provided. In particular, where research is not paid directly by the investment firm out of its own resources but in return for payments from a separate research payment account certain essential conditions should be ensured. […]
(28) In order to ensure that portfolio managers and independent investment advisers properly monitor the amounts paid for research and to ensure that research costs are incurred in the best interests of the client, it is appropriate to specify detailed governance requirements on research spending. Investment firms should retain sufficient control over the overall spending for research, the collection of client research charges and the determination of payments. […]” 14)Emphasis added by TB.
This pivotal change in the rules of the game alone has created a huge debate that will continue for years to come, and it has been predicted that the new regulation will most likely lower sell-side budgets.
As Morningstar’s Connor Sloman has neatly argued, “MiFID II’s unbundling of payments for investment research will prohibit asset managers from receiving research as a ‘free’ added-value service on the back of commissions paid for broker and investment banking services such as trading and execution.” It has been noted by many observers and experts that MiFID II will accurately change and probably improve the investment research industry in the European Union, and as one can expect, it isn’t easy to predict what will ultimately happen.
MiFID II has created numerous challenges for the multibillion-euro global investment research industry as now research is much more like a relationship that needs to be treated with extra caution as research needs to “be priced, monitored, quality assessed, billed and reported” as Emma Margetts from Alpha Exchange argues in Financial News. It has been suggested that the number of independent investment analysis providers and their volume of the total business, companies like Inderes, Morningstar, Standard & Poor, Kepler Cheuvreux, AlphaValue and others, will increase due to the MiFID II as, according to Margetts, “the industry is currently a sprawling mess, with research relationships between the sellside and buyside spread over thousands of daily emails, analyst meetings and individual calls”. So, who will be affected by the MiFID II? Basically every European buy- and/or sell-side institutions, and all the global financial firms with any direct or indirect European presence. According to BCA Research, 4 in 10 asset managers are still struggling with MiFID II unbundling, and a survey released by Investec Wealth & Investment last year shows over half of UK-based investment advisers expect their business model to change.
If you’d like to better understand the upcoming changes, see the video below published by the DTCC.
These arguments are not fantasy, but warranted assertions that are based on available data on the probable effects of the upcoming MiFID II regulation. In a working paper published in June 2017 entitled “Reinventing Equity Research As a Profit-Making Business” a team of consultants from McKinsey & Co. concluded that:
“McKinsey’s view is that there will be an end to equity research as we know it. The buy side will have to discover the value and price of research that justifies separate payments, whether funded by investors or the managers themselves, and cut back considerably on its consumption of lower-value research.”
According to the McKinsey working paper, there are five potential future sell-side research business and organization models that will be adopted due to MiFID II, namely:
- Execution-led businesses at scale with broad equities offering
- Execution leaders with limited research capabilities
- Global universal banks with enough demand from institutional investors, private
clients, and corporate businesses to maintain broad spectrum research
- Regional/sector champions
- Independent research providers with little or no execution
McKinsey report furthermore states that the independent research providers with little or no execution “should see significant growth in the new landscape”. It is predicted in the Accenture report mentioned before that MiFID II might influence other regulatory agencies in other parts of the globe to adopt similar rules in the future, and it can also be assumed that “Faced with the true price of research, money managers will likely scrutinize the research services they purchase, leading to more selective consumption, a flight to quality and declining revenue streams for ‘me too’ research providers.”
According to Financial Times, some European banks, most notably BBVA, Credit Suisse and ING, are planning to release “some or all of their fixed income research for free in preparation for new EU rules” while many US banks are trying to find ways to still charge for their fixed income research. There has also been some initial news on the seemingly extravagantly high pricing of research, and as above-mentioned Morningstar’s Connor Sloman clearly points out, under the MiFID II regime “asset managers will be required to explicitly cover investment research costs from a separate account, or from their own profit and loss account, making the cost of research highly visible […].” So, in the end, there are several ways to pay for research and associated services under MiFID II but
Even though the near future of sell-side research seems somewhat challenging and unclear, sell-side will not disappear as there is still demand research. As I pointed out earlier, buy-side will still need research, analysis, insights, and recommendations to conduct their own business, and therefore the ultimate question is how will this all play out in the post-MiFID II world.
Sell-side needs to figure out how business model innovation and value proposition redesign will take place, and to make sure that inducement management, research budgets, research pricing and different payment models are in place. On the other hand, the buy-side has a lot to do too: find out valid research procurement methodologies and processes, demonstrate that research provides value for the clients, etc. This is not going to be an easy task for buy-side either.
The emergence of independent sell-side analysts, various social research platforms, and various digital means to produce and deliver research at scale are, at least from my point of view, pivotal to create a truly differentiated new breed of investment analysis players in the post-MiFID II world, and at the same time, buy-side will also be affected by MiFID II. As MiFID II is a directive and not a regulation, it’s going to be implemented locally, and therefore local policymakers, regulators, and other stakeholders have more say on the way the legislation is interpreted, written down and applied.
As the question around the future of sell-side research is far-reaching in its scope and reach, and as the research business models, value constellations and value proposition are on a constant move, we will definitely see numerous changes and unexpected moves to take place in this space; and it’s important to remember that not only will be sell- and buy-side be affected but also the vendors for the sell- and buy-side as well as the (retail) clients of the buy-side. I expect, as have numerous studies, which there will be some divergence between business models and operating models, and many incumbents and new players will most certainly put a lot of focus on leveraging their digital capabilities, e.g., data visualization, data analytics, digital service delivery, etc.
So, as I have tried to point out in this article, the sell-side research is living through fascinating times, and in my future article, I will dig deeper into at least one European case study of the emerging independent research providers with no execution at all. I will shortly discuss their business model, and how I perceive the potential of independent research in the post-MiFID II world.
References [ + ]
|1.||↲||Not all research is created equal, and as more and more information is accessible, sell-side research will need to differentiate even more than is experienced as today.|
|2.||↲||Madureira, L. & Underwood, S. (2008). “Information, sell-side research, and market making“. Journal of Financial Economics 90(2): 105-126; Arand, D. & Kerl, A. G. (2015). “Sell-Side Analyst Research and Reported Conflicts of Interest“. European Financial Management 21(1): 20-51; Arand, D., Kerl, A. & Walter, A. (2015). “When Do Sell-side Analyst Reports Really Matter? Shareholder Protection, Institutional Investors and the Informativeness of Equity Research“. European Financial Management 21(3): 524-555; Kerl, A. & Ohlert, M. (2015). “Star Analysts’ Forecast Accuracy and the Role of Corporate Governance“. Journal of Financial Research 38(1): 92-120.|
|3.||↲||Accenture (2017). “Rethinking the Research Function“. Top 10 Challenges for Investment Banks.|
|4.||↲||The issue of bundling vs. unbundling has a long history, and although getting rid of “softening” and “unbundling” research has been discussed for a long time in the global financial community, things have not dramatically changed. See, about other businesses facing demands for unbundling, Greiner, D. J. & Jennings, M. M. (2013). “The Evolution of Unbundling in Litigation Matters: Three Case Studies and a Literature Review“. Denver University Law Review 89(4): 825–849.|
|5.||↲||Healy, P. M. (2007). “How did Regulation Fair Disclosure Affect the US Capital Market? A Review of the Evidence“. Conference Paper; Kwag, A. & Small, K. (2007). “The impact of regulation fair disclosure on earnings management and analyst forecast bias“. Journal of Economics and Finance 31(1): 87-98; Hovakimian, A. & Saenyasiri, E. (2010). “Conflicts of Interest and Analyst Behavior: Evidence from Recent Changes in Regulation“. Financial Analysts Journal 66(4): 96-107; Keskek, S. Myers, L. A., Omer, T. C. & Shelley, M. K. (2017). “The Effects of Disclosure and Analyst Regulations on the Relevance of Analyst Characteristics for Explaining Analyst Forecast Accuracy“. Journal of Business Finance & Accounting 44(5-6): 780-811.|
|6.||↲||Hereafter will refer to MiFID II and MiFIR collectively as “MiFID II”.|
|7.||↲||Council of the European Union (2016). “Markets in financial instruments: One-year delay enacted“. Press Release, 17.6.2016.|
|8.||↲||Healey, R. (2017). “Global Impacts of MiFID II: Part 1, Part 2, Part 3“. Liquidnet, August 2017; EY (2017). “Does MiFID II impact APAC? Extra-territoriality of MiFID II“.|
|9.||↲||Linklaters (2017). “MiFID II/ MIFIR and Asset Management: In a nutshell“.|
|10.||↲||See Article 2(1) of Directive|
|11.||↲||Christian, C. D. & Frase, D. (2016). “MiFID II: Key Considerations for US Asset Managers“. The Investment Lawyer 23(5): 1-13.|
|12.||↲||So, in the context of MiFID II, research materials and services covers a lot of ground.|
|13, 14.||↲||Emphasis added by TB.|