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December 1, 2003

Sellside Research Must Try Harder: Rocked by scandals, institutional sellside research will never b

By Nina Mehta

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It took big scandals like Enron to expose widespread problems with Wall Street stock recommendations: bias, conflicts of interest and outright fraud. It turned institutional sellside research into a dirty word. But the problems were not new.

"Sellside research has always been so conflicted that most institutional investors have taken it with large grains of salt," said Todd Petzel, former chief investment officer at Commonfund Asset Management Company.

At issue was a delicate infrastructure of equity research and investment banking relationships. It was an infrastructure, say regulators, oiled with millions of dollars swindled from unsuspecting investors. Now reform is critical - it is imperative - if this business is to survive. But can it?

Research divisions are said to be mending their ways, but their future may be in doubt. The $1.4 billion global settlement reached last April by 10 of the nation's top investment banks and regulators forced the banks into a collective mea culpa.

More importantly, investment banks with research groups have had to absorb a plethora of regulations and rulemaking intended to wipe out conflicts.

Yet, the global settlement hasn't been finalized by the federal district judge presiding over the case. Nonetheless, many of the pending provisions are being implemented.

Financial Obligations

Whether the settlement can eliminate conflicts of interest is debatable, but the financial obligations on sellside research firms are heavy. The settlement will fund research produced by independent firms. It will cost the settlement firms $430 million over a five-year period. That's expected to stiffen the competition for transaction dollars.

If that isn't enough, regulators in the U.S. and U.K. are looking anew at soft-dollar practices.

So, what does all this mean? To many, the answer is that Wall Street research is in trouble. Institutional sellside research - research provided by investment banks to buyside firms, institutional investors, foundations and others - until now has been paid for in large part by investment banking revenues. Since that revenue stream has dropped off, the central question is how Street research will be funded.

One shift likely is more reliance on commissions from portfolio transactions. However, that isn't a safe bet. Decimalization has crimped spreads, squeezing commissions. Moreover, the increasing use of ECNs by buyside firms has had an indirect impact on research. The rise of ECNs has reduced the availability of commissions for full-service brokerages, according to John Mahoney, senior vice president in research and development at Reuters Research Inc.

(Mahoney, along with some of the other officials quoted in this story, was speaking at a recent research conference sponsored by the Securities Industry Association.)

ECNs, Mahoney contends, have finally revealed the real cost of research. These electronic brokerages have established a baseline cost for transactions, prompting questions about how much the research is really worth. "The cost of production is probably out of line with the sources of funding," Mahoney said.

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