Frost Consulting and Quark Software have jointly published a white paper which examines recent research trends and the pressures on brokerage research: unbundling of research commissions is increasing competition for research allocations, even as commissions have declined and the banks’ cost of capital has increased. Despite the pressures, the paper suggests that asset managers are likely to continue to rely on investment banks for research, partly because it is in their financial interest.
As we have reported in the past, Frost Consulting, a UK based consulting firm specializing in global equity commission unbundling and related market structure/regulatory change, estimates that global institutional equity commissions were $33 billion in 2011. Of this 33% were allocated to execution and the remaining $22.1 billion to advisory services, primarily research.
In its latest paper, “Optimizing Research ROI in an Environment of Structural Change”, Frost estimates that 70% of equity commission volume traded in the UK is being paid through Commission Sharing Arrangements (CSAs), which allow asset managers to pay separately for research and execution services. Frost estimates that 50% of commission volume in Europe (ex-UK) is traded through CSAs and 40% in the U.S.
Compounding the pressures from unbundling, equity commissions have declined significantly since the financial crisis. Frost points out that the decline is worse outside the U.S., where commissions are calculated as a percent of the share price. Frost estimates that 2012 equity commissions were down 48% from their peak in Asia and down 58% in Europe (and a mere 29% in the U.S.)
Despite unbundling and cuts in brokerage research product, asset managers remain highly dependent on brokerage research, especially in Europe. In a survey Frost conducted in 2012, investment banking research represented over 80% of the external research utilized by three quarters of the European CIOs surveyed.
Frost calculates that if the estimated $5 billion of brokerage research costs were shifted to the buy side, asset managers’ 20% profit margins would be cut in half. Frost estimates that brokerage research costs have already shrunk by 42% from their $8 billion peak in 2007, and this rationalization process is likely to continue further.
Reflecting Quark’s sponsorship, the paper outlines how a digital publishing platform such as Quark’s can provide savings and productivity improvements.
We are less bullish than Frost Consulting on unbundling. Regulators are unlikely to force the issue. The predecessor to the UK’s Financial Conduct Authority declared victory on commission transparency in 2009 and, for staffers at the U.S. Securities and Exchange Commission, commission transparency is a dim memory at best.
Nevertheless, the inexorable decline in commissions is proving as powerful a force as regulatory mandates. Unfortunately, this is a cruel process for all research providers, large and small. We believe the end result will be a more open market structure, for those firms which can endure the process.