Last week, we wrote a blog about recent discussions in the UK regarding the possibility that regulators could ban the use of client commissions to pay for sell-side and independent investment research. The following addresses a few of the questions we received on this topic from readers.
Why is the UK focusing on this topic?
One of the first questions we received from clients was why is the UK market focused on this topic. The answer is that the pressure is coming both from journalists and from regulators.
Clearly UK journalists have been beating the drum over the past few years that using client commission to pay for research is not in the best interests of clients. This is due to their concern that asset managers overpay for research when they use commissions versus paying for the same research using cash. The second factor is the concern that investors might over trade in an attempt to generate sufficient commissions to pay for the research they use.
However, UK regulators have also been concerned about asset managers’ use of client commissions to pay for various research-related services. The first issue that the FCA has recently addressed has been asset managers’ use of client commissions to pay for management access. In November of last year the FSA, the predecessor to the FCA, told fund managers that they were breaking regulations by paying for corporate access with research commissions. The FSA’s COBS11.6.3R ruling states that firms may only use client commission to purchase research and execution. In March of this year, the FSA said they were preparing to crack down on asset managers’ use of client commissions to pay for corporate access after discovering that some are spending tens of millions of pounds a year on the service.
Many UK asset managers admit that the FCA’s focus on this issue is likely to draw the regulators attention to the use of client commissions to pay for traditional equity research. In fact a recent survey run by the CFA UK found that 60% of the 350 investment professionals who answered their survey said the current research model of using client commissions to pay for research does not best serve the investor. Only 37% of the survey’s respondents think that investment companies should continue paying for research using the client commissions. A majority (53%) think investment managers should pay for research out of their own pockets. Two-thirds of survey respondents believe that asset managers will eventually be forced to stop paying for bank research using client money.
How would the buy-side respond to paying for research in cash?
Another question we have been asked is how will the buy-side respond to having to pay for sell-side and independent research in cash versus commissions? We think a couple of outcomes are likely.
First, we suspect that many asset managers of all size would reduce their use of external research (both sell-side and independent research) if they could not use client commissions to pay for it. This is because the cash payments for external research would directly impact their profit margins, whereas using client commissions would not.
Second, we expect that some of the largest asset managers may choose to rely more on internally produce research rather than paying third-parties. This would require hiring more analysts to cover more companies. Unfortunately, this would not be a very efficient model as we suspect they would end up spending as much if not more on hiring their own analysts than they would in paying external providers for their research given the economies of scale that third-party research providers enjoy.
Third, we think that many asset managers are likely to increase their management fees in order to compensate for the higher costs associated with either paying for sell-side or independent research out of their own pockets, or else hiring more analysts.
Ultimately, we believe the long-term consequence for the buy-side would be consolidation. Small and mid-sized money managers would not be in a position to absorb the costs of hiring analysts or paying for external research out of their own pockets for too long. Consequently, we would expect many firms would either exit the business, or they would merge with others to give them more scale benefits. Interestingly, many academic studies have proven that the best performing money managers are in fact, small to mid-sized firms. As a result, we would expect that consolidation in the asset management industry would negatively impact investment performance.
Who would be hurt most in a “cash research world”?
Clearly, boutique sell-side firms and independent research providers would suffer the most in the near term if UK regulators were to ban the use of client commissions to pay for research. This is because most mid-sized and larger sell-side firms could subsidize their research businesses from revenue in other divisions, including investment banking, proprietary trading, and prime brokerage.
However, over time the move to cash payments for research would have a dramatic impact on sell-side research as these firms would be forced to right size their research operations, and run them more like businesses than they do today. This could result in pushing some sell-side firms to give up the goal of producing waterfront coverage, and instead focusing on sectors where they have a competitive advantage.
Interestingly, the few independent research firms that could survive the bloodletting that buy-side cutbacks would produce may be in a good position to thrive in a “cash research world”. This is because these firms would have lower cost structures than their sell-side brethren and they would be much more experienced at pricing their research on a cash basis versus a commission model.
What does Integrity think will happen with commissions?
As we said last week, we are betting that the FCA will pull back from an outright ban on the use of client commissions to pay for sell-side and independent research. This is because we suspect the FCA will balk at the thought of the potential consequences of banning commission payments for research on small and mid-sized buy-side firms, and the impact that reduced competition among asset managers and higher management fees will have on investors.
However, this does not mean we think that the FCA won’t try to force some significant changes on the current practice of using client commissions to pay for research. Besides continuing their crack down on the use of client commissions to pay for management access, the FCA could also require asset managers to provide greater justification of the fees they are paying for the research they receive.
This could include a way to quantify exactly what the buy-side is paying for the research they receive, and some clearer justification that these fees are reasonable. While this might be straightforward for the buy-side’s use of independent research firms, it would be slightly more problematic for their use of sell-side research which in most cases doesn’t have a specific price. Ultimately we think such a move would result in an even more transparent unbundling of research from trading — a development that would have its own set of impacts on the asset management and research industries.