The Squeeze on Sell-Side Research in Future


New York, NY – In recent months many journalists have written about the growing popularity of Commission Sharing Agreements and the unbundling of equity commissions between execution and research services.  However, few have discussed who might actually lose as a result of the move to transparency and unbundling.  Over the following few weeks, we will attempt to do just this.  This week we will start our discussion with how CSAs and unbundling will impact sell-side investment banks and broker-dealers.

A Growing Consensus

According to a research report published by Tabb Group in the summer of 2006, the amount of sell-side research purchased by buy-side investors in the US and UK, will fall 30% from $5.60 billion in 2006 to $4.25 billion in 2008.

As a result of this revenue decline, TABB anticipates that sell-side analyst hiring will continue to plunge in the coming years — falling from 16,200 in 2000 to 9,300 in 2006, to 6,000 in 2008.

And while the team at Integrity is not quite so bearish about sell-side research (we expect a decline of slightly less than 20% in US Sell-Side research over the next five years), we agree that the amount of money that institutional investors will spend on research produced by investment banks and brokerage firms reached its zenith a few years ago.  As a result, we expect sell-side research exepnditures will continue to slip in the years to come for a variety of reasons.

The Reasons for This Weakness

The most obvious reason for the projected weakness in sell-side research is due to the fact that sell-side research is bundled in the commission.  As a result, sell-side research revenues are directly tied to equity commissions.  Thus, if commission revenues fall, sell-side research revenues will also fall.

Over the next five years, we expect investment banks and broker-dealers will suffer continued weakness in equity commissions resulting from falling equity commission rates, weak trading volume, and increased use of low cost / low touch ECNs.

Another factor that we expect will contribute to weakness in sell-side research revenues over the next few years is the lack of differentiation seen in much fundamental sell-side equity research.  This is not to say that all sell-side research is of poor quality.  However, it is clear that many sell-side firms are not producing the kind of research geared towards helping buy-side clients (particularly hedge funds) generate alpha.

A third reason for the weakness projected in sell-side research over the next few years is the most recent unbundling trend.  In fact, we suspect that unbundling and commission transparency will lead to buy-side investors to pay their investment banks and brokers less and less for the research they receive from them in the coming years.  This is particulalry true as money managers receive more information about what sell-side and independent research providers charge for their research.

Obvious Losers on the Sell-Side

Of course, we also expect that some sell-side research firms will suffer from the proliferation of CSAs.  As we have discussed in the past, Commission Sharing Agreements are arrangements between buy-side money managers and a small group of execution providers to use the commissions generated by trading with that broker to pay for research services provided by other brokers and independent research providers.

Consequently, some sell-side brokers (particularly second and third tier BDs, regional brokers, and boutique investment banks) could receive cash payments from “CSA Brokers” for providing their research to buy-side clients, rather than getting paid in trading commissions.

Of course the reason that sell-side research brokers “lose” in the CSA arrangement is because money managers will no longer pay them for their trading, but only for the research they provide.  As a result, these firms could receive anywhere from 40% to 60% of the revenues they previously received from that client for the provision of their research.

As we mentioned before, it is quite likely that these brokers be paid less and less for their research as the years go by due to increased competitive environment, enabling money managers to benchmark their research payments more effectively.

Other sell-side firms (particularly regional BDs that have relied on their execution versus their research) will find it difficult to generate significant trading revenues from money managers that have chosen to sign CSA agreements as they may not beleive these firms can provide them with “best execution”.

Some Possible Winners on The Sell-Side

Of course, some sell-side firms will be able to maintain, or even grow, their market share in the research business as a result of these trends.  We suspect that the sell-side firms that look to be the biggest winners in the research space are the bulge bracket firms that aggressively grow their CSA business.

The reason we expect these firms will be able to maintain their research revenues is because many of these firms are able to “negotiate first” with money managers regarding the value of their research.  Consequently, all other research providers (both brokers and non-brokers) are put in the position of fighting between themselves for whatever remains.


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