Is Wall Street Research a Public Good?

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New York – Is Wall Street research a ‘Valuable Social Good’?  Barry Ritholtz, CEO of Fusion IQ, an independent quantitative research firm, poses the question in a recent blog, and suggests the answer is ‘No’.  The broader question, however, is whether equity research is a public good.  The answer to this question will determine how research gets paid for, how much is produced, and who is producing it.  

The catalyst for the question is the ever-fascinating Fly on the Wall case, which faithful readers of this blog know well. In granting injunctive relief, which has since been over-ruled, the court found a ‘Public Policy Consideration:’

“It was undisputed at this trial, and explicitly conceded by Fly, that the production of equity research in general, and its production by the plaintiff Firms specifically, is a valuable social good.”

Ritholtz argues that Wall Street research does not qualify:

“There is no evidence whatsoever that equity research by the firms involved offer any such public good. Indeed, anyone familiar with Wall Street history can demonstrate that over time, the inherent conflicts have cost the public 100s of billions of dollars. It can also be demonstrated that Wall Street research exists to serve the needs of the firm’s syndicate and IPO business, not the public.”

He goes on to cite Wall Street research’s optimistic bias, most recently documented in a McKinsey study.  He disputes the judge’s view that research plays a vital role in modern capital markets by helping to disclose information material to the market, arguing that the information comes from other sources, not Wall Street research.

The Ritholtz argument centers on Wall Street research, but it is not clear that a distinction can be drawn between Wall Street research and equity research generally.  The judge was referring to equity research in aggregate, including Ritholtz’s own research.

If Wall Street research adds no value to equity markets, can it really be argued that independent, third party research does?  Or even if it does (and Wall Street research doesn’t), does independent research make a material impact? At best, alternative research (including use of primary research, industry consulting firms, and other non-traditional research sources) constitutes 30% of the equity research market.

If equity research is not a public good, then the legislation (Section 28(e) of the Securities Act of 1934) that permits client commissions to be paid for investment research is not justified.  With no commission payments, you will have a drastically reduced amount of research.

In the US, we estimate between $6 and $7 billion is spent on research (when you attribute a portion of bundled commissions to research.)  Market data firms in aggregate receive about $3 billion in revenues, much of which is paid through commissions.  That aggregate $9 – $10 billion would easily be halved and perhaps quartered without 28(e).

Competition would be drastically reduced.  Many, if not all, of the Wall Street firms Ritholtz vilifies would exit the research business.  Many firms in the independent research space, which are already stressed in the current environment of reduced commissions, would go under.   Maybe this sounds attractive.   To us it sounds like the research equivalent of “The Road.”  Be careful what you wish for.

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  1. I think the judge in the case was trying to differentiate between rent-extracting behavior and value-creating behavior. If it’s value-creating behavior, then it’s a “public good” — we’re better off as a society if the profit-maximizing behavior leads to this outcome. If it’s just rent-seeking, however — a kind of tax extracted by the Wall Street bulge-bracket as a result of their market position — then it’s not a public good. Assuming research is potentially a public good, then we can rely on the free market to determine whether its benefits outweigh its costs. But if research revenue is just extracted by firms that are able to coerce their clients into paying for it, then we need to look at the regulatory framework to see if its to blame. A useful example of bad regulation leading to this outcome is near to hand: the NRSRO rating agencies, in effect (and tacitly), coerce their clients into buying ratings, as a necessary part of their access to capital markets; and the current regulatory regime (unreformed in the last go-round) hasn’t repaired this. And, interestingly, it’s a case where it’s the presence of regulation, not an absence of regulation, that creates the problem.

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