New York – In the world of real estate the three things that most affect the value of a property are location, location and location. In investment, money management and policy, the three most important things to consider are conflicts, conflicts and conflicts.
Integrity has reviewed the conflicts that can pervade the research space, especially if the firms’ that produce the research also offer other services to investors. Investment banking conflicts have been widely discussed. In fact, we use investment banking services as the dividing line between alternative research providers and non-alternative research providers in our database. While this demarcation is clear and easy to judge, it leaves a significant grey area in the research space. For example, alternative research providers can, under our definition, do money management, have paid-for business models and run trading desks that in some form may create conflicts between the firm’s goals and its research clients.
Compliance versus Conflicts
Before we progress, we should distinguish between conflicts of interest and compliance. By out definition, conflicts are the natural consequence of blurred business lines, incentives and responsibilities. For example, if a firm manages money and creates research, there is a natural conflict between the profit motive and the research. This is commonly called research front-running. Compliance is the structure that is put in place by regulators and the firm to control these conflicts. For example, the compliance steps to limit front-running temptation, might include rules about the separation of research and money management functions, rules that ensure that the in-house money managers do not have access to research before research clients get that information, and rules that limit or prohibit the firms analysts from owning stocks. Stock ownership is a major issue for all research providers and this policy should to be disclosed in research reports, discussed in the policy and procedures and the codes of ethics of all research providers.
Paid-for research is a classic example of a conflicted business model. In this model, a company pays a research provider to cover it, in the hopes that the research coverage will increase the firm’s ability to raise capital at reasonable costs. Despite the fact that there are a number of well managed paid-for research providers and one could argue that this helps the small cap universe to grow larger, there is and will always be a built-in conflict in this business model.
Another issue that faces research providers is whether the research firm is providing information or is actually providing investment advice. This situation is exacerbated when research providers offer access to their analysts. If the firm is deemed to be offering investment advice, it opens up a Pandora’s Box of compliance problems.
In some smaller money management firms, it is not feasible to have a separate compliance officer. However, this means that conflicts exist, regardless of whether they are handled appropriately or not. If the head of the research product also takes on the compliance role and the money management role, then we must rely on the ethical standards of that individual.
The Fed as Super Sheppard
While the motions to put the oversight of systemic risk under the auspices of the Fed seem well thought out, they are really not. While the Fed is certainly the one regulator that could take on this role, it would increase conflicts within the Fed. The most obvious—and the most trivial—is the fact that the Fed already has a pretty focused mandate to control the payments system and support non-inflationary growth. As we have seen recently with the “open all night” discount window, the Fed occasionally hits the liquidity gas pedal to keep market orderly. This action is seen as unavoidable as the Fed responds to the needs of the economy. As such, the Fed is already the first responder to systemic events and arrives on the scene as the rescue vehicle.
If the Fed is formally in charge of systemic risk, it will be both the sinner and the saint of the event. This means that the Fed will be prone to cover up and deal with the event, rather than provide an early warning system. Additionally, the commercial banks are going to be a lot less likely to use the discount window for fear of raising the radar of the Fed.
The short Answer is: It just doesn’t exist. As we head into another round of regulatory activism, it is instructive to remember that there is just no way to regulate or legislate fairness, honestly and ethical behavior. While it is politically expedient to do something to solve the greed and corruption of recent past, these measures should not be reactive. It is probably a much wiser prescription to enforce the rules currently of the books more assertively than to try to rebuild or renovate the regulatory system.