Sometimes the fix is worse than the problem.
That is what seems to be happening across the Pond in Europe, as the recent spate of equity market reforms to unbundle commissions or separate research payments from trades, looks to have more negative effects than positive, according to a recent research piece from Greenwich Associates.
The new Greenwich Associates report, “Business as Usual? Eying Fundamental Change in Payment for Research,” said that this move to unbundle commissions is a “solution in search of a problem.” And not only will it affect the quality of sellside research and availability of it but also harm the buyside that depends on it for possible alpha generation.
The Backdrop
The European Commission is preparing new rules to modify or even eliminate “soft dollar” arrangements by which institutional investors currently compensate research providers with commission payments on equity trades. The most radical change under consideration is full unbundling, which would require investment managers to pay for equity research and advisory services with “hard dollars” out of their own P&Ls or pass costs along in the form of additional fees. Any rule change by the European Commission would have a significant impact on large U.S. investors, many of which have significant global operations.
In its report, Greenwich wrote that given the current stagnation in institutional equity commission payments and the related pressures on broker profitability, even a modest decrease in commissions or broker trading revenues could have a meaningful impact on sell-side provision of research.
“At the very least we are likely to see a narrowing of coverage, with sell-side resources flowing to those investment managers most willing and able to pay,” said John Colon, managing director of Greenwich Associates market structure and technology practice, and author of the report. The reform proposals are a “solution in search of a problem.”
European regulators contend that investment managers are “sloppy buyers” when spending their clients’ money. Greenwich Associates said it disagrees.
“The current system of ‘broker votes’ by which institutions allocate trading volumes to research providers and commission management programs bring structure to valuing and paying for research while also affording investment managers with a high level of access and flexibility and protecting the interests of their clients,” Colon said.
See Traders Cover Story on The Broker Vote
Research as a Process, Not a Product
Greenwich Associates estimated in its report that large U.S. institutional investors pay about $6 billion per year in trading commissions as compensation to brokers and other providers of research and advisory services.
European regulators appear to be pushing the industry towards more explicit pricing for individual services. However, given the inherent difficulty of predicting exactly where value will be derived, an a la carte structure is not in the best interest of brokers, investment managers or investment managers’ clients, Greenwich countered.
Particularly in the case of those brokers providing broad coverage of sectors and companies, giving clients the option to call on different broker resources as their needs dictate provides valuable flexibility. Not unlike mining for gold, experience says the nuggets are there, but a lot of dirt will have to be sifted through to find them, Greenwich wrote.
“Nevertheless, in light of these discussions, many U.S. institutional investors are reviewing their policies and practices to ensure that expenditures efficiently support their investment processes and are in the best interest of their clients,” Colon said.
Given the importance of the issues at hand, Greenwich Associates announced they will soon be releasing a more in-depth look into institutions’ “broker-vote” practices and how they will likely evolve.
